Wednesday, January 12, 2011

Early Doubts About Whether Tax Credits Stimulate Investment

Copyright, The New York Times Company

By its very name, the 2009 American Recovery and Reinvestment Act was advertised to increase investment. Yet years before this stimulus act was proposed, Austan Goolsbee, now chairman of the President’s Council of Economic Advisers, explained in his doctoral dissertation how investment tax credits might do little to stimulate investment during the life of the credit.

In at least one respect, the results of the act appear to confirm his theory.

An investment tax credit permits someone who purchases one of the capital goods covered by the credit to pay less tax in proportion to the amount he spends on the investment. The 2009 stimulus act included tax credits for various capital items, the most publicized being homes: qualified first-time home buyers, for a limited time, received a 10 percent capped tax credit. The program was later expanded to include repeat home buyers.

With the government helping an investor pay for a capital good, each investor is more willing to pay for such goods than he or she would be without the credit. You might guess that eager investors would stimulate more investing – leading to the production of more capital goods. With more capital goods being produced, the credit would create jobs for people who make those goods.

This guess is correct in the long run when it comes to housing tax credits: a housing credit or subsidy does result in the building of more houses (I’ll explore this subject in more detail next week).

But in the short run, the situation may be very different, as Mr. Goolsbee’s dissertation explained. The production of capital goods may get more expensive. In the extreme case, investors may pay more for their capital goods, and more of those goods will not be available. (In technical terms, we economists say that the supply of capital goods is inelastic.)

With no additional capital goods being produced, the credit would not create any jobs – just create a windfall for people already making those goods.

Mr. Goolsbee’s statistical analysis found that “much of the benefit of investment tax incentives does not go to investing firms but rather to capital suppliers through higher prices. A 10 percent investment tax credit increases equipment prices 3.5-7.0 percent.”

Mr. Goolsbee’s study looked at equipment and not structures, and we cannot assume that the nature of housing supply is identical to the nature of equipment supply. Economic theory and experience suggest that housing is even less elastically supplied in the short run than is business equipment.

In other words, an increase in housing demand – which the tax credit helped create – would, in the short run, do more to make housing construction expensive, less to create houses and less to create jobs than Mr. Goolsbee found for equipment.

And, indeed, whatever the overall objectives of the stimulus bill, it appears to have made construction more expensive.

I do not know if President Obama’s advisers discussed this issue, or whether they expected job creation to come from other parts of the stimulus act.

White House economists are probably Keynesian, in the sense that they believe that the 2008-9 recession was a special time when supply did not matter, even though it normally matters in most economic circumstances.

Mr. Goolsbee’s dissertation examined a number of tax credits that were put in place during recessions and seems to refute the idea that supply doesn’t matter during recessions.

Yet we have to acknowledge that the home construction industry was unusually depressed in 2008-9 and might have been a rare example where a stimulus could create jobs without increasing prices.

Now that the Home Buyer Tax Credit has come and gone (it began in early 2009 and ended April 30, 2010, although some buyers had until September to finish transactions), we can look at home construction costs and home construction activity during that period.

The chart below displays the monthly producer price index for home building materials (the blue line, measured relative to the producer price index for all finished goods), along with employment in the residential building industry (the red line), for the period January 2008 through December 2010.

The blue line shows a curious spike in the prices of home building materials, peaking at the end of April 2010, almost exactly when the home buyer credit expired.

Perhaps Mr. Goolsbee’s dissertation applies here, and the rush to finish home transactions before the credit expired made home building 3 to 5 percent more expensive during that period than it would have been without the credit. In contrast, the red employment series shows no visible spike in people employed as home builders.

The Home Buyer Tax Credit is just one part of a complicated stimulus law, but it illustrates a general principle of economics.

Even when government spending, subsidy or credit is targeted at a highly depressed industry, with plenty of unemployed workers apparently available for hire, the government’s purchases may, in the short run, raise prices and costs without necessarily causing more of those items to be produced.

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