Paying for Tax Reform without Selling the Farm

October 31, 2013

Everyone knows the U.S. has high tax rates on business and that these rates need to come down. But just as importantly is what the U.S. tax code classifies as income. Currently the tax code has a heavy bias against savings and investment. While there are tax expenditures that try to correct for this, looking at tax reform from a revenue neutral, “blank slate” perspective, starts the debate with the wrong slate.

To help pay for the revenue neutral rate cuts to 25 percent, one tax provision that could be considered as a source of revenue is depreciation (the schedule under which businesses can claim business expenses). Moving from the Modified Accelerated Cost Recovery System (MACRS) to the Alternative Depreciation System (ADS) for corporate and non-corporate businesses would stretch out a business’s write-offs for investments over a longer period of time and raise $641 billion in revenue for the Treasury, but would result in lower investment at the firm level and economy wide.

This is because depreciation generally overstates profits and understates expenses and allows inflation to cut away at a business’s cost recovery. This leads to a larger tax bill for a business than would occur under the correct definition of income (revenue less costs).

But in a recent paper, our senior fellow, Stephen Entin, presents a solution to finding the revenue we need without damaging the economy. It’s called the Neutral Cost Recovery System (NCRS).

NCRS modifies ADS to retain more of the present value of the MACRS system while still allowing for slower write-offs during the budget window.

Full NRCS would eliminate the bias against savings created by the current depreciation schedules, specifically preventing the additional damage that a shift to ADS would cause. It does this by using the ADS system, but accounting for inflation and the real discount rate (which represents the opportunity cost of the capital invested into equipment, buildings, and machinery instead of something else).

In the end, NCRS treats investment neutrally, granting businesses 100 percent cost recovery on their investments, even under the longer depreciation schedule. Unfortunately, NCRS would bring in $179 billion less in revenue than ADS. But this isn’t as much of a problem as it would initially seem.

One solution would be to phase in the corporate rate cut as so many international countries have done. If Congress were to phase in the corporate rate cut over three years, it would save $88 billion. If it were to phase in the rate cut over five years, it would save $210 billion and completely pay for NCRS, with money to spare.

More crucial than revenue, though, it’s important that tax reform achieves the economic growth the economy needs. A lower tax rate for businesses is a big part of that goal, but in order achieve maximum growth, the tax code needs to move towards neutrality, not away from it. There are solutions to achieve tax reform without wrongly defining income; neutral cost recovery and a phase in on tax rate cuts for businesses are possible solutions.

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