Temporary Investment Tax Incentives: Theory with Evidence from Bonus Depreciation

There are strong incentives to delay or accelerate investment to take advantage of predictable changes in after-tax prices. For sufficiently long-lived capital goods, these incentives are so strong that the intertemporal elasticity of investment demand is nearly infinite. For temporary tax changes, the equilibrium shadow price of long-lived capital goods should fully reflect the tax subsidy regardless of the elasticity of investment supply. Because the shadow price moves one-for-one with temporary tax subsidies, the elasticity can be inferred from quantity data alone. The bonus depreciation allowance passed in 2002 and increased in 2003 provides an opportunity to use the theory to estimate structural parameters that govern investment. Because certain types of long-lived capital goods qualify for substantial tax subsides while others do not, the policy change provides an ideal setting to estimate these parameters. The data clearly show that investment in qualified properties was substantially higher than for unqualified properties. The estimated elasticity of investment supply is high—between 6 and 13. In contrast, there is no evidence that market prices of investment goods react to the subsidy as the theory dictates, which suggests that either internal, unmeasured adjustment costs play a significant role or that measurement problems in price data effectively conceal the price changes. Christopher L. House Matthew D. Shapiro Department of Economics Department of Economics University of Michigan University of Michigan Ann Arbor MI 49109-1220 Ann Arbor MI 48109-1220 and NBER and NBER tel. 734 764-2364 tel. 734 764-5419 [email protected] [email protected] Even modest reductions in the after-tax cost of capital purchases provide strong incentives for increased investment. Indeed, for tax subsidies that are temporary, and for capital goods that are very long-lived, the incentive to invest when the after-tax price is temporarily low is essentially infinite. Firms that would have purchased new capital equipment in the future, instead make their purchases during the period of the subsidy. For tax increases, the effects are the opposite. Firms that would have normally invested now, instead delay until the tax rate returns to normal. We present a model of the equilibrium effects of temporary investment tax incentives. The model reveals a simple relationship between the shadow price of investment goods and the size of a temporary investment tax incentive. Specifically, for sufficiently long-lived capital goods (goods with very low rates of economic depreciation) and for sufficiently short-lived investment tax subsidies, the shadow value of capital should be nearly unchanged and thus the pre-tax shadow price of capital goods should fully reflect the magnitude of the tax subsidy. This result holds regardless of the elasticity of investment supply and regardless of the underlying structure of the demand for capital equipment. Two conclusions immediately follow. First, observing price increases following a temporary tax incentive is not evidence that investment supply is relatively inelastic. Second, because economic theory dictates that the underlying shadow price of investment moves one-for-one with a temporary tax subsidy, the elasticity of supply can be inferred from quantity data alone. Recent changes in U.S. tax law allow us to use the model and its implications to estimate structural parameters that govern the supply of investment. The 2002 and 2003 tax bills provided temporarily accelerated tax depreciation called bonus depreciation for certain types of qualified capital goods. Under the 2002 bill, firms could immediately deduct 30 percent of investment purchases and then depreciate the remaining 70 percent under standard depreciation schedules. Under the 2003 bill, the immediate deduction increased to 50 percent. This investment subsidy was explicitly temporary. Only investments made through the end of 2004 qualified for this tax treatment. Moreover, the subsidy applied differentially to different types of capital. Our empirical research design examines disaggregate investment data in the wake of these tax provisions. The