President-elect Joe Biden campaigned on bringing manufacturing back to America as part of his post-pandemic economic-recovery plan. In his “Made in America” plan, Biden promises to strengthen heavy industry, delivering results where the Trump administration failed. However, Biden’s proposal for a tax on minimum book income, intended to reduce corporate tax avoidance, would make this promise harder to keep.
The minimum tax is a response to stories about companies such as Amazon avoiding income taxes despite making profits (Amazon paid $162 million in U.S. federal income taxes in 2019 after paying none in 2017 and 2018). The outcry over this jarring statistic reflects a basic misunderstanding about taxable income. Specifically, people fail to realize that book income is calculated differently from taxable income.
Corporate profits are equal to revenues minus costs. When calculating book income, capital spending is spread out over the course of an asset’s life — e.g., a $20,000 investment in a truck that lasts ten years with no resale value means a $2,000 annual deduction. However, when calculating taxable income, there are several tax rules that allow companies to deduct a larger portion (or all) of their investments in the year they’re made.
There are good reasons for this difference. For book income, spreading investment costs out on the income statement rather than recording them all in one year prevents them from having to report giant losses in years when they make large capital investments. Such losses would make businesses’ expenditures needlessly volatile, conflating short-term spending with long-term financial commitments.
For taxable income, on the other hand, it makes sense for companies to deduct the entire cost of capital investment in the first year, because it more accurately measures annual profits. Otherwise, companies have to pay taxes on profit that does not exist. More important, not letting companies deduct the full cost of their investments raises taxes on investment, which is bad for the economy and for workers. Investment drives productivity growth, which is in turn the core of long-term wage growth.
This arrangement creates a bias against industries more reliant on capital investment — among them, manufacturing. Companies can deduct the full cost of their spending on workers and day-to-day expenses, but often cannot deduct the full cost of their capital spending. As a result, companies in less capital-intensive industries (whether a financial services firm such as Citigroup or a food service company such as McDonald’s) can deduct a higher percentage of their costs than manufacturing companies such as U.S. Steel or General Motors can. For this reason, Matthew Lesh of the London-based Adam Smith Institute has dubbed this imbalance “The Factory Tax,” an appropriate way to describe a policy which disproportionately harms industry.
There’s plenty of evidence suggesting that accelerated depreciation (and other tax policies that allow companies to deduct investment spending faster) increases investment, productivity, and growth. Eric Ohrn of Grinnell College found that states that adopted a form of accelerated depreciation saw significant increases in manufacturing investment and wages compared with states that didn’t adopt this policy.
Disadvantaging capital-intensive industries might end up also hurting Biden’s environmental agenda, a cornerstone of which is significant private investment in new forms of energy production. According to a working paper by Princeton’s Jordan Richmond, the tax would fall most heavily on utility companies as well as manufacturers. Energy, unsurprisingly, is a capital-intensive sector, and increasing the cost of investment means that companies will replace older, less energy-efficient technology more slowly, keeping emissions high. In the power sector, this means it will be more costly for companies to invest in renewable replacements for fossil fuel.
Instead of imposing this minimum tax, the president-elect should consider working with Republicans to make permanent certain provisions of the Tax Cuts and Jobs Act (TCJA) that are scheduled to phase out in 2022. Specifically, the TCJA allows companies to deduct the full cost of investments in equipment and machinery in the year they are made, a policy called “full expensing.” Additionally, the president-elect could also support making investment in structures, such as warehouses or apartment buildings, eligible for the same benefits.
A system of full expensing, where all investment costs are deducted immediately, is more consistent with Biden’s goals for the American economy than the minimum tax is. Biden has championed an agenda to “build back better,” particularly in manufacturing and industrial communities, and there’s no better tax policy for incentivizing real, tangible investment in building than full expensing for all capital investment.
Unsurprisingly and understandably, Biden and congressional progressives have an aversion to anything that looks like a corporate tax cut. But in all likelihood, they will need to compromise with a Republican Senate to pass additional stimulus legislation. And this would be a good place for them to make a deal: Democrats may be skeptical, but it would certainly help the president-elect achieve some of his major economic goals.