Full expensing: the best idea in politics you've never heard of

What’s the best idea in politics that nobody’s ever heard of? I think it’s what’s called “full expensing”, a tweak to the corporation tax rules that could eliminate a lot of the damage that tax does. It’s obscure in Britain, but new evidence is beginning to show that it might just be the single best tax reform the government could do to raise productivity and growth.

Basically, “full expensing” means letting businesses deduct the cost of any investment they do from their corporation tax bills straight away. At the moment, for ongoing expenses like pens and paper, you can do that already. But for longer-term expenses, like investments in a new building or in new machinery, you can only deduct a small fraction of the cost of investment each year over the accounting lifespan of that investment. 

The problem is that this means that, in fact, businesses don’t actually get back the full cost of the investment. £100 today is worth more than £100 in ten years because of inflation and the things (like other investment) you could have done with the money in the mean time. The longer the write-off time, the less of the cost of the investment you can write off.

As the Tax Foundation’s excellent Kyle Pomerleau explains here, between 2008 and 2013 the UK reduced the value of deductions for machinery and property – from 87.5 percent to 84 percent for machinery, and from 59.2 percent to zero for industrial buildings. As Kyle says, “This means that corporations cannot write off the cost of investing in buildings over time at all!” (Kyle points out that this blunted the economic effects of the reductions in the headline corporation tax rate under the coalition.)

You may be able to see why this matters quite a lot. If we allowed businesses to deduct their investments from their tax bills immediately, we’d effectively be allowing them to deduct the full cost of those investments.

Now for the evidence. If our theory tells us what might happen, what does our evidence tell us what actually did happen? Two new papers, one from the US and one from the UK, suggest that full expensing could have very big positive economic effects.

The first, from Eric Ohrn, looks at states that adopted an full expensing policy temporarily in 2002 and 2008. It uses what’s called a ‘difference-in-differences’ technique which controls for the fact that states did not adopt these policies randomly – states starting from a lower level may have been more likely to adopt this sort of policy, for example.

Ohrn’s results are staggeringly large. Full expensing increased investment by 17.5% and grew wages by 2.5%. Five years after the full expensing window had been available, states that adopted it had 7.7% higher employment levels than comparable states that did not adopt it, and 10.5% higher production output (which means lower prices too, though not necessarily concentrated in that state).

This is such a large result that it sounds unbelievable. But it’s consistent with a paper from last year that looked at UK evidence too, from the introduction of a policy that allowed small- and medium-sized firms to write off more of their investments in plant and machinery early on – not full expensing, but closer than before (40% in the first year instead of 25%). A change in what allowed a firm to count as an SME gives the paper a quasi-experimental event, where they can look at firms that did not qualify one year and did the next, and compare them to firms whose status did not change.

Access to more generous capital allowances increased investment by 11% (2.1%–2.6% percentage points). That’s roughly consistent with the other paper (where the policy was more generous), and still shows a large effect. Both seem to suggest a high elasticity of investment, where every extra pound raised causes much less investment to take place.

Finally, Estonia's system of full expensing has helped to give it the most competitive tax system in the developed world, even though its headline rate of 20% is higher than many other's, including the UK's. In the four years after introducing full expensing in 2000, along with other reforms to its corporation tax, investment growth was 39 percentage points higher there than in its Baltic neighbours.

Full expensing sounds technical and obscure, and is unlikely to win votes on the doorstep. It is not the sort of policy to win headlines. But its effects seem like they could be very large, and could deliver the sort of jobs and wages boost that would be popular. For a government that seems desperate to boost investment, especially investment in machinery-intensive sectors like manufacturing, it could be one of the few policy silver bullets it has left.

No, full expensing isn’t crony capitalism

Writing for Bloomberg View, Tyler Cowen argues that ‘full expensing’, a key part of the GOP’s tax reform plans, is being oversold. I disagree.

Under the status quo firms can immediately deduct labour and running costs (stationary, raw materials) from their total tax bill, but can only deduct capital costs (plants, machinery) as they depreciate. Rather than being able to deduct £1,000 investment in a new computer from my tax bill right away, I must instead deduct gradually over five years as it depreciates. The problem is that £1,000 up front is more valuable than £1,000 in instalments over five years (after all that £1,000 could be collecting interest in a bank). This creates a tax incentive for firms to spend more on labour and day to day expenses, and invest less in new plants and machinery. That’s a problem not only because capital expenditure drives worker productivity and as a result, drives wages, but because it likely distorts investment across regions with areas that would benefit from capital-intensive manufacturing missing out.

The problem’s compounded by the fact that there are numerous different depreciation schedules for investments in equipment, plants and research and development. If it takes 10 years to depreciate a new robot, but only five years to depreciate a delivery van, and both investments will produce the same amount of revenue, then I will choose to invest in the delivery van over the robot. In essence, depreciation schedules end up favouring one kind of investment over another.

Full expensing solves that problem. It allows firms to immediately deduct productivity-boosting investments regardless of asset-class. It should encourage more investment and should prevent the current ‘picking winners’ aspect of the status quo.

Cowen suggests that the benefits of ‘full expensing’ are overhyped for two reasons.

First, Cowen suggests that full expensing won’t stimulate investment by a huge degree because the businesses most likely may be turning losses and thus won’t benefit from a shortened depreciation schedule.

He writes:

“If nothing else, full expensing would benefit businesses by accelerating when the relevant deductions could be taken (right away, rather than over a multiyear period), and for that reason it would boost investment. But that in turn benefits some kinds of businesses more than others. What about businesses that invest a lot today, but earn back the cash slowly and turn a profit only years later? Without a big tax bill, they won’t get a significant tax reduction now, which would blunt the benefits of full expensing. That’s OK, but again it means not to expect a miracle from tax reform.

“As it is likely to be implemented, full expensing applies most easily to companies that already have steady profits. And those are the companies where “getting the expensing benefits now” versus “getting the expensing benefits later” probably matters the least.”

Cowen’s right that full expensing by itself wouldn’t create a tax incentive for loss-making firms to invest. But, he’s failed to mention that the GOP’s tax reform plan adjusts the tax code to fix the existing bias against loss-making upstarts.

Firms are currently able to carry forward tax losses to years where they run a profit. It often causes confusion amongst journalists but it’s a fundamentally sensible system. The problem is that the value of a loss carry forward declines because of inflation and opportunity cost (it could have been in the bank collecting interest after all), the GOP’s tax plan corrects for this by adding an interest factor to carry forwards. (1) As a result, contra Cowen even firms who are not currently running a profit receive a tax benefit from full expensing. 

Second, Cowen’s worried that full expensing would devolve into the crony capitalism that its advocates decry.

He writes:

“Under one pure version of full expensing, the government would transfer funds to companies once those companies have started new investments, even if those companies are not yet making money. For instance, Gavin Ekins at the Tax Foundation has suggested: “In some cases, the federal government could consider refunding deductions above the taxable income of the business or allow larger companies to lease investments to small companies.”

"That I find worrying, because the government would be fronting money to companies and wouldn’t see the money again if those companies failed. Furthermore, companies would end up lobbying for what would evolve into corporate subsidies, no matter how hard legislators tried to write neutrality into the tax code. Full expensing again ends up as less neutral than it seemed in theory.”

It is easy to see the potential for abuse with refunding deductions upfront for loss-making firms, and Ekins himself points out you would need robust anti-fraud rules. But, as I’ve already mentioned adding an interest factor to tax loss carry forwards eliminates the need for the government to front money to companies that might crash and burn.

But even if full expensing were to create an incentive for cronies to lobby for favourable treatment it’s unlikely to be as favourable to cronyism and winner-picking as the status quo. As Cowen points out “current methods of determining expensing and depreciation seem to be chaotic, capricious and uneven in their impact across sectors.”.

If the US follows through with tax reform and lets firms fully deduct capital expenditures then we should expect a significant boost to investment. A paper from Devereux, Maffini and Xing suggests that when the UK expanded First Year Allowances allowing firms to deduct more of their investments straight away, firms benefitting invested substantially more (an 11% increase in the average firms rate of investment). And modelling of the GOP’s business tax reform plan by Kotlikoff, Benzell and LaGarda predicts that GDP would 8% higher after ten years.

Despite being virtually unheard of outside of tax wonks, the case for full expensing is powerful. If anything it’s been undersold.

I advocate for reforming carry forwards and full expensing in The Entrepreneurs Network’ report ‘A Boost For British Businesses: Policies For A New Government’.