Investing for Productivity and Prosperity (1994)

Investing for Productivity and Prosperity

The U.S. economy has simultaneously emerged from a recession and undergone a major restructuring in the private sector. This continuing transformation is shrinking the number of people employed in a variety of industrial processes and management, especially in manufacturing but also increasingly in services. The wave of corporate contraction contributes to the apprehension that job creation and income growth will lag and that this will not be a short-run phenomenon. In addition, there are underlying longer-term weaknesses of the economy. To a large extent, our current problems are the cumulative negative effects of nearly a generation of poor economic performance relative to both the previous generation’s record and the recent performance of other industrial countries: 30 years of lagging income growth per capita, 25 years of declining net investment, 30 years of national saving below other industrialized economies, and 20 years of gross investment in plant and equipment below that of Japan, Germany, France, Canada, and even the United Kingdom. The U.S. economy’s performance in these respects would be of concern even if it compared more favorably with that of other industrial countries, because historically we have done much better in raising Americans’ living standards. The international differences themselves contribute to public dissatisfaction and help illuminate causes and possible remedies.

There are several requirements for the economy to grow faster and

provide challenging jobs and rising incomes: a relatively stable political and regulatory environment that makes it possible to anticipate risks; private management that is skilled at accommodating change, containing costs, and making the best use of people and organization; application of new technology and continuous improvement at each technological level; adequate public sector investment in education and infrastructure; a macroeconomic climate that facilitates job creation and shifts of dislocated workers to new jobs; a supply of capital at reasonable cost; and financial and corporate investors who are able to take a long-term view of growth opportunities. This report addresses the latter two requirements, which are neither more nor less important than the others. On the basis of lengthy deliberations, we conclude that the United States has measurable saving and private investment problems that will, if not solved, seriously impede the fulfillment of American citizens’ material needs and expectations. These are problems of inadequate saving, underinvestment, and excessive pressure for short-term returns on private investment. This report considers their sources and calls for benchmarks for net national saving, investment, and productivity growth and for taking politically and economically difficult steps to move toward these benchmarks over the next decade.

Among the economies in the world trading system, growth is not a zero-sum game. Agreements among governments to undertake growth-promoting policies are in the common interest, and no country, including the United States, entirely controls its own destiny in this respect. Sustained domestic economic growth, nevertheless, depends upon the nation’s enterprises achieving and maintaining a competitive position in the world economy by meeting or exceeding international standards of productivity in existing markets and by being innovative in developing new products and markets.

By the effective development and use of technology by private firms, the United States remains the most productive economy in the world. The radical restructuring and downsizing of U.S. business corporations in the past years have served to shore up this standing by improving the relative efficiency of domestic industry in global markets. This streamlining process is growth promoting in the longer term and, in that respect, beneficial. However, more than likely it is a one-shot gain in efficiency rather than an acceleration in the rate of productivity improvement. It

entails a significant loss of employment, now and for several years to come, because the restructuring is far from complete.

The other principal instrument for achieving growth is investment, including public investment in infrastructure and human capital, private investment in plant equipment and technology, and personal investment in education and training. Investment can increase productivity and create new economic activity and additional employment. The U.S. economy’s performance with respect to private investment and overall saving has been and continues to be inadequate for the challenges currently facing us. This has been recognized in economic assessments, but there has been no identifiable progress in determining the size of the problem and in identifying benchmarks by which to gauge our progress over the time, probably a decade, required to change the economy’s course.

U.S. net national saving as a percentage of gross domestic product (GDP) has been below 3 percent since 1990. A desirable level would approximate the norms among industrial countries, whose net saving rate in most cases is between 8 and 10 percent, except for Japan where it is considerably higher.

About one-half of the U.S. saving shortfall is directly attributable to funding the federal deficit, which has been between 3 and 5 percent of GDP in the past 2 years. The President and Congress are struggling to address this part of the problem. The Omnibus Budget Reconciliation Act of 1993 is intended to reduce the federal deficit by a cumulative $496 billion over 5 years. If achieved, this will be an important accomplishment. Nevertheless, although the legislation reduces previously projected spending increases, net spending and interest payments will continue to rise. After the 5-year deficit reduction, both the deficit and the cumulative debt will resume their growth curve. Health care, a major contributor to this gloomy forecast, is currently being addressed. The competing objectives of expanding access and maintaining quality of care make it unclear how reform will affect medical costs overall and the federal budget in particular.

The nongovernment part of the saving shortfall results from a low and declining rate of private saving by households and companies. The personal saving rate in the United States declined sharply in the late 1980s. Various explanations have been suggested for this decline, including the declining percentage of people in the high-income 45-to-64

age bracket and the rising percentage of retirees, the increasing net worth of individuals as a result of the buoyant real estate and stock markets, tax disincentives, and changes in the social insurance safety net. There is no consensus on the relative importance of these factors, however, and they do not seem to explain the entire decline. Understanding the determinants of private saving is an important research priority, for without a diagnosis in which policymakers can have confidence it is difficult to generate support for solutions to the problem.

U.S. gross investment in plant and equipment is closer to international norms for industrial countries than is the saving rate but is still well below the norms and is declining, reaching a 30-year low of 9.4 percent of GDP in 1992 and advanced only slightly to 9.8 percent of GDP in 1993. Moreover, all but a tiny fraction of gross investment now represents depreciation charges based on the rate at which productive capital wears out and is replaced. Even when there is no net new investment, productivity gains can result from technological improvements incorporated in replacement capital, but this improvement is small compared with the gains achieved by new capital embodying new capabilities.

The combination of low investment and saving rates has several consequences if sustained over another decade or longer. First, investment is not sufficient to sustain productivity growth at a level that will achieve and maintain a satisfactory rate of growth in Americans’ standard of living. Although recessionary and structural changes in the economies of Germany and Japan tend to make the current U.S. economic recovery look better and although structural changes have improved the relative efficiency of much of U.S. industry, the fact is that U.S. standards of living per capita are not increasing, which is the ultimate test of economic performance.

Second, saving is well below both the desired and actual rates of investment. As investment is financed at the national level from domestic and foreign saving; any difference between U.S. investment and saving is financed by foreign sources. The United States relied heavily on foreign capital in the mid- to late 1980s. In an era of low world capital formation attributable to low savings, with increasing demands for capital by many more countries, such dependence raises the cost of capital worldwide. Only Japan is now a real exporter of capital, and the United States is the largest importer.

The U.S. capital allocation system relies mainly on business managers to decide particular capital investments. Firms invest in projects in which the expected return on investment exceeds by an acceptable amount the cost of capital required to make the investment consistent with their assessment of risk. The return on an investment is the amount in percentage terms that the investment produces in excess of the investment itself. The cost of capital is the return financial investors require to induce them to make investments. There is at least indirect evidence, developed by members of the board and described in this report, that the cost of capital has been higher in the United States than in other major industrial countries and remains higher despite the drop in the Japanese stock market index. For example, the achieved rates of return on corporate capital are higher in the United States than they are in Japan.

Differentials in the cost of borrowing funds, which also have been higher in the United States than in Germany and Japan, have been narrowing as international capital markets for debt instruments become more open, more integrated, and less regulated and protected at the national level. Nevertheless, because of the largely floating exchange rates now prevalent, the relatively higher European interest rates do not easily translate to American conditions and hedging techniques are still inadequate.

By contrast, the integration of equity markets, which would narrow international differences in the cost of equity financing, is less advanced and is proceeding more slowly. In view of the pattern of higher returns on corporate investment in the United States, the board believes that our cost of equity capital is higher than that in other industrialized countries. The U.S. tax system contributes to this phenomenon. For example, income generated by corporations and not paid out as interest to holders of corporate debt is taxed twice, once at the corporate level and again as personal income when it is distributed to individual investors. Although corporate marginal rates are higher in other countries than in the United States, the tax burden on the investor is mitigated by accounting methods that permit large accumulations of tax-free reserves; by paying lower dividends while rewarding stockholders with the appreciation through

essentially tax-free capital gains, not available in the United States as a result of the 1986 tax reform act, and by partial or complete offset of taxes on dividends, which have become more prevalent in recent years (Jorgenson and Landau, 1993).

Many types of investment that contribute to a firm’s competitive posture, including investments in technological and market and human resource development, are most appropriately financed with equity capital. Unlike plant and equipment, these investments do not generate collateral for the investor and thus are less appropriately financed with debt. Because of the importance of these intangible assets to long-term growth, the STEP board believes that both public and private sectors should be especially concerned about the cost of equity capital and policies that affect it.

Relative to those of most other countries, U.S. capital markets exhibit many characteristics that are worth preserving: liquidity, openness, and fairness with respect to investors in public companies, among other characteristics. As a consequence of our regulatory system requiring openness and fairness, however, there are limits to the amount of proprietary information made available by issuers to financial investors. Information about competitively sensitive longer-term strategic investments of the corporation is most likely to be withheld from investors. For this reason and because financial investment managers as fiduciaries are usually judged on a short-term basis, U.S. capital markets tend to bias the evaluation of corporate performance toward the short run. Short-run performance is certainly not an irrelevant criterion; it is simply overemphasized to the neglect of long-term growth, especially in publicly held companies. Interestingly, in other parts of the capital allocation system, such as the financing of privately held companies and new ventures, the separation of financial investor and management is substantially less and the time-horizon problem seems much less severe. It is significant that U.S. private and venture capital markets are the ones with internationally acknowledged superior performance.

The board believes that the structural characteristics of the U.S. capital allocation system cause hurdle rates, or the returns demanded by corporate investors on longer-term investments, to be elevated above the cost of capital. This difference is a function of how information is made available to investors and management’s perception of the risk premiums

for particular projects and classes of investment. We are also concerned that the same structural features may cause hurdle rates to remain high, notwithstanding the recent lowering of international differences in the cost of funds resulting from the integration of financial markets.

In view of the pressures to deal with immediate short-run problems in a democratic political system, the board believes that the administration and Congress should set benchmarks for private investment, net saving, and productivity growth. It is neither critical nor even desirable that progress toward the benchmarks occur quickly. Beginning with a recognition of the cumulative negative effects of three decades of low national saving and lagging investment and productivity growth, however, public officials should commence setting a direction and developing a public commitment to moving steadily toward it. If benchmarks are not discussed and generally agreed on, measures to move toward them will be crowded out by the exigencies of the moment.

The board believes that achieving the twin objectives of moving net saving and investment rates toward 8 to 10 percent of GDP over a 5- to 10-year period would contribute measurably to enhancing relative productivity and job growth in the United States. Movement in this direction would not hurt and would probably help the global economy.

The fact that staying on the current saving and investment trajectory does not create a short-run crisis is as much a source of concern as of relief because it allows all of us—policymakers, legislators, and voters—to follow our natural inclination to focus on immediate problems: job losses, slow growth, and the cost and availability of medical care. These issues are not economically or politically unimportant, but the attention devoted to them is crowding out development of a consensus to pursue longer-term objectives with regard to saving, investment, capital allocation, and productivity.

As is now widely recognized, government dissaving needs to be reduced over time to restore the rate of saving to an appropriate level and to stem the growth of interest payments, which are currently about 14 percent of federal outlays. The transition should be gradual to avoid disrupting the recovery. The board is well aware that a rapid reduction in the federal deficit and sudden increase in saving might bring about a drop in aggregate demand rather than an increase in investment. Our concern is that once the recovery is firmly established and the corporate restructur-

ing process has slowed, there will be little inclination to focus on raising levels of saving and investment across cycles.

With respect to private saving, particularly household saving, the board recommends undertaking a comprehensive international comparative study of the highly variable saving rates across countries. Such a study should involve several of the social science disciplines. It would help to identify ways, in addition to changes in the tax system recommended below, to promote a higher level of saving in the United States.

Structural changes in U.S. tax policy would be the most direct and effective way to increase investment and saving and to create incentives for long-term holding of equity in productive enterprises. We believe that, over the next decade, the tax system should be recast as follows:

• While retaining progressivity of the tax structure, move toward a system in which saving and investment are taxed less and consumption is taxed more.

• In the interim, reduce the generous investment subsidy for residential real estate, which encourages investment in this type of capital, by reducing the allowable mortgage interest deduction. Use some or all of the revenue generated to reduce the tax on more productive corporate investment by:

  1. eliminating the double taxation of corporate income to close the gap between the return on corporate investment and the return to the financial investor and

  2. broadening the 1993 tax act’s favorable treatment of long-term gains on new corporate stock of small companies by extending it to gains on long-term holdings of newly issued stock in firms regardless of size.

• Limit targeted business investment incentives to those that can be justified by a clear, strong, and measurable public interest element in the investment return that is not part of the company’s private return calculation, that are designed to provide a sustained rather than temporary incentive for long-term investment, and that are as broad as possible to enable markets and corporate investment decisions to be efficient.