Tax Policy – Weighing the Benefits of Permitting Business Credit Cashouts in Phase 4 Economic Relief
As policymakers explore options for additional business tax relief in “Phase 4” of coronavirus relief legislation, one idea that has received renewed attention over the last week is allowing businesses to cash out business tax credits allowed under Section 38 of the Internal Revenue Code. This proposal would be strengthened by also permitting acceleration of firms’ accrued net operating loss (NOL) deductions and designing the proposal so that firms can quickly convert these tax assets into cash.
Like individual taxpayers, firms may earn tax credits that reduce tax liability dollar-for-dollar, making a tax credit more valuable than an equivalent tax deduction (which reduces taxable income but not tax liability dollar-for-dollar). The federal tax code provides a variety of tax credits for certain kinds of business activity, ranging from tax credits for research & development, investment in certain kinds of (often renewable) energy, and tax credits for fulfilling socially beneficial needs such as investing in orphan drugs or low-income housing.
Generally speaking, business tax credits may only be used if there is tax liability to offset. Otherwise, businesses must carry over the tax credits for future use, keeping accrued tax credits on the books. While the nonrefundability of tax credits may work when economic conditions are good, businesses facing an economic downturn or exogenous shock (such as government-imposed lockdowns) may experience cash constraints while having accrued business credits that they cannot use. Policymakers can help improve liquidity for struggling firms by letting them convert the value of their accrued credits for cash, effectively accelerating when these credits are claimed.
Advancing business tax credits can be designed much like proposals to advance accrued NOL deductions. Both proposals convert tax assets accrued on firms’ books into cash needed today, while mostly representing a timing shift for the federal government. Firms would otherwise take an NOL deduction or business tax credit when earning taxable income in future years.
One weakness of permitting a cashout of business tax credits is the policy would not be well targeted towards firms that are most likely to be struggling through this crisis. Tax credits accrued in the past are not a good proxy for economic distress, though accrued NOLs (especially those accrued in 2020) are a better proxy for potential liquidity problems. This suggests that if policymakers are interested in letting firms convert tax assets into cash, they should permit the acceleration of both NOL deductions and tax credits in Phase 4. This combined approach would maximize liquidity for struggling firms while ensuring that both NOLs and tax credits are working as intended through the downturn.
Any effort to accelerate tax credits or NOLs should be designed carefully to make it easy for firms to quickly convert these tax assets into cash. There has been relatively low take-up of NOL carrybacks by businesses (Treasury processed about $5 billion in refunds in May), for example, partially because of the processing time required and partially because firms experiencing losses this year are not yet eligible for refunds. This makes monetization of tax credits and NOL deductions an attractive supplement to the loss modifications made as part of the CARES Act in March.
When moving forward with monetizing tax credits and NOL deductions, policymakers could consider limits on the total amount of tax assets that can be converted into cash, which minimizes the short-term cost of the proposal and may help target the relief to smaller firms. Policymakers will also have to consider how monetized NOLs can be realized by pass-through firms, as pass-through businesses are subject to a progressive individual income tax and not a flat corporate income tax.
NOL deductions, for example, could be monetized at the top marginal tax rate of 37 percent, or applied up the income tax schedule to calculate a firm’s refund. Either approach presents trade-offs, providing maximum relief to firms when using the top rate but at the expense of super-charging the comparative benefit of those assets if used in future years.
Applying those assets up the income tax schedule may look like a neutral approach, but this may instead undervalue them compared to their future use (e.g., an NOL deduction applied at a 12 percent income tax rate now vs. 37 percent in the future). During a downturn, the marginal tax rate for many firms may be lower than the rates they will pay on higher future incomes. This means that firms may be less likely to monetize tax assets during the downturn if they cannot convert them at the top marginal tax rate.
To be most effective, advancing business tax credits should be paired with accelerating NOL deductions that tend to track firm distress. The design of accelerated tax assets will also matter to make sure firms can realize the value of the additional liquidity during the downturn. When paired with reforms to the unemployment benefits provided in the CARES Act, strengthening programs to keep employees connected to their employers through the Paycheck Protection Program (PPP) and the Employee Retention Tax Credit, and enacting tax policy changes that set the U.S. up for long-term growth, policymakers will have a Phase 4 package that can set the American economy up for a stronger rebound in the months ahead.