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Friday, January 28, 2011

Using Business Tax Cuts to Stimulate the Economy

Jane G. Gravelle
Senior Specialist in Economic Policy

Business tax cuts were part of the economic stimulus, included in the American Recovery and Reinvestment Act of 2009 (P.L. 111-5), provisions that were subsequently extended (in P.L. 111- 240 and P.L. 111-315) and expanded in P.L. 111-315. The major provision adopted was bonus depreciation; the recently expanded and extended bonus depreciation expires at the end of 2011. Extension of loss carrybacks was considered but ultimately limited to small businesses.

Bonus depreciations provisions were enacted in 2002, as increased interest in providing business tax cuts to stimulate the economy followed the terrorist attacks of 2001, which heightened concerns about an economic slowdown. Among the tax proposals discussed at that time were a corporate rate cut and an investment subsidy. A March 2002 tax cut contained temporary partial expensing (bonus depreciation) for equipment. Interest in this issue continued, including proposals by President Bush for reductions in taxes on corporations through temporary dividend relief, which were enacted in May 2003. The temporary bonus depreciation expired at the end of 2004. Dividend relief was extended through 2010 in legislation passed in 2006. Temporary bonus depreciation was also part of a recent fiscal stimulus package adopted in 2008 (P.L. 110-185) and 2009 (P.L. 111-5) and have subsequently been extended and expanded.

Some economists doubt the efficacy of fiscal policy in general even when a stimulus is needed, especially in an open economy and given the difficulties of achieving proper timing. Also, deficit financing of a tax cut has potential negative long run effects because it crowds out investment; a stimulus designed to increase investment spending (rather than consumption spending) would, if successful, reduce that negative effect. Investment subsidies had largely been abandoned as counter-cyclical devices over the last two decades, in part because of lack of evidence from statistical studies relating investment spending to the cost of capital. Some recent empirical evidence has found some larger effects, at least with some studies, although not enough to suggest that all of the tax cut is spent (especially with corporate rate reductions). Moreover, the average behavioral response identified in these studies may be larger than responses during a downturn when many firms have excess capacities, and planning lags may make investment responses poorly timed. Recent studies of the 2002 temporary investment stimulus tended to find it a relatively ineffective stimulus measure.

An investment subsidy has more “bang-for-the-buck” than a corporate rate cut (or dividend relief), since the latter benefits existing as well as new capital. A corporate rate cut is estimated to produce as little as two-thirds of the investment induced by an investment credit with an equivalent revenue loss. The historically most common investment subsidy is the investment credit, although the same effect could be achieved with accelerated depreciation or partial expensing. A temporary investment credit should be more effective than a permanent one, and a temporary investment credit could also be made incremental. (It is not possible to structure a permanent incremental credit.) One disadvantage of a permanent investment credit is that it distorts the allocation of investment and can easily produce negative tax rates. A 10% investment credit would produce negative tax rates in excess of 100% for short-lived assets. Arguments were made for a corporate tax rate cut because of estimated large effects on the stock market. These calculations are overstated because they do not account for the adjustment process and of interest rate increases. Given the uncertainty about the size of stock market effects or their beneficial effect on the economy, there is a case for not considering stock market effects an important factor in choosing an investment subsidy. This report will be updated to reflect major legislative developments.

Date of Report: January 11, 2011
Number of Pages: 17
Order Number: RL31134
Price: $29.95

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