Many tax law provisions that favor certain types of investment are highly visible on a firm's financial statements. For example, tax credits for research and experimentation expenditures reduce a firm's accounting effective tax rate—the ratio of income tax expense to pretax financial accounting income—below the corporate income tax rate of 35 percent. Other provisions, such as tax depreciation in excess of book depreciation, do not change a firm's accounting effective tax rate, but they do defer the payment of tax in a way that creates a deferred tax liability. In each case, both investors and policy makers can see the effects of these tax law provisions on a firm's financial statement.
Yet there are many types of tax-favored investments that are treated the same for tax and financial reporting purposes. Consider brand advertising. From a management perspective, brand advertising expenditures are investments in building a long-term customer base, yet they are typically expensed for both tax and financial reporting purposes. Because of this book-tax conformity, these investments do not decrease a firm's accounting effective tax rate and do not create a deferred tax liability. More generally, any investment in internally developed intangible assets is tax-favored in a managerial sense, but this sort of tax preference is invisible because it affects neither the firm's accounting effective tax rate nor its deferred tax liability.
Two examples illustrate how such investments are tax-favored. Alpha Corporation buys farmland for $4,200, generating annual pretax income of $840 per year in perpetuity. At a 35 percent corporate income tax rate, Alpha would generate a $546 annual after-tax cash flow. The $4,200 investment is not deductible for tax purposes, so Alpha Corporation generates a 20 percent pretax rate of return and a 13 percent after-tax rate of return on this investment. Omega Corporation invests $4,200 in a project that also generates annual pretax cash flow of $840 and an annual after-tax cash flow of $546 in perpetuity; however, Omega's investment consists of $2,600 nondeductible land and a $1,600 tax-deductible investment in an internally developed intangible asset. The after-tax cost of Omega's investment is only $2,600 + $1,600 x (1 - 35%) = $3,640, so Omega generates an annual after-tax rate of return of $546/$3,640, or 15 percent. In effect, Omega faces a tax rate of only 25 percent on its investment, because it retains 75 percent of its 20 percent pretax rate of return.
These "invisible tax preferences" are substantial. In research that I am currently conducting with Tuck Professor Leslie Anne Robinson, we estimate the value of investments in internally developed intangible assets by subtracting the book value of a firm's assets from their market value (market value of stock plus book value of debt). We define the economic effective tax rate as the difference between the pretax and after-tax rates of return on a firm's assets, divided by the pretax rate of return on assets. We find that the tax deduction for investments in internally developed intangible assets reduced the economic effective tax rate that publicly traded corporations faced between 1988 and 2005 to about 22 percent, during which time the statutory rate was either 34 or 35 percent. This rate has fallen over time, from 26 percent in 1988 to 21 percent in 2005, as knowledge assets and intellectual capital have become more important sources of firm value. Not surprisingly, R&D-intensive firms faced the lowest economic effective tax rates, with pharmaceutical firms facing a 10 percent tax rate. Firms whose investments are primarily in tangible property or financial assets faced economic effective tax rates close to the statutory rates.
What is the appropriate policy response? Flat-tax advocates favor a system in which all corporate investments are expensed. The growing importance of intangible assets has moved the corporate income tax in this direction, albeit in a way that favors some industries (such as the pharmaceutical industry) much more than others. One policy alternative is to require the capitalization of investments in internally developed intangible assets. But this is problematic for two reasons. First, it is difficult to determine how an intangible asset loses its value over time, although a statutory amortization rule might achieve roughly the right outcome. (Purchased goodwill is treated in this manner under current law.) Second, and more important, the dividing line between an operating expense that only benefits the current period and an internally developed intangible asset is by no means clear. The practical impediments to a system in which internally developed intangible assets are capitalized are substantial.
However, the appropriate policy response may be to do nothing, because these invisible tax preferences may be offsetting other factors. To begin with, firms with heavy investments in intangible assets use less debt in their capital structure, perhaps because intangible assets have less collateral value. The deduction for intangible investments may in part offset the reduced ability of these firms to use tax-favored debt in their capital structure. Also, it is difficult for investors to distinguish valuable investments in intangible assets from operating expenses, because both are expensed for financial reporting purposes. This in turn may discourage firm managers from making such investments. The tax deductibility of these investments may actually enhance economic efficiency to the extent the tax advantage of investments in internally developed intangible assets offsets their financial reporting disadvantages.
In any case, the growing role of intangible assets in the economy means that these invisible tax preferences will become an even more important tax policy issue in the future.
