1 Why Bonus Depreciation is Not Necessarily a Good Idea

Temporary bonus depreciation rules, enacted as part of the Economic Stimulus Act of 2008, are likely to reduce job growth and depress wages through the end of this year, and perhaps beyond. This post explains why.

The details of the rules are unimportant. What is important is that businesses that buy new equipment in 2008 get a tax break.

So what’s wrong with that? Don’t we want businesses to invest in equipment?

Of course we do. The problem is more subtle.

In Econ 101, we learn that businesses often have choices about how to produce the goods or services they sell. To produce a particular gizmo or service, for example, a business may either use 2 units of equipment and 1 of labor or 1 unit of equipment and 2 of labor. In the absence of government intervention, economists tell us that businesses will generally choose the most efficient combination of labor and equipment.

Now put the tax system’s heavy thumb on one side of the scale – equipment purchases. What happens? Businesses deploy more equipment and less labor. The “more equipment” part is good. The “less labor” part is not. At least in the short run, bonus depreciation depresses the demand for labor. Economics predicts that a depressed demand for labor should have two consequences: slower job growth and lower average wages.

This is precisely what happened the last time we tried bonus depreciation – September 2001 through December 2004 or, for longer-lived equipment, through December 2005. Result? We had what economists called a “jobless recovery.”

Economists struggled mightily to explain this apparently inexplicable phenomenon. In a November 2003 speech entitled “The Jobless Recovery,” Ben Bernanke, now Federal Reserve Chair, considered a series of possible explanations, none of which he found fully persuasive. He did not, unfortunately, consider the fine print of the Internal Revenue Code. Almost no economist does.

The results of bonus depreciation were exactly as economic theory would have predicted. First, the economy produced fewer new jobs. Seasonally adjusted nonfarm employment fell for almost three years after the bonus depreciation rules went into effect, returning to September 2001 levels only in late 2004. This notwithstanding the fact that GDP rose by 8% over the same period. Second, inflation-adjusted weekly earnings in the private sector remained flat from 2001 through 2005, recovering only after the tax system’s heavy thumb came off the scales.

Not surprisingly, since enactment of the new temporary bonus depreciation rules in February 2008, both seasonally adjusted nonfarm employment and inflation-adjusted weekly earnings in the private sector have fallen consistently. If my analysis is correct, we should expect more of the same through the end of the year.

Nor will the problem necessarily go away then. If he is elected President, Sen. John McCain promises to enact even stronger tax incentives for business equipment purchases made between 2009 and 2013. If he succeeds, jobs and wages should remain depressed for at least another five years.

Comments

[Brooks Gracie III]

Great blog! I am a tax attorney who reads approximately 20 blogs per day on economics. Rarely do the economists know much about the tax code. I would also like to see your opinion on this country's disparate tax policies between capital gains and ordinary income. My opinion is that this is shredding the middle class, and we will eventually be in a 1929 crises because no one will be able to afford anything other than the wealthy, who cannot sustain an economy on their own.

[Apep]

Great first post. What happened to construction wages during the first round of bonus depreciation?

As a practitioner, the primary result of bonus depreciation appeared to be greater demand for cost segregation studies to classify nonstructural building components and land improvements as equipment. It's been awhile since I looked at the IRS data, but I don't think there is a way to differentiate between equipment and reclassified building components.

[Mike Sylvester]

I also find this post quite interesting. I am a practicing CPA and run my own blog at SBSCPAGroup.com.

This post takes a very interesting look at bonus depreciation and shows an author who thinks "outside of the box."

I think too many practitioners "mindlessly" take as much depreciation as legally allowed.

Mike Sylvester

[Alan]

Seems almost too obvious to be true, Ted. Um, who makes those new machines?

[Jim Maule]

Ted,

Welcome to the world of blogging, and to its tax blogging corner. I've added you on my MauledAgain blogroll.

Some months ago, I noted this question concerning bonus depreciation: where do the businesses straining under tough economic conditions get the money to make the purchases? Why, they borrow! The enterprises most in need of help don't have much use for more deductions.

Jim

[Aglifter]

How does this factor in with a decreasing labor pool? Japan, the US, Europe, and even Mexico, are either facing tremendous labor shortages, or will be soon. Wouldn't an emphasis on increasing automation, such as Japan is currently focused on, help ease the shortage, w. an increased demand causing an increase in wages?