Do Temporary Tax Cuts Work?

May 12, 2006

With the U.S. economy stumbling along in March 2002, Congress passed a tax bill aimed at stimulating business investment. A key provision allowed companies to expense 30 percent of the cost of new capital investments in the first year—something economists call “accelerated depreciation.”

In most cases, accelerated depreciation gives a tax cut to companies. By letting companies write-off more of things like vehicles and equipment now rather than later, it reduces a company’s taxable income. That lowers their tax bills and makes capital investments a better deal, encouraging them to invest.

However, there was a catch: the 2002 provision was temporary, expiring just two years later at the end of 2004.

In general, these temporary tax cuts are less powerful than permanent cuts. Why? Because it’s costly—both in time and money—for companies to re-juggle their assets in order to position themselves to benefit from tax changes. Temporary bills often don’t last long enough to have much impact.

Unfortunately, according to a new paper from the Federal Reserve Board it appears the temporary 2002 tax provisions suffered from this flaw. The authors find little evidence that the temporary cuts boosted business investment—providing yet another argument for long-term corporate tax reform, rather than short-term Keynesian tax incentives designed to juice up the U.S economy:

Our empirical examination of the details of expenditure patterns before, during, and after partial expensing… suggests only a very limited impact of partial expensing on investment spending, if any. In addition, other evidence, including examination of a sample of corporate tax returns and of survey data, provides only limited support for the effectiveness of partial expensing.

Read the full paper here (PDF).

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