In the past few years, net business capital investment has dropped lower relative to output than at any time since World War II. And without net investment in productive capital, U.S. living standards will cease to grow. The authors find little reason to be optimistic about the future pace of net investment: Current government policies, particularly in the area of taxation, are weakening, rather than strengthening, incentives to work, save and invest—the activities needed to expand the economy.
Government policy over the past decades has relied heavily on conventional Keynesian theory, which focuses on demand as the driving force behind economic activity. Yet the current stagflation—high inflation during a period of economic slowdown—belies conventional theory. Certainly no one can argue that the economy has done poorly in the 1970s because the government has not stimulated demand; government transfer payments have nearly doubled during the past 10 years.
There is, however, an alternative economic framework that explains the existence of stagflation. In this framework, the levels of investment and output are determined by a delicate balance between incentives and disincentives affecting both supply and demand. A sales tax, one form of economic disincentive, creates a “wedge” between supply and demand—a discrepancy between the price paid by a buyer and the price received by the seller. Because the price received by the supplier is lower, supply is discouraged; because the price paid by the demander is higher, demand is curtailed.
A discrepancy between the yield on investment required before taxes and the yield received after taxes—created by such factors as taxes on profit, regulatory restrictions and inflation—forms a capital spending wedge. If the wedge is big enough, investment, output and living standards will stagnate. The authors examine the impact on capital spending of taxation and other disincentives over the last decade.