ASEAN & the EC: Cost of Capital in Major EC Countries and Their Effects on the Production Structure 9789814377218

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ASEAN AND THE EC Trends in the Cost of Capital in Major EC Countries and Their Effects on the Production Structure

The Institute of Southeast Asian Studies was established as an autonomous organization in May 1968. It is a regional research centre for scholars and other specialists concerned with modem Southeast Asia, particularly the multi-faceted problems of stability and security, economic development, and political and social change. The Institute is governed by a twenty-two-member Board of Trustees comprising nominees from the Singapore Government, the National University of Singapore, the various Chambers of Commerce, and professional and civic organizations. A ten-man Executive Committee oversees day-to-day operations; it is chaired by the Director, the Institute's chief academic and administrative officer. The ASEAN Economic Research Unit is an integral part of the Institute, coming under the overall supervision of the Director who is also the Chairman of its Management Committee. The Unit was formed in 1979 in response to the need to deepen understanding of economic change and political developments in ASEAN. The day-to-day operations of the Unit are the responsibility of the Co-ordinator. A Regional Advisory Board, consisting of a senior economist from each of the ASEAN countries, guides the work of the Unit.

ASEAN-EC Economic Relations Series General Editors: Norbert Wagner, Tan Loong-Hoe, Narongchai Akrasanee

ASEAN AND THE EC Trends in the Cost of Capital in Major EC Countries and Their Effects on the Production Structure

Georg Erdmann Bruno Fritsch Center for Economic Research Swiss Federal Institute ofTechnology

ASEAN Economic Research Unit INSTITUTE OF SOUTHEAST ASIAN STUDIES

Published by Institute of Southeast Asian Studies Heng Mui Keng Terrace Pasir Panjang Singapore 0511 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the Institute of Southeast Asian Studies. © 1989 Institute of Southeast Asian Studies The responsibility for facts and opinions expressed in this publication rests exclusively with the authors and their interpretations do not necessarily reflect the views or the policy of the Institute or its supporters.

Cataloguing in Publication Data

Erdmann, Georg. ASEAN and the EC : trends in the cost of capital in major EC countries and their effects on the production structure / Georg Erdmann and Bruno Fritsch. 1. Capital -- Prices -- European Economic Community countries. 2. Production (Economic theory) 3. ASEAN countries --Foreign economic relations -- European Economic Community countries. 4. European Economic Community countries -- Foreign economic relations -- ASEAN countries. I. Fritsch, Bruno. II. Institute of Southeast Asian Studies (Singapore). ASEAN Economic Research Unit. III. Title. HD70 E8E66 1989 ISBN 981-3035-404

Printed in Singapore by Loi Printing Pte Ltd

Contents

List of Tables Foreword Acknowledgements

vii ix xi

I.

Introduction

1

II.

Components of the "Costs of Capital"

3

III.

Lessons from the Past

12

IV.

Some Implications for the European Economy and the ASEAN-EC Relationship

26

Bibliography

35

List of Tables

Table 1

Income Taxation and the Market Interest Rate

Table 2

Yield of Long-term Government Bonds

12

Table 3

Yield of Long-term Government Bonds in Real Terms

13

Table 4

Gross Investment in Machinery and Equipment plus Investment in Housing

14

Table 5

General Government Financial Balance

14

Table 6

Foreign Trade Balance

15

Table 7

Change in Consumer Prices

15

Table 8

Net Household Savings

16

Table 9

Gross Savings

16

Table 10

Total Tax Revenue

19

Table 11

Taxes and Social Security Contributions in 1985

19

Table 12

Personal Income Tax Rates

20

Table 13

Tax Rate on Retained Profits in 1984

21

Table 14

Corporate Tax Rates on Profits

22

Table 15

Average Fiscal Lifetime oflnvestments

22

Table 16

Treatment of Business Losses

23

5

viii

List of Tables

Table 17

User Cost of Capital in 1986

24

Table 18

Private Direct Investment Abroad

27

Table 19

Private Foreign Direct Investment

28

Table 20

Private Direct Investment Net

28

Table 21

Foreign Portfolio Investment Net

29

Table 22

Investment in Machinery and Equipment: Average Annual Growth Rate

30

Table 23

Foreign Direct Investment Net

32

Table 24

Portfolio Investment Net

33

Foreword

Structural change is the essence of economic growth both at the national and international level. Without structural change, stagnation will set in. The production structure in a country at a given point of time is the result of interactions between a number of factors, ranging from the demographic pattern and skill composition of the economically active population, to the available financial resources, the technology and the institutional framework. In addition, the structure of manufacturing is obviously also influenced by the patterns of demand. Changes in these supply and demand factors will affect the production structure and thus lead to structural change. The production structures of individual countries are increasingly linked and interdependent at the global level through international economic relations like trade in goods and services as well as movements of labour, capital, and other resources. Accordingly, changes in the production structure in one country will affect the structure of production in other countries and, hence, may have significant implications for the factors of production in these countries. Some factors of production may be adversely affected while others may benefit. Institutional changes may be required in order to adjust to the modified economic environment. Moreover, technological change may bring about yet unknown new developments in terms of products and production processes. The present study is part of an international research project on "The Development of Manufacturing in ASEAN and the EC and the Potential for Further ASEAN-EC Co-operation". This project is one component of the long-term research programme on ASEAN-EC Economic Relations launched by the ASEAN Economic Research Unit, Institute of Southeast Asian Studies, Singapore, with the generous support of the Konrad Adenauer Foundation, Federal Republic of Germany.

Foreword

X

The project on the development of manufacturing in ASEAN and the EC comprises studies on institutions and structural change; trends in the cost of labour and their effects on the production structure. trends in the cost of capital and their effects on the production structure; and trends in technological change and their effects on the production structure. These trends and their impact on structural change are analysed in the context of both the economies of ASEAN and those of the EC. This international research effort will promote a better understanding of the nature and causes of structural change in each regional grouping as well as the mutual impact of this change may have on both regions. We hope this study and others in the series will stimulate new ideas and reveal other areas for further ASEAN-EC cooperation.

Norbert Wagner Institute of Southeast Asian Studies Tan Loong-Hoe Institute of Southeast Asian Studies

November 1988

Narongchai Akrasanee Thailand Development Research Institute

Acknowledgements

This paper was prepared under the auspices of the international research project on "ASEAN-EC Economic Relations: The Development of Manufacturing in ASEAN and the EC and the Potential for Further ASEAN-EC Co-operation" launched by the Institute of Southeast Asian Studies (ISEAS), Singapore, with financial support from the Konrad Adenauer Foundation. Comments by Torsten Amelung and participants of a workshop on "ASEAN-EC Economic Relations: The Development of Manufacturing in ASEAN and the Potential for Further ASEAN-EC Co-operation", organized by !SEAS, are gratefully acknowledged.

I. Introduction

According to neo-classical economic theory, private investments are, among others, determined by the user cost of capital (Jorgenson 1963). The user cost of capital thereby is defined as the cost to the business firm of using a unit of capital for a period of time, expressed as a fraction of the machine's purchase price. In spite of the fact that the concept of the user cost of capital cannot cover the full range of factors which determine private investment decisions, it can be used as a screening device for the evolution of incentives or disincentives to investments. A long-term rise or fall of the user cost of capital will, ceteris paribus, lead to an inverse change of the investment trend in the economy. Further, changes in the multinational relation of the user cost of capital will probably have some impact on the international allocation of private investments. Recently, major shifts have taken place which in turn have changed the international competitiveness of European and OECD economies. These changes were triggered by the monetary authorities and national governments of these countries aiming at improving the ability to attract foreign private investments through direct subsidies or, more important, through significant tax reductions. However, in as far as these tax reductions are restraints on new investments only (instead of the whole economy), these measures do not improve the welfare position of the country, but create new allocation inefficiencies. In fact, economic and fiscal measures taken by the domestic governments result in shifts in the international flows of capital (direct investment and portfolio investment) which correspond to theoretical predictions. In a world with high capital mobility, economies with subsidized low user cost of new investments can attract high yielded capital from abroad whose marginal returns to investment do not cover the high cost of foreign capital to be transferred abroad. The (foreign) investor receives the benefit of high yields while the society suffers from low returns from investment.

2

Introduction

This analysis will discuss some of the consequences of the recent developments and changes affecting the user cost of capital. It is based upon five countries, namely, the United States, Japan, France, Germany, and the United Kingdom. The paper first demonstrates how the user cost of capital is to be calculated with respect to international comparisons; it then presents some figures about interest yields and tax rates which are condensed in form of estimates about the values of the user cost of capital given in the major EC and OECD countries; and finally it discusses the consequences of the recent evolutions on the international flow of private capital, among which the economic relation between ASEAN and the EC is of major importance.

II. Components of the "Costs of Capital" Formal Approach

The user cost of capital is thought to encompass several distinct cost components, most important of which are: Interest cost. For financing an investment, either money must be borrowed at the nominal interest rate "i" or else an investor loses the interest "i" he would receive by investing in a savings account the funds that he uses to buy the investment goods. Due to risk aversion, this observation is based upon the assumption that the alternative investment bears the same risk structure to the investor. Therefore, interest costs are subject to the risk associated with the investment; Physical deterioration. It affects the ability of capital goods to produce. The depreciation rate indicates the annual decline in value of the capital goods. Increase in the market value by inflation. Some capital goods may depreciate but at the same time their market value is rising due to the effects of inflation, which continuously raises the price of old and new capital goods; Capital income taxation. Firms make investment decisions by equating the marginal product of capital with the user cost of capital before taxes. However, as savers care about the level of their income after taxes, an investment must pay a higher before-tax interest rate and hence incur a higher user cost; Fiscal depreciation. Firms cut some of their corporation tax by reducing the value of depreciation of plant and equipment. The maximal amount of depreciation is determined by rules set by the government; Follow up cost. These are costs for after sales services, maintenance, repairs, and so forth; Subsidies. The government can reduce the user cost of capital by liberalizing depreciation rules allowing for the formation of hidden profits. Similarly, a large number of measures subsidizing investments may reduce the user cost of capital.

4

Components of the "Costs of Capital"

In the following exercise, some functional form will be developed showing how the variation of these factors affects the user cost of capital. Assuming first a situation where earnings are free of income taxation, the average user cost of capital cc(t) is

cc(t) q(t)

+ dep

cc(t) q(t)

q(t+ 1) - q(t + 1) - q(t) q(t)

x q(t)

... (1)

user cost of capital, purchase price for capital goods, expected level of annual earnings (revenues) plus interest payments for debt in relation to the purchase cost of investment goods, economic depreciation rate.

dep

In general, 1 IS a weighted average of profits paid to the holders of the company's assets plus the retained profits r, and the unit cost of debt k, which includes interest payments and the cost of banking, flotation cost, and so forth. According to the Modigliani-Miller theorem (1958), both r and k should be equal on perfect capital markets and only depend upon risk, but as the capital markets are usually organized in such a way that assets and debt instruments incorporate different degrees of default risk, this does not hold in practice. Accordingly, the marginal user cost of capital turns out to be

cc(t) q(t)

r_ret + r_dis +

X [

q(t) r ret r dis dE dA k

dep

1

+

(1

dE -d.A ) x k + dep

q(t+ 1) - q(1) q(t+ 1) - q(t) q(t) ] - [ q(t) ]

... (2)

purchase price for capital goods, rate of retained profits per unit investment, rate of distributed profits per unit investment, marginal propensity to finance new investments (assets) by equity, unit cost of debt, mainly the market interest rate, economic depreciation rate.

The situation becomes more complex, if income taxation is included. Generally speaking, any tax system gives rise to a wedge between the pre-tax return to an investment (that is, the gross return on real invesment minus its

Trends in the Cost of Capital in Major EC Countries

5

economic depreciation) and the ultimate return to the saver. The wedge is usually divided into two components: one which is legally levied on the business sector (say, through the corporate tax system) and which creates a wedge between the pre-tax return and the market interest rate; and another that is levied on the individual and creates a wedge between the market interest rate and the return to the saver. TABLE 1 Income Taxation and the Market Interest Rate (Assumption: 0 per cent inflation)

consumer time preference

< personal income taxation

market interest rate