Capital Cost Recovery and Fundamental Tax Reform President’s Advisory Panel on Federal Tax Reform Kevin A. Hassett AEI

2 Overview of Testimony Four Issues  Where do the depreciation rules fit into the theory of tax reform?  How big are the distortions associated with current law?  What do we know about the effect of depreciation rules on economic activity?  Given the importance of neutrality, is the current research credit good tax policy?

3 Depreciation Rules and the Theory of Tax Reform  Tax reform proposals are motivated by two insights from the literature on the optimal design of a tax system: –A tax system should not favor one type of input over another. If it does, then economic inefficiency results. (Diamond and Mirlees) –A tax system should not tax capital income, as taxes on capital income impose distortions that explode over time. (Chamley, Judd)  Current depreciation rules violate both principles.

4 Depreciation Rules and the Theory of Tax Reform (cont.)  Depreciation rules and economic distortions –Tax depreciation rules create economic distortions when the depreciation allowance differs from true economic depreciation. This leads firms to substitute tax-favored types of equipment for other types of equipment. –Current depreciation rules introduce a non-optimal tax on capital because firms do not receive the full benefit of depreciation in the year that they purchase an asset. With expensing, a dollar spent on a machine, for example, would generate a deduction worth one dollar. When a deduction is spread out over many years, the present value of the deduction declines sharply.

5 Depreciation Rules and the Theory of Tax Reform (cont.)  Estimates suggest that the economic cost resulting from the differential tax treatment of capital goods is relatively inconsequential. (Auerbach)  However, the tax on capital income, which includes the corporate and individual income taxes on capital income, likely has very large efficiency effects. Recent studies of the gains from a wholesale switch to a consumption tax suggest that output could increase enormously, with a healthy share of the gain attributable to lower taxes on capital income. (Altig et al.)  Accordingly, almost all of the benefit from revising depreciation rules would come from the associated reduction of the tax on capital income if depreciation allowances were expanded in the direction of expensing and not from an improved allocation of business investment across assets.

6 How Big Is the Distortion?  Current law gives firms deductions that are lower in present value than what they could take with expensing. –For 7-year tax life assets, each dollar of equipment spending is allowed a deduction worth only 84 cents in present value. With expensing, firms could deduct the full dollar of spending. –For 5-year equipment, the current deduction is worth 88 cents. –For 3 year equipment, the current deduction is worth 94 cents. (Cohen, Hansen and Hassett)

7 Depreciation Rules and the Cost of New Investment  Since the value of the deduction is lower than under expensing, the cost of investing is higher. This drives down investment and reduces economic activity.  Assuming a 42% corporate tax rate (35% federal statutory tax rate plus an average 7% state and local tax rate), the cost of new investment under current law relative to expensing is: –11.5 percent higher for 7-year equipment –8.7 percent higher for 5-year equipment –4.3 percent higher for 3-year equipment

8 The Effect of Depreciation Rules on Economic Activity  A large literature exists that has found a strong and statistically significant link between taxes that affect the cost of investment and investment activity. (Hassett and Hubbard) –The basic investment model can take many different forms. The implied responsiveness of investment to tax policy is remarkably similar across specifications and data sets.  A recently updated study found results that reinforced these findings, suggesting that the effects of tax policy on investment may be even larger. (Desai and Goolsbee)  While the economic science is an uncertain one, the link between tax policy and investment is one of the better- documented and least-disputed results in the literature on the effects of taxation on economic activity.  Tax reforms that reduce the tax on investment activity will almost certainly significantly spur investment.

9 Is it Ever Appropriate to Favor Certain Types of Investment?  Economic theory tells us that under some conditions it is optimal for the government to subsidize particular types of capital. –For example, monopolists tend to increase profit by reducing output. The result is an inefficiently low level of output. Subsidizing the capital expenditures of monopolies, although politically infeasible, can move the economy toward a better outcome by inducing them to produce more output. –More interestingly, some activities may have positive external effects. Chief among these are research and development expenditures. Since research discoveries often lead to additional discoveries, the social benefit from research is greater than the private benefit, with some estimates suggesting the benefit to society is double the private benefit. Accordingly, in theory, it may be beneficial to provide special subsidies for research.

10 The Current Research Credit is Terrible Tax Design  Designing an efficient subsidy to encourage new research expenditures is difficult (who should be undertaking the research, how much research should be undertaken, etc.).  Credits to encourage research activity through the tax code may be even more difficult to structure. –Requires not only picking the appropriate research activities to subsidize, but also ensuring that the firms who should be undertaking the beneficial research are the firms receiving the subsidy. (Does research into new types of potato chips qualify?) –Credits that attempt to reward incremental expenditures can be extremely complicated and of questionable effectiveness. (Altshuler) –Moreover, Section 382 limitations often eliminate tax benefits for small innovative firms. Equity issuance can count as an ownership change and essentially eliminate benefits that are carried forward. Unless credits are refundable, it may be difficult to provide a tax benefit to the most innovative start-up firms.(Hassett)  While in theory a credit to encourage additional research may be appropriate, in practice it is has been impossible to get right.

11 References  Altig, David, et al. (2001). “Simulating Fundamental Tax Reform in the United States,” American Economic Review 91(3):  Altshuler, Rosanne (1988). “A Dynamic Analysis of the Research and Experimentation Credit,” National Tax Journal 41(4):  Auerbach, Alan J. (1989). “The Deadweight Loss from ‘Nonneutral’ Capital Income Taxation,” Journal of Public Economics 40(1):  Chamley, Christophe P. (1986). “Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives,” Econometrica 54 (3):  Cohen, Darrel S., Dorthe-Pernille Hansen, and Kevin A. Hassett (2002). “The Effects of Temporary Partial Expensing on Investment Incentives in the United States,” National Tax Journal 55(3):  Desai, Mihir and Austan Goolsbee (2004). “Investment, Overhang, and Tax Policy,” Brookings Papers on Economic Activity 2:  Diamond, Peter A. and James A. Mirrlees (1971). “Optimal Taxation and Public Production,” American Economic Review 61: 8-27,  Judd, Kenneth L. (1985). “Redistributive Taxation in a Simple Perfect Foresight Model,” Journal of Public Economics 28 (1):

12 References (cont.)  Hassett, Kevin A. (2003). “Taxation and the Incentive to Invest in the Biotech Industry,” White Paper, Biotechnology Industry Organization.  Hassett, Kevin, and R. Glenn Hubbard (2002). “Tax Policy and Business Investment,” in Handbook of Public Economics Vol. III, edited by Auerbach and Feldstein. Amsterdam: Elsevier Science B.V.,