Full Expensing is the Federal Government’s Best Investment in the U.S. Economy
January 9, 2017
With the elections over and Donald Trump the President-elect, the question becomes how Trump can fulfill his campaign promises. One of his promises is job growth in the U.S. But in an economy where below 2 percent growth has become normal, Trump will have to think creatively about stimulating the economy. Republicans have specifically said that the government should not pick winners and losers by giving tax credits to specific industries.
But what if the government could invest in the economy as a whole, similar to investing in an index fund instead of an individual company’s stock? Allowing businesses to expense the full value of capital expenditures, known as full expensing, has a similar effect to the government investing in a nationwide index fund.
Assume that each time a business purchases equipment or a building, the government purchases a portion of the equipment. For example, a bakery purchases a $1,000 professional oven for baking bread. The government tells the baker it will purchase $350 of the oven and the baker must provide the remaining $650. In return, the government receives a 35 percent stake in the oven, which gives the government 35 percent of all the capital income from the oven.
After paying for all the flour, utilities, facilities, and labor costs, the oven makes $200 per year for 10 years, at which point the oven must be retired. Each year the baker returns to the government $70 for its stake in the oven, and the baker keeps $130 for herself. Both the baker and the government receive 20 cents per year for each dollar they spent on the oven. Not a bad return for both investors.
If the government did not purchase the 35 percent share, the baker would have to pay the entire $1,000 for the oven. The baker would still receive $200 per year, but could keep it all for herself. Just as before, the baker receives 20 cents per year for each dollar spent. The baker receives the same income per dollar per year as she would with the government as a co-investor but has laid out $350 more than if the government were a co-investor.
Full expensing has a similar effect to the government directly investing in a portion of the equipment or building purchased by businesses. Assume the government has a 35 percent tax rate on business income along with full expensing. When the baker purchases a $1,000 oven, she can deduct the expense from her taxable income, which reduces her taxes by $350. This effectively returns to the baker $350 when she files her taxes.
Just as before the baker makes $200 from the oven each year. The baker pays her taxes, $70, and keeps the remaining $130 for herself. In both cases, the baker receives $130 after-tax per year for an investment of $650 after-tax rebate. Similarly, the government receives $70 per year but loses $350 initially. As such, full expensing with a tax is equivalent to an investment by the government without a tax.
Similar to an investment, if the business does better than expected, the government also benefits from the additional income. If artisanal bread becomes trendy in the first five years and doubles the returns to the baker, the government receives twice as much revenue from the oven as it did previously. Conversely, if an anti-carb movement decreases the demand for bread, reducing the baker’s income by half, the government also loses half the tax revenue from the oven.
Full expensing is advantageous because it generates tax revenues from a dynamic and growing economy without the distortionary effects of taxes on investment. Because any business can buy equipment or buildings, the government invests in all business activity throughout the U.S. economy, similar to an index fund investing in a basket of stocks that represents the entire stock market. In this way, the federal government becomes a co-investor with the American people as a whole, sharing both the gains and the losses from American entrepreneurship. Full expensing is effectively a win-win for both the government and the business community.
This is a different approach to economic stimulus than industry-specific tax credits or grants. These approaches are analogous to investing in a particular company. Tax credits only affect the industry they are targeting, favoring the growth of one industry over others. As such, full expensing avoids the problem of “picking winners and losers.”
In practice, businesses can expense equipment and building purchases through tax depreciation schedules, but this method of expensing requires businesses to pay the entire equipment and building costs upfront and receive a complicated schedule of deductions over time. Since this method requires the business to pay upfront but receive more profit in the future, the business must pay the additional expense of financing the upfront investment which would have been covered under full expensing. As such, the value of the tax depreciation schedule is much less than full expense and is not structurally equivalent to the government co-investing in the business.
If the baker is allowed to deduct $100 of value from the taxable income each year, then she can deduct the entire value of the oven over 10 years. But deducting the value of the oven over time changes the calculus for the baker. In this instance, the baker pays $1,000 upfront to receive $200 in income per year minus taxes. Taxes are 35 percent of $200 minus the $100 deduction for the oven, which amounts to $35. The baker takes home $165 of income a year after taxes. Thus, the baker makes 16.5 cents per dollar spent on the oven, 3.5 cents less than when the oven can be fully expensed.
However, full expensing has some problems. When a business does not have enough taxable income to deduct the entire cost of equipment and buildings, the government cannot effectively become a co-investor with the business. In this case, the ability of businesses to carry forward the deduction through net operating losses from year to year is necessary. In fact, it may require the government to index the remaining deductions for inflation so that the business receives the full advantage of full expensing.
In some cases, the federal government could consider refunding deductions above the taxable income of the business or allow larger companies to lease investments to small companies. For example, a baker purchases an oven for $1,000 but makes no money in the first year. In this case, the government or a leasing company could rebate the baker the $350. This option would help small, capital-intensive businesses develop positive cash flow immediately, spurring economic growth, but appropriate rules must be put in place to avoid fraudulent claims.
In practice, small businesses are able to fully expense equipment under section 179 of the U.S. tax code, but many small businesses do not have the income against which the business could deduct the cost of the equipment. Thus, small business owners often must wait until the business generates sufficient income to use the deductions, and inflation may reduce the overall value of the deductions.
Full expensing offers President-elect Trump a means of investing in America. If the rules are strategically designed, businesses will behave as if they are untaxed and the government will receive tax revenues from what is effectively an American index fund. As the U.S. economy grows, invests, and hires more American workers, the federal government reaps the benefits in tax revenue. As such, full expensing, which costs the federal government a little upfront, is the best investment the federal government can make in Americans, bar none.
To see the macroeconomic effects of switching to full expensing, check out the Tax Foundation’s Options Book.