Obama's business tax cuts

With the economy stalled and his party’s November electoral chances sagging, President Obama is rolling out a new plan to boost growth—a mix of infrastructure spending and business tax cuts. The tax changes make some sense on their own merits, although I’m not sure how much they’d do to jumpstart an economy that can’t seem to get untracked.

The White House has leaked two major proposals that it will formally announce later this week: Through 2011, it would allow all businesses to write-off the full cost of capital equipment in the year they buy it, and it would permanently extend the research and experimentation tax credit.

Immediate tax write-offs for business investment—called expensing in tax jargon—has some real benefits. The current system, where firms gradually deduct the cost of new equipment over time, is complicated and often unfair. Some gear qualifies for very generous tax treatment while other investments get the short end of the stick.

But true reform requires another step: Eliminating the deduction businesses get for borrowing to buy this equipment. Combined, taking these two steps would be big steps twoard a business consumption tax. But permitting firms to both deduct interest costs and expense equipment would create troubling opportunities for tax shelters.

Moreover, it is not clear whether a temporary shift to expensing will do much to boost today's weak economy. After bottoming out at the beginning of 2009, orders for U.S. made durable goods had been rising smartly until they lost steam again over the last couple of months. Will temporary expensing get capital spending back on track? Perhaps, but keep in mind that today’s economic malaise is caused largely by a lack of consumer demand. And if a company sees no pickup in orders for widgets, it isn’t likely to go out and buy a new widget stamper—even with a new tax break. On the other hand, firms that are running at full capacity will happily take advantage of the new expensing rule, though it isn’t clear why they need government help.

A word about the life expectancy of this proposal. Don’t count on expensing to go away in 15 months, as Obama proposed. Once companies make this tax accounting change, they won’t willingly go back. Just look at what’s happened to the allegedly temporary expensing rules for small business.

The story of the research credit is a bit different. This subsidy has been on the books for decades, but as only a temporary measure. This is a good thing for those lobbyists who are paid big money to advocate for extending it, and for politicians who find the debate a steady source of campaign contributions.

But it is stupid tax policy. R&D benefits the overall economy, and if policymakers believe the tax credit encourages research, they should make it permanent so companies can develop long-term research budgets. If, on the other hand, the credit is little more than a windfall to those firms that would be doing research anyway, Congress should just kill it. My own sense is that the temporary credit has been less useful than many inside the Beltway believe. Perhaps Congress could improve the credit by making it permanent.

Keep in mind that while Obama’s initiatives seem expansive, their real budget cost is relatively low. Because companies would have deducted this newly-expensed investment over time anyway, they will effectively pay back any short-term tax savings and Treasury will eventually recover most of its revenue loss. The White House claims business would get an immediate tax cut of $200 billion but figures the 10-year cost of this 15-month proposal would be only about $30 billion.

Similarly, while permanently extending the R&D credit will seem expensive under budget rules, its real cost will be relatively small. After all, there isn’t much difference between extending a tax subsidy one year at a time forever or putting it in the law once and for all.

But let’s face it, while the economics is interesting, this proposal is all about politics. And it will be fun to see how business executives respond to the implicit tradeoff Obama is offering: We’ll cut some taxes for your companies, raise others, and make you give up the low personal tax rates you’ve enjoyed for the past decade. Stay tuned.

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