In my last blog post I offered a simple illustration of the problems that may result from the Senate Finance Committee's planning to enact expanded expensing immediately, while delaying the corporate rate cut for a year. Again, it said: expense $100 in December 2018, collect $35 in tax savings from the expensing, earn $90 in January 2019, pay $18 of tax at the new 20% rate. Result: a $10 pre-tax loss is converted into a $7 after-tax gain, by reason of one's extracting $17 net from the U.S. Treasury.
This is just a toy example, but the more I think about it, the more it becomes clear to me that this is potentially a huge problem - in terms both of revenue and ridiculous tax planning games.
Whenever the tax rate on a given actor is declining with a delay, it has an incentive to accelerate deductions and defer realizing positive income. We already knew that. But here the spread is really large - 15 percent - and the period of pre-announcement is really long - more than a year. Has there ever before, in U.S. tax history, been so large a rate cut that (if the Senate approach becomes law) was pre-announced so far in advance? Willing to stand corrected, but I think not.
Plus, the problem is hugely worsened by the presence of expensing. In the 1986 tax reform process, when the corporate rate did indeed decline by 12 points, not only was there offsetting base-broadening, but there was movement towards economic depreciation, rather than towards expensing. Now, as a matter of steady-state tax policy, you may prefer one, or you may prefer the other. But one thing that's indisputable is that expensing creates a much greater gulf between the time when the deduction arises, and that when the income arises. So it is much more problematic and gameable when the specific issue is one of tax rate changes between years.
So again, we can take it just for starters that there will be huge incentives to accelerate deductions and defer income realization. But beyond that, there will be huge incentives to arrange economically senseless (or meaningless) transactions in order to extract huge boatloads of money from the Treasury.
Example: in December 2018, a U.S. corporation pays $100 million to a tax-indifferent counter-party that generates an immediate expensing deduction. In January 2019, the corporation sells it for $90 million, in the simplest case to the very same counter-party. Bingo, everybody wins except for the American people via the effect on the U.S. Treasury.
Who are tax-indifferent counter-parties? We can start with tax-exempts, foreigners under appropriate circumstances, etcetera. But the counter-party doesn't have to be literally tax-indifferent. It just has to be tax-indifferent as between 2018 and 2019. So everyone outside the corporate sector who has the same tax rate in 2018 and 2019 is a potential counter-party.
Okay, as described here that's a sham transaction that would lose under the economic substance rules. But not to worry, build in some economic reality - there's plenty of juice to make sure it will still be worth everybody's while. Companies are starting at huge tax savings from circular cash flows, and there's plenty of room to accommodate tax-indifferent counter-parties, when this is even necessary, and also to tolerate real economic effects (sufficient to defeat the economic substance doctrine) that they'd just as soon do without.
Did the Joint Committee on Taxation include this, and at a proper level, in their revenue estimates? Sorry to be skeptical regarding my old employer, and I know they're doing their best under trying circumstances and at hyper-speed, but I would bet not.