Small and cash-poor companies respond more to tax breaks for new equipment

Dec 27, 2016

Economists have long made the case that cutting taxes can lead to economic growth, as companies use the money saved to invest in plants and equipment. A study that focuses on one area of US tax policy—bonus depreciation—provides more evidence of this, and suggests that smaller companies and companies in need of immediate liquidity are particularly receptive to the tax break.

Chicago Booth’s Eric Zwick and economist James Mahon studied bonus depreciation, the additional amount of depreciation that businesses can deduct from federal taxes after purchasing a piece of equipment. Under normal, straight-line depreciation, companies deduct an equal amount for every year of the asset’s useful life. But bonus depreciation is a form of accelerated depreciation, which allows businesses to deduct a larger portion of their investment immediately for items—such as vehicles or machinery—that would otherwise depreciate more slowly over time.

In 2001, Congress voted to allow companies to write off 30 percent of the cost of qualified investments right away, with a recovery period of up to 20 years. The bonus increased to 50 percent in 2003 and expired in 2004. Congress reinstated the bonus-depreciation provision at 50 percent four years later under the Economic Stimulus Act of 2008, intended to help spur recovery from the Great Recession.

Using data on more than 120,000 unaudited corporate tax returns, the researchers investigated how companies responded to the bonus-depreciation deduction, and they find that the policy response—the amount of investment purchases a business makes—was higher for small and medium-sized companies than for large ones. “Small firms respond 95 percent more than big firms,” they write. Small businesses tend to have low levels of cash, so they got an immediate benefit when the deduction provided a bump to cash flow—and they responded to the promise of immediate benefits, not to the idea of future ones.

As the policy change freed up cash, companies used it to expand productive capacity. Policy responses were higher for companies that made more of their investments in long-lived product categories, such as solar turbines, which can last for decades, as opposed to assets with shorter lives, such as light vehicles or office equipment.

“The results imply that stimulus policies that target investment directly and yield immediate payoffs are most likely to influence investment activity,” the researchers write.