Barro: Investment and Taxation

On the weekend, in the New York Times, Barro proposed a program of fiscal reform to deal with our current ills. Paul Krugman, still struggling to understand how a dynamic economy behaves by using an obsolete static model from 1937, can't seem to figure out what Barro is trying to say, but Tyler Cowen does a pretty good job.

Krugman puzzles:

I would have expected Barro to offer some kind of argument based on real business cycle theory or whatever he believes about macro these days.

Here's what Barro says about the determinants of investment:

What drives investment? Stable expectations of a sound economic environment, including the long-run path of tax rates, regulations and so on.

Barro is of course dressing this up for lay people reading the NYT, but what he says seems consistent with the standard neoclassical growth model. You have to add some details, of course, to the basic model - distorting taxes and regulation. However, the basic idea is that investment decisions are made based on long-run factors. Given time-to-build for new capital, and the long life of the capital after it is put in place, any firm contemplating an investment decision will be looking far into the future. Even if one thinks that sticky prices and wages matter for some of a firm's decisions - employment and utilization - stickiness has to be irrelevant over the investment-decision horizon.

Old-fashioned accelerator theories, to the extent there is any serious theory backing them up, appear to rely on the idea that output is demand-determined. Then, since capital is required to produce output, and investment is the change in the capital stock, investment depends on the change in output, i.e. the change in "demand." But for this to work requires that wages and prices be stuck for very long periods of time, which is not consistent with empirical evidence. This seems to be why New Keynesians do not get into accelerator discussions (except for the financial accelerator, but that's entirely different).

Barro goes on with this:

And employment is akin to investment in that hiring decisions take into account the long-run economic climate.

The lesson is that effective incentives for investment and employment require permanence and transparency. Measures that are transient or uncertain will be ineffective.

The first point is a useful one, and I don't think anyone has been discussing this in the context of the current recession. Employment decisions by a firm are indeed investment decisions, though of course this varies across different types of jobs. In some cases, the firm makes a substantial investment in specific human capital when hiring a worker (shared with the worker in some fashion, as determined by the labor contract), and in other cases the primary human capital input in the job is general human capital that can be used at any firm. Thus, to some extent, employment decisions are governed by the same long-run factors that determine investment. Therefore, if we can understand what is holding investment down, we can understand part of what is holding back employment. Interesting idea.

Here are the components of Barro's tax reform proposal:

1. Bowles-Simpson proposals. Barro says:

reforming Social Security and Medicare by increasing ages of eligibility and shifting to an appropriate formula for indexing benefits to inflation; phasing out “tax expenditures” like the deductions for mortgage interest, state and local taxes and employer-provided health care; and lowering the marginal income-tax rates for individuals.

These all seem fine. Politically, changes in Social Security and Medicare seem difficult to obtain, and elimination of mortgage interest deductibility impossible, except perhaps as part of a larger package - i.e. we take this away from you but give you this in return.

2. A value-added tax. This is common in Western Europe, and Canada has a federal value-added tax. Taxation is not something I work on, so I'm not familiar with the economic arguments in favor of the value-added tax. In the long run, you get the same distortion on the consumption/leisure margin as with the income tax. Maybe the tax base is larger than for the income tax, so you can lower the tax rate and reduce the distortion, but you lose the progressivity you get from the income tax.

3. Eliminate corporate taxation. Optimal dynamic taxation tells us that taxing capital income is a bad idea, though I'm sure there are plenty of qualifications in the taxation literature. In any case, there are at least some sound economic arguments for this one.

4. Other stuff. Barro wants to (i) reverse spending increases that have occurred since 2000; (ii) eliminate estate taxes. For us to evaluate (i), Barro would have to be more specific (Bush's prescription drug plan?), and there seems no particular economic rationale for (ii).

So, Barro has given us a few things to think about. What he wrote is certainly much more useful than this, from Krugman:

So the best thing we could do to spur business investment would be to get a recovery going by whatever means necessary, including fiscal stimulus.

That conclusion is based on an accelerator idea - another obsolete piece of economics.