The Hidden Entitlements

1. Accelerated depreciation

Born in scandal during the Nixon administration and the cause of many tax scandals thereafter, accelerated depreciation now is the largest of all corporate tax loopholes. Technically, accelerated depreciation lets companies write off the costs of their machinery and buildings faster than they actually wear out. In practice, that means sharply lower tax bills for corporations and individuals that can take advantage of the tax breaks.

In 1970, after repeal of a large tax credit for business investment the previous year, the Nixon Treasury Department sought a new way to subsidize corporate profits. What it came up with was called the "Asset Depreciation Range" or "ADR" system. Put into place by executive fiat,it shortened depreciation periods by 20% across the board and also allowed accelerated write-off methods that concentrated deductions in the early years that equipment is used (thereby increasing their real value).

Nixon's ADR approach was immediately challenged in court by public interest tax attorneys, who said it was far beyond Treasury's authority under the tax code and therefore an unconstitutional giveaway to big business. But while the lawsuit was pending, a heavily lobbied Congress passed Nixon's 1971 revenue act. That infamous bill retroactively ratified the ADR system,and reinstated the investment tax credit to boot. The combination was deadly for the corporate income tax. A sharp decline in corporate tax payments quickly ensued. Coincidentally or not, productivity growth also collapsed soon thereafter.

By the late seventies, widely publicized studies by the congressional Joint Committee on Taxation and the nonprofit Tax Analysts and Advocates were finding that many companies and even whole industries were paying effective tax rates far below those envisioned in the tax code. But worse was to come.

In 1979, Sen. Lloyd Bentsen (D-Tex.), Rep. Barber Conable (R-NY) and Rep.James Jones (D-Okla.) introduced a corporate tax cut bill. In it, they proposed to shorten depreciation periods and accelerate write-offs far more radically even than ADR. Disingenuously, Bentsen et al. claimed that their plan would cost only $2 billion a year. That was indeed the estimated cost of the planing its first nine months. But the sponsors knew full well, although they never mentioned, that by its fifth year the plan was expected to cut business taxes by a staggering $50 billion annually.

Urged on by a massive corporate lobbying campaign, believing the low-cost promises of the sponsors and naively hoping to help the economy, hundreds of congressmen and Senators signed onto the Bentsen-Conable-Jones accelerated depreciation bill. In conjunction with an expanded investment tax credit,a version of the depreciation plan was eventually adopted as part of President Reagan's hugely expensive 1981 tax cut act (and made retroactive to the start of 1981).

With that, the floodgates opened. By 1983, as studies by Citizens for Tax Justice found, half of the largest and most profitable companies in the nation had paid no federal income tax at all in at least one of the years the depreciation changes had been in effect. More than a quarter of the 250 well-known companies surveyed paid nothing at all over the entire three-year period, despite $50 billion in pretax U.S. profits. General Electric, for example, reported $6.5 billion in pretax profits and $283 million in tax rebates. Boeing made $1.5 billion before tax and got $267 million in tax rebates. Dupont's pretax profits were $2.6 billion; after tax it made $132 million more! CTJ studies found similar outrages in 1984, 1985 and 1986.

In response to public clamor,his own newfound misgivings and the disappointing economic results of the 1981 corporate tax cuts, Ronald Reagan helped lead the fight for the loophole-closing Tax Reform Act of 1986. The 1986 act repealed the investment tax credit and sharply reduced depreciation write-offs for buildings. The changes greatly scaled back corporate tax avoidance opportunities and made taxpayers out of most of the former corporate freeloaders.

While companies paid more in taxes after 1986, however, business investment flourished. To the chagrin of the supply-side advocates of corporate tax loop holes, real business investment grew by 2.7% a year from 1986 to 1989.That was 43 percent faster than the paltry 1.9% growth rate from 1981 to 1986. Even more significant, while construction of unneeded office buildings tapered off after tax reform, business investment in industrial machinery and plants boomed. As money flowed out of wasteful tax shelters, industrial investment jumped by 5.1% a year from 1986 to 1989, after actually falling at a 2% annual rate from 1981 to 1986. As former Reagan Treasury official,J. Gregory Ballentine, told Business Week: "It's very difficult to find much relationship between [corporate tax breaks] and investment. In 1981 manufacturing had its largest tax cut ever and immediately went down the tubes. In 1986 they had their largest tax increase and went gangbusters[on investment]."

Despite its advances, the 1986 Tax Reform Act did not end corporate depreciation abuses. Even today, businesses are allowed to write off the cost of their machinery and equipment considerably faster than it actually wears out.This remaining loophole has proven much more expensive than originally anticipated by the drafters of the 1986 Tax Reform Act. In fact, accelerated depreciation tax breaks are expected to cost $259 billion over the next seven years.Like any tax break targeted to corporations, accelerated depreciation is primarily a benefit to the very well off (who own the lion's share of corporate stock and other capital). In fact, tax breaks from accelerated depreciation are worth an average of more than $13,000 a year to people making more than$200,000, but less than $70 a year to families earning under $50,000.

Today's depreciation rules already reduce the effective tax rate on the profits from typical investments in machinery to about half the statutory 35% rate. One can see examples of that effect by a quick perusal of corporate annual reports. For example, in 1995, Eastman Kodak paid an effective federal tax rate of only 17.3%--less than half the 35% statutory corporate tax rate-mainly because of $124 million in tax subsidies from accelerated depreciation.Accelerated depreciation was one of the key reasons why American Home Products paid only a 15.6% tax rate on its $4.2 billion in U.S. profits from 1992-94.Allied Signal got $51 million in accelerated depreciation tax breaks in 1995, helping it pay a tax rate of only 10.7% on its $3.4 billion in U.S.profits over the past four years.

Economists also complain--rightfully--that accelerated depreciation often skews investment decisions away from what makes the most business sense and toward tax-sheltering activities. This can, for example, favor short-term,tax-motivated investments over long-term investments. Moreover, when equipment is purchased with borrowed money, the current tax system produces outright"negative" tax rates--making such investments more profitable after tax than before tax! As a result, corporate buying and selling of excess tax breaks through equipment "leasing" deals have remained widespread.With its huge cost, minimal direct value to most people and sad economic record, accelerated depreciation might seem to have little going for it.Indeed, some might see curbs on excessive depreciation as a promising target for reducing the federal budget deficit. Several recent proposals, however,would vastly expand depreciation tax subsidies far beyond their current levels.

The GOP's 1995 "Contract With America" originally included a $30-billion-dollar year depreciation plan promoted by Budget Committee Chairman John Kasich (R-Ohio) that would have let companies write off more than they actually spent buying new equipment. A conceptually similar increase in depreciation write-offs is a key feature of the "flat tax" proposed by Rep.Dick Armey (R-Tex.) and endorsed by GOP presidential candidate S. Forbes, Jr. and former Rep. Jack Kemp.2

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