Corporate taxes decrease investment specifically during inflation – 1970s prove

EXPENSING, PROFITS, AND INFLATION The loss of full expensing is most economically costly during times of high inflation because inflation erodes the deduction’s value more quickly. At 2 percent inflation, a new building’s present value tax deduction is worth 45 cents of each dollar invested. If inflation is 5 percent, the write-off value falls to 32 cents on the dollar. 3 Following persistent high inflation in the 1970s, inflation was relatively low and stable for almost 40 years. In the decade before the 2020 pandemic, the average annual inflation rate was 2.2 percent as measured by the Consumer Price Index for All Urban Consumers. Since the beginning of 2021, the inflation rate has remained at a stubbornly high average rate of 6.3 percent.10 In March 2023, inflation was 5 percent over the previous 12 months.11 Even if inflation continues to retreat from its post‐pandemic highs, there is substantial risk that it will remain above the historical average for some time. Businesses and their investors make decisions about future investments based on the project’s projected aftertax rate of return compared to its alternatives. The normal depreciation system lowers after-tax returns because the value of the investment deduction declines over time as inflation and time erode its real present value. By effectively recognizing only a portion of the investment’s true cost, the tax system raises effective tax rates by artificially increasing business profits (by reducing the real value of allowable expenses). Table 1 shows how the present value of investment deductions can vary significantly according to the length of the asset life and the rate of inflation. Congress and the IRS assign investments to asset classes, between 3 years (for example, certain livestock) and 39 years (office buildings and other structures). There are multiple ways an asset can be depreciated, but most investments are depreciated under the Modified Accelerated Cost Recovery System’s general depreciation system (GDS).12 Table 1 shows estimates for different asset classes under GDS with no expensing and research and development expenditures amortized over five years. The calculations assume a 3 percent real discount rate and inflation rates of between 0 and 8 percent.13 At 2 percent inflation, Table 1 shows that a $1 investment depreciated over seven years under the GDS (without expensing) is worth only 90 cents to the business in present value. At 5 percent inflation, it is worth only 85 cents in present value. Under full expensing, the business can write off the full investment immediately, recovering the entire cost. A $1 investment in a nonresidential structure, depreciated over 39 years, has a present value of 45 cents at 2 percent inflation and 32 cents at 5 percent inflation. While it is unlikely that inflation will stay above 5 percent for the next three decades, even low inflation levels over long periods erode the real value of investment tax deductions. Because economy-wide investment is not evenly distributed across the IRS asset classes, it is helpful to estimate how much of a firm’s annual investment is ultimately denied as a tax deduction. To get such an estimate, we can roughly assign investment data by type from the Bureau of Economic Analysis’s private fixed assets accounts tables to IRS asset class lives. The present value deduction estimates from Table 1 can then be weighted by the estimates of 2021 private investment in each asset class.14 This exercise shows that at 2 percent inflation, U.S. businesses would only be able to deduct about 78 percent of the value of their investments in the absence of full expensing. If inflation is sustained at 5 percent, U.S. businesses would only be able to deduct 72 percent of the value of their annual investment spending. Denial of a full tax deduction can have a significant effect on an investment’s after-tax rate of return. Table 2 shows a $100 investment in a farm structure (with asset class life Inflation erodes the value of investment deductions Table 1 Present value of $1 write-off when ination is 0% 0.98 0.96 0.94 0.91 0.83 0.78 0.69 0.60 0.93 2% 0.97 0.93 0.90 0.85 0.74 0.68 0.56 0.45 0.89 5% 0.96 0.90 0.85 0.78 0.64 0.56 0.43 0.32 0.83 8% 0.94 0.87 0.81 0.72 0.56 0.47 0.34 0.25 0.78 Asset lives' years → 3 5 7 10 15 20 27.5 39 Amortized R&D Source: Author’s calculations. Notes: R&D = research and development; present value assumes a 3 percent real discount rate; 3-year to 20-year assets are placed in service in the first quarter of the year using 200 percent (3–10 years) or 150 percent (15 years and 20 years) declining balance general depreciation system (GDS); 27.5-year to 39-year assets are placed in service in January using GDS straight line method; and R&D is amortized over 5 years using the midyear convention. 4 of 20 years) that generates $115 in revenue. Under immediate expensing, the investment returns $15 in profit, which is taxed at 20 percent for a 12 percent after-tax rate of return. Under a system of tax depreciation and 5 percent inflation, the same $100 write-off’s present value is reduced to $56 (from Table 1). This smaller write-off increases the taxable profit from $15 to $59 and increases taxes paid to $12. Table 2 shows that the rate of return on the same investment falls from 12 percent to 3 percent due entirely to how the investment is treated in the tax code. Under higher tax rates and higher inflation, the effect of expensing is even more pronounced. At a tax rate of 28 percent, the Table 2 investment would have a negative after-tax return under depreciation. 1970s Inflation Stunted Investment A largely forgotten cost of high inflation in the 1970s was the resulting decrease in business investment due, in part, to the tax code’s treatment of depreciation. The high costs of inflation helped motivate cost recovery reforms that shortened asset lives in the 1981 Economic Recovery Tax Act.15 In 1979, Martin Feldstein and Lawrence Summers estimated that inflation increased the total effective tax rate on capital income by 23 percentage points, from 43 percent to 66 percent. They concluded that the principal reason inflation raises effective tax rates is because “depreciation causes a major overstatement of taxable profits.”16 Feldstein concludes in a separate econometric analysis in 1980 that “the rising rate of inflation has, because of the structure of existing U.S tax rules, substantially discouraged investment in the past 15 years.”17 In the years after the high inflation, a series of similar papers confirm that inflation—even at relatively low levels— significantly increases the after-tax cost of capital, which decreases business investment.18 International Monetary Fund research similarly shows that under certain assumptions (22 percent tax rate and 25 percent depreciation rate), “the optimal investment level would decrease by 0.42 percent in response to a one-percentage point increase in inflation.”19 Facing high inflation again, the U.S. tax code is set to begin denying businesses the full investment deduction. By requiring long and variable depreciation deductions, the tax code will accelerate the negative effects of inflation on investment and economic growth.