President Reagan wants to encourage business investment. He says the large business tax cuts enacted last summer as part of his economic program will do this. But so far business has revised its spending plans downward rather than upward.
What is wrong?
While the tax cuts in the president's package may have raised the incentive to invest, it has been offset by rising interest rates and recession. Reagan blames these on his predecessor. But many economists fear that the hoped-for investment boom will not materialize in the years ahead, unless the president changes his economic program.
At present, the combination of tight money administered by the Federal Reserve and large budget deficits run by the administration and Congress puts the main burden of fighting inflation on business, according to a top Wall Street economist. The Fed's tight money policy limits the room for overall growth, by keeping interest rates relatively high. Big federal credit demands as a result of the burgeoning deficits push up interest rates still further and skew whatever growth there is toward consumption rather than investment.
"It is impossible to have an entrepreneurial revival in an economy which has very high interest rates and which isn't going anywhere" the Wall Street economist commented last week. "The burden of fighting inflation is shifted, ironically, under the Thatcher or Reagan policy from the consumers to the business sector."
Despite the pro-business philosophy of the Reagan administration, economic policy over the last year "has unambiguously reduced rather than increased the incentives for investment," according to Barry Bosworth of the Brookings Institution.
Bosworth believes the first requirement for investment is that businessmen be convinced that they can sell the goods they would produce with a new plant or new machines. No matter how attractive the tax breaks for investment, they will not change this basic business decision, Bosworth said last week.
It is hardly surprising that firms are unwilling to build new plants or buy new machines in today's recession, when manufacturers are using only just over 70 percent of their existing capacity, and firms are still laying off employes and cutting back production.
But what about those who would consider new investment and for whom the tax cuts effective in January 1981 might have been an incentive? Bosworth calculates that the sharp rise in interest rates last year wiped out all, or almost all of the incentive to invest that Reagan's more generous depreciation rules had provided.
Higher interest rates offset 90 percent of the tax break for short-lived assets in last summer's Economic Recovery Tax Act, he said. For longer-lasting machinery and buildings--which were treated slightly less generously in the tax bill--the rate rise between 1980 and 1981 more than offsets the tax cut, he says.
Experts differ over the precise effects of the new depreciation rules in the tax code, and so have different views of how high interest rates must rise before canceling out the tax incentive. But many agree that the rise in the cost of long-term borrowing since 1980 has been so large that it must, at the least, come close to offsetting the 1981 tax breaks. Long-term corporate bonds, which averaged just under 12 percent in 1980, climbed to an average 14 percent last year and are now close to 17 percent.
Economist Rudy Penner of the American Enterprise Institute said last week he believed the cross-over point had passed, and the additional cost of capital because of higher interest rates now outweighs the tax-induced reduction in the cost of buying new plants and equipment. Other economists agree that the jump in long-term corporate bond rates since 1980 has made it more costly to invest, even with the new tax breaks, than it was without the tax changes.
If they are right, then the business tax cuts would not have worked to raise investment plans last year even if the deteriorating economy had not forced many firms to plan for retrenchment rather than expansion.
Moreover, many economists argue that the rise in interest rates has been exacerbated by the very tax cut that Reagan said should help spur investment. They blame big budget deficits for much of the rate increase that is hurting investment. To the extent that the business tax cut has added to the deficit, then it has contributed to the interest rate offset.
The administration ignores these arguments in its latest projections for the economy. While it has scaled down its original forecasts showing a spectacular rise in business investment, it still predicts a substantial rise. By 1984 business fixed investment will be 12 1/2 percent of gross national product, the administration says, compared with just over 11 percent last year, and 10 1/2 percent in 1970 and 9.6 percent in 1960.