Bonus Depreciation Boosts Investment, New Research Confirms

We have previously highlighted the economic benefits of bonus depreciation, or bonus expensing, using our Taxes and Growth (TAG) model. A new NBER paper strongly confirms our model’s assumptions, finding that bonus depreciation significantly increases investment. The paper’s authors estimate that bonus depreciation raised investment by 10.4% from 2001 to 2004 and 16.9% between 2008 and 2010. Additionally, they observe an investment response that is 27% higher for small and medium-sized firms than larger companies.

Bonus depreciation accelerates the schedule at which firms can deduct their costs of capital from their tax liability. It allows firms to immediately deduct 50% of their investments in equipment and software, while the remainder follows regular depreciation schedules. Bonus depreciation encourages investment because firms value a present stream of income more than a future one. For a more expansive illustration of this concept, see our recent post on this topic.

But what if a firm does not have a tax liability, because it generated a net loss that year? The authors’ find that firms respond to a change in depreciation if the change allows their investment to immediately generate a positive cash flow. These findings hold even though a firm can offset its tax liabilities in later years with unused deductions.

Financial constraints affect the investment response to accelerated depreciation. Financially-strapped firms value future cash flows with higher discount rates, allowing them to reap more benefits from the immediate deductions. The authors find that these firms respond by borrowing more and cutting their dividend payments. Since smaller businesses typically have less access to financial markets than larger, mature firms, this explains why the authors identify a particularly robust response to bonus depreciation for small and medium-sized firms.

The research sample mainly draws from the corporate sector. However, a substantial portion of investment that is eligible for bonus depreciation is undertaken by sole proprietorships and partnerships. The authors conservatively estimate the non-corporate sector’s response to accelerated depreciation using an extrapolation technique. In other words, the aggregate estimates provided in this paper represent a lower bound approximation, and the true investment response to bonus depreciation may be even larger. Overall, this paper provides compelling support for using bonus expensing to boost investment and economic growth.