Accelerated Depreciation of Capital Spending

One of the questions which has been puzzling me for quite a while is this: Why have Economists been so wrong — and by so much, and for so long — about Job Growth?

Or as the WSJ put it, why is “Slow Job Growth Puzzling Economists?”

That quandry was the muse for this series on a relatively unknown portion of the Bush tax cuts. I decided to take a closer look at the effects of the soon-to-sunset bonus of Accelerated Depreciation of Capital Spending (ADCS). Our report is in two parts.

My conclusion?

1) ACDS stimulated corporate capital spending;
2) Very aggressive spending was made in ERP / Business Intelligence software;
3) Some of this capital spending came at the expense of new Hiring;
4) We are likely to see one last spasm of spending heading into Q4;
5) Some of this spending is being pulled through from 2005;
6) Once ADCS sunsets, there may possibly be an improvement in Hiring in 2005.

That’s the broad overview; continue on if you want to read the gritty details.

Understanding Accelerated Depreciation (part I)

One of the more important changes in tax legislation passed by President Bush is scheduled to expire this year: Accelerated Depreciation of Capital Investment.

No one is even remotely suggesting that anyone do some thing about this sunsetting on December 31, 2004. Nor are they likely to, for reasons that will become abundantly clear later.

Most investors seem to understand very little about what is, at its heart, a change in the rules governing certain accounting operations. Surprisingly, weve seen very little in the way of analysis or commentary on it from the Wall Street; Nor has there been much said in the financial press about what is essentially an intriguing corporate tax cut.

Lets see if we can change all that.

What is Accelerated Depreciation?

When making large capital purchases, businesses get to write them down over time, deducting their original cost, based upon certain schedules and accounting conventions. This is called Depreciation. If that word sounds familiar, it should: Depreciation is the D in EBITDA (Earnings before Interest, taxes, depreciation and amortization).

For those of you whose eyes glaze over at the mere mention of accounting, consider this: What would it be like if you could write off big ticket purchases much faster than your accountant was able to do historically? What would you buy if you could deduct the lions share of the equipment purchase expenses in year one — instead of the usual seven? And this deduction covers just about everything bigger than a Blackberry, and smaller than real estate even a Lear jet . . .

Have I got your attention yet?

All that and more is what the accelerated depreciation of capital investments entails.

Lets drill down into the details: Traditionally, major capital investments were depreciated based upon a rough schedule of their useful expected lifespan. For example: a laptop is expected to last 3 years; Telecom switching equipment should be around for 5 years; And large trucks or construction vehicles are expected to last 7 years. (Any accountants out there — feel free to send me other examples you think are more illustrative, or tell me why my expectation on these three are wrong).

To grossly oversimplify how these purchases get written down, imagine your firm needs to buy a large (and fictional) widget doohickey. It costs about a million dollars, and should last you 5 years. Straight-line depreciation means that you get to deduct the expense of about a fifth of the purchase price each year for 5 years.

If you were to buy this widget doohickey in 2005, you would get to write down $200,000 that first year.

Under accelerated depreciation, however, you get a bonus: 50% of the purchase price. And all you have to give up is half of the first years usual depreciation.

What does that look like for our million-dollar doohickey? Instead of depreciating $200k in year one, our lucky accountant gets to write down $600k: The 50% accelerated depreciation, plus half of the usual 20%.

Thats an enormous difference.

The key is that in order to qualify for the 2004 depreciation schedule, the capital equipment must be Placed in Service by that 12/31/04 — not merely ordered, or sitting in a warehouse, but in actual use.

The impact on corporate balance sheets is so large, any firm that misses this opportunity to purchase needed equipment would be foolish not to do so this year. As I mentioned the other day on Squawk Box, every CFO in the country should be calling their Chief Information Officers and Chief Technology Officers into their office, and demanding to know what planned 2005 purchases can be pulled forward into 2004.

This is why I believe all the hand wringing over the inventory build up is just so much chicken little: Inventory build is a problem when it occurs in customers warehouses. It is exceedingly hard to sell something when the prospective buyer has millions of the item for sale piled up on loading docks around the World.

When inventory build up occurs at the manufacturers side, however, thats an indication they are expecting an upswing in orders. It takes strategic planning — and some optimism about the future — to produce an inventory build. The risk factor for corporate manufacturers is one of margin pressure. If sales do not materialize, then prices will need to be cut to move the goods. The goods will get sold eventually but at less of a profit.

But consider the opposite: What happens if demand picks up, but you have no inventory to sell? Those lost sales are gone forever.

Why were the Accelerated Depreciation accounting rules changed?

In the years leading up to market bubble, there was a massive build up in productive capacity. By 1999, the watchword was becoming over capacity. Corporate America had the ability to produce far more than was necessary to meet demand.

It wasnt just tech and telecom, either: From the chemical industry to industrial manufacturing, nearly all sectors were seeing signs of excess capacity. They had built the infrastructure to service more demand than actually existed. Except for a few grumpy old bears, no one on Wall Street seemed to care very much about it.

The run up to the top saw too much capital chasing too few ideas. The result was an excess capacity Then came the crash, followed by the recession.

In the immediate aftermath, businesses had a precipitous drop off in new orders. Given the how massive the bubble was, a real possibility existed for a prolonged capital investment slump. The new depreciation rules were designed to temporarily soften the impact of post-bubble environment.

Excess capacity can be squeezed out of the system only through the passage of time, and concurrent increase in end user demand.

Conclusion, part I

Although the economy is expanding, it is hardly growing at a robust pace. That could see a positive change soon. A potential surge in orders may hit late in the 4th quarter, as corporate management rushes to take advantage of this rule before its expiration. In particular, we note the impact of the depreciation rule in Semi-conductor equipment, Telecom, and Industrial manufacturing.

Coming in part II: We all know theres no such thing as a free lunch. So what are the negative, unintended consequences of the changes in the Accelerated Depreciation rules? Reverse channel stuffing and deferred hiring are the two big ones. We will look at these in the coming weeks.

Unintended Consequences of Accelerated Depreciation (part II)

Id gladly pay you tomorrow for a hamburger today.
-J. Wellington Wimpy, (Popeye)

Earlier this week, we discussed the importance of changes in tax rules governing Accelerated Depreciation of Capital Investment, the tax advantaged accounting change that is scheduled to expire on December 31, 2004.

From its inception, it was expected to be a temporary stimulus designed to assist industries hurting in the post-bubble environment.

It has had that effect, in varying degrees, across many industries. The rule change has been stimulating capital purchases in a variety of sectors: In particular, Semiconductors, Industrial Manufacturing, Aircraft, Heavy Trucks, Telecom, and in particular, large Enterprise-wide Software applications.

The kicker to that stimulus is that Accelerated Depreciation is scheduled to sunset this year and the governing provision is that to qualify for the tax advantage, capital purchases must be placed into service by December 31. That creates a possibility of a Y2K-like run up in the late 3rd and early 4th Quarters, as companies scramble to catch the last of the tax benefit before the rules expiration.

Unintended Consequences

Because there’s no such thing as a free lunch this fact forces the question: What are the negative, unintended consequences of the changes in the accelerated depreciation rules? We know that many sectors have benefited from the rule but what has been the cost? In what ways has the rule been harmful to the recovery?

There are two particular dangers: deferred hiring (macroeconomic) and future purchase pull through (microeconomic). Lets briefly review each issue, to see if we can determine what, if any, the financial and/or economic impact the rule might have for the rest of this year and into 2005.

1) Deferred Hiring

The rule has had an unambiguous macro-impact on the broader economy: Large capital purchases have come at the expense of hiring.

Unlike prior economic recoveries, the post-2001 recession period has seen very unusual dynamics in expansion hiring patterns. I attribute this atypical aberration to excess post-bubble capacity, large increases in worker productivity, and cost-effective overseas outsourcing.

Graphic courtesy Chart of the Day

But we should not overlook the impact of a subtle structural change in Corporate America: The widespread usage of business intelligence applications and enterprise resource planning software (ERP). These efficiency and productivity apps have had a significant impact on the economic recovery.

It has long been a staple of economic belief that corporate capital spending boosts profits, adds to the gross domestic product, and puts people to work. This held true throughout most of the 20th century. When companies purchased oil-rigs, drill presses, or large trucks, someone had to manufacture those goods. Companies needed workers to meet the rising demand for this capital equipment. And once that widget was manufactured, someone else was hired to operate it, drive it, or work it.

In all likelihood that was the White House’s intent in accelerating the depreciation schedule for capital improvements. If companies get a larger tax benefit for making bigger purchases, then jobs should be the natural net result.

But this 20th century economic concept runs into some decidedly 21st century issues. Namely, labor requirements are very different in the age of intellectual property and software.

The problem seems to be that a large percentage of the capital purchases have been made in the software sector: Enterprise-wide applications make companies more efficient, productive and competitive. So efficient in fact that it reduces (or even eliminates) the need for additional hiring.

Our channel checks confirmed that suspicion: CIOs and CTOs, especially at small and medium sized firms, have been aggressively purchasing these enterprise apps over the past 2 years. Firms that design these ERPs market them as “paying for themselves” in a few years specifically, in labor savings. The tax advantage of accelerated depreciation provided management with an incentive to install these apps sooner rather than later.

In order to stay competitive in the global marketplace, most firms would have had to install these apps eventually anyway. There is a global efficiency arms race, and if any firm garners an advantage using these tools, tools, than its inevitable that all their competitors will have to just to stay competitive.

Thats good news for the U.S.s competitive stance vis–vis the rest of the world. Up against cheap foreign labor, technology had better provide a cost advantage to compensate.

The bad news is that the deferred hiring comes at an economically sensitive juncture during the recovery. We have already seen the impact in slowing GDP and anemic job creation, and with the exception of continued low interest rates, most of the stimulus is behind us. The present phase of recovery should be one of organic growth where increased hiring leads to more consumer spending.

Yet that has not been happening in any appreciable way.

Thats one of the unintended consequence of the ERP and business intelligence applications: a dampening of hiring needs. Even at software firms, one of the main beneficiaries of this capital spending spree, there has not been a huge increase in headcount. Thats one of the great ironies of accelerated depreciation: Intellectual property doesn’t require many new hires in response to an uptick in demand: How many people are needed to make another installation disc? At best, software firms see a small increase of hires in sales and support staff but its relatively tiny. Compare that to the 20th century equivalent: When a steel mill or an auto factory hired in response to rising demand, they would add tens of thousands of new employees.

Thus, the unintended consequence of this 20th century solution to a 21st century problem: lackluster job growth.

2) Future Purchase Pull Through

Given the tax advantaged status of purchases made in 2004 vs. 2005, its reasonable to expect to see accelerated buying in the second half of this year. Any firm planning on making a large capital purchase in Q1 2005 would greatly benefit from doing so in 2004 instead. Anecdotally, we have seen that.

Our working assumption is that many of the buys being made now are coming at the expense of the first half of 2005. Thats the pull through which is the result of this rule. Its like channel stuffing only in reverse.

Consider an analogous period: The run up to Y2K and the immediate aftermath. Prior to Dec. 31, 1999, the widely feared Y2k problem generated lots and lots of activity. Some of it, like COBOL programming and updating, were one-shot deals. We are unlikely to see another frenzy of COBOL programming activity again until the year 9,999.

Other buys, like PC purchases and software upgrades, did benefit from the flurry of activity, but that benefit came at the expense of 2000 first half purchases. And while the Nasdaq did scream higher for the first three months of 2000, the handwriting was already on wall. Indeed, it can be argued that the preannouncement period in March of 2000 was, at least in part, the pin that helped prick the bubble. (We all recall what happened after March 21, 2000).

While our technical work does not suggest a similar crash is imminent, we can and should expect a similar phenomena in terms of pull through. Many of the second half 2004 purchases will come at the expense of first half of 2005 sales.

Conclusion

Accelerated depreciation helped stimulate capital spending at a time when the economy had become inert. But it accomplished this at a cost. Corporate management, given an incentive to make capital purchases, did so at the expense of hiring. We saw that in the corporate preference for equipment over labor these last few years. That could ultimately make this economic recovery somewhat more muted than prior upturns.

There is reason to hope that hiring will begin to swing upward in 2005. With the tax incentive to choose equipment over labor removed, there will be one less obstacle in the way away of corporate hiring. And if that were to occur, it would bode well for further economic expansion.

Sources:
Has Structural Change Contributed to a Jobless Recovery?
Authors: Erica L. Groshen and Simon Potter
August 2003 Volume 9, Number 8
JEL classification: E3, E24, J6
http://www.newyorkfed.org/rmaghome/curr_iss/html/civ9n8/civ9n8.html

Has Structural Change Contributed to a Jobless Recovery?
Authors: Erica L. Groshen and Simon Potter
August 2003 Volume 9, Number 8
JEL classification: E3, E24, J6
http://www.newyorkfed.org/rmaghome/curr_iss/html/civ9n8/civ9n8.html

Don’t Blame Outsourcing for Slow Job Growth
Jane R. Hagerty and Jon E. Hilsenrath
WSJ, March 30, 2004
http://www.adweek.com/aw/classifieds/article_display.jsp?vnu_content_id=1000474935