Pennsylvania’s New Penalties on Investment Could Scare off Amazon, Others

February 2, 2018

Amazon shortlisted both Pittsburgh and Philadelphia as potential locations for its new headquarters, but a week before Christmas, the state Department of Revenue made both bids much less attractive, not just for Amazon HQ2, but for all businesses. While other states are positioning themselves to attract new investment, Pennsylvania quietly adopted a policy—by way of a Department of Revenue bulletin—which heavily penalizes investment in the state.

House Bill 2017 should not have been necessary. It addresses an issue that need not have existed. Given the Department of Revenue’s December tax bulletin, however, it is now a matter of urgency.

Corporate income taxes, at both the federal and state level, are intended to be levied on net income. To that end, deductions are allowed for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business” (IRC § 162(a)). This is why there are deductions for compensation and for costs of goods sold, and for paying down debt. The major outlier is capital expenditures, where depreciation deductions are taken instead.

By allowing an immediate deduction for other business expenses, but not for capital expenditures, the tax code disincentivizes investment. Inflation erodes the value of these tax deductions, so they wind up understating the cost of the equipment and overstating corporate returns. We have estimated that, over time, corporations are only able to deduct about 87 percent of costs of investment.

Depreciation schedules also do a poor job of aligning with the real world: equipment may become outdated, and thus subject to replacement, long before it physically wears out.

Faster cost recovery favors the future over the past, whereas long depreciation schedules benefit companies that aren’t actively investing or creating jobs. Improvements on cost recovery also equalize the treatment of different types of investment, avoiding distorting economic decision-making.

For all these reasons and many others, accelerated cost recovery has been an important goal of tax reformers for years. It is a highly pro-growth policy. At the federal level, there have been many changes to depreciation over the years, but the two most pertinent ones are the introduction of so-called “bonus depreciation,” which allowed 50 percent of the cost of short-lived assets, like machinery and equipment, to be deducted in the first year, and the full expensing for those same short-lived assets, provided for in the new tax law.

Pennsylvania, like many other states, chose to decouple from federal bonus depreciation rules for revenue purposes. Now, while other states are deciding whether to conform to the new full expensing provisions, Pennsylvania is having a very different debate: whether to treat machinery and equipment purchases worse than other investments, and indeed worse than such investment is treated in any other state.

The bonus depreciation addback statute is not a model of clarity. I don’t think there’s any doubt that the legislative intent was to require companies to add back the accelerated depreciation and instead operate under traditional depreciation schedules. That’s the interpretation the Department of Revenue has operated under until now.  In December, however, the Department of Revenue issued a tax bulletin adopting a new interpretation yielding a policy result that few, if any, would champion.

Under the new interpretation, the full deduction must be added back for investments subject to bonus depreciation—or, now, full expensing—at the federal level. Businesses would no longer even receive the depreciation deductions, substantially raising the cost of investment in Pennsylvania.

Both Pittsburgh and Philadelphia are finalists for Amazon HQ2. It’s hard to imagine that the tech giant would be enthusiastic about a policy that dramatically overtaxes investment. Such a policy, though, affects companies of all sizes, particularly those involved in manufacturing or other machinery-intensive operations. No other state penalizes investment the way that Pennsylvania does following the issuance of that tax bulletin.

House Bill 2017 is designed to resolve the existing statutory ambiguity and restore depreciation deductions for machinery and equipment. It does not provide for the old bonus depreciation regime, let alone full expensing. It merely restores the system under which Pennsylvania operated until very recently. Such legislation should not have been necessary. But in the wake of a bulletin which upends the tax treatment of investment, it is suddenly very necessary that something be done. While other states are working to promote investment and growth, Pennsylvania is headed in the other direction.

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