The Bush Investment Shift
The June 2003 tax cuts are functioning precisely as promised.


TThe Bush tax cuts of 2 years ago continue to lay the foundation for a prolonged economic expansion, owing to a conspicuous shift in private expenditures from consumption to investment. The June 2003 tax cuts, in fact, are functioning precisely as promised — boosting GDP to the benefit of all Americans, regardless of income. It’s one of the marvels of supply-side fiscal policy. By raising the incentive to invest, marginal tax-rate reductions augment the ratio of financial capital to labor capital, thus raising labor productivity and, in turn, accelerating growth.

Net nonresidential capital formation has increased 63 percent since the tax cuts, rising by $186.4 billion to a nominal annual rate of $480.1 billion at end-2004. In last year’s fourth quarter alone, net nonresidential capital (i.e., private nonresidential fixed investment less corporate fixed capital consumption) rose by an annualized $72.8 billion, representing a near 18 percent increase from the third quarter and a 36 percent gain year-on-year. Net nonresidential capital formation had peaked at an annual rate of $553.5 billion in the second quarter of 2000 and ebbed at $273.9 billion in the first quarter of 2003.

Since mid-2003, annualized nonresidential capital growth has averaged nearly 30 percent, far surpassing the Clinton-era mean of 13 percent and the 1946-2004 norm of 8 percent.

Total nonresidential investment set a new high of $1.275 trillion in the fourth quarter of last year, up $202 billion, or 18.8 percent, from the second quarter of 2003. Corporate capital consumption increased by less that $16 billion, or 2 percent, over the same period.

An aside: The pronounced rise in net private nonresidential capital formation in the 7-year period commencing in 1993 wasn’t initiated by the Clinton tax hikes of that year, which eventually caused federal revenues to exceed 21.1 percent of nominal GDP, an all-time high, versus a 1946-2004 mean of 18.1 percent. The investment boom of the 1990s was instead initiated by an exogenous factor — i.e., the IT revolution. A mighty Schumpeterian gale swept across the business world in the form of PCs, the Internet, and other information technology. Competitive pressures demanded that businesses invest heavily in IT. Ergo, private fixed non-housing investment climbed in the last decade despite the 1993 tax increases.

By now, the effects of the Bush tax reforms should be obvious to all but the most obtuse observers. From the beginning of 2002 to mid-2003, private investment’s GDP share was flat at 15.3 percent to 15.5 percent. After the June 2003 tax cuts, though, the percentage rose steadily, reaching 17 percent in 2004. As a result, the growth rate of private domestic GDP (i.e., GDP less trade and government) has almost doubled, accelerating from 2.8 percent in the second quarter of 2003 to a year-on-year average of more than 5 percent since then.

Democrats, however, aided by a pliant (and largely economically illiterate) Washington press corps, continue to foist the fiction that the Clinton tax hikes produced the 1990s boom by closing the federal budget deficit. This is patent nonsense. For a start, they’ve got the cause-effect deficit-GDP relationship backwards: The deficit closed because economic growth quickened, not the other way ’round.

GDP growth is clearly more responsive to changes in private investment than personal consumption. Personal consumption expenditures, as a percentage of GDP, have a tendency to rise during economic contractions, while private fixed investment usually shrinks — again confirming the pivotal supply-side role played by investment versus consumption (and also showing why fiscal gimmicks, such as one-time tax rebates, are so economically ineffective).

The effects of investment versus consumption are perhaps best illustrated in terms of a ratio — in this case, the ratio of gross private domestic investment to personal consumption expenditure (PCE). This ratio correlates positively with trends in real private-sector GDP, once again confirming that private investment is the actual catalyst of economic growth.

The ratio of gross private domestic investment to PCE has risen from about 0.22 in the second quarter of 2003 to more than 0.24 in the third quarter of 2004. That’s well above the 1947-2004 mean of 0.19 — and there’s plenty of room for additional growth, given the ratio’s all-time high (set in the 2000 second quarter) of nearly 0.27. In the period 1946-2004, the rate of private nonresidential fixed investment to personal consumption expenditures was 0.16.

And what catalyzes the investment-consumption ratio? Real disposable personal income is one certain factor. Whenever inflation and/or taxation adversely affect personal income, investment suffers and economic activity slows. Stiffer tax rates are never conducive to growth but rather are a drag on an economy.

Truth is, the more after-tax money people have at their disposal, the greater the propensity to save rather than to consume. Much of any increase in real DPI finds its way into nonresidential fixed investment. Increased business investment of course generates further increases in personal income (via enhanced labor productivity and corporate profitability), making even more financing available for business creation and expansion.

Lastly, President Bush’s envisioned ownership society would stimulate strong and lasting economic expansion. His calls for tax cuts and tax simplification, as well Social Security reform, would enhance the economy’s long-term growth prospects by improving the all-important ratio of private investment to personal consumption.

In jawboning members of Congress, therefore, the administration’s strongest argument for new and permanent tax cuts is that they work. Tax-rate reductions redound to everyone’s benefit — regardless of income level — by raising the incentive to invest and thus accelerating the pace of economic expansion. Yes, a rising tide does lift all boats.

– William P. Kucewicz is editor of and a former editorial board member of the Wall Street Journal.