The word investment can mean several things: a purchase of stock by an individual investor, a college student's “investment in herself” in the form of tuition, a company's investment in a new factory or a new fleet of trucks. Only the last of these would be counted in investment in the formula for GDP. The other two would be counted in “C” as consumption.
By definition, a capitalist economy is one in which people in the private sector can raise capital, invest it in a business, produce goods and services, and attempt to sell them in the market at a profit. Several forces drive business investment, and the most important of these are:
Keep in mind that wages and salaries paid by companies are not included in investment. Doing so would double count wages and salaries in GDP, because that money is already included in consumption expenditures.
Why would interest rates and taxes be listed first for business investment but last for consumption? Because, compared with consumption, business investment is more sensitive to interest rates and taxes. Of course, people are people, and people are making a decision to spend money whether they are part of a household or a business. However, people making business investment decisions usually (but not always) make them in a more disciplined and analytical manner than people making household spending decisions.
A business analyzes the amount of money it will earn on a new factory or piece of equipment and expresses it as a percentage of the money invested. That percentage is the investment's rate of return. The managers of the business compare the rate of return on an investment with the interest rate they will have to pay on the money that will finance the investment. If the rate of return on the investment is lower than the interest rate they must pay, the managers will not make the investment. For example, if a piece of equipment that costs $10,000 a year to lease and operate will produce goods that can be sold for a profit of $1,000, then the rate of return on the investment is 10 percent. ($1,000÷$10,000 = 10 percent) If the business pays an interest rate of, say, 7 percent on the money for the investment, then the investment would probably be considered attractive.
The rate of return on an investment is the amount of profit earned on the investment—that is, the amount of money earned after subtracting the expenses from the revenue brought in by the investment—expressed as a percentage of the investment.
Budget deficits occur when a government of a nation, state, or city spends more than it acquires in tax revenue during the period under consideration. The government borrows money from households and businesses to cover the spending that is not covered by taxes. A budget surplus occurs when the government takes in more tax money than it spends in a period.
Lower interest rates mean that more (lower return) projects become attractive to businesses, and therefore they will make more investments. For instance, projects with a rate of return of 12 percent are attractive to a company that only has to pay 8 percent interest. But at an interest rate of 12 percent, the investment is not worth pursuing.
Taxes on business, such as the corporate income tax and the capital gains tax, also affect business investment. This is a politically charged issue. Those who favor taxes (or higher taxes) on business believe a business benefits from government services, such as national defense, and should therefore pay its “fair share” of the cost. Those who favor no taxes (or lower taxes) on business believe that everyone who works for or invests in a business already pays personal income taxes. They also believe that taxes discourage business investment by taking money away from businesses and lowering the amount of money—the return—that the company realizes on an investment.
Although lower taxes can boost business investment, other factors, particularly interest rates, are usually more important drivers than taxes.
The availability of investment capital—that is, money—drives interest rates, but for the sake of clarity I discuss it separately from interest rates. Investment capital comes from households, through the banking system and the financial markets. People save their money in banks, buy insurance policies, and invest in stocks, bonds, and vehicles such as 401(k) accounts and mutual funds. A good portion of that money goes to businesses that invest it in plant and equipment.
As I mentioned earlier, U.S. households have a relatively low savings rate. They spend a larger portion of their income than consumers in most other industrial nations. But the U.S. economy is so stable and productive that many foreign financial institutions, which channel the savings of foreign households into investments, quite willingly invest in the United States. This foreign investment increases the supply of capital in the states beyond what it would be if U.S. businesses relied solely on the savings of U.S. citizens.
The government, however, also borrows money from households through the financial markets to finance budget deficits. When the government borrows truly large sums of money relative to the available capital, a phenomenon known as “crowding out” occurs. Crowding out refers to the fact that the government can borrow enough funds to crowd businesses out of the market for investment capital. In other words, if the government borrows enough money, it can curtail the availability of funds to other borrowers.
The major determinant of business investment may be the one least subject to economic analysis: the number of good investment opportunities that businesses have to choose from. It's true that lower interest rates can make low-return investments more attractive. It's also true that lower taxes and good availability of capital can spur investment. However, unless businesses see good opportunities, they will hold onto their cash or distribute it to their stockholders as dividends.
The business cycle of expansion and recession affects the number of opportunities for better or worse. Business formation—the number of businesses being established in a period—also contributes to or detracts from the level of business investment.
For instance, business investment remained relatively low throughout 2001 and 2002. As mentioned earlier, consumers did their part to hold the economy up. They continued to spend. But businesses saw few opportunities, particularly relative to all the opportunities they saw (or thought they saw) during the “e-business revolution” of the 1990s. Also, during the 1990s, they had invested heavily in productive capital, especially information technology, and needed time integrate it into their operations.
During 2001 and 2002, interest rates remained at 30-year lows. However, when business didn't see opportunities, they certainly weren't about to invest.
Excerpted from The Complete Idiot's Guide to Economics © 2003 by Tom Gorman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.