Some Tax Law Provisions Could Make for a Tougher Recession

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By Lydia O’Neal

An economic downturn could spell trouble for companies in cyclical industries, as the tax law blunted several tools that can help soften the blow of a recession.

The Trump administration is betting that the 2017 tax act will spur a 3 percent gross domestic product growth rate, but economists are voicing concerns that the current growth period may be ripe for a slump.

If that happens, under the new tax law, companies with net operating losses won’t be able to use as much of their NOLs to offset later-year tax liabilities, a benefit the private sector has leaned on to weather previous recessions. Some also will be able to deduct less of their debt interest expenses, a restriction that could squeeze large, leveraged companies if their incomes suddenly drop.

Provisions in the law that help companies shrink their tax bills, such as immediate deductions of research and development and bonus depreciation, begin to wane or sunset completely in a few years. The law’s expansion of government deficits, meanwhile, renders use of a fiscal stimulus in response to a downturn increasingly unrealistic.

International Monetary Fund Managing Director Christine Lagarde recently told Reuters the tax overhaul passed late last year served as an ill-timed stimulus that may cause the U.S. economy to undergo short-term growth and “overheating.” Others, like Dallas Federal Reserve Bank President Robert S. Kaplan, have suggested the law’s $1.45 trillion cost over the decade spanning 2018 to 2027 could be a “headwind for economic growth.”

“This is a very different scenario that we’re seeing,” Bank of America Merrill Lynch Head of U.S. Economics Michelle Meyer told Bloomberg Tax, when asked if there was any historical precedent for the country’s current economic situation. “This is a great amount of fiscal stimulus at a later stage in the business cycle, which is unusual, so I think it’s hard to know which direction we’ll be going.”

NOL Restriction

The GOP tax overhaul limited the net operating loss amount companies can deduct to 80 percent of taxable income under amended tax code Section 172, effective for losses arising in tax years beginning after Dec. 31, 2017. Although it allows unused NOLs to be carried forward indefinitely, the law eliminated NOL carrybacks—effective for tax years ending after Dec. 31, 2017—with the exemption of farming and property and casualty insurance company NOLs, which can be carried back two years. (Insurers also face a 20-year carryforward limit.)

The new restriction “is very unfortunate,” said Alan Auerbach, a University of California, Berkeley economics professor who directs the school’s Robert D. Burch Center for Tax Policy and Public Finance.

“Legislators somehow feel that NOL recovery is sort of an inappropriate gift, whereas it really is a way of cushioning the effects of cyclical income,” he said, calling the provision a “money grab.” “Tightening the rules—getting rid of the loss carrybacks, allowing only 80 percent offset against taxable income in the future—I think that is not good for cyclical industries.”

The change, which the conference committee report said should raise $201.1 billion by 2027, would leave retail, restaurant, consumer product, hospitality, travel, auto, and construction sectors especially vulnerable to a downturn, as their revenues tend to fluctuate in tandem with consumers’ disposable incomes, according to Auerbach and other tax professionals.

Lower Interest Deduction

Another deduction limit, capping interest expense write-offs at 30 percent of earnings before interest, taxes, depreciation, and amortization under amended Section 163(j), effective for tax years starting after Dec. 31, 2017, could also do damage in a downturn, precisely because it is based on income in the year of the interest payment, as opposed to an average of incomes over some number of years, tax professionals said.

“You’re expecting a certain level of income and you don’t get it, but your interest is still fixed,” said Duke University School of Law professor Lawrence Zelenak. “Whammy one is you were expecting that income and whammy two is you don’t get to deduct most of your interest either.”

The measure of income from which the 30 percent figure is taken narrows to just earnings before interest and taxes starting in 2022, making the provision more serious for companies reliant on debt financing.

But tax professionals who spoke with Bloomberg Tax generally didn’t expect lawmakers—and the companies and groups that lobby them—to allow that to happen. The limit only applies to corporations with average annual gross receipts above $25 million, and excludes regulated public utilities and electing real property trades or businesses, making its application relatively narrow.

Although professionals told Bloomberg Tax the law may incentivize companies to deleverage, especially ahead of the change in 2022, a team of S&P Global Ratings analysts suggested otherwise.

The analysts wrote in a Feb. 8 report that they “don’t envision sweeping changes to capital structures,” and instead expected companies to “make incremental adjustments” as a result of the new interest deduction cap. If they’re subject to the act’s mandatory repatriation tax, the report continued, “some companies might have to borrow if they have permanently reinvested foreign earnings.”

Perks to Expire

Because of the recent corporate rate reduction, a recession in the next year or two might even be a fortuitous way to punctuate the latest growth period—at least, as fortuitous as a recession can be, said Eric Toder, co-director of the Urban-Brookings Tax Policy Center.

Several years further down the line, however, as many of the tax law’s benefits begin to expire and the interest deduction limit tightens, absent legislative change, the effects could be more worrisome. The law’s temporary 100 percent bonus depreciation allowance, for example, starts phasing out in increments of 20 percentage points beginning in 2023, and amortization of research and experimental expenditures kicks in for tax years starting after Dec. 31, 2021. (Under amended Section 179, immediate full expensing remains available, and for more types of property, up to a higher dollar limit.)

“If the recession came a few years from now, I think we’d say, ‘Why did we do all this stimulus when we didn’t need it?’” said Toder, a former deputy assistant secretary for the Office of Tax Analysis at the Treasury Department and former director of research at the Internal Revenue Service.

Although these incentives encourage investment when they’re in place, Toder said, they would’ve had little impact during a downturn anyway, “because if companies don’t have profits that they need to shelter with deductions, having these faster deductions is not much of a benefit.”

Fiscal ‘Tool’ Lost

Perhaps the biggest risk, tax professionals agreed, is the law’s expansion of the government deficit, which Meyer, of Bank of America Merrill Lynch, described as “worrisome.” The bank’s calculations, she said, pegged the expected deficit for fiscal year 2019 at $1.1 trillion, or 5 percent of GDP. That’s a nearly $300 billion increase from the bank’s projection for fiscal year 2018.

“For an economy that’s at full employment, that’s a very high deficit share,” she said. “When the next recession hits, how much of a capacity is there going to be for further deficit expansion? That’s an unknown—that’s more of a political question.”

Michelle Hanlon, a professor of accounting at the Massachusetts Institute of Technology Sloan School of Management, said lawmakers may step in to ease restrictions on NOL deductions or other somewhat punitive measures if a downturn were to occur. But it’s unclear where else the government could turn to enact some sort of stimulus, if needed, let alone how lawmakers would fit it into the budget, said Caroline Bruckner, an American University professor and managing director of the school’s Kogod Tax Policy Center.

“Tax rates are so low that you’re taking a major tool out of the fiscal toolbox,” said Bruckner, former chief counsel on the Senate Committee on Small Business and Entrepreneurship. “You’ve eliminated that.”

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