I’ve often wondered about a puzzling issue: if the stock market is doing so well and technology keeps advancing, why are companies so hesitant to invest in new projects? Sure, they’re still spending, but the rate of business investment is slower than you’d think, particularly in areas outside of AI.
If you catch the headlines about slowing business investment, even in companies with rising profits, you’re not alone in your confusion. This has baffled economists and investors for quite a while. Back in 1975, public companies in the U.S. reinvested around 25 cents for every dollar on their balance sheets. Today, that figure has dropped to close to 12 cents.
In essence, while Corporate America has plenty of cash, its willingness to reinvest in its future is surprisingly minimal. What’s going on?
My colleague, an economist named Gustavo Grullon, and I recently published a research piece that challenges traditional views on this matter. We suggest that the issue isn’t simply bad executives or an unstable market; rather, it’s about how company incentives have historically been measured.
Reexamining the Questions
For a long time, economists have used straightforward, appealing ratios—like Tobin’s Q, named after the noted economist James Tobin—to gauge whether companies are likely to increase their investments. This ratio compares a company’s market value (the cash cost to buy it outright) to its replacement cost (what it would take to recreate it from scratch). A higher Q typically indicates more reasons for executives to invest.
Yet, reality doesn’t fully align with this theory. Over the last 50 years, even though Tobin’s Q has increased, the investment rate has noticeably declined.
What’s causing this? Our findings point to one significant factor: excess capacity. Many U.S. companies have more machinery and facilities than they’re currently utilizing. This underlying issue skews Tobin’s Q, making it seem like businesses have more reasons to grow than they actually do.
To illustrate, think about a commercial real estate firm with a range of office buildings. The shift towards e-commerce and remote work has left many of its properties underutilized. If new tenants start renting and filling up some of that empty space, the firm’s stock price and Q will increase. However, that could mislead the company into thinking it’s a good moment to invest in new buildings when, in reality, they still have vacant floors in existing ones.
The crucial point is that it’s not just the average value of assets that matters. Instead, it’s about the marginal value of investing another dollar. As companies face declining capacity utilization over the past decades, many perceive little incentive to invest further.
This might be surprising, but, unlike post-World War I, the U.S. economy isn’t struggling to maintain operations today. Many sectors are functioning well below their full potential. This gradual systemic growth partly explains why investment rates have dropped, even as profits and market values rise.
So, why has capacity utilization decreased so significantly in recent years? The reasons aren’t entirely clear, but what economists term “structural and economic rigidity”—including regulations, labor market issues, and changes in cost structures—contributes to this trend, especially after economic downturns.
The Bigger Picture
This isn’t just an academic debate. It holds substantial implications, whether you’re closely monitoring Wall Street or casually discussing economic policies. This dynamic might shed light on why tax cuts haven’t spurred investment as proponents hoped.
Take the Tax Cuts and Jobs Act of 2017. It lowered the corporate tax rate and introduced full expensing for equipment investments, prompting supporters to anticipate a surge in business investment.
However, after analyzing the data, we found quite the opposite. In the four years leading up to the tax cuts, U.S. companies’ investment rates—including intangibles—averaged 13.9%. Four years after the cut, this rate dropped to 12.4%. No surge in investment materialized.
So, where did that extra cash go? Instead of investing it in new projects, many companies opted to buy back stocks and increase dividends.
Looking back, this seems logical. If companies already have excess capacity, even lower prices due to tax breaks won’t incentivize them to invest. Without sufficient demand, the reasoning falls flat.
Even generous tax incentives won’t change the core challenges at play. You can’t compel investment in an environment already overwhelmed by excess capacity. Unless companies see genuine demand for growth, mere tax credits likely won’t lead to a significant increase in business spending.
This doesn’t mean tax policy isn’t crucial. It certainly has a role, especially for small and medium enterprises with genuine growth potential. However, for the larger, established firms that dominate the economy, the pressing issues relate to underlying demand. Instead of solely encouraging more investment, policymakers may need to focus on understanding why demand is sluggish and work on reducing economic barriers to help newly generated investments find their purpose.
