If firms get to expense investments, Congress should remove their interest deduction

Egged on by business lobbyists, congressional tax writers seem increasingly interested in allowing firms to rapidly write off the cost of their capital investments. Especially in the House, lawmakers would allow small businesses to expense the full cost of their investments in the year they are acquired, and let larger firms heavily front-load tax depreciation for their capital purchases.

There is some logic to this idea. Expensing is a key element of a business consumption tax, for instance. But in a well-designed consumption levy, expensing comes with an important trade-off:  Firms lose their ability to deduct interest costs associated with those purchases.

Unsurprisingly, none of the supporters of expensing or rapid depreciation has suggested this. But they should.

The reason for the trade-off is simple. When a firm can expense its capital costs, the tax rate on that investment is zero. If the business can also deduct interest, it is paying a negative tax on that equipment—effectively receiving an investment subsidy from the government. Here’s a nice Tax Notes essay from a few years back by Cleveland State law professor Deborah Geier that explains what’s going on.

Despite this problem, supporters of very generous tax treatment for capital investment are steaming ahead. Two key depreciation provisions expired at the end of the last year (two of the dozens of so-called extenders). And many lawmakers would bring them back to life.

Senate Finance Committee Chair Ron Wyden (D-OR) would restore through 2015 a measure that would allow small business to expense up to $500,000 in equipment (phasing out for investments of up to $2 million) and a second provision called bonus depreciation that would let all firms write-off their investment costs faster than usual.

In the House, senior Ways & Means Committee member Pat Tiberi (R-OH) along with Democrat Ron Kind (D-WI) have proposed making the small business provision permanent. Extending these two ideas for 10 years would add nearly $350 billion to the deficit over the decade.

Interestingly, panel chairman Dave Camp (R-MI) has gone in a very different direction in his tax reform plan and would repeal accelerated depreciation. But while his reform is going nowhere, Camp has begun an exercise to determine which of the expired provisions should be made permanent and which would be allowed to die. He’s been noncommittal when asked about Tiberi’s bill.

The bonus depreciation provision has been in and out of the tax code for more than a decade. In 2008 it was made especially generous as part of the big anti-recession stimulus bill and it was extended in 2010. Though businesses are currently awash in cash, many are pushing hard to make the generous depreciation rules permanent or, at the very least, bring them back for a few more years.

By some estimates, these provisions are worth in excess of $70 billion-a-year in increased up-front cash flow for the S&P 500 alone. Of course, they’ll eventually have to pay it back but firms nearly always want the cash now rather than later (especially when it comes in the form of an interest-free loan from the government). And when interest rates rise, the subsidy will be even more valuable. It is no wonder K Street is pushing so hard to restore the rules.

But combining expensing or even very generous multi-year depreciation with an interest deduction allows firms to exploit tax preferences with borrowed money.  It creates a classic tax arbitrage. If expensing and bonus depreciation are going to be made permanent, Congress should limit the interest expense deduction too.