Tax reform needn’t dim US economic bright spot

Published in Oil & Gas Journal | September 3, 2012

While most US states remain stuck in economic doldrums, signs of rebound are on the rise across the Midwest and Great Plains states. A recent Wall Street Journal report looked at Commerce Department data and found that energy-producing states including Texas, Oklahoma, Montana, Wyoming, North and South Dakota, and Nebraska are seeing impressive income and job growth gains mostly attributed to the growing demands for their rich commodities, including oil and gas. The boom in energy, including low natural gas prices, has also benefited other industries including steel, chemical, and plastics manufacturers as plants are being built and workers are being hired.

A new analysis by the Progressive Policy Institute notes that in 2011, four of the top 10 nonfinancial companies investing in the US were oil and gas companies that have invested a total of $28.3 billion domestically in 2011. Historically, each $1 billion increase in investment is associated with an additional 23,300 jobs in the US. Thus, the $28.3 billion of investment by the four oil and gas companies may have produced over 600,000 new jobs in 2011.

Given this growth, it’s puzzling and troubling that some lawmakers would consider dimming this one bright spot in the economy by targeting and eliminating many of the tax code provisions for traditional energy sources that have facilitated investment and jobs. Earlier this year, President Barack Obama proposed a tax reform plan that slashes broad-based provisions that benefit all industries, such as accelerated depreciation, deductions for interest expense, and last-in/first-out (LIFO) for inventory accounting, along with tax provisions applicable especially to the oil and gas industry in exchange for a reduction in the corporate income tax rate.

As lawmakers grapple with tax reform and the many tradeoffs that may come with it, it’s important to ask how the reduction of cash flow to capital-intensive industries by eliminating provisions such as accelerated depreciation and Section 199 and other provisions will impact US investment and economic growth.

New research provides evidence of the strong link between investment and cash flow. Dartmouth College Professors Jonathan and Katharina Lewellen conclude that a dollar of cash flow is associated with between $0.32 and $0.63 of additional investment. The authors also provide evidence that suggests firms with lower net cash flows, which may be more liquidity-constrained, are more responsive to changes in the cost of capital. If this is true, then firms with less access to capital markets are particularly sensitive to changes in tax incentives for investment.

History and economic literature also show that investment is highly responsive to changes in the cost of capital. One study looking at the period from 1953 to 1988, during which time accelerated depreciation and investment tax credit provisions were both enacted and repealed, found that tax policy had a strong effect on the level of investment, especially for machinery and equipment. Also, a new report by the Joint Committee on Taxation notes, “Research on the bonus depreciation provisions enacted in 2002 and 2003 found a noticeable impact of tax incentives on investment in capital goods.” These results have implications for US investment and job growth since American Council for Capital Formation research shows that each $1 billion in new investment is associated with an additional 23,300 jobs. Moreover, insofar as tax changes affect both net cash flows and the user cost of capital, some economists have found that the cash-flow effect is stronger.

If accelerated depreciation for equipment is repealed and replaced with economic depreciation, which is generally longer than the current Modified Accelerated Cost Recovery System (MACRS), the cost of capital for new equipment will rise and investment is likely to decline, impacting the US economic recovery.

True, a lower corporate income tax rate would also make investment attractive, but if MACRS and other provisions that increase the cash flow from investment are repealed, it seems likely that the slower payback period will raise the hurdle rates and slow the productivity-enhancing investment in new equipment. In addition, reducing corporate income tax rates benefits “old capital” and provides a windfall to previous investments. So to the extent that the rate reduction is “paid for” by repealing accelerated cost-recovery provisions, new investment will be slowed, exactly the opposite result that policymakers would want to achieve.

Elimination of accelerated depreciation and other deductions is central to a number of proposals, including the program recommended by the National Commission on Fiscal Responsibility and Reform led by Erskine Bowles, former White House chief of staff, and former Sen. Alan Simpson. A plausible alternative to that approach, suggested by many economists, is a consumed income tax, in which all investment is charged to expense. Allen Sinai, president and chief global economist of Decision Economics, conducted a macroeconomic analysis and found that, if a consumed income tax system had been in place starting in 1991, gross domestic product (GDP) would have been 5.2% higher, consumption and investment would have been greater, and employment would have been higher by over 140,000 jobs/year by 2001. In addition, federal tax receipts would have been $428.5 billion larger in 2001 compared to the baseline forecast.

Cutting the corporate tax rate is a worthwhile goal, but policy-makers must weigh carefully the consequences of how it is pursued. It may be well to consider “paying for” corporate and business income tax rate reductions with cuts to entitlements for upper income individuals (as suggested in the Bowles-Simpson tax reform plan) rather than eliminating proven investment provisions such as accelerated depreciation that enhance growth. Further, extending the recovery periods for geological and geophysical costs and intangible drilling costs is likely to slow the development of US energy resources and hinder US economic recovery.

If the US is to embark on the enormously complex and difficult task of comprehensive tax reform, it is important to maximize the economic benefits from that exercise. Thus ACCF also recommends considering even more powerful approaches to tax reform such as a consumed income tax where all investment is expensed.

Margo Thorning is senior vice-president and chief economist of the American Council for Capital Formation, a nonprofit, nonpartisan organization advocating tax, energy, regulatory, and environmental policies that facilitate saving, investment, economic growth, and job growth.. Thorning has served at the US Department of Energy, the Department of Commerce, and the Federal Trade Commission. She holds a BA from Texas Christian University, an MA in economics from the University of Texas, and a PhD in economics from the University of Georgia. ACCF’s web site is at www.accf.org.