The Biden government has signaled its openness to raising the corporate tax rate, possibly by increasing it gradually over several years. While gradually rolling in a tax hike as opposed to wandering right now seems like a reasonable middle ground, it would be worst of both worlds as old investments are offered at a lower rate while new investments are penalized.
To understand why, we need to think about what happens when corporate tax rates change, such as when the Tax Cut and Jobs Act (TCJA) cuts the corporate tax rate from 35 percent to 21 percent. First, TCJA has increased the return on potential new investments, which on the side makes new projects more attractive for companies. It also reduced taxes on the return on investments already made.
As former colleague Scott Greenberg explained in 2017, tax cuts on the return of old capital do not change the marginal investment incentives. However, tax changes on future investments do so. Gradually increasing the corporate tax rate over time is the worst of both worlds: Existing investments will pay a lower tax rate for a number of years, while new investments that may take years of profitability will be subject to a higher tax rate. The benefits of a gradual increase in corporate income tax will mainly benefit the owners of the old capital and not the potential new capital and therefore will not mitigate negative investment effects.
Consider investing in manufacturing new drugs. It takes many years (usually) for a drug to get to market from discovery through multiple rounds of clinical trials to review by the Food and Drug Administration (FDA). As a result, they don’t make profits for the company until a few years later.
When a company is considering investing in the development of a new drug, a lower corporate tax rate for the first few years while it is in development and not yet profitable doesn’t matter. In this way, a gradual tax hike is like a temporary tax cut. Taxpayers face a lower tax rate in the short term, but know they will see a higher tax rate in the future.
Paradoxically, the gradual introduction of a corporate tax hike could also cause companies to delay their investments. A company would delay an investment because deductions are more valuable at a higher corporate tax rate. If a company has a million dollar investment, it would be more valuable to subtract that rate at 28 percent (saving $ 280,000 in taxes) than at a rate of 21 percent (saving $ 210,000 in taxes).
The reversal of this phenomenon came in response to the TCJA cutting the corporate tax rate from 35 percent to 21 percent. According to a new publication in the National Tax Journal, companies have moved the deductions on their investments back to 2017 to claim them against the company’s 35 percent rate.
Ultimately, a gradual increase in the corporate tax rate would reduce investment by pushing companies to delay large-scale projects while reducing marginal incentives for long-term investment.
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