A new definition of madness: legislating potent new fiscal incentives for capital spending when the longest running and most severe asset inflation in modern times has gained new and threatening momentum. That is what happened in the US last year. The chickens are already coming home to roost as the spectre of calamitous malinvestment looms large.
It should not surprise monetary diagnosticians that malinvestment stemming from this asset inflation could be reaching extremes - including now a new dimension, apocalyptic risk. Alongside the deeply flawed monetary regime responsible for all this woe is a tax madness making the prognosis so much worse.
The core of the tax madness is the tax subsidy on business capital spending as legislated in the One Big and Beautiful Act (OBBA) 2025. Stimulating investment which responds to capital market signalling deeply corrupted by asset inflation is surely not good policy, to put matters politely.
The OBBA provides for 100 per cent initial write off against tax on a whole range of business investment expenditures, including data warehouses! If a data warehouse were written off over 20 years against tax (in fact 40 years were stipulated by previous tax rules) the present value of those tax deductions, at say a discount rate of 10% p.a., would be about half of what an initial 100% deduction is worth. Some of those future deductions might never have materialized if by then the business was not earning sufficient revenue to offset.
There is an additional tax subsidy on business investment, joined with a tax subsidy on leverage, contained in the OBBA. This takes the form of raising the limit for deducting interest expense against tax. The exact limit for any business is based on EBITDA (profits with depreciation and interest expense added back in). Hence this limit rises with capital investment in equipment and buildings.
Nonsense of nonsenses: subsidizing leverage at any time and especially when virulent asset inflation featuring widespread financial engineering is rampant. And adding injury to injury: to make the extent of subsidy a rising function of the likely malinvestment which the given business is carrying out.
Total US spending on infrastructure for AI could be running annually now at as much as 5% of US GDP, with other AI equipment spending on top. In total the tax subsidies as granted by the OBBA could now be running at 1% of GDP or even more. On top of that, there is the reality that much of the current expenses (such as salaries) written off against tax by businesses is in fact camouflaged capital expenditure (think here of training and marketing) especially in the area of technology including AI.
Under a neutral tax regime (means here not designed to stimulate business investment) those current expenditures would be in part capitalized and then depreciated over several years. Instead, the tax regime has a built-in tendency to over-expense capital, even without considering the OBBA and its gifts, including new tax incentives for research and experimentation.
How to make sense of all this – stimulating by tax subsidy capital spending at a time of monetary inflation and symptomatic asset inflation? After all, both history and principle suggest that monetary inflation, especially during technological revolution, fans (via the mal signalling in capital markets infected by asset inflation) malinvestment and financial fragility.
Consider for example the great asset inflation of 1924-9 and the related US malinvestment whether in electrification and automobiles or in the Weimar bubble economy on the dollar standard; or the over-extension of heavy industry sectors in Japan, Germany and the US from the mid -1950s to the late 1960s when the Federal Reserve as global monetary hegemon was accommodating CPI inflation at a time of record productivity growth; or real estate and financial industry boom in the late 1980s most of all in Japan.
The authors of US fiscal policy have ignored all this evidence, in part no doubt because for many reasons they do not recognize asset inflation and malinvestment as relevant concepts in the present economic situation. If we take the Treasury Secretary at his word, the markets are misinterpreting the red ink. Scott Bessent has indicated in TV interviews that concerns about the Federal budget deficit are bogus. There is a boom in capital investment to match the deficit, and this will in turn boost economic prosperity. The treasury secretary’s confidence in additional prosperity would be understandable – though ideally tempered by essential uncertainty – in the hypothetical context of sound money. But in the present monetary context confidence is unfounded and indeed perverse.
Yes, lone optimists can still build a partially comforting picture of the US fiscal position, albeit serious. With one percentage point of the deficit-to-GDP ratio explained by tax subsidies on investment and another two to three percentage points by the inflation compensation component of nominal interest on the federal debt, the real fiscal deficit, once those subsidies run off, could be under 3% of GDP. But that run-off of tax subsidies (explained by dwindling depreciation deductions as these are all front-loaded) could take a long time to emerge.
In the meantime, real interest rates on government debt could increase further whether due to anxiety about eventual default or optimism on the broad strength of capital spending, fanned by the direct incentives of the OBBA. Treasury Secretary Bessent makes no mention of the capital spending in the economy outside the area of AI which has been squeezed by the high real rates; he only mentions the technology side of the ledger.
Yes, were a great recession to emerge at some point, then real interest rates could plunge, of definite advantage to the fiscal arithmetic especially given the present Treasury policy of hiking the share of debt raised in effectively floating rate form. At best though, that cyclical fall in debt interest payments would only partially offset to plunges in tax revenue in other parts of the overall federal budget.
In fanciful mood we could imagine a fiscal and debt market reform package emerging with cross-aisle support in the next Congress after the mid-terms. The key element: a schedule for reducing giant depreciation deductions and a curtailing of interest cost expensing. Yes, the US Treasury market would respond positively. Equities and debt issued by businesses at the core of malinvestment could plunge. Crucial to how all this would unfold would be the path of monetary conditions, notoriously treacherous to assess in the present anchorless system.
