Obama’s Investment Equivalent of “Cash for Clunkers”

The Obama administration seems poised to do to business investment what the ill-conceived federal policies aimed at helping the auto and housing markets did – incentivize short-term activity at the expense of future sales while failing to improve conditions for the long-term.

Undeterred by the boom and bust experiences of the “cash for clunkers” program and the first-time homebuyers tax credit, President Obama will reportedly announce on Wednesday a new tax plan aimed at jump-starting business investment by allowing firms to immediately expense new capital purchases made in 2011 rather than depreciate them over many years as they must do now under current tax rules.

While economists generally prefer expensing over depreciation, the problem with the Obama plan is its short-term and temporary nature. To whatever extent the Obama plan encourages firms to buy new equipment or invest in new factories it will be simply be bringing those investments to the present from the future. At the end of the day, the economy may be no better off overall.

An analysis by University of Michigan economists of the 2002 “bonus depreciation” legislation – which allowed firms to immediately deduct a large fraction of their investment – found that it may have had little overall impact on increasing economic output (0.1 percent to 0.2 percent) or employment (100,000 to 200,000 jobs), but it did alter the composition of investment made during the period. The authors found that the policy shifted investment away from disallowed investments such as structures, to allowed investments such as equipment.[1] It is likely the Obama plan will have a similar effect.

Other economists have pointed out that investment incentives are pointless if firms have little free cash to invest during a recession or if firms are in a net operating loss position and cannot use the tax benefit. Such was the case in 2002 and 2003 with the bonus depreciation program and such is likely to be a problem today.

Obama should be praised for recommending making the Research and Experimentation tax credit permanent. Congress’ on again, off again efforts to extend the credit has likely reduced its effectiveness in promoting R&D spending.

However, none of Obama’s proposals fix what ails the nation’s business climate and lagging global competitiveness – the fact that the U.S. corporate tax rate is so far out of step with the rest of the world. Economists at the OECD have determined that the corporate income tax is the most harmful tax for long-term economic growth. Thus, a permanent cut in the corporate rate would be far more effective in promoting long-term economic growth than any of Obama’s proposals.

[1] Christopher House and Matthew D. Shapiro, “Temporary Investment Tax Incentives: Theory with Evidence from Bonus Depreciation,” National Bureau of Economic Research Working Paper 12514, September 2006. http://www.nber.org/papers/w12514.