Want To Incent Capital Formation?

Here’s something the government could do right now, it would have little or no cost, and it would be a major contributor to capital formation among small businesses.

Permit all cash-accounting businesses — which are those that (1) elect it, and (2) meet IRS requirements (the most-important of which is the gross receipts test — under $5m in annual gross) to immediately expense all cash-funded capital goods purchases on a permanent basis.

There was an “immediate expense” provisions in the Obama “recovery” act, but temporary moves like this simply pull forward purchases from one time period to another.

As envisioned I would prevent the use of debt to finance these deductible expenses; a better change would be to prohibit the deductibility of interest entirely (thereby removing the preference for debt over equity) but in the short term that’s going to be much harder to get through Congress than the above would be.

Detractors of this change will claim that it will decrease tax revenue from small businesses.  They’re wrong. If I take the deduction against top-line in the year of acquisition I have no depreciation deduction to take in the following years and am thus exposed to taxation on the full value of everything made with that or as a consequence of the capital good in the future.  This change would also simplify tax accounting for small business.

In this world of technology there are many items that businesses acquire that have useful service lifetimes far shorter than the IRS mandates for depreciated property.  When I ran MCSNet we used to run into this all the time — modem banks, for example, or desktop computers on customer agent desks, had service lifetimes that were typically two years or so in actual use (due to obsolescence) and were worth effectively nothing after that two years but IRS depreciation schedules mandated much longer claimed “service lifetimes.”  This effectively caused us to pay taxes unjustly on forward use that never materialized, as we were unable to match the duration of the item’s useful lifetime to its expensing on the balance sheet.

This becomes less of a problem as a business moves to accrual accounting for a whole host of reasons, but for cash-accounting small businesses it is a major issue.  Since accrual accounting records income and expenses when they’re incurred (as opposed to when they’re received) this mismatch tends to have less of an impact on those firms.

This change would lead small businesses to use retained earnings for capital expenditures to grow the company.  It would likely expand government revenue since the capital purchase would be made for the purpose of growing the business and that higher income in future years would not have the deduction of depreciation available to offset it.  This would in turn tend to create a virtuous cycle where growth would again be reinvested into capital goods to further expand.

Restricting this change to cash-based businesses would fuel the engine of our economy — small business and entrepreneurship.  Being a permanent change it would be one that small businesspeople and those thinking of starting a small business could count on into the future and thus write their business plans around; stability is critical when it comes to tax policy and its impact on business in general.

Let’s make a change that will actually make a difference.  While I advocate for much more serious change to the tax system in America this is one that is modest, targeted at the engine of job growth and yet inflicts no direct reduction on Treasury revenue.

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