Finance-Based Growth
Tax capital less, get more capital.


Historically low marginal tax rates on financial capital are having a predictable effect: The amount of capital fueling business creation, funding capital expenditure, and financing the commercialization of knowledge is at an all-time high. It proves, as economist Arthur Laffer long has said, if you want more of something, tax it less.


Net lending in the first quarter totaled a record $4.50 trillion (seasonally adjusted annual rate), up $457 billion, or 11.3 percent, from the previous quarter and $1.46 trillion, or 47.9 percent, above year-earlier levels, according to the Federal Reserve’s latest “Flow of Funds Accounts of the United States.” As a consequence of the Bush tax cuts on income and capital, total net lending (i.e., all credit market instruments excluding corporate equities) has risen $2.57 trillion, or a resounding 132.8 percent, in the past five years.



The primary lender in the first quarter was the financial sector, accounting for two-thirds of all net lending, or about $3.05 trillion. Within the sector, the biggest sources of funds were commercial banking ($900.6 billion), asset-backed securities ($650.1 billion), agency-backed mortgage pools ($348.2 billion), mutual funds ($314.9 billion), funding corporations ($306.6 billion), and insurance companies ($205.8 billion).


Finance is the sine qua non of economic growth. Without it, risk-taking is stymied, knowledge can’t be commercialized, and an economy stagnates. Access to credit creates new businesses through the mechanism of venture capital and expands existing ones by facilitating purchases of new technology, plant, and equipment. Households similarly tap the credit market to finance homes, cars, and other consumer durables. Indeed, within the domestic non-financial sectors, the largest borrowers in the first quarter were households at $1.33 trillion, followed by the federal government ($607.7 billion), non-financial corporate business ($509.4 billion), nonfarm non-corporate business ($336.6 billion), and state and local governments ($107.7 billion).



Furthermore, strong economic growth expectations stimulate borrowing as businesses prepare to meet future demand. This raises dollar demand and mops up any excess liquidity, which helps to explain why economic growth is counter-inflationary.



Marginal tax rates bear directly on financial capital availability by 1) creating incentives (or disincentives) to save and invest and 2) leaving a sufficient (or insufficient) post-tax pool of disposable income to meet the financing needs of a growing economy. In addition, marginal tax rates indirectly affect financial capital availability by bearing on the propensity of foreign direct and portfolio investors to put money in the United States. To the extent tax policy encourages (or discourages) economic growth, foreign investors are either more or less inclined to invest in U.S. assets. Foreign lending to the U.S. in the first quarter totaled $819.1 billion, representing 18.2 percent of all net lending.



Rising interest rates have yet to dampen fixed-income financing. New corporate bond issues in the first quarter topped $965.8 billion (seasonally adjusted annual rate), up 3.9 percent, or $36.2 billion, from the prior quarter and a smashing 50.6 percent, or $324.7 billion, higher than a year before. Throughout much of the first half of the decade, corporations took advantage of low U.S. interest rates by switching from equity to bond financing. In the first quarter, in fact, equity financing totaled about $99 billion, down almost 73 percent, or $267 billion, from a year earlier.



The U.S. corporate debt-equity ratio has leveled off at an average 0.49:1 since the fourth quarter of 2003, during which time outstanding corporate bonds rose 12.5 percent and the market value of equities climbed 27 percent. During this period of exceptionally low interest rates, companies leveraged their assets, borrowing to finance operations and capital spending with the aim of generating more profits. Enhanced corporate profitability in turn raised the market value of equities, helping to lower the debt-equity ratio. Returns on investment, in other words, exceeded interest costs.



Corporate profitability has been so robust, in fact, that the generation of substantial internal funds wiped out the financing gap between capital expenditures and domestic in-house financing (i.e., U.S. internal funds, plus inventory valuation adjustment) during much of last year. The latest reading puts the financing gap at $125.5 billion (seasonally adjusted annual rate) in the first quarter of 2006 versus minus-$130.7 billion in the prior quarter and $54.6 billion a year earlier. From the mid-1990s to a 2000 third-quarter peak of $338.5 billion, the financing gap rose steadily as corporate investment, principally in Internet-related information technology, far exceeded the generation of internal funds available to pay for these hefty capital expenditures.


It is worth noting that corporate capital expenditure in the first quarter of this year set a new record high of $1.01 trillion, up 3.4 percent from the prior quarter and 8.6 percent above a year before.


Among the different types of corporate debt, bonds have been the credit-market instrument of choice. Bonds represented 58.1 percent of all corporate debt obligations in the first quarter. Loans, in comparison, accounted for 27 percent, mortgages 13.1 percent, and commercial paper 1.9 percent. In the years 2001 to 2006, however, mortgage growth outstripped bond growth by 82.7 percent to 31.4 percent, respectively, while total loan obligations actually contracted by 0.5 percent.



Small business, too, has been reaping the benefits of easy credit and heretofore low interest rates. Small business borrowing increased at an average annual rate of 86.6 percent in the past nine quarters, while capital expenditure rose 27.8 percent to an annualized $257.9 billion. Outstanding small business debt, including both credit and equity market instruments, totaled $2.85 trillion in the first quarter of 2006, up 14 percent from a year earlier and 33.6 percent higher than the first quarter of 2003.



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


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