Understanding Tax

2 Why Bonus Depreciation Seems Like a Good Idea

In my last post, I suggested that temporary bonus depreciation rules, enacted pursuant to the Economic Stimulus Act of 2008, were likely to reduce job growth and depress wages through the end of this year, and perhaps beyond.

And yet we all know, in our heart of hearts, that investment in equipment is a good thing. This post will explain how both can be true – that is, how tax incentives to purchase equipment can both hurt wage-earners in the short run and help the economy in the long run. And it will explain why more is at stake than just bonus depreciation.

The simplest way to understand how investment incentives work is to focus on the real economy, by which I mean real investment and real consumption. Ignore cash flows. Money is merely an accounting system that makes the real economy possible. Focus instead on what is really being produced and used, and by whom.

In the real economy, additional equipment purchases are the equivalent of savings. Instead of eating all that our economy produces, we put some aside to generate future product. The more we save, the fast our economy grows.

In other words, if tax incentives to purchase equipment work and have no adverse side effects, our economy should grow faster in the long run. Hence our intuition that investment in equipment is a good thing.

But this raises two obvious questions: Who is not consuming? And who ends up owning the resulting wealth?

The answer to the first is simple: Under bonus depreciation, the unemployed workers and workers whose wages are depressed consume less, thus freeing up real capacity for equipment production. Tax incentives for business investment force wage-earners not to consume – in real economic terms, to save.

The answer to the second is equally clear: The newly purchased equipment ends up being owned by the owners of capital, not by the wage-earners who were forced to forego consumption. In other words, in addition to forcing wage-earners not to consume, tax incentives for business investment transfer the resulting savings to owners of capital. Robin Hood in reverse, if you will. (Some of these owners are American, many are not.)

In my last post, I noted that Sen. McCain proposes to enact even more favorable rules for business equipment purchased between 2009 and 2013. He is not, however, the first to advocate such rules. He is merely echoing a number of tax academics and economists, many of whom are liberal Democrats.

For quite some time now, many tax academics and economists have urged that the United States shift to a consumption tax. Under such a tax, businesses would be allowed to expense equipment purchases without limitation. In other words, the super-bonus-depreciation rules that Sen. McCain wants to implement for five years would become a permanent part of the U.S. tax system.

The main argument for such a change is that under a consumption tax, the U.S. economy would grow more quickly.

This is true.

Like temporary bonus depreciation, a consumption tax would have the effect of depressing job and wage growth, forcing some wage-earners to forego consumption. The economic capacity thus freed-up would be diverted to real capital investment, enabling the economy to expand more quickly. That’s the good news.

The bad news (or not, depending on your perspective) is that ownership of this new capital would vest in the owners of capital. In other words, permanent Robin Hood in reverse.

There are other ways to stimulate capital investment. I, for one, believe we should think more about the collateral effects of investment tax incentives before making them permanent - indeed, before using them at all. In any event, using such incentives for short-term stimulus purposes doesn’t make sense.

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.