The Role of Public Policy
in Promoting Investment
Murtaza Syed
Institute for Fiscal Studies
1
Key Issues
1. Does the investment rate matter?
Should the government be concerned
with the level of investment?
If so,
2. Does the UK invest too much or
too little?
3. What should the government
attempt to do about it?
Does it have any appropriate policy
tools at its disposal to address these
problems?
 Relevant for core papers, IO and
public economics
2
References
• Bond and Jenkinson. “The
Assessment: Investment Performance
and Policy”. Oxford Review of
Economic Policy, Summer 1996 (vol 12
no. 2).
Very good revision paper and good for
further citations; this volume is on
investment and contains other good
papers
• Whitaker. “Investment in this Recovery:
An Assessment”. Bank of England
Quarterly Bulletin, February 1998.
Applied and not technical
• Nickell. “The Investment Decisions of
Firms”. Cambridge University Press,
1978.
3
Outline
1. What is Investment?
2. Why should we care about
Investment?
3. Is there a case for Public
Intervention?
4. Evidence on UK Investment
Levels: Are they too low?
5. Determinants of Investment
6. Options for Public Policy
4
1. What is Investment?
•
1.
2.
3.

There are 3 broad types of
investment, involving the formation of
capital:
Fixed capital, e.g.
machinery or factories
Intangible capital, e.g. reputations
(advertising) or technical knowledge
(R&D)
Human capital, e.g.
skills or education
All involve “foregoing current
consumption for future consumption”
5
2. Why should we care
about Investment?
• Macro:
Y = C + I + G +NX
One of the most important (and
volatile) components of GDP
• Employment
• Business Cycles
• Associated with Growth
• Micro:
Effects of industry structure,
taxation and supply side policies;
links with productivity and R&D
6
Potential Policy Concern!
• Level of investment may not be
“optimal”
• Misconception: Investment is
good, and more is better
• In reality, Investment can be too
low or too high!
• For most of post war period, UK has
had extensive system of tax breaks,
special allowances and subsidies to
investment
• Consensus seems to be
• investment is too low
• public policy has a role
• But, any intervention needs to be
justified!
7
3. Is there a Case for
Intervention?
•
Government intervention in markets
usually justified on equity or
efficiency grounds
1. Equity
•
•
Usually focus on equity of Y or C
Achieved more effectively through
public services, tax system or social
security system
Some exceptions (regional
investment grants to alleviate
regional inequities)
But in general, concerns over
inequality not sufficient
justification in this case!
•
•
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2. Efficiency
a. No Market Failures
• No efficiency grounds for
intervention in investment
market
• Investment will take place
until MB=MC of capital
under profit maximisation
• Solow Growth Model:
Perfect markets &
diminishing returns to
capital and labour
• LR economic growth
depends on exogenous
technical change only.
9
b. Market Failures
• Arise when individuals are unable
to trade to achieve a Pareto
optimal outcome. Due to:
1.
Imperfect excludability
•
2.
Incomplete information
•
3.
Adverse selection and moral
hazard
Incomplete contracts
•
4.
5.
intangibles such as process
innovations
hold up problem
Missing/imperfect capital markets
Externalities
10
Externalities: An Example
• Investment may generate externalities:
capital goods embody new knowledge
(Romer (1987), endogenous growth)
• 1 firm’s investment enables others to
learn about new technology.
• Economy level externality raises
productivity of all other I and L
• No one firm can capture all benefits of
its own investment, implying social rate
of return > private rate
• Do these externalities exist?
• some (controversial) evidence
that investment rates are
significant determinants of
cross-country differences in
growth rates
11
Graph from page 87 of
Mankiw
12
Departures from
“Optimality”
•
Investment levels may diverge
from optimal levels due to
1. Market Failures
as well as
2. Imperfect Competition
3. Tax Distortions
 Potential role for intervention
provided
•
•
Address source of problem
Improvement in efficiency >
Costs of intervention
13
4. UK Investment Levels: Some
Evidence
•
Are UK investment levels too
high or too low?
1. Required Rate of Return:
•
•
•
•
•
Minimum rate of profit needed
before tax to keep investors
satisfied
Equals the nominal interest rate
+ risk premium + tax wedge
Rough calculation suggests
4% + 8% +1% = 14%
According to survey evidence,
about 17-20%
Suggestive of market failures:
high rate requirements reduce
investment levels
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2. International Comparisons
•
•

1.
2.
Complicated by variety of
measures and ways of
measurement
Table 1 reports OECD figures for
share of gross investment in GDP
in Japan, Germany, France, Italy,
USA and UK over 1980-97 and
1960-97.
UK has invested a lower share
of GDP than any of these
countries since 1979
Notice:
Not entirely explained by low
investment in housing
Not a new phenomenon: also the
case since 1960
15
• INSERT TABLE 1 from B&J 1996
HERE
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Summary
•
Clear pattern from international
comparison:
1. Japan is an outlier, invests
substantially higher fraction of
GDP than any other country
2. Continental Europe of next
3. US and UK consistently
allocate lower shares of
national income to investment
17
5. Determinants of Investment (or
what could be behind low UK
investment?)
• Firms invest to make money
• Investment a forward looking decision:
expectations matter!
• Firms only undertake projects if
expected future returns > costs
• Expected Future returns affected by
(uncertain expectations of ) interest
rates, taxes, risk premia, demand,
public policy
• Costs are affected by wages, price of
capital, availability/cost of finance
• Backed by survey evidence
18
• Table 8.7 from B&J
19
Some Key Potential
factors
1. High macro and/or e rate
uncertainty
2. Tax distortions
Factors potentially specific to
UK
3. Costly external finance? True
they rely mostly on internal finance
(see table); but unclear whether
this is cause or consequence of
low investment
4. Hostile Take Over Threat
Insecure managers dissuaded
from profitable long term
investments
20
• Table 3 from Bond paper
21
6. Options for Public
Policy
• Governments in Britain and elsewhere
have sought to influence level &
allocation of I expenditure
• Highly likely that they will continue to
do so in future
• ? Effectiveness: Do such interventions
have a significant impact?
• UK Government has a number of
policy options
• Could try to target the 2 factors
we identified as being potentially
primarily responsible for low
investment levels
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1. Improving Sources of Finance
• No clear policy
• Is there anything wrong with investment being
predominantly internally financed?
• Predominance of internal finance for UK
investment results from:
• Lack of desire for external funding?
• Inevitable asymmetry of information
between managers and external
financiers (no obvious way for govt to
address this)
• Current financial institutional
arrangements
• Needs a change in share ownership,
institutional arrangements and attitudes of
investment financing bodies (e.g by promoting
banks and discouraging stock market listings)
• However, institutions are a function of history,
accident and legal framework
 Evidence of lack of external financing not
sufficient to validate risky and costly major
institutional reform of UK corporate finance
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2. Addressing Take over Threat
• How do you reduce this threat? Making
it harder for shareholders to sell their
shares
• No clear policy. Options:
• Increase capital gains taxes? (not
paid by institutional investors and
bid premiums usually much larger)
• Fundamental institutional change?
• But what about monitoring function of
threat as an additional mechanism for
disciplining managers?
• If change is desirable, why hasn’t
private sector adopted it?
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3. Macroeconomic Stability
• High on public policy agenda
• Problems:
1. What policies promote
stability?
2. Stability of what?
3. No theoretical consensus or
empirical evidence of any
direct relationship
• On current evidence,
“caution against emphasizing
notion that policies that
promote a particular view of
macro stability are the key to
raising level of investment”
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4. Taxation
1.
Cut Corporation tax: Disincentive to
investment? Raises required rate of return
and so reduces PDV of investment
2.
Dividend taxation: tax system gave
substantial tax incentive for dividends to be
paid out to tax-exempt shareholders; if
external funding is costly, then higher
dividend payments will reduce investment
3.
Cut Savings Tax:
•
Closed economy: S = I : Will increase supply
of funds, decrease interest rate and spur
investment;
•
Small open economy, interest rate equals
world rate so level of domestic savings will
have little impact on investment

UK somewhere in between so tax cut on
S could generate moderate reduction in i
rates and stimulate I
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Conclusions
1.
Without strong evidence of market failures,
equity arguments not enough to justify
intervention in I
2. Evidence that UK investment levels may
be too low
• High required rates of return
• International comparisons
• Suggestive of market failures?
3. Potential culprits:
• Limited external finance
• High take over threat
• Government cannot do much about
these 2 factors: require institutional
change and excessive intervention
4. Most appropriate tool is tax system even
though perhaps not root cause of the
market failure
• has happened in the UK (changes to
dividend taxation and
cutting/modifying corporation tax)
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