More bang for the investment buck

By , William C. Freund is senior vice-president and chief economist, New York Stock Exchange; and professor of economics, Graduate School of Business, Pace University, New York City.

Economic growth in the '70s lagged far behind the '60s -- we all know that. Since growth primarily depends on capital investment, it is easy to assume that less investment per worker was them factor responsible. Easy but wrong: A major roadblock to growth was a smaller "bang" for each investment buck.

This is our conclusion at the New York Stock Exchange where we have developed a new measure of economic performance, the Investment Efficiency Ratio or IER. The IER is calculated to show how much real growth the economy has produced for each investment dollar, after deducting the growth attributable to more labor hours. If we apply the IER to the period of the last three decades, we get an instructive view of what went wrong in the '70s.

Our calculations show that for each investment dollar, the economy produced 30 cents of real growth from 1950 to 1959, 27 cents of real growth from 1960 to 1969, and only 13 cents of real growth from 1970 to 1978. In other words, by the '70s the IER had declined to less than half of what it was in the '60s and to even lower levels compared with the '50s. We measured the IER for 1970-78 for four other countries -- France, Japan, West Germany, and the United Kingdom. In all of them investment efficiency was higher than in the US.

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Our low IER makes imperative a boost in the rate of investment. Otherwise we cannot expect to return to acceptable rates of growth in the new decade. To the extent that we can increase the IER itself, we can achieve higher growth without the short-run sacrifices in consumption that higher investment normally entails. We need to examine the reasons for the decline in investment efficiency and what , if anything, can be done about them:

* Declining entrepreneurship. A primary determinant of the level of the IER is the level of entrepreneurship -- creative risk-taking that channels investment into high-growth areas. A recent study by the New York Stock Exchange, "Building a Better Future," blames much of the decline in the IER on the dwindling of entrepreneurial initiatives. But the potentialm for entrepreneurial drive is still there. The problem is that entrepreneurship has been stifled by two significant trends in public policy that developed over the past decade.

* High capital gains taxes. First, public policy increased tax impediments to risk investment -- particularly by narrowing the difference between the tax rate on capital gains and the tax rate on dividends and interest. When the gap is narrowed -- when the historically lower rate on capital gains rises in relation to the rate on dividends and interest -- the IER declines. The reason is that a narrower spread lowers the after-tax return on growth-oriented investment (such as non-dividend-yielding stock) compared with the after-tax return on income-oriented investment (such as bonds). As a result, some growth-oriented programs simply cannot raise funds. And since income-oriented investment tends to be less innovative than growth-oriented investment, entrepreneurship stagnates.

The Tax Reform Act of 1978 -- which lowered the rate on capital gains -- finally took a first necessary step toward widening the spread between the capital gains and the dividends and interest tax rates.

* Overregulation. The dramatic increase in regulatory burdens imposed on the economy in the 1970s also exerted serious downward pressure on investment efficiency. Government regulation is an essential element in our modern socio-economic structure. But overregulation stifles the responsible entrepreneur. Too often today an entrepreneur who wants to start a new venture faces the risk that government will delay approval of the venture long enough to make it prohibitively costly. The prospective entrepreneur also often must face the high costs of complying with government regulation -- costs that can make or break a project. Quite apart from discouraging entrepreneurship, excessive compliance costs lower investment efficiency by diverting capital to nonproductive uses.

The prescription for the '80s is clear: We can boost the IER by easing tax burdens on investment and by doing away with unnecessary government regulation.

The New York Stock Exchange study shows that intelligent tax and regulatory policy shifts could lift the IER to almost 20 cents per investment dollar, compared with 13 cents during 1970-78 -- a good start on the road to real economic growth. In addition, we must increase the ratio of investment to gross national product by at least 20 percent if we are to travel that road smoothly.

With a combined boost in the investment rate and investment efficiency we can achieve an annual rate of real economic growth of 3.4 percent in the '80s -- less than growth rates of the '60s but substantially above our disappointing performance in the decade just ended.

In any case, much of the payoff must come from an increase in investment efficiency. Economic growth in the decade we've just entered will depend crucially on our determination and ability to create an environment that will release the full creative potential of entrepreneurs now waiting in the wings.

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