Dark Skies Threaten Capital-Investment Returns

With Congress looking to cut ordinary corporate tax rates in a revenue-neutral way, a switch to a less-favorable depreciation methodology could be ...
David McCannAugust 7, 2013

A potential change in tax rules governing the depreciation of physical assets would not generate the additional corporate tax revenue the move would be designed to stimulate, according to a report from the Tax Foundation, a Washington, D.C.-based think tank.

In fact, the report claims, the change would effectively reduce tax revenues by $6.4 billion, cause the loss of 68,000 jobs, pare hourly wages by 0.3 percent and reduce gross domestic product by $59 billion, or 0.4 percent.

The Senate Finance Committee and the House Ways and Means Committee are scouring the tax code for ways to pay for the corporate income tax rate cuts envisioned by tax-reform efforts. Business groups fear that the Modified Accelerated Cost Recovery System (MACRS), the primary method of depreciating physical assets like buildings and equipment for the last quarter century, may be lost.

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The consequences of that would be unpleasant, the foundation claims, because companies would presumably then be forced to use the Alternative Depreciation System (ADS), a less-generous method that the tax code currently requires only for foreign subsidiaries of U.S. companies.

Under ADS, asset lives are much longer. Longer asset lives discourage investment, and lower corporate tax rates encourage investment. “The question is, which influence dominates?” says Stephen Entin, senior fellow for the Tax Foundation, which says it’s nonpartisan but also favors a free-market outlook. “And dollar for dollar, the cost of plant and equipment goes up more from longer asset lives than it goes down for an equal-dollar tax-rate reduction. The mathematics of it are quite clear.”

But new number crunching shouldn’t actually be necessary to understand why adopting ADS as the required depreciation methodology will harm, not raise federal revenue collection, says Entin. After all, it is imposed on multinationals’ foreign subsidiaries as a way to encourage domestic investment.

Because of inflation and the time value of money, a stretched-out write-off of investment costs forces businesses to understate those costs in present-value terms and thereby overstate their true incomes, the report notes. If a company earns $1 million in a particular country with a 25 percent tax rate, it owes $250,000 to that government. The U.S. tax rate, meanwhile, is 35 percent, and the company must pay the difference, or $100,000, to the IRS.

If, however, depreciation rules say that for U.S. taxation purposes the company earned not $1 million but $1.1 million, with the difference created by the ADS depreciation methodology, the IRS calculates that the actual rate paid in that country was not 25 percent but 23.5 percent, and the company now owes the U.S. government $112,500, not $100,000.

Imposing ADS on parent-company income would similarly lower investment returns. “We’ve put that on the foreign subsidiaries because we knew it was bad for companies. Why would we want to bring that here?” says Entin. Discouraging capital investment will decrease productivity, employment and wages, hence the anticipated drops in tax revenue and GDP, the Tax Foundation calculates.

A similar change in depreciation methodology included in the Tax Reform Act of 1986, from the Accelerated Cost Recovery System to the less-generous MACRS (which is still more generous than ADS), contributed to a slight slowdown in the economic growth in the late 1980s, according to Entin.

“It’s a trick,” he says, referring to the government lowering the ordinary corporate income tax rate by squeezing out extra revenue from other changes to the tax code. But, he adds, the government is “in a box,” with many companies desperately needing a rate cut to compete with foreign competitors abroad.

“They want to do this in a revenue-neutral manner,” Entin says. “It’s like raising taxes through the back door at 112 Maple Street and lowering them through the front door at 124 Maple Street. The people at 112 are ticked off because they’re subsidizing the people at 124. There’s going to be an uproar in the business community about winners and losers.”