Tax Foundation Economist Will McBride, PhD, and Fellow Michael Schuyler explain tax expenditures and the importance of saving and investment.
Tax Foundation President Scott Hodge and Economist Kyle Pomerleau explain the ins and outs of capital gains taxes in the United States.
Questions answered in the video:
- What are capital gains?
- What are capital gains taxes?
- How does the US treat capital gains differently than its competitors?
- How do taxes on capital gains impact the economy?
- Are taxes on capital gains smart tax policy?
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An overview of cost recovery in the United States. Learn more at: http://taxfoundation.org/
Cost recovery is the deduction that businesses take for the cost of their capital spending. Capital spending is allowances for buying equipment, factories, housing units, office buildings, shopping malls, railroad lines
Typically when a business calculates its profits, it takes its revenue and subtracts its cost. These costs are typically wages, or state and local taxes. However, when it comes to capital investments, the calculation is much more complication, and this is what is called cost recovery.
Cost recovery is an important part in determining what your income is. You have to know what you’re taxing. Sales aren’t profits. Sales aren’t profits until they exceed your costs.The government sets the pace at which businesses can write off their costs. Wages are written off immediately, whenever they are paid out. But spending on capital items is not ordinarily given an immediate deduction
If a business has to deduct the cost of a building over 40 years, that’s going to determine if it’s worth it for the business to invest in that.
A dollar ten years from now is not the same thing as a dollar today. So when we tell a business that it can’t deduct its costs for five or ten years, we’re cheating them out of part of the value of the deduction, we are in fact overstating their income, accelerating their tax payments to the point where they’re not even really earning money yet, but we’re making them pay tax sort of ahead of the game, and it reduces the value of the investment.
Due to the fact that the United States’ cost recovery system increases the cost of capital, it has the effect of reducing the amount of investment in the economy. Because it’s more expensive to invest in buildings and machinery, you’re just going to have less of it in the overall economy. A reduced capital stock means there are fewer buildings, fewer machines, fewer shovels, and this means that workers are less productive, and when workers are less productive, their wages, overall, are lower.
If we lower the cost of capital by speeding up depreciation allowances, we would get more investment and more capital. When there is more capital, workers have more capital to work with. There is more output. Because workers are more productive, they are paid more, and more are hired. That means more jobs and higher wages and this is especially true in the capital-intensive manufacturing and energy sectors.
Currently the United States requires most businesses to deduct their investments over a long period of time. However, this doesn’t properly account for the full cost of these capital investments. Over a long period of time, if you account for the time value of money and interest, they are only able to deduct, say, 60 percent or 80 percent of that total investment.
Our cost recovery system is worse than about two-thirds of the 34 most developed nations, and better than about one third. At the same time, our corporate tax rate is the highest when you put the two mistakes together, we really have an economy that is struggling to stay competitive, and struggling to grow.
The problem with stretching out assets lives over time, or making businesses deduct the cost of a computer over five years is it doesn’t account for the time value of money or inflation. So over a 5 year period, the value of these deductions don’t add up to the true cost of these investments.
The difference between a better cost recovery plan and a worse cost recovery plan could amount to as much as 2% to 5% of GDP over time. If we went to immediate expensing of all investment, we would eventually raise incomes by about 5% across the board. That’s about $2,000 to $4,000 dollars a year for middle income families.
The ideal cost recovery policy is full expensing. That means, when businesses invest in a building, or a machine, or a piece of equipment, that they can deduct that full cost in the year in which they made that investment.
Full expensing would eventually boost GDP by about 5 percent. It would take about five to ten years for the added growth to occur, but during the process you’d get a good strong recovery, you’d get rising wages, you’d get additional revenue coming in for the federal government from other taxes — because the economy would be growing — it would actually help the budget situation, and it would be a win-win. The government wouldn’t be hurt in any way, but the population would benefit enormously. And, really, that is what ought to be the focus here. We’re trying to more jobs and higher wages, and higher incomes for the people. It’s not so much about the Washington budget situation. Or it shouldn’t be.
Tax Foundation Senior Fellow Stephen J. Entin with his views on cost recovery and the current status of tax reform efforts in Washington. (click "show more" to view transcript)
"The current tax reform efforts in both the House and the Senate appear to be focused on worsening the depreciation allowances in order to raise money to lower the corporate tax rate and to lower other tax rates. These sectors are already hit by inadequate depreciation allowances, so the capital intensive sectors would be facing, in fact, a higher tax burden in order to lower everyone else’s taxes, creating an even bigger distortion and chasing away even more blue collar jobs. I think this is a very poor way to fund fundamental tax reform. We’d do a lot better for the population by trimming the growth of government spending, possibly accepting a small near term tax reduction to get the country growing again, and then having the higher levels of employment and income and prosperity generate revenues down the road. That’s the approach John Kennedy took. He cut the corporate tax rate, and he accelerated depreciation, and he even threw in an investment tax credit. The economy boomed, the revenue loss was absolutely negligible, and we had a good strong economic rebound until Lyndon Johnson raised tax rates by ten percent across the board to pay for the Vietnam War. We do not have to make this kind of a trade-off to pay for fundamental tax reform. It’s the wrong way to go."