What is a loophole?

In the Pathology of Privilege, I had this to say about “accelerated depreciation,” an artifact of the corporate tax code that many consider to be a loophole:

If income is the base of taxation, it makes sense to allow firms to “write off” expenses necessary to earn that income. For capital items that wear out over time, expenses should be written off as the items wear out. Some provisions of the tax code, however, permit firms to write off big capital expenses in one year rather than gradually as the items depreciate. These provisions privilege those firms that happen to make large capital purchases.

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 tax reformers, including Senator Bill Bradley and officials in the Reagan Treasury Department. When the Congressional Joint Committee on Taxation began cataloguing loopholes in their annual “tax expenditure” list in 1972, they too called accelerated depreciation a loophole. Here is how Leonard Berman and Joel Slemrod describe the issue in Taxes in America:

Why not let businesses write off their investments right away? It would make the process of determining taxable income easier, as businesses would no longer have to keep track of depreciation schedules for long-lived capital goods. The problem is that it would mean abandoning the attempt to tax business income, or at least part of it. Only a small fraction of the cost of a factory that will last twenty years is really a cost of earning income this year. (p. 72, emphasis original).

This thinking persuaded me to list accelerated depreciation alongside other tax loopholes as a privilege. In conversations with friends and colleagues over the last few weeks, however, I’ve come to change my mind on this one. Why?

To begin with, it is not obvious that generality requires corporate taxation at all. Though much maligned, Mitt Romney’s famous statement that “corporations are people” is—in some form or another—taught in just about every economics 101 course. When a government levies a tax on a corporation, some combination of the following three groups pay it: customers, investors, or employees. All three, it goes without saying, are humans. Moreover, as every student of economics knows, the statutory incidence of a tax is not the same as its economic incidence. Even if legislators earnestly want investors (or managers) to bear 100 percent of the tax, it is supply and demand, and not legislator intent which ultimately determines who pays. Each of these groups is already taxed in some other way, through sales, payroll, income, or capital gains taxes. So when a government levies a corporate income tax, it is imposing an additional levy on someone and this, by itself, is a violation of generality.

Second, if we are going to tax businesses, it isn’t clear that the tax base should be corporate income. Note that Berman and Slemrod say that 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 (which, by the way, would apply to all businesses, not just corporations).

Setting these concerns aside, doesn’t accelerated depreciation privilege capital-intensive firms over labor-intensive firms? This is an argument often made against accelerated depreciation. But if you think this through, it’s not a particularly strong argument. Labor-intensive firms (appropriately) get to write off the salaries that they pay their employees as they make payroll. That makes sense. So long as we are taxing income, we shouldn’t penalize those that have to incur expenses in order to earn that income. Why shouldn’t capital-intensive firms also get to expense equipment when they cut the check for the equipment? The rate at which equipment breaks down bears no relation to the expense of buying it. In fact, one could go a step further and argue that any measure requiring capital-intensive firms to write off their expenses over a long period of time amounts to a privilege to labor-intensive firms.

I am always open to new arguments and in light of my changed view, I’ve decided to update the paper and remove these lines.