Bring Back Bonus Expensing, Bring Back Jobs

April 18, 2014

One of the provisions under consideration in the tax extenders discussion is a reinstatement of 50 percent bonus expensing for equipment. This would strengthen investment spending and boost the sluggish recovery. It has done so in the past, most clearly in 2002 and 2003 when it helped to turn around a slump in investment and convert the “jobless recovery” into a mini-boom. The provision would do more to bolster the economy if it were made permanent, but half a loaf is better than none.

Some critics of bonus expensing argue that it creates a subsidy for investment financed with borrowed money. In a recent blog post, Howard Gleckman of the Tax Policy Center made this argument, stating: “When a firm can expense its capital costs, the tax rate on that investment is zero. If the business can also deduct interest, it is paying a negative tax on that equipment – effectively receiving an investment subsidy from the government.”

This claim is a false argument from the topmost attic of the ivory tower.

The general argument goes: “All profits are eventually competed away, so businesses only earn returns on their assets that are barely equal in value to the cost of the assets. Therefore, if a firm gets to deduct the full cost of the assets on its tax return, it will have zero reportable taxable income over the life of the investments, and pay no tax. That is OK if it buys the asset with its own (after-tax) money. But if it borrows money to buy the asset, and gets to deduct the interest, it will have a negative tax on the projects due to the interest deduction. So if we let the business deduct the entire cost of buying the asset, we should deny the business a deduction for the interest it pays on the borrowed money.”

There are three glaring errors with this analysis.

Most obviously, the analysis looks at only one side of the coin, as it were. Where there is a borrower, there is also a lender. It is true that borrowers deduct interest, but the interest then becomes taxable income to the lenders. Unless we stop taxing interest received by banks and bondholders, the deduction by the borrower imposes no net reduction in revenue to the Treasury. The lender is in league with the borrower to finance the purchase of the asset; he receives some of the return in the form of interest and pays tax on that portion. The business pays tax on the rest. Those who claim there is a net negative tax are usually neglecting to include the tax paid by the lender.

Yes, some interest is collected in tax deferred pensions, but the government gets the tax later. And some small fraction of interest goes to tax exempt charities and colleges, but the decision not to tax those entities was made by the government, presumably for some good reason. Also, these donation-dependent entities have limited flexibility to alter their saving; they are not the marginal lenders who can step up with additional money to fund the growth of the capital stock. That some lenders are tax exempt is no excuse for not allowing a business to deduct its costs.

More fundamentally, the initial premise is wrong. Not all profits are competed away. They can get pretty low in some industries, but the need to cover the basic time value of money plus a cushion for risk requires there to be some prospect of net income as the norm. In addition, innovation always keeps a large number of businesses ahead of the competition. Patents issued to encourage innovation (the rationale explicitly set out for them in the Constitution) ensure that a significant net return on assets will always exist somewhere in the system. So expensing does not eliminate taxable income, nor send taxes to zero.

Finally, no rational business would borrow to buy an asset if there were no return left over after paying the bank or the bondholder. The business takes the risk of not recovering the cost of the asset. A recession, a better product newly invented by a competitor, or a change in the buying habits of the public can wipe out any return to the investor. The investor must expect to be earning a net profit on the asset, even after paying the bank. On no account would a firm borrow to buy an asset expected to yield nothing more than the purchase price, because it would end up losing money on the interest.

For all these reasons, the argument that expensing produces negative tax rates on investment and constitutes a subsidy is flat wrong. Expensing is a key element of any tax system which seeks to avoid discrimination against investment. Not expensing understates costs and overstates profits. Fifty percent bonus expensing is a good first step toward eliminating that bias, and getting job growth back on track.

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