Baucus Releases Cost Recovery Draft
This week, Senate Finance Chairman Max Baucus (D-MT) has been moving forward with tax reform, releasing three discussion drafts. On Tuesday, he released a draft of international tax reform intended to make the U.S. more competitive with other developed countries. On Wednesday, he released a draft on tax administration, intended to fight fraud and simplify the filing process. Yesterday, he released a draft changing how businesses treat their expenses, most notably by dramatically simplifying depreciation.
This final draft was intended to achieve a "modern, simpler, and fairer" system that "promotes tax neutrality," equalizing the treatment of different industries and different types of investments. Currently, different industries pay wildly different tax rates. According to the Treasury Department, these rates range from 14 percent for utilities to 31 percent for construction or retail sales.
As with the draft on international taxation, this draft is intended to be revenue-neutral for corporations over the long term, using revenue raised from corporations to lower the corporate tax rate. Some of the revenues raised from small business would be given back to them in better-targeted incentives, which are not all discussed in this draft. Many provisions appear to generate a one-time infusion of revenue since many of the provisions involve a shift in the timing of tax liability rather than an increase. We applaud Senator Baucus for taking the fiscally responsible step of not using temporary revenue for permanent tax cuts, which would increase the deficit in later years.
Because many large expenses (for example, purchases of buildings or equipment) are used over a number of years to produce income, they must be "depreciated" over the life of the asset. The tax code currently groups assets into over 100 categories with over 40 different rates – the number of years over which the asset must be depreciated.
The current system is called "accelerated" because it allows assets to be written off faster than their economic life; companies can claim higher expenses upfront and thus lower their taxable income. Because of these different rates on assets, accelerated depreciation gives an implied subsidy to certain assets and penalizes others. See our Tax Break-Down on accelerated depreciation for a table showing effective tax rates for various types of equipment.
The draft repeals the current depreciation systems and simplifies more than 40 depreciation rates into 5. The draft dramatically simplifies accounting: rather than tracking depreciation for each asset, companies would group their purchases into 4 pools and calculate depreciation once for the entire pool.
Under the current system, a business owner that wants to properly account for a purchase has to consult pages of tables from the IRS, determine when during the year an item began to be used, and find how many years that particular category of item is allowed to be depreciated. For instance, when a store owner buys a $300 cash register and a $1,000 carpet, the IRS tables dictate that both have a 5-year life. The tables then specify what percentage of the cost that can be claimed in each year. In this case, the store owner can deduct $60 of the cost of the cash register and $200 of the carpet in the first year. If the owner buys a desk, which has a 7-year life, the next year, the deductions become even more complicated to track. As a business buys more and more items, tracking deductions for each one becomes increasingly complex.
The Baucus draft would dramatically simplify this system. Instead of calculating deductions for each item individually, the cost of every item with a similar life is combined into the same "pool." In our example case, both the $300 cash register and the $1,000 carpet are combined in the same pool for everything with a life between 5 and 8 years. The pool is $1,300, and the business owner can claim 18 percent as a deduction every year. For the next year, the pool is 18 percent smaller, but increases when future purchases are added.
Finance Committee staff asked CBO to calculate economic lives of assets based on economic data from the Bureau of Economic Analysis. By setting depreciation schedules roughly equal to economic lives, the draft removes implied subsidies from the depreciation schedules. It makes the tax code more transparent, implying that incentives should be given directly through credits or deductions, rather than indirectly through faster depreciation schedules.
Certain assets would still be depreciated asset-by-asset, but the time periods would increase to reflect economic life. The time period for intangibles (copyrights, patents, customer lists, etc.) would increase from 15 to 20 years while the time period for real property (real estate) would lengthen to 43 years.
Earlier this year, we estimated repealing accelerated depreciation in favor of the so-called Alternative Depreciation Schedule would raise roughly $775 billion, including $550 billion from C-Corporations. Once temporary revenue from timing shifts were excluded, those numbers would fall to close $520 billion and $350 billion, respectively. It is not clear whether the Chairman’s plan would raise more or less than this policy. According to our Corporate Rate Calculator, raising $350 billion from this provision would be enough to reduce the corporate rate by approximately 3 percentage points.
Generally, spending that generates income over time must be amortized over the time that the income will be earned. However, several types of spending are exempt from the general rule under the current system. Money spent on research and experimentation, natural resource extraction, or advertising can be deducted immediately, even though they generate income over time. Under this plan, expenses for research and natural resource extraction must be deducted over five years. Half of advertising expenses can still be deducted immediately, but the other half must also be deducted over five years.
The treatment of research expenses is a tax expenditure, or a deviation from a "normal" income tax code. Several tax expenditures make up the special treatment of natural resource extraction. The ability to deduct advertising expenses, however, is considered a normal part of the income tax code, and amortizing advertising expenses is a non-tax expenditure base provision (NTEBP) that has been considered for decades. Even though it's not officially a tax expenditure, changing the treatment of advertising expenses can still broaden the tax base and equalize treatment of similar long-term investments that build brand loyalty.
Completely repealing the expensing of research and experimental expenditures, which make them be depreciated over the same time period as the benefits, would raise $160 billion, nearly all from C-Corporations. The draft allows expenditures to be expensed over 5 years, which would raise less money than completely repealing expensing. As we estimated in our Tax Break-Down, repealing drilling cost expensing would raise $18 billion (the Baucus draft would raise less). And we previously estimated that amortizing one quarter of the advertising deduction over 15 years would raise $20 billion per year. It is not clear whether amortizing one-half the deduction over five years would raise more or less money.
The majority of the money raised from small businesses would be spent to allow them to immediately deduct costs. Currently, a temporary provision allows small businesses to deduct $500,000 of expenses immediately, regardless of whether they normally have to be depreciated over time. The $500,000 amount phases out for businesses that buy over $2 million of property in a year. Baucus' draft would make the provision permanent and double it to $1 million of property (indexed to inflation). In contrast, Chairman Dave Camp's draft would revert the deduction to 2012 levels of $250,000. The bill extends some smaller expensing provisions, such as the inclusion of computer software, and lets others expire.
The deduction is currently set to shrink at the end of the year. Extending the deduction at the lower levels proposed by Chairman Camp would cost approximately $35 billion, while extending at the deduction at current levels would cost approximately $65 billion. It is unknown how much more the expanded Baucus version would cost.
The draft also allows small businesses with under $10 million in receipts to use cash accounting, which eliminates the need to account for inventories and depreciate property. This draft also includes a provision from Camp's small business draft, doubling the deduction for start-up expenses, which costs less than $1 billion.
Repealing certain tax expenditures
The draft repeals last-in, first-out accounting (LIFO), a special system available to U.S. companies that is not available under international accounting standards. LIFO allows certain companies that have held inventories over long periods of time to claim smaller profits (and pay less tax) than they otherwise would. We described LIFO in detail in our Tax Break-down series, including more information on the types of companies affected. The draft also repeals another preferential method for measuring inventories, the "lower of cost or market" rules.
Several smaller tax expenditures are repealed like percentage depletion rules, which allow oil and gas companies to deduct drilling costs faster than otherwise, and like-kind exchanges, which let taxpayers avoid capital gains tax from selling an asset if they use a gain to buy a similar ("like-kind") asset.
Repealing LIFO will generate between $90-$110 billion, of mostly temporary revenue as companies are forced to revalue their existing inventories. Repealing the lower-of-cost-or-market rules will raise $5 billion, repealing percentage depletion will generate $10 billion, and repealing like-kind exchanges will raise $20 billion.
The draft released by the Finance Committee today would dramatically change the way that businesses claim expenses. It would reduce economic distortions between different types of investment, creatively improve simplicity, and recognizes the types of hard choices that will have to be made in tax reform. Some industries will lose the indirect subsidies of current system; however, every business will benefit from the lower rates and simpler accounting system under the new bill. We look forward to seeing the comments and responses around this new bill. The bill is a large step moving the process forward towards responsibly reforming our tax code.
This post corrected on November 25, 2013 to clarify the expanation on intangible expensing.