Tax Incentives and Economic Growth

By Barry P. Bosworth | Go to book overview

CHAPTER FOUR
Investment Demand and Its Relation to Saving

THE EFFORT to discover the basic determinants of investment demand has been one of the most active areas of economic research and debate. From a theoretical perspective, current investment should be a function of expected future sales (a scale factor) and the cost of substituting capital for labor. The cost of capital is a composite measure of the cost of hiring a unit of capital, including depreciation, financing, any capital gain or loss because of price changes, and taxes. A controversy arises, however, from conflicting views about the importance of the cost of capital in investment decisions.

The primary issue is an empirical one, involving the technological constraints on the substitution of capital for labor in production. If firms can choose from a range of production processes using different combinations of capital and labor, they should be sensitive to the relative costs of the two factors in their investment decisions. If the opportunities for substitution are limited, the components of the cost of capital--inflation, interest rates, and taxes--are largely irrelevant to investment decisions; and the government's ability to affect investment is limited largely to altering expectations about the future growth of sales.

The neoclassical model of investment behavior is based on the assumption that substitution among the factors of production in response to variations in their relative costs is an important element of firms' decisions. The opposing hypothesis is identified with the pure accelerator model of investment. The accelerator model does not require fixed proportions of capital and labor over time (it acknowledges that technology does change); but it does assume that these proportions are not influenced by changes in relative prices. That may be because the potential for substitution at any point in time is limited or because firms do not accurately perceive the full range of possibilities in making their investment decisions.

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Tax Incentives and Economic Growth
Table of contents

Table of contents

  • Title Page iii
  • Foreword vii
  • Contents ix
  • Chapter One - the Supply-Side Debate 1
  • Chapter Two - the Role of Capital Formation 23
  • Summary 55
  • Chapter Three - Saving and Private Capital Formation 59
  • Summary 94
  • Chapter Four - Investment Demand and Its Relation to Saving 97
  • Summary 127
  • Chapter Five - Labor Supply 130
  • Summary 172
  • Chapter Six - Implications for Economic Policy 177
  • Index 205
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