Expensing: The Right Tax Treatment for All Investment Regardless of Financing Arrangements
October 1, 2015
A number of candidates for the Republican nomination for President have released tax proposals that include a provision to allow businesses to deduct the full cost of plant and equipment as soon as it is purchased. This is called “immediate expensing,” or just “expensing.” Under current law, businesses must take depreciation allowances (capital consumption allowances) that stretch the recognition of the costs over several years, or even decades. The delay in claiming the costs overstates current profits and accelerates tax collections. Delayed depreciation raises the cost of plant and equipment, discourages capital formation, and depresses productivity and wages. Expensing would correct that flaw in the tax system, and would boost investment, productivity, and wages. It is a powerful force for economic growth.
Permanent expensing is a key part of a pro-growth tax reform. It is far more effective than the on again – off again bonus expensing on equipment that has been tried since 2003. If applied permanently, expensing would influence the cost benefit analysis behind businesses’ long term expansion plans. The Tax Foundation Taxes and Growth Model (TAG) calculates that enacting full expensing for equipment and buildings could add more than five percent to GDP over time, and more than sixteen percent to the capital stock. It would boost wages by 4.5 percent, and create nearly a million full-time equivalent jobs. After a few years, federal revenue would be higher than under current law due to the added economic growth. Even advocates of deficit reduction or more federal spending should favor expensing.
Fly in the ointment?
Some admirers of the current income tax system might reluctantly tolerate expensing in the case of an asset bought with a business’s own money (equity finance) but not if the asset is bought with borrowed money (debt finance). They worry that the business would get to deduct both the cost of the asset and the interest on the borrowed money. They fret that this could result in a “negative tax rate” on the business. In fact, this is not a problem. To see why not, consider the two cases, equity and debt.
Equity: If a business buys as asset with its own money, it would expense the investment outlay and pay tax on all the earnings of the asset over time. Assuming the business has been around awhile, its revenues from previously installed capital assets would generally exceed current investment in new ones. New investment would be less than current revenue, and the deduction could be taken in its entirety right away. In rare cases, if a big new investment exceeded current revenue, creating a net operating loss (NOL), the loss could be carried back to previous tax returns (up to two years), or deferred until later years (up to twenty years, after which the loss is disallowed). This is seldom a problem.
Debt: In the case of an investment bought with borrowed money, the interest cost and the expensing of the asset cost are more likely to exceed current earnings, resulting in a zero taxable income and the need to defer taking some of the deduction (carry forward a NOL). In addition, 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.)
In practice, taxing some of the income from a debt-financed investment on the lender’s tax form and applying all of the capital expense to the investor’s tax form can, for a time, cause the business’s taxable income to go to zero before all the costs are included, and create a NOL. The business may have to defer a portion of its expensing allowance until a later year in which investment is less or revenues are higher. Having to wait to receive credit for the cost is not a loophole, it is a hindrance. The supposed fly in the ointment is a false lure to catch the unwary or timid tax reformer.