The tax law is infamous for its technicalities. Terms like “depreciation” glaze eyes faster than “subatomic particles” or “covalent bonds.” (I have learned the hard way not to introduce myself at parties as a tax professor.)
But the smokescreen of technical talk permits savvy politicians, like stage magicians, to misdirect the audience’s attention. Enter Donald Trump’s tax plan, announced last week. Many commentators focused, reasonably enough, on Trump’s proposed rate cuts, including a 15% rate on business income.
At the same time, the Trump speech quietly slipped in a bland, one-sentence proposal that would, if adopted, repeal the income tax in favor of a consumption tax (essentially, a national sales tax). Sometimes called expensing or an immediate write-off, the new rule would permit businesses to take immediate deductions for all business investments.
The expensing of business investment may seem like a big yawn. Indeed, the proposal is missing from the Trump campaign website’s outline of his tax plan, although it appears in one sentence in his speech. Even the otherwise-excellent Upshot analysis in the New York Times didn’t highlight the proposal.
But the arcane terminology masks a huge shift in tax policy. Start with a one-sentence explanation for the impatient among us: Expensing business investment would massively shift income tax liability away from businesses and the rich and toward individuals and the middle class.
Trump didn’t invent this tax maneuver. Republicans, most recently Ted Cruz and Rand Paul, have employed this sleight-of-hand in proposing a so-called flat tax. Progressives tend to ― you guessed it ― focus on the flat tax rate, objecting that it would be unfair to tax rich and poor at the same rate. Too often, they overlook the fact that (nearly every) flat tax would also permit the immediate deduction of business investment.
The impact on the tax system would be huge. Tax expert Len Burman’s 2015 analysis of an expensing proposal by Jeb Bush showed that immediate deduction of business investment would cost the federal government more than $1.5 trillion in tax revenue over 10 years.
For readers who can muster a tad more patience, three paragraphs should suffice to explain why this seemingly technical change would effectively repeal the income tax in favor of a consumption tax.
An income tax permits businesses to deduct some purchases right away. A restaurant owner, for instance, can deduct the cost of food and other supplies. So if the restaurant takes in $60,000 in sales and spends $10,000 on supplies, the owner’s net income is $50,000. But some business investments aren’t used up right away. A $50,000 walk-in refrigerator, for instance, should last for at least five years. So an income tax requires the restaurant owner to spread out the cost of the refrigerator over time — deducting, say, $10,000 per year for 5 years. Put another way, an income tax aims to measure profits accurately over time. By contrast, an immediate deduction for the cost of the fridge would dramatically understate profits: the restaurant owner would report $0 income in the year she makes the investment.
So expensing offers a massive tax cut to profitable businesses by permitting them to claim big deductions right away instead of over time. The difference is purely one of timing, but any rational person would rather pay lower taxes now and higher taxes later.
Taking the matter one step further, expensing amounts to a consumption tax. A consumption tax, by design, doesn’t even try to tax profits. Instead, it taxes personal consumption — the money that individuals spend on non-business items. A retail sales tax, for instance, is a familiar consumption tax. In principle, an individual should pay sales tax when he buys sweaters or a convertible — but not when he buys work uniforms or a delivery van for his dry-cleaning shop. An immediate deduction for business investment has the same effect: When business owners can expense all business inputs, what’s left on the tax return is consumption (and not income). None of this is news to tax experts, but the point can be opaque even to policy wonks who aren’t tax specialists.
So we should all pay attention when Trump (or flat taxers) endorse an immediate deduction for business investment. To be sure, there is a respectable and long-standing case for a consumption tax. Proponents argue that a consumption tax could simplify the law and spur the economy. But opponents worry, with reason, that a consumption tax tends to be regressive compared to an income tax.
In either case, though, a policy change of this magnitude deserves an open debate.