How Do We Increase Business Investment?

Greg Mankiw, after noting the too low level of business investment (something I’ve mentioned from time to time around here), produces some suggestions for increasing business investment:

One obvious step would be a cut in the taxation of income from corporate capital. According to a 2008 study by the Organization for Economic Cooperation and Development, “Corporate taxes are found to be most harmful for growth.” Tax reform that reduced the burden on capital income and shifted it toward consumption would improve prospects for long-run growth and, in so doing, encourage greater investment today.

Yet it would be overly optimistic to think that any single public policy, by itself, could lead to the kind of robust investment spending seen in previous recoveries. Myriad government actions influence the expected future profitability of capital. These include not only policies concerning taxation but also those concerning trade and regulation.

For example, passing the free trade agreement with South Korea, which has languished in Congress more than four years after first being negotiated, would be a step in the right direction. So would reining in the National Labor Relations Board; its decision to block Boeing from opening a nonunion plant in South Carolina may have been hailed by organized labor, but it surely did not hearten investors.

As I have previously written here, we should eliminate the corporate income tax altogether. Not only does it disincentivize capital investment, it produces deadweight loss. GE, for example, has a department of nearly 1,000 people whose job it is to reduce the company’s exposure to the corporate income tax. And that’s just a single company.

If your concern is the loss of revenue, increase the personal income tax to cover the difference. If your concern is fairness, how is it fair to tax the same income twice? That’s what happens: the income is taxed once when it’s received by the company and again when it’s paid out in the form of wages to company employees or dividends to owners.

If your concern is that reducing corporate income taxes won’t be an efficient way of spurring demand on the part of business because they’re already sitting on piles of cash, remember that not all businesses are sitting on piles of cash. Newly-formed companies, the ones that create most of the new jobs, aren’t typically cash-rich.

Robert Barro writes on a related topic:

What drives investment? Stable expectations of a sound economic environment, including the long-run path of tax rates, regulations and so on. And employment is akin to investment in that hiring decisions take into account the long-run economic climate.

The lesson is that effective incentives for investment and employment require permanence and transparency. Measures that are transient or uncertain will be ineffective.

And yet these are precisely the kinds of policies the Obama administration has pursued: temporarily cutting the payroll tax rate, maintaining the marginal income-tax rates from the George W. Bush era while vowing to raise them in the future, holding off on clean-air regulations while promising to implement them later and enacting an ambitious overhaul of Wall Street regulations while leaving lots of rules undefined and ambiguous.

Is there a better way? I believe that a long-term fiscal plan for the country requires six big steps.

He goes on to propose six measures for reducing the deficit and boosting the economy:

• Increasing the Social Security retirement age and adjusting the formula by which increases in benefits are calculated.
• Phase out the home mortgage interest and state and local tax deductions and beginning to tax employer-paid healthcare benefits.
• Reduce marginal personal income tax rates.
• Return the baseline of federal spending to what it was in 2006 (adjusted for inflation).
• Introduce a value-added tax.
• Eliminate corporate and estate taxes.

The first three were parts of the Bowles-Simpson deficit reduction commission recommendations.

I think that all of those are good ideas. I would also add eliminating agricultural subsidies just to name one.

The most important thing is that we need to change how we view the role of the federal government and sub-prioritize what it does. That’s the unspoken message behind all of the proposals in the two op-eds. So, for example, in coming years regardless of what we do the federal government is going to be spending more money on the elderly than we’ve been accustomed to for the last half century. That’s no surprise. We’ve known that would be the case for sixty years.

However, that means we must adjust priorities rather than just trying to pile Ossa upon Pelion.