Pro-growth Economics Points to Full Expensing

August 1, 2013

President Obama’s comments on corporate tax reform have received a lot of talk this week, but as my colleague points out, President Obama’s desire to curb accelerated depreciation could have damaging effects on small businesses.

Last week, Sen. Jeff Flake (R-AZ) introduced a bill to help mitigate this damage for small businesses by making permanent the ability to write-off certain expenses. Sen. Flake’s bill, which is identical to Rep. Dave Camp’s discussion draft, gives small businesses an expensing limit of $250,000 that phases out for investments exceeding $800,000, returning it to the pre-stimulus levels. Under current law, these limits will fall to $25,000 and $200,000, respectively, in 2014.

Sen. Flake’s bill would lessen the blow to the economy that current law would present and help businesses continue to grow. An even better solution would be to fix this element of the tax code all together by granting permanent full expensing for small and large businesses.

According to previous analysis, if we were to implement 100 percent expensing while changing nothing else in the tax code, GDP would increase by $359.1 billion over the long-run.

Under current law, the tax code discourages savings and investment because it incorrectly defines the tax base. By not allowing businesses to fully account for the cost of doing business, the tax code overstates business profits and understates business costs. This tax treatment increases the tax liability for businesses and further diverts funds from productive use. Instead, the tax code should incorporate some common sense economics.

One of the best explanations I’ve read of why full expensing is common sense comes from an IRET bulletin written in the late 1990s:

[S]uppose you were to open up a pizza shop. Along with the usual expenses, such as rent, wages, electricity, flour, tomatoes, cheese, and anchovies, you would also have to purchase a pizza oven. Now suppose that you sell a lot of pizzas over the course of the year. What is your profit? It is the difference between two money streams: the money received from pizza sales minus the money paid out in the form of expenses to make those pizzas, including rent, materials, etc. And don't forget to subtract the money you paid for that pizza oven.

Isn't that how business profit is calculated for accounting and tax purposes?

No, it isn't. The accounting profession and the Internal Revenue Code do not allow businesses to expense more than a small portion of their capital outlays. The rest must be ‘depreciated’.”

There are thousands of businesses across the country like this hypothetical start-up pizza shop. In fact, 90 percent of firms employ less than 20 employees. To these types of businesses, capital expenses are a big deal. A cluttered tax code that improperly defines taxable income hampers the ability of these businesses to operate.

The treatment of business expenses has a real impact on the economy at large as well. In a Tax Foundation report on expensing, Steve Entin illuminates this point:

“How capital assets are accounted for in the tax code dramatically affects what is defined as taxable income and, thereby, directly influences the cost of capital. The higher the cost, the less capital is formed, and the slower the economy will grow. The lower the cost, the bigger the economy will be, and with it the number of jobs and the level of wages.”

The goal of tax reform should be to grow the economy. If we want small businesses to grow and create jobs, we need tax policy that allows them to do so. For an economy where growth is so hard to find, moving closer to full expensing would be a good start.


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