The Minimum Corporate Income Tax Provision Will Hurt U.S. Competitiveness and Threatens to Exacerbate Inflation
The proposed Inflation Reduction Act of 2022 seeks to expand credits and subsidies for green energy investments and health care provided under the Affordable Care Act (ACA) and strengthen the IRS through an enhanced budget. The primary source of revenue in the Act is a corporate alternative minimum tax (AMT) equal to 15 percent of the company’s book net income—that is, the net income a company reports to its shareholder on its financial statement. The AMT would only apply to corporations with an average book net income of over $1 billion over the previous three tax years. The AMT is touted as an act of fairness, finally forcing the largest corporations to pay their fair share. However, it is really a populist anti-big-business proposal that is likely to make America’s largest companies less competitive, especially internationally; make affected corporations less likely to make the capital investments necessary to sustain long-term economic growth; and exacerbate inflationary pressures, at least in the short term, as firms shift part of the tax incidence onto consumers. This is incredibly dismaying following the passing of the CHIPS and Science Act, which marks an important step in the right direction toward bolstering America’s competitiveness in key advanced-technology industries. Indeed, there are several key shortcomings in the AMT proposal that are either erased or mitigated by superior alternatives.
For starters, it is unclear why this 15 percent AMT should be established only for large corporations. If the matter is one purely of economic fairness, why does “less than 15 percent” indicate nefariousness for large corporations but not smaller ones? Or, put another way, why is a large corporation paying 10 percent of its book income in federal taxes somehow cheating the American people while a smaller corporation not paying any federal income taxes is not? If the implicit goal is to provide support to small- and medium-sized enterprises (SMEs) relative to large corporations, then it is left to be explained why this is sound policy when evidence suggests larger corporations offer greater societal benefits, such as higher wages, greater employee benefits, and greater contributions to productivity and innovation. Targeting only the largest corporations is simply an anti-corporation, populist proposal that has no economic rationale.
Luckily, the bill will allow an AMT-affected company to draw on general business credits (e.g., the R&D, investment, and low-income housing tax credits) to the extent that its tax bills can still be below 15 percent of its book net income. Business tax credits are not a loophole or a mistake. They were intentionally put in place by the government, often with bipartisan support, to incentivize activities deemed societally useful. It is therefore crucial that they remain available, especially to large corporations. While the act establishes a non-zero minimum tax for corporations, it also adds a provision that the value of the tax credits a corporation can claim are not bounded by the any minimum tax the corporation faces. Instead, corporations can claim up to 75 percent of the value of their net income tax in tax credits. Thus, one of the key investment incentives is fortunately maintained.
Unfortunately, business investment incentives are still diminished through the loss of accelerated depreciation schedules and full expensing. Generally Accepted Accounting Principles (GAAP)—the accounting method large public companies are subject to under the Financial Accounting Standards Board—uses a “straight-line” schedule, whereby the value of a capital asset is expensed in equal increments over the asset’s useful life. IRS reporting, on the other hand, uses an “accelerated” schedule, in which depreciation expenses start out high (higher than the straight-line amount) and then decrease each period such that the total value of the capital asset is still expensed over the entirety of the asset’s useful life. Therefore, IRS depreciation expenses are higher than GAAP depreciation expenses for the first half of the asset’s useful life—and thus result in a lower tax bill— and lower for the second half—resulting in a larger tax bill. These differences should nominally offset over the course of the asset’s useful life (although corporations can actually switch over to the straight-line depreciation schedule once it becomes advantageous to do so). However, in real and discounted terms, the accelerated schedule offers a greater benefit to corporations because the sum of the real, time-discounted depreciation expenditures is greater under the accelerated schedule than under the straight-line schedule. Forcing large corporations to use the straight-line schedule consistent with GAAP reporting decreases the depreciation costs the firms can expense, raising their taxable income in real, time-discounted terms and thus removing the incentive to make capital investments, which was the purpose of the accelerated schedule in the first place.
Related to accelerated depreciation is “full expensing,” where companies can deduct the total value of qualifying capital investments in the first year of the asset’s useful life. While this provision of the Tax Cut and Jobs Act of 2017 (TCJA)begins phasing out after this year, it does not fully phase out until 2026 as the proportion of a capital investment’s value that can be expensed in the first year falls by 20 percentage points per year. Thus, large corporations subject to the AMT will also be unable to take advantage of this expensing option designed to make production-boosting capital investments more attractive.
The manufacturing industry, in which the United States’ competitiveness has already been waning for decades, is expected to be hit the hardest by the AMT due to the sector’s capital intensity. The Joint Tax Committee estimates that half of the increased revenue will be collected from manufacturing firms, with 16.1 percent coming from chemical manufacturers, specifically. Thus, an industry that is in desperate need of a competitive boost will get just the opposite.
Lastly, the AMT risks exacerbating inflation in the short run. While it is comforting to some to think that the full incidence of this tax increase is borne by large corporations, empirical evidence suggests corporate income tax increases are shouldered by some mix of shareholders (including institutional shareholders such as mutual and pension funds, which largely represent everyday Americans), providers of the capital and labor that the firms employ, and customers. The extent to which these (often overlapping) interest groups shoulder the tax incidence depends on the individual markets in question, but it is naïve to believe that at least some part of this increase will not be passed along to consumers.
Arguments suggesting that the Act itself will be disinflationary rely on two points: that subsidies will increase supply and that the Act is deficit-reducing over the entire budget window. However, subsidies’ effects on supply will take time to play out, especially when the subsidies are for capital and R&D investments. Moreover, as pointed out in the Penn Wharton Budget Model’s analysis of the Act’s inflationary effects, the Act is actually deficit-increasing until 2027, when the ACA subsidy provisions expire. As such, the report estimates that the Act will initially have a very slight inflationary effect and then a disinflationary effect (although its estimates for the Act’s added or subtracted inflation are not statistically significant). This model also disregards any potential shifting of the tax incidence onto consumers in the form of higher prices. Thus, if anything, the Act will exacerbate the current inflation problem rather than mitigate it.
Better alternatives exist. Instead of implementing an AMT, raising the top marginal personal income tax rate and taxing dividends as normal income are two ways in which tax revenues could be raised without directly jeopardizing long-term growth. For example, the U.S. Treasury Department estimated that raising the tax rate for the top personal income bracket by just 2.6 percentage points from 37 percent to 39.6 percent—its rate prior to the TCJA—as suggested last year in the American Families Act would have increased tax revenues by $132 billion between 2022 and 2026 (after which the 39.6 percent rate is reinstated anyway). A higher top marginal personal income tax rate would maintain corporate investment incentives, reduce demand for high-income households (thus relieving inflationary pressures), and prevent any tax increase from being reflected in higher consumer prices. While dividend tax incidence can still partially be spread around between shareholders, capital, labor, and consumers, firms can still take full advantage of investment incentives, and the higher tax rate may further incentivize firms to retain earnings and channel them toward more productive purposes to increase production in the long term.
The corporate AMT represents a misguided source of revenue to cover the expenditures in this bill. While the crucial ability of affected firms to draw on business tax credits beyond that suggested by an AMT is maintained, the country’s long-term economic growth and competitiveness are jeopardized through diminished incentives to make long-term investments in capital assets, primarily through less-generous depreciation schedules and the inability to take advantage of the TCJA’s full-expensing provision while it lasts. The tax is also likely to exacerbate the economy’s current inflationary woes as part of the tax incidence is shifted to consumers, especially while the bill itself is deficit-increasing. A better alternative, progressive sources of tax revenue, certainly exist, although they may not be as popular as an anti-big-business crusade. Increasing the tax rates for the highest personal income brackets even marginally would yield sufficient revenues while also reducing the demand of the highest earning households, which would directly help fight inflation. Alternatively, taxing dividends would incentivize firms to retain earnings and make the prospect of investing those earnings in longer-term projects more enticing. It is important that policymakers properly rethink the effects of the corporate AMT, especially in an inflationary period, and realize that better sources of revenue not only exist but should replace the corporate AMT in the Inflation Reduction Act.