What is the Deal with Tax Extenders? Or “Don’t Extend the Tax Extenders”
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This week, the Senate is set to consider the “tax extenders” bill. Each year, a large portion of the Internal Revenue Code expires, requiring Congress to pass a new law to extend these provisions or allow taxes to increase on a range of corporations and households. There is nothing particularly controversial about these provisions that would necessitate an annual review of their merits. Each year, a large bipartisan consensus embraces passage of “tax extenders.” Nor is there a coherent economic rationale for making these provisions temporary. In fact, in many cases the recurring expiration injects uncertainty that blunts whatever positive economic impact these provisions would otherwise provide.
For example, the most significant annual “tax extender” is the research and development tax credit. This credit provides a subsidy to encourage corporations to invest in fundamental research and experimentation in the belief that innovation is the essential driver of productivity growth. The goal of the credit, therefore, is to induce additional amounts of R&D spending to boost long-run growth, not to reward those who would have made such investments anyway. But how could the credit possibly impact long-run investment decisions when it expires every year?
Businesses inclined to increase R&D budgets above the amount targeted in the absence of the credit would have to weigh the probability of the credit not being extended. This injects so much uncertainty into the planning process that the credit simply provides a tax windfall for those businesses that would have made the investments anyway and have made the accounting and back office investments necessary to comply with the credit’s copious documentation requirements. Moreover, in its 28-year history as a temporary provision, the R&D credit has been allowed to expire and then applied retroactively, making a mockery of the suggestion that this changes behavior on a prospective basis. The same logic applies to the New Markets Tax Credit, which is supposed to induce additional investments in underserved urban areas.
The question is why these provisions expire every year if they’re non-controversial and their recurring expiration is economically counterproductive. The national press corps routinely reports on the “tax extenders” bill without ever taking a moment to ask lawmakers why they willfully preside over a system that injects so much policy uncertainty into business decision-making. But there are three basic reasons why Congress goes through this annual exercise:
1. Budgetary – The budgetary scorekeeping game obliges the Joint Committee on Taxation (JCT) to score these tax expenditures as only being in force for a single year. This reduces out-year budget deficits relative to what they would be if Congress budgeted honestly for the lost revenue. It also lowers the bar for complying with the Democrats’ new statutory PAYGO rules. To offset the full ten years of lost revenue from the expiring tax provisions would require more than $300 billion of tax increases. By pretending as though these provisions will expire at the end of the year, Democrats only have to increase taxes by $31 billion. This introduces a maturity mismatch in that permanent tax increases are used to offset a one year extension of expiring credits. But this perversity is inherent to the “logic” of tax extenders. If Democrats proposed tax increases that could raise $31 billion per year to offset the one-year cost of H.R. 4213, then these tax increases would raise $310 billion over 10 years and be able to fully offset the cost of making the “tax extenders” permanent. Therefore, the entire tax extenders exercise depends on trading short-term extensions for permanent tax increases.
2. Political Economy – The taxpayers impacted by the tax extenders bill know who they are. They’re not inclined to allow the provisions to go away without a fight. Impacted corporations have formed the R&D tax credit coalition to lobby annually for its extension. The Chamber of Commerce runs a broad tax extenders coalition that operates perpetually to secure passage of extenders each year. Were there no tax extenders bill, there would be no need for businesses to spend the money necessary to form these coalitions, lobby for extension of the provisions relevant to their business, or make campaign contributions to lawmakers on the tax-writing committees. The annual “tax extenders” bill has become an integral part of the “business” of Washington.
3. Political – Because of their importance to businesses and households, “tax extenders” are viewed as “must pass” legislation. And so they provide a vehicle for Congressional leaders to enact sweeping pieces of legislation that might have otherwise collapsed under their own weight. It is no coincidence that the TARP bill was added to “tax extenders” legislation in the Senate. In the latest iteration, “tax extenders” are being added to increases to physician payments under Medicare and an extension of unemployment insurance. Adding tax extenders to unrelated legislation allows the Senate leadership to piece together the 60 votes that might not exist for a series of stand-alone bills.
This year, the tax extenders farce has taken a pernicious turn. Democrats have proposed “paying for” one year of extenders with a permanent increase on the long-term capital gains income received through a carried interest in a partnership. By raising the effective tax rate on investment partnerships’ long-term capital income from 15% to 38.5%, Congress would inflict economic damage several orders of magnitude greater than whatever benefits might come from extenders. The investment partnerships impacted by the tax increase are long-term investors in commercial real estate, start-up and seed capital, and later-stage private equity. The conditions in the commercial real estate market are bad and likely to deteriorate when market prices fall in response to the reduced bids offered by the 1.48 million real estate partnerships forced to endure a doubling of their effective tax rate. The reduction in long-term corporate finance-oriented partnership investment is likely to be even more damaging to the economy given the substantial productivity gains associated with private equity investment.
“Tax extenders” are an affront to honest budgeting, undermine the effectiveness of the underlying provisions, and create significant deadweight costs in the form of the lobbying expenses incurred to ensure relevant provisions are renewed. With the looming possibility of a permanent tax increase that would impact investment partnerships, and slow the economic recovery, it’s even more important than ever to end this legislative farce once and for all.