The Wrong Spur for Small Business Investment

President Barack Obama recently proposed to let businesses immediately deduct the entire cost of expenditures made from now until the end of 2011 as a way to stimulate business investment. (This proposal differs from the provisions in the jobs bill that just passed the Senate.) While the Administration claims that this accelerated depreciation will stimulate economic growth and create a lot of jobs, I disagree.

Under the proposal, companies could deduct the full amount of virtually all non-real estate investments in the year the investments are made. That is, instead of getting the tax deductions over time, businesses would get them all at once. Because companies can depreciate most investments over a 3-to-20-year period, the Obama initiative would amount to accelerated depreciation.

The Administration argues that accelerating depreciation will spur business investment because it will put more cash in the hands of those businesses. The American Enterprise Institute's Kevin Hassett calculates that this would increase business investment in the short term by up to 10 percent, according to a recent Wall Street Journal article.

I'm with the economists who challenge the stimulative effect of this policy, especially for small businesses. Companies invest only if they believe there will be demand for their products and services in the future. Right now, few small business owners believe that demand will be strong at any time soon. The National Federation of Independent Business' monthly optimism survey of about 2,000 members shows that by a 15 percent margin, more small business owners believe economic conditions will worsen than think they will improve over the next six months. It also shows that only 5 percent of owners think now is a favorable time to expand. If small business owners think demand is weak, they won't invest in plant and equipment, regardless of how quickly they can depreciate the investments.

Why rush the deductions?

The accelerated depreciation proposal wouldn't even affect most small business owners' investments, even if they were more optimistic. As Mel Schwarz, partner at Grant Thornton's Washington national tax office, explained: "Most small businesses aren't making large enough investments to be affected by the proposal. Any business can immediately deduct the first $250,000 of depreciable property under current law, and that amount will increase to $500,000 for 2010 and 2011 under the [new jobs] bill." That's already a large amount for most small businesses, Schwarz points out.

The proposal isn't likely to trigger much investment by owners of the largest small businesses, either. For the measure proposed by President Obama to motivate business owners to invest this year, instead of waiting, the owners need to believe that reducing today's tax liabilities is more valuable than reducing them down the road. With a lot of small businesses currently losing money—and taxes on small businesses likely to go up in the future—few owners are now in a rush to get these deductions.

Moreover, accelerated depreciation will do little to stimulate investment because cost isn't what's keeping small business owners from investing. Since companies can already borrow at very low interest rates, Harvard University's Gregory Mankiw explained, reducing the cost further through tax breaks will do little to trigger investment, according to the same Journal article.

Much of the proposed tax change will reward those businesses that would have made capital investments anyway. Spending on new plant and equipment isn't something that many businesses decide to do on the spur of the moment. Few small business owners make these investments for tax purposes. Therefore, most owners currently not planning to invest will not reverse course to accelerate depreciation. Many businesses that are planning to invest will take the accelerated depreciation and reduce their 2010 and 2011 tax bills.

Accelerated Depreciation's Third Call

For those keeping score, we've already tried to stimulate business investment during the current economic downturn by accelerating depreciation—twice. The 2008 Economic Stimulus Act gave businesses a 50 percent depreciation allowance for tangible property and software bought in 2008. The government then extended and increased the limits on this "bonus depreciation" in 2009.

Accelerating depreciation in 2008 and 2009 did little to spur small business owners to make capital investments. Despite the possibility of bonus depreciation in 2008 and 2009, the percentage of small business owners in the NFIB survey who reported making a capital expenditure in the prior six months was lower in 2009 than in 2008. The percentage in August 2010 was no higher than at the beginning of 2009.

Rather than accelerating depreciation, which merely borrows a tax deduction from the future, the Obama Administration should instead pledge not to raise taxes on successful small business owners. That's because small business income is highly skewed. A relatively modest number of small companies generate most of the money—and pay most of the taxes. As Kevin Hassett and Alan Viard of the American Enterprise Institute report in a Wall Street Journal opinion piece, almost half of the net income earned by small businesses was earned by households whose incomes exceeded $200,000 in 2007.

The highest-earning small business owners are the ones most likely to make new investments in plant and equipment because successful businesses are more likely to expand than are unsuccessful ones. Raising taxes on wealthy small business owners will reduce their willingness to invest. Research papers by Robert Carroll, Douglas Holtz-Eakin, Harvey Rosen, and Mark Rider showed that increasing marginal income tax rates by 4.6 percent—the amount proposed in the phase-out of Bush tax cuts on those making more than $250,000 per year—would cut average investment by sole proprietors by 9.1 percent.

If the Obama Administration wants to stimulate small business investment, preserving the Bush tax cuts is a much better policy choice than accelerating depreciation.

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