Investment Spending: Exploring The Diverse Sources Of Funds

Investment spending is a crucial aspect of economic growth, and understanding its funding sources is essential. The sources of funds for investment spending can vary, but typically include savings by households, governments, and foreigners. These sources collectively contribute to the financial capital required for businesses to invest in their operations and expansion. This capital is then allocated based on market forces rather than direct government intervention. Domestic savings, which refer to funds saved by individuals and firms within a country, play a significant role in investment funding. Foreign savings, on the other hand, involve capital inflows from abroad, providing additional financial support. In some cases, companies may also utilise retained earnings, debt capital, or equity capital as sources of funding. While investment spending has multiple funding sources, it is important to recognise that consumption is not one of them.

Savings by households

There are several ways in which households can save money. One common method is to set aside a portion of their income on a regular basis. This can be done through automatic transfers from their paycheck or by depositing a fixed amount into a savings account each month. Some people also save money by cutting back on unnecessary expenses, such as eating out or buying luxury items. Another way to save money is to take advantage of tax-deferred savings plans, such as 401(k)s or Individual Retirement Accounts (IRAs), which offer tax benefits that can help their savings grow faster.

It's important to note that not all households are able to save money. This could be due to a variety of factors, such as low income, high living costs, or unexpected expenses. Additionally, some people may choose to spend their money on immediate needs or wants rather than saving for the future.

Household savings can have a significant impact on the economy. When households save money, they are essentially making their funds available for investment. This can help stimulate economic growth by providing capital for businesses to expand, innovate, and create jobs. Household savings can also contribute to the stability of the financial system by providing a source of funds for banks and other financial institutions to lend.

It's worth noting that while household savings can be a source of funds for investment spending, it may not always be sufficient to meet all investment needs. Other sources of funds, such as government savings, foreign investment, and corporate profits, can also play a crucial role in funding investments.

Government savings

In the US, government savings is mostly discretionary, meaning that it is controlled by lawmakers through annual appropriations. It is important to note that only a very small portion of government investment is funded through mandatory spending.

The government's investment spending is spread across three broad areas: physical capital, education and training, and research and development (R&D).

Physical Capital

Physical capital includes structures such as government buildings, transportation infrastructure, and water and power projects. It also includes major equipment like computers, machinery, and vehicles, as well as software, information systems, and technology. To qualify as investment, physical capital must have an estimated useful life of at least two years.

In 2019, physical capital accounted for about 37% of total federal investment outlays, or $112 billion. Of this amount, the majority (54%) was for transportation spending, nearly all of which was distributed as grants to state and local governments from federal trust funds, such as the Highway Trust Fund.

Education and Training

Education and training include early childhood, elementary, secondary, and post-secondary education, as well as job training and vocational training.

In 2019, education and training accounted for about 41% of total federal investment outlays, or $126 billion. The majority of this amount went towards higher education (35%) and elementary, secondary, and vocational education (32%).

Research and Development (R&D)

R&D encompasses basic research, applied research, and the development of new products and technologies.

In 2019, R&D accounted for about 22% of total federal investment outlays, or $68 billion. Just over half of this amount went towards health research, with the remaining funds directed towards general science, space, and technology.

Trends in Government Investment Spending

Over the years, government investment spending as a share of the total federal budget and the economy has trended slightly downward. In 2019, it represented 12% of total federal outlays and 2.5% of the nation's gross domestic product (GDP).

Government investment spending peaked in the early 2010s when the American Recovery and Reinvestment Act of 2009 temporarily expanded funding for many investment programs. During this period, government investment spending reached more than 15% of federal spending and nearly 4% of GDP.

Benefits and Challenges of Government Investment Spending

Government investment in physical capital, education, and R&D can provide long-term benefits and spur economic growth. However, the economic benefits depend on how well the funds are targeted towards high-value projects and whether they displace spending that could be undertaken by the private sector or state and local governments.

One challenge of government investment spending is the large amount of up-front funding required for some types of investments, which can make it difficult to secure funding within the constraints of the budget process.

Additionally, government investment spending may seem expensive relative to other government expenditures due to a mismatch between when costs are recorded and when benefits occur.

Options for Changing the Budgetary Treatment of Government Investment

There are several options to change the budgetary treatment of government investment and potentially address some of the challenges mentioned above. These options include adopting an accrual approach with a separate capital budget, using a mix of cash and accrual measures in a unified budget, implementing separate operating and capital budgets, creating a separate cap on investment funding, creating a mandatory capital revolving fund, or providing supplemental information on investment spending.

Adopting an accrual approach or creating separate capital and operating budgets are more significant changes that would involve switching to an accrual-based accounting system or creating separate budgets for investment and operating expenses, respectively. These options aim to better align the costs of investments with their long-term benefits and provide more transparency around investment spending.

On the other hand, creating a separate cap on investment funding, creating a mandatory capital revolving fund, or providing supplemental information on investment spending are more limited changes that aim to improve visibility and focus on investment spending without altering the current budgetary framework.

Foreign investment

The sources of foreign investment can vary, including investors, companies, or governments from other countries. These entities may seek to expand their operations internationally or target high-growth markets. For instance, the Chinese initiative, One Belt One Road, involves substantial FDI in infrastructure projects across Africa, Asia, and parts of Europe.

When considering foreign investment, it is crucial to evaluate the country risk associated with the potential investment destination. This includes assessing economic, political, and business risks that could lead to unexpected investment losses. Developed markets like the United States, Canada, and Japan are generally considered safer investments due to their stable economies and political systems. In contrast, emerging markets like China, India, and Brazil offer higher growth potential but carry greater political uncertainty and economic volatility.

Retained earnings

There are several advantages to using retained earnings as a source of funding. Firstly, it is cheaper, as companies do not owe anything to anyone. Secondly, it can increase shareholder value, as investing profits back into the business can fuel further growth, boosting profits and the share price. Thirdly, it provides a financial safety net, as less debt and a healthier balance sheet are signs of a well-run business, which can help boost the share price and give the company a greater financial cushion. Finally, it does not dilute ownership, unlike raising capital by selling shares.

However, there are also some disadvantages to using retained earnings. Firstly, there is an opportunity cost, as companies make shareholders give up potential dividends, and there is a risk of not putting the money to work in the best possible way. Secondly, prioritising spending earnings on investment over dividend payments can disappoint income investors who are looking for stocks that pay a decent dividend. Thirdly, retained earnings can be a drag on returns in the short term, as dividends create an immediate return for shareholders. Lastly, there may be limited capital, as there may not be enough retained earnings to fund major growth projects.

Overall, retained earnings are a crucial source of funding for companies, providing them with the capital needed to invest in new projects and grow their business.

Debt capital

Advantages of Debt Capital

• Tax deduction on interest: Interest payments made to banks and other lenders can be tax-deductible.
• Lower interest costs: Interest costs can be less expensive when compared to other sources of capital.
• Credit score boost: Borrowing money can help boost corporate credit scores, which is especially beneficial for new companies.
• No profit-sharing: Funds are borrowed, so there is no need to share profits with investors.
• Company ownership preserved: Raising funds through debt means company ownership is preserved, unlike with equity financing.

Disadvantages of Debt Capital

However, there are also some downfalls and risks associated with debt capital:

• Potential for default: The business must generate enough regular income to pay the principal and interest on the debt. Failure to do so can result in default or bankruptcy.
• Collateral may be required: Lenders often require companies to offer assets as collateral for loans, which means potentially losing important assets critical to running the business.
• Poor credit rating: Debt financing may not be an option for companies with a poor credit rating.
• Interest obligations: Companies are obligated to repay lenders, and failure to do so can affect their credit score and result in bankruptcy.

Frequently asked questions