Small businesses are still having a hard time borrowing to invest in new plant and equipment, despite very low interest rates. So how do we go about letting them do more investment and thus put more people to work?
Well, the government could give them a loan to do it, but that would be a big step in the direction of more government involvement in the private sector. It already does some of it through SBA (Small Business Administration) guarantees on loans. But I’m not sure we want to have a whole bunch of government loan officers going over business plans.
President Obama has proposed something that pretty much works out to the same thing as the government making loans to businesses to finance spending on plant and equipment. It wants to allow companies to immediately be able to write off as an expense investments in plant and equipment.
How is This Like a Loan?
Well as it stands now, businesses have to amortize the cost of these investments over the useful life of the equipment. Thus if you invest $1,000,000 in a spiffy new machine to make widgets that has a useful life of 10 years, you can deduct $100,000 this year from your taxes, and $100,000 in each of the remaining 9 years. Under the new Obama proposal, the entire $1,000,000 would be deductible in the first year.
If the company has a marginal tax rate of 35%, the tax savings from the $1,000,000 million investment would be $35,000 in each of the ten years. Under the new plan, businesses would get the whole $350,000 up front. The government is out $315,000 in tax revenues in the first year, but will be getting $35,000 more in each of the following years, since the widget machine is already written off for tax purposes, and thus is no longer deductable.
From the business point of view, they are getting the cash tax savings up front, but will have more taxable income in the future. Not only is it a loan, but it is a loan at 0% interest.
This is not a permanent change in the tax code, and will only last for purchases that are made before the end of 2011. That should have the effect of pulling forward some demand that might have been naturally there for 2012 and beyond. That is OK, since with overall aggregate demand very low now, and hence lots of slack resources, we need the demand more now than we will in say 2013 or 2014 when presumably the economy will be stronger than it is today.
To the extent though that the business was constrained in buying the widget machine because they could not get financing for it, this could help. Presumably they would still have to borrow from the bank (or the widget machine maker’s captive finance arm) but since they would be able to show a much bigger tax savings, the loan could be repaid quicker.
There is also a subsidy involved, which is the difference between the rate the company would have had to pay to borrow the $1,000,000 and the effective zero percent loan that the government is giving them through the tax code. With T-note yields at historic lows, the cost to the government of providing this “loan” is quite low.
More Equipment When We Have Overcapacity?
A bigger question in some senses is do we want more investment in plant and equipment (actually, this is almost all for equipment, not plant) at a time when many businesses are already plagued with overcapacity? The answer is probably yes.
Investment is an important part of overall demand in the economy, and new equipment cannot only raise capacity, but it can also bring down costs. Perhaps the machine is replacing an older machine and the new model is much more energy efficient, for example.
Business investment in equipment is a fairly volatile part of the overall economy, one that rises faster then the overall economy is in good times, but which falls apart in bad times.
The result is that it can fluctuate as a share of GDP, as shown in the graph below. Between the fourth quarter of 2007 and the second quarter of 2009, overall US real GDP (chained 2005 dollars) fell by $553.3 billion. Investment in equipment and software is a direct component of GDP, and it fell by $221.9 billion over the same time frame.
In other words, 40% of the reduction in overall demand during the Great Recession came from reduced spending by business on equipment and software. In the process, it fell from being 8.42% of GDP to just 7.05% of GDP. We have since seen a nice recovery in equipment spending, and it has helped to power the recovery so far. It has done its part, but other sectors of the economy have not cooperated and hence the recovery has been on the anemic side.
From the second quarter of 2009 to the second quarter of 2010, real GDP has increased by $381.5 billion, and $142.5 billion of that increase has come from more business spending on equipment, or 37.4% of the total recovery can be traced to this sector, which is now back up to 7.93% of the total economy.
Spurring Demand for Investment Spending
This is a relatively low-cost way (the cost to the government is the net present value of not getting the tax revenues this year and instead getting them in future years) of helping to spur current demand for investment spending. While for firms that can access the capital markets at low rates today, that is not that big of an incentive. For smaller firms where financing is hard to get, and especially hard to get at low interest rates, it could be a significant subsidy.
On the down side, much of the equipment spending may go to productivity enhancing equipment. That is good for GDP growth, but does not do much to increase employment.
While this might not be a silver bullet to solve the deep and serious economic problems faced by the economy, it is at least a tile in the mosaic.
Another way of looking at it is that current year expensing is the ultimate in accelerated depreciation. It also has the added benefit of requiring less record keeping than other forms of accelerated depreciation does. For big businesses that is not much of an issue, but for small businesses it can be significant. It is also a very business friendly proposal, and thus it is hard to make it fit with the “Obama hates business” meme that one gets from the Wall Street Journal editorial pages.
Dirk van Dijk, CFA is the Chief Equity Strategist for Zacks.com. With more than 25 years investment experience he has become a popular commentator appearing in the Wall Street Journal and on CNBC. Dirk is also the Editor in charge of the market beating Zacks Strategic Investor service.
