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
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
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the corporate tax incentives helped little and should be repealed, then for what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
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
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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