When economic weakness leads to rising unemployment and falling productivity, policy makers typically offer businesses tax incentives to upgrade equipment, expand operations, and otherwise invest in themselves. Incentives such as the Internal Revenue Service’s special depreciation allowance, which was estimated to cost the United States some $100 billion a year in foregone tax revenue during the last recession, are designed to spur job creation and consumer spending.
But the effectiveness of these incentives has been greatly overstated, according to research by Chicago Booth’s Thomas Winberry. Furthermore, his results suggest that shaping incentives to target only companies that require them for spending commitments is vastly more cost-effective than offering them broadly.
Winberry argues that although the state of the economy affects how stimulus policies influence corporate investment, the most-popular models used by policy makers and economists fail to consider this. Corporate investment can be uneven over time: businesses are less responsive to tax incentives during recessions, and they’re far more responsive when the economy is strong. During a brisk economic expansion, businesses are up to 35 percent more likely to make an investment because of a tax incentive than they are in a similarly deep recession, according to Winberry’s model. His findings give good reason for policy makers to “take seriously that no firm looks exactly like the average,” Winberry says. Yet traditional models average responsiveness across business cycles, which inflates the effectiveness of hypothetical stimulus packages, he says.
Winberry also argues that when it comes to how an individual company is affected by stimulus, the company’s size matters. The model Winberry created teases out the conditions in which a firm ratchets up spending on stimulus, as opposed to when it continues business as usual. The model tackles a common conundrum in fiscal policy: When do incentives spark investment that would not otherwise occur, and when do they simply subsidize expansions that businesses would have undertaken without government help?
He uses the model to test a hypothetical policy that gives incentives to only large corporations, which the model indicates are less likely than small firms to increase investment without stimulus. This targeted stimulus would be five times more effective at generating spending in the economy than the sort of broadly distributed stimulus packages currently in place, the model predicts.
This article was contributed with permission from The University of Chicago Booth School of Business.