Snow Job

by Russ Roberts on February 16, 2006

in Less Than Meets the Eye

Treasury Secretary John Snow tries to make the case for the Bush tax cuts that lowered the tax on capital:

While officially the recession had ended in late 2001, the pace of the
recovery was too slow. Growth was anemic, business confidence low and
– of critical importance — capital investment was way down. As a
result job growth was nonexistent.

President Bush recognized that something needed to be
done to overcome those headwinds and, in particular, to create a more
favorable climate for capital investment that would result in job
creation. To do so he sent Congress far-reaching proposals to encourage
capital formation by lowering taxes on investment returns. Congress
responded with the Jobs and Growth Act, which was signed into law in
May 2003.

Since then we have seen a remarkable turn-around in
the economy. After nine consecutive declining quarters of real annual
business investment, we have had 10 straight quarters of rising
business investment. This business expansion led to a substantial
increase in employment. In the intervening period, some 4.7 million new
jobs have been created and the unemployment rate — 6.3% in 2003 –
today stands at 4.7%, lower than the average of the 1970s, ’80s and

I happen to agree with Snow on the virtues of low (or better yet, zero) taxes on capital.  And he may be right that the Bush tax cuts were good for the economy.  But his evidence is a bit misleading.  At first glance, the case looks pretty strong:

After nine consecutive declining quarters of real annual
business investment, we have had 10 straight quarters of rising
business investment.

Who could argue with that? Then you look at the chart that accompanies the article:


Look at that!  Nine negative quarters followed by ten positive guarters!  Pretty impressive.

Well, actually, it’s eight negative quarters.  But who’s counting?

But that’s not the real problem with the chart.

The problem is that if you took away the dotted line showing the date when Bush signed the tax cuts, the resumption of positive business investment looks perfectly consistent with the trend beginning in mid-2001—the negative rates of investment shrink until they turn positive in 2003.  There doesn’t appear to be any impact at all from the signing of the Act. 

And besides you’d really want to know when the Act took force.  And you’d also expect the behavioral changes the Act induced to begin before the Act took effect and maybe even before the signing.  Now if the signing or the implementation coincided with what looks like the 3rd quarter of 2001, then at least the picture would complement the claim that the tax cuts had driven the improvement in the business climate.  But the picture contradicts the claim of the article.  It makes it look like the return to positive business investment was in the cards even without the tax cuts.

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spencer February 16, 2006 at 3:24 pm

the primary driving force behind nonresidential fixed investment is corporate profits. If you compare investment growth with profits growth this cycle you would have to conclude that the tax cut hurt investments because investment growth has been much weaker then the historic relationship to profits would imply.

Max Born February 16, 2006 at 7:19 pm

Similar success stories:

The celebration of my 28th birthday led to 7 more successful years of ageing.

Man travelling from Florida to New York claims eating lunch in North Carolina was key to success.

In 2002, 7 of my friends opened online checking accounts resulting in continued growth for internet-based economy finally resulting in the success of Google.

There is just so much good news. I need to call my parents and tell them. You do too, Mr Snow!

Robert Higgs February 16, 2006 at 7:52 pm

It seems that the people who write public statements for politicians have studied the classic book by Darrell Huff, "How to Lie with Statistics," because the misuse of data that Huff illustrates is their veritable bread and butter–or should I say, guns and butter?

gump February 16, 2006 at 8:10 pm

I am skeptical of the statement, "the primary driving force behind nonresidential fixed investment is corporate profits." It is my understanding that the theory says that businesses invest when the user costs of capital are less than the rate of return. Therefore, reducing the cost of capital spurs nonresidential investment.

Brian Hart February 16, 2006 at 8:13 pm

I think you are doing the same thing with this graph that you pointed out the Washington Post was doing with the oil consumption graph.

If you graph the actual number, rather than percent change, you will get a line that is going down before the dotted line and going up immediately after. That would be a change in trend, not consistent with the trend.

It is reasonable to argue the extent of the impact the 2003 tax cut had on this change of direction. However, I don't think it is reasonable to argue that a number that is headed down will inevitably turnaround just because the percentage reduction is getting smaller.

spencer February 17, 2006 at 12:07 pm

gunp — your statement on theory is absolutely right. But essentially ever macro economic forecasting model has profits as the primary determinate.
theory vs pratice,

spencer February 17, 2006 at 12:14 pm

The two major reasons that investment is weak this cycle are:

1. Excess capacity in IT because of the 1990s boom.

2. Oil — a very large share of profits is going to oil this cycle and the oil service (drilling) industry does not have sufficient capacity to absorb it.

As one consequence corporate cash flow is unusually strong and corporate borrowing is unusually weak. Some argue this explains the low long term interest rates.

Noah Yetter February 17, 2006 at 1:46 pm

Brian if you graph the actual number instead of the first derivative, you can see the same story. You would not get a line with a negative slope changing suddently to a line with a positive slope. You would get a curve with a negative-but-decreasingly-so slope, that inflects and then turns positive-and-increasingly-so. You are right that the bend back to positive is not inevitable, but a consistently positive second derivative is highly suggestive that it will occur.

(OMG, an Austrian using math!)

Holly W. February 17, 2006 at 3:15 pm

… we have had 10 straight quarters of rising business investment.

I would add the quibble that there aren't 10 straight quarters of "rising" investment on that chart; the last four quarters are going down.

John Dewey February 17, 2006 at 4:35 pm

Spencer and Gump,

Not sure about macroeconomic modeling, but for some industries, profit levels alone have not determined investment. Two recent examples:
- dot.coms gobbled up many billions before showing returns;
- oil industry returned windfall profits to investors, maintaining long-term investment levels rather than funding marginal projects.

Isn't it the expectation of future profits that drives investment? If charismatic CEO's can sell their visions to investors, they'll get funding. But if doomsayers shake our collective confidence, even recent profitability won't overcome fear.

Doomsayers with national audiences may be the economy's biggest threat. FDR may still be right: "The only thing we have to fear is fear itself."

gump February 17, 2006 at 5:48 pm

I think we are saying the same thing. In my post, I was simply pointing out the economic principle behind the notion that reducing the cost of capital (accelerated depreciation, taxes, etc.) spurs business investment (because companies can increase profits). I admit that without any profit motivation there would be no reason for a company to invest, no matter how cheap the capital is. As an aside, the return on capital determines the profit margin.

Overall, I think the Solow Growth Model was an important achievement and the best way to grow society is to increase the amount capital per person. And one of the best ways to do this is to reduce the cost of capital.

Kevin February 17, 2006 at 9:15 pm

*** I would add the quibble that there aren't 10 straight quarters of "rising" investment on that chart; the last four quarters are going down. ***

Pardon if you understand this and were just speaking casually, but the chart is plotting "rising" investment – growth. Anything north of the zero line IS "rising" investment. The ups and downs of the curve above zero represent accelerating or decelerating growth.

And you can't maintain accelerating growth for very long, or you'll soon be breaching absurd numbers; that's not sustainable.

You can't even maintain a stable level of growth as high as, say 10+% for long — business investment is just one piece of the GDP, and even a robust GDP won't get much faster than 3.5 to 4% for more than brief runs.

If Business investment too much outpaced the rest of the GDP for very long, pretty soon business investment is a huge portion of the economy — which just isn't realistic.

save_the_rustbelt February 20, 2006 at 9:51 am

The economy recovered after a recession.

Wow, that is news!

The economy always recovers, the question is the rate and quality.

This recovery has been sluggish and uneven, particularly in labor markets.

Other than making a mess of the tax code for a decade (phase-in, phase-out, sunset, AARRGH!) I'm not certain what the Bush tax cuts have accomplished.

This will be a good week, just got Bruce Bartlett's book.

wulansari July 31, 2008 at 1:09 am

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