1.
Depreciation
Rules
and
Investment
Swings
Thomas
F.
Landstreet,
Robert
P.
Murphy,
and
Jarrett
Wadler
Executive
Summary
Many
analysts
have
been
surprised
by
the
strength
of
certain
economic
indicators,
particularly
investment
spending,
in
recent
months,
leading
them
to
become
more
optimistic
about
future
economic
growth.
We
argue
that
much
of
the
apparent
strength
is
an
illusion,
an
artifact
of
the
“pull-­‐forward”
effect
on
investment
spending
due
to
favorable
depreciation
rules
(“bonus
depreciation”
and
Section
179)
that
are
currently
set
to
expire
at
the
end
of
2011.
We
expect
continued
strength
in
the
4th
quarter
of
2011,
with
a
sharp
reversal
in
early
2012.
Introduction
In
October
2011,
several
economic
reports
were
stronger
than
many
analysts
had
anticipated.
Indeed
such
notable
figures
as
George
Soros
and
Nouriel
Roubini
had
only
recently
declared
that
the
U.S.
was
already
in
a
double-­‐dip
recession.1
The
preliminary
3rd
quarter
GDP
reports
showed
particular
strength
in
annualized
growth
rates
of
nonresidential
fixed
business
investment
(at
16.3
percent)
and
equipment
&
software
(17.4
percent),
their
highest
values
since
early
2010.
These
apparent
glimmers
of
hope
have
caused
many
to
become
more
optimistic
about
the
future
prospects
for
the
U.S.
economy.
Atlanta
Fed
President
Dennis
Lockhart
perfectly
summed
up
this
attitude
in
a
speech
given
on
October
18:

2. 2
As
I
see
it,
recent
data
and
anecdotal
reports
are
signaling
a
gradually
improving
economy,
and
I
think
this
point
needs
to
be
recognized.
In
support
of
this
view,
I'll
paint
a
picture
from
our
working
with
the
data.
We
at
the
Atlanta
Fed
regularly
monitor
the
data
series
that
directly
enter
into
the
GDP
calculation,
along
with
important
other
series,
including
employment.
We
compare
these
data
elements
to
Bloomberg's
published
consensus
expectations
for
each.
In
the
months
leading
up
to
July,
the
downside
surprises
in
the
data
dominated.
In
August
and
September,
upside
and
downside
surprises
were
roughly
equal.
But
in
October,
the
surprises
have
generally
been
to
the
upside.
Importantly,
these
surprises
to
the
upside
exceeded
expectations
by
a
significant
measure.
I've
concluded
an
unqualified
narrative
of
a
downward
trend
is
unjustified.
[Bold
added.]2
Lockhart’s
viewpoint
is
understandable,
but
it
is
wrong.
Generous
tax
incentives
governing
depreciation
schedules
are
currently
set
to
begin
phasing
out
at
the
end
of
2011,
meaning
that
businesses
have
an
incentive
to
pull
forward
their
purchases
into
the
current
calendar
year.
This
has
given,
and
will
continue
to
give,
a
false
appearance
of
strength
in
the
conventional
economic
indicators,
particularly
measures
of
business
investment.
However,
we
expect
a
dramatic
reversal
in
the
first
quarter
of
2012,
because
normal
periodic
replacement
of
worn
out
equipment
(which
otherwise
would
have
occurred
in
these
months)
will
have
already
been
pulled
forward
into
2011,
to
take
advantage
of
the
beneficial
depreciation
rules.
Just
as
Lockhart
and
many
other
analysts
were
pleasantly
surprised
by
the
apparent
health
of
the
economy
in
the
second
half
of
2011,
we
expect
them
to
be
unpleasantly
surprised
by
its
sudden
weakness
in
the
beginning
of
2012.
Investors
must
be
aware
of
the
scheduled
changes
in
the
tax
code’s
depreciation
rules.
Even
if
Congress
ultimately
extends
the
generous
depreciation
rules
(which
we
summarize
in
the
next
section),
a
slowdown
in
early
2012
is
likely
already
“baked
into
the
cake”
because
of
the
nature
of
the
purchases
qualifying
for
the
depreciation
treatment.
For
example,
if
a
shipping
company
had
been
planning
on
replacing
its
older
vehicles,
at
this
late
date
(November)
it
will
likely
already
have

3. 3
placed
its
orders,
in
order
to
have
the
new
equipment
“placed
in
service”
(to
qualify
for
the
tax
writeoff)
before
the
deadline.
The
investment
implications
of
the
soon-­‐to-­‐change
depreciation
rules
are
serious.
Academic
research
suggests
that
a
previous
episode
(in
the
early
2000s)
with
temporary
bonus
depreciation
fueled
a
surge
in
economic
growth
and
investment
spending,
and
there
are
reasons
to
believe
that
the
effect
will
be
relatively
stronger
this
time
around.
Some
of
the
obvious
sectors
that
are
likely
to
be
experiencing
temporarily
high
sales—with
a
coming
reversal
in
early
2012—are
computer
hardware
and
software,
telecom
equipment,
healthcare,
vehicles
(particularly
agricultural),
and
other
heavy
equipment.
Stimulating
Investment
(Temporarily):
Bonus
Depreciation
and
“Small
Business”
Depreciation
Although
more
people
are
beginning
to
discuss
the
bonus
depreciation
rule
and
its
phasing
out
beginning
in
2012,
there
are
actually
two
special
depreciation
schedules
currently
available
for
business
investment.
In
addition
to
the
bonus
depreciation
rules
(handled
in
Section
168(k)
of
the
IRS
code),
there
is
what
is
sometimes
referred
to
as
a
small
business
deduction,
handled
in
Section
179
of
the
tax
code.
Within
limits,
businesses
can
immediately
deduct
the
full
expense
of
qualifying
investments
under
Section
179
of
the
IRS
code.
By
reducing
its
taxable
income,
this
option
of
immediate
expensing
obviously
reduces
the
business’
tax
liability
for
the
year.
However,
there
is
a
cap
on
the
maximum
deduction
that
can
be
taken,
and
additionally
there
is
an
upper
limit
of
expenses
beyond
which
the
Section
179
deduction
is
phased
out,
dollar
for
dollar.
(The
deduction
can
never
become
negative.)
Because
of
this
structure,
the
Section
179
deduction
used
to
be
considered
one
available
strictly
for
small
or
mid-­‐sized
businesses,
since
the
two
thresholds
are
typically
chosen
to
be
relevant
only
for
relatively
minor
investment
purchases
in
a
given
year.

4. 4
The
so-­‐called
bonus
depreciation
rules
are
available
under
Section
168(k)
of
the
IRS
code,
and
typically
apply
to
qualified
property
with
no
limits.
Thus
if
a
business
has
made
investments
in
excess
of
the
cap
available
under
Section
179,
it
can
still
fully
deduct
the
proportion
of
expenses
allowed
under
that
year’s
ruling
Section
168
percentage.
Over
the
last
decade,
the
federal
government
has
repeatedly
tinkered
with
the
two
thresholds
of
the
Section
179
rule,
and
with
the
percentage
applicable
under
bonus
depreciation.
The
following
tables
summarize
the
major
changes
in
policy,
with
italics
indicated
the
scheduled
changes
under
current
legislation:
Table
1.
Thresholds
for
“Small
Business
Deduction”
(Section
179)3
Year
Maximum
Deduction
Allowed
Dollar-­‐for-­‐Dollar
Phase
Out
Begins
2002
$24,000
$125,000
2003
$100,000
$400,000
2004
$102,000
$410,000
2005
$105,000
$420,000
2006
$108,000
$430,000
2007
$125,000
$500,000
2008
$250,000
$800,000
2009
$250,000
$800,000
2010
$500,000
$2,000,000
2011
$500,000
$2,000,000
2012
$125,000
+
COLA
$500,000
2013
$25,000
$200,000
Table
2.
Bonus
Depreciation
(Section
168)
Rates4
Period
Percentage
Deductible

5. 5
September
11,
2001
–
May
5,
2003
30%
May
6,
2003
–
December
31,
2004
50%
January
1,
2005
–
December
31,
2007
0%
January
1,
2008
–
September
8,
2010
50%
September
9,
2010
–
December
31,
2011
100%
January
1,
2012
–
December
31,
2012
50%
January
1,
2013
–
0%
As
Tables
1
and
2
make
clear,
the
generous
depreciation
rules
are
set
to
fall
back
by
75%
and
50%
respectively
in
January
2012,
and
will
be
virtually
phased
out
completely
in
2013.
Both
economic
theory
and
historical
evidence
lead
us
to
predict
that
these
policies
will
lead
to
an
artificial
increase
in
business
investments
in
late
2011,
and
an
artificial
slump
in
early
2012.
Why
Depreciation
Rules
Affect
Investment
Timing:
Theory
The
theory
behind
the
stimulative
effect
of
immediate
expensing
is
straightforward:
By
allowing
businesses
to
deduct
more
(or
all)
of
the
cost
of
investments
in
the
first
year,
rather
than
the
more
traditional
approach
of
depreciating
over
a
number
of
years,
the
business
can
reduce
its
taxable
income
upfront.
This
eases
the
cashflow
of
a
strapped
business,
and
(depending
on
the
applicable
discount
rate)
the
time-­‐value
of
money
makes
such
investment
yield
a
higher
(after-­‐tax)
rate
of
return.
Thus
the
special
depreciation
rules
enhance
both
the
liquidity
and
profitability
of
businesses.
A
Treasury
Department
report5
on
100
percent
expensing
gave
the
following
numerical
example
to
illustrate
the
potency
of
the
rule:
Consider
a
business
investing
$1
million
in
new
equipment
that
would
normally
be
depreciated
over
a
7-­‐
year
period.
Under
standard
rules,
the
business
could
only
deduct
$143,000
from
its
taxable
income
in
the
first
year,
when
the
investment
was
actually
made.
At
a
tax
rate
of
35
percent,
that
deduction
would
reduce
the
actual
tax
liability
by
some
$50,000.

6. 6
However,
under
the
current
schedule
allowing
100
percent
expensing,
the
entire
$1
million
expense
could
be
deducted
in
the
current
year’s
taxes,
reducing
tax
liability
by
$350,000.
Not
only
does
this
give
the
business
access
to
$167,000
more
in
cashflow
in
the
current
year,
but
at
a
6
percent
discount
rate,
the
after-­‐tax
cost
of
the
investment
is
$47,000
lower.
Thus
we
would
expect
businesses
to
invest
more
in
qualifying
purchases,
with
the
more
generous
depreciation
rules.
Because
of
the
presumed
stimulus
to
business
investment,
accelerated
depreciation
has
been
a
popular
tool
used
by
the
federal
government
during
various
economic
downturns,
including
the
present
one.
However,
it’s
important
to
note
that
if
these
measures
are
temporary,
then
the
long-­‐term
impact
may
be
muted.
In
particular,
as
the
expiration
deadline
for
a
particular
benefit
approaches,
we
might
see
businesses
simply
pull
forward
their
routine
replacement
of
equipment.
Thus
the
surge
in
investment
during
the
period
of
eligibility
might
be
matched
by
a
collapse
in
investment
after
the
expiration.
Depreciation
Rules
Affect
Investment
Timing:
Historical
Evidence
In
addition
to
the
theoretical
case,
there
is
historical
evidence
that
depreciation
rules
can
affect
investment.
For
example,
in
a
2008
paper
in
the
American
Economic
Review,
Christopher
House
and
Matthew
Shapiro
estimated
that
the
(relatively
weak)
bonus
rules
of
2002
and
2003
increased
GDP
by
$10
to
$20
billion
and
created
100,000
to
200,000
jobs.6
We
can
also
look
at
the
behavior
of
two
components
of
GDP
that
are
particularly
sensitive
to
depreciation
rules—nonresidential
fixed
investment
and
equipment
&
software.
Recall
that
these
two
categories
of
investment
came
in
particularly
strong
in
our
most
recent
GDP
report.
To
get
a
sense
of
what
may
happen
to
these
spending
categories
in
4th
quarter
2011
and
then
in
1st
quarter
2012,
we
can
go
back
to
the
last
time
there
was
a
major
change.
As
Table
2
indicates,
the
bonus
depreciation
rate
dropped
from
50%
in

7. 7
2004
down
to
0%
in
2005.
The
behavior
of
nonresidential
fixed
investment,
as
well
as
equipment
&
software
spending,
around
this
event
matched
up
with
our
theory.
Specifically,
even
though
there
was
strong
growth
in
these
investment
categories
over
the
two-­‐year
period
as
a
whole,
the
timing
of
the
growth
wasn’t
uniform.
Instead,
investment
growth
was
quite
strong
throughout
2004,
but
then
abruptly
slowed
down
in
early
2005.
(See
Table
3.)
We
believe
that
many
businesses
simply
pulled
forward
their
planned
investments
from
early
2005
into
late
2004,
in
order
to
qualify
for
the
expiring
50%
bonus
depreciation.
Table
3.
Annualized
Real
Growth
in
Business
Investment
Components
of
GDP7
Time
Period
Nonresidential
Fixed
Equipment
&
Software
2004-­‐2005
avg.
8.4%
10.2%
3Q
2004
11.4%
13.9%
4Q
2004
9.1%
12.1%
1Q
2005
3.7%
2.4%
2Q
2005
6.0%
8.8%
To
reiterate,
Table
3
indicates
that
the
expiring
50%
bonus
deprecation
rule
at
the
end
of
2004
may
have
significantly
rearranged
the
timing
of
major
investment
purchases.
Over
the
entire
two-­‐year
period,
nonresidential
fixed
investment
grew
an
average
of
8.4%
per
year,
while
equipment
&
software
grew
10.2%
per
year.
However,
this
growth
was
concentrated
in
the
latter
half
of
2004,
and
fell
off
sharply
in
the
first
half
of
2005.
We
expect
to
see
a
similar
pattern—though
even
more
pronounced—with
the
second-­‐half
of
2011
compared
to
the
first
half
of
2012.
Depreciation
Rules
Affect
Investment
Timing:
Anecdotal
Evidence
Besides
the
general
theoretical
and
specific
historical
evidence
presented
above,
we
know
anecdotally
that
many
businesses
right
now
are
rushing
to
get
major
investment
orders
“placed
in
service”
this
calendar
year.
A
Wunderlich
Securities
note
from
August
9
reported
the
following:

8. 8
We
surveyed
50
of
our
accounting
contacts
and
100%
of
them
indicated
that
their
domestic
subsidiaries
are
taking
advantage
of
the
increased
bonus
depreciation
rate
for
2011.
76%
indicated
that
the
benefit
was
expected
to
apply
to
more
than
50%
of
their
current
year
CAPEX
spending.
The
majority
of
participants,
56%,
expected
their
companies
to
move
some
of
their
original
CAPEX
spending
planned
for
2012
into
2011
to
take
advantage
of
the
higher
deduction
rates…
After
the
financial
crisis
ensued
in
the
fall
of
2008,
many
firms
understandably
hunkered
down
and
hoarded
cash
as
best
they
could,
waiting
for
signs
to
see
which
way
the
economy
would
go.
At
this
point,
corporate
profits
are
at
historic
highs
and
firms
are
flush
with
cash.
If
they
have
been
postponing
purchases
to
gain
a
better
read
on
the
economy,
the
expiring
depreciation
incentives
will
be
a
strong
prod
to
make
needed
replacements
in
2011
rather
than
delaying
a
few
more
quarters.
Conclusion
Many
analysts
have
been
surprised
by
the
recent
strength
of
the
economy.
This
is
largely
an
illusion,
an
artifact
of
the
“pull-­‐forward”
effect
on
investment
spending
due
to
favorable
depreciation
rules
that
are
currently
set
to
expire
at
the
end
of
2011.
We
expect
continued
strength
in
the
4th
quarter
of
2011,
with
a
sharp
reversal
in
early
2012.
In
a
forthcoming
paper
we
will
explore
the
specific
sectoral
impacts
of
these
coming
shifts,
but
in
the
meantime
investors
should
prepare
for
“surprising”
early
2012
reversals
in
areas
such
as
computer
hardware
and
software,
telecom
equipment,
healthcare,
vehicles
(particularly
agricultural),
and
other
heavy
equipment.
1
See
Bradford,
Harry,
“George
Soros,
Billionaire
Investor,
Says
U.S.
Already
in
Recession,”
The
Huffintgton
Post,
9/22/11,
available
at:
http://www.huffingtonpost.com/2011/09/22/george-­‐soros-­‐
billionaire-­‐investor-­‐already-­‐recession_n_975864.html,
and
“US
and
UK
already
in
recession,
warns
Nouriel
Roubini,”
The
Telegraph,
9/27/11,
available
at:
http://www.telegraph.co.uk/finance/financialcrisis/8792864/US-­‐and-­‐UK-­‐already-­‐in-­‐recession-­‐
warns-­‐Nouriel-­‐Roubini.html.

9. 9
2
Lockhart,
Dennis,
“Expectations
and
the
Economy,”
Speech
delivered
to
CFA
Society
of
East
Tennessee,
10/18/11,
available
at:
http://www.frbatlanta.org/news/speeches/111018_lockhart.cfm.
3
The
information
in
Table
1
is
available
at
numerous
online
sources,
including:
http://www.taxguru.org/incometax/Rates/Sec179.htm,
http://www.ipc.org/ContentPage.aspx?pageid=Bonus-­‐Depreciation,
http://sharpbz.com/sharpbzblog/tag/section-­‐179/,
and
http://www.section179.org/stimulus_acts.html.
4
The
information
in
Table
2
is
based
on
“Mother
of
All
Stimulus:
100%
Capital
Expenditure
Deductions,”
Highland
Capital,
March
2011,
which
in
turn
derived
most
of
the
timeline
from
“The
Case
for
Temporary
100
Percent
Expensing:
Encouraging
Business
to
Expand
Now
By
Lowering
the
Cost
of
Investment,”
U.S.
Department
of
Treasury,
October
29,
2010.
(The
percentages
and
deadlines
are
also
available
at
numerous
online
tax
sites.)
Note
that
the
percentages
refer
to
the
major
eligibility;
e.g.
specific
sectors
such
as
the
Gulf
region
were
granted
extensions
of
bonus
depreciation
because
of
hurricane
damage.
5
See
“The
Case
for
Temporary
100
Percent
Expensing:
Encouraging
Business
to
Expand
Now
By
Lowering
the
Cost
of
Investment,”
U.S.
Department
of
Treasury,
October
29,
2010,
p.
3.
6
House,
Christopher
L.
and
Matthew
D.
Shapiro.
“Temporary
Investment
Tax
Incentives:
Theory
with
Evidence
from
Bonus
Depreciation.”
American
Economic
Review
2008,
98:3,
737-­‐768.
7
Source:
Bureau
of
Economic
Analysis.
Disclosure
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