Determinants of investment

Taxes and investment

Policymakers change the tax code to shift the investment function and influence aggregate demand
and the two most important provisions of the taxation are
 Corporate income tax
 Investment tax credit

Corporate income tax

Taxes levied on corporate profits. The effect of a corporate income tax on investment depends on
how the law defines “profit’’ for the purpose of taxation.
In the case, tax defined on profits without any further provisions will be calculated on
Rental Price – Cost of capital
Which will be not a matter of worries for sharing fraction of profit with government until, rental price >
cost of capital because rationally investment incentives doesn’t get affected.
Also disinvest if rental price falls short of cost of capital.

In the other case, treatment of depreciation states definition of profit deducts the current value of
depreciation as a cost. On contrast, historical cost (value at the date of purchase)/expected years of
operation is deducted from the profit.

Profit– Depreciation = Net profit before tax – Tax = Net profit.

But during the period of inflation. Replacement cost is greater than historical cost, so the corporate
tax tends to understate the cost of depreciation and overstate profit. As a result, the tax law sees a
profit and levies a tax even when economic profit is zero, which makes owning capital less attractive.
For this many economists believe that the corporate income tax discourages investment .

Investment tax credit

A tax provision that reduces a firm’s taxes by a certain amount for each dollar spent on capital goods.
Because a firm recoups part of its expenditure on new capital in lower taxes, the credit reduces the
effective purchase price of a unit of capital. Thus, the investment tax credit reduces the cost of capital
and raises investment.

The stock market and the Tobin’s q

Stock refers to shares in the ownership of corporations and the stock market is the market in which
these shares are traded.

Stock rises when firms have many opportunities for profitable investment, because these profit
opportunities mean higher future income for the shareholders. Thus, stock prices reflect the
incentives to invest.
James Tobin proposed that firms base their investment decisions on the following ratio,

The numerator is value of the economy’s capital as determined by the stock market. The
denominator is the price of that capital if it were purchased today.
Tobin reasoned that net investment should depend on whether q > 1 or q < 1.
If q > 1, then the stock market values installed capital at more than its replacement cost. In this
case, managers can raise the market value of their firms’ stock by buying more capital.
And if q < 1, the stock market values capital at less than its replacement cost. In the case,
managers will not replace capital as it wears out.
Tobin q’s depends upon the current and future expected profits which is closely related neoclassical
model of investment.
If the marginal product of capital exceeds the cost of capital, then firms are earning profits on their
installed capital. These profits make the firms more desirable to own, which raises the market value of
these firms’ stock, implying a high value of q. Similarly, if the marginal product of capital falls short of
the cost of capital, then firms are incurring losses on their installed capital, implying a low market
value and a low value of q.
It reflects the expected future profitability of capital as well as the current profitability

Financing constraints
The limits on the amount firms can raise in financial markets.
When a firm is unable to raise funds in financial markets, the amount it can spend on new capital
goods is limited to the amount it is currently earning. Financing constraints can prevent firms from
undertaking profitable investments.
Financing constraints influence the investment behavior of firms just as borrowing constraints
influence the consumption behavior of households. Financing constraints cause firms to determine
their investment on the basis of their current cash flow rather than expected profitability.
Banking crisis and credit crunches
Banks have an important role in the economy because they allocate financial resources to their most
productive uses: they serve as intermediaries between those people who have income they want to
save and those people who have profitable investment projects but need to borrow the funds to
invest.
IS–LM model to interpret the short-run effects of a credit crunch
When some would-be investors are denied credit, the demand for investment goods falls at every
interest rate. The result is a contractionary shift in the IS curve. This reduces aggregate demand,
production, and employment.

The long-run effects of a credit crunch

When a credit crunch prevents some firms from investing, the financial markets fail to allocate
national saving to its best use. Less productive investment projects may take the place of more
productive projects, reducing the economy’s potential for producing goods and services.
From the look of emphasis on capital accumulation as a source of growth.
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