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5-YEAR CARRYBACK OF NET OPERATING LOSSES

Key Points

·        Current law allows businesses to carry net operating losses back for two years to offset past taxable income. This proposal would allow businesses the option of carrying back losses an additional three years. However, if the business decides to use the additional carry-back period, losses are permanently reduced by 10 percent. The provision would allow businesses to redo prior-year tax returns and get immediate cash refunds for previously unusable losses.

·        The proposal would make temporary investment incentives such as bonus depreciation and expensing more effective.

·        The proposal would increase cash flow to businesses that are constrained in borrowing, enabling them to increase investment

·        The increase in the carry-back period would benefit previously profitable businesses that face large losses now. Given the state of the economy, this may be insufficient to induce those businesses to invest more now. Start-ups, as well as businesses that have large losses relative to past gains receive no benefit from the provision.

·        JCT estimates that the proposal will cost $15 billion over 10 years.

Current Law

Businesses calculate taxable income by subtracting expenses from revenues. While net income is taxed immediately, net operating losses do not qualify for immediate refunds on current tax returns. However, businesses may effectively receive a refund to the extent that they can be “carried back” against income taxed in previous years. Under current law, businesses may use current losses to offset only the past two years of profits. Losses that exceed the sum of the previous two years of positive income may be “carried forward” and used to offset taxable income earned in future years. Losses can currently be carried forward for twenty years (without interest, so their present value is lower than if they could be claimed immediately).

Stimulus Proposal

The provision would increase the net operating loss carry-back period from two years to five years for tax years 2008 and 2009. Businesses have the option of using the additional three years. If they choose to use the additional period, net operating losses are permanently reduced by 10 percent. The benefit would not be available to Fannie Mae, Freddie Mac and businesses that received money from the Temporary Asset Relief Program.

Discussion

Businesses that are unable to absorb their current losses with past tax payments do not receive immediate benefits from investment tax incentives such as expensing or bonus depreciation. Unused deductions can’t be used until future years. Because this blunts any stimulus provided by investment tax incentives, extending the carry-back period enhances these incentives. The more generous carry-back period can allow a company to benefit immediately from temporary investment incentives.

The provision also gives an infusion of cash to businesses that are running losses, which may promote investment. This may be especially important if those businesses have trouble borrowing because of financial market problems. The carry-back provision acts like an interest-free loan to these businesses. The Congressional Budget Office (2008) has concluded, however, that “effects of taxes on investment that stem from their impact on cash-flow are generally believed to be weaker, dollar for dollar, than those that stem from the direct effects of taxes on the cost of capital.” But this relationship may be reversed in a period when businesses are having difficulty obtaining external finance.

The provision would also help businesses that were relatively healthy in the past but now face large losses. The provision benefits old capital held by these businesses, but it is not clear whether it would induce them to undertake new investment. Start-ups and businesses that have large losses relative to past gains receive no benefit from the provision.

The provision would not be extended to Freddie Mac, Fannie Mae, and businesses already receiving TARP benefits. These businesses have already received cash benefits from the government.

The Job Creation and Worker Assistance Act of 2002 applied a five-year carry back to losses from 2001 and 2002. In 2003, the carry-back period reverted to two years. There is no research that we are aware of evaluating the effects of that tax law change on business investment.

Increasing the carry-back period is not necessarily bad tax policy. By not providing full refunds for losses, the government discriminates against risky investments relative to safe ones. Allowing full and immediate refunds of losses would level the playing field. But not all losses claimed by businesses are “real”. Some are generated by differences between income measured for tax and accounting purposes. Other losses may not be genuine and are taken to reduce taxable income in an attempt to evade taxation. Limiting the carry-back period can be viewed as a compromise between discouraging tax evasion and not discouraging risk-taking. Extending the carry-back period reduces the penalty on risk-taking and provides for more neutral treatment between risky and safe investments.

The proposal would cost an estimated $15 billion over 10 years. The loss of revenue occurs in fiscal years 2009 and 2010. In later years there will be revenue gains due to the reduction in the stock of losses that can be deducted from future profits. As a result, the short-term stimulus effect is likely greater than the 10-year costs suggest.

Grade: B

Increases effectiveness of temporary investment incentives such as bonus depreciation and expensing. By increasing cash flow to businesses that cannot borrow, it could also stimulate new investment but effect would be modest at best given current economic downturn.

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