Discussion of “General-Equilibrium Effects of Investment Tax Incentives” by R. Edge and J. Rudd Roland Straub European Central Bank Rome, 30 June 2009.

Discussion of “General-Equilibrium

Effects of Investment Tax Incentives” by

R. Edge and J. Rudd

Roland Straub European Central Bank

Rome, 30 June 2009

Summary of the Paper

Assessing the effect of changes in investment tax policy on capital spending and macro aggregates Partial expensing allowance vs. capital tax rate

“Good and bad news” delivered in the paper: Goods news: under “realistic” nominal rigidities

the impact of partial expensing allowances on investment is stronger than previously contemplated

Bad news: countercyclical fiscal rule with temporary partial expensing can be destabilizing

Framework

Prototype New Keynesian DSGE model with nominal taxation Utility and profit maximisation

Capital accumulation: investment and capital adjustment costs

Sticky prices and wages

Nominal tax on capital and personal income

Balance budget rule: (distortionary) tax income is redistributed (lump-sum) among households

Taylor-style monetary policy rule

Partial Expensing Allowance

Budget constraint of households:

Partial Expensing Allowance: partial rebate of the purchase price of new capital good.

Previously expensed allowance does not receive depreciation allowance.

Good News Partial vs. General Equilibrium Model (flex

price model) DSGE model: flexible price model

Partial model: Tobin’s Q set-up

Capital and Investment adjustment cost

Permanent introduction of (real) partial expensing allowance: Partial equilibrium: only restriction to reach new

equilibrium is due to capital/ investment adjustment cost

GE framework implies a trade-off between capital accumulation and (indirectly) labour supply

Temporary introduction of (real) partial expensing allowance: pulling forward investment

Good News Adding realistic nominal rigidities: sticky prices and

wages, nominal tax system Investment response is stronger than in the flexible price GE and

PE case

Driven by the assumption of sticky wages and unindexed nominal tax system

Sticky wages makes AS curve flatter – investment response is stronger to changes in fiscal policy

Unindexed nominal tax system: investment is a function of nominal interest rates – lower inflation rate further stimulates investment by inducing lower nominal ineterest rates.

Expansionary fiscal policy can also push down inflation (see also Straub and Tchakarov, 2006 for government investment)

Bad News Countercyclical Investment tax is destabilising

Christiano (1984): anticipation of the introduction of partial expense allowance is destabilising

Investment decision are postponed

Further weakening investment in the run-up of the enactment of the expensing allowance

Still partly true in this model, but is partly offset by the desire to avoid large swings in capital stock and investment spending due to adjustment costs.

Partial Expensing vs. Capital Income Tax cuts

Impact of capital income tax cuts are frontloaded Best “tax-savings strategy” for an individual firm is to purchase

and hold capital right at the beginning and hold it until the end.

Expense allowance is worth roughly the same at any point of the allowance period.

Partial Expensing has a stronger revenue impact

Capital income tax cuts are fiscally expensive: Capital income tax applies income to all capital while expensing

allowance applies only to new investment

Some Remarks and Suggestions

Fiscal Policy (partial expensing allowance) as a countercyclical tool

Normative issues

Investment tax and the open economy

Distributional issues

Comments : Fiscal Policy as a Countercyclical Tool

Under which circumstance are investment tax incentives the best tool?

The paper provides an interesting overview of the advantages of partial expense allowance compared to other fiscal instruments

Comments : Fiscal Policy as a Countercyclical Tool

Investment based tax incentives have some appeal compare to other fiscal measures

Income taxes, in general, stimulate the least when they are expected to be temporary, but permanent income tax cuts might jeopardize budget discipline (Laffer-curve)

Government consumption may face constraints in the existence of Ricardian Equivalence

Government investment might have some appeal, but require that government decides about the “sensibility” of investment projects – long time lag

Comments : The role of credit constraint

What is the scope of investment tax incentives for the current crisis?

Investment tax incentives might not work if credit market are distorted (as currently) Investment will not be responsive to changes in

the intertemporal price due to credit constraints

Important to identify the reason for the downturn to assess the efficiency of the instrument

Important to check for the role of credit constraints

Comments : Normative issues

What is the goal of fiscal policy in the model? Metric (seems to be): (i) maximum response of

investment/ output, (ii) fiscal efficiency

Metric could be spelled out more clearly

Possibly, but not necessarily based on micro-founded welfare

Comments: What is the goal of fiscal policy? Temporary investment tax incentives in an open

economy Investment tax incentives might have substantial impact

on the trade balance

Alternative policies can have differential impact on the external positions

Temporary investment tax incentives might have consequences on income distribution Major differences in the response of asset holders and

non-asset holders

To check some of the hypothesis, I utilise the open-economy version of the NAWM (Coenen and Straub, 2005)

New Area Wide Model

Two-country Open Economy Model (Coenen and Straub, 2005) Calibrated to match US and euro area macro data

New Keynesian DSGE Model

Real rigidities: monopolistic competition, investment adjustment costs, variable capacity utilisation

Nominal Price and wage rigidities

Open Economy: consumption and investment imported goods, producer currency pricing.

New Area Wide Model

Two-country Open Economy Model (Coenen and Straub, 2005) Heterogeneous Households: asset holders (HH I)

and non-asset holders (HH J).

Fiscal Policy: government consumption, government investment, distortionary taxes (consumption, capital, income).

A fall in distortionary taxes are matched by am asymmetric reduction of lump-sum transfers.

Open Economy Issues: Capital Tax Shock

0 5 10 150

0.02

0.04

0.06Output

0 5 10 150

0.05

0.1Capital Stock

0 5 10 15-0.01

-0.005

0

0.005

0.01Consumption

0 5 10 150

0.1

0.2

0.3

0.4Investment

One percent capital tax cut

0 5 10 150

0.05

0.1

0.15

0.2Imports

0 5 10 150

0.02

0.04

0.06Exports

0 5 10 15-0.03

-0.02

-0.01

0

0.01Trade Balance

0 5 10 15-0.02

0

0.02

0.04

0.06Terms of Trade

Triggering a trade balance deficit

Open Economy Issues: Capital Tax Shock

Open Economy Issues: Income Tax Shock

0 5 10 150

0.1

0.2

0.3

0.4

0.5Output

0 5 10 150

0.05

0.1

0.15

0.2Capital Stock

0 5 10 150

0.1

0.2

0.3

0.4Consumption

0 5 10 150

0.2

0.4

0.6

0.8Investment

One percent income tax cut

0 5 10 150

0.05

0.1

0.15

0.2Imports

0 5 10 150

0.5

1

1.5Exports

0 5 10 15-0.05

0

0.05

0.1

0.15Trade Balance

0 5 10 150

0.2

0.4

0.6

0.8Terms of Trade

Open Economy Issues: Income Tax Shock Triggering a trade balance surplus

Distributional Issues: Capital Tax Shock

0 5 10 150

0.02

0.04

0.06

0.08

0.1Hours Worked

0 5 10 150

2

4

6

8x 10

-3 Real Wage

0 5 10 150

0.005

0.01Consumption: HH I

0 5 10 15-0.08

-0.06

-0.04

-0.02

0Consumption: HH J

Negative correlation of consumption of HH I and J

Distributional Issues: Capital Tax Shock

0 5 10 15-0.02

0

0.02

0.04

0.06

0.08Hours Worked: HH I

0 5 10 150

0.05

0.1

0.15

0.2Hours Worked: HH J

0 5 10 150

0.005

0.01

0.015Real Wage: HH I

0 5 10 15-1

0

1

2

3x 10

-3Real Wage: HH J

Mainly driven by a fall in transfers to HH J

Distributional Issues: Income Tax Shock

0 5 10 150

0.2

0.4

0.6

0.8Hours Worked

0 5 10 15-0.4

-0.3

-0.2

-0.1

0Real Wage

0 5 10 150

0.1

0.2

0.3

0.4Consumption: HH I

0 5 10 150

0.5

1

1.5Consumption: HH J

Positive correlation of consumption of HH I and J

Distributional Issues: Income Tax Shock Similar path of labour effort and real wages of HH I and J

0 5 10 150

0.2

0.4

0.6

0.8Hours Worked: HH I

0 5 10 150

0.2

0.4

0.6

0.8Hours Worked: HH J

0 5 10 15-0.4

-0.3

-0.2

-0.1

0Real Wage: HH I

0 5 10 15-0.4

-0.3

-0.2

-0.1

0Real Wage: HH J

Conclusion Very interesting paper

It is very timely and relevant to think about the macro effects of fiscal policy beyond government spending

Credit constraints and investment tax incentives

What is the right metric for a normative approach?

Open Economy issues

Distributional issues