The word "investment" has different meanings to different people. In finance, investment means the purchase of financial products or other assets, such as mutual funds or gold, with an expectation of favorable future returns. For businesses, it can mean the purchase of a physical good, such as a durable machine or inventory, with the hope of improving future business. In economics, investment is defined as any use of resources intended to increase future production output or income. In particular, capital investment is money spent on physical capital such as buildings, equipment, or machinery, or on human capital such as education or job training. Because a larger capital stock makes labor more productive, investment is a primary driver of greater economic growth and higher standards of living.

   If governments pursue policies that involve the least amount of government interference necessary for a well-functioning capital investment market, this will encourage an efficient amount of investment. One type of policy that is key to encouraging an efficient level of investment is pro-growth tax policy. One of the goals of pro-growth tax policy is to finance government services in a way that minimizes the effect of taxes on the capital investment decisions of households or businesses. By taxing investment returns too heavily or by providing tax advantages to certain types of investment, a tax system can discourage overall investment, as well as prevent capital from being used efficiently. A tax system that affects investment decisions in these ways is called "distortionary" because it creates incentives for people to base their saving and investment decisions on taxes, rather than making those decisions based solely on where they can use their resources most productively.

   This chapter discusses the advantages of adopting a more pro-growth tax system. It reviews recent changes that have reduced tax distortions on capital investment decisions, and evaluates options to further reduce such distortions. It draws the following four main conclusions.

   1. The goal of pro-growth tax policy is to reduce tax distortions that hamper economic growth. Most economists agree that lower taxes on capital income stimulate greater investment, resulting in greater economic growth, greater international competitiveness, and higher standards of living.

   2. The current tax code contains provisions that discourage investment and create distortions that affect the level, structure, and financing of capital investment. These distortions dampen capital investment and contribute to an inefficient allocation of capital throughout the economy.

   3. Estimates from research suggest that removing these tax distortions to investment decisions could increase real gross domestic product (GDP) by as much as 8 percent in the long run.

   4. Since 2001, temporary changes in the tax code have reduced the tax on investment. These pro-growth policies have stimulated short-run investment and economic growth. However, the temporary nature of the provisions eliminates desirable long-run economic stimulus.