Tax Policy Improvements Needed to Help Industries through the Semiconductor Shortage

March 16, 2021

The Biden administration has responded to recent reports of a global semiconductor shortage with an executive order calling for a 100-day review of supply chains and $37 billion to boost semiconductor manufacturing. Instead of implementing a stopgap industrial policy that picks winners and losers, lawmakers should consider broad improvements to the U.S. tax system that could address the problem in a more sustainable and evenhanded way. The shortage, which experts say could persist through the year, is affecting industries from automakers to game console producers and electronics manufacturers.

Demand for electronics increased during the pandemic as more people work and attend school virtually and the supply of semiconductors became bottlenecked. At the same time, demand dropped for goods like vehicles, and automakers cut production. As demand has picked up, automakers find they are at the back of the line to order already-scarce chips.

Semiconductors take a significant amount of time to make, and new capacity cannot just be turned on, as the supply chain is extraordinarily complicated. The manufacturing equipment needed to make chips is intricate, expensive, and takes significant time to make. The United States makes up only about 12 percent of global chip manufacturing, with about three-fourths of supply manufactured in China, Taiwan, Japan, and South Korea, according to The Wall Street Journal.

Rather than store extras of all the pieces needed to manufacture a final product, companies have developed a process to have just what they need, just in time to make their products. Just-in-time manufacturing is particularly common among automakers. Normally, avoiding excess inventories is very efficient, but automakers that stockpiled chips in the early months of the pandemic are now faring better and are less affected by the global shortage. That’s led some to call for abandoning that type of practice.

Going forward, though, manufacturers will need to consider the tax consequence of shifting from just-in-time practices. In 2021, the marginal effective tax rate on business inventories is 30 percent. The tax bias against inventories is partially caused by the tax code making firms wait to take deductions for their inventory costs until inventories are sold. Firms can choose from a few methods to deduct their inventory costs, which affect their taxable income differently, but delayed deductions understate costs and overstate taxable income in real terms due to inflation and the time value of money. If instead the tax code allowed immediate deductions for inventories, it could remove the tax bias from the decision.

Some have also suggested the United States increase its chip-making capacity. Building a foundry (where chips are made) is very expensive. For example, Samsung is considering a $17 billion foundry in Austin, Texas. Here too, the tax code penalizes the capital investment that would go into building a foundry.

Investment in industrial factories, such as a semiconductor foundry, cannot be deducted immediately but instead must be deducted over a 39-year period. The tax treatment of short-lived assets, such as some of the machinery and equipment that would go inside a foundry, is currently eligible for 100 percent bonus depreciation. That provision allows full write-offs in the year an asset is placed in service, but it will begin phasing out in 2023. Research and development expenses, also crucial to the semiconductor industry, are currently eligible for full expensing, but beginning next year will instead be amortized over five years. If a business builds a new foundry, it would not be able to fully deduct the cost of its investment, increasing the after-tax cost of the project. In 2021, structures face a marginal effective tax rate of 21 percent, compared to 7.5 percent for equipment. By 2030, the rates will rise to 25.6 percent and 23.7 percent, under current law.

The current tax code is biased against investment in general and distorts decisions across investment types too. Marginal effective tax rates measure the tax rate that a new, break-even investment would face. Under a tax code that was neutral between present and future consumption, the marginal effective tax rate would be zero—it would place no burden on saving or investment. A neutral tax code would also have the same marginal effective tax rate across types of investment.

As lawmakers evaluate how to respond to the global semiconductor shortage, they should consider allowing full cost recovery across all types of capital investment—inventories, machinery and equipment, structures, and R&D. While not a panacea, improved cost recovery would help eliminate the tax bias that encourages just-in-time manufacturing and would reduce the after-tax cost of making semiconductor investments in the United States. In contrast with industrial policies aimed only at certain sectors, improving cost recovery would spur domestic investment across industries.

 

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Cost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. 

Taxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.