The latest version of the Biden Build Back Better agenda, released last week by the House Ways and Means committee (see our estimates of the budgetary, economic, and distributional impacts), is dense, with too many provisions to flesh out completely. Here’s a rundown of the good, the bad, and the ugly of it.
R&D 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. Improvement
Most provisions in the Ways and Means package would raise the cost of capital, thus reducing both the incentive to invest and long-term productivity growth. Two provisions, however, would improve the 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. treatment of investment, albeit temporarily.
The first is the delay of the requirement to amortize research and development (R&D) expenses. Historically, firms have been able to deduct the cost of R&D the year it is incurred. However, the 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. of 2017 included a requirement that R&D expenses be amortized over five years after 2021. With the impact of 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, companies would not be able to deduct the full real value of their R&D investments. This would create a disincentive for investment in R&D, which would in the long run reduce productivity growth and living standards as companies would put less money towards innovation-driving activity.
The Ways and Means plan would postpone the amortization requirement for four years, until 2026. A temporary delay is not the ideal policy, which would be to make R&D expenses fully and immediately deductible on a permanent basis. But at least the Ways and Means proposal would give policymakers a chance to make it permanent down the road.
Permanence and Stability (for Some Things)
The proposal makes several policies permanent, reducing uncertainty for taxpayers. Recent changes to the Earned Income 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. (EITC) and the Child and Dependent Care Tax Credit (CDCTC) would become permanent, as would the New Markets Tax Credit (NMTC, which has needed to be renewed several times since its enactment in 2000).
The programs have mixed merits. Some, like the EITC, might be better-suited as spending programs rather than tax code provisions. Others, like the NMTC, ought to be eliminated entirely, or, like the CDCTC, would overlap with new spending proposals for childcare and be duplicative. Nonetheless, if the provisions go into effect, it makes sense to follow the core principle of stability.
Repealing Expense Allocation for GILTI
Expense allocation rules require that certain domestic expenses of U.S. multinational enterprises (MNEs) be partly reclassified as foreign expenses, which results in some foreign taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. getting reclassified as domestic taxable income. Then, if U.S. MNEs face a higher corporate tax rate abroad than at home, they end up having to pay domestic as well as foreign corporate tax on that income. The Global Intangible Low-Tax Income (GILTI) provision in the TCJA interacted poorly with this policy, expanding the frequency of this kind of double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. . The Ways and Means plan would repeal expense allocation rules for GILTI.
Raising the 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. Rate to 26.5 Percent
The Biden proposal would raise the top corporate tax rate to 26.5 percent, while creating three tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s for corporations: 18 percent for corporations with under $400,000 in net income, 21 percent from $400,000 to $5 million in net income, and 26.5 percent over $5 million.
Although an improvement over the Biden administration’s proposals to raise the rate to 28 percent, a 26.5 percent rate would still have significant costs. A higher corporate tax rate will reduce capital investment by reducing the potential returns to new projects. In the long term, that results in lower productivity growth and lower wages, and increased incentives to shift profits and move headquarters out of the United States.
Raising Top Income and Capital Gains TaxA capital gains tax is levied on the profit made from selling an asset and is often in addition to corporate income taxes, frequently resulting in double taxation. Capital gains taxes create a bias against saving, leading to a lower level of national income by encouraging present consumption over investment. Rates
The plan raises the top 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. on individual income from 37 percent to 39.6 percent and the top marginal tax rate on long-term capital gains and dividends from 20 percent to 25 percent. It then adds a 3 percent surcharge on income above $5 million for a married household (or $2.5 million for an individual filer) and expands the base of the 3.8 percent Net Investment Income Tax (NIIT) to include active pass-through businessA pass-through business is a sole proprietorship, partnership, or S corporation that is not subject to the corporate income tax; instead, this business reports its income on the individual income tax returns of the owners and is taxed at individual income tax rates. income. When including state and local taxes, the top marginal federal-state tax rate on capital gains would average nearly 37 percent, and on pass-through business income, would exceed 50 percent in most states. These tax increases reduce incentives to save, invest, and work, resulting in a smaller economy and fewer job opportunities.
Higher Tax Rates for GILTI and FDII
The GILTI policy created a minimum 10.5 percent tax on foreign income deemed attributable to intangible assets (defined as income in excess of a 10 percent profit from tangible assets). While intended to impose a minimum tax in the range of 10.5 to 13.125 percent, the effective tax from GILTI can exceed this. GILTI provides a penalty for booking profits abroad, but the TCJA also created a positive incentive to book profits in the U.S. with the Foreign-Derived Intangible Income (FDII)Foreign Derived Intangible Income (FDII) is a special category of earnings that come from the sale of products related to intellectual property (IP). If a U.S. company holds IP in the U.S., such as patents or trademarks, and has sales to foreign customers based on that IP, the profits from those sales face a lower tax rate. deduction, providing a 13.125 percent tax rate on this income if booked in the U.S. Combined, the lower corporate tax rate, the incentive from GILTI, and the incentive from FDII substantially reduced profit-shifting incentives for U.S. multinationals.
The Ways and Means bill would raise the GILTI tax rate to 16.5 percent and make several modifications to its structure. Similarly, the bill would raise the tax rate for FDII to 20.7 percent.
There are many ways the U.S.’s international tax rules could be changed, good or bad. Increasing tax rates on U.S. MNEs does not necessarily accomplish the goal of reducing or eliminating 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 it would in fact worsen it, primarily due to the higher FDII rate. A well-designed international tax reform proposal should alleviate, not exacerbate, such problems.
Selectively Protecting the Pledge
The Ways and Means proposal is designed to be consistent with the Biden administration’s promise not to raise taxes on taxpayers earning below $400,000. The biggest problem with the approach is that it focuses solely on the legal incidence of taxes and not the economic. But by aiming to keep the pledge in terms of direct taxA direct tax is levied on individuals and organizations and cannot be shifted to another payer. Often with a direct tax, such as the personal income tax, tax rates increase as the taxpayer’s ability to pay increases, resulting in what’s called a progressive tax. increases, the plan has some very strange design in several areas, while effectively ignoring it in others.
For example, the proposal to double excise taxAn excise tax is a tax imposed on a specific good or activity. Excise taxes are commonly levied on cigarettes, alcoholic beverages, soda, gasoline, insurance premiums, amusement activities, and betting, and typically make up a relatively small and volatile portion of state and local and, to a lesser extent, federal tax collections. es on tobacco would certainly run afoul of the promise not to raise taxes on people earning below $400,000. Indeed, tobacco taxes are among the most regressive. In addition, by attempting to establish neutrality across products, the policy would ultimately disincentivize much less harmful forms of nicotine consumption and thus worsen public health.
On the other hand, the approach to not directly raise taxes on people earning below $400,000 results in tortured design of certain tax changes like expanding the base of the NIIT. The 3.8 percent tax currently applies to some types of investment income when single taxpayers make more than $200,000 ($250,000 joint), but not all types. The proposal would apply the tax to currently-excluded types of income above $400,000 for single taxpayers ($500,000 for joint filers), leaving a gap between $200,000 and $400,000 where some types of income would still not face the 3.8 percent tax.
A New Tax Credit in Every Pot
For every temporary tax credit that the bill eliminates or makes permanent, it creates at least four new credits (22 in total), while expanding existing (often temporary) ones. For example, it would expand the existing Low-Income Housing Tax Credit and create a separate credit directed at housing construction, even though credits are not the most efficient tax change for creating new housing. Similarly, while some energy credits are simpler than existing policy, the inclusion of prevailing wage and apprenticeship requirements is especially bureaucratic, and unrelated to the goal of reducing carbon emissions.
Drug Price Controls
The House Democrats’ bill includes a provision to allow the government to set prescription drug prices under Medicare Part D. To enforce the set prices, it would include a steep excise tax on sales from manufacturers who do not submit to the negotiated prices: up to 1,900 percent in some cases, making it prohibitive to not participate in the Medicare price control regime. While this program would reduce government spending on prescription drugs, it would also reduce the long-term incentives to invest in medical R&D by shrinking potential future returns. According to the Congressional Budget Office (CBO)The Congressional Budget Office (CBO) provides nonpartisan analysis to the U.S. Congress on federal economic and budgetary matters. , a drop in pharmaceutical company revenue from such a provision would lead to eight to 15 fewer new drugs entering the market over the next decade. Meanwhile, former CBO director Douglas Holtz-Eakin argues that the CBO’s current estimates are closer to the best-case scenario for this proposal’s impact on pharmaceutical innovation.
Lower drug prices would be nice, but not at the expense of fewer drugs and less innovation.
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