Part 1: Puzzlement over Interest Rates
A recent piece by the Center for American Progress (CAP), “Long-Termism or Lemons: The Role of Public Policy in Promoting Long-Term Investments,” by Marc Jarsulic, Brendan Duke, Michael Madowitz, laments the lack of growth in median household income over the last few decades. The authors correctly put part of the blame for the slow growth in income on lack of investment in recent years.
The authors state, “One of the primary reasons for anemic middle-class income growth in both post-2001 recoveries is a retreat in business investment, which has remained well below its historic trend.” They note that “… lack of investment is the primary driver behind the recent productivity growth slowdown. While the failure of middle-class compensation to keep up with economy-wide productivity demonstrates that higher productivity does not automatically translate into middle-class income growth, economists and policymakers almost universally acknowledge that it is still necessary for long-term growth in living standards.”
Up to that point in the paper, they are on the right track. However, they quickly go off the rails.
The authors express surprise at the low level of investment given historically low interest rates, although the interest rate situation is largely irrelevant to the investment slump. They incorrectly blame the low private investment on corporate leaders who have a fixation on short term gains for shareholders. They reject taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. cuts for capital investment to counter the investment slump. They incorrectly claim that research shows little relationship between taxation of capital and investment, and give several spurious arguments as to why lower taxes on saving and investment would not increase capital formation. Instead of reducing the tax barriers to investment, they advocate higher levels of government spending or tax subsidies for infrastructure, education, and child care to solve the income and investment problem.
The authors’ arguments that a pro-investment tax reduction would not spur capital formation are confused and ill-founded. Their proposed alternatives would be largely ineffective at boosting productivity and wages, or inefficient and ruinously expensive.
I shall first address the authors’ puzzlement over the failure of low interest rates to promote investment. In later blogs I shall explain why lower taxes are key to promoting capital formation and boosting wages, and why the CAP arguments about deficits, saving, and cutting taxes on capital are wrong.
The role of interest rates. The authors find the investment slowdown “especially perplexing because corporate profits are robust and borrowing costs are historically low.” Yet this should come as no surprise. Former Federal Reserve Chairman Ben Bernanke was recently cited in the Wall Street Journal as stating that low interest rates are not the Fed’s doing. He attributed low interest rates to a shortage of good capital projects. He said that if there were good investment projects, interest rates would rise.
Indeed, interest rates are not an outside force driving investment; they are a reflection of returns available from investing in real assets such as plant, equipment, and buildings. When expected returns on physical capital are low, borrowers are not willing to offer lenders a high rate of interest. When returns on capital investment are high, firms bid up interest rates to obtain additional funds. In effect, they are sharing the high returns on the capital investment with the savers. Lowering taxes on capital investment would raise after-tax returns, stimulate investment, increase the capital stock, and raise returns on loans and bonds.
Life would be easier if we could rely on easier money from the Fed to boost investment without the need to cut taxes. It would be easier to fund more government spending if high taxes on capital income did not do bad things, such as depressing capital formation, productivity, wages, and employment. For about fifty years in the mid-1900s, economic textbooks suggested that the depressing effects of high corporate and individual taxes on saving and investment could be countered by easy monetary policy, which would presumably lower interest rates and keep investment strong. This has turned out to be a false hope. The Federal Reserve cannot counter high taxes with easy money.
Market interest rates, especially interest rates on the Treasury securities most often bought by the Federal Reserve, have relatively little impact on investment in plant, equipment, and structures. Most investment by established businesses is funded by business cash flow, not by borrowed money. These internal sources of funds include capital consumption (depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. ) allowances (current revenues deemed to be a return of the cost of past investment, set aside before tax) and retained after-tax earnings. Additional funding comes from new stock issue. Relatively little comes from net new borrowing. New businesses are more apt to be funded by venture capital, borrowing, or person saving.
The key point is that investment decisions are based on whether the investment is expected to yield a decent profit after taxes, regardless of how it is funded. Investment must pay for itself whether it is funded with borrowed money or a business’s own funds. If a machine costs $100, it must earn back the invested $100, plus a bit more to pay taxes and leave a net reward for the money being tied up in the machine. If the $100 was internally financed, the recovered cost replaces the money the business invested, with the rest, after taxes, going to the business owners for their management and risk-taking. If the $100 was borrowed money, the first $100 of recovered cost plus some of the additional net return must be paid to the lender as principal and interest, with anything left over going to the business owners for their management and risk-taking.
The revenue must cover all taxes owed. On investment funded with equity, the whole tax is paid by the business owners. On investment funded by borrowed money, the lender pays tax on the returns passed on as interest, and the business pays tax on the remaining income. Either way, if the investment is not expected to cover its cost, after taxes, it will not be undertaken regardless of the level of interest rates. If taxes are lowered, more possible investment projects will be estimated to cover their costs, and more plant, equipment, and buildings will be created.
Economists call the required pre-tax return needed to make investment worthwhile the “service price” or the “cost of capital.” While this may sound much like an interest rate, it is not at all the same thing. As described above, the service price is the rate of return an asset must earn over its lifetime to cover its cost, pay any taxes owed, and leave the investor with a minimally acceptable after-tax reward, which historically has meant a bit more than a three percent annual yield on a very predictable and safe activity. Risky investments require an additional return called a risk premium. This is not just an abstract ivory tower economic concept. Business schools teach their students how to make these calculations on a project-by-project and asset-by-asset basis.
Finance textbooks used in business schools instruct MBA students to judge an investment by calculating by comparing expected revenues, less taxes, to expected costs over its life. This is determined by discounting the stream of expected future revenues and the stream of expected future costs by a discount rate or “hurdle rate” that reflects the returns available to the firm on other uses of the money, with an appropriate risk premium added. The firm’s own internal discount rate, reflecting returns on other possible uses of its money, governs the calculation, not just market interest rates such as the Treasury bill rate. Other uses include other capital investment projects, reductions in outstanding debt, share buybacks, or acquisitions.
If the discounted revenues, after taxes, exceed the discounted costs, the investment is worth doing. Investments with the greatest discounted net return are done first, others later. Only then, after the decision is made to proceed with an investment, does the corporate planner decide whether to finance it with equity or debt. If interest rates are attractive, he may borrow. If not, he may use internal funds or issue additional stock.
Another way to think of this is to remember that financial assets and physical capital are competing uses for saving. If direct investment in businesses’ physical assets is yielding a high return, financial instruments must be priced to give savers the same risk-adjusted yield. Therefore, interest rates reflect the return on real capital, not just Federal Reserve money creation. The Fed may buy Treasury bonds or other securities to try to lower interest rates. But absent decent returns on investment, the expanded bank reserves will lie idle or move into commodity speculation. Easy money may cause inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. eventually, but will not do much to spur real fixed investment in plant and equipment, or raise real economic activity. Higher inflation actually discourages investment by eroding the value of capital consumption allowances, understating costs and overstating profits, thereby raising effective tax rates. Fed easing cannot counter high tax rates or regulatory obstacles to investment.