Expensing Concentrates the Corporate Tax Burden on Economic Profits

The One Big Beautiful Bill Act (OBBBA) improved the corporate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. system with permanent bonus depreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. for machinery and equipment investment and immediate expensing for research and development (R&D) costs. But now, as scrutiny over data center investment and AI rises, some commentators are concerned about how expensing interacts with these ongoing investments. Most of these concerns misunderstand what expensing does. Expensing stops the tax code from discouraging marginal investment, but it doesn’t subsidize investment that isn’t worthwhile on its own merits, nor does it eliminate taxes on profitable projects.

Full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. allows firms to immediately deduct what they expend on capital investment in the same year the capital investment starts being used. Aligning the timing of the deduction to the timing of the expense preserves its full value; firms fully recover investment costs, as opposed to taking deductions over time and experiencing the erosion brought on by inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spendin and opportunity cost. This treatment eliminates the burden of the tax system on the normal return to investment, the amount needed to break even. It does not eliminate tax on the supernormal return, which arises when firms earn economic profits.

Imagine two firms that each undertake a $100 investment in a world of 2 percent inflation and a 3 percent real discount rate (which we approximate with a 5 percent rate for simplicity).

Firm A’s investment will just break even, returning $105 in year 2, equal in present value terms to the $100 upfront cost. It’s a marginal investment, and the firm wouldn’t undertake it if the tax system imposed a burden on marginal investment. Firm B’s investment will earn economic profits, returning $110 in year 2. It is not a marginal investment, but is something so profitable the firm would undertake it even under a biased tax system.

Table 1. Before Taxes, Firm A Breaks Even and Firm B Earns an Economic Profit

Source: Author’s calculations.

Now we’ll add taxes, using the 21 percent corporate tax rate and an illustrative depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and disco system that requires the firms to use straight-line depreciation over the two-year period, deducting $50 in year 1 and the remaining $50 in year 2. Firm A’s investment broke even before taxes, but the requirement to delay depreciation deductions imposes a tax burden on the normal return to investment, making the project no longer pencil out. Firm B still clears a profit, even in the presence of depreciation.

Table 2. Delayed Depreciation Deductions Turn Firm A’s Break-Even Investment Unprofitable

Source: Author’s calculations.

Waiting to take the depreciation deduction in year 2 reduces its real value: the $10.50 of tax savings in year 2 ($50 depreciation deduction x 21 percent corporate rate) is only worth $10.00 today. This erosion in the real value of the deductions flips Firm A’s after-tax net present value negative, while it costs Firm B $0.50 of its after-tax net present value.

But if the tax system instead permitted the firms to deduct the investment cost upfront, the tax burden on the break-even investment would be eliminated. Firm A would break even, while Firm B still earns a profit of $3.76 in present value, down $1.00 from the no-tax scenario and up $0.50 from the depreciation scenario. Expensing concentrates the tax burden on the supernormal returnSupernormal returns are payoffs to investment greater than the typical market rate of return. They are often approximated as company profits that exceed 10 percent. This additional return on capital or labor is above breaking even on an investment relative to the amount of risk and time that investment required. (21 percent of $4.76) and leaves the normal return untaxed.

Table 3. Full Expensing Restores Firm A’s Break-Even Investment

Source: Author’s calculations.

Expensing would not make an unprofitable investment worthwhile. For example, consider Firm C, with the same $100 upfront investment cost but a return of $104 in year 2. In present value, the project loses $0.95 before taxes. Under full expensing, it would still lose $0.75, so Firm C still would not invest. Expensing makes the tax code neutral toward investment; it does not turn a pre-tax loss into an after-tax gain (see the discussion on potential interactions with interest deductions below).

Table 4 separates each firm’s tax into the normal and supernormal return components. Depreciation taxes both, while expensing removes the burden on the normal return and places it entirely on the supernormal return. Expensing thus removes most of the corporate tax’s adverse impact on economic efficiency and growth, while still generating revenues from projects with positive economic profits.

Table 4. Expensing Removes the Tax on the Normal Return but Still Taxes Economic Profit

Note: All values in present value. $100 invested in year 1; 21 percent tax rate; 5 percent discount rate. Depreciation deducts $50 in year 1 and $50 in year 2.
Source: Author’s calculations.

Some argue that in the presence of deductions for business interest paid, full expensing more than eliminates the burden on the normal return and leads to negative effective tax rates. Under the current tax code, business interest deductions are limited to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA). Further, the concern over negative effective tax rates typically excludes consideration of the tax that applies to the interest income received by lenders, as Stephen J. Entin explains for Tax Foundation:

Some students of taxation claim that the two deductions result in a negative tax rate on some businesses, because between the two write-offs the business would appear to be writing off more than the cost of the asset. But that argument looks only at one side of the financial transaction (the borrower’s side) and misses a key point. The interest payment deducted from the borrower’s income is added to the lender’s income. Looking at lender and borrower together shows there is no excess deduction. Some of the earnings of the asset are passed on to be taxed on the lender’s tax form instead of on the business’s tax form. The earnings are still taxed. There is no negative tax on the investment and its returns. (Note: some limited lending comes from tax exempt groups, but their endowments are relatively inflexible and are not generally funding new investment, at the margin, which determines the amount of capital formation. The issue with the non-taxable entities is whether they deserve that status; it is not a reason to avoid expensing.)

As Entin explains elsewhere, simply disallowing interest deductions while still taxing lenders on the interest they receive would lead to double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income.. Consistent reform of interest deductions would move toward cash flow taxation: either disallowing deductions for borrowers and excluding interest income for lenders, or the reverse, permitting deductions and ensuring full taxability. But reforming the treatment of interest is not a prerequisite for a tax system built on expensing.

Expensing is the right policy because it eliminates the tax burden on the normal return to investment—the margin that matters most for growing the capital stock—and it concentrates the burden of the corporate tax on economic profits. Profitable data center investment may be like the economic profits case, and expensing still taxes its economic profits in full. Expensing does not make a higher corporate tax rate fully harmless, as the statutory rate and the burden on supernormal returns affect incentives for profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens. and innovation, but it right-sizes the corporate tax system.

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