The question of who will replace outgoing Federal Reserve Chairman Ben Bernanke is important, not simply because the Fed plays a central role in monetary policy and banking system oversight, but because of policymakers’ reliance on the chair as a sage voice on broader economic policy. Former Fed chairman Alan Greenspan’s blessing of the 2001 Bush tax cuts, for example, gave skittish lawmakers worried about the impact of tax cuts on the federal budget deficit the cover to vote yes. Current Chairman Bernanke’s support for what became the American Recovery and Reinvestment Act of 2009 helped its passage.

One leading candidate to replace Bernanke is Larry Summers, the former head of the National Economic Council under President Obama and former Secretary of the Treasury under President Clinton. If Summers becomes Fed chair, one issue in which he could play a key role is the restoration of private sector capital investment.

As a forthcoming report by ITIF will show, America’s capital stock of machines, equipment and software has stagnated over the past decade thanks to a 30 percent drop in the rate of private sector capital investment compared to just two decades ago. This matters because investment in new machines, equipment and software is what helps diffuse innovation throughout the economy, thus driving economic growth. Without new capital investment refreshing the businesses’ capital stock, innovation loses its power, productivity growth stagnates, and U.S. competitiveness declines: exactly what we have been seeing.

One tool to boost private sector capital investment is the tax code, either through accelerated depreciation (writing off the value of machinery before its useful life is over) or even better, an investment tax credit, which would give companies a tax break for a portion of what they invest in new machines, equipment and software.

But if Larry Summers were to assume the helm of the Fed, how sympathetic would he be to the need for new measures to stimulate the private sector capital investment our economy desperately needs?

If you had asked Summers 30 years ago, the answer would have been, “not at all.”

In a 1979 National Bureau of Economic Research Working Paper 404, titled “The Investment Tax Credit: An Evaluation,” then economics professor Larry Summers and fellow economist Alan Auerbach modeled the impact of an investment tax credit (ITC). They found that a 12 percent ITC would increase the stock of equipment by 18 percent because companies would invest more as the after-tax cost of new equipment declines, which in turn would lead to higher gross domestic product (GDP).

Sounds good, right? Wrong. Summers and Auerbach go on to say that, “while it is relatively clear that the credit will spur investment in equipment… The credit will bid up interest rates… discouraging purchase of non-favored capital goods, principally structures.”

In other words, the ITC would lead to slightly fewer housing starts because mortgage interest rates would increase very slightly. In fact, the authors argue that the absence of a credit would have meant 600,000 more housing units by 1979, while “a constant 12% credit would have eliminated another one million housing units.” As a consequence, Summers and Auerbach conclude, “On balance, our examination of the empirical evidence leads us to conclude that the investment tax credit has had and continues to have an undesirable effect on the economy.”

After the massive overinvestment in housing in the first half of the 2000s brought the global economy to its knees in 2008, it’s a bit strange to be opposing policies that increase and sustain economic growth and competitiveness because they reduce housing starts.

Here’s Summers’ rationale: Even though an investment tax credit would lead to a higher GDP (and presumably a more globally competitive U.S. economy), Summers opposed it because it would distort the “natural” market-based pattern of investment, and its impact on housing would not favor “long-run capital accumulation.” This is an echo of Bush I economic advisor Michael Boskin’s famous statement: “potato chips, computer chips, what’s the difference?”

Summers is in essence saying “machines, mobile homes, what’s the difference? It’s all long-run capital accumulation.” Yet, housing is not capital accumulation; it is consumption that happens to get paid for through long-term loans that last more than one year.

The economy does not become more productive, innovative or competitive if we build another 100,000 McMansions. Real capital stock is not just any purchase or investment that lasts more than a year (the government definition of capital investment), it’s something that also generates productivity and/or innovation. Machines do this. Houses do not.

Seven years after their paper was released, Congress agreed with Summers and Auerbach. As part of the 1986 Tax Reform Act (the Holy Grail for neoclassical economists like Summers), Congress not only eliminated the investment tax credit (while of course keeping the mortgage interest deduction, which favors housing construction), but also increased corporate taxes while cutting individual taxes.

Talk about getting it wrong all the way around. After the 1986 reform, the tax code favored housing consumption over machine investment and cut taxes on rich people (who don’t move to China) while raising taxes on companies (that do move production to places like China in search of lower costs).

To be fair to Summers and Auerbach, they wrote this before the U.S. began to face the fierce international economic competition it does today. They assumed that U.S. manufacturing was healthy (it wasn’t), that investment swings were cyclical (they were not), and that housing was just as valuable as computers and machine tools (it is not).

But as we have written in Innovation Economics: The Race for Global Advantage, today the U.S. economy is in a race for its life, competing against other nations that will do anything to win in industries like autos, aerospace, computers, and life sciences. Rejecting a tax policy that favors investment because it is “industrial policy” – e.g., because it distorts natural market forces away from “non-favored investment” – is 20th century thinking.

As the Senate weighs the issue of who will chair the Fed, one central question as they consider Summers’ candidacy should be whether Summers’ current views on investment tax policy will help America compete globally – or push us even further behind.

Rob Atkinson is President of the Information Technology & Innovation Foundation, based in Washington, D.C.

Rob Atkinson

Rob Atkinson is president of the Information Technology and Innovation Foundation, a non-profit, non-partisan economic and technology policy think based in Washington.