The House and the Senate 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. bills restrict the deduction of business interest. Each bill limits the deduction to 30 percent of “modified income” with carryover of the excess to later years. Unfortunately, the Senate definition of “modified income” is much lower than in the House bill, and it undercuts the investment incentive provided by the expensing provision.
The House definition is basically gross incomeFor individuals, gross income is the total pre-tax earnings from wages, tips, investments, interest, and other forms of income and is also referred to as “gross pay.” For businesses, gross income is total revenue minus cost of goods sold and is also known as “gross profit” or “gross margin.” . Gross income is EBITDA, which stands for “earnings before interest, taxes, and 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.” Firms may deduct up to 30 percent of EBITDA before facing the limit.
The Senate bill puts the limit at gross income less depreciation and amortization, or EBIT. Firms must subtract depreciation and amortization to calculate the income ceiling. The result:
- This is a lower number, and the interest deduction would be more constrained.
- Worse, if a firm increases its investment, its depreciation rises, and the limit becomes tighter. The act of investment may cost a firm a portion of its interest deduction.
- Worse yet, this might happen even if the new investment is done with cash from current sales, or repatriated profits from abroad, or proceeds from new share issues, without any new borrowing. It would penalize past investment funded by old debt.
- Worst of all, it undercuts the investment incentive of the expensing provision for equipment. It also undermines the Senate bill’s granting of a lower, 25-year asset life to new buildings and other structures, which would do wonders for construction, factory creation, transportation, and urban redevelopment.
The Senate’s unwarranted attack on depreciation may stem from the erroneous concern, prevalent in tax circles, that one should not allow interest deductions when expensing is available, for fear of “negative tax rates.” This concern comes from a misunderstanding of the size and nature of returns on ordinary investment, and disregard of the taxes paid by the taxable lenders who set interest rates in the market. The earnings stream from the investment is taxed appropriately, some on the borrower’s tax return, some on the lender’s.
The concern is debunked in my article “Expensing: The Right Tax Treatment for All Investment Regardless of Financing Arrangements.”
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