Can US Tax Reforms Keep Up with China?

How does tax policy shape a nation's competitiveness? Today, we’re diving into the showdown between the US and China, exploring how China’s enticing tax incentives pose a formidable challenge to America’s economic supremacy. 

Joining Kyle is Alex Muresianu, Senior Policy Analyst at the Tax Foundation. Together, they explore how changes to US corporate taxes, including the restoration of full expensing for research and development, could be the key to ensuring America remains competitive on the global stage. 

Links: 

https://taxfoundation.org/research/all/federal/us-chinese-economy-investment-manufacturing/ 

Transcript

Kyle Hulehan: 0:00

How does tax policy shape a nation's competitiveness today? We're diving into the showdown between the us and China exploring how China's enticing tax incentives pose a formidable challenge to America's economic supremacy and welcome to the Deduction, a Tax Foundation Podcast. I'm your host, Kyle O'Hanlon, and today we are joined by Alex Muresiana, Senior Policy Analyst at the Tax Foundation. Alex, how are you doing today?

Alex Muresianu: 0:26

I'm doing well. How are you, Kyle?

Kyle Hulehan: 0:27

I'm good. I'm good. It's good to have you here. You recently released a really interesting paper about the US and China, and we can just dive right into that. I'm really wondering, how does the economy factor into the competition we have?

Alex Muresianu: 0:43

So I think that there are a few dimensions, here. I think, the U. S. and China are undeniably number one and two in terms of global economic powers. depending on how you adjust, currencies, the U. S. accounts for roughly, 26 percent of the world economy. China accounts for roughly 17. And the next highest is somewhere around 4%. so economic superpowers. It's the U. S. And China and everyone else is a footnote. and As far as how that matters for sort of political relations, the, as geopolitical rivalries, you know, a bigger domestic economy for either country means, greater influence in international markets. Uh, and that you know, has implications for, relations with other countries, more influence in trade. There's also the sort of more sort of hard military aspect where, you know, a stronger domestic economy means you have, more money available for defense spending and other sort of defense adjacent things, sort of Redundancies, you might think of, things that don't necessarily like grow the economy, but have some sort of additional security purpose. and so and then I think at another level, and that sort of ties in with a lot of, what's been most recently a concern, which is related to supply chains. And, resiliency, greater investment and growth in the U. S. can also mean, can also allow for more investments in redundancy, across the economy as well.

Kyle Hulehan: 2:20

Yeah. So I, I think there's maybe, you know, What I'm trying to understand here is the way that we structure our corporate tax system is, maybe a little different from China, but how does that impact how businesses invest in grow?

Alex Muresianu: 2:34

Sure. When people talk about taxes and tax competition, they often go to the corporate tax rate, which does matter corporate, companies, look at the corporate tax rate as they're evaluating a potential project and they say all right, if we're only able to keep you know, 75 of the profits, then this Project isn't really worth the risks, but if we're allowed to keep, you know, 80 percent of the profits, then, the expected profits, then, you know, this project is worth the risk and they'll initiate the investment corporate tax rate, does. Matter for investment. And another way it matters in competition people sort of, uh, sort of two different things. There's a, the matter of profit shifting where, companies can shift the sort of paper profits, around according to, the, different corporate tax regimes. But that's distinct from, capital investment, sort of real capital investment. corporate rate matters for both of those. But beyond that, the corporate tax base is possibly, if anything, more important. when calculating your tax liability, if you're a company, usually you can deduct operating costs, right away. Think about, salaries for workers, your electric bill. this is sort of a slightly complicated question, but inventory costs for the sake of argument. You can deduct those costs immediately or almost immediately. now for capital costs, say a piece of equipment, a new building, a warehouse, usually those costs have to be deducted Spread over time. under what, what's called depreciation. And over time, that sort of eats away at the real value of the deduction because, you're giving up some sort of opportunity cost by having to spread those deductions out. You could have invested that money elsewhere if you'd been able to make the deduction faster. and inflation also eats away at the value of these deductions. And This system has introduces sort of two biases on the one hand, it penalizes investment in firms across the economy, no matter what type of firm you are, namely, if you're not sure whether you should invest in some sort of labor saving technology, that will make, you know, workers more productive versus just hiring a couple more people. no matter what business you are, you're a nail salon, or you're a, complex navigational equipment manufacturer. it impacts your investment decisions, but both firms are negatively impacted here if they're deciding on making an investment. but also it impacts it, investment, or, Different impacts sectors differently. Some businesses are much more reliant on new investment and improved sort of technology and equipment than others. So In this example, yes, nail salon and the navigational equipment manufacturer both suffer here, but one fundamentally is a very sort of capital and technology intensive business, and they are going to suffer. Suffer if more if they are deprived from of the ability to deduct their investment costs and long story short how companies can deduct their investment costs Is very important for how you know, the corporate tax impacts the economy.

Kyle Hulehan: 5:50

So then what do you see as the key differences between the U. S. and Chinese economies that make them, compete differently at the global stage?

Alex Muresianu: 6:00

So I guess one thing to keep in mind is like, Depending on how you do the, adjustment for what's called purchasing power parity, either the U. S. is the largest economy in the world and China is second or China is the largest economy in the world and the U. S. is second depending on how you do these purchasing power parity adjustments. but it is worth keeping in mind that the U. S. is still a, is a much sort of richer economy, GDP per capita basis. and I think the That's important to keep in mind for how, the u the economies differ. There's a pattern that is true, exists across developed. economies of a shift towards sort of manufacturing, as a share of the economy and a shift towards sort of high technology services, where sort of high income and particularly skilled individuals, what sometimes is called human capital. think, scientific research software, finance, often, these sorts of businesses, grow as a share of the economy. And meanwhile, China is of course a very large economy, but in the large part because there are a lot of people who live there and are still developing and they have grown very quickly and what development economists might call catch up growth as they've gone from a, what was once relatively recently in agrarian economy, towards manufacturing. Manufacturing. And initially that was light manufacturing, shoes, t shirts, that sort of thing. but over time they've moved into much more complex, types of manufactured goods. but right now their goal is to start to challenge the United States for leadership and sort of the sort of high end innovation, rather than, just being the sort of place of assembly. the way that, I can't remember actually if it's the Chinese, Communist Party itself or a sort of commentator describing their view, is that they want to go from being the world's factory to being the world's sort of. R and d lab. and so they want to be where the sort of high level innovation, happens, the way the United States has, historically.

Kyle Hulehan: 8:10

Yeah, and it's interesting. obviously China has made a lot of ground over the past, 20 years or so. And I think what we're going to talk about coming up here is going to play into that is, China has something called a super deduction for R and D investments. How does that stack up against how the U S is currently, treating R and D spending?

Alex Muresianu: 8:27

Yeah. So one thing I ought to mention somewhere is that. It's worth keeping in mind, tax is just one of many different policy levers to talk about in terms of U. S. and Chinese economic policy, particularly in China, they still do have a substantial amount of state ownership, in certain sectors and, How they handle sort of land is pretty important for understanding sort of China's development policy So worth keeping in mind that tax is not the only issue here But now that we've gotten that disclaimer out of the way. so China's super deduction for R& D. Usually when you think about a deduction for costs say I have spent 100 or 101 on research and development, so I will deduct, 100 from my, taxes, and so that will reduce my taxable income by 100. and depending on what the corporate tax rate is, let's say your corporate tax rate is 25%. that means that will pay, 25 less in taxes. But that effectively means it's because you spent that money. It's not profit. You know, it's not a subsidy or something. corporate income is, revenues minus costs and R and D is a cost. So you subtract it out, to calculate your profits. And so that would be like a hundred percent deduction. What China has for R& D is a, 200 percent deduction, what we call a super deduction, which is, you spend, a hundred dollars on research and development. You're able to deduct 200 from your, revenue when calculating your taxable income. and so that will reduce your, tax liability by another 25. And so effectively, because China has a 25 percent corporate income tax, that effectively means for every sort of dollar you invest in R& D, the Chinese government would give you, or gives you in tax terms, a 25 percent subsidy. this is juxtaposed with the US, tax treatment of R& D, where we have a system called R& D amortization. Which, spreads deductions for R& D out over five years for domestic R& D. and, In practice, that actually creates a penalty, as those deductions decline, effectively, you can only deduct about 88, 89 percent of your R& D costs, which under a 21%, corporate rate amounts to a two and a half percent penalty, on R& D. And, that's a pretty big difference. R and D investment obviously matters for long term technological development on growth. Now, there are some downsides. The Chinese approach of really heavily subsidizing it. there's some good theoretical justifications about, the R and D has spillover benefits from the whole economy and other firms also benefit from one firm investing in R and D. eventually it will produce technologies that other firms will adopt. Et cetera, et cetera. but on the other hand, it creates incentives to sort of relabel regular expenses as R and D expenses so that they'll be eligible for this subsidy. So there are some, trade offs to this sort of big subsidy, but having a tax penalty, Really doesn't make a ton of sense.

Kyle Hulehan: 11:51

Yeah. And so the U S has a penalty and then China has this, this extra 200 percent deduction and. So the reason for this, I just want to hammer this on. The reason that the China's doing this is because they want people to invest. And this is just that extra massive incentive for these people to invest. Is that right?

Alex Muresianu: 12:10

Yeah. Yeah. And they've brought in the policy over time. initially it was focused on a few sort of, designated industries that they said, Oh, we wanted, we want specifically, we want this industry to, to develop, in China. Over time they've expanded eligibility, for it to almost the whole economy. so any firm doing R& D with the exception of a couple of specific industries, like I think one of them is, tobacco, and there might be like a couple other ones, not significant. Effectively it's the whole, whole economy, across industries. It's effectively a broad sort of economy wide policy. yeah.

Kyle Hulehan: 12:46

So now let's get into, some of the corporate and investment changes that happened here in the U S happened with in 2017 with the tax cuts and jobs act. on investment in the U S what lessons do you think maybe we could take away from what we did with the TCJ? Okay.

Alex Muresianu: 13:03

Yeah. So The Tax Cuts and Jobs Act in 2017, reduced the corporate tax rate to, 21%, from 35, and introduced, what's called 100 percent bonus depreciation for short lived assets, which meant companies had the option to fully deduct the cost of, investment in equipment, Much like you would, operating costs like again, salaries, your electricity bill, et cetera. and, It's tough, you know, it's tough to say, you can't just sort of look at a graph of investment over time and, see, how a policy changed here and then investment, what did investment do after that? okay, if investment was flat afterwards, then, clearly it didn't have any effect. You need to have some sort of counterfactual and, you also need to think about what other. things also happened in the economy at the same time. And those sorts of analyses tend to take a little bit longer. and so now we're finally seeing some sort of clearer analysis of, investment after the Tax Cuts and Jobs Act and isolating the effect, that those changes had, and there was a quite significant, in response in terms of capital investment, particularly for capital intensive firms, which would make sense, given the what I talked about earlier with the importance of, that provision for sort of capital intensive businesses, being able to deduct their investment costs is, particularly important for them. another, paper recently came out, compared investment behavior of U. S. firms and Canadian firms the policy change happening in the U. S. but not in Canada. also confirmed the, strong investment response that came in the U. S. and so I think that, is, What we would expect, given that it's a sort of this sort of broad reform to make the U. S. more investment, friendly. I think that it's a relatively intuitive conclusion. I think it, it, at some level, there are certain studies that you see in economics where it's, it seems like, uh, you know, Sky is blue sort of finding, but it's good to empirically confirm that once in a while. that's that's very much what those studies that have come out so far have found

Kyle Hulehan: 15:19

there are these. Other, bills that have come through and passed recently they've had like some tax credits and some subsidies and some different approaches in there. and when we would call them, that's the chips and science act and the inflation reduction act, which we've talked about on here before, I want to hit on these because there's a certain contrast to what's going on with the tax cuts and jobs act. So how do you think, those targeted subsidies differ from the broader tax policy? When we see the overall economic growth,

Alex Muresianu: 15:50

sure Yeah, so the way, um I guess people often talk about, in economics, people talk about, relative prices. How do you, how are you changing the price of one thing relative to the other? And, tax policy related to investment is usually intended to do one of two things. Either you're changing the price of investment relative to consumption, which means that, you know, Overall, people are more likely to invest their money and into future product productivity rather than consuming it today. that policy, a policy sort of changing the price of investment relative to consumption, Tax Cuts and Jobs Act is that sort of policy, reducing the corporate rate, having this, policy for equipment investment across the board, that would be that philosophy. And with, the other, philosophy would be changing the relative price of the different types of investment. You say we need investment in this industry, that industry, and that industry, because, for a variety of potential reasons, you might think that it's important for growth. They're special for some reason. We need them for the military or security purposes or, you know, the Inflation Reduction Act. It's a climate bill. And so you have this sort of really big tax cuts for those specific industries in order to change the relative price of different types of investment. You've lowered the cost of investment in this sector or this industry in order to move investment around. across sectors. They're not entire, like they both of these ideas that they are not fully separable, because sometimes, on the first one, when you do a broad policy to improve incentives for investment across the board, you're not working from a neutral baseline. And just by introducing this reform, you may have actually it. Change the relative prices of different investments at the same time And on the latter one where you're trying to change investment, shifting it around across sectors by doing a big Subsidy for some specific type of investment you may change the overall Level of investment as well, because you have created a big tax break for an investment in a specific sector, but that can change overall relative prices as well, ultimately, and I think that's what we've seen so far with the inflation Reduction Act and the CHIPS Act, there has been a lot of investment in the sort of subsidized sectors, And there has been, investment has been relatively strong recently, but it was projected to, be relatively strong, before the act was passed. Has there been a little over performance, relative to the pre law baselines, a little bit. It seems like that's the case, but it's, uh, again, we, we have to wait a little bit for the sort of higher quality counterfactual, but I think that would also be consistent. You might see some boosted investment overall, but for, from a targeted subsidy, but, and I guess the other factor here, and I hinted at it earlier is, why are we targeting these industries? part of the justification, at least, is that these are growth industries. and we, the government, policymakers, we know that these investments will produce, more growth. but from some sort of more pro market or a sort of pro free market perspective is, if these are such powerful growth sectors, like presumably like companies want to make money. And if this is like a true growth sector, then they would want to like invest in it too. and you did actually see some growth and investment in the sort of computer manufacturing semiconductors before the chips act. but, the concern with, and so one of the concerns with sort of these big subsidies for investments in specific industries is that they won't actually end up translating into productivity growth, which is really what you're after, when you want investment, and, uh, if policymakers are really trying to like plan out where investment should go, there's a real concern that investment won't translate to productivity growth and again, that is going to take even longer, to study than just, where, the investment response investment, productivity lags behind, investment, like new investment doesn't translate to productivity growth overnight. that'll take a long time to figure out. I think there are some reasons to be skeptical, um, for the IRA and NCHIPS Act so far, but we really don't know for certain.

Kyle Hulehan: 20:18

I'd want to jump in real quick and just say for lay people like me, could you just explain, the productivity growth that you mean? what exactly do you mean by that?

Alex Muresianu: 20:27

So if you gave me a typewriter, if I have a typewriter and, I have to get a new piece of paper every time I make a spelling mistake or something, and, yeah, if I have a typewriter, I have to go get a new piece of paper every time I make a spelling mistake. and then. You give me a computer with a word processor where it can tab over and fix things or better yet, it has auto correct. by investing in a new computer. I will have a much higher. written output as a result of, this new investment. I think the concern would be, for sort of unproductive investment is again, if you created a tech, I think this is a silly example, but it's an illustrative example is if today you said, I would like to create an investment tax credit for typewriter production. Presumably some companies are going to be like, hell, well, I want to get this investment credit. that'll really lower my, tax liability. If it's, big enough, they might want to get in on that. but there's not a whole lot of market demand, for typewriters. And so we would be skeptical that would be a good policy idea. Now, I think there are more coherent justifications for the IRA and CHIPS Act than that. but. To illustrate the principle. Yeah,

Kyle Hulehan: 21:47

that's honestly, that's really helpful and understanding. And I really appreciate that analogy. And it is a little silly and fun. I had one other thing that I wanted to follow up with. about the Chips and Science Act and IRA and TCJA. And you can tell me if this is right or wrong or parse out the difference is, again, as a lay person, like I, I don't understand, the economic implications and all of this quite as well as you do. but it struck me as TCJ is like eating your vegetables and it felt like the chips and science act and IRA are a little bit like a caffeine high of sorts and it's not perfect but it's just a little bit like one's a little bit more you're investing in your future and it's long sustainable and the other one is like a short burst of growth if that makes sense.

Alex Muresianu: 22:30

I think what the, IRA and Chipsack does is when you have a really targeted, you have a really targeted policy for a couple of industries. You spend a lot of money, the Chips and Science Act and, IRA, that's a lot of money targeted, it's not fully the same cost of the TCGA, but it's, which, is mostly an individual tax cut worth keeping in mind that corporate and pro investment provisions of the TCGA, are not the majority of the bill. it's somewhat comparable in scale, but it's just focused on a couple of industries. You get really big investment increases in those industries. And those are very appealing charts, look up 80%. Now it's very small subsector of the economy and investment, but, 80%, that's a big number. But if you cut taxes for investment across the economy and like marginal increases in investment across the board, which translate to solid investment growth in aggregate. That's there's no one sector where you can be like, Oh, look, see, like 80 percent this year. I would say it's like, I would say it's like a, it's like a sports team building, like a baseball team. TCGA is like, Building out the farm, you know, developing prospects like, uh, you know, investing in better coaching and, um, analytics, that sort of thing. And IRA and the chips act are signing a big ticket free agent. I think that's the analogy. I'll go with that analogy. I like that.

Kyle Hulehan: 24:03

crushed that, no, that was good, it's, you're raising, TCAJ is raising the floor, and this, I think you see the spikes and it's cool, we got ticket sales and some things worked, but it's raising the floor across the board for everyone that actually makes the biggest difference, would that be fair to say?

Alex Muresianu: 24:20

Yeah. And I think that's sort of one of the difficult things again, I think, in the long term, especially about evaluating the IRA and the chips. Actually, they have many policy goals and coming back to the beginning. Some of those have to do with the U. S. And China and security, particularly the chips and science. and it's worth it. Keeping those the sort of growth justifications for the chips and science act and the security goals separate, in terms of evaluation, because, I think people like to sell it as a a package. But there are a lot of things that we might do for security purposes or military purposes, that we don't say, Oh, this is going to like transform our economic growth. Don't want to go too deep into like growth using like abstract growth theory concepts as like a, as a punchline here. But it's generally it's if we like mean to buy more bullets. That's not like a strategy for transforming technological development, but it may well be a good idea for national security to, have an extra stockpile of a couple of billion more bullets, and. some parts of the chips act, maybe may end up being like a very good idea for the same reason that keeping a billion bullets hidden in a mountain in Wyoming would be a good idea. but that doesn't make that a sort of good idea for general sort of economic growth. Flipping that around. I think that the sort of pro growth tax policy sort of across the board, the pro investment tax policy, things like, bonus depreciation for equipment and returning to expensing for R and D, getting rid of the R and D amortization, which creates a tax penalty for R and D. that, yeah. Will help the U. S. economy and aggregate. And that again has all these sort of spillover benefits for the U. S. as a whole for its, global standing in the world. but there might still be. It's not a it's not a it's not a cure all for any of these sort of security specific woes. So there may be needed for, you know, we're not going to fix all our security problems or whatever with better tax premium capital investment. But if you're interested in growth and growth matters for that sort of thing, then that's where you want to go

Kyle Hulehan: 26:29

you've already discussed this a little bit, but maybe we just dive a little further into it. What kind of policy changes do you think the U S needs to make to stay competitive with China and boost the economic growth?

Alex Muresianu: 26:38

Yeah. So, you know, I think bonus depreciation for equipment and R and D expensing. Those are the ones that have been, uh, or sort of more current with policy debates. because they were parts of tax cuts and jobs act. And so those provisions, even though, bonus depreciation has already started phasing out, they're tied in with the, debate over extending other parts of the tax cuts and jobs act, which is going to really dominate policy conversation next year. The other thing is, keeping the 21 percent corporate rate. that's important to for investment incentives on the last. I think policy to cover is improved, tax treatment or cost recovery of structures, equipment. Relatively self explanatory, it's, machines and then, structures are buildings, and. very much. you know, improving tax treatment of those. Those have to be depreciated out usually over decades, spread the deductions out over decades. So there's a pretty large tax penalty, for that sort of investment and, we have a policy called a neutral cost recovery, which instead of moving to just deducting those costs immediately, they're still spread out, but they're adjusted to grow over time, which basically Is ultimately economically equivalent to getting to deduct them immediately. and that's a, an important policy for what I would consider capacity building investment. That's been sort of a buzzword recently. and if you want to build like a new facility or you're expanding a facility that you already have, a lot of those costs, are going to be like the new building that you put it in. Whereas if you're just slightly expanding production at an existing plant, that might be mostly equipment, but if you're actually like doing something that's already a new, a second factory or whatever, then you're going to have to build the structures as well. and I think also, This is, I think, a problem with the sort of targeted approach, for supply chains, you know, a big part of supply chains and supply chain resilience is like warehousing capacity. That's like a, not a very exciting, case for, people going out to cut ribbons with big scissors about what their new like subsidy policy is. You know, people love to talk about like high tech jobs or, these glamorous stuff, or infrastructure, that's what government is for, but like a big part of supply chain resilience is warehousing space and that was a big issue during the supply chain, challenges in 2021, 2022, no one's come out with a tax credit for warehouses as far as I know, because it's like not an exciting topic, but it does really matter if you're worried about like resiliency is if you want people to keep deeper inventories like they got to put them somewhere I would say that's like the three are people R and D equipment structures. Those are the sort of three things to think about in addition to the corporate rate. yeah, I think that's the takeaway for important pro investment policy to think about going into 2025 and to keep, In mind the importance of pro investment policy when thinking about us growth and competition on a global stage.

Kyle Hulehan: 29:42

I think the only thing that I'm going to totally take away from this is that warehouses aren't sexy. they're not moving political. They're not moving anything politically. They're not like making things happen. Nobody cares about warehouses that

Alex Muresianu: 29:52

But they should, but

Kyle Hulehan: 29:53

they should, they

Alex Muresianu: 29:55

they should.

Kyle Hulehan: 29:55

Just like they should care about R and D credits and investing. But,

Alex Muresianu: 29:59

R& D credits. R& D credits. Kyle. R& D expensing. Credits are different.

Kyle Hulehan: 30:04

Excuse me. Credits are different. I'm sorry. I blew it. I'm I shouldn't work at the tax foundation, but anyway, we'll wrap up the show here. Alex, thank you for being on the show today. This is a really interesting, fascinating topic. I just always toss it over. Is there anything you're working on right now? Anything you want to plug and get out to the people?

Alex Muresianu: 30:22

check out the China paper. There's like a lot in there. it's a pretty long piece, but it covers a lot. Oh, I will say it's covers a lot of different topics. So if you don't like one topic, keep reading and you might find something that you find interesting. you know, I think that's the big thing. I had a paper with a colleague, uh, Garrett Watson on super normal returns, which is a pretty, technical topic, but If you read people arguing about economic policy, like assumptions about supernormal returns is usually like something that if you dig down, that's really what they're arguing about. and so I would recommend checking that piece out as well.

Kyle Hulehan: 30:57

All right. Alex, thank you for being on the show today and we'll wrap things up there. for the listeners, if you guys have any questions, you can email us at podcast at tax foundation. org, or you can find us on Twitter at deduction pod. Thank you for listening.