POLICY 2: INVESTMENT INCENTIVES
Suppose that Congress passed a tax reform aimed at making investment more attractive. In essence, this is what Congress does when it institutes an investment tax credit, which it does from time to time. An investment tax credit gives a tax advantage to any firm building a new factory or buying a new piece of equipment. Let’s consider the effect of such a tax reform on the market for loan able funds, as illustrated in Figure 3.
Figure 3 Investment Incentives Increase the Demand for Loan able Funds
If the passage of an investment tax credit encouraged firms to invest more, the demand for loan able funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate would stimulate saving. Here, when the demand curve shifts from D1 ·to Dz’ the equilibrium interest rate rises from 5 percent t~ 6 percent, and the equilibrium quantity of loan able funds saved and invested rises from $1,200 billion to $1,400 billion
First, would the law affect supply or demand? Because the tax credit would reward firms that borrow and invest in new capital, it would alter investment at any given interest rate and, thereby, change the demand for loan able funds. By contrast, because the tax credit would not affect the amount that households save at any given interest rate, it would not affect the supply of loan able funds.Second, which way would the demand curve shift? Because firms would have an incentive to increase investment at any interest rate, the quantity of loan able funds demanded would be higher at any given interest rate. Thus, the demand curve for loan able funds would move to the. right, as shown by the shift from DI to D2 in the figure. Third, consider how the equilibrium would change. In Figure 3, the increased demand for loan able funds raises the interest rate from 5 percent to 6 percent, and the higher interest rate in turn increases the quantity of loan able funds supplied from $1,200 billion to $1,400 billion, as households respond by increasing the amount they save. This change in household behavior is represented here as a movement along the supply curve. Thus, if a reform of the tax laws encouraged investment, the would I be higher interest rates and greater saving.
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