Disentangling CAP Arguments against Tax Cuts for Capital Formation: Part 3
November 24, 2015
Part 3: Lower Tax Rates on Saving and Investment Discourage Saving and Investment (?)
This blog continues a discussion of a recent piece by the Center for American Progress, “Long-Termism or Lemons: The Role of Public Policy in Promoting Long-Term Investments,”by Marc Jarsulic, Brendan Duke, Michael Madowitz. The authors correctly put part of the blame for the slow growth in income on lack of investment in recent years. But they argue against the one policy response that might remedy the situation, a cut in taxes on capital formation.
The paper states: ”Some policymakers and analysts have argued that the key to increasing investment is cutting taxes on capital since that would boost the incentive to save and invest in new capital goods. This argument misses that higher after-tax returns also allow investors to do just as well in the future while saving and investing at a lower rate. Moreover, tax cuts themselves can lead to higher deficits, which reduce national saving.” The first statement is true. The next two statements are false.
“This argument [that higher returns spur investment] misses that higher after-tax returns also allow investors to do just as well in the future while saving and investing at a lower rate.”
The CAP argument, commonly heard but wrong, is based two fallacies. First is the erroneous assumption that people have a fixed amount of desired savings (a savings target) that they wish to acquire, and that when they reach their target, they stop adding to savings. So if rates of return are high, they can meet their targets sooner, with less saving thereafter, which would support less capital formation.
The assumption is false. The desired amount of saving is not a constant. When returns to saving increase, people have an opportunity to more easily boost wealth and future consumption to a higher level than was possible under the old lower rate of return. This increased opportunity to raise future income raises the desired level of wealth and the amount of saving that people desire to do (a positive substitution effect). As returns on saving go up, so does investment, productivity and income. At higher incomes, people are willing and able to save even more (an income effect). They can and will consume more at a higher level of income, but they will save more too.
The second error is a confusion of the rate of saving with the desired amount of capital formation. Capital formation is the goal affected by the tax change. Saving is the means of achieving it. A cut in the tax on capital raises the amount of physical capital that the economy can profitably create and employ. It reduces the required “hurdle rate” and increases the affordability of plant, industrial equipment, vehicles, commercial and residential buildings, other structures, and inventory to be employed in farms, mines, factories, utilities, the housing sector, retail trade, and the service sector. The resulting increase in the desired capital stock attracts saving to fund it.
“Moreover, tax cuts themselves can lead to higher deficits, which reduce national saving.”
This argument mistakes the effects of deficits and tax cuts on private and national saving, and neglects international capital flows that give the country access to global saving. It also continues the confusion between an increase in the amount of capital want to hold with the saving needed to acquire it.
When business taxes are cut, the immediate effect is that business saving (depreciation allowances and retained after-tax earnings) goes up dollar for dollar with the tax reduction. The deficit and private saving rise together. National saving does not fall. Businesses have less need to borrow. The government must borrow more. Similarly, when individuals’ taxes are cut in a manner that makes saving and investment more attractive, and people use the tax cut to add to saving, national saving does not fall. In fact, saving may rise by more than the tax reduction if people choose to consume less or work more to take advantage of the savings opportunities. If individuals’ taxes are cut in a manner that has no effect on the incentive to save, and some of the tax cut is spent on consumption, then national saving may fall.
Most business investment is funded by depreciation allowances and retained earnings, a business’s own money. Relatively little business financing comes from the credit markets. The initial investment has to be financed with a new source of funds (in this case, the tax cut), but future replacement of the new capital is funded by its future earnings. Businesses will only invest in new projects that are expected to return more than enough to replace themselves. As the stock of capital expands, and the economy grows over the next several years, additional earnings become available for further expansion of capital.
Firms wishing to invest even more than the immediate rise in cash flow due to the tax cut might borrow or to issue new shares to raise additional funds. The higher returns would enable them to pay higher interest payments or increased dividends to attract new money through borrowing or new stock issues. Interest rates might rise in response to this higher return on physical capital, but that would be a result of higher returns on capital investment being shared with savers. This type of interest rate hike would not prevent investment, it would facilitate it by attracting saving. (It is a contradiction for CAP to admit that lower interest rates have not spurred investment, and yet imply that higher interest rates would retard it.)
Of course, if the added business or individual saving is invested in additional capital formation, instead of government bonds, then other saving must be found to cover the government’s additional borrowing. That is not hard to do. Saving available to the United States can be increased five ways: by Americans consuming less and saving more; by individuals reducing leisure and working harder to earn additional money to save; by retaining more business income for reinvestment instead of paying larger dividends or other distributions to owners when new investment opportunities arise; by lending less U.S. saving abroad, including repatriating foreign U.S. holdings (smaller capital outflow); or by attracting more foreign savings (larger capital inflow).
There is more than $20 trillion in annual saving in the world. A small amount of that could easily be reallocated toward the United States. U.S. savers and lenders acquire hundreds of billions of dollars of foreign financial assets each year, and foreign savers and lender buy hundreds of billions of dollars of U.S. financial assets each year. There are also major cross border purchases of physical assets (direct business investment). A modest shift in the destination of existing world saving could finance a huge expansion of the U.S. capital stock, provided it becomes attractive to do so.
As one historical example of this effect, the United States reduced tax rates and accelerated depreciation allowances in 1981, and began to restore the stability of the U.S. dollar by ending the 1970s inflation. Instead of lending to Latin America, Europe, and Asia, U.S. banks lent more at home. Lending by U.S. banks to foreign borrowers dropped by $100 billion (over 80 percent!) between 1982 and 1984, funding the tax cuts and a revival of U.S. business investment by keeping more home-generated saving inside the United States. Later in the decade, increased foreign investment in the United States contributed further to the expansion.
For an earlier example, when the pound sterling was the world currency, and the British Empire spanned a fourth of the planet, the Bank of England was able to use the tiniest of interest rate tweaks to attract or repel global saving as needed to maintain the gold parity of the pound and the level of its gold and currency reserves. That system lasted a century from the end of the Napoleonic Wars until World War I.
Most recently, note that the government had no trouble issuing new bonds to fund its trillion-dollar-plus stimulus plan during the recent financial crisis, even as interest rates on government debt plunged to record low post-WWII levels, abetted by a bond-buying spree by the Federal Reserve.
The availability of saving may influence the pace at which computers, machine tools, buildings, airplanes, railroads, and harbors can be expanded. But the ultimate level of physical capital formation depends on expected earnings after taxes, not on market interest rates. History tells us that tax cuts on capital spur capital accumulation, and that we reach the desired level of capital stock sooner rather than later.
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