Center for American Progress

Corporate Tax Break Puts the Cart Before the Horse

Corporate Tax Break Puts the Cart Before the Horse

Net Operating Loss Tax Break May Be Least Effective Recovery Provision

The award for the least effect measure in the recovery and reinvestment package may go to the Net Operating Loss corporate tax break, writes Michael Ettlinger.

A more generous Net Operating Loss tax break gives corporations no incentive to hire anybody or make any investment—it just throws cash at them that is more likely to be hoarded than serve a useful purpose in the economy. (AP/Lucy Pemoni)
A more generous Net Operating Loss tax break gives corporations no incentive to hire anybody or make any investment—it just throws cash at them that is more likely to be hoarded than serve a useful purpose in the economy. (AP/Lucy Pemoni)

The recovery and reinvestment package is critical to getting the nation back on course. It’s imperative that it be designed carefully to have the largest possible effect on the economy. Almost all of the vast sums being seriously considered in Congress will be spent in ways that make sense. The package overall is well designed. But there are also compromises in the mix—many of which are designed to attract conservative votes to ensure passage and demonstrate bipartisanship in this time of crisis. The least-bang-for-the-buck award for the measures currently under consideration may belong to the Net Operating Loss corporate tax break—a proposal that would allow corporations with current tax form losses to get refunds for as many as five years of back taxes.

Cutting taxes for corporations in order to promote investment or hire workers puts the cart before the horse when it comes to a downward spiraling economy. Handing a corporation cash in the form of a tax break won’t get it to hire workers or invest if there is no prospect for profits. And businesses right now just don’t have much confidence that there are profits to be made.

That’s why the American Recovery and Reinvestment Act’s emphasis is appropriately focused on spurring demand in the economy. The act uses direct government purchasing and measures that enable private consumers to give businesses confidence that they have customers and can profit from hiring workers and making investments. Those additional workers and investments will, in turn, further fuel growth and get us on the road to recovery. Corporate tax breaks don’t do much to spur this upward spiral.

The NOL corporate tax break is a particularly poor choice. Current NOL law lets corporations deduct losses in one year from profits in another year. In general, corporations pay corporate income tax in years when they have profits, and the more profits they have, the more tax they pay. If they have a year with no profits or with losses, they don’t pay any corporate income tax that year. It’s long been recognized, however, that the one-year timeframe for taxing profits is somewhat artificial.

A company may, for example, show a loss in a year because it made a lot of investments (e.g. buying computers, purchasing machinery, refurbishing a building) or because its revenue is down as it revamps its product line to better compete (e.g. moving over from making VCRs to making DVD players). The next year it may make a profit but that single year’s profits really overstate how well the company is doing. After all, it had a loss the year before that enabled this year’s profits; the years together are really all part of the same period of corporate activity.

Strictly limiting the tax accounting to a single year would result in the Treasury sharing in the profits during good years but not sharing the losses in bad years—an inequitable and economically distorting result. For that reason, tax losses from one year are allowed to offset profits from another year so that, over time, taxes reflect a corporation’s overall profitability.

Companies are thus allowed to carry their losses forward, subtracting them from later year profits and only paying tax on the net amount—reducing their later year tax bill. Companies can also carry their losses back to offset profits from previous years and actually get taxes back that they already paid.

The law, however, puts limits on corporations’ ability to carry losses into other years for several reasons. First, the corporate income tax’s measure of income is far from perfect; it has loopholes that create opportunities to create tax losses on paper that don’t necessarily equate to a company’s actual profitability. There are constraints on the ability to use losses in one year to offset profits of another year so that companies can’t regularly avoid taxes through loopholes. Second, the constraints ensure that losses that offset profits are reasonably proximate to each other—from a common period of business activity. Finally, it’s important for responsible government fiscal planning that the government be able to close its books on past years at some point so that it doesn’t forever carry the risk of having to refund taxes it’s already collected.

One of the primary limitations on using losses to offset profits from other years is a limitation on how far forward and back in time they can be carried. In general, losses may be carried forward to offset profits on tax returns for 20 years. That is, losses incurred in 2008 can be used to offset profits through 2028, although a company would only use the full period if it experienced a very big loss or very low profits for a sustained period. Companies can also carry losses back to offset profits from the previous two years. So if a company had profits in 2006 and 2007, but losses in 2008, it could offset its profits from 2006 and 2007 to the extent of its 2008 losses and get taxes it paid in 2006 and 2007 refunded.

Corporations particularly cherish the ability to carry losses backward. They get an immediate tax refund if they qualify—not just the likelihood of lower taxes at an unknown point in the future.

There are currently many companies with losses. And losses in the hardest hit industries such as home building and mortgage lending easily outstrip the last two years of modest profits as the bubble days slowed before the collapse. So it’s not surprising that corporations and their representatives in Congress are calling to extend the NOL carry back from two years to five years. The longer the carryback period, the better the chance that there’s a year in the period with sufficient profits to offset current losses so they can claim an immediate tax refund. The Joint Committee on Taxation estimates that this would give the benefiting corporations $67 billion over the next two years, although the 10-year cost is a net of about $20 billion because corporations will be claiming losses today that they would have eventually claimed in the future.

Is this a good idea? There is some intuitive appeal to helping businesses that have experienced big losses—after all, they’re hurting the most. But there are serious questions as to whether this infusion of cash will actually create jobs or help the economy. Businesses that have the biggest losses—and profits from the past to offset them against—are the most likely to suffer from a dearth of customers and have the greatest existing overcapacity. The more generous NOL treatment gives them no incentive to hire anybody or make any investment—it just throws cash at them that is more likely to be hoarded than to serve a useful purpose in the economy.

Put another way, extending the NOL is likely to cause a replay of what is happening with the money given to banks without meaningful conditions attached through the TARP. That money has largely not found its way into the economy; the banks may have been “too big to fail,” making the infusions arguably justifiable, but the NOL beneficiaries can’t make such a claim.

Think, for example, about a homebuilder. There is barely any market for new homes right now and there is a huge backlog of inventory both in new and existing homes. This situation is going to persist for some time. Handing a homebuilder cash is not going to inspire him or her to hire people to build more homes that won’t sell. In fact, the homebuilder might, at this point, be simply a shell corporation with little actual business activity, perhaps selling off homes that are already built or perhaps doing absolutely nothing. Whatever the case, the NOL cash is not likely to put people to work or be used to make investments—it’s going to go into the pockets of the homebuilder where it will do little for the economy.

One argument made for the NOL tax break is that it allows other, better-targeted tax breaks to work. That is, there are other tax breaks for corporations in the recovery package that are more connected to employment and investment. The argument is that if companies are not making profits, they don’t owe any taxes and therefore cannot benefit from further tax breaks. The NOL provision addresses this by allowing corporations to benefit immediately from greater tax losses due to the new tax breaks.

Leaving aside the merits of those provisions, which have their own problems, the flaw in this argument is that one could solve this suggested problem in a much less expensive way than providing the universal NOL tax break. The answer is to draft more targeted provisions so that corporations can benefit from them even if they do not currently have profits. It’s a simple thing to do.

The NOL provision might have some effect on economic activity. The current state of the economy means that any cash flow probably helps. But it’s little bang for a lot of “bucks.” The NOL tax break is so far down the list of effectiveness relative to other uses of taxpayer dollars to address our economic problems that it shouldn’t be done.

More from CAP on the recovery package:

Brief: Recovery and Reinvestment 101

Interactive Map: Beyond the Beltway: Helping Those Most in Need

Column: How to Help 12 Million Low-Income Children

Interactive: Build Your Own Stimulus Package

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Michael Ettlinger

Vice President, Economic Policy