Wall Street Journal Downplays Beneficial Effects of Bonus Depreciation

An article in today’s Wall Street Journal presents conflicting evidence on the benefits of bonus depreciation, a provision in the tax extenders package currently being debated in Congress. Bonus depreciation allows companies to immediately write-off (expense) 50 percent of the cost of equipment and software. Normally, companies are required to depreciate these costs, which means waiting years or decades to take the deductions without any adjustment for inflation or the time value of money.

In the article, bonus depreciation is described as a “zero-interest loan from the government”, but our view is that normal depreciation is a zero-interest loan from businesses to government. Whose money is it in the first place?

We see permanent bonus depreciation as a big step towards full expensing of capital costs, which greatly increases incentives to invest. I am quoted in the article saying as much, but none of the evidence I mentioned made the cut.

Instead, the article focuses on the experiences of two companies, AT&T and Verizon, whose CEOs give conflicting reports on how bonus depreciation factors into investment plans. First, two is not a huge sample of companies, considering that bonus depreciation is used by millions of companies, big and small. Second, the CEOs are talking about bonus depreciation as it has been implemented, i.e. on a temporary basis and often retroactively (as is being considered now). The greatest positive incentive would come from permanent bonus depreciation. The CEO of AT&T seems to acknowledge that.

However, even though bonus depreciation has been temporary and sometimes retroactive, a recent study indicates that it has had a huge positive effect on investment, particularly for small and medium-size firms. The reason is that these companies are liquidity constrained, i.e. they are less able to borrow from the bank and raise money through issuing bonds or stock, so they do most of their investment out of retained earnings. Bonus depreciation, whether temporary or retroactive, boosts retained earnings.

The authors of the study are Eric Zwick of the University of Chicago and James Mahon of Harvard. They sampled 120,000 firms, more than any previous study on the matter, and they found that “bonus depreciation raised investment 17.3 percent on average between 2001 and 2004 and 29.5 percent between 2008 and 2010.” The authors conclude: “The empirical results imply that policies which target investment directly and yield immediate payoffs are most likely to influence investment activity.”

The benefits of bonus depreciation appear to be two-fold. First, it increases incentives to invest going forward, by reducing the cost of capital. Second, it increases retained earnings for those companies that invest in equipment and software, thus leading to more investment. The second effect may be the larger under the current economic conditions of low inflation yet high lending standards. It indicates that bonus depreciation should be passed on a permanent basis, but, barring this, it should at least be passed on a temporary basis.

The study does not fully investigate the effects of retroactively passing bonus depreciation, as is being discussed now in Congress. However, it would certainly boost retained earnings for those companies that invested in equipment and software this year, providing the cash to invest next year. As well, to some degree it creates the expectation that such a policy will continue, essentially making bonus depreciation quasi-permanent in the minds of many business planners.

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