Looming Tax-Code Changes Threaten American Prosperity

A merica is facing an uncertain domestic environment and a hostile international one. At home, the Federal Reserve is winning the war on inflation, but Congress isn’t helping much on the fiscal side, and high interest rates are probably going to stick around for a while. Meanwhile, Congress is on the verge of saddling the economy with a tax code that punishes employers who invest in themselves, fights the Federal Reserve’s disinflation effort, and scores an own goal in favor of our enemies abroad.

Unless Congress acts by the end of this year, three achievements of the 2017 Tax Cuts and Jobs Act (TCJA) will expire or continue to shrink. All of them have to do with cost recovery, whereby the tax code allows businesses to immediately deduct the costs of doing business against taxable business profits. The act’s cost-recovery provisions are so commonsense that most people probably think the tax code has always worked this way.

In the area of business fixed investment, TCJA created 100 percent expensing of all business purchases except most buildings (restaurants, retail stores, and leasehold improvements can be expensed, but office buildings and residential rental properties cannot). This means that the cost of every computer, every desk, every oven, and every machine could be immediately deducted in full in the year of its purchase. This put these purchases on par with wages, rent, and all other ordinary and necessary business expenses.

Starting in 2023, however, only 80 percent of such costs have been eligible to be immediately expensed. This number will decline to 60 percent in 2024 and down to zero thereafter. What cannot be expensed is subject to partial deductions over time (five years for a computer, for instance), known as “depreciation.” A similar provision regarding research costs has begun to wind down. Since 2022, companies have no longer been able to deduct the cost of research and development, such as laboratory expenses or those of pursuing a patent. Instead, these costs have to be “amortized” (a close cousin of depreciation) over five years. Thousands of small and midsize businesses have faced surprise tax bills as a result of the gradual expiration of TCJA provisions. Finally, at the same time as the research-cost stretch, the tax code has made it harder for companies that borrow in order to finance business fixed investment or research to deduct the interest that they pay on their loans.

Picture two identical companies across the street from each other, one that chooses to reinvest in itself and one that does not. They are treated differently by our tax code — and the one that chooses to invest in itself is treated worse.

Cost recovery is not a perk — it isn’t a loophole or a tax expenditure either. Rather, it’s the intuitive way in which a tax code should account for business expenses. If a company pays a salary, funds a 401(k) plan, buys a package of pencils, pays rent, or does research, it ought to be able to deduct those costs from its revenue in order to determine profit. Congress is now being heavily lobbied by businesses and conservative groups to restore full cost recovery to the tax code before the end of this year.

When Congress makes businesses wait years to recover their costs, it not only makes investment less likely (since almost anything else the business does gets better tax treatment), it also claws back the value of the deduction to less than the full amount of the investment. For example, accounting for inflation, if a $1,000 computer depreciates at $200 per year for five years, the value of the $200 deduction in year five will be worth a lot less in real terms than the year-one deduction. These effects are beginning to show up in the economic data. The year-over-year growth rate of research expenses, for example, has declined from nearly 10 percent before the shrinking of the TCJA’s relevant provision to just 1 percent today:

A similar story applies to the assets eligible for full business expensing. What was 8 percent year-over-year growth is now closer to 2 percent (the following chart does not include structures and research expenses):

Even worse, this departure from a commonsense cost-recovery base has made the United States less competitive internationally. Sovereign entities such as China, Russia, and Iran have no problem directly subsidizing their domestic industries in order to give them a leg up on the United States. At the very least, we should expect our own tax code to treat our companies neutrally, not punish them when they invest in themselves. Politicians from both parties talk a lot about bringing American manufacturing home from China, for example, then institute fiscal policies that punish that very economic activity domestically.

If for no other reason, the tax code needs to stop punishing businesses that invest in themselves because, by doing so, they help fight inflation. A company that invests in faster computers for its workforce or plows money into research labs is a company whose productivity is going to rise. At the same time, rather than consume dollars, such companies save and invest dollars, creating a virtuous cycle of business investment that lowers inflation and interest rates.

The Tax Foundation recently commented on a study from the nonpartisan National Bureau of Economic Research on how neutral, commonsense cash-flow expensing has increased domestic private-capital stock, wages, and economic growth. But temporary policy will produce temporary benefits. Companies are far more likely to make long-term investments when they can rely on a stable tax code, which is why the cost-recovery policies I describe should be made permanent by Congress.

There are lots of good arguments to be had about tax policy, and we’re going to have them in 2025 when the individual- and death-tax provisions of TCJA expire. But if there’s one thing both parties in Washington should be able to agree on it’s that cost recovery is essential to fight inflation — and to keep America ahead of our enemies abroad.