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An alternative plan to save Europe’s economy

Frankfurt City FeatureFrankfurt City Feature

European Central Bank President Mario Draghi is expected to soon announce a quantitative easing-style bond buying stimulus program, aimed at lowering interest rates and stimulating investment in the deeply depressed eurozone economy.

While some economic commentators have been calling for such a program for years, as my colleague Geoffrey Smith points out, there’s plenty of reason to believe the effort won’t work as intended. Opponents of a European QE program argue that it won’t stimulate investment because the continent’s badly damaged banks and slack demand are the primary cause of the problems in Europe, rather than tight credit conditions.

Meanwhile, governments like Germany, which are running balanced budgets, are loathe to spend more to stimulate deeply depressed and indebted countries elsewhere in the Eurozone, an aggressive strategy that many economists deem necessary to jolt the continent back into growth mode.

Economist Martin Feldstein of Harvard University published a paper with the National Bureau of Economics this week that argues for an alternative approach European governments can adopt to stimulate investment. He advocates for a tax credit to businesses that invest in new projects, which can be paid for by an overall increase in the corporate tax rate. Writes Feldstein:

There are many ways that changing tax rules can increase aggregate spending without raising the fiscal deficit. Investment in plant and equipment can be stimulated by a temporary increase in the tax deductible depreciation rate on new investments in plant and equipment or by an enlarged investment tax credit. It would also be possible to reduce the net cost of funds by converting the deduction for business interest to a refundable credit at a higher effective rate. The cost of equity capital could be reduced by allowing deductions for dividends on common stock or preferred equity.

The resulting revenue loss could be balanced by a temporary rise in the corporate tax rate, effectively taxing the return on old capital while stimulating new investment. The necessary rise in the corporate tax rate could be adjusted after seeing the favorable effect of the policy on economic activity and tax revenue.

Feldstein argues that these benefits could be extended to consumers by giving tax breaks to home builders and homebuyers in the form of mortgage interest deductions. Such deductions could be rendered revenue neutral by raising rates on income elsewhere.

Another appealing part of this program is that while it would work better in a coordinated effort between countries, individual countries could enact these programs without approval from the EU government, as these measures would be revenue neutral and not run afoul of EU restrictions on increasing budget deficits.