President Bush has appointed a commission to study tax reform and said that he wants to make his tax cuts permanent. However, no major tax reform will occur soon. One modest proposal for immediate reform is to make permanent a Bush tax cut that has been allowed to expire.
I am referring to the bonus depreciation provisions that expired on January 1, 2005, raising taxes for all businesses. Unfortunately, there were no headlines noting this tax increase, possibly because bonus depreciation is an issue that excites only tax economists and accountants. It is important to all, however, because bonus depreciation increases economic growth by encouraging firms to invest.
Under ordinary depreciation, every business, even a corner mom-and-pop grocery, deducts the cost of each investment over its lifetime. For example, if a business buys a $1 million machine that lasts for ten years, it garners a $100,000 tax deduction each year for ten years. Under bonus depreciation, in contrast, it receives a $500,000 "bonus" deduction at the time of purchase and takes a $50,000 deduction each year for ten years. The total tax deductions are equal, but bonus depreciation moves half the deductions to the time of purchase, a valuable change because a dollar today is better than a dollar next year or later. For a business in the 35 percent tax bracket that can borrow at 6 percent (currently the prime rate), bonus depreciation increases the after-tax value of these deductions from $273,059 to $311,530, an increase of more than $38,000. The value is greater for firms that pay higher interest rates and for those constrained by a lack of cash.
To put this in perspective, consider expensing, where the entire purchase price is immediately deducted, making the government essentially a partner. For example, if a firm is in the 35 percent bracket, the government pays 35 percent of the purchase price through expensing and receives 35 percent of future earnings in taxes, essentially relieving the business of all taxes on the income from its 65 percent. Furthermore, if all investments were expensed and deducted from income, then the tax system would become a consumption tax because consumption equals income minus investment. Therefore, the bonus depreciation provision in force in 2004 cut the tax rate on income from qualifying investments by half and brought the tax code closer to a consumption tax.
Bonus depreciation was enacted in 2003 to help the economy recover from the recession. Many economists have correctly questioned this rationale. The long-run effectiveness of bonus depreciation, and the similar investment tax credit first enacted by the Kennedy-Johnson administration, however, is unquestioned. My work shows that these measures stimulate the economy more per dollar of lost revenue than other kinds of tax cuts and that the benefits are shared by both business and labor because the new investments increase worker productivity and wages.
Bonus depreciation is a simple tax cut that benefits economic growth and has historically had bipartisan support. Let's bring it back now.
