Can Policymakers Time the Ending of Macroeconomic Incentives?: Part Three: New Versus Old Business and Complexity

Can Policymakers Time the Ending of Macroeconomic Incentives?Part Three: New Versus Old Business and ComplexityC. Eugene Steuerle"Economic Perspective" column reprinted withpermission.Copyright 2002 TAX ANALYSTSThe nonpartisan Urban Institute publishes studies, reports,and books on timely topics worthy of public consideration.The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees,or its funders.© TAX ANALYSTS. Reprinted with permission.[1] When policy makers decide that they are going to grant a temporary write-off for new capitalinvestments, they essentially conclude that its macroeconomic advantages exceed other alternatives such asadditional monetary stimulus, a one-time grant or tax credit to taxpayers, or a greater reduction in tax rates.Any special accounting treatment for physical capital investment in a limited time period, however, inevitablyis going to have some side costs that must be weighed in assessing its overall merit. [2] Here I deal with two of the costs not covered in the first two parts of this series. First, the incentiveeffects apply more powerfully to established or old business than to new business -- a potential threat toinnovation. Second, new temporary allowances set in motion a set of additional accounting requirements thatboth increase complexity and encourage firms to play games with the timing of billing or delivery of assetsnear to when the incentives expire. New Versus Old Wealth [3] In 1986, Congress adopted a major reform proposed by the Reagan administration to replace variousinvestment incentives with lower tax rates. The incentives that were eliminated at that time included aninvestment tax credit and an accelerated cost recovery system for depreciable capital. The administration waseven willing to abandon its own particular cost recovery scheme first proposed and put into law in 1981. The1981 scheme must be taken in the context of the time: It was only the latest in a long series of allowancesthat substantially shortened the depreciable lives for assets; its importance relative to provisions already inplace was exaggerated by some friends and foes alike. [4] Despite the switchover, the 1986 change still was consistent with the Reagan philosophy of lower ratesand lower taxes. In 1981, business tax reduction was achieved indirectly; in 1986, direct rate reduction wasfound to be a superior method. [5] Among the most important arguments used for the superiority of rate reduction was that the formermethod had favored old business over new business. Established businesses with positive tax liability might begiven an incentive to invest in physical capital with accelerated write-offs, but firms with little or no taxliability generally could not make use of them. Hence, a competitive advantage was given to firm that coulduse the new tax breaks to offset taxes earned elsewhere. A bit of truth in labeling: I developed this argumentin some earlier research and proposed its use when acting as economic coordinator of the Treasury's taxreform effort. Nonetheless, the argument was accepted and used by the administration. [6] Who were among the losers in the old setup of accelerated allowances? Interestingly, it included manyestablished firms that had recently gone through hard times. In the end, for instance, a number of old line,established, companies with substantial physical investment -- such as some steel companies anticipated tooppose the change because of their heavy past investment -- ended up favoring 1986-style lower rates to theprior system. Having gone through a recession in their own industry or geographic area, they realized thataccelerated allowances were really working against their survival. They couldn't use them, at least for awhile,and the firms that could use them would either bid up interest rates or lower prices, all of which hurt therelative position of the firms without sufficient liability to make use of the tax breaks. [7] Perhaps even more important, the new business is put at a competitive disadvantage by these types ofincentives. Many start-up firms go for a period of time before their sales are adequate to generate positiveprofits. Even if they would be profitable from day one, the profits of a new firm with significant capitalDocument date: April 29, 2002Released online: April 29, 2002 investment are unlikely to be high enough to make full use of the incentives. [8] The new allowance has some of the same problems as the old, pre-1986, law. Even new capitalimmediately generating a real rate of return of 10 percent could not possibly make use of this write-offprovision. For instance, a 30 percent write-off of costs, along with other depreciation, requires that a typicalpiece of equipment (with a tax life of seven years) provide return of receipts in the first year of more than 40cents for every dollar spent on that equipment. Few, if any, start up firms are going to be able to make use ofthis level