Expiring Tax Break to Spur Seesaw Spending

Don't despair over a likely slow first quarter next year. Company purchases will rebound in the spring.

By Jerome Idaszak, Associate Editor, The Kiplinger Letter

December 10, 2004

Growth in business spending on equipment will post a sharp but temporary slowdown in the first quarter of next year after an enhanced depreciation tax break expires at the end of 2004. The investment pause, combined with slack consumer spending after the holidays, means that gross domestic product (GDP) growth is going to dip to around 2.5% on an annualized basis in the first quarter, from around 4% in the current quarter. But spending and GDP growth will pick up again in the spring.

The tax break that expires Dec. 31 allows bonus depreciation up to 50% of the value of new equipment purchased in a given year. That comes on top of regular depreciation, which together would enable a company to write off around 60% of the cost in the year of purchase. When the old depreciation rules return next year, businesses will be able to write off only around 20% of the purchase value right off the bat.

To take full advantage of the tax break, many companies are buying items in the current half that they otherwise might have bought in early 2005. The bulk of these purchases involves items that don't require long lead times or heavy customization, such as vehicles, computers, software and off-the-shelf industrial equipment. The latter could include lighting, sensors, conveyor belts or warehouse scaffolding.

These advanced purchases contributed to growth in spending on equipment and software of about 17% in the third quarter and 12% in the fourth. That pace will slow to roughly 5% in the first quarter. That slow start will limit overall business spending, which also includes outlays on structures, to about 6% or 7% in 2005 compared with 10% this year. Growth in spending on structures—buildings, warehouses, factories, etc.—is likely to hold steady at about 2%.

At the macroeconomic level, the tax break also has provided an indirect boost to spending by raising after-tax corporate profits. Even if a company didn't choose to frontload equipment purchases this year, it still benefited from the fact that the equipment write-off leaves it and its customers with more cash at the bottom line.

Kendig Kneen, president of Al-Jon Inc., a recycling equipment maker in Ottumwa, Iowa, explains: "Because we operate in a global economy, we have to leap at every chance we get for our companies to be successful. Does a tax break mean that I will hire more people or buy more equipment? No. Does it mean I will get more orders and have higher profit margins? Yes."

Congress originally approved bonus depreciation in 2001 that allowed big and small firms to take an immediate 30% write-off, and that was expanded to 50% during 2003. There's no way to precisely measure how much additional spending the tax break has spawned, but Mark Zandi, chief economist with Economy.com, estimates that it accounted for 25% of the rise in business spending on equipment and software in the past three years.

Business investment refers to an asset that lasts one year or longer. About 75% is spent on equipment, with 25% spent on structures. In equipment, half is spent on computers and software, and the other half is about evenly split on industrial machinery, transportation equipment and "other," which includes a wide variety of goods such as furniture, construction machinery and oil field equipment. Total business investment in 2003 was $1 trillion, or 9% of GDP.