Obama Discovers Incentives

Earlier this week President Obama proposed tax cuts for business, including 100% expensing through 2011. In other words, firms that purchase new machines and other capital goods would be able to write them off immediately, instead of over many years.

Such a move offers a sound departure from the Keynesian thrust of the administration's earlier initiatives. Mr. Obama and his team now appear to accept that growth-oriented tax cuts provide a more reliable stimulus than government spending. The investment incentive the administration proposes is meaningful--though not without some potential pitfalls--and it offers a road map for future policy change to emphasize economic growth.

A well-developed body of research by economists confirms what businessmen will tell you if you ask: When the cost of capital is low, firms are much more likely to expand their capital stock. And full expensing can reduce the cost of capital significantly. Future deductions are not as valuable as current deductions because of the time value of money, and because these deductions are not indexed for inflation. Expensing gives firms the entire deduction up front.

Expensing--or its close cousin, the investment tax credit--has been regularly used by presidents of both parties. John F. Kennedy was the first to enact an investment tax credit, in 1962, and more recently George W. Bush made partial expensing the centerpiece of his own stimulus plan in 2002. They are a potent tool for increasing investment at a low cost to taxpayers.

Because the benefit of expensing depends on the time value of money and interest rates are currently quite low, one might think that expensing would have a small effect now. Nevertheless, all but the most prominent firms have to pay interest rates that are much higher than Treasury rates today when they borrow. Similarly, firms that raise funds in equity markets also must pay dearly.

Expensing can have especially big stimulative effects when temporary. A typical machine purchased in 2011, for example, would generate deductions that are about 5% more valuable (in terms of present value) than those for a machine purchased in 2012. That's because of the time value of money--investors can make full use of the money saved earlier.

While that difference is not enormous, it can have a tremendous impact as firms time their expenditures to reduce their taxes. All else equal, a temporary investment incentive is like a "sale" on the cost of investment for a period, pulling investment forward from the future.

Drawing on our own work that maps changes in tax policy to changes in capital spending, we estimate that the president's plan could easily lead to a five-to-10 percentage point increase in capital spending next year. This would be mostly a result of changed investment timing in response to the temporary nature of the expensing.

This gain is not a free lunch. Expensing will induce a hangover in 2012 because a portion of the higher investment spending in 2011 will be borrowed from that year. The policy might also cause firms to postpone capital spending in the future if they believe economic weakness will induce government officials to offer up another round of expensing. More importantly, the administration's desire to allow sharply increased tax rates on dividends and capital gains beginning Jan. 1, 2011 would blunt the effect of any investment incentive.

We hope the administration's policy pivot reflects a genuine realization that its previous approach to stimulus was misguided. If so, then this measure could be viewed as a first step down the road of meaningful and fundamental tax reform. Most tax reform proposals have permanent expensing as a centerpiece. They also have low or zero tax rates on capital income.

Mr. Obama could assuage fears that his move is more about politics than economics by committing publicly to pursue a tax reform next year that is guided by the same insights that motivated the expensing proposal. If he does that--and does not allow other tax rates on saving and investment to increase--then his latest policy suggestion should receive broad bipartisan consideration.

Kevin A. Hassett is a senior fellow and the director of economic policy studies at AEI. R. Glenn Hubbard is a visiting scholar at AEI.

Photo Credit: White House Photo/Pete Souza

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