Two primary goals for economic policy in the 1980s are to reduce inflation and to increase investment in business plant and equipment. The monetary authorities have been focusing on fighting inflation by slowing the growth of the money supply. This tight money policy has, in turn, pushed interest rates to extraordinary highs. The prime rate charged by banks to their best customers is now over 20 percent, and new long-term corporate bonds are yielding more than 15 percent. These rates are not only high by comparison with interest levels in recent years but also imply an especially high "real" rate of interest -- the difference between the interest rate and the rate of inflation.
Some critics of tight money argue that these high real interest rates will make it impossible to achieve the widely held companion goal of increasing investment and, ultimately, productivity. We disagree. While high real interest rates undoubtedly do in themselves tend to discourage investments by making it more costly and therefore less profitable to invest, the combination of fiscal and monetary policies that is currently being put into place will, on balance, have the effect of encouraging investment in plant and equipment.
The opponents of the tight money policy ignore the fact that this administration is pursuing a new economic strategy in its fight against the twin-headed monster of inflation and slow growth. It is combining monetary and fiscal policy in a way that is quite different from the combination used over the past dozen years. In particular, the critics of the monetary strategy overlook the fact that powerful tax changes that will encourage investment are now strongly supported by both the administration and Congress.
For the past two decades, monetary policy aimed at keeping interest rates low in order to stimulate investment. The old strategy called for combining this policy of easy money with a tight fiscal policy of government surpluses that would thereby reduce inflationary pressure.
The easy money strategy didn't work as its advocates had hoped. The effort to keep interest rates low led to a rapid growth of the money supply and that in turn led to rising inflation.
As inflation rose, interest rates rose about point for point with inflation, leaving the "real" interest rate unchanged. Thus although the higher interest rates meant that more had to be repaid for every dollar that a business borrowed, that repayment could be made with cheaper inflated dollars.
More important, because interest payments are deducted in calculating taxable income, the relevant cost of borrowing is the real after-tax rate of interest -- that is, the cost of funds after both the tax deduction and inflation. When correctly measured in this way, the rise in interest rates caused by inflation actually reduced the true cost of borrowing.
To see how this can happen, consider an individual in the 40 percent bracket. If there were no inflation, he might be able to get a mortgage with a four percent interest rate. Since every dollar of interest expense reduces his tax by 40 cents, the after-tax interest rate is 60 percent of 4 percent, or 2.4 percent.
Now add an inflation rate of 8 percent into the calculation to get a nominal interest rate of about 12 percent. After deducting the full 12 percent interest payment, his net interest cost is 60 percent of 12 percent, or 7.2 percent. But since he repays the debt with dollars that are cheaper by 8 percent a year than when he borrowed the money, his true interest "cost" is actually a negative 0.8 percent. It is not surprising that individual mortgage borrowing skyrocketed in the past decade.
For business investors, the effect of inflation is more complex. In addition to lowering the cost of borrowing, the interaction of inflation and tax laws has a separate depressing effect on business investment. When there is inflation, the existing accounting method used for tax purposes understates the true cost of replacing equipment because depreciation allowances are based on the original purchase price of the equipment and are spread over a substantial number of years while prices are rising. This understatement of replacement costs has created artificial accounting profits and thus higher tax liabilities. This has the effect of lowering the profitability of prospective investments in plant and equipment.
Over the past decade and especially in the last six to seven years, this reduction in after-tax profitability has exceeded the decline in the cost of funds. The resulting fall in the incentive to invest has, in turn, caused a sharp fall in plant and equipment investment.
In contrast, the housing industry has been affected very differently by the interaction of inflation and laws. Investment in owner-occupied housing has benefited fully from the lower cost of funds without the problem of inadequate tax depreciation. And as a result, investment in housing has risen sharply relative to investment in plant and equipment.
The new strategy of tight money and high real interest rates will, as such, discourage investment both in housing and in plant and equipment. But the business tax cuts that are about to be enacted will provide more than enough additional stimulus to business to raise the level of investment in plant and equipment. This is true both of the administration's plan to shorten depreciation lives (to five years for most equipment and 15 years for most business structures) and of the congressional Democrats' plan to phase in immediate 100 percent write-offs for equipment and to lower the corporate tax rate gradually while eliminating the investment tax credit. In either case, the profitability of investment will rise enough to outweigh the higher cost of funds.
The proposed tax changes will do nothing to encourage more spending on owner-occupied housing. Indeed, the reduction in the high-bracket marginal individual tax rates will raise the net-of-tax cost of borrowing and therefore will reduce further spending on owner-occupied housing.
The new economic strategy thus represents a twist in the mix of economic policy: a high cost of funds to discourage housing and consumer durable spending combined with fiscal incentives for investment in plant and equipment that will outweigh the high cost of funds. We think the new strategy has a good chance of achieving the double goal of lowering inflation and increasing investment.