New Economic Challenges, New Supply-Side Playbook: How Congress Can Fight the Next Recession
Low-Cost Recession Fighters
Introduction
Despite the persistence of a strong job market, the conventional wisdom among business and academic economists forecasts a recession in 2023. Even as supply-chain disruptions fade, other inflationary pressures are proving more durable, most notably a tight labor market that has contributed to an acceleration in wage growth. Given the Federal Reserve’s stated commitment to lowering inflation, it is not unreasonable to anticipate that it will continue raising interest rates, even if that means sparking an economic contraction. The question for Congress, then, is how exactly to prepare for the next economic downturn.
In recent years, Congress has followed a straightforward playbook for fighting recessions: unleash a flood of federal spending. In the aftermath of the 2007–08 global financial crisis, Congress enacted $1.8 trillion in fiscal stimulus, disbursed gradually from 2008 to 2012. During the Covid-19 crisis, Congress passed a series of federal stimulus measures that in total added $5 trillion to federal deficits, much of it spent over a much shorter interval. While this extraordinary infusion of federal funds may have helped avert a sharper, more prolonged downturn, there is little doubt that it contributed to the recent sharp increase in inflation.
The current inflationary environment means many in Congress are reluctant to revisit the post-crisis playbook of the recent past. For one thing, it’s not at all obvious that a surge in federal spending would be well-advised in light of the Fed’s anti-inflationary efforts. Moreover, rising interest rates have forced lawmakers to confront the rising cost of servicing surging federal debt, a challenge that will only grow more pronounced in the years to come as entitlement shortfalls mount.
Congress needs a fresh approach to tackling the next recession, one that limits deficit spending in favor of a supply-side approach that would help mitigate inflation rather than exacerbate it. In this study, we offer a series of incremental policy measures that could foster economic growth in the face of a looming recession, all at relatively low cost to the taxpayer. This is not, to be clear, a comprehensive agenda for fiscal consolidation or revitalizing long-run economic growth, but it does aim to point lawmakers in the right direction as the U.S. economy enters what could be a painful downturn.
Investment Tax Reform
Despite recent reforms, burdensome taxes are still one of the greatest barriers to U.S. dynamism and growth. To avert the upcoming economic downturn, Congress must remove taxes that penalize investment and productivity. Stimulus bills in the 2008 crisis and the 2020 pandemic provided large tax rebates and credits to individuals, which increased spending but did not change incentives or spur production. In this crisis, the need for supply-side tax reform is obvious.
Business Equipment and Expenses
The most important supply-side stimulus would be to return to the full expensing of business equipment and research investment. The 2017 Tax Cuts and Jobs Act allowed businesses to deduct 100% of their qualified equipment purchases.[1] That, however, decreased to 80% in 2023, and it will keep decreasing 20 percentage points a year until the ability to expense is eliminated in 2026. Also beginning in 2022, businesses no longer receive a 100% deduction equal to their research and development expenses in the year the expenditure took place. Instead, research expenses are amortized over five years. Slower depreciation schedules for both types of investment are particularly painful for businesses in inflationary times when the costs of delayed income are higher.
To incentivize investment, and to bring future investment into the present, Congress should keep full expensing at 100% of qualified purchases for at least 2023 and 2024. It can also, at least for those same two years, return to the full expensing of research and development, which is especially important for increasing productivity.
Incentivize Construction
Finally, Congress should accelerate the depreciation of building structures. Real property depreciation saw little reform in the 2017 tax act, and real estate still has very long depreciation schedules. Commercial property is depreciated over 39 years, and residential rental properties are depreciated over 27.5 years.[2] To incentivize more building, these schedules should be reduced by 10 years, which would help increase construction in a period when that industry is particularly hard hit.
Full expensing is one of the most powerful options imaginable for spurring the economy. The Tax Foundation estimates that a complete and permanent expensing of all equipment, research, and buildings (a more expansive reform than proposed here) would increase Gross Domestic Product by over 5% and lead to over 1 million new jobs.[3]
Such expensing carries revenue costs for the federal government, but many of these costs are bringing forward future deductions into the present. To pay for the upfront costs of reform, there are several options. Congress can continue the ceiling on the State and Local Tax (SALT) deduction at $10,000 beyond the current end date of 2025. Congress could also reduce the high capital gains exemption for housing sales, cutting the present $500,000 exemption maximum in half. Both of these tax deductions largely benefit wealthy individuals in a few expensive states. They also encourage states and local governments to increase taxes on their own citizens and place restrictive regulations on home building to incur more capital gains. Such negative, anti-growth incentives are exactly what the economy does not need now.