A Misbegotten Tax Break

Turns out that the bonus depreciation did almost nothing to boost capital investment. Is this any way to manage an economy?

By Howard Gleckman and Rich Miller

When it comes to using the tax code to micromanage the economy, policymakers never seem to learn.

Despite the fervent hopes of supporters, these targeted tax breaks nearly always end up having little or no impact on economic growth. They may encourage business to shuffle assets, but after all the boxes get moved around, few of us are better off. Except, of course, the lobbyists, who can proudly chisel another tax-cut notch in their Gucci Gulch gunbelt, and a handful of their corporate clients that get rich at the expense of taxpayers and often their competitors.

The latest case in point: A tax break passed in 2002 that was supposed to encourage companies to purchase new equipment. The scheme, supporters insisted, would give capital investment a much-needed shot in the arm after years of stagnation. Called bonus depreciation, it initially let companies take big first-year write-offs for gear purchased before September, 2004. Then, in 2003, the pols sweetened the incentive, extending it through the end of 2004.


  At the end of the year the tax break quietly expired. Some of the same supporters warned that without it, capital spending would collapse. After all, they figured, like shoppers rushing to buy before a sale ends, companies would have accelerated big-ticket purchases into 2004 to take advantage of the expiring tax benefit. Then, once the subsidy died, investment would sag. That fear led economists at the Federal Reserve to worry about business investment hitting a "pothole" in early 2005.

Well, the early returns are in, and the evidence is that bonus depreciation generated barely a ripple in overall business investment. It did little to increase total capital spending in 2003 and 2004. And so far this year, its absence has had little measurable impact on spending, which continues to increase smartly. As a result, the demise of the subsidy "is more of a hiccup than pothole," says University of Michigan economist Matthew D. Shapiro, who has authored a new study on the tax change.

Oh, sure, investment was up in 2003 and 2004. But that's no surprise, considering that corporate profits, which collapsed in 2001, were on the rebound. Investment in equipment and software plunged from $919 billion in 2000 to $792 billion in 2002, bouncing back to $833 billion in 2003 and $940 billion in 2004. That pretty much tracked profits, which boomed from an anemic $767 billion in 2001 to more than $1.1 trillion by 2004. With that kind of money sloshing around, it was no wonder investment took off. The question is: Did the tax subsidies have anything to do with it?


  The answer is a clear "no." Shapiro figures the tax breaks did change the kind of investment companies made. Certain big-ticket equipment, such as electrical towers and electric turbines, got a windfall. And, sure enough, investment in that equipment was up. But the new subsidy made little difference in the aftertax expense of computers and similar equipment, because most of the cost of that gear could already be written off in the year it was purchased.

Thus the extra tax incentive did little to boost investment in computers and such. And it did nothing for commercial real estate, which didn't get the new tax benefit at all. Overall, Shapiro figures, total investment increased by perhaps $10 billion. He figures that was enough to boost gross domestic product by 0.1%. But a 0.1% increase in GDP is a rounding error -- something most of us will never notice.

Several surveys taken over the past year reaffirm that the tax break was mostly a nonevent. A National Association of Business Economists (NABE) poll in January, 2004, found that fewer than 6% of all companies questioned reported they boosted investment "a significant amount" as a result of the subsidy. Just 21% said they had increased equipment purchases "a little," and a thumping 73% said they hadn't responded at all to the tax break.


  In October, 2004, NABE had asked companies if they were accelerating their purchases of equipment to take advantage of the tax break before it expired. An astounding 91% said the subsidy had either a small impact or none at all on their capital-spending decisions. And earlier this year investment firm ISI asked businesses if the tax subsidy had any impact on the timing of their outlays. Two-thirds said it had no impact, while the rest said it had only a marginal one.

So continuing solid capital investment since the tax break expired should be no surprise. New orders for nondefense capital goods, excluding notoriously volatile aircraft, were up 3.4% in December, 2004. And they continued to increase by a solid 2.9% in January -- without the tax break. That's hardly the picture of an investment collapse.

If Shapiro is right, the misbegotten tax subsidy may have helped companies buy transmission towers or special farm equipment. The question is: Why on earth does the government want to encourage such purchases at the expense of other investment -- or at the expense of hiring new workers? Is it really better for the economy that the nation purchase more sewers and docks, rather than servers or office furniture? Why not let companies make those choices without having to figure out the tax consequences?

Says Doug Shackelford, accounting professor at the University of North Carolina's Kenan-Flagler Business School: "We ought to be very, very hesitant to put any of these incentives in to try to manipulate business decisions."


  One reason the tax break may have had such little impact is that many companies already pay no tax. Effective corporate tax rates are at historic lows. And thanks to a combination of low profits in 2001-02 and aggressive tax sheltering, many businesses not only owe no taxes but are carrying billions of dollars in tax losses on their books. A company with big unused tax breaks is not going to change its behavior just to rack up more unusable write-offs.

Earlier this year, President George W. Bush created a panel to review the tax code and suggest ways to fix it. The members could do worse than study the experience of bonus depreciation. It may encourage them to suggest clearing out the dozens of similar provisions that still lard the code to the benefit of special interests, but that do little or nothing to boost the overall economy.

Gleckman is a senior correspondent for BusinessWeek in Washington, and Miller is a senior writer for BusinessWeek in Washington

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