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January 07, 2009

Will tax stimulus stimulate investment?

Update: Reader Doug Lee points out that the fixed investment series above is dominated by the extraordinary decline in residential investment over the past several years. For that sector, the questions posed above are in a bit sharper focus. Are firms in the residential investment sector pessimistic about future prospects? Absolutely. Are compromised credit markets behind the low investment levels? Quite possibly, though given the large inventory overhang in housing it is improbable that activity in the sector would be robust in any case. Is the low investment/net worth ratio symptomatic of a general deleveraging within the nonfinancial business sector? Not so clear, as it is pretty hard to see through the effect in residential category.

Here, then is a chart of the history of nonresidential fixed investment relative to corporate net worth:


The recent decline in the ratio, while still there, is much less dramatic and, in fact, seems to be part of a more persistent trend that commenced prior to the 2001 recession (and which may have been temporarily disguised by the housing boom that followed).

Was the nonfinancial nonresidential business sector ahead in the deleveraging game—ahead of residential construction businesses, financial firms, and consumers? And could this bode well for this sector when the recovery begins? Unfortunately, I have more questions than answers.

By David Altig, senior vice president and research director at the Atlanta Fed

Original post:

On Monday, the form of potential fiscal stimulus, 2009-style, took a step forward detail-wise. From the Wall Street Journal:

“President-elect Barack Obama and congressional Democrats are crafting a plan to offer about $300 billion of tax cuts to individuals and businesses, a move aimed at attracting Republican support for an economic-stimulus package and prodding companies to create jobs.

“The size of the proposed tax cuts—which would account for about 40% of a stimulus package that could reach $775 billion over two years—is greater than many on both sides of the aisle in Congress had anticipated.”

The plan appears to make concessions to both economic theory—which suggests that consumers will save a relatively large fraction of temporary increases in disposable income—and recent experience—which seems to suggest that what works in theory sometimes works in practice. Again, from the Wall Street Journal:

“Economists of all political stripes widely agree the checks sent out last spring were ineffective in stemming the economic slide, partly because many strapped consumers paid bills or saved the cash rather than spend it. But Obama aides wanted a provision that could get money into consumers’ hands fast, and hope they will be persuaded to spend money this time if the credit is made a permanent feature of the tax code.”

As for the business tax package:

“… a key provision would allow companies to write off huge losses incurred last year, as well as any losses from 2009, to retroactively reduce tax bills dating back five years. Obama aides note that businesses would have been able to claim most of the tax write-offs on future tax returns, and the proposal simply accelerates those write-offs to make them available in the current tax season, when a lack of available credit is leaving many companies short of cash.

“A second provision would entice firms to plow that money back into new investment. The write-offs would be retroactive to expenditures made as of Jan. 1, 2009, to ensure that companies don’t sit on their money until after Congress passes the measure.”

A relevant question here is really quite similar to the one we ask when the tax cuts are aimed at households: Will the extra cash be spent? This graph provides some interesting perspective:


Relative to net worth (of nonfarm nonfinancial corporate businesses), private fixed investment has been in consistent decline since the second quarter of 2006. (The level of fixed investment has declined in each quarter, save one.) In fact, the investment/net worth ratio is currently at a postwar low.

Why? A couple of hypotheses come to mind. (1) Firms are extremely pessimistic about the outlook and see relatively few worthwhile projects in which to commit funds. (2) Credit markets are so impaired that the net worth of firms—a critical variable in mainstream models of the so-called “credit channel” of monetary policy—is supporting increasingly smaller levels of lending. (3) Nonfinancial firms, like financial firms, are deleveraging and hence not expanding.

Of course, even if one of these hypotheses is true, it need not be the case that marginal dollars sent in the direction of businesses will go uninvested. But it makes you wonder.

By David Altig, senior vice president and research director at the Atlanta Fed

January 7, 2009 in Capital Markets, Saving, Capital, and Investment, Taxes | Permalink


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Very interesting to see some real data on this, which seems to support recent anecdotal evidence. I have written up two separate but related thoughts on stimulating business investment:

1. Should the stimulus aim at boosting investment instead of consumption, and how?

2. Should central banks consider equity investments if debt instruments are not effective in routing funding to the non-financial sector?

Posted by: Leigh Caldwell | January 07, 2009 at 11:10 AM

The loss carry back provisions seem to me like a particularly poor way to encourage investment and seem to smack of political pork to produce big transfer payments to financial sector companies. An investment tax credit would be much better, but I suspect investment demand is inelastic with respect to the cost of capital so most of the credit would go to projects that would have been undertaken anyway. Summers touted investment tax credits for machinery and equipment at one time. Has he been intimidated by the comment that crushed his research findings on the topic?

Posted by: don | January 07, 2009 at 02:00 PM

Since it seems to be a key question at the moment, can someone (Dave?) please explain to me why it matters whether a stimulus is saved or spent? Surely, in order to save it is necessary to find someone to lend to (even just holding a banknote is effectively an interest-free loan to the government). And they are not going to borrow unless they have a use for the money, so any money that is saved must be spent anyway.

Posted by: RebelEconomist | January 09, 2009 at 04:11 PM

Very interesting data indeed. Especially when you cross pollinate the data with Greg Mankiw's that shows that tax cuts have a greater effect on GDP than government spending.

We are in a deflationary time. Everything just gets cheaper. I don't view it as a spiral, because we were severely overleveraged. Once the leverage of the market reaches equilibrium, there should be some stable footing.

The government spending package will of course have a bunch of lard in it. Unfortunately, it will be too big, and because the government can't keep it up forever, people will save instead of spend. The jobs created for road building and bridge building are temporary. Once the road is built, the job goes away.
There will be some ancillary jobs that remain, but those will be small.

The way to really get business to invest is to make the cost of investing a lot cheaper. Businesses view taxes as a cost, so lower the corporate tax rate and the capital gains rate a bunch. This will spur business investment in long term capital projects that will encourage long term economic development.

But the bureaucrats in DC and Congress don't think that way.

Posted by: Jeff | January 12, 2009 at 08:46 AM


Very clear analysis, and reasonable conclusion. It's nice to read something about the stimulus subject that isn't completely guided by preconceived notions and admits to ambiguity.

Posted by: Bob_in_MA | January 12, 2009 at 08:46 AM

How about redistributing purchasing power through the tax system?

Poor people generally spend more of an extra dollar than rich people do. So redistribution can be expected to boost aggregate demand without simultaneously boosting public deficits.

Even weak households can of course be expected to save some of the extra dollars. Given their indebtedness, that’s not a bad thing.

One may argue that poorer people spend their dollars differently from richer. But many products sold lately were anyway meant to satisfy needs for rather conspicuous consumption. More resources must be allocated to the satisfaction of (slightly) more basic demands.

Growing inequality is a major explanation for the crises. For many households credit growth has worked as a substitute for wage growth.

This process will have to be reversed one way or another. We must make sure that wage differentials decreases rather than the opposite. In addition to tax breaks for the weaker households, mortgage assistance is needed.

When you run out of helicopters, distribute fresh money through increased unemployment benefits. This will improve the bargaining power of the weakest employees. But make sure the informal economy doesn’t explode. ID-cards for all wage earners are needed!

Jan Tomas Owe

Posted by: Jan Tomas Owe | January 13, 2009 at 08:12 AM

"The way to really get business to invest is to make the cost of investing a lot cheaper. Businesses view taxes as a cost, so lower the corporate tax rate and the capital gains rate a bunch. This will spur business investment in long term capital projects that will encourage long term economic development.

But the bureaucrats in DC and Congress don't think that way."

I agree, but the politicians are intent on solving the wrong problem with the wrong tools. You mention "long term" economic development - everything the Democrats and Obama want to do is SHORT TERM.

If the 'problem' they have to fix is short-term recession fighting, then the only lever that works efficiently at that is federal reserve monetary policy, and they've already done the "flood the zone" approach with 0% interest rates and 'quantitative easing'. Even though unemployment is no higher than in 1992, they want to go far far beyond what has been done in previous recessions. Why? I can think of no reason other than a sense of panic among the political elites, or a desire to misuse a recession for political aggrandizement.

But the short-term is the WRONG PROBLEM TO SOLVE. The correct problem to solve is to set the country back on the path of stable long-term economic growth. When we look back in 2012 at what was done in 2009, we wont care if the Q4 2009 numbers were this or that, we WILL care if we are saddled with an extra trillion of foriegn debt that we can't easily pay back, suffering under subpar growth because our deficits and inflationary policies got out of hand and we had to 'fix' that with high-tax high-interest-rate stagflation-era policies.

It's a myth that govt deficits will reflate the economy. What ever happened to the 'rational expectations' refutation of this? Every attempt to grow the govt will be met by more private sector layoffs - as the private sector realizes they will bear the pain of paying for this mess the govt makes.

Keynes was wrong. In the long run we aren't dead, in the long run we look back, older and wiser, and say: "What the hell were we THINKING?!?"

Posted by: Travis Monitor | January 18, 2009 at 11:32 PM

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