The advantage of spurring economic growth through either private or public investment is that it not only spurs jobs in the short run (by producing the goods or services involved in the investment), but it spurs productivity and innovation in the moderate to long term.

Unfortunately, Washington is caught in an ideological dispute between those who favor public investment and those who favor private investment. When Bruce Bartlett says that "Republicans should try to be the party of investment, because Democrats are basically the party of consumption," he's really saying that he does not believe that public investments broadband, smart electric grids, health IT, and university research (all items in the American Recovery and Reinvestment Act) don't produce long-term returns and therefore are not investments. He goes on to state that "while some Democratic spending will be called 'investments,' Republicans can make a strong case that the only ones that really add to the nation's capital stock are those directed by the market." Really? I guess all that money wasted by companies like Citibank and Wachovia on sub-prime mortgages was investment while federal support to the National Institutes of Health and National Science Foundation was just spending.

To say that the "market" invests and government spends is simply ideology masquerading as reasoned analysis. On other side to say that any tax cuts to spur private sector investment is corporate welfare, as some on the left will claim, is just as ideologically driven. For example, when the liberal advocacy group Free Press fought against the inclusion of tax credits for broadband investment in the stimulus bill, deriding them as "corporate welfare," they were being as extreme as Bartlett. For them and other liberal ideologues the only "real" investment is public.

The reality is that both governments and business make investments that spur long run productivity and innovation, just as both governments and business spend money that does nothing to spur long run productivity and investment. What 21st century knowledge economies need to be successful is much higher rates of both public and private investment. And the sooner Washington can recognize this, while seeing through these kinds of ideological-driven views from both sides for exactly what they are, the sooner we can get the economy back on track in the short and long run.

Now to the actual proposal: Mankiw and Bartlett are right in identifying the importance of business capital expenditures as important to recovery and long-term growth and in proposing an Investment Tax Credit as a key tool to spur more cap ex. But rather than simply adopting the Mankiw proposal of a 20 percent flat ITC, Congress should adopt a more strategic proposal.

Mankiw estimates that a 20 percent ITC in 2009 would have cost the Treasury about $200 billion. A proposal of this fiscal magnitude is not in the cards now. However, an effective ITC need not cost this much. First, an ITC could and should be designed as an incremental credit, applying to only a portion of investment, not all of it. Congress could provide an ITC of 20 percent in 2010 on the amount of investment a firm makes above 75 percent of the amount invested in 2009. This would cut the cost by approximately 75 percent ($50 billion) without substantially reducing the impact on spurring new investment.

Second, the ITC could be targeted to just investments in information technology capital. Notwithstanding the beliefs of conventional neo-classical economists that all capital expenditures have the same rates of return, the reality IT capital expenditures generate increases in productivity significantly greater than other kinds of capital invest¬ment (see including Gilchrist, Gurbaxani and Town: and Plice and Kraemer). Moreover, because IT transforms organizations and leads to innovations within other organizations, it operates in the same way as R&D, with high spillovers that may be taken advantage of by other organizations. This means that absent public policy interventions (such as more favorable tax treatment) that companies will under invest in IT capital relative to what is societally desirable.

Therefore, focusing the ITC on IT capital would spur productivity-inducing investment (and create jobs in the short run), but reduce the total cost to around $20 billion, since U.S. companies invest about $400 billion in IT capital equipment annually, compared to the almost $1 billion in total business investment.

Some will argue that an ITC is not needed because companies won't invest absent more robust demand, or, as John Maggs notes, that the cost of capital is already quite low. But both objections miss the point. For while it is true that companies may not expand overall capital equipment levels until sales of goods or services start to expand, companies will replace old equipment with new, even if they do not see sales rising, as long as they believe that the new equipment will perform better than old and that the rate of return on the investment is adequate. Allowing companies to expense IT investments will make more investments turn the corner on profitability, (even with already low capital costs) leading them to expand investments.

Finally, as Alan Auerbach notes here, one limitation of an ITC or expensing during a downturn is that many firms do not have tax liability. One way to reduce this barrier would be to make sure that any ITC credits are allowed to be carried forward a number of years, as firms can now with the R&E tax credit.

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This additionally from Bruce Bartlett, on the Investment Tax Credit:

I just wish to note that I proposed the ITC earlier this year as an alternative to consumption-oriented stimulus spending and as a temporary measure. I probably wouldn’t support it as a permanent feature of the tax code, but I have to think about it. I was also consciously trying to devise a tax cut that Republicans might support in lieu of the same-old/same-old tax cuts they were proposing at the time, which I didn’t think would have done the slightest bit of good. The ITC would at least spur one type of spending, which is what I thought the economy needed, and position the GOP as the party of investment while branding the Democrats as the party of consumption. I would add that I have hope that we may see an investment led recovery. At this point, I don’t think an ITC is necessary because the cost of capital is already quite low.

Updated at 12:29 p.m. on Dec. 23.

I agree with Greg that the dominant empirical fact about investment is its procyclical volatility (the main reason investment has been depressed for the last two years is that the economy has been depressed), and also that the recent credit crunch made it worse. But I don't agree with a third item on his list: "the policy environment seems adverse to business." As in many areas, it is when we get to the politics that I disagree.

Greg cites trade policy, fiscal imbalances, and energy costs, in support of his proposition that the current policy environment is anti-business. Let's consider each of the three.

Trade. I wasn't happy in September when the White House put tariffs on imports of Chinese tires. But President Obama, despite the pressures of the most severe recession since the 1930s, has yet to succumb to any protectionist measures as big or as blatantly in violation of international trade agreements as were Ronald Reagan's quotas on Japanese auto imports or George W. Bush's tariffs on steel imports. (Greg, of course, was the Chair of Bush's Council of Economic Advisers.)

Budget. Most of us think that the $787 billion fiscal stimulus and the distasteful banking rescues were minimal necessary responses to the recession. But let's address the serious question of the bleak longer term fiscal outlook. It is known to those who look carefully at the budget numbers that Obama's recent actions are a distant 5th on the list of contributors. #1 in the long term (by far) are the future costs of Social Security and Medicare. #2 are the long term effects of Bush's tax cuts. A close #3 are the effects of Bush's spending increases (including foreign wars and the expansion of Medicare benefits, among other things). #4 is the loss of tax revenues from the recession that began December 2007. A distant #5, as I say, is the recent fiscal stimulus. (The banking layouts are being repaid, usually with a high return for the Treasury -- as the Administration had predicted, to critics' ridicule.) I believe that as the recovery becomes better established Obama will, as he says, take much more serious steps than his predecessor in the direction of long-run fiscal consolidation. But only time will tell.

Energy costs. Greg Mankiw in fact believes that a system of energy taxes or cap-and-trade would increase the efficiency of the economy, even though it would raise the relative price of energy. (This is all the more true if the comparison is to past policies of subsidizing oil and other fossil fuels.) Greg founded the Pigou Club on this principle, and I heartily congratulate him for it.

I am skeptical that investment is currently depressed by perceptions of an anti-business climate. But if the average businessperson does in fact have the perception that recent Democratic administrations have been worse for business than Republican administrations, I suggest setting aside campaign rhetoric and looking at actual history. Start with the fact that, in the graph in Greg's blog post, investment growth was substantially higher during the Clinton Administration than during the Reagan or Bush Administrations. Investment will recover when the economy does.

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Washington is on a path that will spell much economic pain for many years, with ballooning budget deficits, accelerating inflation and meager business investment by small business, and there is little hope of reversing this path. Even a shift toward Republican leadership in 2013 will not be enough to make a difference unless the new Republican leadership decides to behave very differently that it has in the past decade, which seems highly unlikely.

Long-term cuts in marginal income tax rates -- not the phony "tax cuts" that are really government subsidies in disguise, or short-term cuts in rates -- are the only way to spur investment by small businesses, which are the bulk of our economy, and the main engine of growth and innovation. Credit giveaways to small businesses, which are now the flavor of the month, might produce some short-term growth, but they are wasteful (even the existing SBA lending program suffers from significant adverse selection and moral hazard problems) and address a problem (the current credit crunch) that will disappear in a year or so. The big problems that are discouraging investment are much deeper than that.

Although permanent tax cuts (or extending existing tax rates beyond next year) would make a big difference, permanently lower tax rates alone cannot spur lasting growth because tax cuts that would breed more and faster inflation will not produce lasting high growth. That is why tax cuts must be combined with deep, credible, long-term entitlement expenditure cuts. The arithmetic of exploding deficits is undeniable, and politics as usual (much less the major new expenditure programs of the Obama Administration) isn't going to solve this problem. We need to make huge cuts in promised entitlements and soon. By huge I mean that the cuts must make a significant dent in the more than $70 trillion (present value) of unfunded promises currently in place, which will cause the budget deficit to grow exponentially over the next two decades.

This political change will not happen in 2013, no matter who is in office. As Winston Churchill said, America will always do the right thing...after it has tried everything else. We will not make the politically difficult decisions to restore growth until after we have suffered high inflation and low growth. We have in store a very painful decade of slow growth and high inflation while we re-learn basic economics. Shame on any arithmetic-challenged economist who is saying otherwise.

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Although some observers may be unaware, recent U.S. tax policy has included frequent attempts at stimulating business fixed investment, primarily through temporary “bonus depreciation” provisions that provided immediate expensing of a fraction of all purchases of qualifying investment (primary equipment). Bonus depreciation was first introduced, at an expensing fraction of 30%, in 2002; the expensing fraction was increased to 50% in 2003. The provision expired at the end of 2004, only to be reintroduced for a year in 2008 and extended for a year in 2009, as part of the February stimulus package. As a temporary investment stimulus, bonus depreciation, like a temporary investment tax credit, encourages investment not simply by reducing the user cost of capital, but also by encouraging investment bunching. Unlike an investment credit, however, bonus depreciation is ideally suited to firms facing credit constraints. By deferring tax payments rather than simply reducing them, it can provide a much bigger benefit to firms facing a high cost of funds than it costs the government.

Unfortunately, both bonus depreciation and temporary investment tax credits have two considerable shortcomings. First, firms must have tax liability in order to take advantage of them. If the most recent prior recession in 2001 is any indication, a large share of corporate investors would not be able to take advantage of these additional tax benefits at present (Altshuler et al. Tax Policy and the Economy, 2009). Moreover, temporary tax incentives, even if effective, can have strong side effects in the form of destabilizing investment, causing investment to fall prior to their enactment (if they are anticipated) and after their repeal (because of the bunching already mentioned above). The history of enactment of U.S. investment tax incentives shows that their timing is relatively well-predicted using a simple model based on observable aggregates (Auerbach, AER, May 2009), so it would be foolish to think that they cannot be anticipated.

In short, temporary investment incentives may be at once too weak (because many firms cannot take advantage of them) and too strong (because of their potential to destabilize investment). We could stand some more careful thought about tax policies to encourage investment over the long term.

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