2 business tax increases go into effect this year

By Kyle Pomerleau

Two major changes to the business tax base enacted as part of the Tax Cuts and Jobs Act (TCJA) will go into effect this year. First, businesses will be required to amortize research and development (R&D) costs over five years. Second, the limitation on net interest deduction will tighten from 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA) to 30 percent of earnings before interest and taxes (EBIT) — a narrower definition of income. While both policies increase the tax burden on business investment, lawmakers should not view these policies the same way.

Amortization of R&D expenses and the limitation on net interest expense were enacted to help offset the ten-year cost of other business tax cuts in the TCJA and were two of the largest business base broadeners in the law. The Joint Committee on Taxation (JCT) projected that requiring businesses to amortize R&D expenses would raise $119 billion between FY2018 and FY2027. The limitation on net interest expense deduction was projected to raise $253 billion over the same period. Between 2018 and 2021, the years during which EBITDA was in force, the limitation would raise, on average, $18 billion a year. After 2022 and the switch to EBIT, the limitation was projected to raise about $30 billion on average each year.

Both provisions will increase the tax burden on new investment. The effective tax rate on overall investment will increase from 2021 policy by 0.9 percentage points as a result of R&D amortization. This result is driven by the provision’s 16.8 percentage point increase in the tax burden on intellectual property. The EBIT limitation on net interest expense would increase the tax burden on overall investment from 2021 policy by 0.4 percentage points by making debt-financed investment more expensive across all asset types.

Source: Author’s Calculations. Notes: marginal effective tax rates reflect the combined tax burden on corporate and pass-through business investment. These estimates include both the individual income tax and the corporate income tax. “EBIT” and “R&D Amortization” columns show the impact of those policies relative to 2021 policy. Columns 2 and 3 do not necessarily add to “2022 Policy” due to interactions.

Although these two scheduled changes are both tax increases on businesses, they should not necessarily be viewed in the same way. A common goal of business tax reform is to reduce distortions and promote economic growth. One such reform that would accomplish both goals would be to replace the corporate tax with a cash flow tax. Under a cash flow tax, all investments are immediately deducted, but businesses receive no deduction for interest expense. Businesses would face no tax on new investment, regardless of the type of investment and form of financing.

These business tax increases would move in opposite directions with respect to a more neutral cash flow tax. Under a cash flow tax, R&D expenses would be expensed — as they were under prior law. Amortization of R&D would move farther away from the neutral tax treatment of R&D and would discourage this important type of investment. In contrast, limiting the deduction for interest moves in the direction of a cash flow tax. The stricter limitation on interest deductions helps reduce the corporate income tax’s bias in favor of debt-financed investment.

Lawmakers will likely consider legislation this year to cancel or delay these two tax increases. In fact, the Build Back Better Act includes a delay of the amortization of R&D expenses to 2026. Rather than simply delaying or canceling these changes because they are tax increases, lawmakers should consider their place in a more fundamental reform of business taxation.

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Source: aei.org

2 business tax increases go into effect this year