Taxes, Capital Spending, and Jobs
Corporate spending got a boost this year from a change in tax rules called accelerated depreciation. This lets companies that purchase big-ticket items and equipment before yearend write off the cost sooner than usual. It has spurred capital spending in a variety of industries, particularly software, telecom, heavy trucks, and aircraft, says Barry Ritholtz, market strategist at New York investment firm Maxim Group.
BusinessWeek Online's Karyn McCormack recently spoke with Ritholtz, who has been studying the effects of the rule and what it means for the economy, and particularly for hiring. Edited excerpts of their conversation follow:
Q: What's so interesting about accelerated depreciation? A:
Q: What's so interesting about accelerated depreciation?
A:The main reason I look at things like accelerated depreciation is to find what's missing from the economists' models that's causing them to get the job numbers so wrong. The old joke is, "we keep economists around to make weathermen look good." There's a touch of truth in that. But eventually they get it right. They've been just so wildly wrong that you have to go back to square one and figure out what are their models overlooking?
After the market crash and the start of the recession, companies just weren't making major capital expenditures. So the [Bush] Administration decided to test a theory that if we can give them an incentive to depreciate things faster, they would buy more of these big-ticket items and theoretically, it would stimulate the economy and would create jobs.
Q: Business spending has risen mainly because of this rule? A:
Q: Business spending has risen mainly because of this rule?
A:After the war started and after the tax law was passed in May of 2003, we saw purchases of major items start to pick up. It encourages companies that are sitting on the fence about making these large capital expenditures, and tips the scales a bit and gets them to pull the trigger on those big purchases perhaps a little faster that they would have otherwise. In fact, it [expires] this year, and the rule is [the equipment] has to be "placed in service" by Dec. 31, 2004.
Accelerated depreciation gave companies an incentive, when they did spend money, to spend it on capital goods as opposed to hiring people. Normally at this stage of an economic recovery, we should be seeing robust hiring -- 250,000 or 300,000 new jobs a month. Clearly, that just hasn't happened.
Q: How does accelerated depreciation work? A:
Q: How does accelerated depreciation work?
A:To oversimplify, let's say a purchase is intended to last five years, you'll depreciate 20% of the purchase cost each year. So if something costs $1 million, you get to deduct $200,000 of the cost of that each year for five years against your total gains.
The advantage of accelerated depreciation is instead of depreciating a five-year item by 20% a year, you get in year one a bonus acceleration of the depreciation of 50%, plus half of your normal depreciation. So you end up with a 60% depreciation of that $1 million widget, which would be $600,000, vs. the ordinary 20%, which would be $200,000. That's a very big incentive to a company.
Q: Which companies have been taking advantage of it? A:
Q: Which companies have been taking advantage of it?
A:We've been hearing that a lot of the Verizon (VZ ) fiber-to-the-premise build-out was accelerated to take advantage of accelerated depreciation in 2003 and 2004. Knowing they would do the build-out anyway in 2005 and 2006, they'd rather get as much of the writedown on the books in 2004 as possible. A fiber-to-the-premise build-out might have a 7- or 10-year depreciation schedule. So the acceleration is a huge benefit from their profit-loss perspective, only because they get to write off more of it sooner.
[Despite the accelerated depreciation rules] we're still dealing with somewhat anemic demand on the corporate side. We still see consumers spending pretty heavily, but companies have been very cautious with their spending. They've been very concerned about the bottom line.
Q: Which sectors are benefiting the most? A:
Q: Which sectors are benefiting the most?
A:It breaks down into two groups. One is enterprise-resource-planning (ERP) software applications, and on the other hand we've heard about everything else, from fiber-to-the-premise to routers and computers. We've spoken to a number of accounting firms, and they've told us that a number of their clients have been actually going out and buying personal jets to take advantage of the writedown. If you get to buy a $60 million jet that you would ordinarily depreciate over 10 years that you could [normally] write down only $6 million a year, and you get to write down $30 million in year one, that's a huge incentive.
In ERP software applications, it's not about buying Microsoft Office and a couple of CDs. We're taking about large, full installs of software that overlays a corporate database and is designed to make companies more efficient and give them better usage of their own data. This in turn helps companies manage their business in a way that's more productive and more profitable. This software helps them determine how much of their products are selling, and then they can fix any problems.
The downside is that these sort of applications make companies so productive that they're actually able to do all these additional things with less staff. And the great irony of accelerated depreciation is it may actually have encouraged companies to buy these big software packages at a time when the recovery is somewhat delicate.
Q: So this explains why the job recovery hasn't been very strong? A:
Q: So this explains why the job recovery hasn't been very strong?
A:I don't think it explains the entire situation. It explains some of it. The reality is, in a post-bubble environment -- and I think people very much have forgotten that the Nasdaq dropped 80% and new orders, especially in technology, across the economy fell off a cliff -- it's barely three years, and we're off to the races again. It takes a long time to work off the effects of a major bubble.
What we've seen over the past 18 months has been a very meager, anemic recovery, and quite frankly, it's what one should expect after a bubble of this magnitude blows up.
Q: Will business spending slow down next year? A:
Q: Will business spending slow down next year?
A:I think a percentage of what we're seeing in 2004 certainly is coming at the expense of spending in the first half of 2005. The positive side of it is that, if a corporate budget committee tries to decide whether to add to headcount or buy [big equipment], if the thumb was on the side of capex [capital expenditures], that's now coming off. Perhaps if we're lucky, we'll see some improvement in hiring in 2005 now that that incentive for capex is gone.
Q: What's does it all mean? A:
Q: What's does it all mean?
A:The bottom line comes down to ultimate demand. I'm not a supply-sider. I believe that purchases happen because the end user needs to buy something. So no matter what the incentives are to hire people or for capex, if companies don't see demand from their clients, they're not going to buy new equipment and hire new people.