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More on Tax Reform

 

In yesterday’s posting, I cited Rob Atkinson’s new report on tax reform.  In that report, he argues that there is no evidence of the claim that tax incentives automatically lead to unproductive over investments in the favored sectors.  For example, some investment tax credits may actually boost productivity because of an underlying under investment in certain productivity raising activities.  I am prepared to admit that some tax incentives lead to economic distortions.  For example, I’m not sure the mortgage tax deduction for second homes leading to greater vacation home production is the most productive use of capital.  But I do agree that there is knee-jerk assumption about differential treatment in the tax code. 

Atkinson points to a recent report by the President’s Economic Recovery Advisory Board (PERAB), Report on Tax Reform Options.  That report asserts “Because certain assets and investments are tax favored, tax considerations drive overinvestment in those assets at the expense of more economically productive investments.”

I ran into an example of this thinking specifically with respect to intangibles in the previous Administration’s Treasury Department’s 2007 report on tax reform (see earlier posting).  That paper claims that we may be overinvesting in intangibles, especially human capital, because of favorable tax treatment.  This is because investments in intangibles are immediately expensed whereas investments in physical assets are depreciated over their useful lives.  Frankly, I find that idea that somehow we are overinvesting in intangible assets to be laughable.  If the tax code gives intangibles an advantage, then it is a unintended benefit that we should exploit not eliminate.

The PERAB seems to accept this claim, without actually making it.  In their discussion of expensing of plant and equipment, they buy implicitly into the notion that investments in intangibles is favored by the tax code:

Providing expensing for physical capital would also eliminate the differential tax treatment between investments in physical capital, which are currently deducted over many years, and investments in certain intangible capital (like research and development, or advertising), which businesses can currently deduct immediately.

PERAB does not, at least, make the mistake of then claiming that we are overinvesting in intangibles.  While business investment in intangibles has increased over the past few decades, both absolute and relative to physical capital, it is not at all clear that we are overinvesting.  In some areas, such as basic research and worker training, I believe it is clear that we are underinvesting.

For this reason, I would propose a principle for reform which turns the differential tax treatment on its head.  We need to make sure that treats investments in intangible assets at least as well in tangible assets.  The tax code should not distort investment decisions by skewing it toward physical assets.

Last year’s tax deal gives a perfect example of how this bias against intangibles works.  In the stimulus bill (sec. 144(a)(12)(C)), there was a minor change to allow the use of industrial development bonds (IBDs) to finance facilities manufacturing intangible property.  Before this change, only traditional factories were eligible for this program.  The change would allow local government to support new facilities for software development or bio-tech research facilities, for example, as well.  That expired at the end of 2010 — and was not included in the tax deal.  This simply act of putting physical and intangible investments on the same footing was forgotten and ignored.

This example of ignoring intangibles is all too common in the tax code.  Yes, intangibles are expensed.  But I doubt that causes any CEO to say to themselves, “I’m going to increase my training budget and not buy that new machine because I get a bigger tax break from spending on training.” 

We need to look at how investment decision really get made – and adjust our tax code accordingly.  And one of the adjustments we need to make is ensuring that the tax code fosters, not discourages, investments in intangible assets.  After all, intangibles are the fuel that runs this new knowledge economy.

 

(Cross posted from The Intangible Economy)

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