While much of Washington is focused on negotiations over a government spending bill on competitiveness with China, Representatives Jackie Walorski (R-IN) and Jim Banks (R-IN) have introduced a policy of common sense to boost American competitiveness. The Renewal Investment in American Workers and Supply Chains Act would improve the tax treatment of investments in structures, such as factories and warehouses, which currently face some of the heaviest penalties in the system tax.
The US tax system is biased against capital-intensive manufacturers because it prevents companies from fully deducting capital costs. While most business costs, such as utility bills or wages and salaries, are immediately deducted when incurred, business costs associated with physical investments and research and development (R&D ) are not immediately deducted. Instead, businesses must follow payback periods set by lawmakers – and structures face some of the longest cost payback periods, 27.5 years for residential buildings and 39 years for commercial buildings. .
Table 1 illustrates why long payback periods are problematic: inflation and the time value of money erode the real value of deductions over time. Businesses cannot fully recover their costs when deductions are delayed, which means their profits are overstated and their tax burden increases. In other words, the current cost recovery system (MACRS) artificially increases the cost of domestic investment.
|Cost-neutral recovery||MACRS with 1.5% inflation||MACRS with 2% inflation||MACRS with 3% inflation||MACRS with 5% inflation||MACRS with 7% inflation|
|39 year old Trump||$100||$47.50||$44.38||$39.06||$31.20||$25.80|
Source: Author’s calculations. Assumes straight-line amortization, semi-annual convention and real discount rate of 3%.
The China Competitiveness Bills under consideration do not include any tax changes to correct the tax code’s inherent bias against investment (including investment in structures, R&D and, in the coming year next, machinery and equipment) and focus mainly on new public spending, much of which may turn out to be very inefficient. On the other hand, the new bill from Representatives Walorski and Banks tackles the tax bias against investment head-on.
The bill would correct the bias against investing in structures by shortening current timelines to 20 years and providing the same economic benefit as full spending by implementing what is called a neutral cost recovery system. (NCRS).
An NCRS adjustment would apply to the depreciation companies take for their investments to account for both inflation (using the GDP deflator) and the time value of money (using a rate of real return of 3%). Economically, the adjustments come close to a complete and immediate deduction. The bill would also make the adjustment for any remaining write-offs that companies have on the books to avoid unnecessary waste that might otherwise occur.
The Tax Foundation estimates that the policy would increase long-term GDP by 1.2% and increase employment by 230,000 full-time equivalent jobs. Over the current 10-year budget window, this would reduce federal revenue by $185.7 billion on a conventional basis. Taking into account the positive macroeconomic feedback, the policy would increase federal revenue by $126.6 billion.
|Conventional revenue, 2022-2031||-$187.5 billion|
|Dynamic income, 2022-2031||+$126.6 billion|
Source: Tax Foundation General Equilibrium Model.
At this point, one might wonder why the NCRS as opposed to a full and immediate deduction in the first year. Such an approach has two major drawbacks that do not apply to NCRS.
First, there’s the high initial cost to the federal government of transitioning to full structural support. Companies with investments made before the policy change would still receive capital cost allowances for existing buildings, while companies with new investments would receive full deductions for new buildings. The combination of legacy write-offs from old investments and 100% write-offs for new investments makes the transition cost to go full load quite high, although it would decrease over time. In contrast, NCRS adjustments start small, resulting in a much lower cost in the 10-year budget window.
Second, investments in structures are large and voluminous. If a business does not have enough revenue to absorb the entire expense deduction, this would generate a net operating loss (NOL) that the business would have to carry forward to future tax years. NOL results in the same problem that full expensing aims to solve: the value of the deduction would erode over time and the business would not recoup the full cost of the investment in real terms. The NCRS largely prevents the NOL issue by spreading the deductions over time but making adjustments to prevent the actual values from eroding.
Full spend and NCRS would provide a significant advantage to new buildings over existing buildings if no mitigation policy were adopted in tandem. For example, a structure put in place the year before the policy change should be amortized over 39 years, while a structure built the following year as part of the policy change would have access to full cost recovery. Providing a partial benefit to existing structures, as Representatives Walorski and Banks’ bill does, would reduce the disparity between old and new structures.
In short, Walorski and Banks’ bill would stimulate investment and put the United States on a more competitive footing by ending existing tax penalties against domestic investment and boosting economic output, productive capacity and employment in the United States.