A Quick Overview of the Asymmetric Taxation of Business Gains and Losses

May 31, 2017

The current tax treatment of operating losses

If a business has tax liability from the prior two tax years, it may carry the net operating loss (NOL) back to offset that liability. However, if the NOL exceeds its profit from the recent two years, the business cannot exhaust the NOL deductions through carryback. It can carry the NOL forward to be used as a NOL deduction against future taxable income. The current U.S. law allows NOL to be carried forward up to 20 years.  

When all NOLs in this tax year are completely carried back to prior years, this firm could immediately utilize all such NOLs and get full NOL deductions. However, if the business must wait for years to deduct its NOLs, the real value of the tax loss is diminished, due to inflation and the time value of money. The deferred tax benefits or refundability of a certain amount of NOL will be worth much less to the business.

Tax asymmetry on business profits and business loss

Current law taxes profits immediately, while losses often reduce taxes only with a delay. A perfectly symmetrical treatment of losses and profits would require the income tax value of a loss to be refunded in the year the loss is incurred, just as profits are taxed immediately as they occur. If the losses are carried forward, the real value of losses should be preserved by adjusting them by an appropriate rate of inflation and the normal real return to capital (in effect, augmenting them by an appropriate interest rate).  Instead, U.S. tax systems operate under a partial loss-offset system where firms can only carry the fixed nominal balance of their losses forward up to 20 years without any interest-like adjustment added to lower future taxable income.

The impacts of partial refunding of net operating losses

Tax asymmetry penalizes new firms disproportionately. New businesses usually run losses for several years before generating profits. There is no way for them to carry back the losses or utilize the NOL deduction before they make profits. It is highly possible that the startups do not survive and their losses expire and never get utilized. As a result, the share of NOLs reported by new corporations (less than five years old) was 17 percentage points lower than that for old ones in late 1990s. Startups thus face a significant tax disadvantage compared to established businesses that can deduct losses on new ventures against ongoing profits from other activities.

Tax asymmetry is especially disadvantageous to risky business investment due to the high uncertainty associated with the investment’s streams of return for the upcoming years. When choosing between two projects with equal expected pretax rates of return, the risky one is less likely to be selected because of the penalization caused by partial loss offsets, should they occur, compared to the less risky one.

The partial loss-deduction system has noneconomic effects on firm financing decisions. Current law allows interest payments from debt financing to be deductible for tax purposes, making debt financing generally less expensive than equity financing. However, firms in a loss position are not able to utilize interest deductions immediately (having no profits to deduct against). This diminishes the tax advantage of debt financing and thus potentially causes a shift away from debt financing due to the added cost of financing.

Currently, no OECD countries with corporate taxes have a full loss-offset system or even pay interest to maintain their real values. The partial loss-offset regime clearly has its inherent merits in fighting against fraud and abuse. Nevertheless, for tax policymaking, it is important to take into consideration the impacts of this asymmetry and how it is related to other features of the tax code and how they impact business decisions. 

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