By stimulating capital investment. It implies adjusting capital depreciation rates and the deductibility of interest payments, both Union-level instruments. Such policies may deliver a more effective stimulus to investment than the ECB’s interest rate policy.
Amongst the EU’s most significant challenges in the coming years is arresting the sluggish/declining productivity growth of the past few years and return to income growth at (least at) the long-term pace of inflation target of 2%.
As a job-intensive recovery depressed investment, despite the efforts of ECB and Commission, real disposable income grew at 55% slower from 2009 than in the nine years preceding that year.
A labour market squeeze could threaten these gains in the years going forward. Productivity actually grew faster from 2009 than in the years preceding it, regardless of whether we measure it by employee or work intensity.
Table above: Labour Productivity indexed to 2010
The link between productivity and income could hint at higher capital intensity fostering productivity growth – or lower labour costs relative to the production horizon of capital and technology (in the neoclassical framework of Romer).
Because investment measured by Gross Fixed Capital Formation as a percentage of GDP decreased 7% from 2000, productivity gains are most likely the product of a labour market rout (coupled with wage restrain) than of efficiency gains in how inputs are transformed. This hypothesis is coherent with slowing growth of real income per capita.
Table above: Gross Fixed Capital Formation as a percentage of GDP
Imported inflation, the labour market squeeze or a demand shock could very easily erode the gains in productivity and income – if investment and innovation don’t resume.
The current series of posts questions the assumption that firms increase investment when interest rates are lower. Survey data and microeconomic research question this assumption too.
For instance, Acemoglu’s capital-augmenting technology function hints at lower incentives to capital investment from lower interest rates.
Caballero defines a capital investment equation that considers labour-capital elasticity (or the incentive for firms to invest instead of hiring) based on capital cost (the so-called user cost) and capital intensity (or the amount of capital involved in production). Caballero argues that firms consider the current level of capital and the interest rate when deciding whether to invest, subject to other costs of investing such as availability of qualified persons to operate that investment.
In practice, holding the value added of buying a new machine constant, a ten-fold decrease in the interest rate only increases investment by 25% controlling for adjustment costs.
That is, higher adjustment costs affect capital investment. Typically governments let higher capital intensity increase adjustment costs as there’s only so much capital intensity a firm may accumulate before becoming costly to integrate yet more capital.
Governments may otherwise choose to affect capital levels through higher depreciation rates that increase the incentive to invest; or introduce incentives to investment that decrease the costs of capital such as increased depreciation rates.
These instruments may reveal essential when market interest rates increase from 2019 onwards, and may be activated at European Union-level through the CCTB, the Common Corporate Tax Base. The Union may adopt flexible calculations of the depreciation base of a leased asset (increasing or decreasing the incentive to investment, Article 32) and of the deductibility of interest (increasing or decreasing the disincentive to investment, Article 69, CCCTB) in the scope of these directives. Combined, both affect a firm’s decision to invest.
The work of Cummins and Hassett is undoubtedly valuable to understand the firm’s investment decision. Beyond finding a relationship between the user cost of capital and investment by focusing on tax reform years, the authors define the tax-adjusted user cost as increasing with lower interest rates (hence, the low interest rate environment hampers investment – as long argued in this blog – albeit lightly as the ECB agrees) and decreasing with lower depreciation rates.
In other words, lower interest rates should be combined with extended depreciation rates such that firms are enticed to accumulate capital. Otherwise, a policy-bound accelerated depreciation schedule accelerates firm investment decisions.
As such, in the years after 2019, the Union should focus on an accelerated, policy-bound accelerated schedule of depreciation to induce capital renewal followed by gradually increasing depreciation rates (to a steady state) that permanently decreases the capital user cost.
In practice, this implies the Union can consider the labour-intensive recovery when granting leeway to investment while preventing overinvestment.