How a Good Tax Reform Goes Bad

"Full expensing" is a potent incentive for businesses, until it becomes crony capitalism.

As congressional Republicans turn their attention to tax reform this fall, one of the biggest debates will concern “full expensing” for corporations. There are many proposals, but the common core of this idea is to offer tax breaks only if a business buys something, or in essence makes a new investment.

The good news is that full expensing can be a more potent incentive than a cut in the corporate income tax rate, which also confers a benefit on investments already in place. The bad news is that full expensing, in part because of its very potency, may boost crony capitalism in our tax code. 

Ideally, full expensing avoids the problems of direct, targeted tax credits for specific businesses, like those the government of Wisconsin is considering for Foxconn Technology Group. This approach is unpopular with economists, as it requires the government to pick winners and losers. The political influence of companies tends to turn this into crony capitalism, where many of the benefits go to lobbyists rather than the citizenry.

Full expensing seeks to create a more level playing field for promoting business investment, but is that possible?

Since 2008, the federal government has extended “bonus expensing,” which allows for a 50 percent deduction for many investments and covers about two-thirds of all investment. There are already various expensing provisions for investing in equipment, advertising, and research and development, and many forms of accelerated depreciation. By one estimate, corporations in 2012 were able to deduct more than 87 percent of the value of their investments, over time. So moving to “full expensing” may not be a complete economic game changer.

If nothing else, full expensing would benefit businesses by accelerating when the relevant deductions could be taken (right away, rather than over a multiyear period), and for that reason it would boost investment. But that in turn benefits some kinds of businesses more than others. What about businesses that invest a lot today, but earn back the cash slowly and turn a profit only years later? Without a big tax bill, they won’t get a significant tax reduction now, which would blunt the benefits of full expensing. That’s OK, but again it means not to expect a miracle from tax reform.

As it is likely to be implemented, full expensing applies most easily to companies that already have steady profits. And those are the companies where “getting the expensing benefits now” versus “getting the expensing benefits later” probably matters the least.

Under one pure version of full expensing, the government would transfer funds to companies once those companies have started new investments, even if those companies are not yet making money. For instance, Gavin Ekins at the Tax Foundation has suggested: “In some cases, the federal government could consider refunding deductions above the taxable income of the business or allow larger companies to lease investments to small companies.”

That I find worrying, because the government would be fronting money to companies and wouldn’t see the money again if those companies failed. Furthermore, companies would end up lobbying for what would evolve into corporate subsidies, no matter how hard legislators tried to write neutrality into the tax code. Full expensing again ends up as less neutral than it seemed in theory.

I’m sympathetic to the basic idea behind full expensing, as it reflects a time-honored economic principle that we should focus on incentives at the margins that will most boost growth. And current methods of determining expensing and depreciation seem to be chaotic, capricious and uneven in their impact across sectors. There is room for improvement. But so often the devil is in the details, and the simple idea of applying economic logic to the tax code can be harder to pull off than it might seem at first.

For full expensing to have a major positive effect, and outperform the “skinny” option of just slashing the corporate tax rate, it will have to bring more than just a marginal gain in expensing benefits. It will have to stay relatively neutral across different classes of investment, and it will have to avoid becoming another form of crony capitalism.

All we need for that is an administration and a congressional process fully devoted to mastering detail and rendering objective assessments and communicating them transparently. Hmm …