Are Incentives Needed To Encourage Investment?
by James Kroeger
The supreme importance of investment is understood by all economists. Without it, long-run improvements in economic welfare are impossible. We want investment to occur whenever it is likely to improve our lives. Unfortunately, very few of the tax policy proposals touted in Congress as "investment-friendly" are likely to do anything at all to increase desirable investment in the United States’ economy. To understand the flaws in these proposals we first need to understand the difference between financial investments and real economic investments.
Economic investments---the kind that actually end up improving the economic welfare of a population---involve purchases of capital goods or other economic resources that are used to either produce more capital goods or more final goods that consumers find desirable. In other words, they either increase output or expand the supply-side's productive capacity. This happens whenever firms purchase machinery/equipment to improve productive efficiency or when they spend money on the construction of new stores or factories or on the salaries of new employees. However, not all firm expenditures are economic investments, e.g., money spent by firms on advertising that either (a) misleads consumers or (b) does nothing to help them with their purchasing decisions.
Financial investments---are purchases or commitments of money that provide the "investor" with an income stream. Saving money is a financial investment because it provides interest income; purchases of assets can be financial investments if they eventually provide a capital gain. Economic investments made by firms are usually also financial investments because they generate income that exceeds their cost. The economic investments made by governments that improve infrastructure or human capital are not financial investments because they do not provide the government with an income stream.
Some financial investments are also economic investments, but many of them are not. The purchase of a piece of land, for example, is a financial investment if it appreciates in value over time, but it is not an economic investment if it just sits there, undeveloped. Purchases of stocks in secondary markets (e.g., NYSE, NASDAQ) are clearly financial investments if the stocks appreciate in value, but they are not economic investments because they involve nothing more than exchanges of titles of ownership of already existing assets. They do not typically put any money into the hands of firm managers that could be used for economic investments. That normally happens only when stocks are first sold to underwriters, prior to an initial public offering.
Supply-Side theorists have taken advantage of the impreciseness of the word investment to craft tax policy proposals that sound as though they are beneficial to the economy, but actually are not. The famous Capital Gains Tax Cut, for example, is frequently promoted as an incentive that would stimulate “investment.” Unfortunately, the only “investment” that such a tax cut is likely to stimulate is increased financial investment in stocks and other real assets. One financial investor hands money over to another financial investor for a piece of paper. Very little if any of the money involved in these transactions ends up being spent on capital goods that would increase output or the productive capacity of the economy.
When do firms need special incentives to motivate them to invest in new capital goods? The answer is never. In modern market economies, competition provides firm managers with the most powerful motivation to continually invest that they will ever need: fear. They ultimately face both the fear of bankruptcy and the fear of lost opportunity. If your competition lowers its costs by investing in new equipment, or improves the appeal of its products by incorporating new innovations, then you’d better do the same or you will soon find yourself driven out of business. With only a few exceptions, additional government-provided financial incentives are nothing more than an unnecessary waste of tax dollars.
Entrepreneurs do not need special additional incentives provided by the government to encourage them to assume the risks of creating a new business. True risk takers believe that their ideas will succeed in the market and have so much of their identities invested in them, they really don’t care if they receive any return at all on their invested time and money, sometimes for several years, as long as they have hope of eventual success. The problem for them is not that they lack motivation; it's that they can't find someone who is willing to provide them with a loan that banks, venture capitalists, and angel investors find too risky.
In confronting this situation, Congress has a couple of options. It can choose to do nothing and simply allow the marketplace to reward firms-that-make-wise-investments with the market share of firms-that-do-not. The other option would be for lawmakers to help entrepreneurs [and established 'too-risky' firms] to obtain the funding they need in the hope that they might then be competitive with better established firms. The rational way to do this would be to provide these marginal firms with targeted investment tax credits or perhaps with guarantees on private loans.
These kinds of initiatives would put the money directly into the hands of those who will be investing the money. Compare this to the insane idea of giving tremendous amounts of extra disposable dollars to wealthy savers in the hope that their extra savings might somehow make their way into the hands of true economic investors when private banks have already rejected their borrowing plans as too risky. Very little, if any, of those billions of dollars would actually end up helping needy entrepreneurs and firm managers.
Related Economic Analysis:
MEASURING SAVINGS AND INFLATION
THE RELATIONSHIP BETWEEN SAVINGS AND INVESTMENT
DO TAX CUTS STIMULATE THE ECONOMY?
IS THE INCOME TAX FAIR TO RICH PEOPLE?
MAKE THE AMERICAN PEOPLE RICHER