Federal Conformity: The "Other" Business Tax Relief

Two new studies suggest full conformity with federal treatment of new capital investments merits consideration in the forthcoming 2016 business tax relief debates.  From our January-February 2016 edition of Fiscal Focus. 

If sports books offered betting lines on what business tax relief might materialize next legislative session, smart money would be going into reducing the statewide property tax.  It’s scalable to fit any budget negotiation, interest in it has been bipartisan, it conforms to good tax policy, and contrary to some suggestions otherwise, all business benefits to some extent.  (Even tiny, space-leasing non-profits like ours since business tax incidence does not magically vanish once tax fairness battles recede into the background.)

But most every December, another potential avenue arises as the federal government passes legislation to prevent various tax benefits from expiring at the end of the year.  True to form, Congress enacted the “Protecting Americans from Tax Hikes Act of 2015” on December 18, which extends and modifies a wide range of tax provisions giving longer leases on life to what are theoretically “temporary” tax cuts.  To reduce tax filing headaches, Minnesota policy makers work hard and as expeditiously as possible to conform to these federal provisions.  Occasionally, however, the price tag of full federal conformity conflicts with budget realities and revenue demands.

Such is the case with Minnesota’s relationship to “Section 179 expensing” and “bonus depreciation” – two federal provisions designed to reduce business’ cost of capital.  Each allows businesses to deduct a larger portion of new investment purchases as a current business expense than the regular depreciation schedules provide for.  This both “speeds up” cost recovery of new business investment and increases the present value of the cost recovered because a dollar today is worth more than a dollar tomorrow.

Unappreciated Depreciation

Two recently released reports have shed additional light on these provisions – why they exist, and the policy issues surrounding them.  The first is a report released last month by the Tax Foundation1 examining the underlying economics and practice of corporate investment cost recovery.  The report points out the growing economic criticism being directed at current income tax frameworks, which treat capital investment differently from other forms of business consumption.  The current system prevents full cost recovery and thereby discourages businesses from making investments that would otherwise be profitable.  The Tax Foundation concluded that U.S corporations will only be able to deduct 87.14% of the value of investments made in 2012.  Therefore, absent a tax system allowing immediate and full expensing of capital costs, accelerated depreciation mechanisms like Section 179 expensing and bonus depreciation are important tools to correct for this problem.  According to the report, bonus depreciation alone moves the U.S. tax system a quarter of the way toward full cost recovery.

The second report from the Congressional Research Service (CRS)2 looks in more detail at the history and evolution of these provisions and their economic effects.  Their assessment concludes that the macro effects of these policies are questionable as research findings indicate accelerated depreciation, “is a relatively ineffective tool for stimulating the overall economy during periods of weak growth,” and “may have a minor effect at best on the level and composition of business investment.”  However, at the micro or firm level, such mechanisms can significantly lower a firm’s cost of capital and improve the cash flow of investing firms in the short run “offering the potential to stimulate increased small business investment.”

For many years Minnesota has “partially conformed” to both Section 179 expensing and bonus depreciation affecting the timing of when a business realizes the benefits of accelerated depreciation.  With respect to Section 179 expensing, Minnesota’s $25,000 maximum deduction is much lower than the federal government’s $500,000 maximum and Minnesota’s phase out threshold for eligibility is also a fraction of the federal government’s ($200,000 vs $2,000,000).  Minnesota does allow the entire federal Section 179 deduction for state taxes; but requires businesses to claim the difference between the Minnesota and federal benefit over a six-year period instead of just one year.  The state stretches the bonus depreciation benefits from a one-year to a six-year period in the same way.

Although non-conformity ultimately is an issue of timing rather than substance, the near term impacts on state revenue collections are quite noticeable.  According to a 2015 revenue analysis by the Department of Revenue, adopting full federal conformity for Section 179 expensing would have reduced general fund receipts by $78 million in FY 2016 (declining to $18 million by FY 2019).  According to the Department, the short term price tag of for conforming with bonus depreciation ($218 million in FY 2016) was substantially larger.

Undelayed Gratification?

Federal conformity may not have the visibility and sizzle of other business tax relief ideas but economics aside, there are a few other reasons why it deserves serious consideration.  The first is tax administration.  The reason why federal conformity bills typically receive such prompt attention and bipartisan support is the recognition that conforming reduces administrative and compliance costs for all stakeholders in the tax system, making life simpler for everyone.  Partial conformity essentially requires businesses to keep and reconcile two sets of books for their fixed assets.  Administrative costs are particularly relevant to the small business community, which is a prime target for these policies.  According to a Brookings Institute publication, The Crisis in Tax Administration, tax administration costs are “regressive to firm size” imposing greater burdens on smaller companies.  Adding to the administrative rationale: the federal government has now made its more generous Section 179 provisions permanent.

Another consideration is that concerns about budgetary “tails” are mitigated.  Most of the costs are upfront, with very small effects on the state budget over the long-term.

Thirdly, it satisfies the common political demand that something be done to “earn” business tax relief.  Minnesota’s long history with business and individual tax expenditures demonstrates we are quick to criticize them in the abstract, but no less quick to embrace them if linked to some desirable and tangible behavior or policy outcome.  The benefits of federal conformity directly flow to those making investments in the Minnesota economy.

One can make a strong argument that – based on efficient tax administration, economic principle, and the ability to improve both business cost recovery and cash flow -- full federal conformity on this issue is an important policy initiative to pursue.  One might also make an argument that macro-economic evidence does not support these initiatives and all the implications of federal non-conformity are worth it.  But probably the weakest policy position is the one we embrace now: partial conformity based not on economic evidence and merit but on budgetary convenience.

Footnotes
  • 1 Cost Recovery in New Corporate Investments in 2012. Tax Foundation, January 2016.
  • 2 "The Section 179 and Bonus Depreciation Allowances: Current Law and Issues for the 114th Congress", Congressional Research Service, August 2015.