Tax policy and investment.

• Author: Hubbard, R. Glenn
• Position: Evaluation of 'neoclassical' investment models

Much of my recent research has focused on determinants of business fixed investment and how tax policy affects investment decisions in both the short and the long run. This article briefly reviews my work in three areas of this research. First, I describe challenges in applying the economic intuition of the neoclassical family of models. Second, I summarize my work on complications raised by capital-market imperfections and lumpy investment projects. Finally, I explore the implications of recent empirical work for normative analysis of tax policy.

Modeling Investment: Back to the Future

Policymakers in the United States and other industrial economies evidently believe that business fixed investment responds strongly to tax changes (given the frequency with which governments manipulate tax policy parameters). Hence it is disturbing that models emphasizing the net return to investing - the "neoclassical" family of dynamic models emphasizing the role of the user cost of capital, or Q, or estimating the Euler equation for the choice of the capital stock - are defeated by ad hoc models in forecasting "horse races," and that structural variables frequently are found to be economically or statistically insignificant.

The problem is seen easily in aggregate data. Movements of aggregate variables, including investment, over the business cycle are determined simultaneously; disentangling the marginal impact of a single forcing variable is difficult. For example, an exogenous increase in aggregate demand might lead firms to be more optimistic about their sales prospects and to purchase more investment goods; it also might be expected at least in the short run to lead to higher interest rates. If we examine the correlation between investment and the interest rate, we might even find that the sign is the opposite of that predicted by the neoclassical theory. While an instrumental variables procedure might allow us to overcome this simultaneity problem, the estimator is only as good as the instruments, and good instruments are in short supply. Microeconomic data, however, provide a rich additional source of variation; my own work has focused on tests using firm-level data.

Conventional empirical tests of neoclassical models assume convex costs of adjusting the capital stock and attempt to estimate a parameter related to marginal adjustment costs.(1) Jason Cummins, Kevin Hassett, and I note that conventional estimated coefficients on fundamental variables in firm-level panel data for the United States and other countries are very small, implying implausibly large marginal costs of adjustment.(2) Such estimates imply very small effects of permanent investment incentives on investment.

In my research, I have focused on two general explanations of the failure to estimate significant tax effects on investment: measurement error in fundamental variables and misspecification of costs of adjusting the capital stock.

A major problem in using investment models based on Q or the user cost of capital to estimate effects of tax changes on investment is that measurement error in Q or the user cost of capital may bias downward the estimated coefficient. On a statistical level, Cummins, Hassett, and I estimate neoclassical models in firm-level data using first differences and longer differences (as opposed to the usual fixed-effects, within-group estimator) to address measurement error problems. We find lower adjustment costs and a greater response of investment to fundamentals) In other work, I depart from the strategy of using proxies for marginal Q and rely on the firms's Euler equation to model the investment decision. Using Compustat data for the United States, Anil Kashyap, Toni Whited, and I could not reject the frictionless neoclassical model for most firms, and the estimated adjustment cost parameters are more reasonable than those found in estimates of Q models. Very similar results are reported for European manufacturing firms by Cummins, Trevor Harris, and Hassett and for investment in overseas...