While all eyes are on impeachment, some folks in Washington are still continuing to propose legislation on bread and butter policy issues. Notably, there are two tax policy ideas some Republicans in DC have kicked around, one of which would be a welcome fix to the tax reform from two years ago, while the other wouldn’t provide many economic benefits.
A Good Idea: Extending the Tax Treatment of R&D
Representatives John Larson (D-CT) and Ron Estes (R-KS) have introduced a bill called the American Innovation and Competitive Act, which would extend the Tax Cuts and Jobs Act’s tax treatment of research and development spending.
The corporate income tax should be a tax on corporate profits, or revenue minus costs. As Nicole Kaeding of the National Taxpayers Union explained, under current law, corporations can subtract their spending on research and development the year they made those investments. However, in order to raise revenue during the passage of tax reform, the TCJA authors made this tax treatment expire in 2022, after which companies will have to amortize research and development spending over the course of five years.
In other words, if a company spends $1,000 on new research this year, under amoritization, they’d have to deduct $200 each year for five years. Under expensing, they could deduct all $1,000 of the new research spending this year.
Forcing companies to spread the deduction of investment over several years is a mistake. Thanks to the time value of money, in which money available at the present time is worth more than the same sum of money in the future, $200 five years from now is worth less than $200 now. As a result, forcing companies to spread deductions for investment over future years means that companies cannot subtract the full real value of their costs, and can lead to companies having to pay taxes on “profits” that don’t exist.
Not letting companies deduct the full value of research and development spending increases the cost of investment, and there’s a lot of economic evidence that investment and R&D are very responsive to changes in tax treatment. Investment and R&D are crucial to long-term productivity growth, and along with productivity growth come wage growth and economic prosperity. As productivity growth and investment have slowed, policymakers should work to be sure that the tax code isn’t adding insult to injury by disincentivizing investment.
A Bad Idea: Indexing Capital Gains to Inflation
The Trump administration has pondered making a rule change that would adjust capital gains to inflation, possibly bypassing the legislative branch, although the Trump administration has since shelved this proposal.
Under current law, when someone sells an asset, they pay a tax on the difference between the value of the sale and the amount they originally bought the asset for. However, thanks to gradual inflation over time, the asset’s real value might not have gone up, so sometimes taxpayers might have to pay taxes on gains that don’t really exist. Indexing capital gains to inflation would get rid of this bias.
Sen. Ted Cruz (R-TX) and Americans for Tax Reform president Grover Norquist have been two of the leading advocates of indexing capital gains. But there’s not much reason to believe that this change would provide much economic growth, and while in isolation, indexing might make sense, it would create opportunities for tax avoidance.
As The Wall Street Journal reported this August, economists projected only modest economic growth from indexing capital gains to inflation, such as the Tax Foundation, the Penn-Wharton Budget Model, and the Congressional Research Service. A study from economist Danny Yagan of the dividend tax cut in the 2003 tax reform found little evidence that the cut increased capital investment or employee compensation.
Furthermore, as economist Kyle Pomerleau told Slate, indexing one part of the tax code while not indexing other parts of the tax code could create opportunities for tax avoidance. For example, with only capital gains indexed, a taxpayer could borrow money to buy stocks and deduct the (larger) nominal value of their interest payments, while only paying taxes on inflation-adjusted (smaller) capital gains.
Conclusion
Given that the federal government ran a deficit of almost $1 trillion dollars in 2019, additional tax cuts might not be appealing. However, pro-growth revenue-neutral tax changes would be welcome. As the Tax Foundation proposed, the federal government could pay for making the TCJA’s tax treatment of R&D by eliminating two relatively small tax breaks, the rental loss exemption and the credit union exemption. On the other hand, shelving indexing capital gains was the right decision.
