During the campaign, Donald Trump told us he knew the tax code better than anyone and promised that he alone could fix it. Now his party is finally poised to take on tax reform. As with health care, Trump has offered no details and issued contradictory statements. (After promising big tax cuts for all, he’s more recently stated that the wealthy won’t benefit from reform.) So what can we expect from the plan Republicans say they’ll release this week? One possibility touted by the conservative Tax Foundation and recently floated by Texas Sen. Ted Cruz is immediate expensing, which would allow businesses to deduct the cost of any assets they acquire right away.
Expensing sounds like a simple accounting change and is being sold as a way to simplify the tax code. In fact, it represents a direct attack on the idea of a corporate income tax, one that provides a significant and unwarranted tax break to a small subset of favored entities. It could also fundamentally alter how our tax system works.
A hypothetical is useful to understand why. Imagine a business that earns $1 million. In a 40 percent tax world, the business would owe $400,000 in taxes. This business has $1 million in $100 bills in a vault. Exchanging these $100 bills for $20 bills would not affect its tax liability. All it has done is change the form its wealth takes. But what if it were to buy an asset worth $1 million? Should it be allowed to deduct the $1 million it spent against its $1 million in income, leaving it with $0 income, thus eliminating its tax liability?
The correct answer under an income tax is no. Just as when the business changed its $100 bills into $20 bills, it has simply changed the form of its wealth from cash to some other asset. As a result, it should not get to deduct the purchase immediately. Instead, it will get to deduct that cost either when it sells the asset or through depreciation deductions over time.
Let’s assume that the business buys a $1 million asset. Under a properly structured income tax, it cannot deduct that cost immediately. However, if it later sells the asset for $1.2 million, say, 10 years later, it can subtract the purchase price from the amount received, leaving a $200,000 gain that will be subject to tax. Assuming a 40 percent rate, it will pay $80,000 in year 10, for a total of $480,000 in taxes paid. Alternately, the business may be allowed to deduct a portion of the purchase price over time, using those deductions to offset other income. (We don’t need to go into the details of depreciation for purposes of this explanation.)
So, if the business is ultimately allowed to deduct the purchase price when it sells the asset or over time through depreciation, what is the big deal of just letting it deduct the cost now? If it does so, it will owe no taxes in year 1, but when it sells the asset in year 10, it will have to report the full $1.2 million received on the sale in income and will pay a total of $480,000 in taxes on that amount.
Setting aside the fact that asset purchases are not properly deductible under an income tax, the problem here is that timing matters. A lot. There is a considerable difference between paying $400,000 in taxes in year 1 and waiting until year 10 to pay that $400,000. In particular, because of the time value of money, pushing an income tax liability out into the future actually reduces the present value cost to the taxpayer. To pay the tax liability now, the business would have to write a check for $400,000. To pay it in 10 years, it might be able to set aside $350,000 and let the magic of compound interest do its work. The precise amount depends on interest rates. In other words, allowing expensing provides a significant tax cut to those who buy assets. However, it goes largely unnoticed because the nominal tax rate and taxes paid do not change.
This seemingly simple accounting change actually does far more than just provide a secret tax cut. In the 1940s, MIT economist E. Cary Brown demonstrated that allowing expensing can actually convert a nominal income tax into a de facto consumption tax. He demonstrated that immediately expensing asset purchases was economically equivalent to exempting the income those assets produced from tax, which is the hallmark of a consumption tax. Thus, expensing can change the very nature of the tax system without acknowledging there’s even been a change. The difference between income taxes and consumption taxes is that income taxes impose a tax on increases in wealth, while consumption taxes do not. For example, under an income tax, someone who has $1 million in the bank and earns $100,000 in interest has an accession to wealth and must pay tax on the interest. In contrast, consumption taxes exclude such gains. As a result, income taxes are better aligned with a taxpayer’s ability to pay than consumption taxes, which focus solely on how much taxpayers consume in a given year. A lot of really smart people think a consumption tax would be preferable to an income tax, but if we decide to go that route, we should do so openly and knowingly.
Another problem with expensing is that it would impose consumption tax treatment only on those businesses that buy a significant amount of assets. Lawyers, accountants, doctors, and others who don’t typically buy assets would continue to be taxed under an income tax regime. Indeed, the differential treatment of these two groups of taxpayers may be what dooms the proposal in the end. Expensing reduces government revenues, making it difficult to lower rates without exploding the deficit. Thus, businesses that cannot take advantage of expensing to lower their taxable income will likely bear the brunt of high marginal rates they cannot avoid. We can expect them to put up quite a fight.
Supporters argue that expensing will boost the economy because it will provide an incentive for businesses to buy more assets. The first point to make is that this belies the claim that this is just a small accounting change. The second is to note that such arguments come from the very same people who routinely claim that the market is the most efficient way of organizing human activities and that the only justification for government intervention is if there is a market failure. Businesses can be presumed to buy the assets they need, based on market conditions. In the absence of a market failure, altering the tax code to create additional incentives for businesses violates this core principle. Finally, this move tips the scales even more in favor of the robopocalypse, at least for workers, because employers will have an even greater incentive to replace them with machines.
If all of this seems a bit esoteric, just consider the following. Let’s go back to our business that earns $1 million this year and would normally owe $400,000 in taxes. If expensing is allowed, it can go out, borrow $1 million, buy an asset, and zero out its tax liability. Sure, it may owe those taxes somewhere down the line, but that could be 10 years from now. That should give anyone pause.
The closer you look at what expensing will do, the more it’s clear this move to “simplify” the tax code will deliver significant tax cuts to one subset of taxpayers, radically change the nature of the tax system, and create significant opportunities to game the system. Maybe this idea won’t even make it into the reform plan. But if it does, forewarned is forearmed.