The Heritage Foundation

WebMemo #412 on Taxes

February 3, 2004

February 3, 2004 | WebMemo on Taxes

Tax Cuts Boost Business Investment

In the second quarter of 2003, President Bush signed into law the Jobs and Growth Tax Relief Reconciliation Act of 2003, which dramatically reduced taxes on capital investment for businesses. The result has been a boom in business investment that has contributed substantially to strong GDP growth in recent quarters. Congress should make these pro-growth provisions-and especially the provision for "bonus" depreciation, which expires at the end of 2004-permanent to ensure continued prosperity.

 

Slumping Business Investment

According to the Bureau of Economic Analysis, growth in business investment fell sharply in the summer of 2000, dropping from an annualized growth rate of 14.8 percent in the second quarter of 2000 to 2.2 percent in the third quarter. Business investment dropped still further in the fourth quarter of that year and then went negative, and investment declined for the next nine quarters. This weak business investment was a dead weight on the U.S. economy and contributed to anemic growth and unemployment.[1]

 

As business investment continued to shrink during 2001-02, economic forecasting models predicted a weaker and delayed recovery. From 2002 to 2003, Global Insight cut its predicted business investment growth rate for the last three quarters of 2003 in half.[2] In May 2003, GI predicted a growth rate of only 3.8 percent.

 

The Impact of the Tax Cut

During the spring of 2003, businesses saw a tax cut package moving through Congress that would reduce the cost of new equipment and capital improvements. The President took the bold step of proposing to eliminate the taxation of dividends and to expand some previously enacted small-business provisions. Most of the President's pro-growth provisions became law in the Jobs and Growth Tax Relief Reconciliation Act of 2003. While the tax on dividends was not eliminated, it was greatly reduced, as was the tax on capital gains.

 

Advocates of this tax policy argued at the time that passing the President's bill would significantly boost business investment and raise the economy's overall growth rate. Indeed, supporters of reductions in the tax rate on dividend income believed that the resulting boost to equity prices would be enough on its own to substantially increase business activity.

 

Did the Act produce these investment results? The answer appears to be yes.

 

Non-residential fixed investment responded strongly to the reductions in taxation. Business investment increased by 7 percent in the second quarter of 2003 and 12.8 percent and 6.9 percent, respectively, in the third and fourth quarters. This reversed the trend of the earlier three quarters when investment declined by 1.1 percent, 0.1 percent, and 0.6 percent, respectively.[3]

 

Business investment now contributes to GDP growth instead of reducing GDP. The upturn in investment contributed to the 8.2 percent GDP growth in the third quarter of 2003. Since the tax cut, business investment has added more to GDP growth than it had at any time since the spring of 2000. Stronger business investment will lead to increased job opportunities for American workers as the demand for labor rises.

 

Making the Tax Cuts Permanent

To ensure continued growth, Congress should make the provisions that reduce the tax burden on business investment permanent. Permanent tax cuts allow companies to prepare and execute better expansion plans without worrying about deadlines and rate changes. Temporary tax measures, however, because of the uncertainty of expiring provisions, provide less economic growth than permanent tax changes provide.

 

Some of the Act's provisions are set to expire at the end of 2004, and others over the next ten years. Many companies cannot take advantage of the expanded expensing provisions because of timing issues. Even worse, according to a Goldman Sachs survey of corporate chief information officers, more than a third did not even know about the "bonus" depreciation, and most CIOs would not be able take advantage of the provision before it expires at the end of 2004.[4]

 

If these provisions do expire, the cost of capital will rise and the business investment growth rate will slow. Congress should make them permanent; if it fails to do so, it risks a slowdown in investment that will reduce economic growth and threaten recovery in the job market.



[1]See Bureau of Economic Analysis, "Gross Domestic Product: Fourth Quarter 2003 (Advance)," BEA 04-04.

[2]Global Insight made these forecasts in their monthly U.S. Economic Outlook series based on their U.S. macroeconomic model.

[3]All percent changes are annualized rates of change. For the data underlying these rates of change, see BEA, "Gross Domestic Product: Fourth Quarter 2003 (Advance)."

[4]Mark Veverka, "Techdom's Heroes: Small and Medium-Sized Firms," Barron's, January 26, 2004, p. T2.

About the Author

Rea S. Hederman, Jr. Director, Center for Data Analysis and Lazof Family Fellow
Center for Data Analysis

Related Issues: Taxes