Nice Tax Break While It Lasted

If corporate profit growth hits a wall next year, as many economists expect, one of the biggest reasons will be the end of a major tax break that was enacted to jump-start the economy in the wake of the September 11 terrorist attacks. In March, 2002, Congress passed a bill that let companies take an immediate bonus depreciation allowance on capital investments such as computers and cars. At first, 30% of the cost of capital goods could be deducted from earnings, and the rate was later raised to 50%. But that bonus is now set to end on Jan. 1.

For corporations, the bottom line is that depreciation write-offs lower the amount of income that is taxable. With business investment on equipment and software projected to near $1 trillion this year, the depreciation bonus will reduce many 2004 corporate tax bills -- though total taxes paid will still rise as a result of economic growth. But a return to the old depreciation schedules will hike the effective corporate tax rate next year by about one-third, to 30%, says David A. Wyss, chief economist at Standard & Poor's (MHP ). That change alone will account for $90 billion of the projected $113 billion increase in corporate taxes next year.

Businesses with a high proportion of capital spending to sales, such as utilities or telecom, will suffer the biggest tax bite. But Richard B. Berner, chief U.S. economist at Morgan Stanley (MWD ), says that a survey of the company's analysts shows that within the next six months, telecom, biotech, semiconductors, air freight, railroads, and steel will actually increase capital spending.

Why? Because ultimately, economic fundamentals are the driving force for spending plans. "Our customers appear to still have pent-up demand," says Rockwell Automation Inc. (ROK ) Chief Financial Officer James V. Gelly. The Milwaukee maker of factory automation equipment says it expects orders to keep growing in the first half of 2005, so Rockwell will ratchet up its own capital spending, mainly on software and computer systems, by 20%, to $120 million next year. And in September, the Federal Reserve Bank of Philadelphia asked manufacturers in its region about spending plans: Some 56% planned to raise investment outlays in 2005, while 16% said they would cut spending.

The effects of the overall tax boost next year won't hit everyone the same way. Some companies can use previous years' losses to shield future profits. While it plans to more than double capital spending to $1.5 billion this year Sunnyvale (Calif.) chipmaker Advanced Micro Devices Inc. (AMD ), for instance, has enough losses over the past three years to offset future taxable income.

In any case, don't cry for big business. Many companies got new breaks as part of the tax bill passed in October. Congress granted a tax holiday on repatriated earnings, for instance, slashing the rate on foreign profits earned before 2003. The money must be used to pay down debt, to hire new employees, or on capital spending. Boston Scientific Corp. (BSX ), the Natick (Mass.) stent maker, says it is eligible to repatriate $1 billion. By some estimates, U.S. companies will repatriate up to $300 billion in 2005. So as the government takes away with one hand, it's hard at work providing new breaks with the other.

By James Mehring in New York, with Michael Arndt in Chicago

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