Yesterday’s third quarter gross domestic product report included some seemingly encouraging data on business investment. Unfortunately, it was probably just another head fake.
The silver lining that springs from a seldom-noticed subcomponent of gross domestic product (GDP) known as gross private domestic investment: equipment. It measures business investment in new machinery, furniture, vehicles and other more durable goods. It can be a leading indicator of economic conditions, as companies tend to invest more in equipment when they expect better times.
In the third quarter, business investment in equipment grew at an annual rate of 10.8%, a marked improvement from the low 0.2% recorded in the second quarter. At first glance, this looks like a sign that companies may not think the impending recession everyone is talking about will be too bad.
Closer examination, however, dispels this optimistic interpretation. First, it could be a sign that companies are expecting inflation to rise. Computers become obsolete, delivery trucks break down and desks need to be replaced. Businesses that expect prices to continue to rise can turn back the replacement cycle, similar to how consumers stock up when they fear rising prices. These replacement purchases are accounted for as investments in equipment in the same way as investments that represent an expansion of business activity.
More importantly, there is probably a tax code provision causing this. The Tax Cuts and Jobs Act 2017 contained a provision known as the “bonus depreciation”. This allowed companies to immediately write-off 100% of the costs of equipment and various other investments made by the companies, rather than having to write them off over the years. The catch is that this provision is starting to phase out at the end of this year. Next year, companies will only be able to pay 80% of the cost of newly acquired goods. This creates a powerful incentive for businesses to make purchases now instead of next year.
This means that instead of acting as a leading indicator, equipment investment in the third and fourth quarters of this year could be a contrary indicator. Some of the investment that would otherwise have been made next year has been deferred to this year. As a result, next year’s investment will likely be lower than it would have been. Much of the surge in investment in the third quarter came from the purchase of vehicles and computers, so these could be the hardest hit next year.
It is not a small component of GDP. In the third quarter, it added just over half a percentage point to the top annual growth rate of 2.6%. Lower investment in equipment next year could significantly reduce GDP and deepen the recession.