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McCain’s Expensing Idea Revisited: Still A Massive Tax Shelter

Our guest blogger is Reuven S. Avi-Yonah, the Irwin I. Cohn Professor of Law at University of Michigan Law School.

For a while, Senator John McCain has been advocating letting corporations expense (currently deduct) the cost of purchasing business equipment. This is touted as a way of helping the economy, despite the lack of any evidence that it would do so.

Sen. McCain’s original proposal involved open ended expensing with no limitations. As I pointed out in an earlier paper, this proposal would not only “bust the budget” because of its direct cost, but it would also open the door to an immense increase in tax sheltering.

That is because corporations could borrow funds and use these funds to buy business equipment. The whole amount of the investment would be immediately deductible, as would the interest on the loan. The deductions would be larger than the size of the investment, generating extra deductions that could shield other income from taxes. Tax lawyers call this a “negative tax rate” and it is similar to the shelters that proliferated before the 1986 Tax Reform Act.

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Sen. McCain has recently revised his proposal in the face of such criticism. He now proposes to limit expensing to equipment purchased between 2009 and 2013 and to limit the deduction of interest on loans incurred to purchase such equipment.

Ending the tax break in 2013 severely undercuts the proposal. If it is such a good idea, why let it expire? And since Sen. McCain claims that letting the Bush tax cuts expire to plug the looming budget deficit is a “tax increase,” can we expect him to apply a different standard to his own tax cuts and let them expire?

More importantly, the revised proposal is still open to massive tax sheltering. Limitations on interest deductibility have proven unworkable because money is fungible. If interest on loans incurred to finance business equipment purchases cannot be deducted, corporations would borrow to fund other expenditures and use the money freed up that way to buy the equipment.

For example, instead of borrowing $100,000 to buy new computers and paying salaries out of its operating budget, a company could just borrow $100,000 to pay salaries and pay for the new computer out of its operating budget. That way, it could still deduct the full cost of the computers and the interest on the loan. Repeat, over and over again. Corporate tax sheltering can be that simple.

The Internal Revenue Code has two types of interest limitations. The first is used in determining how much interest expense should be allocated to the US and how much to the foreign income of corporations. It assumes that money is fungible, and allocates all interest expense on a worldwide basis, regardless of where it is incurred. This provision has been expanded recently and works well.

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However, the Code also has provisions similar to Sen. McCain’s proposal, which involve tracing of interest expense to the use of the borrowed funds. These are the investment interest limitations and the borrowing to acquire or carry tax exempt bonds. They are very complicated, and because of the fungibility of money, they do not work.

Sen. McCain’s revised proposal will not work either. There is no evidence it will help the economy, the budgetary cost would still be significant, and the anti-tax shelters provision would just add complexity without deterring the shelters. This whole proposal is wrong-headed and should simply be scrapped.