CBO’s Model for Forecasting Business Investment: Working Paper 2018-09

By Mark Lasky (CBO)

CBO models most business investment by using a modified neoclassical specification. That specification is similar to the neoclassical model in that the desired capital stock depends positively on output and negatively on the cost of capital, which includes the price of capital, taxes, and rates of return. The specification differs from the neoclassical model in that the capital stock adjusts more rapidly to changes in output than to changes in the cost of capital. In contrast, CBO models investment in capital used by agriculture and extractive industries as depending primarily on output prices. The model contains two important innovations with respect to past modified neoclassical models. First, capital is modeled in a way that allows the productivity of new capital to be observed by using the productivity of existing capital, making it possible to estimate a time-varying coefficient of capital in the production function. Second, capital income is separated into that generated by "measured capital"—equipment, structures, intellectual property products, inventories, and land—and that generated by other sources—market power and unmeasured capital. An increase in the relative importance of unmeasured sources of capital income helps explain why business investment has not kept pace in recent years with high levels of capital income.