The Investment Tax Credit: Likely Even Less Effective Than I Thought


JW Mason channels my favorite economics professor, Austan Goolsbee, on investment tax credits.  According to Goolsbee's early work, investment tax credits produce surprisingly little extra investment.  Instead, the benefit accrues in the form of "rents" (economic windfalls) to producers of capital goods.  Since in the short term, supply is constrained, the prices of capital goods are bid up, generating a windfall for makers of capital goods, but little bang for your buck in terms of actual productivity enhancement (h/t Rortybomb):

From his Investment Tax Incentives, Prices, and the Supply of Capital Goods:
Although there appears to be an abiding faith among policy makers that tax incentives can influence the investment decisions of firms and serve as a tool for stabilizing the economy, empirical evidence for the connection is weak. Econometric research has commonly found that tax policy and the cost of capital have little effect on real investment. Economic theory predicts that the marginal user cost of capital should be the primary determinant of investment demand but actual estimates of the price elasticity of nvestment ... mostly lie between zero and -0.4... The evidence that investment is only modestly responsive to price has been one of the most robust findings of the empirical investment literature...

In addition to their large revenue costs, investment tax subsidies may give large, unintended rents to capital suppliers without increasing real investment until several years later because of the short-run asset price responses of capital goods. For policy makers interested in using tax policy to stimulate investment or, especially, to smooth business cycle fluctuations, the results are not promising.

Needless to say, a temporary tax credit--like the one the Obama administration has proposed--should have even less real effect.  In theory, short-term price increases lead to long-term production increases.  But if the tax cut is temporary, the makers of capital goods simply pocket the windfall and don't increase production.  Though perhaps one could argue that with demand depressed, producers won't have so much room to raise prices.

There's going to be some inevitable accusations of hypocrisy here, but I think that in general it's not very helpful to throw the academic work of presidential advisors up against them.  It's great for scoring political points, but the fact is that economic advisors cannot run around saying that presidential policies are a bad idea.  Presidents are naturally going to do a bunch of things that are economically sub-optimal, politics being what it is.  If you pillory good economists for giving cover to those economic policies, the result will be that the president will only get hack advisors who will give him terrible, ideologically-driven advice.  This does not sound like a better outcome, unless you are an ideologically-driven hack who doesn't really care whether the president is in touch with reality, as long as he's serving your ends.

I was disappointed when people who should have known better did this sort of thing to Mankiw and Hubbard, and I feel the same way now about Goolsbee and Romer.  I would much rather have them in office, making awkward public statements in favor of policies I'm quite sure they don't fully support, and giving the president excellent advice, than to have them in the ivory tower, maintaining their intellectual purity while political hacks drive policy.
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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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