Goldman Sachs Analysis of House GOP Blueprint is Questionable
December 5, 2016
As the tax reform debate begins to heat up, businesses and investors are beginning to pay closer attention to the House GOP Tax Reform Blueprint, a tax plan released last June by Speaker Paul Ryan and House Ways and Means Chairman Kevin Brady. The Blueprint is designed to encourage business investment and generate economic growth, and independent analyses from the Tax Foundation and the Tax Policy Center have concluded that it would have a positive effect on investment and the U.S. economy.
However, last week, Goldman Sachs released a more pessimistic analysis of the House GOP Tax Reform Blueprint. The report evaluates two key provisions of the GOP plan: allowing full expensing of capital investments, and eliminating the deductibility of net interest. Surprisingly, the report concludes that these two provisions, taken together, would have a negative impact on business investment in the long run.
Nevertheless, there is reason to take Goldman’s recent report with a grain of salt. Specifically, several of the assumptions in the “user cost of capital” model employed by the Goldman analysis are questionable.
The analysis assumes a constant debt-equity ratio
The two provisions evaluated by Goldman Sachs would have opposite effects on investment. Full expensing of capital investment would lower the cost of equity-financed investment, while eliminating net interest deductibility would raise the cost of debt-financed investment. The relevant question is how to weigh the magnitude of these two effects, to determine which predominates.
The Goldman Sachs analysis begins by calculating how the cost of funding for equity-financed and debt-financed investment would change under the House GOP tax plan. However, it averages the two figures together, weighted by businesses’ current mix of debt and equity funding.
This is a serious methodological flaw. The House GOP plan is designed to remove the tax bias for debt over equity, but the Goldman analysis assumes that businesses would continue to finance their operations in exactly the same way. In reality, it is likely that if the House GOP plan were passed, businesses would become significantly less leveraged. As a result, the Goldman analysis overemphasizes the role of debt capital in determining the overall cost of business investment.
The analysis overstates the importance of debt finance in determining the capital stock
There is reason to believe that equity finance is generally more important than debt finance in determining business investment levels. Unlike bondholders, equity holders bear the bulk of the risk of marginal capital investments.
In fact, normal business practice is to first evaluate potential investments using a firm’s internal discount rate, and only afterward to determine whether the investment will be funded through borrowing, retained earnings, or another funding source. Businesses’ internal discount rates are often much higher than market interest rates, and are often in excess of 10 percent. In other words, the constraining factor on business investment is generally whether a potential investment makes a large enough after-tax return to satisfy the discount rate of equity holders, not whether the investment will be able attract debt financing at a low enough interest rate.
This is why the Tax Foundation’s macroeconomic model assumes that businesses make investment decisions solely based on their internal discount rate, rather than market interest rates. We believe that all economic models should assign a higher weight to the cost of equity capital than the cost of debt capital.
The analysis assumes that bonus depreciation is permanent policy
Under current law, companies can expense, or deduct, 50 percent of qualifying investments against their taxable income in the first year. This provision, called bonus depreciation, allows companies to recover more of their investment costs and moves the tax code closer to full expensing. However, this provision—bonus depreciation—is set to phase out over the next three years, which will lengthen asset lives and move further from full expensing.
Goldman assumes that absent any major tax change, Congress would continue to extend 50 percent bonus depreciation indefinitely. This causes Goldman’s analysis to show a smaller impact from moving to full expensing, because its baseline tax code already includes bonus depreciation, a partial step toward full expensing.
While it is plausible that Congress will extend bonus depreciation indefinitely, there is still a good amount of uncertainty around the future of the provision. In fact, that uncertainty in and of itself can have a negative impact on investment behavior and limit the benefit of the provision.
Because the future of bonus expensing is unclear, it would be more appropriate to take this uncertainty into account by excluding bonus depreciation from the baseline after its expiration, as is the practice of the Joint Committee on Taxation, the Tax Foundation, and the Tax Policy Center. If Goldman had adopted this baseline, its results would show a larger impact from moving to full expensing.
The analysis ignores taxes on individual investors and lenders
While the House GOP tax plan would deny businesses a deduction for net interest expense, it would also lower the marginal tax rate on individual interest income from 39.6 percent to 16.5 percent. These two provisions of the plan are inextricably linked, as the plan is designed to “flip” the tax treatment of interest.
However, the Goldman analysis only examines the effects of eliminating interest deductibility, not the effects of lowering taxes on interest income. This is an important detail, because reducing taxes on individual interest income will lead lenders to demand lower interest rates from businesses, lowering the cost of debt-financed capital, and counteracting the effect of eliminating interest deductibility.
In general, “user cost” analyses should not leave out individual-level taxes on capital income.