For years, I’ve puzzled over a question that seems to defy common sense: If stock markets are hitting records and tech innovation seems endless, why aren’t companies pouring money back into new projects?
Yes, they’re still investing – but the pace of business spending is slower than you’d expect.
And if you’ve noticed headlines about sluggish business spending even as corporate profits soar, you’re not alone. That’s confounded economists, policymakers and investors for decades.
My colleague Gustavo Grullon and I recently published a study that turns the field’s conventional wisdom on its head. Our research suggests the issue isn’t cautious executives or jittery markets – it’s about how economists have historically measured companies’ incentives to invest.
For decades, economists have relied on a simple ratio – Tobin’s Q, named after the economist James Tobin – to gauge whether companies should ramp up investment.
They calculate this by dividing a company’s market value – what it would take to purchase the firm outright with cash – by its replacement value, or how much it would cost to rebuild from scratch. The higher the ratio, the theory goes, the more incentive executives have to invest.
But reality hasn’t conformed to fit the theory. Over the past half-century, Tobin’s Q has gone up, yet investment rates have gone down sharply.
Why? Our research points to one key culprit: excess capacity. Many U.S. companies already have more factories, machines or service capability than they can use. By not correcting for this issue, the traditional Tobin’s Q will overstate the incentive that companies have to grow.
Consider a commercial real estate company that owns office buildings. With the rise of e-commerce and remote work, many of their properties have been running well below capacity. Now, suppose a few new tenants start absorbing a portion of that empty space. Stock prices will rise in response to seeing these new cash flows, which in turn will lead Q to rise.
Traditionally, this increase in Q would suggest that it’s a good time to invest in new buildings – but the reality is quite different.
This key idea is that what matters isn’t the average value of all assets – it’s the marginal value of adding one more dollar of investment. And because capacity utilization has been steadily eroding over the past half-century, many firms see little reason to invest.
Indeed, the U.S. economy, with all its factories and offices, isn’t nearly as active as it was after World War II. Many sectors operate well below full throttle. This growing slack in the system over time helps explain why companies have pulled back on investment.
Part of the reason might be what economists call “structural economic rigidities” – things such as regulatory hurdles. These factors can drag businesses into a state of chronic underuse.
The implications are profound, whether you closely follow Wall Street or debate economic policy. For one thing, this dynamic might help explain why tax cuts haven’t spurred investment the way supporters have hoped.
Take the $1.5 trillion tax cut in 2017, which slashed the top corporate tax rate from 35% to 21% and introduced full expensing for equipment investments. Supporters promised a wave of new investment.
But we found the opposite. In the four years before the tax cuts, publicly traded U.S. firms had an aggregate investment rate, including intangibles, of 13.9%. In the four years after the tax cut, the average investment rate fell to 12.4%.
Instead of plowing this newfound cash after the tax cuts into new projects, many companies funneled it into stock buybacks and dividends.
In retrospect, this makes sense. If a company has excess capacity, the incentive to invest should be more muted, even if new machines are suddenly cheaper.
You can’t force-feed investment into an economy already swimming in excess capacity. If companies don’t see real, scalable demand, tax breaks alone aren’t likely to unlock business spending.
That doesn’t mean tax policy doesn’t matter – it does. But for the large, well-established firms that make up the lion’s share of the economy, the bigger challenge is demand. Rather than trying to stimulate even more investment, policymakers should prioritize understanding why demand is sagging relative to supply and reducing economic rigidities where they can. That way, the capacity generated by new investment has somewhere useful to go.
David Ikenberry is a finance professor at Leeds School of Business at the University of Colorado Boulder. Distributed by The Conversation and The Associated Press.
