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Posts Tagged ‘Depreciation’

I’ve complained over and over again that America’s tax code is a nightmare that undermines competitiveness and retards growth.

Our aggregate fiscal burden may not be as high as it is for many of our foreign competitors, but high tax rates and poor design mean the system is very punitive on a per-dollar-raised basis.

For more information, the Tax Foundation has put together an excellent report measuring international tax competitiveness.

Here’s the methodology.

The Tax Foundation’s International Tax Competitiveness Index (ITCI) measures the degree to which the 34 OECD countries’ tax systems promote competitiveness through low tax burdens on business investment and neutrality through a well-structured tax code. …No longer can a country tax business investment and activity at a high rate without adversely affecting its economic performance. In recent years, many countries have recognized this fact and have moved to reform their tax codes to be more competitive. However, others have failed to do so and are falling behind the global movement. …The competitiveness of a tax code is determined by several factors. The structure and rate of corporate taxes, property taxes, income taxes, cost recovery of business investment, and whether a country has a territorial system are some of the factors that determine whether a country’s tax code is competitive.

And here’s how the United States ranks.

The United States provides a good example of an uncompetitive tax code. …the United States now has the highest corporate income tax rate in the industrialized world. …The United States places 32nd out of the 34 OECD countries on the ITCI. There are three main drivers behind the U.S.’s low score. First, it has the highest corporate income tax rate in the OECD at 39.1 percent. Second, it is one of the only countries in the OECD that does not have a territorial tax system, which would exempt foreign profits earned by domestic corporations from domestic taxation. Finally, the United States loses points for having a relatively high, progressive individual income tax (combined top rate of 46.3 percent) that taxes both dividends and capital gains, albeit at a reduced rate.

Here are the rankings, including scores for the various components.

You have to scroll to the bottom to find the United States. It’s embarrassing that we’re below even Spain and Italy, though I guess it’s good that we managed to edge out Portugal and France.

Looking at the component data, all I can say is that we should be very thankful that politicians haven’t yet figured out how to impose a value-added tax.

I’m also wondering whether it’s better to be ranked 32 out of 34 nations or ranked 94 out of 100 nations?

But rather than focus too much on America’s bad score, let’s look at what some nations are doing right.

Estonia – I’m not surprised that this Baltic nations scores well. Any country that rejects Paul Krugman must be doing something right.

New Zealand – The Kiwis can maintain a decent tax system because they control government spending and limit government coercion.

Switzerland – Fiscal decentralization and sensible citizens are key factors in restraining bad tax policy in Switzerland.

Sweden – The individual income tax is onerous, but Sweden’s penchant for pro-market reform has helped generate good scores in other categories.

Australia – I’m worried the Aussies are drifting in the wrong direction, but any nations that abolishes its death tax deserves a high score.

To close, here’s some of what the editors at the Wall Street Journal opined this morning.

…the inaugural ranking puts the U.S. at 32nd out of 34 industrialized countries in the Organization for Economic Co-operation and Development (OECD). With the developed world’s highest corporate tax rate at over 39% including state levies, plus a rare demand that money earned overseas should be taxed as if it were earned domestically, the U.S. is almost in a class by itself. It ranks just behind Spain and Italy, of all economic humiliations. America did beat Portugal and France, which is currently run by an avowed socialist. …the U.S. would do even worse if it were measured against the world’s roughly 190 countries. The accounting firm KPMG maintains a corporate tax table that includes more than 130 countries and only one has a higher overall corporate tax rate than the U.S. The United Arab Emirates’ 55% rate is an exception, however, because it usually applies only to foreign oil companies.

The WSJ adds a very important point about the liberalizing impact of tax competition.

Liberals argue that U.S. tax rates don’t need to come down because they are already well below the level when Ronald Reagan came into office. But unlike the U.S., the world hasn’t stood still. Reagan’s tax-cutting example ignited a worldwide revolution that has seen waves of corporate tax-rate reductions. The U.S. last reduced the top marginal corporate income tax rate in 1986. But the Tax Foundation reports that other countries have reduced “the OECD average corporate tax rate from 47.5 percent in the early 1980s to around 25 percent today.”

This final excerpt should help explain why I spend a lot of time defending and promoting tax competition.

As bad as the tax system is now, just imagine how bad it would be if politicians didn’t have to worry about jobs and investment escaping.

P.S. If there was a way of measuring tax policies for foreign investors, I suspect the United States would jump a few spots in the rankings.

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The tax code is a complicated nightmare, particularly for businesses.

Some people may think this is because of multiple tax rates, which definitely is an issue for all the non-corporate businesses that file “Schedule C” forms using the personal income tax.

A discriminatory rate structure adds to complexity, to be sure, but the main reason for a convoluted business tax system (for large and small companies) is that politicians don’t allow firms to use the simple and logical (and theoretically sound) approach of cash-flow taxation.

Here’s how a sensible business tax would work.

Total Revenue – Total Cost = Profit

And it would be wonderful if our tax system was this simple, and that’s basically how the business portion of the flat tax operates, but that’s not how the current tax code works.

We have about 76,000 pages of tax rules in large part because politicians and bureaucrats have decided that the “cash flow” approach doesn’t give them enough money.

So they’ve created all sorts of rules that in many cases prevent businesses from properly subtracting (or deducting) their costs when calculating their profits.

One of the worst examples is depreciation, which deals with the tax treatment of business investment expenses. You might think lawmakers would like investment since that boosts productivity, wage, and competitiveness, but you would be wrong. The tax code rarely allows companies to fully deduct investment expenses (factories, machines, etc) in the year they occur. Instead, they have to deduct (or depreciate) those costs over many years. In some cases, even decades.

But rather than write about the boring topic of depreciation to make my point about legitimate tax deductions, I’m going to venture into the world of popular culture.

Though since I’m a middle-aged curmudgeon, my example of popular culture is a band that was big about 30 years ago.

The UK-based Guardian is reporting on the supposed scandal of ABBA’s tax deductions. Here are the relevant passages.

The glittering hotpants, sequined jumpsuits and platform heels that Abba wore at the peak of their fame were designed not just for the four band members to stand out – but also for tax efficiency, according to claims over the weekend. Abba…And the reason for their bold fashion choices lay not just in the pop glamour of the late 70s and early 80s, but also in the Swedish tax code. According to Abba: The Official Photo Book, published to mark 40 years since they won Eurovision with Waterloo, the band’s style was influenced in part by laws that allowed the cost of outfits to be deducted against tax – so long as the costumes were so outrageous they could not possibly be worn on the street.

When I read the story, I kept waiting to get to the scandalous part.

But then I realized that the scandal – according to our statist friends – is that ABBA could have paid even more in tax if they wore regular street clothes for their performances.

In other words, this is not a scandal at all. It’s simply the latest iteration of the left-wing campaign (bolstered by tax-free bureaucrats at the Paris-based OECD) to de-legitimize normal and proper tax deductions.

So I guess this means that the New York Yankees should play in t-shirts and gym shorts since getting rid of the pinstripes would increase the team’s taxable income.

And companies should set their thermostats at 60 degrees in the winter since that also would lead to more taxable income.

Or, returning to the example of ABBA, perhaps they should have used these outfits since there wouldn’t be much cost to deduct and that would have boosted taxable income.

Shifting to the individual income tax, another potential revenue raiser is for households to follow this example from Monty Python and sell their kids for medical experiments. That would eliminate personal exemptions and lead to more taxable income.

Heck, maybe our friends on the left should pass a law mandating weekend jobs so we could have more income for them to tax.

Though I’m not sure how that would work since the statists are now saying Obamacare is a good thing because it “liberates” millions of people from having to work.

I’m not sure how they square that circle, but I’m sure the answer is more class-warfare tax policy.

P.S. If you want to a simple rule to determine what’s a legitimate tax deduction, just remember that economic activity should be taxed equally (and at the lowest possible rate). That’s why businesses should have a cash-flow tax, and it’s why households should have a neutral system like a flat tax or national sales tax.

P.P.S. Though it would be nice if we had the very limited government envisioned by the Founding Fathers. In that case, we wouldn’t need any broad-based tax whatsoever.

P.P.P.S. A very low tax rate is the best way of encouraging taxpayers to declare income and minimize deductions. Sweden Individual Income tax ratesWhen ABBA first became famous, the top personal tax rate in Sweden was at the confiscatory level of about 80 percent and the corporate tax rate was about 55 percent. With rates so high, that meant taxpayers had big incentives to reduce taxable income and little reason to control costs.

After all, a krona of deductible expense only reduced income by about 20 öre for individual taxpayers.

Corporate taxpayers weren’t treated as badly, but a rate of 55 percent still meant that a krona of deductible expense only reduced after-tax income by 45 öre.

But if the rate was very modest, say 20 percent, then taxpayers might be far more frugal about costs (whether the cost of uniforms or anything else) because a krona of deductible expense would reduce income by 80 öre.

By the way, the United States conducted an experiment of this type in the 1980s and the rich wound up declaring far more income to the IRS.

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I’m very leery of corporate tax reform, largely because I don’t think there are enough genuine loopholes on the business side of the tax code to finance a meaningful reduction in the corporate tax rate.

That leads me to worry that politicians might try to “pay for” lower rates by forcing companies to overstate their income.

Based on a new study about so-called corporate tax expenditures from the Government Accountability Office, my concerns are quite warranted.

The vast majority of the $181 billion in annual “tax expenditures” listed by the GAO are not loopholes. Instead, they are provisions designed to mitigate mistakes in the tax code that force firms to exaggerate their income.

Here are the key findings.

In 2011, the Department of the Treasury estimated 80 tax expenditures resulted in the government forgoing corporate tax revenue totaling more than $181 billion. …approximately the same size as the amount of corporate income tax revenue the federal government collected that year. …According to Treasury’s 2011 estimates, 80 tax expenditures had corporate revenue losses. Of those, two expenditures accounted for 65 percent of all estimated corporate revenues losses in 2011 while another five tax expenditures—each with at least $5 billion or more in estimated revenue loss for 2011—accounted for an additional 21 percent of corporate revenue loss estimates.

Sounds innocuous, but take a look at this table from the report, which identifies the “seven largest corporate tax expenditures.”

GAO Tax Expenditure Table

To be blunt, there’s a huge problem in the GAO analysis. Neither depreciation nor deferral are loopholes.

I wrote a detailed post explaining depreciation earlier this month, citing three different experts on the issue. But if you want a short-and-sweet description, here’s how I described depreciation in my post on corporate jets.

If a company purchases a jet for $20 million, they should be able to deduct – or expense – that $20 million when calculating that year’s taxable income… A sensible tax system defines profit as total revenue minus total costs – including purchases of private jets. But today’s screwy tax code forces them to wait five years before fully deducting the cost of the jet (a process known as depreciation). Given that money today has more value than money in the future, this is a penalty that creates a tax bias against investment (the tax code also requires depreciation for purchases of machines, structures, and other forms of investment).

In other words, businesses should be allowed to immediately “expense” investment expenditures. What the GAO refers to as “accelerated depreciation” is simply the partial mitigation of a penalty, not a loophole.

The same is true about “deferral.” Here’s what I wrote about that issue in February 2010.

Under current law, the “foreign-source” income of multinationals is subject to tax by the IRS even though it already is subject to all applicable tax where it is earned (just as the IRS taxes foreign companies on income they earn in America). But at least companies have the ability to sometimes delay when this double taxation occurs, thanks to a policy known as deferral.

I added to those remarks later in the year.

From a tax policy perspective, the right approach is “territorial” taxation, which is the common-sense notion of only taxing activity inside national borders. It’s no coincidence that all pro-growth tax reform plans, such as the flat tax and national sales tax, use this approach. Unfortunately, America is one of the world’s few nations to utilize the opposite approach of “worldwide” taxation, which means that U.S. companies face the competitive disadvantage of having two nations tax the same income. Fortunately, the damaging impact of worldwide taxation is mitigated by a policy known as deferral, which allows multinationals to postpone the second layer of tax.

Simply stated, the U.S. government should not be trying to tax income earned in other countries. “Deferral” is the mitigation of a penalty, not a loophole.

So why would the GAO make these mistakes? Well, to be fair to the bureaucrats, they simply relied on the analysis of the Treasury Department.

But why does Treasury (and the Joint Committee on Taxation) make these mistakes? The answer is that they use the “Haig-Simons” tax base as a benchmark, and that approach assumes bad policies such as the double taxation of income that is saved and invested. If you want to get deep in the weeds of tax policy, I shared late last year some good analysis on Haig-Simons produced by my colleague Chris Edwards.

By the way, properly defining loopholes also is an issue for reform on the individual portions of the tax code. I’ve previously pointed out the flawed analysis of the Tax Policy Center, which put together a list of the 12 largest “tax expenditure” and included six items that don’t belong.

To conclude, the right tax base is what’s called “consumed income.” But that’s simply another way of saying that the system should only tax income one time, and it’s how income is defined for both the flat tax and national sales tax.

One final comment about GAO. It’s understandable that they used the Treasury Department’s methodology, but they also should have produced a list of tax expenditures based on a consumed-income tax base. That’s basic competence and fairness.

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I’m normally reluctant to write about “depreciation” because I imagine eyes glazing around the world. After all, not many people care about the tax treatment of business investment expenses.

But I was surprised by the positive response I received after writing a post about Obama’s demagoguery against “tax loopholes” for corporate jets. So with considerable trepidation let’s take another look at the issue.

First, a bit of background. Every economic theory agrees that investment is a key for long-run growth and higher living standards. Even Marxist and socialist theory agrees with this insight (though they foolishly think government somehow is competent to be in charge of investments).

Let’s look at two remarkable charts, starting with one that shows the very powerful link between total investment and wages for workers.

As you can see (click the chart to see a larger version), if we want people to earn more money, it definitely helps for there to be more investment. More “capital” means that workers have higher productivity, and that’s the primary determinant of wages and salary.

Our second chart shows how the internal revenue code treats income that is consumed compared to how it penalizes income that is saved and invested. Simply stated, the current system is very biased against capital formation because of the combined impact of capital gains taxes, corporate income taxes, double taxes on dividends, and death taxes.

Indeed, one of the reasons why the right kind of tax reform will generate more prosperity is that double taxation of saving and investment is eliminated. With either a flat tax or national sales tax, economic activity is taxed only one time. No death tax, no capital gains tax, no double tax on dividends in either plan.

All of this background information helps underscore why it is especially foolish for the tax code to specifically penalize business investment. And this happens because companies have to “depreciate” rather than “expense” their investments.

Here’s how I described depreciation in my post on corporate jets.

If a company purchases a jet for $20 million, they should be able to deduct – or expense – that $20 million when calculating that year’s taxable income… A sensible tax system defines profit as total revenue minus total costs – including purchases of private jets. But today’s screwy tax code forces them to wait five years before fully deducting the cost of the jet (a process known as depreciation). Given that money today has more value than money in the future, this is a penalty that creates a tax bias against investment (the tax code also requires depreciation for purchases of machines, structures, and other forms of investment).

And I also addressed the issue when writing about the economic illiteracy in one of the Obama-Romney debates.

Now let’s see what some experts on the topic have to say.

Here’s some very sage analysis from Alan Viard of the American Enterprise Institute.

…a deal that cuts the corporate rate could end up doing more harm than good. The problem is that Congress and the Obama administration are thinking of pairing the rate cut with a slow-down of companies’ depreciation deductions. That’s a bad combination. A key goal of corporate tax reform should be to reduce the tax penalty on business investment. Investments in equipment, factories, and other forms of capital help power the long-run economic growth that boosts wages and living standards for American workers. …If depreciation is slowed down enough to offset the full revenue loss from the rate cut, then there’s no reduction in the investment penalty, on balance. The depreciation changes take back with the left hand everything that the rate cut gives with the right hand. …In fact, the policy makes the tax penalty on new investments bigger. …Why is this bad combination being considered? Maybe because the rate cut is easy to understand and the harm of slower depreciation is easy to overlook. …Yes, let’s cut the corporate tax rate. But, let’s not slow down depreciation to pay for it.

Amen. Proposals to lower America’s destructively high corporate tax rate are needed, but I don’t want politicians “paying for” the change with other policies that are similarly harmful to growth and competitiveness.

Margo Thorning of the American Council for Capital Formation adds some wisdom with her column in today’s Wall Street Journal.

…proposals that would increase the tax burden on capital-intensive industries—which are contributing to U.S. economic growth and employment—should be viewed with caution. …stretching out depreciation allowances reduces a company’s annual cash flow and raises the “hurdle rate” that new investments would have to meet before they are approved. For capital-intensive firms in sectors such as energy, manufacturing, utilities and transportation, the trade-off between delayed cash flow and lower corporate income-tax rates may result in cutbacks in capital spending. …Each additional $1 billion in investment is associated with 23,000 new jobs, according to data from the Department of Commerce and the Bureau of Labor Statistics. …Rather than drawing out depreciation schedules, a better, pro-growth approach to corporate tax reform would be to allow all investment to be expensed—in other words, deducted from income in the first year.

I share Margo’s concerns, which is why I’m very suspicious when the President says he wants to lower the corporate tax rate and “reform” the system.

Last but not least, Matt Mitchell (no relation) of the Mercatus Center recently added his two cents to the discussion.

The idea that “accelerated” depreciation is a loophole can be traced back to Stanley Surrey, the Harvard law professor whose work in the 1950s, 60s, and 70s influenced many…, including Senator Bill Bradley. …immediate expensing would mean abandoning “the attempt to tax business income.” That’s because it would essentially turn the corporate income tax into a corporate consumption tax. And that may be a good thing. Capital taxation is notoriously inefficient. This is one reason why Robert Hall and Alvin Rabushka permitted immediate 100 percent expensing in their famous flat consumption tax.

You should realize, by the way, that the distorted view of what’s a loophole doesn’t just apply to depreciation. The Joint Committee on Taxation (the same folks who basically assume that the revenue-maximizing tax rate is 100 percent) also tells lawmakers that it’s a loophole if you don’t double-tax capital gains, or if you allow people to avoid double taxation by utilizing IRAs.

With advice like that, no wonder the tax code is a mess.

Anyhow, congratulations are in order. If you’ve made it this far, you almost surely know more about depreciation than every single politician in Washington. Though, to be sure, that’s not exactly a big achievement.

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I’m not a fan of loopholes in the tax code.

I’ve complained about the number of pages in the tax code, the number of provisions in the tax code, and I’ve even groused about the rising number of pages in the instruction manual for the 1040 tax form.

And I’ve specifically come out against tax preferences for ethanol, housing, municipal bonds, charity, and state and local taxes.

But just as you don’t necessarily know whether someone is tall or short without knowing the average height of a population, you can’t automatically identify loopholes without first defining an ideal tax system. In other words, you need a benchmark (referred to as “the tax base” or “taxable income”) in order to measure what’s a loophole.

Unfortunately, that’s not an easy task because there are two competing visions of the ideal benchmark. I’ve addressed this issue previously, in this post on the “tax expenditure con job,” but let’s dig into the weeds a bit.

  1. Those on the left, including the Joint Committee on Taxation, use what is sometimes called the “Haig-Simons” definition of a tax base. Also known as the “comprehensive income tax base,” this system assumes that there should be double taxation of income that is saved and invested (as shown by this startling chart). Another way of saying this is that the Haig-Simons approach assumes the government should tax income plus changes in the value of assets. Moreover, the Haig-Simons system assumes “worldwide taxation” and that businesses can’t deduct investment costs as they occur.
  2. Those on the right, by contrast, support what is generally called “consumption-based” taxation. This doesn’t mean a tax collected at the cash register (though a national sales tax is an example of a tax with a “consumption base”). Instead, it simply refers to a system where income is taxed only one time. So, for example, a flat tax is a consumption-base tax since income is taxed only one time as it is earned, just as a national sales tax is a consumption-base tax since income is taxed only one time as it is spent. Moreover, a consumption-base system assumes “territorial taxation” and that business expenses should be deductible in the year the money changes hands.

While some features of the tax code – such as the healthcare exclusion – are loopholes according to both the Haig-Simons system and the consumption-base system, you get a divergence of opinion in key areas.

a) In a consumption-base world, there’s no double taxation and the capital gains tax therefore doesn’t exist. But from the perspective of the Haig-Simons tax base, the fact that capital gains are taxed at 23.8 percent instead of 39.6 percent is characterized as a loophole.

b) In a consumption-base world, there’s no double taxation and all savings gets the equivalent of IRA or 401(k) treatment. But from the perspective of Haig-Simons tax base, IRAs and 401(k)s are loopholes.

c) In a consumption-base world, there’s territorial taxation and no attempt to impose tax on income earned (and subject to tax) in other countries. But the Haig-Simons tax base assumes “worldwide taxation,” which means that “deferral” is a loophole rather than a way of mitigating a discriminatory penalty.

So why am I getting into boring details on this wonky issue? In part, because it helps people understand that tax reform is not just a matter of having a low tax rate. It’s also very important to define income correctly.

But I also think some background knowledge is necessary to explain why the White House is blowing smoke when they relentlessly demagogue against “corporate jets” as part of their never-ending campaign for class-warfare tax policy.

Let’s examine some excerpts from an ABC News report.

Listening to the White House, you’d think the key to averting the across-the-board spending cuts (the dreaded “sequester”) set to in place on March 1 is closing the tax break for owners of private jets. …Carney has brought up the corporate jet tax break at every single briefing this week. Listening to the White House, you might think that the “balanced” Democratic plan to avert the spending cuts would close that loophole for private jets. But you would be wrong. The Senate Democratic plan – which has been endorsed by the White House and is, in fact, the only Democratic plan actively under consideration right now – doesn’t touch corporate jets. …The tax break…allows the owners of private jets to depreciate their airplanes over five years instead of the standard seven years for commercial airplanes.

I don’t want you to focus on the demagoguery or the potential hypocrisy. Instead, consider the final sentence of the excerpt.

It turns out that the supposed “loophole” is really a penalty from a consumption-base perspective. If a company purchases a jet for $20 million, they should be able to deduct – or expense – that $20 million when calculating that year’s taxable income (after all, what is profit other than total revenue minus total costs?).

A sensible tax system defines profit as total revenue minus total costs – including purchases of private jets

But today’s screwy tax code forces them to wait five years before fully deducting the cost of the jet (a process known as depreciation). Given that money today has more value than money in the future, this is a penalty that creates a tax bias against investment (the tax code also requires depreciation for purchases of machines, structures, and other forms of investment).

Anyhow, because the tax bias imposes a five-year wait rather than a seven-year wait, the Obama White House would like us to believe that companies are getting some sort of egregious loophole.

Nonsense. In a good tax regime, companies should be able to deduct expenses in the year they are incurred. The fact that they have to wait five years is a penalty. But the White House wants us to perceive this penalty as a loophole or subsidy because it could be even more onerous.

By the way, if we’re worried about actual subsidies that benefit corporate jets, Tim Carney’s already explained that we should focus on the cronyists at the Export-Import Bank. And I heartily agree.

P.S. Defining the right “tax base” doesn’t imply anything about tax rates. You can have a so-called progressive rate structure or a single rate with either the Haig-Simons system or a consumption-base system.

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According to an article in the New York Times, the Obama Administration is seriously examining a proposal to reduce America’s anti-competitive 35 percent corporate tax rate.

The Obama administration is preparing to inject an unpredictable new variable into its economic policy clash with Republicans: a plan to overhaul corporate taxes. Economic advisers have nearly completed the process initiated in January by the Treasury secretary, Timothy F. Geithner, at President Obama’s behest. That process, intended to make the United States more competitive internationally, has explored the willingness of business leaders to sacrifice loopholes in return for lowering the top corporate tax rate, currently 35 percent. The approach officials are now discussing would drop the top rate as low as 26 percent, largely by curbing or eliminating tax breaks for depreciation and for domestic manufacturing.

This may be a worthwhile proposal, but this is an example where it would be wise to “look before you leap.” Or, for fans of Let’s Make a Deal, let’s see what’s behind Door Number 2.

To judge Obama’s plan, it is important to have the right benchmark. An ideal corporate tax system obviously should have a low tax rate. And it also should have no double taxation (tax corporate income at the business level or tax it at the individual level, but don’t tax it at both levels).

But it’s also important to have a simple and neutral system. The right definition of corporate income for any given year is (or should be) total revenue minus total costs. What’s left is income.

This may seem to be a statement of the obvious, but it’s not the way the corporate tax code works. The system has thousands of complicated provisions, some of which provide special loopholes (such as the corrupt ethanol credit) that allow firms to understate their income, and some of which impose discriminatory penalties by forcing companies to overstate their income.

Consider the case of depreciation. The vast majority of people understandably have no idea what this term means, but it sounds like a special tax break. After all, who wants big corporations to lower their tax bills by taking advantage of something that sounds so indecipherable.

In reality, though, depreciation simply refers to the tax treatment of investment costs. Let’s say a company buys a new machine (which would increase productivity and thus boost wages) for $10 million. Under a sensible and simple tax system, that company would include that $10 million when adding up all their costs, which then would be subtracted from total revenue to determine income.

But the corporate tax code doesn’t let companies properly recognize the cost of new investments. Instead, they are only allowed to deduct (depreciate) a fraction of the cost the first year, followed by more the next year, and so on and so on depending on the specific depreciation rules for different types of investments.

To keep the example simple, let’s say there is “10-year straight line depreciation” for the new machine. That means a company can only deduct $1 million each year and they have to wait an entire decade before getting to fully deduct the cost of the new machine.

Ultimately, the firm does deduct the full $10 million, but the delay (in some cases, about 40 years) means that a company, for all intents and purposes, is being taxed on a portion of its investment expenditures. This is because they lose the use of their money, and also because even low levels of inflation mean that deductions are worth significantly less in future years than they are today.

To put it in terms that are easy to understand, imagine if the government suddenly told you that you had to wait 10 years to deduct your personal exemption!

Let’s now circle back to President Obama’s proposal. With the information we now have, there is no way of determining whether this proposal is a net plus or a net minus. A lower rate is great, of course, but perhaps not if the government doesn’t let you accurately measure your expenses and therefore forces you to overstate your income.

I’ll hope for the best and prepare for the worst.

P.S. It’s also important to understand that a “deduction” in the business tax code does not imply loophole. If you remember the correct definition of business income (total revenue minus total costs), this means a business gets to “deduct” its expenses (such as wages paid to workers) from total revenue to determine taxable income. Some deductions are loopholes, of course, which is why a  simple, fair, and honest system should be based on cash flow. Which is how business are treated under the flat tax.

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