Discussion of “General-Equilibrium Effects of Investment Tax Incentives” by R. Edge and J. Rudd Roland Straub European Central Bank Rome, 30 June 2009

Summary of the Paper Assessing the effect of changes in investment tax policy on capital spending and macro aggregates  Partial expensing allowance vs. capital tax rate “Good and bad news” delivered in the paper:  Goods news: under “realistic” nominal rigidities the impact of partial expensing allowances on investment is stronger than previously contemplated  Bad news: countercyclical fiscal rule with temporary partial expensing can be destabilizing

Framework Prototype New Keynesian DSGE model with nominal taxation  Utility and profit maximisation  Capital accumulation: investment and capital adjustment costs  Sticky prices and wages  Nominal tax on capital and personal income  Balance budget rule: (distortionary) tax income is redistributed (lump-sum) among households  Taylor-style monetary policy rule

Partial Expensing Allowance Budget constraint of households:  Partial Expensing Allowance: partial rebate of the purchase price of new capital good.  Previously expensed allowance does not receive depreciation allowance.

Good News Partial vs. General Equilibrium Model (flex price model)  DSGE model: flexible price model  Partial model: Tobin’s Q set-up  Capital and Investment adjustment cost  Permanent introduction of (real) partial expensing allowance: Partial equilibrium: only restriction to reach new equilibrium is due to capital/ investment adjustment cost GE framework implies a trade-off between capital accumulation and (indirectly) labour supply  Temporary introduction of (real) partial expensing allowance: pulling forward investment

Good News Adding realistic nominal rigidities: sticky prices and wages, nominal tax system  Investment response is stronger than in the flexible price GE and PE case  Driven by the assumption of sticky wages and unindexed nominal tax system  Sticky wages makes AS curve flatter – investment response is stronger to changes in fiscal policy  Unindexed nominal tax system: investment is a function of nominal interest rates – lower inflation rate further stimulates investment by inducing lower nominal ineterest rates.  Expansionary fiscal policy can also push down inflation (see also Straub and Tchakarov, 2006 for government investment)

Bad News Countercyclical Investment tax is destabilising  Christiano (1984): anticipation of the introduction of partial expense allowance is destabilising  Investment decision are postponed  Further weakening investment in the run-up of the enactment of the expensing allowance  Still partly true in this model, but is partly offset by the desire to avoid large swings in capital stock and investment spending due to adjustment costs.

Partial Expensing vs. Capital Income Tax cuts  Impact of capital income tax cuts are frontloaded Best “tax-savings strategy” for an individual firm is to purchase and hold capital right at the beginning and hold it until the end. Expense allowance is worth roughly the same at any point of the allowance period.  Partial Expensing has a stronger revenue impact  Capital income tax cuts are fiscally expensive: Capital income tax applies income to all capital while expensing allowance applies only to new investment

Some Remarks and Suggestions Fiscal Policy (partial expensing allowance) as a countercyclical tool Normative issues Investment tax and the open economy Distributional issues

Comments : Fiscal Policy as a Countercyclical Tool Under which circumstance are investment tax incentives the best tool? The paper provides an interesting overview of the advantages of partial expense allowance compared to other fiscal instruments

Comments : Fiscal Policy as a Countercyclical Tool Investment based tax incentives have some appeal compare to other fiscal measures Income taxes, in general, stimulate the least when they are expected to be temporary, but permanent income tax cuts might jeopardize budget discipline (Laffer-curve) Government consumption may face constraints in the existence of Ricardian Equivalence Government investment might have some appeal, but require that government decides about the “sensibility” of investment projects – long time lag

Comments : The role of credit constraint What is the scope of investment tax incentives for the current crisis? Investment tax incentives might not work if credit market are distorted (as currently)  Investment will not be responsive to changes in the intertemporal price due to credit constraints Important to identify the reason for the downturn to assess the efficiency of the instrument Important to check for the role of credit constraints

Comments : Normative issues What is the goal of fiscal policy in the model?  Metric (seems to be): (i) maximum response of investment/ output, (ii) fiscal efficiency  Metric could be spelled out more clearly  Possibly, but not necessarily based on micro-founded welfare

Comments: What is the goal of fiscal policy? Temporary investment tax incentives in an open economy  Investment tax incentives might have substantial impact on the trade balance  Alternative policies can have differential impact on the external positions Temporary investment tax incentives might have consequences on income distribution  Major differences in the response of asset holders and non- asset holders To check some of the hypothesis, I utilise the open- economy version of the NAWM (Coenen and Straub, 2005)

New Area Wide Model Two-country Open Economy Model (Coenen and Straub, 2005)  Calibrated to match US and euro area macro data  New Keynesian DSGE Model  Real rigidities: monopolistic competition, investment adjustment costs, variable capacity utilisation  Nominal Price and wage rigidities  Open Economy: consumption and investment imported goods, producer currency pricing.

New Area Wide Model Two-country Open Economy Model (Coenen and Straub, 2005)  Heterogeneous Households: asset holders (HH I) and non- asset holders (HH J).  Fiscal Policy: government consumption, government investment, distortionary taxes (consumption, capital, income).  A fall in distortionary taxes are matched by am asymmetric reduction of lump-sum transfers.

Open Economy Issues: Capital Tax Shock One percent capital tax cut

Triggering a trade balance deficit Open Economy Issues: Capital Tax Shock

Open Economy Issues: Income Tax Shock One percent income tax cut

Open Economy Issues: Income Tax Shock Triggering a trade balance surplus

Distributional Issues: Capital Tax Shock Negative correlation of consumption of HH I and J

Distributional Issues: Capital Tax Shock Mainly driven by a fall in transfers to HH J

Distributional Issues: Income Tax Shock Positive correlation of consumption of HH I and J

Distributional Issues: Income Tax Shock Similar path of labour effort and real wages of HH I and J

Conclusion Very interesting paper It is very timely and relevant to think about the macro effects of fiscal policy beyond government spending Credit constraints and investment tax incentives What is the right metric for a normative approach? Open Economy issues Distributional issues