August 25, 1985
"Evidence of Boom from Tax Cuts is in Short Supply"
San Jose Mercury News
By Timothy Taylor
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BY now, anyone who can do arithmetic knows that the tax cuts enacted by the President Reagan's Economic Recovery Tax Act of 1981 have not reduced the federal budget deficits. But supporters of the supply-side philosophy have argued that they have been a great success in achieving a more limited goal: stimulating business investment.

The Council of Economic Advisers provided supporting evidence in its Annual Report, published last February. In dissecting the components of the 1983-84 economic recovery, the council found that personal consumption, residential investment and government purchases all increased about as quickly during the first eight quarters of this recovery as they had in other business cycle upswings since World War II.

The factor that made this recovery exceptionally powerful, though, was that business fixed investment rose three times faster than average. The CEA lists several reasons for the investment boom -- the fall in inflation, the pull of overall economic growth, the ease of investing in foreign imports with a strong dollar -- but first on its list are the tax cuts.

If true, this conclusion poses a hard dilemma for the White House. If the accelerated depreciation and expanded investment tax credits enacted in 1981 touched off an investment boom that led the recovery, then why is the Reagan administration now proposing to repeal those incentives in its recent tax reform proposal? But if the corporate tax incentives helped little and should be repealed, then for what reason did the nation sacrifice tens of billions of dollars of tax revenue?

A fuller picture of the evidence on investment is now emerging, fleshing out the snapshot view provided by the CEA. That evidence casts doubt on the supply-side contention that corporate tax cuts were the main stimulus behind the recent investment boom.

From an overall view, the most remarkable thing about the investment recovery is not the height it reached, but the depth from which it started.

Over the last 25 years, net private investment has averaged 6.1 percent of GNP. During that time, the worst year for net investment was 1982, when it sank to a mere 1.8 percent of GNP. The second lowest year was 1983, when net investment rebounded soggily all the way to 2.8 percent of GNP. In the boom year of 1984, net investment climbed to 6.4 percent, somewhat above the historical average.

That climb appears to have slowed with the economy this year. According to Data Resources Inc., gross business spending on equipment, which was rising at 20 percent in the first two quarters of 1984, showed no increase in the first two quarters of 1985.

At best, advocates of the 1981 corporate tax incentives can claim to have hastened the return to normal investment levels. At worst, the incentives were just enacted at a fortunate time, when investment was ready to turn up regardless.

In the latest issue of the Brookings Papers on Economic Activity, Barry P. Bosworth argues for the pessimistic interpretation. He takes apart the investment boom and finds: "Overall, office equipment and automobiles account for 93 percent of the growth in equipment spending since 1979 -- a pattern that causes problems for an explanation of the growth in investment spending that emphasizes the 1981-2 tax reduction.

"Not only did the tax change make almost no change in the tax treatment of automobiles," he points out, "but it actually increased the tax rate on computers."

John Shoven, a Stanford economics professor, points out in his commentary accompanying Bosworth's article that the converse holds as well. For example, although the tax rate on investment in mining equipment fell sharply in 1981 and 1982, actual investment in mining equipment fell by 24 percent in 1983.

Of course, mining might have done even worse without the tax cut and computers might have done even better. The nature of economic analysis is that no one can tell what might have been. But Bosworth found no statistical relationship between investments that were specially favored by the 1981 tax cuts and those that actually increased in 1983 and 1984.

If not because of the tax cuts, then why did the investment boom occur? While Bosworth is not optimistic about finding even the right measurements to disentangle possible causes, he argues that the price level and how much it costs business to borrow have effects larger than tax changes. Other factors contributing to the boom include a lower inflation rate that reduced the risk of investing, a rebound from an abnormal investment low, the expanded possibilities of the new computer technology, and more businesses managing their own automobile fleets.

Bosworth argues not that tax policy has no effect, but that its effects redistribute investment rather than necessarily increasing it. He writes, "In fact, the major conclusion that emerges from the recent research is that the tax system is so diverse in its treatment of different investments that its net influence on investment decisions is virtually impossible to determine in any overall sense."

The tax incentive bill that Reagan pushed and Congress enacted in 1981 means playing both ends against the middle, because favoring one set of investments necessarily means disadvantaging others. A flatter corporate tax -- with fewer special incentives, lower marginal rates and more predictability -- would provide a healthier climate for investment, where decisions would be based on the opportunities provided by a dynamic economy rather than special breaks given to every politically muscular interest group.

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