Chairman of the Senate Finance Committee Max Baucus (D–MT) continues to release draft proposals on important parts of tax reform. His latest draft proposal is a deeply troubling plan.
Baucus proposes to change the way businesses deduct the cost of their capital expenses—things such as machinery, equipment, structures, property, and software that are necessary for them to produce their product or provide their service.
Accounting for businesses’ cost of capital is a vital component of tax reform because it directly influences the cost of capital. Get it wrong and taxes artificially drive up those important costs and will reduce investment, job creation, productivity improvements, and international competitiveness.
The right way for businesses to recover the cost of their capital expenses is for them to be able to deduct from their income their full capital costs in the year those purchases are made. This correct policy is known as “expensing,” and it would stop taxes from increasing capital costs.
Currently, the tax code falls well short of this sound and neutral policy. Instead, businesses are forced to depreciate their capital purchases over many years on time frames set arbitrarily by Congress, a policy known as “economic depreciation.” The cost of most machinery, equipment, and furniture is recovered over five to seven years, and it may take as long as 39 years to deduct the cost of buildings (such as factories or offices).
Rather than move policy closer to a proper expensing system, Baucus wants to lengthen depreciation schedules, which would be even worse than current policy. Baucus would also create a system whereby businesses would place their capital assets into various pools and be allowed to depreciate a certain percentage of each pool annually. This would ease administration but would mean that businesses would never fully deduct the cost of their capital purchases.
America’s already beleaguered workforce would feel the pain of Baucus’s error. Under Baucus’s backward approach, the cost of capital for businesses would rise, and they would therefore purchase less. A reduced capital stock means fewer jobs and lower wages.
Baucus’s plan also repeals the Last-In-First-Out (LIFO) method of inventory accounting, another grievous mistake. The income tax does not allow businesses to deduct the cost of buying inventory until they sell that inventory. Under LIFO accounting, when a business sells a good, it deducts the cost of the most recently acquired good of that type (i.e., the last in).
LIFO accounting can protect businesses that hold inventory from paying taxes on phantom inflationary profits. LIFO accounting has been available for all taxpayers since 1939.
Given recent Federal Reserve monetary policy, much higher levels of inflation are a more serious possibility than they’ve been in recent memory. Repealing LIFO accounting would enable the federal government to increase tax revenue by adopting inflationary policies. The tax code should not provide incentives for the federal government to adopt inflationary policies.
And bizarrely, Baucus would force businesses to amortize their advertising expenses for the first time. This represents a capricious hit at a particular industry and has no grounding in sound economy policy. Advertising is a normal business expense that should be deducted in the year incurred, not over a five-year period. All industries should be on notice that they could also be on deck for such arbitrary targeting.
About the only positive aspect of the Baucus plan is that he makes permanent and expands expensing policy for small businesses. Right now, small businesses are allowed to expense their capital purchases up to $500,000. This amount will drop drastically to only $25,000 in 2014. Baucus would double the current amount to $1 million.
However, the small business exception is the sole positive in a terrible plan. Full expensing for all businesses is the right policy and the one Congress should pursue.