As Congress prepares to move tax reform legislation, manufacturers await the details: How much lower will the corporate tax rate become? How will pass-through entities be addressed? Which deductions are likely to be eliminated?
A key issue relates to full expensing, included in the 2016 House Republican Blueprint, which would allow a business to immediately deduct the full cost of an investment, rather than deduct the cost over time. Proponents argue that such a reform would reduce the marginal effective tax rate (METR) to zero or even below zero (depending on whether net interest is deductible), and therefore reduce the cost of capital investment. The METR (computed as the present value of current and future taxes owed on a marginal investment, divided by the present value of its pre-tax returns) is seen by economists as the correct metric to use when making investment decisions. Currently, U.S. manufacturers face a METR that is much higher than manufacturers in most other OECD countries, and tax reform, if enacted, is expected to improve competitiveness. The nonpartisan Tax Foundation has long extolled the virtues of full expensing, arguing that it would provide a greater incentive for investment than simply lowering the corporate rate.
Opponents argue that full expensing is prohibitively expensive, and would require Congress to pay for it by keeping the tax rate higher than it otherwise would be. This is problematic for Republicans and businesses that favor the lowest possible rate. Republicans must be mindful of the cost of tax reform given Senate rules that make it impossible, without Democratic support, to enact permanent tax code changes that add to budget deficits for more than 10 years.
Some opponents of full expensing favor economic cost recovery, an approach in which an investment is deducted proportionately across its lifetime based on its declining value. Such an approach would result in cost savings that could be used to lower the statutory rate even further. The status quo represents a third, hybrid approach, where investment is encouraged, somewhat less than full expensing but more than under economic cost recovery. Congress may also choose to make cost recovery more generous than under the status quo to avoid the cost associated with full expensing while still increasing incentives for investment. For example, consider bonus depreciation, a form of accelerated depreciation that Congress temporarily put in place in 2001 and extended several times. According to the Tax Foundation, making bonus depreciation permanent would have a large positive impact on investment, but not as great as full expensing.
Full expensing, however, may not provide the large investment incentive that economists theorize. In a January 2017 working paper, Lily Batchelder from NYU School of Law wrote that businesses do not make decisions based on the METR but instead on the statutory tax rate or the accounting “book” rate (i.e., Generally Accepted Accounting Principles effective tax rate). She cited a recent survey of tax executives in both public and private companies, which found that fewer than 13% used the METR in decision-making. Publicly traded companies used the accounting rate the most. Private sector firms used the statutory tax rate most often. Companies not using the METR were found to make suboptimal financial decisions leading to a loss in firm value.
Batchelder used the survey results to estimate the investment effects of various tax policy reforms. She found that the best investment incentive for public and very large companies, including pass-through entities, is economic cost recovery coupled with a lower statutory rate. Her methodology did not allow for an estimate of the investment impact for smaller private companies.
One issue not addressed in the debate over full expensing relates to the purpose of investment. Presumably, productivity growth (which sets the pace for economic growth) is the reason that policy makers want to encourage business investment. In which case, the kinds of investments subject to reform matter—not just the level of investment. For example, investments in software and certain types of equipment may be more important than purchases of new property if the goal is to increase productivity.
Manufacturers should keep a close eye on the contours of tax reform as it works its way through Congress over the next few months. Should tax reform be enacted, its final shape will impact manufacturing investment for decades to come.
Keith Belton is director of the Manufacturing Policy Initiative at the School of Public and Environmental Affairs (SPEA) at Indiana University in Bloomington, Ind.