1. 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 macro-economic models of the U.S. economy (for example, Brayton and Clark (1985)). A second approach--that which is most common in the literature and into which category this study falls--is essentially partial-equilibrium, and relates investment to its proximate macro-economic 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 macro-economic approach to the behavior of business investment (for example Roberts (1982)). However, 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 recently been provided by Bosworth (1984) and Chirinko (1986). These surveys note that overall agreement does not appear to exist as to the role of tax policy, with some studies ascribing very little influence to tax variables in affecting the course of business fixed investment, while 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, while generally found to be significant, appears to play a subsidiary role.

One substantial strand of the literature involves assessment of the impact on business fixed investment of the Economic Recovery and Tax Act (ERTA) of 1981 and the Tax Equity and Fiscal Responsibility Act (TEFRA) of 1982, the relevant provisions of which are outlined in Table 3. 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 underpredicted investment growth, the areas of strongest increase were not those which 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/acelerator 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 (BEA) 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 relying 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.

Table 3.

United States: Principal Legislative Changes Affecting Business Fixed Investment, 1980–87

^1/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.

Table 3.

United States: Principal Legislative Changes Affecting Business Fixed Investment, 1980–87

1981	The Economic Recovery Tax Act (ERTA) was passed in August 1981 but was applicable to investment after December 31, 1980. Its main points included: (i) The introduction of the Accelerated Cost Recovery System (ACRS) for calculating depreciation allowances. Under this system the number of asset depreciation classes allowed under the previous Asset Depreciation Ranges System (ADR) 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 to about 15 years. Partly 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 ADR. More generous 175 percent declining balance methods were allowed for structures. Over the years 1983-86, the depreciation schedules were scheduled to become progressively more accelerated. (ii) 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. (iii) 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.
1982	The Tax Equity and Fiscal Responsibility Act (TEFRA) which was effective from January 1, 1983 contained the following changes: (i) The acceleration of depreciation schedules that had been proposed under ERTA was canceled. (ii) The depreciable base of an asset was reduced by 50 percent of the value of the ITC. 1/ (iii) 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.
1984	The Deficit Reduction Act (DEFRA), with effect from March 16, 1984 increased the top depreciation tax life from 15 to 19 years.
1986	The Tax Reform Act (TRA) took effect from October 22, 1986. Its enactment took almost 12 months to be completed, and some major provisions--such as the retroactive abolition of the investment tax credit--had been widely anticipated since late 1985. The investment tax credit was abolished effective from the beginning of 1986. The depreciation life for nonresidential structures was raised from 19 to 31.5 years, and for producers’ durable equipment on average from 4.6 to 6 years. Machinery and equipment was 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 cut to 40 percent in 1987 and 34 percent from 1988 onward, from 46 percent previously.

^1/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.

View Table

Table 3.

United States: Principal Legislative Changes Affecting Business Fixed Investment, 1980–87

1981	The Economic Recovery Tax Act (ERTA) was passed in August 1981 but was applicable to investment after December 31, 1980. Its main points included: (i) The introduction of the Accelerated Cost Recovery System (ACRS) for calculating depreciation allowances. Under this system the number of asset depreciation classes allowed under the previous Asset Depreciation Ranges System (ADR) 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 to about 15 years. Partly 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 ADR. More generous 175 percent declining balance methods were allowed for structures. Over the years 1983-86, the depreciation schedules were scheduled to become progressively more accelerated. (ii) 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. (iii) 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.
1982	The Tax Equity and Fiscal Responsibility Act (TEFRA) which was effective from January 1, 1983 contained the following changes: (i) The acceleration of depreciation schedules that had been proposed under ERTA was canceled. (ii) The depreciable base of an asset was reduced by 50 percent of the value of the ITC. 1/ (iii) 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.
1984	The Deficit Reduction Act (DEFRA), with effect from March 16, 1984 increased the top depreciation tax life from 15 to 19 years.
1986	The Tax Reform Act (TRA) took effect from October 22, 1986. Its enactment took almost 12 months to be completed, and some major provisions--such as the retroactive abolition of the investment tax credit--had been widely anticipated since late 1985. The investment tax credit was abolished effective from the beginning of 1986. The depreciation life for nonresidential structures was raised from 19 to 31.5 years, and for producers’ durable equipment on average from 4.6 to 6 years. Machinery and equipment was 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 cut to 40 percent in 1987 and 34 percent from 1988 onward, from 46 percent previously.

^1/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.

A second major strand of the literature examines the potential impact of the Tax Reform Act (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 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.

2. 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: ⁸

where

• K^d = 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 (i.e., the change in the net capital stock) will depend on current and lagged values of the desired capital stock:

where

${\mathrm{I}}_{\mathrm{t}}^{\mathrm{N}}$ = net investment and

is a polynomial in the lag operator, L, such that (L^jx_t= x_t-j). Combining (1) and (2) and assuming that replacement investment is proportional to the lagged capital stock, we can write gross investment, I^g, as:

where

• γ(L) = αβ(L) and

• δ is the rate of economic depreciation.

Equations such as (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 γ_1i = γ_2i 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.

3. 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 sub-section. 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: ⁹

where,

• u = the marginal corporate tax rate.

• i = the average cost of funds. ¹⁰

• δ = the rate of economic depreciation.

• ṗ^e = the expected rate of change of the price of fixed assets. ¹¹

• τ = the tax rate on capital gains. ¹²

• 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 is the case, 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 et al 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 Economic Recovery and Tax Act of 1981; subsequently there was a sharp decline in such expenditures when it became clear that the Tax Reform Act of 1986 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. It may be noted, however, that this 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 the following tabulation. The first measure sets the capital gains tax rate to its maximum, while 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.

		1982	1983	1984	1985	1986
Equipment
Real cost of capital
	With capital gains tax rate set to maximum rate	9.7	8.6	9.4	9.3	8.3
	With capital gains tax rate set to zero	8.1	7.3	8.2	8.3	7.3
Structures
Real cost of capital
	With capital gains tax rate set to maximum rate	7.2	5.1	5.9	5.8	4.5
	With capital gains tax rate set to zero	5.2	3.4	4.3	4.5	3.2

View Table

		1982	1983	1984	1985	1986
Equipment
Real cost of capital
	With capital gains tax rate set to maximum rate	9.7	8.6	9.4	9.3	8.3
	With capital gains tax rate set to zero	8.1	7.3	8.2	8.3	7.3
Structures
Real cost of capital
	With capital gains tax rate set to maximum rate	7.2	5.1	5.9	5.8	4.5
	With capital gains tax rate set to zero	5.2	3.4	4.3	4.5	3.2

4. Estimation

Equations corresponding to (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 in order to reduce potential heteroskedasticity, and the restrictions γ_li = -γ_2i were imposed, as noted earlier. ¹³

The changes to the investment tax laws during the 1980s were substantial and, in the case of the Tax Reform Act of 1986 (TRA), involved a fundamental shift in philosophy away from the previous approach of using tax concessions to encourage investment. Under these circumstances, a conventional investment function such as equation (4) could well fall victim to the so-called Lucas critique. ¹⁴ 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-Doublas coefficient (a) 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 ERTA. The estimation period was then extended to the fourth quarter of 1985, covering the implementation of 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 these sub-periods. The structures equation exhibited stability in the first sub-period but marginally failed the Chow test at the 5 percent significant level--although it passed at the 1 percent significance level--in the latter sub-period. 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 while 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 test is only a necessary condition--it is not sufficient--for parameter stability; nevertheless, the test results provide some confidence that the 1980s tax legislation 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 IV, the estimation end period for both equations was chosen to be the fourth quarter of 1985, 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 TRA.

1. The effects of tax policy on the cost of capital

The 1981 Economic Recovery and Tax Act reflected the underlying view which 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 investment tax credit to a broader range of equipment raised the value of the variable k in equation (5) while ACRS increased the present value of depreciation allowances--the variable z in equation (5).

Under the 1982 Tax Equity and Fiscal Responsibility Act (TEFRA), tax incentives to investment were reduced, offsetting in part the effects of ERTA. ¹⁸ The rationale for the changes was essentially twofold: first it was judged necessary to take measures aimed at reducing fiscal deficits, and second, the reduction in taxation of corporate income resulting from ERTA had led to concerns about tax equity. The planned extension of ACRS toward even more favorable depreciation methods (175 percent declining balance compared with 150 percent declining balance under 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 TEFRA, the underlying approach of using the tax code to encourage business investment remained in place.

The Tax Reform Act of 1986 (TRA) made further substantial changes to tax laws affecting business fixed investment. ¹⁹ 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 investment tax credit was abolished, effective from 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 from 1988. ²⁰

Effect of Tax Changes on the Real Cost of Capital ²¹

Effect of Tax Changes on the Real Cost of Capital ²¹

			1982	1983	1984	1985	1986	First Half 1987
A. Equipment
	Present value of depreciation allowances 22		0.86	0.88	0.88	0.89	0.91	0.89
		Excluding tax policy changes 23	0.78	0.82	0.82	0.83	0.86	0.86
	Real cost of capital		9.7	8.6	9.4	9.3	8.3	9.6
		Excluding tax policy changes 23/	10.6	9.3	10.2	10.0	8.8	8.3
B. Structures
	Present value of depreciation allowances 22/		0.65	0.70	0.67	0.66	0.71	0.53
		Excluding tax policy changes 23/	0.46	0.52	0.50	0.53	0.59	0.61
	Real cost of capital		7.2	5.1	5.9	5.8	4.5	5.0
		Excluding tax policy changes 23/	8.5	6.3	7.2	6.9	5.2	4.5

View Table

Effect of Tax Changes on the Real Cost of Capital ²¹

			1982	1983	1984	1985	1986	First Half 1987
A. Equipment
	Present value of depreciation allowances 22		0.86	0.88	0.88	0.89	0.91	0.89
		Excluding tax policy changes 23	0.78	0.82	0.82	0.83	0.86	0.86
	Real cost of capital		9.7	8.6	9.4	9.3	8.3	9.6
		Excluding tax policy changes 23/	10.6	9.3	10.2	10.0	8.8	8.3
B. Structures
	Present value of depreciation allowances 22/		0.65	0.70	0.67	0.66	0.71	0.53
		Excluding tax policy changes 23/	0.46	0.52	0.50	0.53	0.59	0.61
	Real cost of capital		7.2	5.1	5.9	5.8	4.5	5.0
		Excluding tax policy changes 23/	8.5	6.3	7.2	6.9	5.2	4.5

Chart 6 and the above tabulation 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 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 due to ERTA from 46 cents to 65 cents. As a result, the cost of capital for structures was 1 1/4 percentage points lower than it would have been in the absence of ERTA.

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UNITED STATES REAL USER COST OF CAPITAL

Citation: IMF Working Papers 1988, 034; 10.5089/9781451978728.001.A001

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The benefit of the ITC on producers’ durable equipment was reduced by TEFRA in 1983, offsetting in part the effects of ERTA on the cost of capital (see preceding tabulation). In 1983, the combined effects of ERTA/TEFRA lowered the cost of capital for equipment by 3/4 percentage points relative to what it would have been in the absence of both pieces of legislation. In the case of structures, both TEFRA and the 1984 Deficit Reduction Act 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 1 1/4 percentage points compared with what it otherwise would have been.

As noted above, the Tax Reform Act of 1986 brought about further major changes to business taxation. The net effect was to increase the cost of capital substantially 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 1 1/4 and by 1/2 percentage points, respectively, relative to what they would have been in the absence of all these pieces of legislation.

2. Tax policy simulations ²⁴

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. It should be noted that 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 4. On this basis, the stimulative effect of the legislative changes on investment amounted to roughly 2 percent of the level of both producers’ durables and nonresidential structures by 1985.

Table 4.

United States: Sources of Change in Business Fixed Investment

(As percent of investment in the first quarter of 1983)

^1/Normal growth was taken to be the average of output growth that took place in the economic expansions that began after troughs in real GNP in 1960:IV and 1975:I. The subsequent expansions were the only two of comparable length to the present one. The calculation was made by comparing results from a simulation with normal output growth thus defined, to one with real GNP held constant at its value of 1982:IV.

^2/Calculated by comparing a simulation with actual output growth to one with “normal” output growth.

^3/Calculated using a simulation in which the cost of funds was held at its 1982:III value.

^4/Calculated using a simulation in which the relative prices of investment goods were held at their 1982:III values.

^5/Calculated by comparing simulation assuming that none of the changes in tax policy from 1981 onward took place to one in which all the changes took place.

^6/Calculated multiplicatively. A positive residual indicates growth in investment in excess of that explained by the contributing factors.

Table 4.

United States: Sources of Change in Business Fixed Investment

(As percent of investment in the first quarter of 1983)

Year	Actual Change	Normal Output Recovery 1/	Above Average Output Recovery 2/	Lower Cost of Funds 3/	Changes in Relative Prices 4/	Tax Policy 5/	Petroleum Drilling Collapse 6/	Residual 7/
			A. Nonresidential Fixed Investment
1983:IV	14.3	8.6	0.8	1.8	0.3	0.6	—	1.7
1984:1V	30.1	17.1	4.8	4.2	1.1	1.6	—	-1.0
1985:1V	36.2	23.6	1.6	4.8	1.7	1.9	—	-0.1
1987:II	28.2	31.1	-8.9	5.1	2.5	1.3	-3.6	2.0
			B. Producers’ Durables
1983:1V	21.3	10.7	1.0	1.9	0.3	0.5	—	5.6
1984:IV	39.3	22.3	6.3	4.8	1.3	1.6	—	-0.7
1985:IV	49.0	31.2	2.1	5.5	2.3	2.0	—	1.0
1987:II	48.8	41.9	-11.5	6.2	3.6	1.5	—	6.1
			C. Nonresidential Structures
1983:IV	2.6	5.0	0.4	1.6	0.3	0.7	—	-5.2
1984:IV	14.8	8.4	2.4	3.2	0.7	1.7	—	-2.1
1985:IV	14.8	9.0	0.8	3.5	0.8	1.9	—	-1.7
1987:II	-6.1	13.4	-4.6	3.3	0.6	1.0	-9.7	-8.4

^1/Normal growth was taken to be the average of output growth that took place in the economic expansions that began after troughs in real GNP in 1960:IV and 1975:I. The subsequent expansions were the only two of comparable length to the present one. The calculation was made by comparing results from a simulation with normal output growth thus defined, to one with real GNP held constant at its value of 1982:IV.

^2/Calculated by comparing a simulation with actual output growth to one with “normal” output growth.

^3/Calculated using a simulation in which the cost of funds was held at its 1982:III value.

^4/Calculated using a simulation in which the relative prices of investment goods were held at their 1982:III values.

^5/Calculated by comparing simulation assuming that none of the changes in tax policy from 1981 onward took place to one in which all the changes took place.

^6/Calculated multiplicatively. A positive residual indicates growth in investment in excess of that explained by the contributing factors.

View Table

Table 4.

United States: Sources of Change in Business Fixed Investment

(As percent of investment in the first quarter of 1983)

Year	Actual Change	Normal Output Recovery 1/	Above Average Output Recovery 2/	Lower Cost of Funds 3/	Changes in Relative Prices 4/	Tax Policy 5/	Petroleum Drilling Collapse 6/	Residual 7/
			A. Nonresidential Fixed Investment
1983:IV	14.3	8.6	0.8	1.8	0.3	0.6	—	1.7
1984:1V	30.1	17.1	4.8	4.2	1.1	1.6	—	-1.0
1985:1V	36.2	23.6	1.6	4.8	1.7	1.9	—	-0.1
1987:II	28.2	31.1	-8.9	5.1	2.5	1.3	-3.6	2.0
			B. Producers’ Durables
1983:1V	21.3	10.7	1.0	1.9	0.3	0.5	—	5.6
1984:IV	39.3	22.3	6.3	4.8	1.3	1.6	—	-0.7
1985:IV	49.0	31.2	2.1	5.5	2.3	2.0	—	1.0
1987:II	48.8	41.9	-11.5	6.2	3.6	1.5	—	6.1
			C. Nonresidential Structures
1983:IV	2.6	5.0	0.4	1.6	0.3	0.7	—	-5.2
1984:IV	14.8	8.4	2.4	3.2	0.7	1.7	—	-2.1
1985:IV	14.8	9.0	0.8	3.5	0.8	1.9	—	-1.7
1987:II	-6.1	13.4	-4.6	3.3	0.6	1.0	-9.7	-8.4

^1/Normal growth was taken to be the average of output growth that took place in the economic expansions that began after troughs in real GNP in 1960:IV and 1975:I. The subsequent expansions were the only two of comparable length to the present one. The calculation was made by comparing results from a simulation with normal output growth thus defined, to one with real GNP held constant at its value of 1982:IV.

^2/Calculated by comparing a simulation with actual output growth to one with “normal” output growth.

^3/Calculated using a simulation in which the cost of funds was held at its 1982:III value.

^4/Calculated using a simulation in which the relative prices of investment goods were held at their 1982:III values.

^5/Calculated by comparing simulation assuming that none of the changes in tax policy from 1981 onward took place to one in which all the changes took place.

^6/Calculated multiplicatively. A positive residual indicates growth in investment in excess of that explained by the contributing factors.

By the second quarter of 1987, with the negative effects of the 1986 Tax Reform Act 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 where none of the packages was enacted. Alternatively stated, these tax policy changes accounted for 1.3 percentage points of cumulative investment growth from the first quarter of 1983 to the second quarter of 1987.

In order 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 IMF World Economic Outlook exercise. This approach was made necessary because the full impact of the Tax Reform Act (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 TRA on business fixed investment would dominate those from ERTA/TEFRA; by the fourth quarter of 1991 total business fixed investment would be 1 3/4 percent lower than had the tax code remained entirely as it was before 1981.

3. Other simulations

Three other sets of simulations were carried out to separate 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, while all other variables--including inflation--followed their actual historical paths. ²⁵ 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. ²⁶ In the second, 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 4). 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.

4. Summary of simulation results