Tax Reform: Possible Consequences of Trading Accelerated Depreciation for Corporate Income Tax Rate Reduction

Executive Summary

Determinates of U.S. Investment: Over the past three decades economics and finance experts have examined the question of whether financial variables such as cash flow and cash stocks  have  a significant effect on investment. Numerous economic analyses and surveys have concluded that financial factors are important in determining investment levels. For example, a 1998 empirical analysis by Professors Gilchrist and Himmelberg concludes that for the average firm in their sample, cash flow and cash stocks raise the overall response of investment to an expansionary shock by 25% relative to a baseline case where financial frictions (capital market imperfections) are zero.

Accelerated Depreciation, the Cost of Capital, U.S. Investment and Jobs: If accelerated depreciation for equipment is repealed and replaced with economic depreciation which is generally longer than the current Modified Accelerated Cost Recovery System (MACRS), the cost of capital for new equipment will rise and investment is likely be as much as $191 billion lower in 2015 compared  to the baseline.  Each  $1 billion decline in investment is associated with a loss of 23,300 jobs.

Bonus Depreciation and U.S. Investment: Since the 4th quarter of 2007, which marks the beginning of the recession, through the 4th quarter of 2011, U.S. equipment investment has increased by 3.4%. Given the weakness of consumer demand during this period (real personal consumption expenditures increased only 1.8% during the past 4 years) it seems likely that accelerated and bonus deprecation have played a major role in sustaining investment in equipment.

Conclusions: As policymakers contemplate fundamental tax reform they need to weigh carefully the possible consequences of eliminating accelerated depreciation in return for a lower corporate income tax. It may be well to consider “paying for” corporate income tax rate reductions with cuts to entitlements for upper income individuals rather than eliminating proven investment provisions such as accelerated depreciation. Another option would be to move toward a consumed income tax where all investment is expensed.

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