MACROECONOMIC

ENVIRONMENT
4. INVESTMENT
FUNCTION
 Introduction
• Investment:
 Links the present to the future
 Links the goods and money markets
 Drives much of the business cycle.

• Investment is the most volatile sector of

aggregate demand; changes in investment
account for much of the change in GDP.

• We wish to study how investment depends on

interest rates and income.
 Introduction
• Investment is the flow of spending that adds to the stock
of capital.
• Both GDP and investment are flow variables.
• Capital is the rupee value of all the buildings, machines,
and inventories at a given point in time - stock value.
• Investment is the amount spent by businesses to add to
the existing capital stock over a given period.
• Flow of investment is quite small compared to the stock of
capital.

• The theory of investment is the theory of the demand for

capital.
 The Desired Capital Stock
• Firms use capital, along with labor and other resources, to
produce output. The goal of a given firm is to maximize profits.

- When deciding the optimal level of capital, firms must

balance the contribution that more capital makes to their
revenues against the cost of acquiring additional capital.

- The marginal product of capital is the increase in output

produced by using 1 more unit of capital in production.
- The rental (user) cost of capital is the cost of using 1 more
unit of capital in production.
 The Desired Capital Stock
• To derive the rental cost of capital:
– firms finance the purchase of capital by borrowing over time, at an
interest rate of n.
– In the presence of inflation, the real cost of capital(r) differs from the
nominal cost of capital(n).

Real cost of capital (r) = nominal interest rate(n) – inflation rate(πe).

– At the time the firm makes an investment, the nominal interest rate is
known, but the inflation rate for the coming year is not.

• Real cost of borrowing is the expected real interest rate:

– Capital wears out over time - rc must include depreciation, d.

– The complete formula for the rental cost of dcapital is:
rc r  d n   e 
 The Desired Stock of Capital
•Firms add capital until the marginal
return of the last unit added drops to
the rental cost of capital.

•Diminishing MPK means that each

successive unit of capital yields less than
the previous unit.

•An increase in the rental cost of capital

can only be justified by an increase in the
MPK, and a lower level of K.

•The relationship among the desired

We assume that the total population and capital stock, K*, rc, and output is -
aggregate labor input and the level of
technology remain constant. K *  g ( rc , Y )
 The Desired Stock of Capital
_ +
*
K  g (rc , Y )
• An increase in rc decreases K*. An increase in Y
increases K*.

• Tax holidays decrease rc. An increase in

corporate tax rate increases rc.
• An investment tax credit (subsidy) by govt
reduces rc.
• Tax Incentives In India focus mainly
on establishing new industries,
encouraging investments in
underdeveloped areas, infrastructure,
& promoting exports.
 2019
• Tax incentives for infrastructure development undertakings
• Enterprises engaged in the business of power generation,
transmission, or distribution; developing or operating and maintaining a
notified infrastructure facility, industrial park, or SEZ; or laying and
operating a cross-country natural gas distribution network are eligible
for a tax exemption of 100% of profits for any ten consecutive years
falling within the first 15 years of operation (first 20 years in the case of
infrastructure projects, except for ports, airports, inland waterways,
water supply projects, and navigational channels to the sea).

• Since now there are investment-linked deductions, the profit-linked

deduction available for infrastructure facilities have a sunset clause of
31 March 2017 for commencement of the operations. Thereafter,
deduction of 100% of capital expenditure incurred on setting up of the
said infrastructure facility is available with effect from 1 April 2017.
• Tax incentives for exports
• Export profit from a new undertaking, satisfying prescribed conditions and
set up in an SEZ, is eligible for tax exemption of 100% for the first five
years, from the year in which manufacturing commences, followed by a
partial tax exemption of 50% for the next five years. A further tax exemption
of 50% of the export profit for five years is also available after that, subject
to an equal amount of profit being retained and transferred to a special
reserve in the books of account. The said exemption is available on
commencement of eligible business between 1 April 2006 and 31 March
2021.
• Research and development (R&D) expenditure
• A weighted deduction of 150% of expenditure is available in respect of
expenditure incurred on scientific research in an in-house R&D facility
approved by the prescribed authority for companies engaged in
specified businesses and in research associations, universities, etc.,
respectively. Such weighted deduction will be restricted to 100% of the
expenditure from tax year 2019/20 onwards.

• A payment made to an approved research association undertaking

research in the social sciences or in statistical research, or to an
Indian company to be used by it for scientific research, is eligible for a
deduction of 100% of the payment made.

• Contributions made to any National Laboratory, approved scientific

research associations, universities, and the Indian Institute of
Technology are eligible for a weighted deduction of 150% of the
contributions made up to 31 March 2021. Thereafter, the deduction
will be restricted to 100% of the contribution.
 Tax Incentives In India
Tax Incentives of Capital Expenditure on Certain Specified
Businesses
Capital expenditure is allowed at 100% from 1st April, 2017 in respect of
the following specified businesses –

•Setting up and operating cold chain facilities

•Warehousing facilities for storage of agriculture produce
•Setting up and operating a hotel of 2 star and above category
•Building and operating a hospital with at least 100 beds
•Laying and operating a cross country natural gas or crude or
petroleum oil pipeline network for distribution incl storage facilities.
•Notified affordable housing projects
•Production of fertilizer.
 Tax Incentives In India
Tax incentives for units in the NE
•Undertakings located in the NE and in Sikkim that commence an
eligible business between 1st April 2007 and 1st April 2017 are eligible
for a 100 % deduction of profits for 10 consecutive years.

•Eligible businesses include – hotels(2 star and above); adventure and

leisure sports; provision of medical and health services in nursing
homes with at least 25 beds; civil aviation related training; fashion
design and industrial training; mfg of IT hardware and biotechnology.

Patent Box Regime

•To encourage innovation, govt has introduced a concessional tax rate
of 10% for royalty income from patents, starting from the year 2016-17.
 Lower Corporate Tax Rates In India, 2019
• a. In order to promote growth and investment, the Income-tax Act with
effect from FY 2019-20 allows any domestic company an option to pay
income-tax at the rate of 22% subject to condition that they will not avail
any exemption/incentive. The effective tax rate for these companies shall
be 25.17% inclusive of surcharge & cess. Also, such companies shall not
be required to pay MAT.

• b. In order to attract fresh investment in manufacturing and thereby boost

the ‘Make-in-India’ initiative of the Government, another new provision in
the Income-tax Act w.e.f FY 2019-20, allows any new domestic company
incorporated on or after 1st October 2019 making fresh investment in
manufacturing, an option to pay income-tax at the rate of 15%. This benefit
is available to companies which do not avail any exemption/incentive and
commences their production on or before 31st March, 2023. The effective
tax rate for these companies shall be 17.01% inclusive of surcharge &
cess. Also, such companies shall not be required to pay MAT.
• c. A company which does not opt for the concessional
tax regime and avails the tax exemption/incentive shall
continue to pay tax at the pre-amended rate. However,
these companies can opt for the concessional tax regime
after expiry of their tax holiday/exemption period. After
the exercise of the option they shall be liable to pay tax
at the rate of 22% and option once exercised cannot be
subsequently withdrawn. Further, in order to provide
relief to companies which continue to avail exemptions
/incentives, the rate of MAT has been reduced from
existing 18.5% to 15%.
 Tobin’s q
• The q theory of investment restates the marginal benefit equals marginal
cost rule in more easily quantifiable terms. It points out that that the
price of a company’s stock, is a measure of the value of that capital.
Likewise, the amount of money that would be required to replace all of
the capital that a firm owns is a measure of that firm’s cost of capital.

• Looking at the ratio of the market value of a firm (the number of shares
of stock it has issued times the market value of those shares) to that
firm’s replacement cost of capital, we get the ‘q’ ratio -

market val
ueof firm
q
replacemen
t costof firm's capital
• The q ratio tells us something about the ratio of marginal benefits to
marginal costs: A q greater than 1 suggests that the benefit of acquiring
new capital exceeds the cost, or that the firm should invest more. A q
smaller than one suggests that the cost of acquiring new capital is
greater than the benefit, or that the firm should disinvest -allow its capital
stock to fall. A q exactly equal to 1 suggests that the firm has exactly the
right amount of capital, or capital is at its desired level.
 Capital Stock Adjustment
• The rate of investment depends on the difference between
the actual capital stock (K) and the desired capital stock
(K*). The flexible accelerator model is based on the
notion that firms with larger gaps between their actual and
desired capital stocks should be investing more than firms
whose actual capital stock is closer to its desired level. It
assumes that firms try to close some fraction, λ , of this
gap each period, or that

I  K  K  1   K *  K 1
• where K–1 represents the capital stock that the firm had at
the end of the previous period.
• Equation shows investment spending as a function of K *
and K-1. Any factor that increases K*, increases the rate of
investment.
Capital Stock Adjustment

Figure illustrates how the

capital stock adjusts from
an initial level of K-1 to the
desired level K*.

Upper panel shows the

stock of capital.

Lower panel shows the

corresponding level of I.
Monetary, Fiscal Policy & Desired Capital
Stock

• K* increases when rc falls and when expected Y

increases. Increase in K* affects ‘I’ spending.

• roi is a prime determinant of the cost of capital.

• Loose MP lowers roi and increases the K*.

• A high tax-low G policy keeps roi low (due to budget

surplus) & increases K*. A low tax-high G policy keeps
roi high (due to budget deficits) and decreases K*.
 Investment and Aggregate Supply
• Investment is a component of aggregate
demand, but doesn’t it also increase potential
output? In the long run, yes.

• Investment is one of the most effective ways to

expand capacity. In fact, countries which invest
a substantial fraction of their output tend to grow
much faster than countries which do not.

• But the supply-side effects of any type of

investment are rarely felt in the short run, so can
be ignored in the Keynesian model since
Keynesian macroeconomics is short run
macroeconomics.
xxx

Economic Survey 2018-19 Volume 2

India Data
India Data
India Data
2017
GFCF

47.16
41.89
28.49
2012-13(38.6%); 2013-14(34.7%); 2014-15(34.2%); 2015-16(32.1%)
Economic survey, 2014-15