Capital Cost Recovery and Fundamental Tax Reform

1
Capital Cost Recovery and Fundamental Tax Reform

• Presidents Advisory Panel on Federal Tax Reform
• Kevin A. Hassett
• AEI

2
Overview of TestimonyFour Issues

• Where do the depreciation rules fit into the
  theory of tax reform?
• How big are the distortions associated with
  current law?
• What do we know about the effect of depreciation
  rules on economic activity?
• Given the importance of neutrality, is the
  current research credit good tax policy?

3
Depreciation Rules and the Theory of Tax Reform

• Tax reform proposals are motivated by two
  insights from the literature on the optimal
  design of a tax system
• A tax system should not favor one type of input
  over another. If it does, then economic
  inefficiency results. (Diamond and Mirlees)
• A tax system should not tax capital income, as
  taxes on capital income impose distortions that
  explode over time. (Chamley, Judd)
• Current depreciation rules violate both
  principles.

4
Depreciation Rules and the Theory of Tax Reform
(cont.)

• Depreciation rules and economic distortions
• Tax depreciation rules create economic
  distortions when the depreciation allowance
  differs from true economic depreciation. This
  leads firms to substitute tax-favored types of
  equipment for other types of equipment.
• Current depreciation rules introduce a
  non-optimal tax on capital because firms do not
  receive the full benefit of depreciation in the
  year that they purchase an asset. With expensing,
  a dollar spent on a machine, for example, would
  generate a deduction worth one dollar. When a
  deduction is spread out over many years, the
  present value of the deduction declines sharply.

5
Depreciation Rules and the Theory of Tax Reform
(cont.)

• Estimates suggest that the economic cost
  resulting from the differential tax treatment of
  capital goods is relatively inconsequential.
  (Auerbach)
• However, the tax on capital income, which
  includes the corporate and individual income
  taxes on capital income, likely has very large
  efficiency effects. Recent studies of the gains
  from a wholesale switch to a consumption tax
  suggest that output could increase enormously,
  with a healthy share of the gain attributable to
  lower taxes on capital income. (Altig et al.)
• Accordingly, almost all of the benefit from
  revising depreciation rules would come from the
  associated reduction of the tax on capital income
  if depreciation allowances were expanded in the
  direction of expensing and not from an improved
  allocation of business investment across assets.

6
How Big Is the Distortion?

• Current law gives firms deductions that are lower
  in present value than what they could take with
  expensing.
• For 7-year tax life assets, each dollar of
  equipment spending is allowed a deduction worth
  only 84 cents in present value. With expensing,
  firms could deduct the full dollar of spending.
• For 5-year equipment, the current deduction is
  worth 88 cents.
• For 3 year equipment, the current deduction is
  worth 94 cents. (Cohen, Hansen and Hassett)

7
Depreciation Rules and the Cost of New Investment

• Since the value of the deduction is lower than
  under expensing, the cost of investing is higher.
  This drives down investment and reduces economic
  activity.
• Assuming a 42 corporate tax rate (35 federal
  statutory tax rate plus an average 7 state and
  local tax rate), the cost of new investment under
  current law relative to expensing is
• 11.5 percent higher for 7-year equipment
• 8.7 percent higher for 5-year equipment
• 4.3 percent higher for 3-year equipment

8
The Effect of Depreciation Rules on Economic
Activity

• A large literature exists that has found a strong
  and statistically significant link between taxes
  that affect the cost of investment and investment
  activity. (Hassett and Hubbard)
• The basic investment model can take many
  different forms. The implied responsiveness of
  investment to tax policy is remarkably similar
  across specifications and data sets.
• A recently updated study found results that
  reinforced these findings, suggesting that the
  effects of tax policy on investment may be even
  larger. (Desai and Goolsbee)
• While the economic science is an uncertain one,
  the link between tax policy and investment is one
  of the better-documented and least-disputed
  results in the literature on the effects of
  taxation on economic activity.
• Tax reforms that reduce the tax on investment
  activity will almost certainly significantly spur
  investment.

9
Is it Ever Appropriate to Favor Certain Types of
Investment?

• Economic theory tells us that under some
  conditions it is optimal for the government to
  subsidize particular types of capital.
• For example, monopolists tend to increase profit
  by reducing output. The result is an
  inefficiently low level of output. Subsidizing
  the capital expenditures of monopolies, although
  politically infeasible, can move the economy
  toward a better outcome by inducing them to
  produce more output.
• More interestingly, some activities may have
  positive external effects. Chief among these are
  research and development expenditures. Since
  research discoveries often lead to additional
  discoveries, the social benefit from research is
  greater than the private benefit, with some
  estimates suggesting the benefit to society is
  double the private benefit. Accordingly, in
  theory, it may be beneficial to provide special
  subsidies for research.

10
The Current Research Credit is Terrible Tax
Design

• Designing an efficient subsidy to encourage new
  research expenditures is difficult (who should be
  undertaking the research, how much research
  should be undertaken, etc.).
• Credits to encourage research activity through
  the tax code may be even more difficult to
  structure.
• Requires not only picking the appropriate
  research activities to subsidize, but also
  ensuring that the firms who should be undertaking
  the beneficial research are the firms receiving
  the subsidy. (Does research into new types of
  potato chips qualify?)
• Credits that attempt to reward incremental
  expenditures can be extremely complicated and of
  questionable effectiveness. (Altshuler)
• Moreover, Section 382 limitations often eliminate
  tax benefits for small innovative firms. Equity
  issuance can count as an ownership change and
  essentially eliminate benefits that are carried
  forward. Unless credits are refundable, it may be
  difficult to provide a tax benefit to the most
  innovative start-up firms.(Hassett)
• While in theory a credit to encourage additional
  research may be appropriate, in practice it is
  has been impossible to get right.

11
References

• Altig, David, et al. (2001). Simulating
  Fundamental Tax Reform in the United States,
  American Economic Review  91(3) 574-595.
• Altshuler, Rosanne (1988). A Dynamic Analysis
  of the Research and Experimentation Credit,
  National Tax Journal 41(4) 453-466.
• Auerbach, Alan J. (1989). The Deadweight Loss
  from Nonneutral Capital Income Taxation,
  Journal of Public Economics 40(1) 1-36.
• Chamley, Christophe P. (1986). Optimal Taxation
  of Capital Income in General Equilibrium with
  Infinite Lives, Econometrica 54 (3) 607-22.
• Cohen, Darrel S., Dorthe-Pernille Hansen, and
  Kevin A. Hassett (2002). The Effects of
  Temporary Partial Expensing on Investment
  Incentives in the United States, National Tax
  Journal 55(3) 457-466.
• Desai, Mihir and Austan Goolsbee (2004).
  Investment, Overhang, and Tax Policy, Brookings
  Papers on Economic Activity 2 285-338.
• Diamond, Peter A. and James A. Mirrlees (1971).
  Optimal Taxation and Public Production,
  American Economic Review 61 8-27, 261-278.
• Judd, Kenneth L. (1985). Redistributive
  Taxation in a Simple Perfect Foresight Model,
  Journal of Public Economics 28 (1) 59-83.

12
References (cont.)

• Hassett, Kevin A. (2003). Taxation and the
  Incentive to Invest in the Biotech Industry,
  White Paper, Biotechnology Industry Organization.
• Hassett, Kevin, and R. Glenn Hubbard (2002). Tax
  Policy and Business Investment, in Handbook of
  Public Economics Vol. III, edited by Auerbach and
  Feldstein. Amsterdam Elsevier Science B.V.,
  1293-1343.