The Agenda

Greg Mankiw on Business Investment

If we consider business investment from the first quarter of 2009 to the second quarter of 2011, it looks fairly stable. But if you take a somewhat broader view, it does not, as Greg Mankiw reminds us in his latest column for the New York Times:

The most volatile component of G.D.P. over the business cycle is spending on investment goods. This spending category includes equipment, software, inventory accumulation, and residential and nonresidential construction. And the recent economic downturn offers this case in point about the problem: From the economy’s peak in the fourth quarter of 2007 to the recession’s official end, G.D.P. fell by only 5.1 percent, while investment spending fell by a whopping 34 percent.

 

The subpar recovery has coincided with a historically weak investment recovery. Compare our recent experience with that of the early 1980s, when the nation last experienced a deep economic downturn in which unemployment topped 10 percent. That recession ended in the fourth quarter of 1982. In the subsequent two years, investment spending grew by a total of 54 percent. By contrast, in the first two years of this recovery, it grew by half that amount.

While the sluggish housing market can explain the slow pace of residential investment, it is not the whole story. Business investment has also been weak. Over the last two years, nonresidential fixed investment has grown by only 12 percent, whereas during the two years after the 1982 recession, it grew by 27 percent. Similarly, the narrow category of spending on business equipment and software fell more than twice as much in this recession as it did in the 1982 recession, and it has been slower to recover. [Emphasis added]

With regards to business equipment and software spending, I’m reminded of an argument Erik Brynjolfsson made in 2003:

IT hardware can be purchased, but implementing the digital organization requires a more difficult process of “co-invention” by IT users. …

Identifying and implementing organizational co-inventions is difficult, costly, and uncertain, yielding both successes and failures. Our data showed that these adjustment difficulties—including financial constraints, obsolete work rules, and even incompatible corporate culture—led to significant variations in the use of IT and the resulting outcomes. Ironically, the difficulty that so many companies have in implementing the practices of the digital organization is exactly what creates the opportunity for extraordinary returns among the successful implementers. If implementing these practices were easy and straightforward, all competitors in an industry would already have done so, driving their competitive advantage to zero. Today, adopting an ATM network is no longer correlated with a competitive advantage for a bank, but adopting the practices of the digital organization is.

The main conclusion is that in advanced economies, IT is a promising source of productivity growth, but it makes little direct contribution to the overall performance of a company or the economy until it’s combined with complementary investments in work practices, human capital, and organizational restructuring.We do find evidence of a substantial relationship between computers and productivity growth, but closer examination reveals that the biggest benefits accrue to companies that adopt an identifiable cluster of business practices we call the digital organization.

IT investment was a necessary but not sufficient condition for the productivity improvements of that era. It is possible that the scope for productivity improvements is somewhat lower in the current economic environment, perhaps because organizational co-invention is more difficult and thus less common due to a higher level of risk-aversion. Another possibility is that we’re seeing a great deal of invisible organizational co-invention, which is leading firms to economize on capital expenditures and hiring. 

According to Mankiw, sluggish investment spending could actually be a driver of our economic woes rather than merely an indicator of them:

 

Advocates of traditional fiscal stimulus often view low levels of investment as a symptom, rather than a cause, of the weak recovery. Businesses are reluctant to invest, they argue, because they lack customers eager to spend. If the government can goose demand by handing out dollars to households short on cash, or by buying goods and services directly, businesses will respond by expanding their own spending as well.

Yet fluctuations in investment spending, rather than being only a passive response, are also one of the driving forces of the booms and busts of the business cycle. The great economist John Maynard Keynes suggested that investment spending is in part determined by the “animal spirits” of investors, which he described as “a spontaneous urge to action rather than inaction.” Recessions occur when optimism turns to pessimism, and businesses are reluctant to place bets on a prosperous future. Recovery occurs when investor confidence returns.

Assuming there is at least some truth to this framework, Mankiw  suggests easing the tax burden on income from corporate capital:

 

One obvious step would be a cut in the taxation of income from corporate capital. According to a 2008 study by the Organization for Economic Cooperation and Development, “Corporate taxes are found to be most harmful for growth.” Tax reform that reduced the burden on capital income and shifted it toward consumption would improve prospects for long-run growth and, in so doing, encourage greater investment today.

Yet it would be overly optimistic to think that any single public policy, by itself, could lead to the kind of robust investment spending seen in previous recoveries. Myriad government actions influence the expected future profitability of capital. These include not only policies concerning taxation but also those concerning trade and regulation. [Emphasis added.]

Mankiw could have made a stronger case for easing the taxation of income from corporate capital by making the important observation that this income is in many cases double-taxed. This is one reason why the president’s recent emphasis on the tax burden faced by Warren Buffett is a bit misleading: Buffett is careful not to make reference to the taxes he pays through the companies he owns, which changes the picture considerably. And of course some portion of the corporate tax burden falls not on the owners of capital but on labor, with estimates ranging widely. To be sure, Mankiw was making the case for cutting taxes on income from corporate capital as a stimulative measure, so the decision not to mention ancillary arguments was fully appropriate.

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.
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