As Congress considers new tax cuts to shore up the ailing economy, it is getting conflicting advice regarding which stimulus options would be the most effective.
Some analysts are suggesting that payroll tax reductions would shore up consumer confidence. But the slowdown has been driven by a huge drop in business investment, while consumers have continued a moderate spending pace until recently.
Therefore, it makes the most sense to aim a tax cut directly at the core problem, which is slumping investment in machinery and equipment.
During the late 1990s, investment in computers, telecommunications gear, and other machinery soared, with real business equipment spending increasing at more than 12 percent annually between 1994 and 2000. During this period, real investment in information technology equipment was growing at 20 percent annually.
This spending surge drove U.S. industry to new productivity highs and sustained nine years of economic growth.
That surge has now ended. The dropoff in business investment began about a year ago. By August 2001, the Congressional Budget Office was declaring that "business investment in equipment and inventories has all but collapsed."
Aggressive tax-cutting policy can get the capital investment engine running again. In particular, the tax rules for depreciation deductions should be immediately liberalized. That would lower the cost of new capital spending and provide a stimulus for everything from telecom firms investing in broadband equipment to automobile firms modernizing their assembly plants.
Investments that had seemed marginal because depreciation rules created high effective tax rates could then earn decent after-tax returns.
Allowing companies to depreciate, or deduct, machine purchases more quickly would provide a short-term stimulus, but also makes long-term economic sense. Under current rules, when a company buys a $10 million asset, it cannot simply deduct the expense as a current cost of doing business.
Instead, the government requires that it take deductions over a schedule of future years, even though the cash went out the door today. Future deductions are worth less than deductions today, in part because inflation eats away at a deduction's value in distant years. Essentially, depreciation rules get in the way of many otherwise sound investments by reducing the benefits that new machines bring to firms willing to take the risks of investment.
It makes no sense to penalize investment this way. The more machines that workers have to work with, the higher their incomes will be. In addition, capital investment is the primary way that new technologies get diffused throughout the economy. When firms replace worn out machines, they replace them with updated ones that produce higher-quality products more efficiently. Once again, the main beneficiaries are workers whose incomes will rise as their productivity increases.
Experts have pointed out for years that our depreciation rules haven't kept up with our fast-paced economy. Today, much business investment consists of computers and computerized machinery that are subject to rapid obsolescence.
But under current tax rules, a machine that lasts, say, three years before needing replacement, may face a five-year write-off schedule, thus pushing up the machine's tax burden.
In congressional testimony earlier this year, the Tax Executives Institute concluded that the depreciation system is "hopelessly outdated and needlessly complex." Some members of Congress are listening. Reps. Phil English, Pennsylvania Republican, and Richard Neal, Massachusetts Democrat, have introduced H.R. 2485 which would shorten depreciation schedules across the board. And the proposal would allow high-tech equipment to be immediately deducted when purchased.
Top administration economic advisers, such as Lawrence Lindsey and Glenn Hubbard, have called for depreciation reforms, so now is the time to move on this agenda.
Ultimately, the goal should be to scrap the depreciation system altogether in place of capital expensing, or immediate write-off of business assets when purchased. This is a key principle behind all the consumption-based tax reform proposals of recent years, such as the flat tax proposed by House Majority Leader Dick Armey, Texas Republican.
Liberalizing depreciation deductions this year to get business investment back on track would be a good start down this road of long-term tax reform.