Tax Cuts for Incentive

November 26, 1962

This year, at the initiative of the Kennedy Administration, two important steps were taken to increase the incentives for new investment. One was the tax credit of 7 percent of the cost of new equipment. The other was the Treasury’s new rulings permitting business to depreciate equipment over shorter periods.

The Treasury estimates that in a full year the tax credit will cost it $1 billion in revenues, and that the new depreciation rulings will cost it another annual loss of about $1.5 billion. If this were so, business could keep $2.5 billion more a year (about 5 percent) of present profits and the added amount would be available for new investment.

But such estimates are likely to apply only in the early years of the new reforms. As business cannot in the long run write off more than 100 percent of the cost of equipment, the government must stand to make up any early revenue loss in later years. Broadly speaking, in fact, all that changes in depreciation allowances do (unless, as in France, they allow also for depreciation of the currency) is to shift the amount of reported earnings, and hence the amount of taxes, as between one year and another. Accelerated depreciation allowances reduce reported profits, and hence taxes, in earlier years at the cost of increasing profits and taxes in later years.

TO STIMULATE GROWTH

Yet because the long-term return on investment in new equipment is always problematical, particularly over more remote years (the rate of obsolescence, or shifts in demand, can never be known in advance), because the principal of the investment is more surely and quickly recouped, and because the net outlay in the early years is less, shorter depreciation periods increase the incentive for new investment. This means two things. As a result of accelerated depreciation the government in the long run increases revenue rather than loses it. More importantly, corporations invest more, scrap obsolescent equipment sooner, expand and modernize, meet foreign competition better, provide higher-paid jobs. In brief, the economy expands faster and so does the tax base.

The Machinery and Allied Products Institute has just published a study of the probable stimulating effects of the new investment credit and the changes in depreciation rules. It estimates that the tax credit is equivalent to an initial depreciation write-off of about 25 percent, and that the credit and shortened depreciation life are together equivalent to an initial write-off of 33 percent.

INITIAL WRITE-OFF

The stimulating effect of the changes on new investment may be substantial. This is the kind of “tax reduction” most likely to appeal to conservative members of Congress. It promises to reduce the depressing effect of taxes without in the long run reducing revenues. It might be even better if, instead of the complications of the new investment credit and “guideline class” depreciation rules, we simply followed the example of Sweden and allowed corporations to write off new machinery and equipment within five years, or (as in Britain) to write off 40 percent of a new investment in the first year, or to choose one of several such options. We might be astonished at the effect on our economic growth.

It is reassuring to learn that the Administration’s tax planners are considering the possibility of spreading its proposed tax reduction over five years, to prevent a massive budget deficit in a single year that could set off inflation fears. In such a program an initial moderate change in the corporation income tax will probably be considered. One such change might be to keep the present rate of 52 percent on undistributed profits, but to reduce the rate to 48 percent on all profits paid out in dividends As corporations in recent years have been paying in dividends about 30 percent of their profits before taxes, this would be equivalent to an average overall corporate rate of 50.8 percent. Even if this were made a substitute for the present 4 percent tax credit allowed to individuals on dividends received, it would mitigate the double’ tax on dividends in a way less open to misunderstanding.