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CRS STUDY IDENTIFIES TOPICS OF INQUIRY TO DETERMINE APPROPRIATE FEDERAL TAXATION OF THE STEEL INDUSTRY.

DEC. 18, 1988

88-5 E

DATED DEC. 18, 1988
DOCUMENT ATTRIBUTES
  • Authors
    Brumbaugh, David L.
  • Institutional Authors
    Congressional Research Service
  • Index Terms
    net operating loss
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 88-9590
  • Tax Analysts Electronic Citation
    88 TNT 251-7
Citations: 88-5 E

CRS REPORT FOR CONGRESS

The effect of Federal taxes on the steel industry varies from firm to firm, depending on whether the company in question has accumulated a stock of tax attributes known as "net operating loss (NOL) carryforwards." Firms without carryforwards are taxed at about the same effective rate as most other firms. However, new investment by steel firms with carryforwards may bear either a heavier or lighter tax burden than that of other corporations, depending on the size of the NOL carryforward.

                                 by

 

                           David Brumbaugh

 

                      Analyst in Public Finance

 

                         Economics Division

 

 

                          December 18, 1987

 

 

                              CONTENTS

 

 

PROLOGUE: TAXES AND INVESTMENT

 

TAXATION OF STEEL FIRMS WITHOUT NOL CARRYFORWARDS

 

     Steel and the Tax Reform Act of 1986

 

     Summary

 

TAXATION OF STEEL FIRMS WITH NOL CARRYFORWARDS

 

     Net Operating Loss Rules

 

     NOL Carryforwards as Tax Deferrals

 

     Impact of NOL Carryforwards on Effective Tax Rates

 

     NOL Carryforwards and Steel

 

SUMMARY AND CONCLUSIONS

 

 

FEDERAL TAXES, THE STEEL INDUSTRY, AND NET OPERATING LOSS CARRYFORWARDS

Federal policy towards the steel industry has been a matter of increased congressional concern in recent years -- a concern that has stemmed from the bankruptcies and continuing losses registered by major firms in the industry, and from the industry's decline from its previous position at the center of the United States economy. A central question for policymakers is: should the Federal Government provide assistance -- whether in the form of protection from imports, financial assistance, or through taxes -- designed to arrest the industry's decline? Or should Federal policies be designed simply to ease the inevitable dislocation that accompanies any major economic change? This report looks at current policy towards steel in one particular area -- that of Federal taxation.

The Internal Revenue Code contains no permanent provisions designed to provide sustenance to the steel industry through the tax code. Indeed, current tax rules are such that a part of the industry is taxed just like most other firms. Specifically, those firms that have not accumulated supplies of tax attributes known as net operating gloss (NOL) carryforwards pay taxes at an effective rate that is very slightly lower than that of other manufacturing firms and is slightly higher than all corporations on the average.

But the steel industry is currently distinct from other industries in that a large part of it does have NOL carryforwards -- tax losses that were incurred in prior years, but which firms were unable to deduct from taxable income. The analysis here indicates that steel firms with NOLs bear different tax burdens than either their fellow steel companies or most other firms. If a steel firm's carryforward is large enough, it can reduce the firm's effective tax rate on new investment below that of other steel companies as well as corporations in most other industries. On the other hand, steel firms with only small carryforwards face effective tax rates slightly higher than firms without NOLs.

Federal tax policy towards steel is thus ambivalent. It treats firms without NOLs neither more nor less favorably than other companies. However, the tax burden it places on companies with carryforwards may be either higher or lower than that on other firms.

The story of steel taxation that follows has two parts. The first part is confined to those steel firms that do not have NOL carryforwards.

The second chapter analyzes the tax treatment of firms with NOL carryforwards. It is best, however, to begin every story at the beginning. Thus, before turning to the steel industry itself, we take a brief look at how the corporate income tax affects firms and industries in general.

PROLOGUE: TAXES AND INVESTMENT

A firm's business receipts include both a return to labor and a return to capital investment. The return to labor is not subject to the corporate income tax; the entire amount is paid out as wages and can be deducted by firms from taxable income. The return to capital investment is, however, subject to taxes. In consequence, the corporate income tax registers its most direct effects on corporate investment.

Taxes affect corporate investment by driving a wedge between the return that an asset produces before taxes and its return after taxes. Most capital assets contribute to a firm's business receipts for a period of time -- in some cases for decades. An asset's return is therefore commonly calculated for its entire lifetime. Its before tax return consists of the receipts it produces over its lifetime minus its acquisition cost. An asset's after-tax return consists of the before tax return minus the tax liability the investment generates over its lifetime.

The larger the wedge that taxes create between an asset's before tax and aftertax return, the less attractive is that investment for a firm, and the less the firm will employ that asset compared to other, more favorably taxed investments. Also, the more heavily all of a firm or industry's investments are taxed, the less investment that firm or industry undertakes compared to other, less heavily taxed firms or industries.

We should note, finally, that the focus throughout this report is on how taxes affect the return a firm EXPECTS to earn on new investment, because it is by altering the attractiveness of new investment that taxes affect the level of investment a firm undertakes. The effect of taxes on the return produced by investments made 10, 5, or even one year ago may reveal little about how taxes affect a firm's current investment decisions.

TAXATION OF STEEL FIRMS WITHOUT NOL CARRYFORWARDS

There are no permanent provisions in the Federal tax code that single out investment by the steel industry for special tax treatment. 1 The code does, however, contain an array of provisions that assigns different tax treatments for different types of investment, whether the investment is in steel or elsewhere. Further, the steel industry -- like other industries -- undertakes a mix of investment projects that is different from that of other industries, and that depends heavily on the technical requirements of making its particular product. Thus, even without provisions that tax steel firms separately, the tax burden of the industry as distinct from that of other industries.

Several different tax provisions are responsible for the variation of tax burdens across types of investments. Investment in inventory is taxed relatively heavily compared to assets that depreciate because of the tax rules that govern inventory accounting. The accounting rules result in taxes being assessed against the component of inventory income that consists of illusory, inflation- induced profits, as well as real income. Tax burdens also vary among depreciable assets because the cost of some assets can be depreciated (deducted from taxable income) more rapidly than that of others.

What, then, is the tax burden on steel, based on the particular combination of assets firms in the industry typically use?. As long as net operating losses are ignored, steel is taxed neither more nor less favorably than other industries. Table 1, below, presents CRS estimates of the effective tax rates of steel and other major industries. The left-hand column of the table shows that under current law, the effective tax rate faced by steel firms occupies an intermediate position compared to other firms. The table's numbers show that steel is taxed at a very slightly lower rate than is manufacturing in general and at a very slightly higher rate than most corporations.

There are several different types of "effective" tax rates that are commonly used to estimate business tax burdens, and so it is useful to state precisely the nature of those in table 1. The rates in table 1 are of a type known as "marginal" effective tax rates. Marginal effective tax rates begin with the idea that each investment a firm undertakes generates a stream of income over its lifetime, and that the return on an investment depends on how the present value of that income compares to the asset's acquisition cost.

The rates measure the impact of taxes by gauging the rate of return before taxes and the rate of return after taxes. More precisely, a marginal effective tax rate is the difference between the before-tax return and the after-tax return to investment, divided by the before-tax return. Marginal effective tax rates, further, measure the impact of taxes only on new, prospective corporate investment. 2

As noted above in the prologue, taxes affect investment decisions by altering the rate of return on new investment. Because this is precisely what marginal effective tax rates measure, they are especially well-suited to measuring the importance of taxes to a particular type of investment, firm, or industry.

                               TABLE 1.

 

 

      Marginal Effective Tax Rates in Steel and Other Industries

 

 ____________________________________________________________________

 

                                     Effective Tax Rate

 

                             ________________________________________

 

                                               Law Prior to the Tax

 

 Industry                    Current Law       Reform Act of 1986

 

 ____________________________________________________________________

 

 

 Agriculture                      42                    41

 

 Mining                           37                    30

 

 Oil Extraction                   28                    23

 

 Construction                     40                    28

 

 Manufacturing                    43                    43

 

      Steel                       42                    39

 

      _____                       __                    __

 

 Transportation                   37                    23

 

 Communications                   35                    24

 

 Radio/TV                         38                    32

 

 Electric/Gas                     38                    28

 

 Trade                            44                    47

 

 Services                         40                    32

 

 

 AVERAGE                          41                    38

 

 ____________________________________________________________________

 

      Source: CRS Capital Stock Mode 1

 

 

STEEL AND THE TAX REFORM ACT OF 1986

The Tax Reform Act of 1986 contained a number of important changes in business taxation; the changes had a mixed effect on business tax burdens. On the one hand, the Act eliminated a sizable tax benefit for business by repealing the investment tax credit; it also provided for a modest scaling-back of depreciation allowances. Both of these changes, if enacted alone, would have resulted in higher tax burdens for most businesses. But at the same time, the Act provided for a substantial reduction in the statutory tax rates that the tax applies to taxable income, a change that, in isolation, had the effect of reducing business tax burdens.

Representatives of the steel industry varied in their attitude towards business tax reform, with its combination of curtailed tax benefits and reduced statutory tax rates. The chairman of one major steel firm, for example, testified before the House Ways and Means Committee that repeal of the investment credit would reduce investment by the steel industry itself, and would also curtail demand for the capital goods that comprise a significant portion of steel sales. 3 In contrast, the chairman of another steel corporation testified before the Senate Finance Committee that "major basic manufacturing industries would not be badly damaged as a result of the trade off between the reduction in corporate tax rates and the repeal of the investment tax credit." 4

The effective tax rates in table 1 support the latter viewpoint more than the former. Comparison of the column labelled "Law Prior to the Tax Reform Act of 1986" with the rates in the column labelled "current law" show the combined effect of the Tax Reform Act's most important business tax provisions. According to the table, the treatment of steel relative to corporations on the average was not substantially changed by the Act. In absolute terms, the effective tax rate for steel was slightly increased by the Tax Reform Act, but the same was true for firms on the average. Thus, after the Act as before, steel received tax treatment that was generally neither more nor less favorable than that of most other industries.

The Tax Reform Act changed the position of steel vis-a-vis other manufacturing firms, but not by a large amount. Table 1 shows that prior to the Tax Reform Act, steel firms had an effective tax rate that was somewhat lower than that of other manufacturing firms. And while the Act increased the tax rate for steel firms slightly, it kept that for manufacturing firms at the same level. Thus, the position of steel deteriorated slightly compared to other manufacturing industries.

The conclusion that the Tax Reform Act did not greatly change the relative tax burden on the steel industry runs counter to the popularly held notion that certain provisions of the Tax Reform Act -- specifically its repeal of the investment tax credit and less generous depreciation allowances -- was unfavorable towards traditional "smokestack" industries such as steel that invest heavily in machines and equipment. This misconception ignores the fact that the steel industry invests heavily in inventories, as well as in machines and equipment. And while the Tax Reform Act did result in a higher effective tax rate for equipment, it also reduced the tax burden on inventory investment. In the case of steel, the effect of the Act in increasing the tax burden on equipment (resulting principally from repeal of the investment credit) was almost completely offset by the Act's reduction of taxes on inventory investment.

In addition to making changes that applied to other industries as well as steel, the Tax Reform Act contained a provision that applied only to the steel industry: it permitted steel firms, in effect, a cash refund for a portion of their unused investment tax credits. In view of how firms are generally believed to make investment decisions, however, this provision probably has had little impact on investment by steel firms.

Prior to the Tax Reform Act, a number of firms in the steel industry had accumulated large stocks of unused investment tax credits, because low levels of profits in the years preceding the Tax Reform Act had resulted in low before-credit tax liabilities. The investment tax credits steel firms earned tended to outstrip the tax liabilities they could offset.

Prior law's investment tax credit rules, however, allowed firms with unusable credits to "carry back" unused credits earned in a given year, and use them to offset taxes paid in the three previous years, thereby generating tax refunds. If unused credits still remained, they could be "carried forward" or "carried over" for up to 15 years and used to offset taxes due in those years.

While the Tax Reform Act repealed the investment tax credit for property placed in service after December 31, 1985, firms with stocks of unused credits from prior years were still permitted to carryover those credits to years after 1985, albeit at only 65 percent of their previous rate. For the steel industry, section 212 of the Act lengthened the carry back period from three years to 15 years, although credits thus carried back were reduced to 50 percent of their prior rate. The extension of the carryback period was so long that section 212 amounted to a cash refund to steel firms for their stocks of used investment credits.

The Congressional Budget Office has estimated that the extended investment credit carryback created $500 million of tax refunds for steel firms. 5 And while the Tax Reform Act attached a proviso to the measure that required firms to invest their refunds in steel operations, it is doubtful the provision has or will have a large impact on steel investment. The reason is that a firm's decision on whether or not to undertake new investment depends on how it assesses the profitability of that investment, and that investment alone. Clearly, tax refunds generated by credits earned on past investments have little to do with the profitability of prospective investment projects.

Summary

The story thus far has applied only to steel firms that do not have certain tax attributes known as "net operating loss carryforwards." Its conclusion is that the tax treatment of this part of the steel industry occupies an intermediate position among that accorded other industries, and that the enactment of the Tax Reform Act of 1986 did not alter this middling position. Thus, as far as firms without carryforwards are concerned, Federal policy is to treat steel neither more nor less favorably than other industries.

But the tale is incomplete at this point, for a number of reasons. First, recent analyses of net operating gloss carryforwards have concluded that NOLs can significantly alter a firm's tax burden. Second, the same analysis has estimated that the steel industry has recently accumulated huge stocks of these NOLs. We thus now turn to an examination of the impact of NOLs on steel.

TAXATION OF STEEL FIRMS WITH NOL CARRYFORWARDS

Steel firms that have NOL carryforwards account for a large portion of the industry's total assets. Further, carryforwards in steel are larger by far than in most other industries. When it is also considered that these loss carryforwards can drive a firm's tax burden either up or down, the presence of large NOLs must be considered one of the most important factors determining how steel is taxed.

Net Operating Loss Rules

The preceding discussion of the Tax Reform Act described how firms with low tax liabilities may earn more investment tax credits than they can use to offset the current year's tax liability. Net operating losses are similar to these unusable investment tax credits: NOLs are tax deductions that cannot be subtracted from the current year's gross income because that gross income has already been offset by other tax deductions. NOLs, in other words, are the excess of corporate tax deductions for a particular year over gross income.

In a manner similar to investment credits, NOLs that accrue in a particular year can be carried back and deducted from gross income earned in the three preceding years; if the carryback reduces the taxes a firm has paid in any of the three years, the firm receives a tax refund. If the entire NOL is not exhausted by carrying it back, the remaining amount can be saved, carried forward, and used to offset gross income that may accrue in future years. NOLs can be carried forward up to 15 years.

In any particular year, then, a firm can be in one of three positions regarding net operating losses. First, a firm can be in a carryback position. It has incurred an NOL in the current year and earned taxable income in prior years that is sufficient to absorb the current year's tax loss. Second, a firm can incur a loss and be in a carryforward position; taxable income from prior years is insufficient to absorb the entire loss from the current year. Third, a firm can earn positive taxable income in the current year but still be in a carryforward position. In this case, NOLs carried forward from prior years are more than sufficient to offset the current year's taxable income. To make the task manageable, the analysis that follows is confined to steel firms in the last two of these situations: it examines the tax treatment of steel firms with net operating loss carryforwards.

NOL Carryforwards as Tax Deferrals 6

As long as a firm's stock of NOL carryforwards lasts, it is protected from the actual payment of taxes. 7 With each dollar of taxable income a firm earns, it can take a dollar from its stock of NOLs and use it to offset the taxable dollar. But while NOLs protect a firm from current payment of taxes, their impact on the firm's tax burden is like that of a tax deferral (postponement) rather than that of a tax exemption.

A tax exemption reduces the effective tax rate on investment to zero, but the effect of an NOL carryforward varies, depending on how long a firm expects its stock of carryforwards to protect it from current taxation. If a firm expects its carryforwards to last for an indefinitely long period of time, the effective tax rate on its investment is zero; the firm bears no tax burden. In contrast, if a firm does expect to exhaust its NOL carryforward in the foreseeable future, its carryforwards do not eliminate the tax burden on its investment. Depending on the type of asset, carryforwards may either reduce or actually increase the tax burden on investment the firm undertakes.

The way NOL carryforwards register their effect can be seen by looking at an hypothetical investment by a firm that has a stock of NOLs. We shall say that the investment produces gross revenue for only one year (Year 1), after which the investment is worthless. We shall also say that the tax code permits assets of this particular type to be "expensed" -- meaning that their entire acquisition cost can be deducted in the year the investment is made. In short, the imaginary asset produces taxable income (consisting of gross revenue minus deductions) for only one year -- Year 1. Finally, to complete the picture, we shall stipulate that the imaginary firm has a stock of NOL carryforwards that it expects to last for 10 years after the investment is made; the firm expects to become taxable again in Year 10.

Even though the firm in our example is not taxable until Year 10, taxes still have an impact on the hypothetical investment made in Year 1. It is true that the firm pays no taxes on any of the taxable income the investment produces in Year 1; each dollar of taxable income can be offset by a dollar from the firm's stock of carryforwards. But as the firm uses its NOLs to eliminate taxable income produced in Year 1, it draws down its stock of carryforwards. If, for example, the investment produced $1,000 of taxable income in the current year, it will have $1,000 less in its stock of carryforwards. As a consequence, the firm will exhaust its stock of NOLs one thousand dollars sooner. In Year 10, when the stock of NOLs is finally exhausted, the firm will have $1,000 less with which to offset taxable income it earns in that year.

The cost to the firm of taxes actually paid in year 1 is zero. But in assessing the total tax cost of the investment, the firm must add the additional taxes that are paid in Year 10 because the investment in Year 1 has drawn down the stock of NOLs. Since taxable income is increased in Year 10 by precisely the same amount as the taxable income the hypothetical investment generates in Year 1, the effect of the NOL is the same as if the taxable income produced by the investment had been postponed for ten years rather that exempted from taxes altogether. Hence, while NOLs provide current forgiveness of taxes, their effect is merely that of a tax deferral or postponement.

Impact of NOL Carryforwards of Effective Tax Rates

Given that NOLs can be viewed as though they postpone rather than eliminate taxes, how does this postponement alter the tax burden on a particular new investment? From a firm's point of view, the later a given amount of taxes are paid, the better. This is because the firm can invest the funds represented by the deferred taxes and earn a return until the tax liability is ultimately paid.

For some types of investment NOL carryforwards always result in a reduced tax burden regardless of how long or short the period of time before the carryforward is completely exhausted. [sic] Investment in inventory is a case in point. Under the tax code's First-in-First-Out (FIFO) inventory accounting rules, taxable income from inventories is not adjusted to reflect inflation. Thus, a relatively large portion of the gross receipts earned by inventory investment is taxable. Accordingly, when a firm with carryforwards undertakes inventory investment, a relatively large amount of taxable income receives the benefit of the NOL's postponement effect, and the effective tax rate on inventory is reduced. 8

In contrast to inventories, the postponement effect of NOLs may actually increase the tax burden on equipment in some cases -- specifically, in situations where the equipment qualifies for depreciation deductions that are quite accelerated and the investment is undertaken by a firm whose carryforward is not large. Suppose, for example, a firm invests in a particular machine that produces revenue for five years. Like most machines, the cost of this one must be depreciated -- its acquisition cost can be deducted by the firm only in increments and over a number of years. In this particular case, we shall say that the tax code permits depreciation that is so accelerated that the total amount of depreciation deductions permitted over the first few years of the machine's life is larger than the gross revenue the machine produces over those years.

Suppose, now, that the firm in the example has only a small NOL carryforward that it expects to exhaust after the first few years of the machine's life. The NOL has the effect of postponing any taxable income the machine produces as long as the NOL lasts. In this case, however, since deductions exceed gross revenue during the NOL- protected period, taxable income associated with the machine is actually negative: the NOL postpones what is actually a net tax deduction. Accordingly, in situations such as this, the carryforward actually has the effect of increasing the effective tax rate on the investment. 9

Table 2, below, uses marginal effective tax rates of the type described in the preceding section to portray the impact of NOL carryovers on three different assets. The table shows effective tax rates for two assets that are representative of the two principle types of depreciable assets: equipment and structures. The table also presents rates for inventories. For each asset, an effective tax rate is given for NOL carryforwards of varying duration. Column 1, for example, shows the rates that apply to investment in different assets by firms that do not have NOLs and are thus taxable in the year the investment is made and in each year thereafter. Column 2 shows the rates faced by a firm with a carryforward that will protect it from taxes for 5 years. Columns 3, 4, 5, 6, and 7 show rates where a firm has carryforwards expected to last 10, 15, 20, 25, and 30 years, respectively.

Table 2's message is that the impact of NOLs varies, depending on the type of investment and depending on the expected duration of a firm's NOL carryforward. For example, the particular type of equipment listed in column 1 (general industrial equipment) is eligible for depreciation allowances that are relatively accelerated. NOL carryforwards result in higher effective tax rates for this type of asset because the cost of postponing the depreciation deductions is greater than the benefit of postponed recognition of gross revenue; the increase in tax rates moderates as the expected duration of the carryforward increases beyond 10 years.

                               TABLE 2.

 

 

            Effective Tax Rates for Representative Types of

 

         Investment Undertaken by Firms with NOL Carryforwards

 

                         of Varying Durations

 

 _____________________________________________________________________

 

 

                               Expected Duration of Carryforward

 

                        ______________________________________________

 

                          (1)    (2)    (3)   (4)    (5)    (6)    (7)

 

 Representative                   5     10    15     20     25     30

 

 Assets                    NOL   yrs    yrs   yrs    yrs    yrs    yrs

 

 _____________________________________________________________________

 

 General Industrial

 

   Equipment              27     39     39     37     34     31     28

 

 Industrial Structures    37     36     34     31     29     27     25

 

 Inventory                42     34     26     21     16     12     10

 

 ____________________________________________________________________

 

      Source: Author's calculations. The numbers are for investment

 

 financed one-third by debt and two-thirds by equity. Other

 

 assumptions include a 5 percent inflation rate, and 11 percent

 

 interest rate.

 

 

Depreciation for industrial structures, however, is less accelerated; NOLs reduce effective tax rates for this type of structure regardless of whether the NOLs are expected to last 5 years or 30. Table 2 also shows the effect NOLs of all durations have in reducing the effective tax rate on inventory.

NOL Carryforwards and Steel

NOL carryforwards can have a powerful impact, depending on the particular investment that is involved, and when the investing firm expects to emerge into taxable status. But in a recent study entitled "Tax Loss Carryforwards and Corporate Tax Incentives," Alan J. Auerbach and James M. Poterba found that carryforwards are unimportant in most industries. According to Auerbach and Poterba, firms with tax carryforwards in 1984 accounted for only 2.4 percent of the equity of all the firms surveyed, suggesting that only a small share of investment is conducted by firms with carryforwards. Also, the carryforwards themselves tended to be small, constituting only 1.1 percent of the equity of all the firms that were included in the study. 10

But carryforwards are more important for the steel industry by a dramatic margin. In 1984, steel firms had an estimated stock of $3.8 billion in carryforwards. Over half (53.7 percent) of the equity value of steel firms was accounted for by firms with carryforwards, suggesting that an important portion of steel industry investment is undertaken by firms with carryforwards. Further, the carryforwards in the industry tended to be relatively large, constituting a full 148.8 percent of the affected firms' equity value.

Table 3, below, reproduces selected carryforward figures developed by Auerbach and Poterba. Column 3 of the table shows that carryforwards were unimportant for most firms over the period 1981- 84. Column 3 indicates that corporations with carryforwards accounted for only a small percentage of the equity of all nonfinancial corporations; the largest percentage was only 3.2 percent, registered in 1983. Thus, it is safe to assume that the bulk of corporate investment was undertaken by firms without NOL carryforwards, and that carryforwards did not affect the tax burden on most investment. [sic]

But the table also shows how the situation in steel contrasts dramatically with the general situation. Column 4 indicates that in 1982, 1983, and 1984, firms with loss carryforwards accounted for over half the equity of all steel firms, implying that a large portion of investment in the steel industry is undertaken by firms with carryforwards. Accordingly, an assessment of the tax burden on steel that does not consider the impact of NOL carryforwards is necessarily incomplete.

What, then, is the tax burden of steel firms with NOL carryforwards? From table 2 and the discussion that preceded that table, we know that the impact of carryforwards depends both on the type of investment a firm undertakes and the expected time over which a firm expects its NOL stock to protect it from current taxation. It is, of course, nearly impossible to determine when a typical steel entrepreneur expects to become taxable again. Nonetheless, we can determine a range of effective tax rates for carryforwards of varying durations that are based on the mix of assets used by a typical steel firm.

                               TABLE 3.

 

 

             Estimated Tax Loss Carryforwards in Steel and

 

                      Other Industries, 1981-1984

 

                     (dollar figures in millions)

 

 ____________________________________________________________________

 

 

          Stock of Carry forwards                       Equity of Steel

 

          _______________________ Equity of all Firms   Firms with Car-

 

               All                Firms with Carry-     ryforwards as a

 

          Nonfinancial     Steel  forwards as a % of    % of Equity of

 

 Year     Corporations     Firms  Equity of all Firms   all Steel Firms

 

               (1)          (2)          (3)                 (4)

 

 ____________________________________________________________________

 

 1981      $ 5,070.1      $ 96.8         1.6%               16.8%

 

 1982       10,000.8     1,274.0         2.3                55.7

 

 1983       15,083.6     2,197.8         3.2                55.9

 

 1984       12,841.7     3,808.3         2.3                53.7

 

 ____________________________________________________________________

 

      Source: Estimates of the carryforwards themselves are from Alan

 

 J. Auerbach and James M. Poterba, Tax Loss Carryforwards. The

 

 percentages in the two righthand columns were calculated from data

 

 contained in Auerbach and Poterba.

 

 

Table 4, below, presents a set of such effective tax rates for firms in the steel industry; the table makes a number of points. First, comparison of columns 1 and 2 show that if a steel firm has an NOL carryforward of limited duration, it is taxed slightly more heavily than both other steel firms and corporations on the average. More specifically, the table shows that if a steel firm has a carryforward it expects to last less than 10 years, it will have an effective tax rate slightly higher than, that of other steel firms and other corporations on the average (the tax rates for steel firms without carryforward and for corporations on the average are shown in the lower part of the table.)

Second, comparison of columns 1 and 3 of the table show that if a firm has an NOL expected to last 10 years, it bears the same effective tax rate as firms without carryforwards. However, the remaining columns show that NOLs expected to last longer than 10 years reduce a firm's effective tax rate, with the reduction becoming more pronounced the longer the NOL is expected to last. While it is not show explicitly in the table, the effective tax rate of a firm with an NOL that is expected to last indefinitely approaches zero.

                               TABLE 4.

 

 

               Effective Tax Rates for Steel Firms with

 

         Net Operating Loss Carryforwards of Varying Durations

 

 ____________________________________________________________________

 

                                  Expected Duration of Carryforward

 

                                  _________________________________

 

                         (1)      (2)       (3)       (4)       (5)

 

                       0 Years  5 Years  10 Years  15 Years  20 Years

 

 ____________________________________________________________________

 

 

 Steel Firm with NOL     35%      37%       35%       33%       30%

 

   Carryforward

 

 

                                      Effective Tax Rate

 

                                 of Firms without Carryforwards

 

                                 ______________________________

 

 

                  Steel Firms                 35

 

 Average for all Corporations                 34

 

 ____________________________________________________________________

 

      Source: Congressional Research Service

 

 

We should note that the results in table 4 assume that one-third of steel investment is financed by debt rather than equity; this fraction is approximately the rate of debt finance by U.S. corporations in general. Because carry forwards have the effect of postponing deductions of interest on debt, a different fraction of debt would alter the results in the table. If the share of debt were larger, the increase in the effective tax rate for smaller carryforwards would be larger. Also, it would require a larger carryforward than one of ten years' duration for a firm's effective tax rate to fall below the rate of firms without carryforwards.

If a firm's fraction of debt finance were lower than the table assumes, the increase in the effective tax rate for small carryforwards would be smaller, and a smaller carryforward would be required to produce a reduced effective tax rate.

Chart 1, below, shows the data from table 4 in the form of a graph. The dark, horizontal line drawn at 35 percent is the effective tax rate faced by steel firms without NOL carryforwards. The line that first rises and then falls is the effective tax rate for firms with carryforwards. The second line shows the same pattern as table 4: when carryforwards are or short expected duration, the effective tax rate is above that faced by other firms. When carryforwards are at about 10 years of expected duration, the effective tax rate is the same for firms with and without carryforwards. Carryforwards expected to last longer than 10 years result in a lower effective rate than that faced by other firm; the rate declines longer the carryforward is expected to last.

CHART 1 EFFECTIVE TAX RATES OF STEEL FIRMS WITH NOL CARRYFORWARDS [omitted]

SUMMARY AND CONCLUSIONS

Whether or not a firm has accumulated a net operating loss carryforward can have an important impact on its tax burden. Given the current accumulation of NOLs by an important part of the steel industry, the story of the industry's tax treatment necessarily has two parts: an episode for companies without carryforwards, and a chapter for firms that have them.

Steel firms without NOL carryforwards are taxed much the same as other incorporated businesses. Their effective tax rate is lower than that of other manufacturing firms, and slightly higher than that of corporations in general. The difference, however, is negligible; steel firms without carryforwards are treated neither more nor less favorably than most other firms.

The outcome is different for steel companies that have accumulated carryforwards. If the carryforward is expected to last for a relatively long period of time (over 10 years, according to estimates here), carry-forwards reduce the effective tax rate on new investment, with the reduction becoming more pronounced as the expected duration of the carryforward increases. The situation is different if a firm has only a small carryforward of less than 10 years in expected duration. Ironically, while carryforwards protect these firms from current taxation, they result in a small increase in the tax burden on new investment. This result stems from the firms' inability to take advantage of accelerated depreciation while they have a carryforward.

The report's results for firms with carryforwards raises a number of questions whose answers are beyond its scope, but nonetheless bear mention. The first of these is factual: what is the relation between a firm's profitability and its carryforward status? The tax code defines profits and losses differently than do economists; it is thus clear that there is not a one-to-one correspondence between firms with carry-forwards and firms that are either losing money or whose profitability has been erratic.

If there is none the less a general correspondence between carryforwards and economic losses, then the report's results raises an additional question, this time of a policy nature: does the pattern of effective tax rates found here reflect the appropriate tax policy for firms with losses? The report shows, for example,that firms with large carryforwards have low effective tax rates. Is it appropriate for firms with the corresponding pattern of economic losses to be taxed more favorably than other companies? Should such favoritism be viewed as retarding necessary and inevitable economic adjustment, or should it be viewed as providing temporary support to vital sectors of the economy?

On the other hand, the report shows that steel firms with small carryforwards are taxed less favorably than other businesses. The question here is not only whether the relatively unfavorable effect of carryforwards are desirable, but whether their modest size of the effects makes them important enough to warrant action.

Similar questions exist even if there is little correspondence between firms with carryforwards and firms that are actually unprofitable. If such is indeed the case, the question is whether to revise carryforward rules so they apply more closely to actual losses. If it is indeed appropriate to do so, should they be applied so that they preserve the pattern of effective tax rates found here, or should the goal be to change the pattern?

 

FOOTNOTES

 

 

1 The analysis in this report applies to all investment (in steel as well as other operations) undertaken by firms classified as steel manufactures by the U.S. Department of Commerce.

2 Marginal effective tax rates assume that the after-tax return each investment earns is dictated by the market for investment funds. Each firm (and each investment a firm makes) must earn a certain return, after corporate taxes, in order to attract investment funds from either stockholders or creditors. Given this after-tax return, and based on the tax rules for different investments, there is a pre-tax return each investment must earn in order to generate the single, market-dictated after-tax return. Since the tax treatment of investments vary, so too will the pre-tax return required of each investment.

We should also note that the marginal effective tax rates in table 1 include both corporate income taxes and the individual income taxes that are paid by stockholders on corporate-source income. The purpose of including individual income taxes is to facilitate comparison between current law and the tax system as it was before the Tax Reform Act of 1986.

3 Roderick, David M., Chairman and Chief Executive Officer of the United States Steel Corporation. Testimony before the House Committee on Ways and Means. June 27, 1985.

4 Trautlein, Donald H., Chairman and Chief Executive Officer of the Bethlehem Steel Corporation. Testimony before the Senate Committee on Finance. June 13, 1985.

5 U.S. Congressional Budget Office. How Federal Policies Affect the Steel Industry. Washington, 1987. p. 19.

6 The analysis here of the effect of carryforwards on different investments is based partly on that of Alan J. Auerbach and James M. Poterba in their Tax Loss Carryforwards and Corporate Tax Incentives. NBER Working Paper No. 1863. Cambridge, Mass. National Bureau of Economic Research. 1986.

7 This ignores the possibility that a firm may still be liable for payment of the corporate Alternative Minimum Tax.

8 A method of inventory accounting known as LIFO (Last-in, First-Out) is also permitted by the Internal Revenue Service. Unlike FIFO, LIFO does adjust taxable income from inventories for inflation. However, due to certain constraints that accompany the use of LIFO, a substantial portion of firms continue to use FIFO.

9 Note that depreciation deductions are normally discounted at a higher discount rate than is gross revenue, because depreciation deductions are not indexed. Thus, a dollar of depreciation that is postponed costs a firm more than the gain from the postponement of a dollar of gross revenue. Accordingly, even if an investment generates a smaller flow of depreciation deductions than gross revenue during the firm's period of tax exemption, the postponement of deductions may still cost the firm more than the benefit from delayed recognition of gross income.

10 Auerbach, and Poterba. Tax Loss Carryforwards and Corporate Tax Incentives, p. 13.

DOCUMENT ATTRIBUTES
  • Authors
    Brumbaugh, David L.
  • Institutional Authors
    Congressional Research Service
  • Index Terms
    net operating loss
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 88-9590
  • Tax Analysts Electronic Citation
    88 TNT 251-7
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