In preparation for Thursday’s short conference on tax policy and competitiveness (see earlier posting), the Treasury Department has released a background paper that makes the case for ending special tax breaks and reducing the corporate tax rate. According to a story in today’s Washington Post (Reconsidering Corporate Tax Breaks), the paper is not meant to be the final word:
Treasury Secretary Henry M. Paulson Jr. said in an interview that the paper is not intended to state a position so much as to open a public discussion about how to streamline taxes and regulations to help U.S. companies compete.
However, the paper is rather forceful in its tone. As the paper states:
Other countries continue to reduce their corporate tax rates, leaving the United States still further behind.
. . .
Our current system for taxing businesses and multinational companies has developed in a patchwork fashion spanning decades, resulting in a web of tax rules that can harm the competitiveness of U.S. companies.
. . .
However, our tax system disrupts and distorts a vast array of business and investment decisions, leading to an inefficient level and allocation of capital through the economy.
There are other worrisome parts to the paper. For example, in the section on “Distortions caused by tax incentives” focuses almost exclusively on the research and experimentation tax credit and the domestic production provisions. What about all the other tax incentives?
I was especially interested in the section on tangible versus intangible assets:
Income from investment in intangible assets (e.g., R&D and advertising) generally receives more favorable tax treatment than does income from investment in tangible assets (e.g., plant and machinery). Investment in intangibles might be excessively encouraged by the tax system, relative to investment in tangible assets.
As discussed above, the cost of purchasing a tangible asset generally is written off (depreciated) over time to compensate for its decline in value due to wear and tear. In contrast, the cost of investment in intangible assets generally is deducted immediately (expensed). Expensing can give a substantial benefit to intangibles over tangible assets. For example, because of expensing, corporate intangibles face an effective tax rate that is close to zero, whereas corporate depreciable assets face an effective tax rate of around 30 percent.
While immediate expensing of intangibles may confer some tax advantage, I’ve seen no evidence to suggest the result is an over-investment in intangibles. In fact, the accounting side of the expensing on intangibles tends to push management toward treating intangibles as an operating expense to be minimized rather than a long term investment.
Likewise the section on physical versus human capital is interesting:
Investment in acquiring skills and abilities shares much in common with investment in more traditional physical assets. Investment in human capital can be thought of as an intermediate input that can be used to produce a final good. Much of the economic cost of acquiring abilities and skills is incurred in the form of earnings that are foregone during the period of training or schooling. Because these foregone earnings are not taxed (i.e., imputed and includable in income), this treatment, in effect, allows an immediate deduction for such investment. Similar to the discussion above on the tax treatment of investment in physical capital, in economic terms, the “deduction” for investment in human capital (i.e., the nontaxation of foregone earnings) equals the tax on the cash flow from the “expected” normal return on the investment, which eliminates the tax on this part of the return (in present value). To the extent that future earnings exceed the expected normal return – perhaps because of luck, innovation, or successful risk taking – the tax on these higher than expected normal returns will exceed the tax value of the initial deduction and would be taxed (in present value).
Investments in physical capital and human capital are treated very differently in our current tax system. Physical capital is typically depreciated over the life of an asset, while human capital is effectively expensed or deducted immediately because of the non-taxation of foregone earnings. This disparate treatment between physical and human capital discourages investment in physical capital relative to human capital. More uniform treatment would reduce this distortion. [Footnote: Of course, more uniform treatment could involve either expensing or applying economic depreciation to all investment (i.e., human and physical capital).]
The current income tax also offers a number of other incentives for investment in human capital. These include the tax exclusion of scholarships, fellowships, and the value of reduced tuition; education tax credits; deduction of student loan interest; tax advantaged education saving accounts; deductibility and exclusion of employer provided education expenses; deductibility of tuition; and allowing students beyond the normal age cut-off to qualify as eligible children when computing their parents’ earned income tax credit and their parents’ dependent deduction.
Again, I see no evidence that all these supposed tax incentives are resulting in an over-investment in human capital and an under-investment in physical capital. What I do see is a preemptive argument against the idea of a knowledge tax credit.
The paper also mounts a spirited defense of the practice of shifting intangible assets offshore:
Multinational corporations have developed a large number of valuable intangible assets such as patents and trademarks that allow them to earn supra-normal or infra-marginal returns on the tangible capital that is necessary to exploit the intangible. The decision on where to locate the production of a particular highly profitable good or service is usually a discrete one in which a certain amount of plant and equipment is required. The decision on how much to invest in any given country therefore is based not only on the effective tax rate on marginal investment, but also on the taxation of the infra-marginal returns.
A U.S. subsidiary abroad has to pay a royalty to the parent company for the use of the U.S. developed intangible. However, the evidence suggests that a substantial portion of the return to the intangible asset remains in the location where it is produced. Furthermore, under the current U.S. tax system, most foreign royalties are shielded from U.S. tax by excess foreign tax credits flowing from more highly taxed income. Multinational companies therefore have a strong incentive to locate the production of any new valuable products and services in low-tax countries. Lowering the corporate tax rate would make the United States a more attractive location.
Interesting, since they just stated that the US tax system benefits investment in intangibles over tangibles. So why is there then an incentive to shift production of intangibles offshore? And not a word about the issue of transfer-pricing, especially of intangibles — which then IRS Commission Mark Everson labeled in Congressional testimony last year as “a high-risk compliance concern”:
Taxpayers, especially in the high technology and pharmaceutical industries, are shifting profits offshore through a variety of arrangements that result in the transfer of valuable intangibles to related foreign entities for inadequate consideration.
and which, this past April, IRS “estimates that inadequate consideration has resulted in material underreporting of taxable income by U.S. Corporations.”
What is also notable in the paper is what is missing. For example, missing from the paper is any discussion of any form of border-refundable tax that many other nations use to boost exports. Also missing is any discussion of payroll taxes.
I would like to think that the Thursday conference will be an open discussion of the issues. The background paper, however, is a set up to a preconceived solution: lower the tax rate. That may or may not be good tax policy. One would not know that from the one-sided advocacy brief that is being used for the background paper.