Expectations

A change in the capital stock changes future production capacity. Therefore, plans to change the capital stock depend crucially on expectations. A firm considers likely future sales; a student weighs prospects in different occupations and their required educational and training levels. As expectations change in a way that increases the expected return from investment, the investment demand curve shifts to the right. Similarly, expectations of reduced profitability shift the investment demand curve to the left.

The Level of Economic Activity

Firms need capital to produce goods and services. An increase in the level of production is likely to boost demand for capital and thus lead to greater investment. Therefore, an increase in GDP is likely to shift the investment demand curve to the right.

To the extent that an increase in GDP boosts investment, the multiplier effect of an initial change in one or more components of aggregate demand will be enhanced. We have already seen that the increase in production that occurs with an initial increase in aggregate demand will increase household incomes, which will increase consumption, thus producing a further increase in aggregate demand. If the increase also induces firms to increase their investment, this multiplier effect will be even stronger.

The Stock of Capital

The quantity of capital already in use affects the level of investment in two ways. First, because most investment replaces capital that has depreciated, a greater capital stock is likely to lead to more investment; there will be more capital to replace. But second, a greater capital stock can tend to reduce investment. That is because investment occurs to adjust the stock of capital to its desired level. Given that desired level, the amount of investment needed to reach it will be lower when the current capital stock is higher.

Suppose, for example, that real estate analysts expect that 100,000 homes will be needed in a particular community by 2010. That will create a boom in construction—and thus in investment—if the current number of houses is 50,000. But it will create hardly a ripple if there are now 99,980 homes.

How will these conflicting effects of a larger capital stock sort themselves out? Because most investment occurs to replace existing capital, a larger capital stock is likely to increase investment. But that larger capital stock will certainly act to reduce net investment. The more capital already in place, the less new capital will be required to reach a given level of capital that may be desired.

Capacity Utilization

The capacity utilization rateA measure of the percentage of the capital stock in use. measures the percentage of the capital stock in use. Because capital generally requires downtime for maintenance and repairs, the measured capacity utilization rate typically falls below 100%. For example, the average manufacturing capacity utilization rate was 79.7% for the period from 1972 to 2007. In November 2008 it stood at 72.3.

If a large percentage of the current capital stock is being utilized, firms are more likely to increase investment than they would if a large percentage of the capital stock were sitting idle. During recessions, the capacity utilization rate tends to fall. The fact that firms have more idle capacity then depresses investment even further. During expansions, as the capacity utilization rate rises, firms wanting to produce more often must increase investment to do so.

The Cost of Capital Goods

The demand curve for investment shows the quantity of investment at each interest rate, all other things unchanged. A change in a variable held constant in drawing this curve shifts the curve. One of those variables is the cost of capital goods themselves. If, for example, the construction cost of new buildings rises, then the quantity of investment at any interest rate is likely to fall. The investment demand curve thus shifts to the left.

The $10,000 cost of the solar energy system in the example given earlier certainly affects a decision to purchase it. We saw that buying the system makes sense at interest rates below 10% and does not make sense at interest rates above 10%. If the system costs $5,000, then the interest return on the investment would be 20% (the annual saving of $1,000 divided by the $5,000 initial cost), and the investment would be undertaken at any interest rate below 20%.

Other Factor Costs

Firms have a range of choices concerning how particular goods can be produced. A factory, for example, might use a sophisticated capital facility and relatively few workers, or it might use more workers and relatively less capital. The choice to use capital will be affected by the cost of the capital goods and the interest rate, but it will also be affected by the cost of labor. As labor costs rise, the demand for capital is likely to increase.

Our solar energy collector example suggests that energy costs influence the demand for capital as well. The assumption that the system would save $1,000 per year in energy costs must have been based on the prices of fuel oil, natural gas, and electricity. If these prices were higher, the savings from the solar energy system would be greater, increasing the demand for this form of capital.

Technological Change

The implementation of new technology often requires new capital. Changes in technology can thus increase the demand for capital. Advances in computer technology have encouraged massive investments in computers. The development of fiber-optic technology for transmitting signals has stimulated huge investments by telephone and cable television companies.

Public Policy

Public policy can have significant effects on the demand for capital. Such policies typically seek to affect the cost of capital to firms. The Kennedy administration introduced two such strategies in the early 1960s. One strategy, accelerated depreciation, allowed firms to depreciate capital assets over a very short period of time. They could report artificially high production costs in the first years of an asset’s life and thus report lower profits and pay lower taxes. Accelerated depreciation did not change the actual rate at which assets depreciated, of course, but it cut tax payments during the early years of the assets’ use and thus reduced the cost of holding capital.

The second strategy was the investment tax credit, which permitted a firm to reduce its tax liability by a percentage of its investment during a period. A firm acquiring new capital could subtract a fraction of its cost—10% under the Kennedy administration’s plan—from the taxes it owed the government. In effect, the government “paid” 10% of the cost of any new capital; the investment tax credit thus reduced the cost of capital for firms.

Though less direct, a third strategy for stimulating investment would be a reduction in taxes on corporate profits (called the corporate income tax). Greater after-tax profits mean that firms can retain a greater portion of any return on an investment.

A fourth measure to encourage greater capital accumulation is a capital gains tax rate that allows gains on assets held during a certain period to be taxed at a different rate than other income. When an asset such as a building is sold for more than its purchase price, the seller of the asset is said to have realized a capital gain. Such a gain could be taxed as income under the personal income tax. Alternatively, it could be taxed at a lower rate reserved exclusively for such gains. A lower capital gains tax rate makes assets subject to the tax more attractive. It thus increases the demand for capital. Congress reduced the capital gains tax rate from 28% to 20% in 1996 and reduced the required holding period in 1998. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the capital gains tax further to 15% and also reduced the tax rate on dividends from 38% to 15%. A proposal to eliminate capital gains taxation for smaller firms was considered but dropped before the stimulus bill of 2009 was enacted.

Accelerated depreciation, the investment tax credit, and lower taxes on corporate profits and capital gains all increase the demand for private physical capital. Public policy can also affect the demands for other forms of capital. The federal government subsidizes state and local government production of transportation, education, and many other facilities to encourage greater investment in public sector capital. For example, the federal government pays 90% of the cost of investment by local government in new buses for public transportation.

Case in Point: Assessing the Impact of a One-Year Tax Break on Investment

Figure 14.8

The U.S. economy was expanding in 2004, but there was a feeling that it still was not functioning as well as it could, as job growth was rather sluggish. To try to spur growth, Congress, supported by President Bush, passed a law in 2004 called the American Jobs Creation Act that gave businesses a one-year special tax break on any profits accumulating overseas that were transferred to the United States. Such profits are called repatriated profits and were estimated at the time to be about $800 billion. For 2005, the tax rate on repatriated profits essentially fell from 25% to 5.25%.

Did the tax break have the desired effect on the economy? To some extent yes, though business also found other uses for the repatriated funds. There were 843 companies that repatriated $312 billion that qualified for the tax break. The Act thus generated about $18 billion in tax revenue, a higher level than had been expected. Some companies announced they were repatriating profits and continuing to downsize. For example, Colgate-Palmolive brought back $800 million and made known it was closing a third of its factories and eliminating 12% of its workforce. However, other companies’ plans seemed more in line with the objectives of the special tax break—to create jobs and spur investment.

For example, spokesman Chuck Mulloy of Intel, which repatriated over $6 billion, said the company was building a $3-billion wafer fabrication facility and spending $345 million on expanding existing facilities. “I can’t say dollar-for-dollar how much of the funding for those comes from off-shore cash,” but he felt that the repatriated funds were contributing to Intel’s overall investments. Spokeswoman Margaret Graham of Bausch and Lomb, which makes eye-care products and repatriated $805 million, said, “We plan to use that cash for capital expenditures, investment in research and development, and paying nonofficer compensation.”

Analysts are skeptical, though, that the repatriated profits really contributed to investment. The New York Times reported on one study that suggested it had not. Rather, the repatriated funds were used for other purposes, such as stock repurchases. The argument is that the companies made investments that they were planning to make and the repatriated funds essentially freed up funding for other purposes.

Sources: Timothy Aeppel, “Tax Break Brings Billion to U.S., But Impact on Hiring Is Unclear,” Wall Street Journal, October 5, 2005, p. A1; Lynnley Browning, “A One-Time Tax Break Saved 843 U.S. Corporations $265 Billion,” New York Times, June 24, 2008, p. C3.

Answers to Try It! Problems

1. The investment demand curve shifts to the left: Panel (b).
2. A higher minimum wage makes labor more expensive. Firms are likely to shift to greater use of capital, so the investment demand curve shifts to the right: Panel (a).
3. The investment demand curve shifts to the right: Panel (a).
4. The investment demand curve shifts to the left: Panel (b).
5. An increase in interest rates causes a movement along the investment demand curve: Panel (c).
6. The investment demand curve shifts to the right: Panel (a).
7. The need to replace capital shifts the investment demand curve to the right: Panel (a).

Figure 14.9