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.