Going Beyond Tax Expenditures

When we talk about tax reform which lowers the rate and broadens the base, the base-broadening portion of the equation usally focuses on tax expenditures. These deductions, exclusions, credits, and special rates are considered a departure from the normal tax code, and so a number of proposals have focused on reducing or eliminating them. However, not all base-broadening need come from tax expenditures; there are changes which can be made beyond the normal tax expenditure list which could raise revenue and improve efficiency.

Our recent paper on corporate tax reform and our fun, interactive tax calculator both include focus on "non-tax expenditure base-broadening." This type of base broadening involves looking at deductions and other provisions considered to be a "normal" part of the tax code  and finding ways to reduce or modify them. On the corporate side, there is almost an unlimited number of these provisions -- since normal business expenses are deductible in the calculation of net (taxable) income. In many cases, the best policy decision is to leave these provisions as they are; but in some cases, reform may be helpful. We looked at three potential areas for reform in our tax calculator:

  • The Deduction for Interest Expenses: Business interest is generally deductible, as long as total interest expenses do not exceed 150 percent of a business's equity or 50 percent of its taxable income. However, the deduction may distort corporate financing decisions by making debt a much more attractive option than equity, which is taxed at both the corporate level and the shareholder level. This encouragement of overleveraging could be problematic, as we have seen in recent years. One way of dealing with this distortion, which the Wyden-Coats plan uses, is to disallow the portion of interest expenses that is attributable to inflation. Another way would be to lower the limits of the current disallowances or to make interest only partially deductible.
  • Meals and Entertainment Expenses: Meals and entertainment expenses incurred during discussions of business would be fully deductible in a "normal tax code," since they are a cost of doing business. However, in part because this provision is abused and because individuals receive personal gain from meals and entertainment, current law allows only 50 percent of the costs to be deductibled and does not allow the deduction for extravagant expenses and expenses incurred at places that are clearly not conducive to business discussions. One option would be to further reduce the deductibility of meals and entertainment; or perhaps eliminate it altogether.
  • Advertising Costs: Normally, if businesses incur costs for assets that will produce income in future years, they are required to write that asset off over a number of years, reflecting the useful life of that asset. Advertising costs may be written off in the year they are incurred, reflecting the belief that they increase sales in the short term. However, a single advertisement may produce income in future years by building a company's reputation or by creating brand loyalty. An option in our tax calculator would require that 15 percent of advertising costs be written off over a 15-year period, with the remaining 85 percent still being deductible immediately.

These are just a few of the possibilities for non-tax expenditure base-broadeners. As with requiring businesses to capitalize advertising costs, one could apply the same rationale to employee training costs. The taxation (or lack thereof) of non-profit organizations could be reformed. Large pass-through businesses, business-like non-profits, and government-sponsored businesses could all be subjected to the corporate income tax. Or regular deductions could be disallowed on certain types of activities (for example, cigarette advertisements). 

As this blog demonstrates, tax reform is not just about getting rid of or reducing tax expenditures. It requires careful and thoughtful examination of what a better tax code should look like.