A Reconsideration of the Effects of Budget Policy on Investment

William Gale and Peter Orszag (2005) note that those using the user cost of capital model have explicitly or implicitly assumed revenue-neutral tax changes. Gale and Orszag expand the traditional model to consider deficit-financed tax reductions. This paper builds upon their approach to quantify the significance of spending changes in a spending and tax user cost of capital framework. Overall, the results suggest that—holding tax policy constant—a decrease in spending will significantly increase overall business demand for investment. This framework is then applied to a policy simulation of the medium- to long-term results of a reduction in federal spending equivalent to the size and timing of the Budget Control Act of 2011 and finds it will result in a 1.5% increase in investment (or a $31.5 billion increase when scaled to the 2013 US economy).

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