Report No. 81-146 E SELECTED EFFECTS OF THE REAGAN ADMINISTRATION'S ‘S’- A ii. ,'\/" .4 7:“ ~ . vx A A =‘ :'W~.~i's §is'1iw:m§Iw RECOVERY PROGRAM ON THE MACHINE TOOL INDUSTRY by A Gary Guenther Analyst in Industry Economics Economics Division R CONGRESSIONAL RESEARCH SERVICE THE LIBRARY OF CONGRESS June 16, 1981 ‘VVVKEEHPQCETIDP4 U “~ ’ F? ‘3§ E”i§”"i’ NOV 17 1989 . ?‘..uz'. - 1 ‘u..-.- “is. 5. E§f.i.£}iJfi, Rig). HD 9743 T11imfiiI\i"iiii1ifumII» 860261 nves |S H in fllfligtltljs ml .1, nmuii The Congressional Research Service works exclusively for the Congress, conducting research, analyzing legislation, and providing information at the request of committees, Mem- ers., and their staffs. The Service makes such research available, without parti- san bias, in many forms including studies, reports, compila- tions, digests, and background briefings. Upon request. CRS assists committees in analyzing legislative proposals and issues, and in assessing the possible effects of these proposals and their alternatives. The Service’s senior specialists and subject analysts are also available for personal consultations in their respective fields of expertise. ABSTRACT The machine tool industry will play a vital role in any Federal effort to reinvigorate the manufacturing sector of the U.S. economy. This paper analyzes recent trends in the domestic machine tool industry, with an emphasis on shipments, orders, capital spending, capacity utilization rates, and the trade balance in machine tools. These trends are then used as the empirical basis for an examination of the likely effects on the machine tool industry of the key elements of President Reagan's economic recovery plan, including business tax incentives, defense spending, monetary policy, and trade policy. II. III. IV. VI. 0000000000000000000000000000000000OOOCCOOOOI AC BO STRUCTURE OF THE INDUSTRY ........ A. B. C. D. OUTLOOK ASSUMING ENACTMENT OF PRESIDENT REAGAN'S ECONOMIC PROPOSALS . A. B. C. D. INDUSTRY FORECASTS oooooooooooooooooocococoocoooooooooooooooooooooooo A. B. CONCLUDING REMARKS 0cocoooooooooooooooooooooooooooooooooooooooooooooo OCOCOOOOOOOOIOOOO0000000000000000000OOOOOOIOIOOOOOOOOOCIOO A. B. C. D. CRS-V CONTENTS Main Elements of the Administration's Economic Recovery Program . Likely Effects on the Machine Tool Industry ..................... 1. Tax Plan .................................................... 2. Defense Spending ............................................ 3. Monetary Policy ............................................. 4. Export Policy ............................................... U1U'I-I’-‘UJU.>UJr-' CO000000000OOOOOIIOOOOOOOOCOOOOOOOO 7 Recent Trends ................................................... 7 Machine Tools and the Business Cycle ............................ 9 Major Problems .................................................. 10 1. Undercapacity ............................................... 10 2. Import Penetration .......................................... 11 Leading Producers ............................................... 12 15 15 16 17 19 21 27 27 28 31 Capital Cost Recovery Program ................................... 1. Proposed Changes in Current Law ............................. 2. Impact on the Machine Tool Industry ......................... 3. Qualifying Considerations ................................... Planned Defense Outlays ......................................... Recommended Monetary Policy ..................................... Export Policies ................................................. 1. Export-Import Bank .......................................... 2. Export Administration Act ................................... 35 35 36 36 37 DRI Forecast ..o..........;...................................... lo Assumptions noooooooooooooooooooooocooooooooooooooooooooooooo Commerce Department Forecast OO0O00OO000000000OCOIOOOOOIOOOOOOOOO 1. 0000O00000OOOOOOOOOOOOOOCOOOOOOOOOOOIOOOOIO000.00 38 40 Machine Tool Orders and Operating Rates for All Manufacturing Industries ...................................................... Machine Tool Output and Defense Procurement ..................... DRI Forecast for Machine Tool Output and Employment ............. Commerce Department Outlook for the Machine Tool Industry in 1981 40 41 42 44 SELECTED EFFECTS OF THE ADMINISTRATION'S ECONOMIC RECOVERY PROGRAM ON THE MACHINE TOOL INDUSTRY* I. INTRODUCTION AND SUMMARY President Reagan's program for strengthening the U.S. economy is built around two broad policy measures: (1) reducing tax rates for individuals and speeding up the recovery of capital costs for businesses; and (2) lowering Federal Government spending in all areas except defense. According to pro- jections contained in the Reagan Administration's budget for fiscal 1982, enactment of these proposals should bring total Federal outlays relative to Gross National Product (GNP) down from 23.0 percent in 1981 to 19.3 percent in 1984 (a drop of 16 percent). Meanwhile, GNP itself is expected to go from $2,920 billion to $4,098 billion in the same period (a rise of 40.3 percent). Most of the commentary on the Reagan economic recovery program has focused on its likely macroeconomic effects in the near term: what will happen to inflation, output, employment, investment, savings, and con- sumption (in the aggregate) if Congress adopts the main elements of the program. Yet because of interdependencies among the innumerable variables making up the economy the Administration's proposals will also have micro- economic effects in the near term. The incomes, savings, investment and consumption behavior of consumers and producers will be affected if the * The following analysts in the Economics Division of the Congressional Research Service contributed to this report: Craig K. Elwell, Jane G. Gravelle, George D. Holliday and Carolyn K. Brancato. CRS-2 policy measures are implemented. It is these effects which ultimately will determine the meaning of the Administration's program for specific industries or regions. A number of domestic industries experienced periods of sharp decline in output, employment, and profits during the 1970s. Many of these declines were accompanied by substantial increases in levels of penetration by competing imported goods. The automobile and carbon steel industries offer prominent examples. Various Federal assistance programs have been advanced to reinvigorate such industries. Although the Reagan Administration has yet to support any particular strategy for reindustrialization, its economic recovery program is bound to have an effect on the output, employment, and profit levels of many industries, including those beset by recurrent and debilitating problems such as vulnerability to cyclical economic downturns. The aim of this paper is to examine the likely effects of the main elements of the Reagan program on an industry which both has been beset by recurrent problems and will unquestionably play a big role in any Federal effort to promote sustained, noninflationary economic growth. This industry is the machine tool industry. Though the problems facing firms in this industry are, for the most part, dissimilar to those of the steel and automobile industries, the machine tool industry is appropriate for a case study of the likely microeconomic impact of the Reagan economic proposals. This is because machine tools are essential to the issues of capital formation and productivity growth, two matters of public policy which the Reagan program seeks constructively to address. CRS-3 ; A. Main Elements of the Administration's Economic Recovery Program Four specific elements of the Reagan program ought to exert some influence over future levels of output and employment in the machine tool industry. These are: a) business tax proposals concerning capital cost recovery; b) sharp increases in outlays (real dollars) for defense procurement over the next four years; c) the monetary policy the Adminis- tration has recommended to the Federal Reserve Board; and d) the kind and amount of support to be lent to efforts by domestic firms to enter foreign markets. B. Likely Effects on the Machine Tool Industry 1. Tax Plan The business tax proposals seem to favor spending on new plant and equipment. But it is unclear whether these proposed changes will induce toolmakers to invest in new production capacity. A lack of adequate capacity typically has been a problem at times of upswing in the overall economy. In view of current order backlogs, and assuming historical trends continue in the future, it is possible that induced investment spending by durable goods producers could be of greater benefit to foreign rather than domestic toolmakers. What seems clear, however, is that enactment of the Administration's plan should strengthen demand for capital equipment (such as machine tools) during the next five to ten years over and above what it would have been without these investment tax incentives. The effect of the incentives will be to augment the total capital stock of the economy in the short run and to lower the rental cost of capital. Simulation of the CRS-4 macroeconomic impact of business tax changes similar to the Reagan plan by CRS shows that between 1980 and 1990, nonresidential investment in producers durable equipment will be 5.5 percent (in nominal terms) and approximately 4 percent (in real terms) above what it would be without the tax incentives. 2. Defense Spending Concern has been expressed recently over the consequences for inflation of the increases in real defense spending proposed by the Administration. Three outcomes are possible. First of all, if the current high rate of capacity utilization in the machine tool industry holds over the next few years, added demand from the defense sector could bid up the prices of machine tools at rates equal to or greater than the ones of the recent past lj, further lengthen delivery times, and stimulate another surge of imports (depending on the type of machine tool and the degree of specialized engineering embodied in it). xsecondly, the proposed rises in real defense spending could persuade firms in the industry to add to capacity as quickly as possible in order to meet the expected surge in orders from the defense sector. In addition, firms might increase outlays on research and development in order to be competitive in the market for high technology goods (such as missile systems). The third outcome lies intermediate between the first two. Under such an outcome, domestic firms gradually expand production capacity while imports continue to account for a significant share of domestic machine tool consumption (this has lbeen happening over the past three years). This process would go on until firms attained their desired ratio of capacity to new order levels. 3/ The Producer Price Indexes for metal-cutting and metal-forming machine tools between 1978 and 1980 went up at average annual rates of 13.9 percent and 11.8 percent, respectively. CRS-5 3. Monetary Policy Interest rates represent the cost of money to firms seeking to finance additions to capital stocks. High rates can deter buyers of machine tools and toolmakers themselves from adding to capacity. Yet it must be recognized that the user cost of capital is only one of the many factors behind the decision to invest. 2] In view of the sensitivity of machine tool order rates to interest rate levels and movements, the future course of monetary policy will play an important role in the determination of the supply of and demand for machine tools. If rates are kept high relative to historical trends, the demand for investment goods could fall below what it would have been under lower rates. This would be detrimental to machine tool producers. 4. Export Policy The Administration can exert some influence over the level of exports of U.S. manufactured goods through the financing activities of the Export- Import Bank and the Commerce Department's enforcement of the Export Admini- stration Act (EAA). Machine tool exports can be directly and indirectly pro- moted through Ex-Im Bank lending. The Administration has proposed substantially reducing the direct lending authority of the Bank. As the Bank traditionally has accounted for only a very small portion of foreign sales of U.S. machine tools, it is unlikely that such a reduction will make much of a difference in the export performance of the domestic industry. The same can be said of the 2/ Others include recent levels of product demand, corporate cash flows, the preferred period of return on investment, the time required to make additions to capital stock fully efficient (e.g., hiring and training skilled labor), and opportunities for substituting capital for labor at the margin. See J.W. Elliott, Macroeconomic Analysis, 1975, p. 144. CRS-6 impact of enforcing the provisions of the EAA. Though doing so has meant the loss of some machine tool sales in the Soviet Union and Eastern Europe in recent years, the value of the license applications for machine tools denied by the Commerce Department has only amounted to a small fraction of the value of the licenses granted. The most important determinant of sales ito countries under the purview of the EAA appears to be the purchaser's ability to pay rather than the licensing procedure. CRS-7 II. STRUCTURE OF THE INDUSTRY A. Recent Trends -- For the machine tool industry,_§/ 1980 was a year of increased out- put, employment, and capital spending (see Table I). Commerce Department data show that 1980 shipments of complete and new machine tools increased from their 1979 level by 20.4 percent_£/, total employment rose 2.2 percent, and capital spending by toolmakers went up 7.6 percent. -- By the end of 1980, the industry's order backlog stood at $5.134 billion. While this was approximately one percent less than the total backlog at the end of 1979, it still was near the all-time peak reached in 1979. A sizable portion of this backlog consisted of unfilled orders from manufacturers of passenger cars and commercial jet aircraft seeking to re-tool. -- New net orders_§/ in 1980 totalled $4.662 billion, 15.8 percent below the 1979 amount. Two major depressive influences were the rapid rise in interest rates during the last two quarters of the year and the sharp decline throughout the economy in industrial production and capacity utilization rates during the second quarter. 3/ According to the Standard Industrial Classification (SIC), machine tools—consist of metal-cutting (SIC 3541) and metal-forming (SIC 3542) types. Tools of the latter sort shape metal parts by excising the unwanted portions. This can be accomplished by turning, boring, planning and shaping, drilling, and grinding and honing. Tools of the metal~forming sort shape metal parts through the delivery of tremendous pressures in varying sequences. Metal- forming can be done by forging, shearing, hammering, extruding, bending, die casting, or pressing into shape. 4/ Unless otherwise indicated, all values are in current dollars. 5/ "New net orders" are the total value of machine tool orders placed in any time period less the value of unfilled orders cancelled in that period. They are an important indicator of future shipment and import levels. CRS-8 -- Capitalizing on the mammoth order backlog from 1979 and early 1980 and the consequent lengthening of domestic producers‘ delivery times, imports of machine tools increased in 1980 by 24.4 percent to $1.298 billion, capturing a little less than one-third of the domestic market. Despite the fact that the value of 1980 exports was $785.3 million, or 22.2 percent above the 1979 level, the United States experienced for the third year in succession a negative trade balance in machine tools. TABLE 1. Machine Tool Industry Profile, 1980 (millions of current dollars) Exports as Imports as _b/ _b/ _b/ _c/ 3] _b/ a Percent _b/ a Percent Capital New Net Unfilled X335 Shipments Exports of Shipments Imports of Shipments Outlays Orders Orders ($) ($) (‘7«») ($) (7«») ($) ($) ($) 1980 4,887.5 785.3 16.0 1,298.5 31.6 N/A 4,662 5,134 1979 4,059.2 648.8 15.9 1,043.8 30.6 240.5 51/ 5,543 5,165 1978 3,015.8 560.2 18.5 715.3 29.1 153.2 4,344 3,498 1977 2,453.4 452.1 18.4 400.9 20.0 105.1 2,997 2,168 ....—...:......_.o a. —— 3/ Complete and new metal-cutting and metal-forming machine tools for domestic use and export. bf Both metal-cutting and metal-forming machine tools. _c/ As of 31 December for each year. _d/ Estimate derived from data on capital spending in Standard & Poorls Industry Survey and Business Week report (September 1, 1980, p. 68). NOTE: N/A - Not Available. Sources: U.S. Department of Commerce, Bureau of the Census, and the National Machine Tool Builders Association. CRS-9 B. Machine Tools and the Business Cycle Production of machine tools is not only highly sensitive to cyclical upswings and downswings in the economy but also tends to be marked by peaks and troughs which lag behind but are generally more acute than the cycles in the overall economy. In addition, machine tool shipment levels also tend to coincide with capital spending trends for durable goods manufacturers because users of machine tools are primarily producers of goods such as automobiles, jet aircraft, and energy production equipment and machine tools are capital goods.i Important signals of future machine tool output levels are the in- dustrial production index, the industrial capacity utilization rate, and interest rates. Their importance stems from the strong correlation between their movements and fixed business investment spending patterns. Capital spending generally responds to changes in the level of industrial production and in the rate of utilization of existing capacity. When the utilization rate reaches relatively high levels, businesses begin to place more and more orders for new capital equipment. Then order backlogs of toolmakers grow, and sharp increases in machine tool company sales and earnings tend to follow shortly. Conversely, declining industrial production, high interest rates, and slack- ening rates of capacity utilization usually portend a downturn in tool machine orders and company profits. In the recent past, new orders for complete machine tools have varied pro- portionately with movements of the industrial capacity utilization rate for dur- able goods industries. A comparison of shifts in the amount of new machine tool orders, total plant and equipment expenditures, and the manufacturing operating rate over time reveals that substantial new machine tool orders are triggered CRS-10 as the operating rate reaches 80 percent and manufacturing industries find it necessary to expand production capacity. 6/ (See Appendix A for an illustration.) C. Major Problems Two interrelated problems have been particularly troublesome to the machine tool industry: undercapacity at times of brisk economic activity and rising levels of import penetration. l. Undercapacity The recent historical record shows that producers of machine tools have been extremely reluctant to invest in new production capacity, even when new orders rates have reached relatively high levels. Between 1968 and” 1978, expenditures on new plant and equipment by establishments primarily en- gaged in the production of metal-cutting and metal-forming machine tools rose from $92.3*mil1ion to $153.2 million, an increase of 66 percent. By contrast, din this same period, net new orders went from $1.474 billion to $4.344 billion and order backlogs from $1.064 billion to $3,498 billion, leaps of 295 percent and 329percent,“respective1y.Z/ Even during the recent upturn in machine tool production, capital spending has responded laggardly. Between 1976 and 1978 (the most recent year for which official data on capital expenditures are available), the average annual rates of growth in new net orders and un- filled orders were 39.6 percent and 55.3 percent, respectively. Expenditures ronVnew plant and equipment, on the other hand, grew at an average annual rate of 30.5 percent.‘ .§/ ~Standard & Poorfls Industry Survey: Machinery, May 29, 1980, p.‘M27. , Z] .Sources for data: .Comerce Department, Bureau of the Census, and National Machine Tool Builders Association. ,CRS-11 There are two explanations for the tendency of domestic toolmaking capacity to fall short of new order rates at or near the peak of a business cycle. One is the volatile and cyclical nature of machine tool demand. This gives rise to uncertainty on the part of machine tool firms over future product demand, inhibiting new investment. The other is the smallness of the typical machine tool firm. According to the Census Manufactuers for 1977, the average employment size of a metal-cutting machinetool company, was 68.1 workers and of a metal-forming machine tool company 57.7 workers. For all types of machine tools, only 41 percent of manufacturing establishments employed 20 or more persons. Companies of this size often lack easy access to capital markets and are reluctant to assume high financial exposure for the dual purpose of plant expansion and product development. §/ These recurrent bouts of undercapacity can give rise to surges in import levels. 2. Import Penetration A strong correlation exists between order backlogs and levels of‘import penetration. As delivery times for domestic toolmakers lengthen, foreign pro- ducers tend to find it increasingly easier to penetrate domestic markets, especially those for non-specialized products. This is because of the desire of buyers of machine tools to shorten as much as possible the time between placing an order for a machine tool and using it to produce goods. In this sense, the problem of undercapacity is closely bound up with the loss of machine tool markets in the United States and abroad. 8/ See L. Beman and S.E. Prokesch, "Getting Machine Tools Humming Once fibre," Business Week, September 1, 1980, p. 69. CRS-12 D. Leading Producers Table II lists some of the leading publicly owned machine tool firms. While profits of some of them in 1980 dropped below 1979 levels, most firms experience marked gains in profits. This was not unexpected in that company profits tend to rise when sales do, reflecting the economies of scale in machine tool production. Operating margins in the machine tool industry vary considerably in different stages of the typical cycle of economic activity. Since overhead and fixed expenses represent a substantial portion of the industry's operating expenses, profits usually grow swiftly once shipment levels exceed the breakeven point, which varies from plant to plant, depending on the capital and labor mix. It should be stressed, however, that the companies shown in Table II are not representative of firms in the industry. The large publicly owned com- panies tend to have more establishments, more employees per establishment, and much more diversified product lines than most firms in the industry. Machine tools as a whole are highly engineered capital goods, for the most part designed according to buyer specifications. Economies of scale in production are largely absent from the operations of most machine tool firms. As a result, the market structure of the industry is fragmented. The typical company is family-owned and small. According to the 1977 Census of Manufactures, the average employment per company in 1977 was 68.1 workers in SIC 3541 and 57.7 workers in SIC 3542; average value of shipments (a surrogate for sales) per company for the same two industries were $3.2 mil- lion and $2.7 million, respectively. 9/ Unlike the large publicly owned com- panies, most firms serve local markets and are very specialized in terms of both product range and production method. 19/ But even some of the larger firms are 9/ Metalworking Machinery and Equipment, 1977 Census of Manufactures (Indus- try Series), Bureau of the Census, June 1980, p. 35C-7. 19/ Marx, Thomas G., "Technological Change and the Structure of the Machine Tool Industry", Michigan State University Business Topics, Winter 1979, p. 43. CRS-13 heavily involved in just one or two end use markets, making them vulner- able to cyclical downturns in economic activity. Perhaps this is the rea- son why two of the companies listed in Table 11 experienced a decline in profits in 1980 relative to 1979. At any rate, the fragmented structure of the machine tool market makes the profitability of machine tool firms highly dependent on their product mixes as well as on the level of and trend in overall durable goods production. TABLE II. Financial Performance of Leading Machine Tool Companies: 1980* Change Change Return Change From Net From on From Sales 1979 Income A 1979 Assets 1979 Company ($ mil.) (%) ($ mil.) (Z) (Z) (Z) Acme-Cleveland 405.0 18 17.2 -12 7.3 -24 Brown & Sharp 227.0 18 14.5 14 8.5 -10 Cincinnati Milacron 816.0 9 75.6 41 23.3 122 Cross & Trecker 355.0 19 33.4 26 13.0 18 Giddings & Lewis 328.0 27 31.9 10 29.4 60 Gleason Works 242.6 12 16.3 -17 17.3 24 Monarch Machine Tool 130.7 34 12.3 35 28.4 108 Source: Standard & Poor's. NOTE: * This group of companies, while not representative of the size distribution of firms in the industry, does offer a cross-section of the types of machine tools made and sold domestically. Mitigating the impact on the machine tool industry of the sharp economic downturn during the second quarter of 1980 was the high level of capital spending by the aerospace, automotive, and energy production and exploration industries. tries which probably accounted for the profit gains recorded by many of the leading machine tool firms in 1980. The aerospace industry has amassed a large order book for quieter, more fuel-efficient commercial jet aircraft. Similarly, the automotive And it was the tremendous order backlog generated by these indus- CRS-14 industry is in the midst of.a massive re-tooling program (some estimates place the total capital outlay on machine tools at $60 billion between 1979 and 1985). This program is aimed at raising the average fuel-efficiency of all passenger cars to 27.5 miles per gallon by 1985 and rapidly turning out smaller, more fuel-efficient cars to be more competitive with imports. Demand for oil and gas field equipment also has soared in the past couple of years, as energy companies have intensified their efforts to locate and bring on-stream new and commercially viable reserves of oil and gas. Yet, it remains to be seen whether machine tool firms will make the needed investments in production capacity and research and development to reduce their order backlogs, thereby regaining some of the share of the market lost to imports in recent years. CRS-15 III. OUTLOOK ASSUMING ENACTMENT OF PRESIDENT REAGAN'S ECONOMIC PROPOSALS In his State of the Union address to Congress on February 18, President Reagan outlined the recovery and revitalization program for the economy he proposes implement over the next four years. Assuming that Congress adopts the President's proposals without substantial modification, their combined effect on the machine tool industry could be profound and enduring. Four elements of the Reagan economic program are bound to have some measurable impact on the machine tool industry. These are the business tax proposals regarding capital cost recovery; the planned outlays for defense procurement; the monetary policy the Administration has recommended to the Federal Reserve Board; and the kind and amount of support to be given to U.S. exports by the Federal government. These policy measures should have an impact because the overall performance of the machine tool industry is strongly associated with the level of expenditure for new plant and equipment in the non-farm business sector, the direction and rate of change in interest rates, and, to a lesser extent, total spending for procurement by the Defense Department and the strength of export markets. A. Capital Cost Recovery Program Of all the parts of the Reagan economic program, the tax proposals aimed at encouraging productive investments by business and industry could have the most beneficial effects on machine tool producers in both the short and long-run. This is because the single most important determinant of levels of employment and output in the industry over time has been actual outlays on new equipment by durable goods manufacturers. CRS-16 1. Proposed Changes in Current Law These proposals consist of two major changes. First, the Reagan tax plan would accelerate the period in which business firms could deduct from their gross income the costs of investing in new plant and equipment. The costs of most cars and light trucks, as well as machinery and equipment used for research and development, could be written off in three years. Other major machinery and equipment would be written off in five years. Factory buildings, retail stores, and warehouses used by their owners could be depreciated over ten years. Machine tools in general would be depreciable in five years instead of 18 years according to present law. Secondly, the size of the investment tax credits for various categories of new plant and equipment expenditure would be increased. Unlike the current law which permits credits of 3-1/3 percent for assets with a useful life of three-years, and 6-2/3 percent for assets depreciated in five to seven-years, the Reagan plan would allow a six percent credit for investments in the three-year depreciation category and a 10 percent credit for those in the five to seven-year category._££/ Machine tools would fall in the five-year category. The expectation is that by speeding up and simplifying the method for depreciating productive assets the cash flows and after-tax rates of return of corporations will increase so much that additional investment will take place. ll] "White House Fact Sheet," February 18, 1981; Bureau of National Affairs, Washington, D.C., pp. 43-46. CRS-17 2. Impact on the Machine Tool Industry Simulations of the probable macroeconomic effects of a 10-5-3 tax proposal strongly suggest that the machine tool industry--whose principal products are all capital goods--would register substantial gains in the short run. One such simulation was done by CRS using the DRI Trendlong Model solution of the U.S. economy. lg] The effects were projected for the period 1980 to 1990. Before reviewing the results it should be stressed that the projections for the various macroeconomic variables in the model may be viewed as optimistic or the "best case." This is due to the strong influence in the DRI model of changes in the rental cost of capital (i.e., a "price" for capital services reflecting the tax variables) on investment, an influence which, at least for the short run, is not necessarily supported by the available empirical evidence. The CRS simulation incorporated the following assumptions: -- a reduction in the effective corporate tax rate to reflect estimated revenue losses from the proposal; -- a phased reduction in the average tax lifetime of producers durable equipment from 11.1 years in 1979 to 5.5 years in 1982 and which remains at 4.5 years thereafter; -- a phased reduction in the average tax lifetime of private non-residential structures«from 22.8 years to 9.1 years in 1982 and which remains at 7.5 years thereafter; and -- an increase in the investment tax credit to 10 percent for equipment and to six percent on automobiles and trucks. 12/ See Gravelle, J. G. and Hull, E. W., Macroeconomic Impact of the Capital Cost Recovery Act; CRS Report, November 2, 1979. CRS-18 To investigate the impact of these fiscal initiatives the changes in economic activity resulting from them were compared with changes derived from a base case simulation. This simulation (or Control forecast) was developed by DRI in September 1979. Although changes have occurred in the economy since then which would alter the projections of the base case, it is unlikely that the differences between the results of the two simulations would be significant. 9 The Control forecast assumes that personal and corporate income taxes are cut by $25 billion, effective January 1, 1981. This tax reduction consists of a personal income tax cut of $10 billion, a $16 billion roll- back in the social security tax increase legislated for that year, and a $5 billion increase in corporate investment incentives by virtue of a higher investment tax credit and improved depreciation allowances. The key indicator for the machine tool industry is the behavior of nonresidential investment in producers durable equipment. Under the base case simulation, this investment goes from $175 billion (current dollars) in 1980 to $529.1 billion in 1990. By comparison, under the 10-5-3 tax simulation, investment is $175.5 in 1980 and grows to $558.4 billion by 1990. (Investment in the second simulation is slightly higher at the beginning of the interval-1980 due to the quarterly structure of the DRI model. This means the stimulative effect of the 10-5-3 tax plan is felt in the first year.) At the end of the interval for both projections, nonresidential investment in producers durable equipment is 5.5 percent higher with enactment of the accelerated depreciation and investment tax credit proposal than without it. Since the stimulus induced an increase in the overall price level, however, the constant dollar increase is somewhat smaller, at around four percent. CRS-19 3. Qualifying Considerations Not all theories of investment behavior in the business sector of the economy posit as high a degree of responsiveness between spending on new plant and equipment and changes in the rate of taxation as the DRI model does. Robert Eisner, for example, argues that tax incentives have only a minor effect on investment, particularly in the short run. Rather, the level of product demand, not the "rental cost of capital," is the main determinant of business investment behavior. lg] Richard Musgrave views the impact of inflation on the assessment of risk by firms as most influential in the determination of investment behavior. lg] If any conclusion is warranted at this stage, it is that the extent of the stimulus which business tax incentives could impart to capital spending is exceedingly difficult to predict. The timing of implementation of these incentives certainly will be of consequence, inasmuch as the level of capital spending varies in direct proportion to the movement of the economy through the business cycle. The Reagan tax plan could serve to bring into sharp focus the struc- tural problems of the machine tool industry. These include the cyclical nature of employment and output in the industry, the historical reluctance of firms to expand capacity during periods of robust economic activity, the smallness of most firms, and the opportunities for import penetration whenever the demand for machine tools far exceeds the supply (both potential 13/ See Gravelle, J. G., The Capital Cost Recovery Act: An Economic Analysis of 10-5-3 Depreciation. CRS Report No. 80-29, January 25, 1980. p. 25. 14/ Musgrave, Richard, "Tax Policy and Capital Formation", National CRS-20 and actual). Given the cyclical nature of the industry and the industry's lagging expansion even in times of large order backlogs, it may be un- reasonable to assume that, as a result of the Reagan business tax proposals, the future supply of and demand for domestically produced machine tools will almost always be in a stable and enduring equilibrium. Offering tax incentives for investment in new equipment should increase demand for that equipment and reduce the price of capital used in the machine tool industry. Nevertheless, machine tool producers typically look at a number of other variables before deciding whether or not to invest in new production capacity. Among these are the expected supply of skilled labor, net return on investment, the outlook for machine tool demand over the course of the payback period, and the interest rate (or rental cost of capital). Which typically proves to be the decisive consideration is hard to say; at the very least, the ordering of investment decision criteria depends in part on the current condition of the overall economy and what the expectations are for its future course. Even if the Reagan tax proposals succeed in stimulating a boom in capital spending by durable goods manufacturers, there is no certainty in the short run that the machine tool industry will realize output and employment levels higher than the present ones. One response might be that imports enlarge their penetration of the domestic market. Another might be rapid and unprecedented rises in machine tool prices. CRS-21 Reacting to the vigorous product demand of the past three years, domestic toolmakers have been steadily (and at times sharply) raising their prices. This is reflected both in the financial data presented in Table II and in the Producer Price Indexes for metal-cutting and metal- forming machine tools, which between 1978 and the end 1980 rose at average annual rates of 13.9 percent and 11.8 percent, respectively._1§/ Continued strong demand could perpetuate or even exacerbate this inflationary trend. Users of machine tools might respond by cutting back on orders for machine tools because of uncertainty over future demand for their output and because labor has become cheaper relative to new capital as a means of expanding output (assuming, of course, that their rates of capacity utilization are below the practical zenith and that wages go up slower than the cost of machine tools). B. Planned Defense Outlays Another aspect of the Reagan economic program which could affect the future performance of the machine tool industry is the planned outlays over the next two years for defense procurement. According to the Reagan Administration's budget for fiscal year 1982, outlays of Federal funds for defense procurement are to be $34.068 billion (current dollars) in fiscal year 1981, up 17.4 percent from 1980, and $40.064 billion in fiscal year 1982, up 17.6 percent from 1981. The Defense Department normally purchases a vast array of goods from the private economy. Among these goods are ships, aircraft, weapons systems, 15/ Source: Department of Labor, Bureau of Labor Statistics. CRS-22 and motor vehicles. To producers of machine tools such purchases mean direct and indirect gains: direct in the sense of the Army buying machine tools from producers, and indirect in the sense of a contractor for the Air Force buying machine tools needed to fabricate jet aircraft. On the basis of data in the U.S. input-output tables computed by the Commerce Department, Bureau of Economic Analysis, it is possible to estimate the direct and indirect gains to the machine tool industry from defense procurement. According to the most recent available data, for 1972, (see calculations in Appendix B) defense procurement was directly and indirectly responsible for approximately 7.1 percent of that year's total shipments of complete machine tools. With the aid of the Data Resources Inc. (DRI) macroeconomic model one can simulate the effect of aggregate business investment of various the multiplier effects of defense procurement in the capital goods sector rates of growth in real defense expenditure between 1981 and 1985. The effects at the various sectoral levels can also be simulated such that the growth of output of all defense and space goods, and of all metal- working machinery can be projected. pThese simulations should permit some inferences about the multiplier effects of defense procurement in the capital goods sector of the economy. Then the implications for the machine tool industry of this induced investment spending can be analyzed. Simulations of the macroeconomic effects of a 6.0 percent, and a 10.0 percent rate of growth in real defense expenditures were performed under three discrete financing scenarios: 1) increased deficit spending; CRS-23 2) reduced non-defense expenditures; and 3) increased personal taxes. 16/ To simplify the analysis and to make the results conform as much as possible to the announced budgetary priorities of the Reagan Administration, only the simulations done under a scenario of increased defense spending financed by matching non-defense expenditure reductions 11/ will be examined in this paper. To explore the effects of these two rates of growth in real defense spending over the simulation interval a "base case" simulation was done. The results of this simulation, which incorporated a 4.7 percent annual rate of increase in real defense spending between 1981 and 1985, served as the standard against which the results of the other two simulations were evaluated. TABLE III. Investment* Effects of Various Rates of Growth in Real Defense Spending Under Non-Defense Spending Reduction ($ billions 1972) (%) Rate of Real Growth 1981 1982 1983 1984 1985 4.7 140.8 148.7 156.8 161.7 169.9 (percent change) 0.0 5.6 .5.4 3.1 5.1 6.0 141.1 149.8 158.2 163.0 171.0 (percent change) 0.0 6.2 5.6 3.0 4.9 10.0 140.9 149.3 158.0 163.5 172.1 (percent change) 0.0 6.0 5.8 3.5 5.3 Source: Elwell, C., Econometric Simulations of the Macroeconomic Effects of Alternative Accelerations of Defense Expenditures: 1981-1985. 16/ Source for all simulation results: Elwell, Craig, Econometric Simulations of the Macroeconomic Effects of Alternative Accelerations of Defense Expenditures: 1978-1985. Congressional Research Service, Economics Division, February 6, 1981. 17/ This means of financing consists of substituting on a dollar-for- dol1ar_basis defense spending for non-defense spending, resulting in "no net change in aggregate demand or the (Federal) deficit." Only the marginal increase in real defense spending is financed this way. CRS-24 Before commenting on the results of these simulations it should be stressed that the DRI macro model is one of a number of different models of the structural relations in the U.S. economy. Had the same simulations been done with one of the other commercial models, different results may have been obtained. Moreover, each of these models tends to be sufficiently flexible to permit alternative assumptions for economic conditions at the start of the simulation interval and for the behavior of the key exogenous variables over the interval. Simulating the DRI model under a different set of assumptions, then, also could result in differing projections. The most important assumptions implicit in the projections presented in Table IV are: l§/ significant excess capacity exists in the economy over the interval (in each simulation unemployment is above 6.7 percent). -- monetary policy remains relatively tight (the prime interest rate rises then declines markedly in all simulations). increases in real defense spending do not lead to increases in key exogenous prices (such as fuel prices). Most noteworthy among the results of the simulations shown in Table IV is the small impact on business investment spending of sustained increases in real defense spending over five years. The average annual rate of change in investment spending with a 4.7 percent rate of increase in real defense spending between 1981 and 1985 is 5.2 p¢rcent; increasing the defense spending rate to 6.0 percent only elevates the average investment rate to 5.3 percent; finally, a further jump in the defense rate to 10 percent only pushes the average investment rate over the simulation interval to 5.5 percent. lg] Elwell, op. cit., pp. 5 and 24. CRS-25 Also deserving comment are the price effects of the added defense spending. The annual rate of change in the GNP price deflator is the same in both simulations. This reflects the redistributional impact of the means of financing the added defense spending. More of national income is accounted for by investment than in the base case results. All other factors affecting levels of and rate of change in business investment spending are held constant during these simulations. But it is the sectoral effects which ought to shed some light on the relationship between defense spending and machine tool output and employment. To estimate these effects, the DRI macro-model was simulated with a 4.7 percent and with a 10.0 percent rate of growth in real defense expenditures between 1980 and 1985 (holding everything else constant). These results were then compared with the changes in economic activity projected by the base case simulation. In both scenarios the additional amount of defense spending was financed by offsetting reductions in non-defense spending. TABLE IV. Changes in Real Output of Selected Sectors in Response to Defense Spending: 1981 to 1985 (1967 = 100) Sector 4 1980 1981 1982 1983 1984 1985 Industrial Production: 4.7 percent 145.8 147.2 157.8 164.6 169.7 181.1 10.0 percent 145.8 147.9 160.1 168.0 173.6 185.9 Defense and Space Durable Goods: 4.7 percent 97.7 100.3 103.6 107.4 111.5 118.5 10.0 percent 97.7 103.0 112.1 120.8 129.7 142.9 Metalworking Machinery: 4.7 percent 10.0 percent 125-1 125.1 118.4 124.6 133.5 138.6 145.8 120.1 129.7 139.6 143.9 151.3 Source: Estimated by CRS analyst Craig Elwell with the DRI Macro Model. CRS-26 As the results of the simulations presented in Table V show, substantially increasing the rate of growth in real defense spending does enlarge output in each of the three sectors. Over the simulation» interval, a 10.0 percent rate of growth results in average annual rates of growth in industrial output of 5.5 percent; of defense and space durable goods of 9.3 percent; and of metalworking machinery of 4.2 percent. Under the base case these rates of growth are 4.8 percent, 4.3 percent, and 3.3 3.3 percent, respectively. What do these simulations portend for the machine tool industry between now and 1985? Unfortunately, no simple, unambiguous answers can be given to such a question. In light of previous production patterns, one might expect machine tool output and employment to rise in line with upward movements of the industrial production index. But the problem of recurrent undercapacity remains. The DRI macro model effectively assumes that the capital stock and labor supply in all sectors will adjust quickly and without dislocation to increases in product demand resulting from exogenous influences such as changes in defense spending. As was emphasized earlier, two conditions are apt to govern how much the machine tool industry benefits from increased real defense spending. The first is the technical requirements (or input) of machine tools in the manufacture of defense-related goods. The second is the effect of proposed repeated rises in real defense spending on the propensity to invest of machine tool firms. If the indirect relationships between defense procurement and machine tool output have not declined since the 1972 input-output data were compiled and if machine tool firms become more willing to expand production capacity in response to the added real defense spending, then the industry should realize significant output and employment gains. CRS-27 C. Recommended Monetary Policy Historically, machine tool production has followed movements of interest rates with a certain lag. When interest rates climb rapidly near the peak of a business cycle, first business investment spending and then machine tool output begin to go down. Given this sensitivity to the direction and rate of change of interest rates, the monetary policy to be pursued by the Federal Reserve Board over the next four years could greatly affect the future performance of the machine tool industry. The best indication to date of what monetary policy the Reagan Administra- tion would like to see the Board adhere to emanated from President Reagan's State of the Union Address. The aim would be to create "a successful program to achieve stable and moderate growth patterns in the money supply." 12/ In the short run (i.e., the next two to five years), this could entail keeping interest rates at or near historic peaks. Under such a scenario, investment spending by manufacturing industries could be adversely affected, pushing downward all the projections for new plant and equipment expenditures already considered. A similar diminution in output and employment in the machine tool industry could then be anticipated. In the long run, such a program could result in lower, less volatile interest rates. To the extent that such an investment climate would be conducive to more regular patterns of capital spending by durable good manufacturers, the machine tool industry may realize output gains and become more willing to add capacity. D. Export Policies Between 1976 and 1980 the value of machine tool exports (on average) equalled 21.9 percent of total shipments of machine tools. Clearly, foreign 19/ New York.Times, February 19, 1981. p. B-9. CRS-28 markets are of great importance to domestic toolmakers, especially during per- iods of slackness in the domestic economy. Therefore, those aspects of the Reagan economic program which might have an impact on export sales could also influence future levels of employment and output in the machine tool industry. One such aspect will be examined briefly here: the budget authority to be sought for the various credit facilities offered by the Export-Import Bank of the United States. Moreover, perhaps of greater concern to toolmakers are the controls imposed on the export of goods embodying sophisticated technology under the provisions of the Export Administration Act of 1979. The implications of enforcing the control provisions of the Act for the machine tool industry will also be discussed. 1. Export-Import Bank In its proposed budget for fiscal 1982 the Reagan Administration is seeking to curtail sharply the direct lending authority of the Ex-Im Bank over the next five years. Direct loan authorizations to foreign borrowers would be $5.15 billion in the current fiscal year and $4.40 billion in fiscal 1982, in- stead of $5.50 billion and $5.00 billion under the fiscal 1982 budget submitted by President Carter. Conditions for obtaining credit "will be less generous," and credit itself will be "more carefully targeted." 29/ The Reagan Administra- tion would also continue the Bank's Discount Loan program at a lending author- ity of $400 million during the next two fiscal years. This program, which enables commercial banks to borrow against the outstanding amount of fixed interest rate export notes, has been of benefit to smaller companies trying to arrange medium-term financing for their export activities. Producers of machine tools have benefited both directly and indirectly from the lending programs of the Ex-Im Bank: directly by virtue of the Bank _2_g/ Wall Street Journal, February 19, 1981, p. 5. CRS—29 financing foreign sales of entire manufacturing projects involving some input of machine tools. However, estimating the amount of these direct and indirect gains in any given year is anything but an easy, straightforward task. The record of loans and financial guarantees maintained by the Bank summarizes lend- ing activities by project type only. The data do not reveal the value of the component parts of the projects nor the portion of those values covered by Ex-Im Bank credits. Consequently, only the direct foreign purchases of machine tools and related equipment can be determined, yielding, at best, a partial estimate of the importance of Ex-Im Bank financing to the export component of total annual domestic machine tool output. The relationship between Ex-Im Bank lending activities and machine tool exports raises two important questions. First, in any given year, what percent- age of the total value of machine tool exports received some form of Ex-Im Bank financing? Secondly, would these foreign transactions have still taken place had the various credit facilities offered by the Ex-Im Bank not been available? Owing to the scope of this analysis, the second question, though critical to any investigation of the effectiveness of the loan subsidies dispensed by the Bank, will not be addressed. Rather, all efforts will focused on measuring the direct role played by the Ex-Im Bank in the sale abroad of U.S. machine tools. Both the amount of the transactions financed and the relative importance of each type of credit extended will be assessed. Between 1974 and the end of January 1981 only four direct loans for the purchase of machine tools and metalworking machinery were approved by the Bank (two in 1974 and two in 1975). The total value of these transactions (in current dollars) was $5l.O83 million. Of this, the Bank agreed to finance $22.4l1 million. According to the Commerce Department, in 1975 alone exports CRS-30 of machine tools and metalworking machinery totalled $1.222 billion, or about 24 times the amount financed by direct loans from the Ex-Im Bank. 21/ From 1972 to the end of January 1981 other types of loans (including dis- count) approved by the Bank financed foreign sales of machine tools and metal- working equipment valued at $63.732 million (in current dollars), of which $47.35O million was covered by Ex-Im Bank financing. This compares with a total value of machine tool exports alone for the years 1972 through 1980 (in current dollars) of $2.899 billion, or around 45 times the value of the exports supported by other types of loans. 22/ A total export value for metalworking machinery and machine tools of $243.859 million was supported by some type of Ex-Im Bank credit facility be- tween the early 1960s and the end of January 1981. Direct credits, discount loans, and the Cooperative Financing Facility (CFF and relending) -- a line of credit at fixed interest rates to foreign financial institutions which use the credit to provide 50 percent of each loan they extend to purchasers of U.S. goods and services -- accounted for 47 percent of this amount. These comparisons suggest two conclusions, one of which relates to the Reagan budget. First, the Ex-Im Bank historically has played, at best, a marginal role in the sale abroad of U.S. machine tools. Secondly, reducing the direct lending authority of the Ex-Im Bank should have no appreciable direct effect on the export activities of domestic toolmakers, even if one ventures to assume that none of the foreign sales of machine tools in recent years would have taken place in the absence of Ex-Im Bank loan subsidies. The 21/ The source for all data on the lending profile of the Export-Import Bank is the Bank itself. 22] Source: National Machine Tool Builders Association. CRS-31 indirect effects could be of some consequence if curtailing the direct loan program of the Bank results in fewer foreign purchases of domestic goods requiring some input of machine tools, such as commercial jet aircraft. 2. Export Administration Act Another policy tool available to the Reagan Administration in its conduct of foreign economic relations is export-controls. The Export Administration Act (EAA) of 1979 vests in the President the power to grant or withhold licenses for the export of goods which could be used against the United States in time of war or which would contravene the foreign policy aims of the United States. The Secretary of Commerce is primarily responsible for administering the provisions of the Act pertaining to export licensing and for establishing which goods or technical services cannot be exported and the circumstances under which other goods may be exported. To this end, the Secretary puts together and maintains a Commodity Control List. gal A large number of metalworking machines are on the current Commodity Control List. Their exportation can be proscribed on both national security and foreign policy grounds. Sales of machine tools to Communist countries (especially the Soviet Union and the Eastern European countries) have been affected the most by the licensing procedures established under the Act. Some toolmakers contend that the EAA is the "single, largest stumbling block to increasing exports" because of the delays encountered in getting a license to export and to the highly political nature of a number of the determinations. 23/ Does the available evidence support this claim? 23/ See P.L. 96-72, Sections 4 and 5, September 29, 1979 (Export Admini- stration Act of 1979). 24/ "Machine Tool Competition Toughness Here and Abroad, Iron Age, vol. 222, Kfigusc 27, 1979, p. 95. CRS-32 Between October 1978 and September 1979, the last fiscal year for which comprehensive data are available, the Commerce Department approved license applications for a wide range of commodities valued at $808.9 million for export to the Soviet Union, Eastern Europe, the Mongolian People's Republic, and the People's Republic of China. All of these commodities were cleared for "national security purposes." During this same period, license applications for export to these countries valued at $10.852 million were denied for reasons of either foreign policy or national security. Licenses for export of just machine tools in this period were valued at $13.082 million. This amounted to 2.3 percent of total 1978 machine tool exports and 2.0 percent of the 1979 total. 32/ Although no breakdown of the license applications that were denied by both product type and value is publicly available, it is reasonable to infer that a portion of these applications were for machine tool transactions already negotiated. There is no denying that the procedures for review of exports containing sensitive technology can deter domestic toolmakers from entering promising foreign markets, such as the Soviet Union and Eastern Europe. And in the absence of such procedures machine tool exports undoubtedly would have been higher. Yet the trade statistics for recent years suggest that removing the review and clearence procedures authorized by the EAA would only have resulted in, at best, a marginal rise in total machine tool exports. Because of the technological sophistication of the U.S. machine tool industry overall, foreign demand for many of its products has been robust in recent years. Control of exports through the Export Administration 25/ See Export Administration Report, pp. 9-20 of No. 119 and pp. 8-19 of No. 150; Department of Commerce, Industry and Trade Administration. CRS-33 Act has constrained machine tool exports somewhat. What position the Reagan Administration adopts on the future administration of EAA will have some bearing on future levels of output and employment in the machine tool industry. By successfully competing in foreign markets on a continuous basis, domestic toolmakers would have a better opportunity to maintain high levels of output and employment when U.S. economic activity slackens. Foreign machine tool demand could thus act as a buffer for the domestic industry. Perhaps then the incentives to invest in additional toolmaking capacity would more than offset the perceived risks, bringing the supply of and demand for machine tools into a more stable equilibrium. CRS—34 (This page intentionally left blank) CRS-35 IV. INDUSTRY FORECASTS Two sharply divergent views of the outlook for the machine tool industry between 1980 and 1985 are given by Data Resources, Inc. (DRI) in its Interindustry Review and by the Commerce Department in its §;§;# Industrial Outlook for 1981. Their forecasts of real industry output. will be briefly reviewed along with the assumptions undergirding them. A. DRI Forecast DRI projects an average annual rate of growth in real output of metal- working machinery of 3.2 percent between 1980 and 1985 under a trend scenario. 32/ (This simulation is based on the macro model solution TRENDLONG 1280 and the companion Cost Forecasting solution CF S811. They both embody eco- nomic conditions as of December 1980.) Real output of both metal-cutting and metal-forming tools is expected to rise at an average annual rate of 4.1 percent. Employment and productivity in the metal-cutting machine 9 tool industry should grow at average annual rates of 2.7 percent and 1.3 percent (respectively) and in the metal-forming machine tool industry at average annual rates 3.5 percent and 0.2 percent. (See Appendix C for the year-to-year changes.) 29/ The trend scenario postulates an economy that is relatively stable between 1980 and 1985. Inflation remains high over the simulation interval but does not deviate from the average experience of the last five years. No major economic shocks (such as a five-fold jump in OPEC oil prices) occur, nor does fiscal or monetary policy have a countercyclical emphasis. After a recession in 1981, the economy expands relatively smoothly, ex- hibiting mild variations somewhat below its balanced growth path. The projected trajectory is exceptionally even when compared to the swings in economic activity over the 1970s. As this scenario tries to represent the mean of likely eventualities, it can be a useful device for analyzing the interindustry implications of a changing economic environment. CRS-36 1. Assumptions The projected growth in real machine tool output is predicated on the occurrence of a series of interrelated economic events. To begin with, nonresidential fixed investment is expected to rise (in nominal terms) at an average annual rate of 21.6 percent between 1981 and 1985. Second, the industrial production index in 1985 will be 24.2 percent above its 1980 average. Third, capital spending by manufacturers of data-processing equipment, transportation equipment, and energy equipment (e.g., oil field machinery, pipelines) will grow substantially, enabling these producers to keep pace with anticipated increases in demand for their output during the five-year period. Lastly, interest rates, after reaching historic highs in late 1980, should gradually come down over the period so that by 1985 the average prime rate will be 12.20 percent. At the same time, capacity limits on machine tool production over the simulation interval are expected to create ideal conditions for import competition, thereby keeping the rate of growth in real machine tool output below what it would be in the absence of such a severe constraint. B. Commerce Department Forecast 21/ A much more optimistic projection of real machine tool output growth is advanced by the Commerce Department. In 1981, real growth in the output of metal-cutting machine tools should be 10 percent and of metal-forming machine tools 8 percent. These rates are also expected to hold without fluctuation between 1981 and 1985. 28/ (See Appendix D for industry project- ions and the price and GNP assumptions.) 21/ This forecast was made on November 1, 1980 and represents a concensus of major econometric forecasts then available. 28/ 1981 U.S. Industrial Outlook, Commerce Department/Bureau of Industrial Economics, January 1981, p. 231. CRS-37 1. Assumptions This projection reflects a number of critical assumptions about economic conditions during the simulation interval. 22/ Most important among these is the expected growth in nonresidential fixed investment between 1981 and 1985: 6.0 percent per annum in real terms. An especially high rate of real growth is projected for spending by producers on durable equipment: 7.1 percent per annum over the period. Machine tools would be one of the industries likely to gain markedly from such spending growth. In making these projections for the investment component of GNP the Commerce Department assumed that a set of business tax incentives for capital expenditure similar to the Administration's proposals would be adopted by Congress, providing a rapid and potent stimulus to capital formation in the short run. £2! , pp. 0 CRS-38 V. CONCLUDING REMARKS To analyze properly the full economic implications of the economic recovery program espoused by the Reagan Administration, more than the program's probable macroeconomic effects must be projected. An examina- tion must also be made of the likely microeconomic effects of the program. Such effects would be on labor markets, on capacity utilization rates in the manufacturing sector, and, most important, on specific industries, especially those industries which in recent years have been beset by extremely low profit levels and considerable excess capacity. This paper can be viewed as a preliminary attempt at such an analysis. A number of conclusions follow from the industry data and econometric model simulations presented earlier: ~-in the late 1970's machine tool firms experienced a tremendous surge in demand for their primary products: metal-cutting and metal-forming machine tools. --the machine tool industry has been and continues to be subject to cyclical fluctuations in the economy: in the second half of 1980 machine tool orders dropped sharply and the cancellation rate increased at the same time that the rate of growth in real GNP decelerated. --over the next ten years the principal problems facing the industry will probably be on the "supply-side": firms may lack the capacity and be unable to hire and train the skilled workers needed to keep pace with the expected growth in machine tool demand. --two ancillary concerns both for machine tool firms and economic policy- makers are the amount of money devoted to research and development in the industry relative to total sales and levels of import penetration in the various domestic machine tool markets: one option for firms whose sales are affected by imports is to shift production to machine tools incorpor- ating more sophisticated technology. --import penetration should lessen as total machine tool capacity begins to achieve equality with demand levels: the penetration most likely will continue to be higher for lower technology rather than higher technology machine tools. CRS-39 --the Reagan Administration's economic recovery program should help keep demand for machine tools strong in the short run: the accelerated invest- ment cost recovery plan and planned increases in real defense spending will be instrumental in this regard. --in the long run, demand is likely to be responsive to the course of monetary policy and changes in the desired level of the capital stock for the economy as a whole. -machine tool firms will benefit from the stimulus offered by the Reagan Administration's economic proposals to the extent that they add to capacity and they take the measures needed to insure an adequate supply of skilled labor. CRS-40 APPENDIX A * New Net Machine T001 Orders: 1968 to 1988 MILLIONS OF DOLLHRS 88 5888 4888 3888 2888 1888 Q 4 1 1 1 1 1 1958 1978 1972 1974 1976 1978 1988 YERR Prepared by CR5 from National Machine Tool Builders Association data. Manu¥acturin Operating Rates: 19 8 to 1988 PERCENT 8 76 - 74 I 1 1 I I 1968 I378 I972 1974 1976 1378 I988 YERR Prepared by CRS from Commerce Dcpoflm-fit C1090. ‘ New net orders are the value of the orders received in a time period less the value of unfilled orders cancelled during that period. The manufacturing operating rate is derived from the capacity utiliza- tion series published quarterly by the Bureau of Economic Analysis of the Department of Commerce. It provides a measure of the percentage of maximum practical capacity utilized by manufacturing companies during the final month of each calender year. The series is based on a quarterly survey in which manufacturing companies are asked to report their actual and preferred operating rates. CRS-41 APPENDIX B DIRECT AND INDIRECT MACHINE TOOL SHIPMENTS RELATED TO DEFENSE PROCUREMENT Direct purchases of machine tools by the Defense Department are given in the appropriate rows and columns of Table I--The Use of Commodities by Industries, 1972, from The Detailed Input-Output Structure of the U.S. Economy: 1972. Indirect purchases can be determined by locating the appropriate technical coefficients for all commodities purchased by the Defense Department in the year (expressed in direct and indirect com- modity requirements per one dollar of delivery of commodities to final demand) in Table IV--Commodity-by-Commodity Total Requirements, 1972, and multiplying them by the total amount of purchases of those commodities. The technical coefficients relevant to machine tools signify the value needed to produce one dollar's worth of each of the commodities purchased by the Defense Department which require the use of machine tools in their production. Or: V = (1) D + (i) D --- + (i) D IM 1 I 2 2 n n where V is the dollar value of indirect shipments of machine tools; (i) is the IM value of the units of machine tools needed to produce one dollar's worth of a Commondity; and D , D ... D are the values of the total amounts of the commod- l 2 n ities purchased by the Defense Department and requiring a certain input of ma- chine tools. Adding together the values of the direct and indirect purchases gives the total effect on the machine tool industry of defense procurement. In 1972, then, defense procurement was directly and indirectly responsible for approximately $73 million of machine tool shipments. This represented 7.1 percent of total shipments of complete machine tools for that year. CRS-42 APPENDIX C SUMMARY TABLES OF THE DRI FORECAST FOR THE MACHINE TOOL INDUSTRY Table 1 Machine Tool Production ($ billion--current) 1980 1981 1982 1983 1984 1985 1/ Sector 271: 2.276 2.235 2.366 2.534 2.632 2.773 .g/ Sector 272: 0.788 0.786 0.829 0.886 0.919 0.963 Source: Data Resources. Inc. (DRI), March 1981. 1/ Sector 271 is the metal-cutting machine tool industry (SIC 3541). .§/ ‘Sector 272 is the metal-forming machine tool industry (SIC 3542). Table'II Machine Tool Industry Employment (millions) 1980 1981 1982 1983 1984 1985 Sector 271: .072 .071 .074 .079 .080 .082 Sector 272: .032 .033 .034 .036 .037 .038 Source: DRI. Table III Machine Tool Industry Productivity ($ output/man-hour) 1980 1981 1982 1983 1984 1985 Sector 271: 31.512 31.367 31.846 32.197 32.846 33.692 Sector 272: 24.867 23.939 24.266 24.494 24.744 25.134 Source: DRI CRS-43 Appendix C (continued) Table IV Change in Production, Employment, and Productivity (%) l2§9_ .£2§£ .£2§§ l2§§_ l2§fl_ l2§§_ Annual Average (Production) Sector 271: - -1.8 5.9 7.1 3.9 5.3 4.1 Sector 272: - -0.3 5.5 6.9 3.7 4.8 4.1 (Employment) Sector 271: - -1.4 4.2 6.7 1.3 2.5 2.7 Sector 272: - 3.1 3.0 5.9 2.8 2.7 3.5 (Productivity) Sector 271: -A -0.5 1.5 1.1 2.0 2.6 1.3 Sector 272: - -3.3 1.4 0.9 1.0 1.6 0.2 Source: DRI. CRS-44 APPENDIX D SUMMARY TABLES OF THE COMMERCE DEPARTMENT"S FORECAST FOR THE MACHINE TOOL INDUSTRY Table I GNP and Price Assumptions ----- ---- Average Annual Rate of Change (%)-------- (Constant 1972 Dollars) Actual Estimated Projected Assumed 1975-79 1979-80 1980-81 1981-85 Gross National Product 4.5 -0.8 A - 3.6 Personal Consumption of Durable Goods 6.9 -8.4 -1.2 5.6 Investment in Producer's Durable Equipment . 7.1 -3.0 -0.5 7.1 Investment in Non- Residential Structures 6.7 -0.3 -6.2 3.7 Federal Government Purchases 0.7 6.4 2.7 3.5 GNP Price Deflator 6.8 9.5 9.7 - Consumer Price Index 7.8 13.4 10.0 — Source: 1981 U.S. Industrial Outlook, Commerce Department/ Bureau of Industrial Economics, January 1981. Table II Metal-Cutting Machine Tools (SIC 3541): Trends and Projections 1975-81 1975 1976 1977 1978 1979 1980 1981 Value of Shipments 2,727 2,510 2,812 3,589 4,776 6,028 7,594 ($ million current) Value added per man-hour 20.08 22.64 23.13 - - - - ($_) Employment (thousands) 63 60 69 73 80 82 - Exports (million) 343 290 247 366 545 660 800 Imports ($ million) 248 245 319 582 1,043 1,250 1,600 Source: Bureau of the Census, Bureau of Labor Statistics, and Bureau of Industrial Economics. CRS~45 Appendix D (continued) Table III Metal-Forming Machine Tools (SIC 3542): Trends and Projections 1975-81 1975 1976 1977 1978 1979 1980 1981 Value of Shipments ($ million-current) 1,110 1,085 1,130 1,289 1,676 1,823 2,240 Value added per man- hour Employment (thousands) 26 23 25 26 28 28.3 “ Exports $ million) 225 257 221 194 220 275 330 Imports ($ million) 69 73 90 133 211 265 340 Source: Bureau of the Census, Bureau of Labor Statistics, and Bureau of Industrial Economics.