The 2017 Tax Cuts and Jobs Act was intended to spur productivity-enhancing investment. For many middle market firms, it represents a once-in-a-generation opportunity to capitalize on a tax windfall. The money could bolster outlays on equipment, software and intellectual property during a time of profound technological disruption across all industrial ecosystems.
However, RSM’s proprietary research shows an apparent reluctance on the part of midsize companies to invest in these areas, presenting one of the emerging economic policy puzzles in the current cyclical expansion.
Just 38% of middle market leaders polled in the second quarter of 2018 in the RSM U.S. Middle Market Business Index say they plan to increase the dollar volume of their capital expenditures over the next three years because of accelerated expensing and depreciation. Of that 38%, only half plan to make new capital investments, while the remainder are accelerating previously planned investments.
The reluctance of middle-market firms to increase private fixed investment amid an uncertain business environment is widely recognized. In a recent Federal Reserve research paper titled, “The Long and Short of It: Do Public and Private Firms Invest Differently?” central bank economists use new IRS data to make a persuasive case that public firms invest significantly more (nearly 50%) than their private counterparts, with a substantial majority of outlays on capital expenditures originating in research and development.
According to the study, diversified public ownership and the use of initial public offerings to raise capital help facilitate investment in R&D, a typically risky asset class, spreading the risk among many shareholders. Small- and medium-size enterprises are often privately held; they tend to focus on best practices, adhering to an overall investment strategy that might best be described as “hold and follow.” In short, they do not have the capacity, capability or financial depth to keep up, so they wait and see.
Even following the recent tax windfall, the lack of breadth and depth of middle market funding markets presents a major constraint on the sector’s risk-taking and its ability to integrate novel technology into the production of goods or provision of services. Thus, it is simply easier hold back and observe what is relevant and what works before making major productivity-enhancing investments.
But the risks surrounding this hold-and-follow strategy are rising disproportionately. The emergence of network-based products and services that gain more value as more people use them, combined with new applications of artificial intelligence and machine learning, have given rise to a host of disruptive technologies. They range from advanced robotics and virtual reality rapidly moving to the factory floor to advancements in industrial 3D printing and the industrial Internet of Things—all which threaten to upend entrenched middle-market ecosystems.
A “hold and follow” approach to private fixed investment is not likely to survive under these conditions. The rapid pace of technological transformation presents a new and unique challenge to the pricing and business models of all middle-market firms.
Middle market companies’ reticence to invest in their businesses may also be due, in part, to a lack of understanding on how certain provisions of the TCJA, such as bonus depreciation, could benefit them and provide opportunities to accelerate capital expenditures,
It is useful to note, for example, that C corporations—entities whose profits are taxed separately from their owners— get the sharply lower federal income tax rate of 21%, down from 35%. S corporations, along with the limited liability corporations, sole proprietorships and others, are pass-through entities, meaning profits from their business flow through to the business owner’s personal tax return. Depending on a variety of factors, including tax bracket, their tax rate could be as low as 29.6% or as high as 40%.
The TCJA offers an attractive bonus depreciation rate of 100% for qualified assets such as personal property—but it ends after Dec. 31, 2022. Prior to the new tax legislation, only 40% of the asset’s value could be immediately written off in 2018, with the rest being amortized over the remainder of the property’s depreciable life—typically five or seven years.
And while the 21% rate is a favorable factor in the current taxation of C corporations, the bonus depreciation incentive isn’t as valuable to them as it is to pass-throughs, which don’t benefit from the lower tax rate.
Joseph Brusuelas is chief economist for RSM, a global accounting firm for the middle market.