Publications

January 08, 2015

Executive Summary

By a vote of 79 percent to 21 percent, Nevada voters on November 4, 2014 rejected a ballot initiative that would have established a 2 percent margin tax on business gross receipts. That debate was only the most recent example of an important state tax discussion that comes up in nearly every recent Nevada legislative session. 

Why do taxes keep coming up? One reason is the volatility of the current system’s tax collections. Another is the difficulty of understanding and complying with sales taxes and property taxes. Yet another is the simultaneous double taxation and complete exemption that exist in the Live Entertainment Tax. Revenue adequacy is also frequently cited. 

This book is meant to continue this conversation by providing a framework for potential changes. In 2014, the Las Vegas Metro Chamber of Commerce commissioned the Tax Foundation to prepare a review of the Nevada tax system and recommend possible improvements. While they commissioned this report, neither the Las Vegas Metro Chamber of Commerce nor any of its sponsors directed this analysis or any of the recommendations. 

We undertook this project as a national organization familiar with tax developments in many states, with the view that tax systems should adhere to sound economic principles, and in the spirit of providing useful information and observations for Nevada policymakers, journalists, and citizens as they evaluate their state’s tax system. 

Over the course of five months, we met with stakeholders from all walks of Nevada life, including small business owners, local government officials, trade associations, industry representatives, state officials, and ordinary taxpayers. We reviewed the history of the tax system, including previous tax reform studies, and available revenue and economic trends. 

Broadly:

  • Nevada should consider fixing what is broken with the current tax system instead of pursuing a brand new tax to layer on top of the narrowly based, complex existing taxes. A number of elements of the tax system exist only in Nevada, and those in particular should be scrutinized.
  • Changes should address state revenue volatility, be fair, and reduce carve-outs that plague the system.
  • The tax system should retain elements that ensure Nevada economic and tax competitiveness.

 

In the following pages, we provide background on Nevada’s economy (Chapter 1) and on the overall tax system (Chapter 2). We then review each major tax, outline concerns, and propose reforms for consideration (Chapters 3, 4, and 5). Chapters 6, 7, and 8 conclude with discussions of several related issues relevant to policymakers but are outside the scope of our recommendations. 

Summary of Tax Reform Options

Option A is a comprehensive tax reform proposal that includes the components of the other three tax reform options outlined hereafter (Options B, C, and D). It simplifies, broadens, and stabilizes the sales tax, Live Entertainment Tax, Modified Business Tax, Bank Branch Excise Tax, Business License Fee, and the property tax. 

Option B stabilizes and modernizes Nevada’s sales tax system and the Live Entertainment Tax, applying it evenly to all final retail transactions without special carve-outs. It would:

  • Eliminate the current sales tax exemption for the service industry. As services grow to be an ever larger share of the economy, the sales tax becomes increasingly volatile and inadequate as it applies primarily to goods. We present three different scenarios of sales tax base expansion to services: small, medium, and large.
  • Lower the 6.85 percent state sales tax rate, subject to revenue triggers.
  • Exempt manufacturing machinery from the sales tax base. Nevada is one of just nine states that have this tax on capital investment, which double taxes final products.
  • Exempt business inputs from the sales tax by issuing an identification number, registered with the Department of Taxation, to all businesses that pay the Modified Business Tax or the Business License Fee, which would exclude their business purchases from the sales tax base.
  • Subsume the Live Entertainment Tax into the sales tax by repealing the current LET but applying the regular sales tax to all admissions charges and food, beverages, and merchandise sold at all venues that charge admission.

 

Option C further improves Nevada’s already competitive business tax structure by applying the existing Modified Business Tax to all businesses and eliminating both special carve-outs and industry-specific rates. It would:

  • Roll back the higher Modified Business Tax rate for financial institutions while adjusting the Modified Business Tax rate for general businesses.
  • Repeal the $85,000 Modified Business Tax carve-out, applying the tax to all businesses.
  • Repeal the Bank Branch Excise Tax, which raises little revenue and has no public policy rationale.
  • Increase Business License Fees while instituting a graduated fee structure.

 

Option D proposes changes that add stability to Nevada’s property tax system and bring it in line with best practices from other states. It would:

  • Change the assessment method from replacement cost to market value and eliminate the depreciation factor.
  • Adjust and reform tax caps, preserving predictability for homeowners and restrain local government spending growth while eliminating the unexpected downward “ratchet” that materialized in the most recent recession.
  • Present an option for a circuit breaker for low-income homeowners as an alternative way to target more meaningful property tax relief for specific individuals.

 

We hope these options continue the tax conversation in Nevada by providing a framework upon which legislators and citizens can make further decisions. The menu of choices we present all ensure that the state builds a tax system for a diversified economy and positions itself as a destination for investment, entrepreneurs, and talented individuals in the years ahead. 

 

Click here to continue reading the full report and methodology

Promoted Types: 
March 18, 2014

How do taxes in your state compare nationally? This convenient pocket-size booklet compares the 50 states on many different measures of taxing and spending, including individual and corporate income tax rates, business tax climates, excise taxes, tax burdens and state spending.

Order a print copy of Facts & Figures

Errata: The print edition of this booklet erroneously left out Ohio's individual income tax reduction in table 12, West Virginia's capital stock tax reduction in table 33, and West Virginia's treatment of candy under the sales tax in table 29. This online version corrects these errors.

Download our Interactive PDF and navigate by clicking through the table of contents or though the bookmarks panel.

Promoted Types: 
March 18, 2014

For our 2015 data on sales taxes, click here.

Key Findings

  • 45 states collect statewide sales taxes.
  • 38 states collect local sales taxes.
  • The five states with the highest average combined state-local sales tax rates are Tennessee (9.45 percent), Arkansas (9.19 percent), Louisiana (8.89 percent), Washington (8.88 percent), and Oklahoma (8.72 percent).
  • Virginia, Arkansas, Ohio, and Maine have recently raised sales tax rates.
  • Arizona, Kansas, and the District of Columbia have recently cut sales tax rates.
  • Sales taxes rates differ by states, but sales tax bases also impact how much revenue is collected from a tax and how the tax effects the economy.
  • Differences in sales tax rates cause consumers to shop across borders or buy products online.

(Click on the map to enlarge it. All maps and other graphics may be published and reposted with credit to the Tax Foundation.)

Introduction

Retail sales taxes are one of the more transparent ways to collect tax revenue. While graduated income tax rates and brackets are complex and confusing to many taxpayers, the sales tax is easier to understand: people can reach into their pocket and see the rate printed on a receipt.

Less known, however, are the local sales taxes collected in 38 states. These rates can be substantial, so a state with a moderate statewide sales tax rate could actually have a very high combined state-local rate compared to other states. This report provides a population-weighted average of local sales taxes in an attempt to give a sense of the statutory local rate for each state. See Table 1 at the end of this Fiscal Fact for the full state-by-state listing of state and local sales tax rates.

Combined Rates

Five states do not have a statewide sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon. Of these, Alaska and Montana allow localities to charge local sales taxes.[1]

The five states with the highest average combined rates are Tennessee (9.45 percent), Arkansas (9.19 percent), Louisiana (8.89 percent), Washington (8.88 percent), and Oklahoma (8.72 percent).

The five states with the lowest average combined rates are Alaska (1.69 percent), Hawaii (4.35 percent), Wisconsin (5.43 percent), Wyoming (5.49 percent), and Maine (5.50 percent).

State Rates

California has the highest state-level rate at 7.5 percent.[2] Five states tie for the second-highest statewide rate with 7 percent each: Indiana, Mississippi, New Jersey, Rhode Island, and Tennessee.

The lowest non-zero statewide sales tax is in Colorado, with a rate of 2.9 percent. Seven states follow with 4 percent: Alabama, Georgia, Hawaii, Louisiana, New York, South Dakota, and Wyoming.[3]

As a result of new transportation legislation, Virginia’s statewide sales tax rate increased on July 1, 2013 from 5 percent to 5.3 percent. Localities in Northern Virginia and Hampton Roads charge a 6 percent combined rate.[4] Also effective July 1, 2013, Arkansas raised its state sales tax rate from 6 percent to 6.5 percent.[5]

On September 1, 2013, Ohio increased its sales tax from 5.5 percent to 5.75 percent as a component of tax reform efforts there this legislative session.[6] Effective October 1, 2013, Maine increased its statewide sales tax from 5 percent to 5.5 percent as a result of a legislative override of Governor Paul LePage’s veto. This increase is scheduled to sunset in June 2015.[7]

Arizona, by contrast, cut its rate from 6.5 percent to 5.5 percent as a temporary sales tax increase expired on July 1, 2013,[8] and Kansas moderately cut its statewide sales tax rate from 6.3 percent to 6.15 percent on the same date.[9] The District of Columbia lowered its sales tax from 6 percent to 5.75 percent on October 1, 2013.[10]

Local Rates

The five states with the highest average local sales tax rates are Louisiana (4.89 percent), Alabama (4.51 percent), Colorado (4.49 percent), New York (4.47 percent), and Oklahoma (4.22 percent).

Mississippi has the lowest non-zero average local rate of 0.004 percent, attributable to the state's only local sales tax: a 0.25 percent sales tax in Tupelo, the birthplace of Elvis Presley.[11]

Salem County, New Jersey is exempt from collecting the 7 percent statewide sales tax and instead collects a 3.5 percent local tax. We represent this anomaly as a negative 0.03 percent statewide average local rate (adjusting for population as described in the methodology section, below), and the combined rate reflects this subtraction. Despite the slightly favorable impact on the overall rate, this lower rate represents an implicit acknowledgement by New Jersey officials that their 7 percent statewide rate is uncompetitive with neighboring Delaware, which has no sales tax.

The Role of Competition in Setting Sales Tax Rates

Avoidance of sales tax is most likely to occur in areas where there is a significant difference between two jurisdictions' sales tax rates. Research indicates that consumers can and do leave high-tax areas to make major purchases in low-tax areas, such as from cities to suburbs.[12] For example, strong evidence exists that Chicago-area consumers make major purchases in surrounding suburbs or online to avoid Chicago's 9.25 percent sales tax rate.[13]

At the statewide level, businesses sometimes locate just outside the borders of high sales tax areas to avoid being subjected to their rates. A stark example of this occurs in the northeast part of the country, where even though I-91 runs up the Vermont side of the Connecticut River, many more retail establishments choose to locate on the New Hampshire side of the river to avoid sales taxes. One study shows that per capita sales in border counties in sales tax-free New Hampshire have tripled since the late 1950s, while per capita sales in border counties in Vermont have remained stagnant.[14]

The state of Delaware actually uses its state border welcome sign to remind motorists that Delaware is the "Home of Tax-Free Shopping."[15] State and local governments should be cautious about raising rates too high relative to their neighbors because doing so will amount to less revenue than expected, or in extreme cases, revenue losses despite the higher tax rate.

Sales Tax Bases: The Other Half of the Equation

This report ranks states and cities based on tax rates and does not account for differences in tax bases (e.g., the structure of sales taxes, defining what is taxable and non-taxable). States can vary greatly in this regard. For instance, most states exempt groceries from the sales tax, others tax groceries at a limited rate, and still others tax groceries at the same rate as all other products.[16] Some states exempt clothing or tax it at a reduced rate.[17]

The taxation of services and business-to-business transactions also vary widely by state.[18] Experts generally agree that Hawaii has the broadest sales tax in the United States, taxing many products multiple times and, by one estimate, ultimately taxing 99.21 percent of the state's personal income.[19] This base is far wider than the national median, where the sales tax base applies to 34.46 percent of personal income.[20]

Methodology

Sales Tax Clearinghouse publishes quarterly sales tax data at the state, county, and city level by ZIP code. We weight these numbers according to Census 2010 population figures in an attempt to give a sense of the prevalence of sales tax rates in a particular state.

It is worth noting that population numbers are only published at the ZIP code level every ten years by the Census Bureau, so the methodology in this version is slightly different than editions of this calculation published before July 1, 2011.

It should also be noted that while the Census Bureau reports population data using a five-digit identifier that looks much like a ZIP code; this is actually what is called a ZIP Code Tabulation Area (ZCTA), which attempts to create a geographical area associated with a given ZIP code. This is done because a surprisingly large number of ZIP codes do not actually have any residents. For example, the National Press Building in Washington, DC, where the Tax Foundation is located, has its own ZIP code solely for postal reasons.

For our purposes, ZIP codes that do not have a corresponding ZCTA population figure are omitted from calculations. These omissions result in some amount of inexactitude but on the whole should not have a palpable effect on resultant averages, because proximate ZIP code areas which do have a ZCTA population number assigned to them capture the tax rate of whatever jurisdiction the area is located in.

Conclusion

Of course, sales taxes are just one part of an overall tax structure and should be considered in context. For example, Washington State has high sales taxes but no income tax; Oregon has no sales tax but high income taxes. While many factors influence business location and investment decisions, sales taxes are something within policymakers' control that can have immediate impacts.

Table 1. State and Local Sales Tax Rates as of January 1, 2014

State State Tax Rate Rank Avg. Local Tax Rate (a) Combined Tax Rate Rank Max Local
Alabama 4.00% 38 4.51% 8.51% 6 7.00%
Alaska None 46 1.69% 1.69% 46 7.50%
Arizona 5.60% 28 2.57% 8.17% 9 7.125%
Arkansas 6.50% 9 2.69% 9.19% 2 5.50%
California (b) 7.50% 1 0.91% 8.41% 8 2.50%
Colorado 2.90% 45 4.49% 7.39% 15 7.10%
Connecticut 6.35% 11 None 6.35% 31  
Delaware None 46 None None 47  
Florida 6.00% 16 0.62% 6.62% 29 1.50%
Georgia 4.00% 38 2.97% 6.97% 23 4.00%
Hawaii (c) 4.00% 38 0.35% 4.35% 45 0.50%
Idaho 6.00% 16 0.03% 6.03% 36 2.50%
Illinois 6.25% 12 1.91% 8.16% 10 3.75%
Indiana 7.00% 2 None 7.00% 21  
Iowa 6.00% 16 0.78% 6.78% 27 1.00%
Kansas 6.15% 15 2.00% 8.15% 12 3.50%
Kentucky 6.00% 16 None 6.00% 37  
Louisiana 4.00% 38 4.89% 8.89% 3 7.00%
Maine 5.50% 29 None 5.50% 42  
Maryland 6.00% 16 None 6.00% 37  
Massachusetts 6.25% 12 None 6.25% 33  
Michigan 6.00% 16 None 6.00% 37  
Minnesota 6.875% 7 0.31% 7.19% 18 1.00%
Mississippi 7.00% 2 0.004% 7.00% 20 0.25%
Missouri 4.225% 37 3.36% 7.58% 14 5.45%
Montana (d) None 46 None None 47  
Nebraska 5.50% 29 1.29% 6.79% 26 2.00%
Nevada 6.85% 8 1.08% 7.93% 13 1.25%
New Hampshire None 46 None None 47  
New Jersey (e) 7.00% 2 -0.03% 6.97% 24  
New Mexico (c) 5.125% 32 2.14% 7.26% 16 3.5625%
New York 4.00% 38 4.47% 8.47% 7 4.875%
North Carolina 4.75% 35 2.15% 6.90% 25 2.75%
North Dakota 5.00% 33 1.55% 6.55% 30 3.00%
Ohio 5.75% 27 1.36% 7.11% 19 2.25%
Oklahoma 4.50% 36 4.22% 8.72% 5 6.50%
Oregon None 46 None None 47  
Pennsylvania 6.00% 16 0.34% 6.34% 32 2.00%
Rhode Island 7.00% 2 None 7.00% 21  
South Carolina 6.00% 16 1.19% 7.19% 17 3.00%
South Dakota (c) 4.00% 38 1.83% 5.83% 40 2.00%
Tennessee 7.00% 2 2.45% 9.45% 1 2.75%
Texas 6.25% 12 1.90% 8.15% 11 2.00%
Utah (b) 5.95% 26 0.73% 6.68% 28 2.00%
Vermont 6.00% 16 0.14% 6.14% 34 1.00%
Virginia (b) 5.30% 31 0.33% 5.63% 41 0.70%
Washington 6.50% 9 2.38% 8.88% 4 3.10%
West Virginia 6.00% 16 0.07% 6.07% 35 1.00%
Wisconsin 5.00% 33 0.43% 5.43% 44 1.50%
Wyoming 4.00% 38 1.49% 5.49% 43 2.00%
D.C. 5.75% (27) None 5.75% (41)  

(a) City, county and municipal rates vary. These rates are weighted by population to compute an average local tax rate.

(b) Three states levy mandatory, statewide, local add-on sales taxes at the state level: California (1%), Utah (1.25%), Virginia (1%), we include these in their state sales tax.

(c) The sales taxes in Hawaii, New Mexico and South Dakota have broad bases that include many services.

(d) Due to data limitations, table does not include sales taxes in local resort areas in Montana.

(e) Salem County is not subject to the statewide sales tax rate and collects a local rate of 3.5%. New Jersey’s average local score is represented as a negative.

Sources: Sales Tax Clearinghouse, Tax Foundation calculations, State Revenue Department websites



[1] Due to data limitations, this study does not include local sales taxes in resort areas in Montana.

[2] This number includes a mandatory 1 percent add-on tax which is collected by the state but distributed to local governments. Because of this, some sources will describe California's sales tax as 6.5 percent. A similar situation exists in Utah and Virginia.

[3] The sales taxes in Hawaii and South Dakota have bases that include many services and so are not strictly comparable to other sales taxes.

[4] Joseph Henchman, Virginia Legislators Approve Increases in Sales Tax, Car Tax, Regional Taxes, Tax Foundation Tax Policy Blog, Feb. 25, 2013, http://taxfoundation.org/blog/virginia-legislators-approve-increases-sales-tax-car-tax-regional-taxes.

[5] Joseph Henchman, State and Local Ballot Initiative Results, Tax Foundation Tax Policy Blog, Nov. 6, 2012, http://taxfoundation.org/blog/state-and-local-ballot-initiative-results.

[6] Scott Drenkard, Ohio Tax Reform Package Keeps Getting Worse, Tax Foundation Tax Policy Blog, June 20, 2013, http://taxfoundation.org/blog/ohio-tax-reform-package-keeps-getting-worse.

[7] Elizabeth Malm & Zachary Bartsch, Maine’s Not-So-Beautiful Sunset, Tax Foundation Tax Policy Blog, June 28, 2013, http://taxfoundation.org/blog/maine%E2%80%99s-not-so-beautiful-sunset.

[8] Angie Holdsworth, Temporary 1 cent Arizona sales tax ends Friday, ABC 15, May 31, 2013, http://www.abc15.com/dpp/news/state/temporary-1-cent-arizona-sales-tax-ends-friday.

[9] Steve Kraske & Zach Murdock, Brownback signs Kansas tax measure, Kansas City Star, June 13, 2013,

http://www.kansascity.com/2013/06/13/4290891/brownback-signs-tax-bill.html.

[10] Scott Drenkard & Joseph Henchman, D.C. Now Better than Virginia and Maryland on Sales Tax Rates, Tax Foundation Tax Policy Blog, Oct. 2, 2013, http://taxfoundation.org/blog/dc-now-better-virginia-and-maryland-sales-tax-rates.

[11] Tupelo Convention & Visitors Bureau, http://tupelo.net/.

[12] Mehmet Serkan Tosun & Mark Skidmore, Cross-Border Shopping and the Sales Tax: A Reexamination of Food Purchases in West Virginia (Working Paper, 2005), http://www.rri.wvu.edu/pdffiles/Tosunwp2005-7.pdf. See also Randolph T. Beard, Paula A. Gant, & Richard P. Saba, Border-Crossing Sales, Tax Avoidance, and State Tax Policies: An Application to Alcohol, Southern Economic Journal, 64(1), 293-306 (1997).

[13] Susan Chandler, The Sales Tax Sidestep, Chicago Tribune, July 20, 2008, http://articles.chicagotribune.com/2008-07-20/business/0807190001_1_sales-tax-tax-avoidance-tax-landscape.

[14] Art Woolf, The Unintended Consequences of Public Policy Choices: The Connecticut River Valley Economy as a Case Study, Northern Economic Consulting (Nov. 2010), http://vtdigger.org/vtdNewsMachine/wp-content/uploads/2011/02/20101101_woolfArtUnintended.pdf.

[15] Len Lazarick, Raise taxes, and they'll move, constituents tell one delegate, Marylandreporter.com, Aug. 3, 2011, http://marylandreporter.com/2011/08/03/raise-taxes-and-theyll-move-constituents-tell-one-delegate/.

[16] For a list, see Tax Foundation, 2014 State Business Tax Climate Index, Tax Foundation Background Paper No. 68 (Oct. 9, 2013), http://taxfoundation.org/article/2014-state-business-tax-climate-index.

[17] Joseph Henchman, State Sales Taxes on Clothing, Tax Foundation Tax Policy Blog (Jan. 24, 2012), http://taxfoundation.org/legacy/show/27915.html.

[18] For a representative list, see Tax Foundation, 2014 State Business Tax Climate Index, Tax Foundation Background Paper No. 68 (Oct. 9, 2013), http://taxfoundation.org/article/2014-state-business-tax-climate-index.

[19] John Mikesell, The Disappearing Retail Sales Tax, State Tax Notes, Mar. 5, 2012, 777-791.

[20] Id.

 

Promoted Types: 
October 29, 2013

Chairman Dave Camp (R-MI) of the House Ways and Means Committee has pledged to offer a tax reform package that would significantly reduce corporate and individual tax rates (to 10 percent and 25 percent for individuals, and to a top rate of 25 percent for corporations) while remaining revenue neutral over the ten-year budget window. The revenue neutrality would be achieved by eliminating many of the tax preferences found on the tax expenditures list published by the Joint Committee on Taxation (JCT). This list measures deviations from a hypothetical “normal” tax system, based on the broad-based income tax, as defined by JCT.[1] Chairman Camp has also suggested that some consideration would be given to the revenues expected from faster economic growth, assuming the tax package would lead to a stronger economy.

The greatest difficulty in crafting such a package lies in the fact that many so-called tax expenditures are necessary to avoid various types of double taxation of saving and investment that are built into the broad-based income tax. The “normal” income tax routinely taxes income used for saving and investment more heavily than income used for consumption. These income tax biases damage growth.

Some of the major tax expenditures (including reduced tax rates on capital gains and dividends, all pension arrangements, and so-called accelerated depreciation) offset these biases to some degree. They either reduce rates directly or provide the equivalent of a tax rate reduction through their impact on taxable income. Repealing these tax expenditures would amount to a rate hike. To the extent that they offset the statutory rate reductions in the tax package, they will also offset any growth that the rate cuts are expected to produce.

One such adverse trade-off consists of switching from the current Modified Accelerated Cost Recovery System (MACRS) to the Alternative Depreciation System (ADS). Cost recovery is slower under ADS than under MACRS. In many cases, asset lives are longer under ADS, and for any given asset life, the depreciation write-offs are more back-loaded than under MACRS. Because the deductions for investment costs would be delayed, the present value of the write-offs (adjusted for inflation and the time value of money) would fall. Taxes would be shifted forward in time, and the after-tax returns on the investments would fall in present value. The result would be less capital formation, lower productivity and wages, and less GDP. The tax base would shrink, and much of the expected revenue from the change in cost recovery would be lost as other tax collections fell.

Any cost recovery system that falls short of immediate expensing denies an investor a tax claim for part of the cost of production. Profit is revenue less costs. Denying costs, in whole or in part, overstates real business profits. To that extent, the system is taxing revenue, not net income. It turns the tax, at least in part, into a gross receipts tax. Imagine the uproar if businesses were not allowed to fully and immediately deduct labor costs, the cost of raw materials, the cost of electricity for lighting or running machines, the cost of coal or natural gas for generating heat or power, or the cost of fuel for trucks, planes, or trains. That would clearly be an arbitrary violation of the concept of profit. Yet the income tax routinely subjects investment in capital assets to exactly that by making the business investor wait years or decades to claim the cost of plant, equipment, or buildings on his tax form.[2] We are so used to this practice that we forget what it means.

Unfortunately, slowing down the pace of cost recovery allowances is one of the biggest apparent revenue raisers on the JCT tax expenditure list. It grabs a lot of money in the first five years of its implementation as new investments get lower tax write-offs in their early years. Beyond that point, revenues begin to slip back toward current levels, because the deferred cost allowances on assets bought early in the period begin to catch up with the slowed depreciation on new investments.[3] Nonetheless, the switch from MACRS to ADS would appear to raise nearly $400 billion from the corporate sector over the budget window, enough to fund about 30 percent of the desired reduction in the corporate tax rate. ADS would raise about $250 billion from non-corporate businesses, helping to fund the individual rate reductions.

The Tax Foundation’s Taxes and Growth Model (TAG Model) estimates that GDP would rise by about 0.83 percent if the tax rates were simply lowered by the amounts that moving from MACRS to ADS would supposedly pay for, but without actually changing the cost allowances. Labor compensation (wage rate and hours worked) would rise by a roughly similar amount. However, actually adopting the switch to the longer asset lives to pay for the rate reductions would raise the cost of capital (in spite of the rate cuts). The combined effect on GDP growth would be a negative 0.95 percent. Labor compensation would decline by a similar amount. Instead of being revenue neutral, the reform would lose money for the Treasury. Worse, it would reduce incomes and employment for the public.

There may be a way around this difficulty, one that would offset the negative growth effects of shifting from MACRS to ADS. The solution is to modify ADS to retain more of the present value of the MACRS system while still allowing for slower write-offs during the budget window. Ideally, the modifications would go even further than matching MACRS, moving the present value of the write-offs nearer to the full cost of the investments. The ultimate adjustment would make them equal to one hundred cents on the dollar. That sort of full adjustment is called a Neutral Cost Recovery System (NCRS) because it treats all assets exactly alike, as they would be treated under immediate expensing. There is no distortion among assets and also no favoring of consumption over investment or of labor over capital. That is, capital expenditures would be treated as favorably as if they had been written off immediately, just as labor costs are written off. The rate reductions combined with NCRS could add more than 4 percent to GDP.

Table 1 shows the cost recovery deductions under several types of schedules. The asset in the illustration is a $100 machine expected to last five years. Inflation is assumed to be 2.2 percent (equal to the Congressional Budget Office forecast for inflation over the budget window). The time value of money for discounting deferred write-offs is assumed to be 5.45 percent.[4]

 

  • Under immediate expensing, the company buying the machine would deduct the full $100 cost in the first year and save $35 in tax in year one.
  • Under MACRS, the company deducts the $100 over 6 years, as shown.[5] The nominal write-offs sums to $100. However, at a 5.45 percent discount rate, the present value of the write-offs is $91.17. Costs are understated, and profit is overstated, by almost $9. The present value of the taxes the business saves is $31.91 instead of the $35 it would save if expensing were allowed, and so the after-tax cost of the machine is $3.09 (or 3.09 percent) higher than under expensing.
  • Under ADS, the write-offs would still sum to $100, but their present value would only be $87.85. The after tax cost of the machine would be higher under ADS than MACRS, and less investment would be undertaken.
  • However, if the ADS write-offs were adjusted (indexed) for inflation each year, their nominal values over the period would total $105.65. Yes, that is more than the $100 purchase price in nominal dollars, but that would just equal $100 in real money after inflation.[6] The inflation-indexed write-offs would equal $92.57 in present value (after adjusting for both inflation and a real discount rate of 3.25 percent). The present value would exceed that of an unindexed MACRS if inflation is 2.2 percent. The asset would appear more valuable than under MACRS, and investment would rise, not fall, in spite of the slower write-off pattern.
  • Alternatively, a more generous adjustment for the delay in the write-off would adjust the deductions each year for a market rate of interest, with a modest real return above inflation. In this example, we use the ten-year Treasury bond rate, equal to 2.86 percent as of this writing. The present value of the write-offs would be higher than adjusting only for inflation.
  • Interest rates are unusually low at the current time. The next line adjusts the write-offs for inflation plus 1.5 percent, which would be nearer to a normal real interest rate for a ten-year Treasury bond[7] and would yield a higher present value of the cost recovery.
  • A discount rate of inflation plus 3.25 percent, the long run real return on private sector capital, would fully reflect the opportunity cost of tying up money in an asset.[8] The present value in this case is equal to immediate expensing or $100 in cost deduction for the $100 machine. This would be full neutral cost recovery and would encourage the optimal, most efficient amount of capital formation in the economy.

Augmenting the cost recovery allowances in these ways would somewhat reduce the amount of tax revenue raised over the budget window compared to a switch to an unadjusted ADS. Table 2 shows the amounts collected over the budget window under the five scenarios using the conventional static scoring. Static scoring assumes no change in economic growth, GDP, and revenue gains from higher incomes.


If the Ways and Means Committee wanted to “pay” for these adjustments to ADS in a static sense, it could do so by phasing in the corporate or individual tax rate reductions over three or five years.[9] For example, the static revenue saving for a phase-in of just the corporate rate is shown in Table 2. A three-year phase-in of the corporate tax rate alone ($88 billion) could cover the static cost of adjusting both the individual and corporate ADS by inflation or by the Treasury bond rate. A five-year phase-in ($210 billion) could more than cover even the most generous scenario of full neutral cost recovery. If the rate cuts are phased in, then the full rate reductions in the unadjusted ADS case could be adopted and paid for with room to spare over the budget window even with the augmented ADS write-offs.
Inflation adjusting ADS would trim about 11 percent from the static revenue gain projected for the unadjusted switch to ADS in the budget window. Full neutral cost recovery would trim about 28 percent from the projected static gain. If the modified ADS systems are chosen, their budget window savings would pay for slightly less tax rate reduction than adoption of unmodified ADS.

The lower half of Table 3 shows the amount of corporate and individual tax rate reductions that could be funded in a static sense over the budget window by adopting ADS or the variations shown. For each case, it assigns all the static revenue (from Table 2) that is assumed to be raised in the budget window from the corporate side of ADS to be used to cut the corporate tax rate and uses the individual ADS savings to cut the individual tax rates. Except for the first column, which shows a rate reduction that is not “paid for,” these cuts would be revenue neutral over the budget period (but not necessarily beyond).

The upper portion of Table 3 shows the cumulative dynamic economic growth that would occur over time if these rates were adopted.[10] In the “Rate Cuts Only” column, the rates are cut by the amount that a switch to ADS would pay for, but without actually making the switch. In the “Offset by ADS” and later columns, the switch is assumed to be made. The static revenue numbers are annual figures for the long-run steady state, beyond the budget window, after the transition from MACRS to one of the alternative depreciation regimes. The dynamic revenue numbers reflect the annual long-run gains for the economy after all economic adjustments (about ten years out). These figures are after the initial revenue gains from the conversion to ADS are mostly dissipated. On a static basis, the augmented write-offs would appear to lose significant revenue in later years, while the unadjusted ADS would almost break even. However, on a dynamic basis, three of the four augmented write-off systems would either break even or raise revenue, while the unadjusted ADS would lose significant revenue. Full NCRS would raise revenues by nearly $58 billion a year.


Our TAG Model indicates that cutting the corporate and individual tax rates by the amounts shown without switching from MACRS to ADS would add 0.83 percent to GDP. Paying for that same amount of rate reduction by switching to ADS would reduce GDP by about 0.95 percent and would lose revenue due to the weaker economy. However, adopting the modified ADS systems would result in economic gains. Merely adjusting ADS for inflation would restore more than three-quarters of the growth lost by moving from MACRS to ADS and would result in a small net expansion of GDP. It would have a modest long-run revenue loss but that would be less than a third of the dynamic revenue loss under an unindexed ADS.
 

The three more generous adjustments to ADS would add more growth. Adjusting for inflation plus 1.5 percent would boost GDP by 1.81 percent. Full neutral cost recovery plus the rate reductions would add 4.07 percent to GDP. (See chart, above.) Labor compensation would rise by roughly the same amounts. Even with the cut in the tax rates, the added growth would eventually raise revenue on a dynamic basis above the levels that would occur under current law. (See Table 3, above.)

Conclusion

Slowing capital cost recovery to pay for an equal dollar amount of tax rate cuts over the budget window may appear to be revenue neutral in the near term. Unfortunately, this ignores any effects on economic growth. Slower cost recovery would overstate and overtax profits by effectively disallowing some of the cost of capital investment, which would discourage capital formation, reduce the growth of GDP and employment, and end up losing revenue near term and long term.

If the longer asset lives and slower write-offs are adjusted for inflation, or inflation plus a normal return on capital, the picture brightens considerably. The reform can still be revenue neutral during the budget window, but the incentive to invest would be greater than under current law, instead of lower. Capital formation would increase, not fall. The losses in GDP due to the restricted capital cost recovery would be reversed, GDP and personal incomes would rise, in some cases significantly. Such a reform could actually succeed in raising revenue and reducing the deficit longer term while increasing economic growth.

 



[1] It bears noting that there is some disagreement about what constitutes a “normal” income tax system and that any definition necessarily involves some arbitrary assumptions.

[2] It also makes businesses wait to declare the cost of inventory until it is sold. That is no problem for perishable groceries that sell in days. It is of more importance for items that stay on the showroom floor for months or years.

[3] The forecast revenues under ADS would never fall all the way back to MACRS levels. In a growing economy, investment outlays increase year over year, so the saving from the slower cost recovery would rise from one year to the next after all investments were converted over time to the ADS system.

[4] The 5.45 percent discount rate is equal to 2.2 percent forecast inflation plus a 3.25 percent long run real return to capital.

[5] The asset is assumed to have been bought mid-year. The company gets a partial write-off in the first year and takes the balance in the sixth year.

[6] This would not be “excess write-off” in any real sense. Current accounting practices ignore inflation, but inflation-adjusted write-offs would merely preserve the real value of the deductions.

[7] Use of a Treasury bond rate reflects the relatively risk-free tax saving from having a deduction. We use the mid-length bond in the example. One could instead use different Treasury rates on bonds of varying lives corresponding to the asset lives in question, such as the five-year bond rate for a five-year asset, a ten-year bond for a ten-year asset, and the thirty-year bond for 39-year or longer buildings.

[8] This consideration of the present value of a dollar of cost or tax over time is merely a recognition of the time value of money. Current accounting practices do not take the time value of money into account, but doing so for tax purposes would avoid distorting investment decisions and depressing capital formation.

[9] The Kennedy corporate and individual tax rate reductions were phased in over two years, 1964 and 1965.

[10] Again, if the rate cuts are phased in, then the full rate reductions in the ADS case could be adopted, and the growth estimates would be higher than shown here.

 

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