A Proven Strategy for Boosting Investment February 17, 2016 Scott Greenberg Scott Greenberg Over at Bloomberg View, Noah Smith has an interesting column about the future of U.S. economic policy. He begins with the worry that the U.S. has run out of ideas for growing the economy: This presidential election has driven home a problem that others have been noticing the last few years: The U.S. seems to be out of ideas for economic growth… We’ve been trying to boost economic freedom for decades now, and there’s a good possibility that all the low-hanging fruit has been picked. But Smith highlights a possible path to jump-starting economic growth: So what else is there? Looking around, I see the glimmer of a new idea forming. I’m tentatively calling it “New Industrialism”… The central idea is to reform the financial system and government policy to boost business investment. Business investment — buying equipment, building buildings, training employees, doing research, etc. — is key to growth. It’s also the most volatile component of the economy, meaning that when investment booms, everything is good. The problem is that we have very little idea of how to get businesses to invest more. Unfortunately, net U.S. business investment has been more or less in decline for decades. Smith correctly identifies business investment as the key to economic growth. In fact, the Tax Foundation’s in-house macroeconomic model treats business investment as the most important determinant of the long-term size of the economy. Smith is also correct that investment has been on the decline over the last fifty years, a topic that my colleague, Alan Cole, has written on. However, I don’t agree with Smith that we have “very little idea of how to get businesses to invest more.” At least within the field of tax policy, there is a simple and obvious policy solution for encouraging investments: ending the disincentive for business investment in the U.S. tax code. Generally, U.S. businesses are allowed to deduct expenses in the year that they occur. However, when it comes to capital expenses, businesses are required to spread out the deduction over time periods ranging from 3 to 50 years. As a result, the U.S. tax code does not allow businesses to deduct the full cost of capital investments, in present value terms; in a recent paper, I estimated that, over time, corporations are only able to deduct 87.14 percent of the costs of investment. In other words, the U.S. tax code distorts business decision-making by encouraging businesses to spend their money on salaries, ordinary expenses, and paying down debt (all of which lead to an immediate deduction) and not to spend their money on investment (which leads to a delayed and reduced deduction). If businesses were allowed to immediately deduct the full cost of their capital investments – a policy known as full expensing – this distortion would disappear. According to the Tax Foundation’s economic model, full expensing would lead to a 15.62 percent increase in the long-term size of the U.S. capital stock. This makes full expensing the most effective tax policy for encouraging investment, bar none. Now, Smith often advocates that economists should focus on empirical evidence, rather than model outputs. Is there real-world evidence that a tax policy like full expensing would actually encourage investment? In fact, there is. Between 2001 and 2004, and since 2008, the U.S. tax code has contained a provision called bonus depreciation, which allows businesses to immediately deduct 50 percent of the cost of some investments. In effect, bonus depreciation is like a smaller, more limited version of full expensing. In a recent paper, Eric Zwick and James Mahon used firm-level data to estimate the effects of bonus depreciation on business investment. They found that bonus depreciation raised investment in eligible capital by 10.4% from 2001 to 2004 and by 16.9% between 2008 and 2010. Another finding from Zwick and Mahon’s paper is particularly germane to one of the concerns expressed in Smith’s column. He suggests that: [Perhaps] the way American businesses make their investment decisions is fundamentally broken… If financial investors have short-term horizons, they may not push businesses to do the long-term investment that really boosts the economy. In fact, Zwick and Mahon found that firms responded most strongly to bonus depreciation when they were able to use the provision to generate immediate cash flows. This suggests that, if financial investors have short time horizons, perhaps the easiest way to encourage businesses to make long-term investments is to link long-term investment with an immediate cash flow through the tax code. This could be accomplished with full expensing. None of the above is meant to dispute the premise of Smith’s article: we need to explore ways to stop the decline of business investment. But instead of imagining new policy programs, we should start by fixing what’s wrong in the current policy regime, and put investment on a level playing field in the U.S. tax code. Stay informed on the tax policies impacting you. Subscribe to get insights from our trusted experts delivered straight to your inbox. 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