One of the disappointing features of the UK economy in recent years has been the performance of fixed investment. The latest reading, for the first quarter of 2022, suggests that the volume of business investment is 9.5 per cent below its pre-Brexit referendum levels. While the extent of the decline has been exacerbated by the pandemic, even before 2020 there were signs that corporate investment activity had tailed off. In view of the fact that the government introduced a ‘super deduction’ for investment in 2021, designed to boost capital spending, the ongoing weakness of investment is worthy of further investigation.
Why does investment matter?
We can think of investment as additions to the capital stock which firms require in order to meet their expected stream of future output. Since the dawn of the industrial revolution the stock of fixed capital has steadily increased, allowing the economy to generate output more efficiently which in turn has resulted in a significant improvement in living standards. Investment is also an important driver on the supply side of the economy where the size and efficiency of the capital stock are key determinants of the economy’s speed limit (the potential growth rate). In short, investment plays an important role in wealth creation and companies that do not invest in their productive potential do not grow and in the long run are unlikely to survive.
However, the forward looking calculations required to make investment decisions involve a number of complex elements. The most important question is whether additional capital investment will add to future profits which in turn requires an estimate of expected demand. Companies must also take a view on future changes to the tax structure which will change their forward-looking calculations. Moreover, they must factor in how to fund capital investment which requires firms to take into account the cost and availability of finance.
Since additions to the capital stock require a major financial commitment and are irreversible in the short term, the presence of uncertainty has a critical impact on decisions. The textbook definition of whether a capital project is worthwhile relies on the discounted value of its future cash flows. If the net present value (NPV) of investment is expected to be positive it is financially viable to go ahead. Since we cannot accurately predict the future, such calculations are fraught with uncertainty which adds a significant margin of error to the calculations. Uncertainty regarding the economic or geopolitical environment will raise question marks about future demand levels, while concerns around the future path of interest rates will affect the NPV calculations. However, even though the NPV may be negative today, it may turn positive in the future if circumstances change. There is thus an advantage to waiting before committing to a capital project. In this sense, there is an option-like feature to investment which can be called when the project in question is expected to make money.
The option feature might go some way towards explaining why investment activity has been weak in recent years. It is not that firms do not want to invest – they may be waiting for the right time to exercise the call option on projects currently in the pipeline. There are good reasons to suppose this may be the case: after all the outlook has been clouded by unprecedented uncertainty in recent years. Following the 2008 financial crash it took six years for business investment to recover to pre-2008 levels. Just as it seemed we were returning to an even keel, UK plc was hit by the result of the Brexit referendum which prompted many businesses to re-evaluate their plans. This was followed by the Covid pandemic (although 90 per cent of the Covid-induced collapse has since been reversed). In the face of all these problems it is no surprise that firms have been circumspect about making long-term decisions.
The good news is that data from the latest Bank of England Decision Maker Panel (DMP) through to May 2022 indicates that Brexit-related uncertainty has fallen to its lowest level on record. Just 1.2 per cent of survey respondents cited Brexit as the biggest source of business uncertainty while the proportion indicating that it was not important was at its highest rate of 28.2 per cent. Similarly, the DMP survey indicates that Covid-related uncertainty is at its lowest in the two years since this question was first asked, although the war in Ukraine has added an additional geopolitical dimension and is now one of the top three concerns for 27 per cent of respondents.
Care should be exercised in interpreting the data. The decline in Brexit-related uncertainty may not necessarily translate into higher investment. To the extent that Brexit is expected to result in a permanent 4 per cent loss of output, the capital stock is likely to adjust accordingly. Moreover, since uncertainty reflects indecision as to whether projects should go ahead, a decision to abandon capital investment plans will be reflected in a reduction in uncertainty just as much as the decision to go ahead. It is also worth bearing in mind the April CBI survey data, which suggests that investment intentions have weakened, with a balance of 9 per cent of respondents intending to increase plant and machinery investment over the next year compared with +26 per cent in January. Uncertainty is still very much the name of the game.
Using taxes and allowances to change the calculus
In a bid to break the cycle of weak investment, the chancellor announced in his 2021 Budget what he described as a ‘super-deduction’ allowance. Such allowances take the place of (non-tax deductible) depreciation allowances by allowing companies to write off the cost of certain capital assets against taxable income. In this case, the super deduction offers 130 per cent first-year tax relief on investment between April 2021 and March 2023. Thus, for every £1mn of qualifying expenditure, a company can deduct £1.3mn from its taxable profits, implying a tax saving of £247,000 (calculated as 19 per cent of £1.3mn, where 19 per cent is the rate of corporation tax). This is significantly more generous than the standard allowance of 18 per cent on plant and machinery.
Capital allowances impact on investment decisions through two main channels: on the one hand, they lower the cost of capital – the minimum pre-tax rate of return required for an investment to be attractive. In addition, they increase the availability of funds for cash constrained firms by reducing tax liabilities. Even though most investment is financed by borrowing, the empirical evidence suggests that firms’ investment behaviour is positively related to cash flow and as a result investment allowances generally do have a positive impact on capital spending. This is backed up a survey conducted by the CBI in February, which suggested that the super deduction has spurred business investment and that a fifth of qualifying capital spending is only taking place as a result of the scheme. However, there is a risk that the generous allowance will merely bring forward activity that would otherwise have occurred in the future and that investment will fall back once the scheme comes to an end next March. For this reason the CBI is calling for a permanent 100 per cent tax deduction for capital spending which it calculates could boost business investment by £40bn by 2026. In the absence of such a scheme, however, it reckons that business investment in the UK will remain the lowest in the G7 by 2026.
Businesses will also have to contend with significant changes to corporate taxes from April 2023 which could have a major bearing on investment decisions. The main corporate tax rate will rise from 19 per cent to 25 per cent for companies with profits of more than £250,000 per year and those earning profits of between £50,000 and £250,000 will be subject to a rate between 19 per cent and 25 per cent. Other things being equal, higher corporate tax rates will increase the cost of capital which will act to depress investment. This puts the government in something of a policy dilemma. It wishes to boost tax revenues while at the same time stimulating investment, but pursuing the former by raising corporate taxes could jeopardise the latter. It is not a circle that will easily be squared.
Why this matters for financial investors
Equity investors generate their return from the cash flows that companies generate. In order to generate these cash flows firms have to invest in productive assets but only if the returns outweigh the costs is the investment worthwhile. The evidence of recent years suggests that companies assess the returns to capital investment as marginal at best. In the manufacturing sector net returns to capital employed have been declining since 2017 and are now running at a rate of 8.7 per cent versus a long-term average in excess of 11 per cent (service sector profitability is holding up rather better). This combination of weakening profitability and an uncertain demand outlook, coupled with the prospect of higher taxes, suggests that investment is not likely to rebound sharply anytime soon. This will ultimately impact on profits. Faced with this prospect, equity investors perhaps ought to hope the government heeds the CBI’s call for an extension of capital allowances beyond 2023.
