Purse-onal Issues
Business investment is the key to getting the economy going again.

Aldona and Gary Robbins are the operators of Fiscal Associates, an economic consulting firm in Arlington, Virginia. Both are Senior Research Fellows with the Institute for Policy Innovation in Lewisville, Texas.
August 22, 2001, 8:00 a.m.

he U.S. economy has slowed dramatically this year, and of the many culprits there may be few more guilty than a business community hesitant to invest in itself.

Commerce estimates released at the end of July put economic growth at an anemic 0.7% in the second quarter and 1.0% since January. That is considerably lower than the 5%-plus pace set during the first half of last year. Estimates due out at the end of August could show zero or negative second-quarter growth.

While many look to the consumer for a read on whether the economy may be headed into a full recession, business investment is the bigger concern. Well before the last recession, which began in July 1990, businesses began to curtail spending on plant and equipment. As the chart below shows, private fixed investment after depreciation declined from 6.2% of net national product (NNP) at the beginning of 1989 to 5.1% as the recession entered its trough in March 1991. (Excel sheet with data and charts may be downloaded here).

History shows that rebounds in business-investment are slow to come, so they should never be allowed to fall too far out of reach. In the first half of the '90s, it took a full five years for net investment to reclaim the same share of NNP that it had enjoyed in 1989.

Spending by businesses on plant and equipment has been the main engine of economic growth over the last five years. In the second quarter of last year, net private fixed investment reached 8.1% of net national product, more than twice what it had been at the start of the recovery. This rapid expansion of capital helped produce the robust, 4%-plus growth witnessed during the second half of the 1990s. Since then, however, the economy has been experiencing a severe investment slump. At the end of July, 2001, net investment had dropped to 6.7 percent of NNP.

Another major factor tied to growth in the later '90s was a surge in productivity, thanks in large part to more and better capital coming out of the information-technology revolution. In five short years (1995 to 1999), private fixed investment in computers quadrupled (from 4.4% to17.2%) while software investment almost doubled (from 7.4% to 12.9%). Information processing equipment, in general, went from a little more than a fifth of private fixed investment (21.9%) to well over a third (38.2%).

Yet, high-tech investment, which started slowing last year, has fallen 16% since January. Computer investment, which had been registering annual growth rates of 40%, has dropped 16% this year. In fact, the investment slump is coming solely from the equipment and software area (see chart below). Investment in the two other major categories — non-residential structures and residential structures and equipment — remains fairly stable. Unless investment, particularly in high technology, picks up, recent productivity gains could reverse.

While there still could be a recovery during the second half of the year, investment signs point in the other direction. In most downturns, the drop in investment and productivity is followed by a decline in hours worked. As capital and labor are cut back, the rate of growth slows further. Since March, the economy has been shedding jobs at a rate of 65,000 a month. Recent reports of layoffs in "new" and "old" economy companies, like AOL and Ford, suggest that the worse may not be over.

For the pace of economic growth to pick up businesses will have to start investing again. And for that to happen, new capital must be able to produce an adequate return. Unfortunately, returns to capital are being squeezed by historically high tax rates, largely the result of bracket creep and an antiquated system of tax depreciation. This year's tax rebate, which stems from the creation of a new 10% bracket, offers little relief.