Reagan, Obama, Summers All Wrong on Tax Credit

Reagan, Obama, Summers All Wrong on Tax Credit: Amity Shlaes

By Amity Shlaes -

Amity Shlaes

A high quality, economically sensible tax cut. That’s the impression Barack Obama wants to convey about the business investment tax-credit plan the president announced last week.

Who can oppose the idea of letting companies expense 100 percent of the cost of their equipment purchases for a year? The plan sounds noble, as though it provides not only for the individual but also for general economic growth and productivity.

There’s also a political argument for this tax incentive. And that’s what the advocates of sustaining the George W. Bush tax rates for the highest earners always talk about: productivity. That makes it harder for House Minority Leader John Boehner to fight to preserve those rates. Obama’s investment tax credit, it can be claimed, already does the work of improving productivity.

In reality, Obama’s idea isn’t such a noble idea. Because the investment tax credit has been around in different forms since the 1950s, it’s possible to examine the record. When you do, you find not great success but uneven performance.

In the early 1980s, then-Senator Lloyd Bentsen of Texas, a Democrat who would later serve as President Bill Clinton’s Treasury secretary, backed a similar plan.

Frustrated at the economy’s refusal to recover, Bentsen, who served also as chairman of the Joint Economic Committee, wrote memos saying that the country desperately needed “supply side incentives to put more goods on the shelves.” In the end, President Ronald Reagan did pass an investment tax credit that offered a then-hefty-sounding 25 cent break for each dollar invested in research and development. The same law, the 1981 Tax Act, also threw in numerous other tax cuts to get the economy moving as unemployment rose toward 9 percent.

No Immediate Boost

The results at first were disappointing. Companies failed to invest in the instantaneous recession-killing fashion politicians had promised. “Mixed Capital Spending Plans: Boom Sought by Reagan Not Yet Seen,” read the headline of a New York Times story in September 1981. The paper noted that many companies failed to boost investment even with the credit. Champion International Corp., for example, which had a plant planned in Michigan, announced a 10 percent cut in capital spending for 1982, according to the story. High interest rates offset any desire businesses might have had to exploit the tax break.

Eventually, companies did use the Bentsen-Reagan tax credit. The economy benefitted, to an extent. But the rule was costly. Austan Goolsbee, now the president’s new chief economic adviser, wrote years ago in a paper that by 1986 the investment credit represented one of the government’s largest tax expenditures.

Ineffective Policy

Besides being costly, this tax policy is ineffective, Goolsbee wrote. “The benefit of investment tax incentives does not go to investing firms but rather to capital suppliers through higher prices,” as well as to wage increases.

It’s nice that equipment makers get orders, and it’s good that workers see higher wages than they otherwise might have. But if tax breaks are eaten up by price increases then the value of the tax break fades.

Goolsbee also noted that politicians alter the tax treatment of capital investment so often that they undermine its effectiveness and hurt those who use the breaks. In the early 1980s, U.S. tax law gave real estate investors enormous breaks in the form of credits for renovations. Many of those breaks ended with passage of Reagan’s 1986 tax reform, which cut income and corporate-tax rates while reducing the old exceptions. Whipsawed by the change, real estate plummeted.

Critique From Summers

Reaganites like to blame increases in deposit insurance put through by corrupt and cavalier lawmakers for the costly thrift industry crisis. But those Reagan-era real estate credits helped.

One of the earliest critiques of the utility of investment tax credits actually came even before Bentsen and Reagan. Its author was another of today’s White House players, the director of the National Economic Council, Lawrence Summers. Back in 1979, Summers published National Bureau of Economic Research Working Paper 404 with colleague Alan Auerbach called “The Investment Tax Credit: An Evaluation.” Summers summed up: “We find little evidence that the investment tax credit is an effective fiscal policy tool.”

The most evocative analysis of the investment tax-credit problem came from economist Amar Bhide, whose book, “Venturesome Economy” sought to explain what makes economies grow. “Virtually all good companies, young entrepreneurial companies,” Bhide told me in an e-mail, “find that development doesn’t fit eligibility rules.”

Wrong Companies Benefit

Not all projects that investment credits fund are entirely wasteful, Bhide notes. A company investment in a new technology may yield only half the productivity gains planned, but it is still better than an investment in, say, housing, where there may be no productivity gains to speak of. Nonetheless, Bhide says, the benefits of investment tax breaks often flow to precisely those companies that shouldn’t survive. “To bad companies, auto and drug companies that pour money down a sinkhole,” he wrote.

When tallying the damage, it’s also important to take into account legislation that an investment tax credit precludes. Because President Obama is reaching out to business, he is more likely to succeed in his plan to allow the Bush top income tax rates to expire. Those tax rates really are precisely the ones that matter to the venturesome innovation Bhide describes. Or, as Summers put it so long ago, there’s “crowding out of non- favored investment.” So sure, investment tax credits are a wonder, but for what they suppress as well as what they create.