9. Tax Policy and Business Investment Evidence from the 1980s

Yusuke Horiguchi
Published Date:
January 1992
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A distinguishing feature of the early phase (from 1983 to 1985) of the economic expansion in the United States in the 1980s was the exceptional strength of gross fixed business investment in the face of historically high real interest rates. By contrast, from late 1985 to the middle of 1987, business fixed investment declined while other components of output continued to rise.1 Several explanations for these movements in investment have been advanced, including changes in inflation and interest rates; changes in relative prices; rapid technological advances that dramatically reduced the cost of processing information; the early unsustained vigor of the economic recovery; and frequent changes in important elements of tax policy.

This paper examines the behavior of business fixed investment in the United States over the course of the economic expansion and seeks to evaluate the relative importance of various contributing factors. It finds that a relatively conventional model can explain investment behavior quite well over this period and that—despite suggestions to the contrary by many commentators—evidence of parameter instability is limited.

The paper is organized as follows. Section I reviews recent changes in the composition of business fixed investment in the context of longer-term trends. Section II provides some empirical evidence on the relation-ship between the major components of business fixed investment and their determinants, especially the cost of capital. These relationships are then used in Section III to examine the extent to which the behavior of investment may be attributed to changes in financial conditions, to changes in fiscal incentives, and to the general expansion of the economy and other factors. Conclusions are presented in Section IV.

I. The Behavior of Fixed Investment in the Present Expansion

In the economic expansion in the 1980s, business fixed investment rose rapidly in the initial phase and then stagnated in the period to mid-1987—in contrast to other expansions of comparable length (upper panel, Figure 1). This section outlines the behavior of business fixed investment since 1982 in the context of previous cyclical episodes and provides a point of departure for the empirical work presented later.

Figure 1.U.S. Business Fixed Investment

1 The troushs in business fixed investment used were 1961, first quarter; 1975, second quarter; and 1983, first quarter.

After declining substantially during the recession of 1981/82, nonresidential gross fixed investment reached a trough in the first quarter of 1983.2 It began to rise rapidly thereafter, against a background of exceptionally strong growth of real GNP. From mid-1985 to mid-1987, however, the level of business fixed investment declined appreciably while real GNP growth tapered off to an annual rate of 2–3 percent.

During the first seven quarters of this expansion (up to the end of 1984) business fixed investment rose more than twice as rapidly as in comparable periods of earlier recoveries (see Table 1).3 Expansion took place against a background of fiscal incentives for investment that were made especially generous under the Economic Recovery and Tax Act (ERTA) of 1981, particularly with regard to depreciation allowances. Investment growth continued until mid-1985 but began to falter thereafter, despite the continued rise of real GNP. Investment in nonresidential structures peaked in the second quarter of 1985 and then plunged in the period up to the second quarter of 1987. Investment in producers’ durable equipment reached a peak in the fourth quarter of 1985 and subsequently fluctuated close to that level. This curtailment of investment spending—while overall economic expansion continued—was in sharp contrast to the pattern evident in the upswings of the mid-1960s and late 1970s, which typically saw an acceleration of investment as the cycle progressed. The slowing down of investment coincided with legislation (culminating in the Tax Reform Act (TRA) of 1986) that withdrew tax concessions for capital spending.

Table 1.Change from Recession Trough(In percent)

Business Fixed




First seven quarters of recovery
Seventeen quarters of expansion

Variations in the growth profiles of the components of business fixed investment were also pronounced during this expansion. With regard to the major components of producers’ durable equipment, spending on high-technology items (primarily computers) and equipment for transportation, construction, and agriculture rose substantially from the first quarter of 1983 to the fourth quarter of 1985 (Table 2), while investment in heavy industrial equipment increased less rapidly. From the fourth quarter of 1985 to the second quarter of 1987, producers’ durable investment was essentially unchanged, with the high-technology component rising and with equipment for heavy industry, transportation, construction, and agriculture declining.

Table 2.Components of U.S. Nonresident Fixed Investment
(Percentage change from first quarter of 1983)(Percentage change from fourth quarter of 1985)
Business fixed investment114.330.136.228.2-4.7-5.9
Producers’ durable equipment21.339.349.048.80.2-0.2
High technology23.558.485.
Heavy industry8.122.825.523.11.1-2.0
Construction and agriculture42.840.449.538.7-11.9-7.3
Nonresidential structures2.614.814.8-6.1-15.3-18.2
Public utilities2.6-4.7-8.4-
Petroleum drilling and mining5.813.7-3.6-39.3-41.3-37.1
Memorandum items:
Business fixed investment, excluding petroleum, etc.15.231.940.735.8-1.9-3.5
Nonresidential structures, excluding petroleum1.515.221.66.2-7.7-12.7
Sources: U.S. Department of Commerce, Bureau of Economic Analysis, and Fund staff calculations. The data used do not include the revisions to historical series made available in July 1988.

With respect to the major components of investment in nonresidential structures, the sharpest divergence has been between petroleum drilling and mining and nonresidential structures excluding petroleum, as a result of pronounced fluctuations in the world price of oil. In the seven quarters to the end of 1984, investment in petroleum drilling and mining rose by 14 percent, before dropping during 1985 under the influence of a falling real oil price. During 1986, when the world price of oil plummeted, mining and drilling investment dropped by 41 percent; by 1987, the share of such investment in total nonresidential investment was only half of what it had been when the recovery began (Figure 2).

Figure 2.U.S. Nonresidential Structures as a Percentage of Real Nonresidential Fixed Investment

Investment in nonresidential structures excluding petroleum drilling and mining increased by 22 percent from the recession trough to the fourth quarter of 1985, driven primarily by investment in commercial structures, which include office buildings and hotels—a component strongly influenced by tax concessions in the ERTA. From the fourth quarter of 1985 to the second quarter of 1987, investment in nonresidential structures excluding petroleum fell by 12½ percent.

These variations in growth patterns among the components of business fixed investment are to an extent a continuation of longer-term trends. As illustrated in the lower panel of Figure 1, the share of producers’ durable equipment in total real business fixed investment increased from 51 percent in 1958 to nearly 71 percent in 1986, while the share of nonresidential structures declined correspondingly. The increased share of producers’ durable equipment has been primarily accounted for by high-technology goods (upper panel, Figure 3), resulting from dramatic advances in the quality—and sharp declines in the prices—of computing equipment in recent years.4 In contrast, the share of heavy industry equipment has dropped markedly in the 1980s, reflecting the long-term decline in the relative importance of this sector.

Figure 3.U.S. Producers’ Durables as a Percentage of Real Nonresidential Fixed Investment

The strongest increases in gross business fixed investment have been in assets with relatively short service lives. For example, almost two thirds of the increase in business fixed investment during the present recovery has been accounted for by high-technology goods, which consist mainly of computing equipment; these have an estimated average service life of less than ten years (Table 3).5

Table 3.Selected Service Lives by Type of Asset
ItemService Life

(In years)
Share of Gross Fixed

Business Investment

(In percent)
Office, computing, and accounting machinery81.316.2
Trucks, buses, and trailers97.79.6
Electrical and communications142.89.3
Public utilities26–5112.65.4
Sources: U.S. Department of Commerce, Bureau of Economic Analysis, and Fund staff calculations.

As the investment mix has shifted toward short-lived assets, the average service life of gross additions to the capital stock has declined markedly (upper panel, Figure 4). The volume of investment necessary to maintain the existing capital stock has increased along with the decline in the average service life of the capital stock. As a result, the ratio of depreciation to gross nonresidential fixed investment has exhibited a distinct upward trend since the late 1960s (lower panel, Figure 4).

Figure 4.U.S. Nonresidential Fixed Investment: Service Life and Depreciation

The rising trend in the proportion of gross investment devoted to replacement has been reflected in an increasing gap between gross and net investment. The ratio of gross business fixed investment to GNP (both measured in constant dollars) rose relatively steadily over the past three decades, and reached a postwar high in 1985 before declining in 1986 (upper panel, Figure 5). By contrast, the ratio of net investment to net national product has not exhibited a long-term rising trend, and in recent years has remained well below its historical peak. The net addition to the productive capital stock in 1983 was near a postwar low despite the strong upturn in gross fixed investment, and it remained low by historical standards in 1984–86 (lower panel, Figure 5).

Figure 5.U.S. Gross and Net Nonresidential Fixed Investment

(in percent)

II. The Determinants of Business Fixed Investment

The empirical framework developed in this paper relates business fixed investment to its proximate macroeconomic determinants—aggregate demand, the cost of funds, and tax factors. The aims are to determine whether the unusual behavior of fixed investment in the economic expansion in the 1980s can be adequately explained in a relatively aggregative framework and to examine the importance of tax effects in that explanation. Although the aggregate determinants of investment are themselves endogenous to the economic system, no attempt is made to analyze business investment in terms of more fundamental explanations—such as fiscal and monetary policies and changes in technology. This section first provides a brief review of other studies. Then it presents the theoretical basis underlying one commonly used formulation of investment equations, together with estimation results and details on the construction of the cost of capital variables—the variables through which the effects of fiscal incentives are transmitted to investment.

Review of Other Studies

Analyses of business fixed investment in the United States may be divided into several categories. One group of studies treats investment in terms of its fundamental determinants, such as fiscal and monetary policies, using complete macroeconomic models of the U.S. economy (for example, Brayton and Clark (1985)). A second approach—the most common one in the literature and the one into which category this study falls—is essentially partial equilibrium and relates investment to its proximate macroeconomic determinants. A third approach dismisses conventional empirical techniques and argues that changes in tax incentives in recent years have been so powerful as to invalidate the conventional macroeconomic approach to the behavior of business investment (for example, Roberts (1982)). But whatever the analytical approach taken, the dominant issue in recent empirical studies of fixed investment has been the importance of fiscal incentives. Excellent surveys of the literature on the impact of tax policy on business investment have been provided by Bosworth (1984) and Chirinko (1986). These surveys note that overall agreement does not appear to exist on the role of tax policy: some studies ascribe very little influence to tax variables in affecting the course of business fixed investment, whereas others indicate a more substantial role. To the extent that a consensus exists, it appears to be that the predominant determinants of business fixed investment are major macroeconomic variables, such as the rate of growth of output, the level of interest rates, and the state of inflationary expectations. Tax policy, although found generally significant, appears to play a subsidiary role.

One substantial strand of the literature involves assessing the impact on business fixed investment of the ERTA of 1981 and the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, the relevant provisions of which are outlined in the annex. Bosworth (1985) examined the behavior of business investment from 1981 to 1984 and suggested that tax policy may not have been the major factor stimulating the growth of business investment. Although he found that aggregate equations under-predicted investment growth, the areas of strongest increase were not those that had received the greatest stimulus from tax policy. Brayton and Clark (1985) performed simulations using the Federal Reserve/MPS model of the U.S. economy. They found quite substantial ERTA/TEFRA effects on business investment, but the bulk of the impact stemmed from the multiplier/accelerator mechanism on output, with the magnitude of the pure tax policy effect—operating through the cost of capital—somewhat smaller. Sahling and Akhtar (1985) estimated two standard investment models—one based on the specification in the MPS model and the other on that of the Bureau of Economic Analysis model. They found that conventional aggregative models tracked behavior quite well, and that the fast growth in business investment in plant and equipment in the early phase of the current expansion stemmed primarily from the rapid increase in output and the steep decline in the cost of funds. The role attributed to changes in tax policy was significant but secondary. Meyer (1984), also employing an approach that relied on the cost of capital, found that changes in tax policy helped to explain changes in investment behavior, but by no means fully. By contrast, Feldstein and Jun (1986) found more substantial tax policy effects than most other studies, but their methodology appeared to confound the conceptually distinct influences of changes in statutory tax policy and changes in effective tax rates attributable to variations in inflation and the associated taxation of artificial inventory profits.

A second major strand of the literature examines the potential impact of the TRA of 1986 on business fixed investment. This body of research is discussed in Evans and Kenward (1988) and will thus not be reviewed at length here. The essential conclusion from that literature is that the TRA raised the cost of capital for both machinery and equipment and nonresidential structures through the elimination of the investment tax credit and the shift to less generous depreciation allowances. These factors are generally judged likely to outweigh a possible enhancement of the efficiency of investment resulting from the shift to a more neutral tax system.

A distinguishing feature of the empirical results presented later in the present paper is that the effects of all major tax policy changes undertaken thus far in the 1980s—ERTA/TEFRA and TRA—are treated in a common framework permitting an overall evaluation to be made. Most other studies have analyzed one episode or the other but not both.

Investment Equations

The equations used in this study are based on the standard neoclassical theory of capital accumulation, according to which the optimal combination of factor inputs used by firms depends on the relative prices of those inputs. If output is produced under competitive conditions and if the production function is of the Cobb-Douglas type, the desired capital stock at each point in time will be given by the expression:6


Kd = desired net capital stock

Y = output

C = real user cost of capital

α = a constant.

The flow of net investment is the change in the actual capital stock as it adjusts toward a new desired level. Because the actual capital stock can be changed only gradually over time, net investment (that is, the change in the net capital stock) will depend on current and lagged values of the desired capital stock:


ItN = net investment

and where

is a polynomial in the lag operator, L, such that (Ljxt = xt-j). Combining equations (1) and (2) and assuming that replacement investment is proportional to the lagged capital stock, we can write gross investment, Ig, as

where γ(L) = αβ(L), and δ is the rate of economic depreciation.

Equations such as equation (3)—pioneered by Jorgenson (see Hall and Jorgenson (1967))—are commonly used in empirical studies of investment behavior (for example, Kopcke (1985)). The variation that is used in this paper is based on the work of Bischoff (1971), as interpreted by Clark (1979). Bischoff’s version of the neoclassical model incorporates the empirical observation that most changes in the capital-output ratio are embodied in new equipment and structures; existing capital goods are less often modified in response to fluctuations in the cost of capital. On this basis, Bischoff allows for different lags on the output and relative price terms so that the level of investment is affected by the level of relative prices and the change in output. That is,

Equation (4) was used in the empirical work presented subsequently, although it was found that the restrictions γ1i = –γ2i could be imposed, resulting in gross investment being a function of a distributed lag on the change in output divided by the level of the cost of capital.

Fiscal Incentives and the Cost of Capital

The cost of capital (C) plays a central role in the theory of investment outlined in the previous subsection. This concept stems from the neoclassical theory of optimal capital accumulation (Hall and Jorgenson (1967)) in which the price of a capital asset is equated to the present value of after-tax services expected to accrue from that good. According to this approach, the cost of capital in real terms may be expressed as follows:7


u = the marginal corporate tax rate

i = the average cost of funds8

δ = the rate of economic depreciation

p˙e = the expected rate of change of the price of fixed assets9

τ = the tax rate on capital gains10

k = the investment tax credit per dollar of new investment

z = the present value of a dollar of depreciation deductions

q = the price of capital assets relative to the GNP deflator.

An important implicit assumption in the traditional cost of capital formulation is that each asset is depreciated for tax purposes only once. However, as observed by Gordon, Hines, and Summers (1986), if a liquid secondary market exists for a particular asset category (as, for example, with several types of transportation equipment and pre-eminently with commercial structures), it may be possible for an asset to be depreciated for tax purposes several times by different owners. Such a practice—described as “asset churning”—would likely magnify the effects of depreciation concessions for such assets and, concomitantly, would magnify the negative effects stemming from withdrawal of previous concessions. Gordon, Hines, and Summers suggest that such a process may have been at work in the case of hotels and office buildings, for which investment expenditure rose sharply in the wake of the ERTA; subsequently, a sharp decline occurred in such expenditures when it became clear that the TRA would curtail previously generous depreciation allowances.

Capital gains taxation raises the level of the cost of capital—via the expected inflation term—and affects the time profile when either tax rates or inflation are changing (see equation (5)). In constructing the cost of capital in real terms, the variable τ is approximated in the empirical work by the (legislated) maximum rate on capital gains. Note, however, that this construction may not be representative of the effective capital gains tax rate because capital gains are often deferred or excluded from tax at the end of the lifetime of the asset. To illustrate the implications of alternative assumptions about the tax rate on capital gains, two measures of the cost of capital variables are provided in Table 4. The first measure sets the capital gains tax rate to its maximum, whereas the second sets the tax rate to zero. The effect of setting the capital gains tax rate to zero is to lower the level of the cost of capital, especially in the early part of the decade when inflation was high.

Table 4.The Cost of Capital Under Alternative Views of Capital Gains Taxation
Real cost of capital
With capital gains tax rate set to maximum rate9.
With capital gains tax rate set to zero8.
Real cost of capital
With capital gains tax rate set to maximum rate7.
With capital gains tax rate set to zero5.


Equations corresponding to equation (4) above were estimated by ordinary least squares (with a correction for serial correlation) over sample periods beginning in the first quarter of 1964. All variables were normalized with respect to middle expansion path GNP, to reduce potential heteroscedasticity, and the restrictions γ1i = –γ2i were imposed, as noted earlier.11

The changes in the investment tax laws during the 1980s were substantial and, in the case of the TRA, involved a fundamental shift in philosophy away from the previous approach of using tax concessions to encourage investment. Some commentators (for example, Roberts (1982)) have argued that economic behavior shifted fundamentally after the tax legislation of the early 1980s, in ways that would not be captured by a traditional approach. Under these circumstances, a conventional investment function such as equation (4) could well fall victim to the so-called Lucas critique.12 In particular, after a change in tax regime, the behavioral responses of economic agents—in this instance, businesses—might change, with the result that empirical parameters, such as the Cobb-Douglas coefficient (α) or the adjustment coefficients (γ), might not be constant over time. Such a result would undermine the simulations reported in the next section.

With this in mind, Chow-Fisher tests to examine parameter stability were conducted. The equations were first estimated over a period to the third quarter of 1981, before the introduction of the ERTA. The estimation period was then extended to the fourth quarter of 1985, covering the implementation of the ERTA and TEFRA. Finally, the equations were estimated over a period extending to the second quarter of 1987. The producers’ durable equipment equation passed the tests at the 5 percent significance level for both of the subperiods. The structures equation exhibited stability in the first subperiod but marginally failed the Chow-Fisher test at the 5 percent significance level—although it passed at the 1 percent significance level—in the second subperiod. Reflecting these results, the out-of-sample dynamic forecast performance of the structures equation from the first quarter of 1986 to the second quarter of 1987 was poor, whereas the machinery and equipment equation tracked developments reasonably well. A large part of the forecast error pertaining to the structures equation stemmed from the collapse of investment in the oil sector following the oil price fall at the end of 1985. This factor is not captured in the structures equation.

Passing a Chow-Fisher test is only a necessary condition—it is not sufficient—for parameter stability; nevertheless, the test results provide some confidence that tax legislation of the 1980s did not alter fundamental investment behavior so that the effects of the tax changes can be adequately analyzed via their effects on the cost of capital using the empirically estimated equations. For the purpose of the counterfactual simulations discussed in Section III, the fourth quarter of 1985 was chosen as the estimation end period for both equations, reflecting a desire to utilize as much information in the data sample as possible while retaining some residual doubts about parameter stability in the structures equation after the introduction of the TRA.

Producers’ Durable Equipment


w0 = 0.0066 (4.8)

w1 = 0.0096 (8.6)

w2 = 0.0118 (10.5)

w3 = 0.0132 (11.0)

w4 = 0.0139 (11.1)

w5 = 0.0140 (11.0)

w6 = 0.0136 (10.6)

w7 = 0.0127 (10.0)

w8 = 0.0115 (8.9)

w9 = 0.0100 (7.6)

w10 = 0.0083 (6.3)

w11 = 0.0066 (5.1)

w12 = 0.0047 (4.0)

w13 = 0.0030 (3.2)

w14 = 0.0014 (2.4)

and where Σwi = 0.1410; R¯2 = 0.967; DW = 2.15; ρ = 0.82 (13.0); and the sample period was 1964:1–1985:4.

Nonresidential Structures


v0 = 0.00121 (2.6)

v1 = 0.00162 (3.9)

v2 = 0.00189 (4.2)

v3 = 0.00203 (4.1)

v4 = 0.00207 (4.0)

v5 = 0.00201 (3.9)

v6 = 0.00188 (3.6)

v7 = 0.00168 (3.2)

v8 = 0.00143 (2.8)

v9 = 0.00115 (2.3)

v10 = 0.00085 (1.8)

v11 =0.00055 (1.4)

v12 = 0.00026 (1.1)

and where Σvi = 0.01863; R¯2 = 0.944; DW = 1.44; ρ = 0.92(20.0); and the sample period was 1964:1–1985:4.

The notation for the foregoing is as follows:

IE = investment in producers’ durable equipment, 1982 dollars

IS = investment in nonresidential structures, 1982 dollars

Y = GNP, 1982 dollars

Y* = middle expansion path GNP, 1982 dollars13

CE = the real cost of capital for producers’ durables

CS = the real cost of capital for nonresidential structures

KS and KE = the stock of nonresidential structures, 1982 dollars, and the stock of producers’ durable equipment, 1982 dollars, respectively14

D = a dummy variable to allow for credit controls in 1980:2

R¯2 = the adjusted coefficient of determination

DW = the Durbin-Watson statistic

ρ = the estimated serial correlation coefficient.

The coefficients wi and vi, were estimated using third-degree Almon polynomial distributed lags with a zero end-point constraint; figures in parentheses beneath coefficients are t-statistics.

III. Simulations with the Model

The estimated equations explain business fixed investment in terms of its proximate macroeconomic determinants, such as output, expected inflation, the cost of funds, and tax variables. In this section, the results of simulations that assess the relative importance of the various contributing factors—in particular changes in tax incentives—are reported.

An additional avenue—the importance of which cannot be assessed in the present framework—through which changes in tax policy may affect macroeconomic performance is through the efficiency of investment rather than its magnitude. By reducing or eliminating a large number of tax preferences, the TRA sought to “level the playing field”—that is, to ensure that different investment projects are taxed similarly—so that investment choices could be made on the basis of economic considerations rather than for tax reasons. According to the 1987 Report of the Council of Economic Advisers, the investment efficiency effect of the TRA would probably be to raise the level of output by only 0.1 percent in the long run;15 consequently the failure to incorporate this channel of influence is unlikely to be of major importance.

The Effects of Tax Policy on the Cost of Capital

The ERTA of 1981 reflected the underlying view that had prevailed through much of the 1960s and 1970s—that the tax code should be used to encourage some activities and discourage others. In this instance, the activity to be encouraged was capital formation, and to this end incentives were provided to promote business fixed investment. The investment tax credit (ITC) was liberalized to cover a broader range of short-lived equipment, and the Accelerated Cost Recovery System (ACRS) for asset depreciation was introduced. Both these measures reduced the after-tax cost of capital for new equipment and nonresidential structures; the extension of the ITC to a broader range of equipment raised the value of the variable k in equation (5), while the ACRS increased the present value of depreciation allowances—the variable z in equation (5).

Under the TEFRA of 1982, tax incentives for investment were reduced, offsetting in part the effects of the ERTA.16 The rationale for the changes was essentially twofold: first, it was judged necessary to take measures aimed to reduce fiscal deficits, and second, the reduction in taxation of corporate income resulting from the ERTA had led to concerns about tax equity. The planned extension of the ACRS toward even more favorable depreciation methods (175 percent declining balance compared with 150 percent declining balance under the ERTA) was withdrawn. In addition, some of the benefits of the ITC were withdrawn by reducing the depreciable base of assets by 50 percent of the ITC. Notwithstanding the changes introduced in the TEFRA, the underlying approach of using the tax code to encourage business investment remained in place.

The TRA of 1986 made further substantial changes in tax laws affecting business fixed investment.17 In particular, the underlying philosophy of tax policy with regard to business investment became substantially less interventionist; henceforth, the tax code was to be as neutral as possible, rather than actively encouraging investment. The new view was that the additional investments encouraged by tax preferences were likely to be relatively inefficient. Consequently, it was better for investment decisions to be made with reduced attention to tax consequences. Such a result could be achieved by eliminating investment incentives and at the same time lowering tax rates. In this vein, the ITC was abolished, effective the beginning of 1986, although the legislation was not passed until late in the year; depreciation schedules for both equipment and structures were made substantially less generous; and the maximum tax rate on capital gains was raised to 28 percent, while the maximum corporate tax rate was reduced from 46 percent to 34 percent, effective 1988.18

Figure 6 and Table 5 show the estimated effects of tax policy changes on the real after-tax cost of capital since 1981. In the case of equipment, the effect of the ERTA was to raise the present value of a dollar of depreciation allowances from 78 cents to 86 cents. The changes in depreciation allowances, when combined with the more generous ITC, lowered the real cost of capital for equipment by 1 percentage point in 1982. As regards structures, the present value per dollar of depreciation allowances increased, owing to the ERTA, from 46 cents to 65 cents. As a result, the cost of capital for structures was 1¼ percentage points lower than it would have been without the ERTA.

Figure 6.U.S. Real User Cost of Capital

Table 5.Effect of Tax Changes on the Real Cost of Capital

Half of

Present value of depreciation allowances10.860.880.880.890.910.89
Excluding tax policy changes20.780.820.820.830.860.86
Real cost of capital9.
Excluding tax policy changes210.69.310.
Present value of depreciation allowances10.650.700.670.660.710.53
Excluding tax policy changes20.460.520.500.530.590.61
Real cost of capital7.
Excluding tax policy changes28.
Note: Figures for the present value of depreciation allowances are in dollars; those for the cost of capital are in percent. Figures exclude relative price effects.

The benefit of the ITC on producers’ durable equipment was reduced by the TEFRA in 1983, offsetting in part the effects of the ERTA on the cost of capital (see Table 5). In 1983, the combined effects of ERTA/TEFRA lowered the cost of capital for equipment by ¾ percentage point relative to what it would have been without both pieces of legislation. In the case of structures, both the TEFRA and the 1984 Deficit Reduction Act (DEFRA) had little impact on the cost of capital. In 1984, the combined effect of all three pieces of legislation was to lower the cost of capital for structures by 1¼ percentage points compared with what it would have been otherwise.

As noted above, the TRA of 1986 brought about further major changes in business taxation. The net effect was to increase substantially the cost of capital for both equipment and structures. The combined effect of ERTA/TEFRA/DEFRA and TRA was to push up the cost of capital for equipment and structures by 1¼ and ½ percentage points, respectively, relative to what they would have been without all this legislation.

Tax Policy Simulations

The first tax policy simulation was performed by assuming no change in the tax treatment of investment over the period 1981–87, and by comparing the path of investment simulated under that assumption with the path of investment predicted by the equation.19 Actual values of output and interest rates were used in the simulation; no attempt was made to determine the secondary effects of tax policy on these variables or any repercussions of these effects on investment. The results of the simulation are presented in Table 6. On this basis, the stimulative effect of the legislative changes on investment amounted to roughly 2 percent of the level of both producers’ durable equipment and nonresidential structures by 1985.

Table 6.Sources of Change in U.S. Business Fixed Investment(As percentage of investment in the first quarter of 1983)
YearActual ChangeNormal Output


Average Output Recovery2
Lower Cost

of Funds3
Changes in


Tax Policy5Petroleum


Nonresidential fixed investment
Producers’ durable equipment
Nonresidential structures

By the second quarter of 1987, with the negative effects of the TRA beginning to feed through, the joint impact of tax policy on both components of business fixed investment was estimated to have been positive by 1 percent—relative to a baseline simulation in which none of the packages was enacted. Alternatively stated, these tax policy changes accounted for 1.4 percentage points of cumulative investment growth from the first quarter of 1983 to the second quarter of 1987.

To assess the long-run implications of the various tax packages, simulations were conducted from 1981 to 1991, with baseline values for the period 1987:3–1991:4 for GNP, interest rates, and inflation in line with the August 1987 version of the Fund’s World Economic Outlook exercise. This approach was made necessary because the full impact of the TRA (which took effect only in late 1986) would not be fully evident in simulations terminating in mid-1987. The results suggested that, by 1991, the effects of the TRA on business fixed investment would dominate those from the ERTA/TEFRA; by the fourth quarter of 1991, total business fixed investment would be 1¾ percent lower than if the tax code had remained entirely as it was before 1981.

Other Simulations

Three other sets of simulations were carried out to indicate the contributions of different explanatory variables to the behavior of business fixed investment in the current expansion. In the first set of simulations, the average cost of funds was maintained at its exceptionally high level of the third quarter of 1982, whereas all other variables—including inflation—followed their actual historical paths.20 As a supplementary exercise, an additional experiment was run in which both the cost of funds and the inflation rate were held at their levels in the third quarter of 1982. In the second simulation, the growth of output was constrained to equal the average growth of output in the only two postwar expansions of comparable length to the present one (see footnote 1 to Table 6). In the final simulation, the deflators for the two categories of investment goods—which declined relative to the GNP deflator during the recovery—were constrained to increase at the same rate as the GNP deflator during the current expansion.

Summary of Simulation Results

The simulation results can be summarized according to factors affecting the growth of business investment in the period 1981–85 and in the period 1986–87.

Factors Underlying the Growth of Business Investment, 1981–85

The most important factor accounting for the rapid rise in business fixed investment in the first phase of the expansion was the robust growth of output, which accounted for almost three fourths of the total rise in fixed investment (Table 6). Among the other factors, the large drop in the cost of funds appears to have been the most important. Roughly three fourths of the effects attributed to the decline in the cost of funds stemmed from the reduction in real interest rates; the remainder reflected positive effects from the simultaneous decline in both the nominal cost of funds and the rate of inflation. When both the inflation rate and the nominal borrowing cost decline, the present value of depreciation allowances is raised, which lowers the cost of capital, while the real after-tax borrowing cost increases because of the tax deductibility of interest payments. In the simulation conducted, the former effect outweighed the latter. The effect of the changing relative price of capital goods had a somewhat smaller impact, as did changes in tax policy. Each of these factors explained about 2 percentage points of the 36 percent growth in business fixed investment in this period.21

The simulation results account almost fully for the actual rise in business fixed investment in the period. However, this result reflects in part offsetting errors in the equations for producers’ durable equipment and for nonresidential structures. The inability of each equation to explain fully the recent change in the composition of investment spending may reflect a shift in demand away from more traditional investment goods (such as industrial structures) toward high-technology items (such as electronic computing equipment) in which dramatic technological breakthroughs have occurred in recent years.

Factors Underlying the Behavior of Business Fixed Investment, 1986–87

From the fourth quarter of 1985 to the second quarter of 1987, spending on producers’ durable equipment remained roughly constant while investment in nonresidential structures plummeted. According to the simulation results presented in Table 6, the stagnation of spending on producers’ durable equipment largely reflected the subdued rate of output growth compared with corresponding periods of other expansions of comparable length. If output had grown as rapidly as in comparable periods of the expansions that began in 1960 and 1975, spending on producers’ durable equipment would have been over 10 percent higher by mid-1987 than it actually was. In addition, the cost of funds and relative prices, although still moving enough to raise investment, had effects less pronounced than during the earlier years of the expansion. Finally, the implementation of the TRA worked to reduce equipment spending.

The collapse of investment in nonresidential structures in the recent period is less well explained. Sluggish output growth played a role, and withdrawal of tax concessions was also important, as indicated in Table 6. A large part of the failure to explain developments in investment in structures in this period is due to the collapse in oil sector investment following the plunge in world oil prices. Nevertheless, even after this component is separated out (Table 6), a significant negative residual remains, leaving open the possibility that there are aspects of the TRA that are not adequately captured in cost-of-capital calculations—which would pertain if “asset churning” as discussed earlier had been a significant phenomenon.

IV. Conclusions

Business fixed investment in the United States grew rapidly in the early stages of the economic expansion in the 1980s. By contrast, from the end of 1985 to mid-1987, investment in producers’ durable equipment stagnated, while investment in nonresidential structures dropped sharply. A notable feature of the results of this paper is that these atypical developments in business fixed investment can largely be explained by a framework that relies on standard macroeconomic factors. Consequently, little support was found for the proposition that fundamental shifts in behavior had been unleashed by recent tax policy changes.

According to the simulations carried out, the major reason for the robust growth of investment—particularly regarding producers’ durable equipment—in the early years of the expansion was the rapid growth of output. The decline in the cost of funds was also important, while the falling relative prices of capital goods, and tax incentives provided by the 1981 and 1982 tax legislation, played significant—but distinctly subsidiary—roles. The argument that the exceptional strength of investment in this phase of the expansion was a direct consequence of tax policy is not borne out by the evidence. The estimated model captures well the growth of business fixed investment over this period, with tax policy effects significant but small.

The main reason for the stagnation of investment in producers’ durable equipment from late 1985 to mid-1987 is estimated to be the sluggish growth of output over that period, with the withdrawal of tax concessions under the TRA of 1986 having appreciable, but secondary effects. Even after allowing explicitly for the collapse in petroleum drilling and mining, the decline in the remainder of investment in nonresidential structures is less well explained by the framework presented, suggesting that other factors may have been at work. In particular, it cannot be ruled out that the withdrawal of tax concessions under tax reform may have had a more pronounced impact than is indicated here.

When simulations were conducted comparing actual business fixed investment with what would have occurred without all the tax packages over this period, the results indicated that the effect of the changes introduced in 1986 more than offset the effect of other changes in the tax code since 1981. Consequently, in the long run, it seemed likely that business fixed investment and the corporate capital stock could be lower than if none of these packages had been enacted.

ANNEX Principal Legislative Changes Affecting U.S. Business Fixed Investment, 1980–87

The Economic Recovery Tax Act (ERTA) was passed in August 1981 but was applicable to investment after December 31, 1980. Its main points included the following.

• The Accelerated Cost Recovery System (ACRS) was introduced for calculating depreciation allowances. Under this system the number of asset depreciation classes allowed under the previous Asset Depreciation Ranges (ADR) system was lowered to four and the average length of tax lives was reduced. For equipment, the average life is estimated to have fallen from 10.5 to 4.6 years; for structures, the estimated decline is from 40 years to about 15 years. Partially offsetting this shortening of tax lives was a change to less generous depreciation schedules. For equipment, the 150 percent declining balance method replaced the previously allowed 200 percent declining balance and sum-of-years digits methods under the ADR. More generous 175 percent declining balance methods were allowed for structures. Over the years 1983–86, the depreciation schedules were to become progressively more accelerated.

• The investment tax credit (ITC) was extended to some short-term assets not previously covered. For equipment, it is estimated that the average tax credit rose from 8.7 to 8.9 percent.

• Leasing laws were relaxed, making it easier for a firm without current profits to take full advantage of investment tax allowances through intermediate leasing firms.

The Tax Equity and Fiscal Responsibility Act (TEFRA), which was effective from January 1, 1983, contained the following changes.

• The acceleration of depreciation schedules that had been proposed under the ERTA was canceled.

• The depreciable base of an asset was reduced by 50 percent of the value of the ITC.22

• Some of the “safe-harbor” leasing clauses of the ERTA were made more restrictive, although leasing was still comparatively easier than in the period before 1981.

The Deficit Reduction Act (DEFRA), with effect from March 16, 1984, increased the top depreciation tax life from 15 years to 19 years.

The Tax Reform Act (TRA) took effect from October 22, 1986. Its enactment took almost a year to be completed, and some major provisions—such as the retroactive abolition of the ITC—had been widely anticipated since late 1985. The ITC was abolished effective the beginning of 1986. The depreciation life for nonresidential structures was raised from 19.0 years to 31.5 years, and for producers’ durable equipment, on average from 4.6 years to 6.0 years. Machinery and equipment were to be depreciated by 200 percent declining balance (previously 150 percent) and nonresidential structures by straight line (previously 175 percent declining balance). The maximum tax rate on capital gains was raised to 28 percent, and the maximum corporate tax rate was cut to 40 percent in 1987 and to 34 percent from 1988 onward, from 46 percent previously.


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This paper was published in Staff Papers, International Monetary Fund, Vol. 39 (March 1989), pp. 31–62.

The paper deals with data up to and including the second quarter of 1987. The data employed do not incorporate revisions to U.S. national accounts data made after July 1988. A subsequently written companion paper examined the role of computers in U.S. business investment (Evans (1989)).

Real gross national product (GNP) reached a trough in the third quarter of 1982, before rising slightly in the fourth quarter.

The episodes beginning in 1961 and 1975 are the only postwar upswings of comparable length to the expansion of the 1980s and were therefore chosen for comparison.

The implicit deflator for high-technology equipment fell by 23 percent from the first quarter of 1983 to the second quarter of 1987, compared with a 1 percent decline for the deflator for total business fixed investment and a 14 percent rise for the GNP deflator for the same period.

Details regarding estimates of average service lives are provided in Department of Commerce, Bureau of Economic Analysis (1982) and Musgrave (1976).

The assumption that the production function is of the Cobb-Douglas type (that is, that the elasticity of substitution between capital and labor in production is unitary) is critical and generates a specification that is potentially susceptible to large effects of tax policy and the cost of capital on investment.

For a derivation and detailed explanation of this formula, see Ott, Ott, and Yoo (1975). If there are no taxes (u = τ = k = 0), the formula reduces to C = q(i + δ – p˙e).

A weighted average of the ten-year BAA corporate bond rate, the Standard and Poor’s dividend/price ratio for common stocks, and the three-month U.S. Treasury bill rate, which is used as the alternative cost of internally generated funds. Both the BAA bond rate and the Treasury bill rate are entered on an after-corporate-tax basis. The weights are the respective proportions of total credit market debt owed by private business, an estimate of total business equity, and corporate cash flow in the sum of these items.

From 1979 onward, the ten-year-ahead survey of expected inflation conducted by Drexel Burnham Lambert, Inc. was used; prior to 1979, a four-quarter moving average of the University of Michigan’s survey of one-year-ahead consumer price expectations was used. A regression of the ten-year-ahead survey on the moving average of the Michigan survey over the period 1979–84 had yielded a regression coefficient of unity.

The maximum rate on capital gains.

The restrictions were not rejected at the 5 percent level by the appropriate F-test for both the structures and equipment equations.

Lucas (1976) criticized standard econometric techniques of policy evaluation, arguing that when government policy changes in a fundamental way—when there is a “regime change” in his terminology—private economic behavior would shift in response, invalidating the assumption of constant economic structure. Since the present paper was finalized, the authors have become aware of a paper by Chirinko (1988), which tests neoclassical investment equations for the kind of instability suggested by the Lucas critique and finds it to be of only minor importance.

See de Leeuw and Holloway (1983) and Holloway, Reeb, and Dunson (1986) for a discussion of this concept.

The series for the quarterly capital stocks were constructed by a two-stage process. First, given an assumed initial value, the actual quarterly gross investment flows, and depreciation rates, an initial quarterly capital stock series was constructed. The final quarterly series was then constructed by interpolating the available annual end-of-year capital stock series according to the pattern of the initially constructed series.

Presumably the previous extension of tax preferences under the ERTA had a negative investment efficiency effect, by making the playing field less level.

The measures affecting business fixed investment contained in the Deficit Reduction Act (DEFRA) of 1984 were relatively minor.

The provisions and possible implications of the TRA are discussed in detail in Evans and Ken ward (1988).

In 1987 the rate was 40 percent.

It was assumed that the retroactivity of the ERTA to the beginning of 1981 was not anticipated by investors; the simulation was carried out as if no change in legislation affecting the first three quarters of 1981 had taken place. But the retroactive abolition of the ITC under the TRA, effective from the beginning of 1986, was assumed to have been anticipated fully—because it was widely forecast in the financial press. The other provisions of the TRA were assumed to take effect from the first quarter of 1987.

In all simulations the capital stock was treated endogenously and assumed to accumulate in line with simulated investment.

Since a unitary elasticity of substitution in production between labor and capital was assumed, the specification was potentially favorable to the existence of large tax policy effects.

For example, in the case of an investment tax credit of 10 percent, the depreciable base of an asset became 95 percent of the purchase price.

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