Depreciation Elimination

A guide to Bush’s first tax hike.

The Bush administration seems to have two basic fiscal principles: Don’t raise taxes and do lots of favors for big corporations. It’s about to violate both of them. Washington Republicans usually insist that the expiration of a temporary tax cut is the same as a tax increase. By that standard, corporate America will be whacked with a huge tax hike on Jan. 1, 2005, when the complicated but lucrative bonus depreciation rules enacted in 2002 and 2003 are set to expire.

The temporary measures allowed companies to instantly write off bigger chunks of capital investments through 2004, thus lowering taxable profits. For companies that loaded up on corporate jets, computers, or capital equipment, the accelerated write-offs were accounting maneuvers, but the tax savings were real.

In 2005, however, companies unable to write off such large portions of those investments will thus have to report (and pay taxes on) higher profits. The Office of Management and Budget wrote that “after 2004, corporate taxable profits will increase because the provision expires, and because less capital will remain on the books to depreciate.” Indeed, the administration is counting on the higher corporate tax revenues as part of its pledge to halve the deficit by 2009.

Last summer, OMB projected corporate profits before taxes would rise from $954 billion in fiscal ‘04 to $1.29 trillion in fiscal ‘05, up 35 percent, and that corporate income taxes would total $230 billion in 2005, up 21.5 percent from the $189 billion collected in 2004. (Final figures for fiscal 2004 can be seen here.) In fiscal 2003, corporate income taxes accounted for just 7.5 percent of total government receipts; in FY ‘05, OMB believes they will account for 11 percent of the total.

The reasoning seems logical—repeal a huge temporary tax break and tax receipts will rise. But it’s not that simple. Depreciation rules, while they can be quite significant for many companies, are only one factor affecting corporate profits and tax receipts. It’s not simply a binary relationship, where the greater potential for depreciation leads to less corporate taxes paid, and vice versa. In fiscal 2003 and 2004, even with the huge deductions available, there were significant increases in the amount of corporate income taxes paid; in fiscal 2004, they rose a whopping 44 percent.

Why? For much of fiscal 2003 and 2004, companies enjoyed low inflation, ultra-cheap financing, rapid growth in the U.S. and other markets, and the ability to squeeze employees on salaries and benefits. This goldilocks profit-making climate helped spur the continued skewing in the chunk of profits going to corporate owners as opposed to workers. And sharply higher profits led to sharply higher tax receipts.

But now, as we enter the third month of fiscal 2005, corporate America seems to be sailing into the wind. As Wal-Mart’s recent results suggest, higher costs for food, energy, commodities, and financing may be eating into the profits of even the most efficient companies. And while the U.S. economy is still growing smartly, the pace of global growth seems to be slowing. Add it up, and the ability of U.S. companies to wring more profits out of their results is deteriorating, not increasing. The Commerce Department reported yesterday (see Table 11) that corporate profits actually fell 2.4 percent in the third quarter of 2004. After rising by 14 percent and 16.8 percent in 2002 and 2003, respectively, the rate of profit growth has fallen for each of the last four quarters.

So, there are two scenarios before us. The first, touted by the administration, is that thanks in large part to the expiration of the depreciation tax break, corporate profits will rise sharply from their current levels—despite the recent slowdown—and that companies will pay a higher percentage of their profits in taxes than in years past, thus bringing significantly more cash into federal coffers.

The second is that profits will grow at a slower pace in 2005 than they have in recent years, thus producing lower taxable profits than expected. And rather than simply pay the higher taxes that result from the end of the depreciation tax breaks, corporations will do what they always do: work with accountants, insurers, banks, lobbyists, and friendly congressmen to find new ways to reduce tax payments. As a result, the expected corporate receipts will fail to materialize. And instead of falling significantly in fiscal 2005, the federal deficit will stay at record-high levels.

My bet is on the second.