Capital Cost Recovery and Capital Cost Recovery and Fundamental Tax ReformFundamental Tax Reform

President’s Advisory Panel on Federal Tax Reform President’s Advisory Panel on Federal Tax Reform

Kevin A. HassettKevin A. Hassett

AEIAEI

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Overview of TestimonyOverview of TestimonyFour IssuesFour Issues

Where do the depreciation rules fit into the Where do the depreciation rules fit into the theory of tax reform?theory of tax reform?

How big are the distortions associated with How big are the distortions associated with current law?current law?

What do we know about the effect of What do we know about the effect of depreciation rules on economic activity?depreciation rules on economic activity?

Given the importance of neutrality, is the Given the importance of neutrality, is the current research credit good tax policy?current research credit good tax policy?

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Depreciation Rules and the Depreciation Rules and the Theory of Tax ReformTheory of Tax Reform

Tax reform proposals are motivated by two Tax reform proposals are motivated by two insights from the literature on the optimal design of insights from the literature on the optimal design of a tax system:a tax system:– A tax system should not favor one type of input over A tax system should not favor one type of input over

another. If it does, then economic inefficiency results. another. If it does, then economic inefficiency results. (Diamond and Mirlees)(Diamond and Mirlees)

– A tax system should not tax capital income, as taxes on A tax system should not tax capital income, as taxes on capital income impose distortions that explode over capital income impose distortions that explode over time. (Chamley, Judd)time. (Chamley, Judd)

Current depreciation rules violate both principles.Current depreciation rules violate both principles.

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

Depreciation rules and economic distortionsDepreciation rules and economic distortions

– Tax depreciation rules create economic distortions when Tax depreciation rules create economic distortions when the depreciation allowance differs from true economic the depreciation allowance differs from true economic depreciation. This leads firms to substitute tax-favored depreciation. This leads firms to substitute tax-favored types of equipment for other types of equipment.types of equipment for other types of equipment.

– Current depreciation rules introduce a non-optimal tax on Current depreciation rules introduce a non-optimal tax on capital because firms do not receive the full benefit of capital because firms do not receive the full benefit of depreciation in the year that they purchase an asset. With depreciation in the year that they purchase an asset. With expensing, a dollar spent on a machine, for example, expensing, a dollar spent on a machine, for example, would generate a deduction worth one dollar. When a would generate a deduction worth one dollar. When a deduction is spread out over many years, the present deduction is spread out over many years, the present value of the deduction declines sharply.value of the deduction declines sharply.

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

Estimates suggest that the economic cost resulting from the Estimates suggest that the economic cost resulting from the differential tax treatment of capital goods is relatively differential tax treatment of capital goods is relatively inconsequential. (Auerbach)inconsequential. (Auerbach)

However, the tax on capital income, which includes the corporate However, the tax on capital income, which includes the corporate and individual income taxes on capital income, likely has very large and individual income taxes on capital income, likely has very large efficiency effects. Recent studies of the gains from a wholesale efficiency effects. Recent studies of the gains from a wholesale switch to a consumption tax suggest that output could increase switch to a consumption tax suggest that output could increase enormously, with a healthy share of the gain attributable to lower enormously, with a healthy share of the gain attributable to lower taxes on capital income. (Altig et al.) taxes on capital income. (Altig et al.)

Accordingly, almost all of the benefit from revising depreciation Accordingly, almost all of the benefit from revising depreciation rules would come from the associated reduction of the tax on rules would come from the associated reduction of the tax on capital income if depreciation allowances were expanded in the capital income if depreciation allowances were expanded in the direction of expensing and not from an improved allocation of direction of expensing and not from an improved allocation of business investment across assets.business investment across assets.

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How Big Is the Distortion?How Big Is the Distortion?

Current law gives firms deductions that are lower Current law gives firms deductions that are lower in present value than what they could take with in present value than what they could take with expensing.expensing.– For 7-year tax life assets, each dollar of equipment For 7-year tax life assets, each dollar of equipment

spending is allowed a deduction worth only 84 cents in spending is allowed a deduction worth only 84 cents in present value. With expensing, firms could deduct the present value. With expensing, firms could deduct the full dollar of spending.full dollar of spending.

– For 5-year equipment, the current deduction is worth 88 For 5-year equipment, the current deduction is worth 88 cents. cents.

– For 3 year equipment, the current deduction is worth 94 For 3 year equipment, the current deduction is worth 94 cents. (Cohen, Hansen and Hassett)cents. (Cohen, Hansen and Hassett)

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Depreciation Rules and the Depreciation Rules and the Cost of New InvestmentCost of New Investment

Since the value of the deduction is lower than Since the value of the deduction is lower than under expensing, the cost of investing is higher. under expensing, the cost of investing is higher. This drives down investment and reduces This drives down investment and reduces economic activity. economic activity.

Assuming a 42% corporate tax rate (35% federal Assuming a 42% corporate tax rate (35% federal statutory tax rate plus an average 7% state and statutory tax rate plus an average 7% state and local tax rate), the cost of new investment under local tax rate), the cost of new investment under current law relative to expensing is:current law relative to expensing is:– 11.5 percent higher for 7-year equipment11.5 percent higher for 7-year equipment– 8.7 percent higher for 5-year equipment8.7 percent higher for 5-year equipment– 4.3 percent higher for 3-year equipment4.3 percent higher for 3-year equipment

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The Effect of Depreciation Rules on The Effect of Depreciation Rules on Economic ActivityEconomic Activity

A large literature exists that has found a strong and A large literature exists that has found a strong and statistically significant link between taxes that affect the cost statistically significant link between taxes that affect the cost of investment and investment activity. (Hassett and Hubbard)of investment and investment activity. (Hassett and Hubbard)– The basic investment model can take many different forms. The The basic investment model can take many different forms. The

implied responsiveness of investment to tax policy is remarkably implied responsiveness of investment to tax policy is remarkably similar across specifications and data sets. similar across specifications and data sets.

A recently updated study found results that reinforced these A recently updated study found results that reinforced these findings, suggesting that the effects of tax policy on findings, suggesting that the effects of tax policy on investment may be even larger. (Desai and Goolsbee)investment may be even larger. (Desai and Goolsbee)

While the economic science is an uncertain one, the link While the economic science is an uncertain one, the link between tax policy and investment is one of the better-between tax policy and investment is one of the better-documented and least-disputed results in the literature on documented and least-disputed results in the literature on the effects of taxation on economic activity. the effects of taxation on economic activity.

Tax reforms that reduce the tax on investment activity will Tax reforms that reduce the tax on investment activity will almost certainly significantly spur investment.almost certainly significantly spur investment.

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

Economic theory tells us that under some conditions it is Economic theory tells us that under some conditions it is optimal for the government to subsidize particular types of optimal for the government to subsidize particular types of capital.capital.

– For example, monopolists tend to increase profit by reducing output. For example, monopolists tend to increase profit by reducing output. The result is an inefficiently low level of output. Subsidizing the The result is an inefficiently low level of output. Subsidizing the capital expenditures of monopolies, although politically infeasible, can capital expenditures of monopolies, although politically infeasible, can move the economy toward a better outcome by inducing them to move the economy toward a better outcome by inducing them to produce more output. produce more output.

– More interestingly, some activities may have positive external effects. More interestingly, some activities may have positive external effects. Chief among these are research and development expenditures. Chief among these are research and development expenditures. Since research discoveries often lead to additional discoveries, the Since research discoveries often lead to additional discoveries, the social benefit from research is greater than the private benefit, with social benefit from research is greater than the private benefit, with some estimates suggesting the benefit to society is double the private some estimates suggesting the benefit to society is double the private benefit. Accordingly, in theory, it may be beneficial to provide special benefit. Accordingly, in theory, it may be beneficial to provide special subsidies for research.subsidies for research.

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The Current Research Credit The Current Research Credit is Terrible Tax Designis Terrible Tax Design

Designing an efficient subsidy to encourage new research expenditures Designing an efficient subsidy to encourage new research expenditures is difficult (who should be undertaking the research, how much research is difficult (who should be undertaking the research, how much research should be undertaken, etc.). should be undertaken, etc.).

Credits to encourage research activity through the tax code may be Credits to encourage research activity through the tax code may be even more difficult to structure.even more difficult to structure.– Requires not only picking the appropriate research activities to subsidize, but Requires not only picking the appropriate research activities to subsidize, but

also ensuring that the firms who should be undertaking the beneficial also ensuring that the firms who should be undertaking the beneficial research are the firms receiving the subsidy. (Does research into new types research are the firms receiving the subsidy. (Does research into new types of potato chips qualify?)of potato chips qualify?)

– Credits that attempt to reward incremental expenditures can be extremely Credits that attempt to reward incremental expenditures can be extremely complicated and of questionable effectiveness. (Altshuler)complicated and of questionable effectiveness. (Altshuler)

– Moreover, Section 382 limitations often eliminate tax benefits for small Moreover, Section 382 limitations often eliminate tax benefits for small innovative firms. Equity issuance can count as an ownership change and innovative firms. Equity issuance can count as an ownership change and essentially eliminate benefits that are carried forward. Unless credits are essentially eliminate benefits that are carried forward. Unless credits are refundable, it may be difficult to provide a tax benefit to the most innovative refundable, it may be difficult to provide a tax benefit to the most innovative start-up firms.(Hassett)start-up firms.(Hassett)

While in theory a credit to encourage additional research may be While in theory a credit to encourage additional research may be appropriate, in practice it is has been impossible to get right. appropriate, in practice it is has been impossible to get right.

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ReferencesReferences Altig, David, et al. (2001). “Simulating Fundamental Tax Reform in the Altig, David, et al. (2001). “Simulating Fundamental Tax Reform in the

United States,” United States,” American Economic Review  American Economic Review  91(3): 574-595.91(3): 574-595. Altshuler, Rosanne (1988). “A Dynamic Analysis of the Research and Altshuler, Rosanne (1988). “A Dynamic Analysis of the Research and

Experimentation Credit,” Experimentation Credit,” National Tax Journal National Tax Journal 41(4): 453-466.41(4): 453-466. Auerbach, Alan J. (1989). “The Deadweight Loss from ‘Nonneutral’ Auerbach, Alan J. (1989). “The Deadweight Loss from ‘Nonneutral’

Capital Income Taxation,” Capital Income Taxation,” Journal of Public EconomicsJournal of Public Economics 40(1): 1-36. 40(1): 1-36. Chamley, Christophe P. (1986). “Optimal Taxation of Capital Income Chamley, Christophe P. (1986). “Optimal Taxation of Capital Income

in General Equilibrium with Infinite Lives,” in General Equilibrium with Infinite Lives,” EconometricaEconometrica 54 (3): 607- 54 (3): 607-22.22.

Cohen, Darrel S., Dorthe-Pernille Hansen, and Kevin A. Hassett Cohen, Darrel S., Dorthe-Pernille Hansen, and Kevin A. Hassett (2002). “The Effects of Temporary Partial Expensing on Investment (2002). “The Effects of Temporary Partial Expensing on Investment Incentives in the United States,” Incentives in the United States,” National Tax JournalNational Tax Journal 55(3): 457-466. 55(3): 457-466.

Desai, Mihir and Austan Goolsbee (2004). “Investment, Overhang, Desai, Mihir and Austan Goolsbee (2004). “Investment, Overhang, and Tax Policy,” and Tax Policy,” Brookings Papers on Economic ActivityBrookings Papers on Economic Activity 2: 285-338. 2: 285-338.

Diamond, Peter A. and James A. Mirrlees (1971). “Optimal Taxation Diamond, Peter A. and James A. Mirrlees (1971). “Optimal Taxation and Public Production,” and Public Production,” American Economic ReviewAmerican Economic Review 61: 8-27, 261- 61: 8-27, 261-278.278.

Judd, Kenneth L. (1985). “Redistributive Taxation in a Simple Perfect Judd, Kenneth L. (1985). “Redistributive Taxation in a Simple Perfect Foresight Model,” Foresight Model,” Journal of Public EconomicsJournal of Public Economics 28 (1): 59-83. 28 (1): 59-83.

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References (cont.)References (cont.)

Hassett, Kevin A. (2003). “Taxation and the Incentive to Invest in the Hassett, Kevin A. (2003). “Taxation and the Incentive to Invest in the Biotech Industry,” White Paper, Biotechnology Industry Organization.Biotech Industry,” White Paper, Biotechnology Industry Organization.

Hassett, Kevin, and R. Glenn Hubbard (2002). “Tax Policy and Hassett, Kevin, and R. Glenn Hubbard (2002). “Tax Policy and Business Investment,” in Business Investment,” in Handbook of Public EconomicsHandbook of Public Economics Vol. III, edited Vol. III, edited by Auerbach and Feldstein. Amsterdam: Elsevier Science B.V., 1293-by Auerbach and Feldstein. Amsterdam: Elsevier Science B.V., 1293-1343.1343.