One interesting dynamic in this year’s federal 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. reform debate is the divide between economists and some members of the business community over the merits of 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. – a policy that features prominently in the House Republican tax reform plan. While economists tend to be enthusiastic about the benefits of full expensing for economic growth, some companies argue that full expensing would not be as conducive to their investment or as helpful to their bottom line as a simple corporate rate cut. In this piece, I’ll make the case that full expensing remains a sensible, pro-growth policy, despite the financial considerations that might lead some companies to prefer a rate cut.
For some background: under the current U.S. tax code, when a business makes a capital investment – such as purchasing a machine or a factory – it is required to deduct the cost over a long time period, according to a set of depreciation schedules. There is strong reason to believe that this serves as a barrier to business investment, because businesses do not value 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 discouraging investment. deductions in the future as much as deductions in the present. As a result, many lawmakers have proposed moving to a system of full expensing – allowing businesses to immediately deduct the full cost of their investments – as a way of removing the bias against investment in the business tax code.
Despite the strong economic case for full expensing, it has never been a particularly popular policy among some members of the business community. In 2006, economist Tom Neubig wrote an article titled “Where’s the Applause? Why Most Corporations Prefer a Rate Cut,” in which he observed the tepid reaction of corporations to a Bush administration proposal for full expensing:
One might have expected that this plan – which many economists claim would result in a zero effective tax rate for new capital investment – would have inspired a standing ovation from corporate finance and tax officers. Instead, the response has been similar to the proverbial sound of “one hand clapping.”
The relative disinterest of some companies toward full expensing continues today. In particular, some businesses are known to claim that “full expensing doesn’t help our bottom line” or that “we don’t make investment decisions based on the timing of deductions.” That’s hard to square with our analysis, which concludes that full expensing would be one of the most effective tax changes for encouraging business investment and economic growth.
To understand the disconnect between economists and businesses here, it may be useful to veer from pure policy analysis and to examine the reasons why some companies may not be enthused about full expensing. Below, I’ve listed four main reasons why some corporations aren’t interested in full expensing – although none is particularly convincing from a policy perspective.
1) Some companies may be more interested in market share than growth.
Full expensing only benefits companies that are undertaking new investments in the United States. However, some businesses may not be interested in pursuing new investment opportunities; instead, they might be more focused on maximizing their profits from existing investments. For companies that are not seeking to expand their operations and grow their business, full expensing has less to offer.
For some large businesses, full expensing might even present a threat: it would make it easier for smaller competitors to scale up their operations and vie for market share. If a large business is primarily interested in preserving its market share, then it might naturally be wary of policies like full expensing, which would make it easier for competitors to expand.
While this is a perfectly understandable rationale for why a business might not be enthused about full expensing, it is not a particularly relevant consideration for policymakers designing a tax reform bill. If lawmakers are interested in promoting investment and economic growth, they should not be concerned if their tax reform bill delivers little benefit to businesses that are not focused on pursuing investments.
2) Full expensing does not provide a tax cut for past economic activity.
Some tax policies are structured in a way that delivers windfall gains to businesses with existing profits. For instance, a corporate rate cut to 25 percent would not only reduce taxes on business profits going forward, but would also reduce taxes on profits that result from investments made in previous years. Understandably, some companies prefer to receive tax cuts on past economic activity, especially if they have significant deferred tax liabilities that have not yet been paid.
Full expensing, on the other hand, does not automatically reduce taxes on profits earned by companies from past economic activity. Instead, full expensing only reduces taxes for companies that reinvest their past profits into the business; in other words, it only reduces taxes on new economic activity. For companies that would prefer to receive windfall gains on their current earnings, full expensing may not be an appealing policy.
Again, this is a reasonable position for a company to take, but not a compelling policy consideration. Lawmakers should not be concerned if a tax policy fails to deliver windfall gains to existing large companies; indeed, reducing taxes on profits earned in the past does little to encourage ongoing economic growth. Instead, lawmakers should focus on whether policies would fix distortions in the tax code going forward.
(One note: none of the above is intended to imply that a lower marginal corporate rate is not a worthwhile goal. Indeed, a lower corporate rate and full expensing would complement one another, as the two policies cost less in combination than they would separately.)
3) Some companies may already receive tax treatment close to full expensing.
Under the current tax code, businesses are subject to widely disparate tax treatment on their capital investments. A few categories of investments – such as research and development costs, advertising, and many other intangible assets – can be deducted fully and immediately. Other investments are subject to an array of depreciation schedules, ranging from three years (for certain short-lived equipment) to 39 years (for nonresidential buildings). These classifications and schedules are largely arbitrary, which means that some industries receive much more favorable tax treatment for their capital investments than others.
If you’re a company that happens to receive favorable tax treatment on your capital investments under the current tax code, then you might not have much to gain from a move to full expensing. For instance, companies that invest primarily in intellectual property might not be helped much by full expensing, given that much of their intangible investment is already fully expensable.
Of course, even though some companies would not benefit greatly from full expensing, the policy can still be worthwhile for the economy as a whole. After all, one of the main arguments for full expensing is that it would level the playing field among different industries, providing the greatest assistance to those industries most held back by the current system of depreciation.
4) Full expensing does not directly affect earnings-per-share on corporate financial statements.
Perhaps the most important reason why some large corporations are not interested in full expensing has to do with a quirky feature of how public companies report their profits to shareholders.
When a U.S. public corporation releases a financial statement to its shareholders, it generally does so using a set of accounting principles known as GAAP. These financial statements are taken seriously by shareholders, who use them to judge a company’s performance and evaluate whether to invest in it. Consequently, many companies also focus a great deal on their own financial statements, seeking ways to make sure that their income appears as high as possible. Importantly, one of the indicators that is included on a company’s financial statement is a measure of its “effective tax rate”: the total current and deferred tax liabilities that a company accrues over the course of the year, divided by its income.
However, when calculating effective tax rates, the GAAP system requires companies to essentially ignore the difference between deductions claimed in the current year and deductions taken in the future. In effect, the GAAP system pretends that firms have a discount rate of zero percent, for the purposes of accounting for the timing of tax payments. As a result, policies that allow companies to take more deductions in the present do not have any impact on a firm’s effective tax rate or earnings-per-share, according to GAAP.
This is especially relevant in the case of full expensing, which shifts all of a company’s deductions for its investments into the current year. Even though full expensing would greatly increase the present value of deductions for capital investment, the GAAP system treats it as having no effect on a business’s bottom line.
Because some large corporations measure their success by looking at their GAAP financial statements, these businesses sometimes perceive full expensing as having little benefit to them. Instead, these companies often advocate for tax policies that would directly lower their GAAP effective tax rate, such as rate cuts and tax creditA tax credit is a provision that reduces a taxpayer’s final tax bill, dollar-for-dollar. A tax credit differs from deductions and exemptions, which reduce taxable income, rather than the taxpayer’s tax bill directly. s. In a 2012 congressional hearing, Michelle Hanlon, an accounting professor, pointed directly to this dynamic:
When asked, corporate management will often reveal a preference for a rate cut over 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 several reasons, one of which is that there is no reduction in income tax expense on the income statement but there would be with a rate cut.
What should lawmakers make of the phenomenon where businesses claim not to care about the timing of deductions for capital investments? When taken to the extreme, this claim is difficult to believe. Very few companies would reasonably be indifferent to a $1 million deduction today versus a $1 million deduction in 50 years, nor would they be able to claim that their shareholders are blind to this distinction.
More importantly, lawmakers should not evaluate tax policies through the idiosyncratic lens of accounting principles. If the tax code is biased against investment, then lawmakers should fix this bias, regardless of whether it is salient to large, public corporations. The current corporate tax punishes companies for undertaking new investments – and whether this bothers businesses, it is still a distortion that should be removed from the tax code.
The Constituency of Full Expensing
The other day, a reporter asked me, “Other than well-meaning economists, who is the constituency for expensing? And why aren’t they more vocal regarding the benefits thereof?” He might has well have been asking, “If full expensing is such a great policy, why doesn’t it have a larger constituency?”
I’m not entirely sure of the answer, but allow me to speculate: if full expensing seems not to have a vocal constituency, it is because the true constituency of full expensing is businesses that aren’t yet large enough to be heard.
The companies that would benefit the most from full expensing are those that haven’t been able to expand their operations due to cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. barriers in the tax code; firms that are driven into the red because they are taxed on accrued income in years where they receive no cash flow; and businesses that have wasted thousands of hours figuring out the appropriate depreciation schedules for their assets. Because full expensing is a pro-growth policy, the constituency most likely to embrace full expensing is companies that haven’t yet grown.
As the tax reform debate continues, lawmakers are likely to keep hearing from companies that don’t think expensing would benefit their bottom line. In these cases, lawmakers should remember that the tax policies that benefit particular businesses are not necessarily the same as those that benefit the economy as a whole.
Update, 6/21/17: Post edited for clarity.