Corporate Tax

Company tax base and tax proposals from President Bidenden

The negative impact of President Biden’s proposed corporate tax rate of 28 percent could be mitigated by improving the treatment of capital expenditures in the corporate tax base. As we explain in our new book Options for Reforming America’s Tax Code 2.0, tax rates matter only because they have a tax base – and the structure of that tax base is important to the economic impact of a rate change.

Changing the tax base by allowing full instant deductions for investments in machinery and equipment would reduce the tax code’s bias towards capital investments, reducing some, but not all, of the harmful effects of a higher corporate tax.

Until the end of 2022, companies will be granted a 100 percent “bonus write-off” for investments in short-lived assets such as machinery and equipment – also known as full cost recovery. From 2023, the bonus depreciation will decrease by 20 percentage points annually until it expires completely at the end of 2026 and companies have to spread the depreciation over several years.

If a company is not granted a full immediate deduction of its investment costs, the company’s profit will be overstated in the tax code, which will result in a higher tax burden. Even if the company is granted deductions for past investment costs in subsequent years, the deductions are less than the actual cost as inflation and the time value of money consume the actual value of the deduction. The following table illustrates the tax implications if you don’t have access to full cost recovery on an investment of $ 100.

Table 1. Illustration of the depreciation allowance at a higher corporate tax rate

5 year asset 15 year asset 20 year asset
Present value of depreciation allowances for a $ 100 investment using the Modified Accelerated Cost Recovery System (MACRS) at 2% inflation $ 88.63 $ 70.66 $ 63.56
Inadmissible reimbursement $ 11.37 $ 29.34 $ 36.44
Tax on improper reimbursement of expenses below 21% corporate tax rate $ 2.39 $ 6.16 $ 7.65
Tax on inadmissible reimbursement of expenses below 28% corporate tax rate $ 3.18 $ 8.21 $ 10.20

Source: author’s calculations. Assuming a semi-annual convention, straight-line depreciation, 3% discount rate and 2% inflation rate.

In other words, when the tax code does not allow a company to fully cover the cost of its investments, it creates an investment barrier by increasing after-tax costs. A higher corporate tax rate would exacerbate this bias by further increasing after-tax investment costs – although it would increase the value of depreciation allowances, the net effect would increase after-tax investment costs.

Full cost recovery would lower the marginal effective tax rate (EMTR, a measure that reflects how much taxation increases the cost of capital at the break-even point of an investment) by lowering taxes on marginal investments in the U.S. above the average effective tax rate ( EATR, the average tax expense for a hypothetically profitable investment from start to finish, z investments as it estimates the tax costs for minor rather than initial investments. The EATR provides information on decisions about the location of discrete investments. “

In other words, while full cost recovery allows more “flexibility” in setting statutory rates, there is still a limit to where policy makers can set the rate and real economic activity is not affected. Even with a more structured tax base, a high statutory rate can encourage profit shifting and influence location decisions.

A permanent bonus write-off would improve the structure by shifting the tax base for short-lived assets to exclude the normal rate of return (the portion of a return that just covers the cost of an investment in present value numbers). However, other components of the tax base, such as depreciation on buildings or interest treatment, can result in the tax regime still having an impact on the normal rate of return for many types of investments.

Using the Tax Foundation’s general equilibrium model, we find that the combination of permanent bonus write-offs and a corporate income tax of 28 percent would reduce the size of the economy by 0.1 percent and American income (GNP) by 0.2 percent. The capital stock would decrease by 0.3 percent, wages by 0.1 percent and full-time equivalents would decrease by 25,000 in the long term.

Table 2. Economic effects of a 28 percent corporate rate and permanent bonus amortization

28% CIT + permanent bonus
GDP -0.1%
E.G -0.2%
Share capital -0.3%
wage -0.1%
Full-time equivalent employment -25,000

Source: General equilibrium model of the tax foundation, May 2021.

We also estimate that the introduction of a corporate tax rate of 28 percent, along with a permanent bonus write-off, would increase federal revenue by $ 681.6 billion on a conventional basis from 2022 to 2031, after accounting for profit shifts from the US due to the higher rate. On a dynamic basis, taking into account macroeconomic feedback, it would raise about $ 672 billion.

Table 3. Sales effects of a 28 percent corporate rate and permanent bonus amortization

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 2022-2031
Conventional $ 68.6 $ 64.4 $ 61.0 $ 58.6 $ 58.4 $ 53.5 $ 66.6 $ 76.4 $ 84.0 $ 90.1 $ 681.6
Dynamic $ 67.9 $ 62.5 $ 58.6 $ 55.7 $ 57.4 $ 52.1 $ 65.9 $ 76.3 $ 84.4 $ 91.2 $ 672.0

Source: General equilibrium model of the tax foundation, May 2021.

Our new options guide shows that corporate tax increases are one of the most damaging ways to increase revenue and that improvements to the corporate tax system are one of the most efficient ways to increase economic performance and incomes. Even if the combination of these two options could reduce the harmful effects of a higher corporate tax, it would still involve trade-offs in economic performance and profit shifting. Policy makers should generate less harmful revenue to fund new projects, while prioritizing tax changes that would reduce the propensity to invest.

Options for Reforming the US Tax Code 2.0

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