Distinguishing Tax ‘Incentives’ From ‘Subsidies’

The New York Times reported last week that lately U.S. businesses have been much more willing to spend money on new equipment than on new employees, which is true, and that tax incentives are subsidizing much of this capital spending, which is not.

The Times fell into the trap of confusing tax incentives with subsidies. The incentives relax certain tax accounting rules, typically reducing taxes in the short term while raising them in the future so that the government’s tax revenue is ultimately unchanged. Subsidies would permanently lower the taxpayer’s tax bill, and would correspondingly lower the government’s tax revenue, over both the short and long term.

The tax code contains plenty of subsidies, but most of them are for individuals – particularly lower- and middle-income individuals – rather than for businesses. The Earned Income Tax Credit and the Hope and Lifetime Learning education credits are examples of such subsidies. Businesses that benefit from subsidies tend to be in politically favored industries such as ethanol, agriculture (which is heavily subsidized outside the tax system), and solar and wind energy. To avoid furious responses from the political left, let’s stipulate here that any nonbusiness tax deduction, such as for mortgage interest, state taxes or charitable contributions, is a subsidy of some sort, since it permanently reduces tax revenue. The bulk of these subsidies go to upper-middle and high-income taxpayers, since they also pay the bulk of the taxes.

Journalists are not the only ones who, wittingly or otherwise, muddle the discussion of business taxes. We periodically hear a lot about companies that report large profits but pay relatively small amounts in taxes. If you think businesses should pay their “fair share” of taxes (another line of reasoning that I consider fallacious, but that’s a topic for another day), this may seem outrageous. But mostly it reflects the non-outrageous fact that financial accounting and tax accounting are designed to do different things.

When we compute business income for financial statements, it is important to smooth out distortions so that the statements can be compared from quarter to quarter or from year to year. When we compute business income for a tax return, we are trying to determine how much money the government expects us to send it. The government does not want a share of our “earnings” or “profits.” It wants cash. But it also recognizes that sometimes it is better to forgo some cash in the short term to increase business profits (which would yield increased taxes) or to create jobs (for people who also pay taxes in cash) in the future.

Suppose your grandfather left you $1.5 million on condition that you open a bagel store. At the beginning of the first year, you spend $1 million on a bagel oven that will last for 10 years. You reserve the remaining $500,000 for ingredients and operating expenses, and you spend it all in the first year. During that first year, you also sell $1.5 million worth of bagels, so you end the year with $1.5 million in the bank before taxes. We will assume, unrealistically, that the only applicable tax is the 35 percent top federal rate on corporate income.

How much money did you make?

Your sales were $1.5 million and your operating expenses were $500,000, so you had an operating profit before depreciation of $1 million. But you have to consider depreciation of that oven. For financial reporting purposes, you will write off the cost of the oven over its 10-year life, reporting an expense of $100,000 for that first year. That leaves you with profits of $900,000. If your second year is exactly like your first, you will sell another $1.5 million in bagels, incur $500,000 in costs plus $100,000 of depreciation, and report another $900,000 profit before taxes. This is what we want, because financial reporting is supposed to let us compare results from year to year. If we had treated the entire cost of the oven as an immediate expense, we would report no profit in the first year and $1 million in the second, even though the operating results were identical.

So why don’t we do the same thing for tax purposes? If you must pay tax on that full $900,000 of first-year profit, you will send the government a check for $315,000. This will leave you with less than $1.2 million in cash as you start your second year. You can continue operating the business, but forget about spending another $1 million on a new oven to open a second store. You don’t have enough cash on hand to cover the new oven plus operating expenses.

If the government wants you to expand, it has to leave you the necessary cash to do so. So the government might let you deduct the entire cost of that oven in the first year. You will owe no taxes immediately, and you will still have $1.5 million in the bank – the same amount your grandfather left you. You can expand to a second location in the second year and repeat the process.

But what if you don’t choose to expand? In that case, in the second year you will sell $1.5 million of bagels, incur $500,000 of expenses, earn $1 million for tax purposes (but only $900,000 for financial reporting, because of depreciation), and owe tax of $350,000. After 10 years, the government will have gotten the same tax revenue in either scenario. But by offering you an immediate deduction of the oven’s cost in the first year, it gave you the opportunity to expand your business sooner.

There is no subsidy involved. The government did not pay for any part of your first $1 million oven, or your second $1 million oven, or your third. You risked your own capital. The government merely waited for some of its money, in hopes of generating jobs and economic growth.

As I mentioned, the tax law contains both incentives and subsidies. The tax bill that President Obama signed last December renewed or extended many of these business incentives.

Such incentives no doubt play a role in executives’ willingness to invest in new equipment, as The Times suggests. Today’s low interest rates also are a factor, at least for companies that have access to the bond market or low-cost bank financing. Equipment costs can be easily quantified, and machines that are underused during an economic slowdown will wait patiently for business to pick up, costing little while they wait.

On the other hand, employees must be paid through a downturn, layoffs are expensive and disruptive, and future personnel costs, especially for health care, are much harder to predict. Not only does new equipment often reduce the need for labor, but managers have good reasons to feel comfortable investing in machinery before they invest in people.

So the fact that capital spending has picked up faster than hiring is not surprising. It is a function of where we are in the business cycle, with an economic expansion that has been slow and uncertain. Companies that are looking ahead to better times are ready to put some machinery in place today, but they’ll wait until growth prospects are more certain to bring staff aboard.

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