Three upcoming 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. law changes scheduled by the 2017 Tax Cuts and Jobs Act (TCJA)The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by .47 trillion over 10 years before accounting for economic growth. to help offset its revenue losses would be canceled by proposed legislation that would prevent the tax treatment of investment from worsening over the coming years.
|Requirement to amortize R&D expenses over 5 years||After the end of 2021|
|Limitation on Business Net Interest Deduction tightens to 30 percent on EBIT||After the end of 2021|
|100 Percent Bonus Depreciation begins to phase down||After the end of 2022|
1. Research & Development (R&D) Amortization
Starting in 2022, rather than fully deducting research & development (R&D) costs as has been the norm since 1954, companies will be required to amortize R&D expenses over five years. Amortization raises the marginal cost of investments and reduces growth in the long term by reducing the real value of the deductions to the business.
A bipartisan group of House policymakers introduced the “American Innovation and R&D Competitiveness Act of 2021” and a bipartisan group of Senators introduced the “American Innovation and Jobs Act.” Both would eliminate the five-year amortization requirement for R&D expenses, which would allow companies to continue fully deducting R&D expenses. The American Innovation and Jobs Act would also increase R&D 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. for small and start-up firms.
2. Tightening of the Business Net Interest Deduction
Prior to enactment of the TCJA, businesses were generally allowed to deduct their total amount of interest paid, subject to a few minor limitations like a debt-to-equity limit and not exceeding 50 percent of adjusted taxable income.
The TCJA introduced a limit on net interest expense to 30 percent of EBITDA (earnings before interest, taxes, 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. , and amortization) intended to reduce the tax code’s preference for debt over equity. Starting in 2022, the limit will narrow again to 30 percent of EBIT (earnings before interest and taxes).
The limits help put the tax treatment of debt and equity financing on a more level footing, as there is no deduction allowed for equity financing. The tightening of the limit from EBITDA to EBIT will further reduce the tax bias in favor of debt-financed investment and will have a small negative effect on the overall incentive to invest by increasing the cost of new investment.
The Permanently Preserving America’s Investment in Manufacturing Act, introduced by Senators Rob Portman (R-OH), Roy Blunt (R-MO), James Lankford (R-OK), and James Inhofe (R-OK), would maintain the limitation on the business interest deduction at 30 percent of EBITDA. This change would prevent the increased cost of borrowing and keep the interest limitation in line with the income definitions used abroad. However, lawmakers may want to consider reducing the limitation from 30 percent of EBITDA to a lower EBITDA threshold to offset the revenue loss from canceling the switch and further reduce the tax bias in favor of debt-financing.
3. Phaseout and Expiration of 100 Percent 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.
The TCJA enacted 100 percent bonus depreciation for short-lived assets to address a flaw in how the tax system treats investment costs. When a company calculates its corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. liability, it subtracts its costs from its revenue. However, companies are not allowed to immediately deduct all costs. Some assets are deducted over several years based on preset depreciation schedules—a building might be deducted over 39 years while an office desk might be deducted over seven years.
Because of inflation and the time value of money, the present value of write-offs under depreciation schedules is smaller than the original cost of the investment. This raises the marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. of capital which reduces investment, output, and wages in the long run. The TCJA’s 100 percent bonus depreciation temporarily remedies the issue for short-lived investments, but it will start phasing down after the end of 2022 until it expires entirely at the end of 2026.
The Accelerate Long-term Investment Growth Now Act (ALIGN), introduced by Senators Pat Toomey (R-PA) and Representative Jodey Arrington (R-TX), would make permanent the TCJA’s 100 percent bonus depreciation for short-lived assets. The Cost Recovery and Expensing Acceleration to Transform the Economy and Jumpstart Opportunities for Businesses and Startups Act (CREATE JOBS), introduced by Senator Ted Cruz (R-TX), would cancel R&D amortization and make permanent the TCJA’s 100 percent bonus depreciation for short-lived assets. It would also provide the economically equivalent treatment to long-lived assets, such as residential and commercial structures, by implementing a neutral cost recovery system (NCRS). Under NCRS, companies would continue taking depreciation deductions, but the real value of the deductions would be maintained through adjustments for 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 spending power. and the time value of money.
The three looming tax changes may act as a catalyst to a year-end tax bill that would address these and other year-end tax law expirations. Lawmakers should prioritize permanence for the parts of the code that are conducive to growth, neutrality, and simplicity.
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