How Taxes Affect the Incentive to Invest in New Intangible Assets
CBO found that the tax burden on intangible assets is lower than that on tangible assets. In CBO’s estimation, the 2017 tax act increases the tax burden on research and development but reduces it on most other intangible assets.
A business’s worth includes not only its tangible assets, such as equipment, structures, land, and inventory, but also its intangible assets. In contrast to tangible assets, intangible assets have value because of attributes that have no physical substance. For example, the value of a typical book resides in its content, not in the paper it is printed on—unlike the value of a car, which is based on physical attributes. That lack of physical substance makes the value of intangible assets more difficult to determine. The value of a book cannot be firmly established immediately after the book is written; it can be determined only through the book’s sales. By contrast, the existence of a well-developed market for cars makes it easy to place a value on any automobile without selling it.
Investing in intangible assets is also different from investing in tangible assets—in part because the time it takes to develop intangible assets is typically longer, and in part because the investments are generally riskier.
The importance of intangible assets relative to tangible assets has grown over time. For example, the Bureau of Economic Analysis (BEA) finds that intellectual property products—which represent over two-thirds of the intangible assets covered in this report—rose as a share of business assets (excluding land and inventory) from 5 percent in 1982 to 10 percent in 2016.
In Taxing Capital Income: Effective Marginal Tax Rates Under 2014 Law and Selected Policy Options (hereafter referred to as Taxing Capital Income), CBO analyzed the tax burden on income from investments in tangible assets. In this report, CBO extends its analysis to debt- and equity-financed investments in intangible assets by corporations and other business entities and implements a new method that incorporates the effects of multiyear development periods and the risk of failure. The report contains estimates of the tax burden on income from investment by established profitable companies in five types of intangible assets:
- Purchased software;
- Assets resulting from research and development (R&D);
- Entertainment, literary, and artistic (ELA) originals;
- Assets derived from mineral exploration and development (ME&D); and
- Brand identity arising from advertising.
The new method is illustrated using the permanent features of the tax law in place during 2017 (hereafter referred to as pre-2018 law). That method is also applied to an analysis of selected features of Public Law 115-97 (originally called the Tax Cuts and Jobs Act and called the 2017 tax act in this report) for equity-financed investments of businesses subject to the corporate income tax.
CBO finds that under pre-2018 law, the tax system favored investments in many types of intangible assets over those in tangible assets. For example, the cost of investing in most intangible assets was expensed—that is, deducted in the year the cost was incurred. The cost of investing in tangible assets, by contrast, was deducted over a multiyear period. As a result, the before-tax rate of return needed to induce an investment in tangible assets was higher than that required for intangible assets. Furthermore, investment in certain intangible assets benefited from the research and experimentation (R&E) tax credit. Those tax benefits offset, to some extent, the discouraging effects of lengthy development times and risk of failure.
The 2017 tax act increases incentives to invest in most types of assets, but not all. Specifically, the act changes the methods of deducting investment costs in ways that will reduce the incentive to invest in R&D.
How Does CBO Measure the Tax Burden on Investments in Intangible Assets?
CBO estimates the tax burden—including both corporate and individual income taxes—on capital income over the lifetime of a marginal investment. A marginal investment is expected to generate a rate of return that, after taxes, is just high enough to attract investors. For this analysis, that threshold is the rate investors could receive from a comparable index fund (that is, one in which the ratio of corporate bonds to equities is the same as the ratio of debt to equity financing that is anticipated for the marginal investment). To achieve that after-tax rate of return, an investment must clear a hurdle rate—a before-tax rate of return that compensates the investor for the taxes due on the resulting income.
CBO uses three measures to estimate the magnitude of the tax burden. The first measure, the difference between the before-tax rate of return and the after-tax rate of return, is referred to as the standard tax wedge. A second measure of the tax burden, the effective marginal tax rate (hereafter referred to as the effective tax rate, or ETR), is derived by dividing the standard tax wedge by the before-tax rate of return. Those two measures are useful for analyzing most investments with short development periods and negligible failure risks. Because those conditions do not apply to most intangible assets, however, CBO introduces a third measure in this report—the success-state tax wedge, which accounts for the above-market rates of return that investors require from successful investments in order to compensate for long development periods and the risk of failure.
What Was the Tax Burden on Different Types of Investments Under Pre-2018 Law?
With regard to the ETR under pre-2018 law—the measure of the tax burden reported in Taxing Capital Income—CBO estimates:
- The ETR on capital income from investment in the five examined types of intangible assets was, on average, 3 percent (see table below). That ETR was 25 percentage points lower than the average ETR on the income from investments in tangible assets.
- Of the five examined types of intangible assets, purchased software—which generally cannot be expensed—had the highest ETR, at 37 percent. R&D had the lowest, at −31 percent (meaning that it was actually subsidized, not taxed).
CBO also finds that the success-state tax wedge increases relative to the standard tax wedge as development periods grow lengthier and the risk of failure rises—a phenomenon that the ETR fails to capture. That pattern is illustrated by CBO’s estimates for investments in three types of intangible assets for which sufficient data were available:
- The success-state tax wedge for the development of oil wells by integrated oil and gas companies (that is, those that also own refineries or retail outlets) was 0.9 percentage points, compared with a standard tax wedge of 0.7 percentage points. That estimate reflects an average development period of 6 years and a failure rate of 10 percent.
- The success-state tax wedge for R&D for a new drug was 0.4 percentage points, compared with a standard tax wedge of −0.9 percentage points. That estimate reflects an average development period of 12 years and a failure rate of 90 percent.
- The success-state tax wedge for motion picture development and production was 4.7 percentage points, compared with a standard tax wedge of 3.1 percentage points. That estimate reflects an average development time of 3 years and a hypothetical failure rate of 50 percent.
How Does the 2017 Tax Act Affect the Tax Burden on Investments in Intangible Assets?
The 2017 tax act contained a number of provisions that affect investment. The maximum corporate tax rate has been lowered permanently, and most individual income tax rates have been lowered through the end of 2025. Those changes increase incentives to invest in both tangible and intangible assets. Other provisions in the act— particularly those affecting methods of recovering the costs of investments—also affect investment incentives, but the effects of those changes are not uniform among different types of assets or sources of financing. Through 2026, for example, the act allows more of the cost of investing in certain types of tangible and intangible assets (specifically, equipment, prepackaged software, and movies and television programs) to be expensed. Beginning in 2022, however, companies can no longer expense the costs of investments in R&D but must deduct those costs over five years. Other changes affect businesses not subject to the corporate income tax and the use of debt (but not equity) to finance investments.
Considering only the equity-financed investments of businesses subject to the corporate income tax, CBO estimates that the change in the treatment of R&D will increase the overall ETR on capital income from investments in the five examined types of intangible assets. Specifically, CBO arrived at the following conclusions with respect to the permanent features of the 2017 tax act:
- The ETR on capital income from investments in tangible assets will fall from 35 percent to 24 percent, whereas the ETR associated with intangible assets will rise from 11 percent to 15 percent.
- Only investments in R&D, among all five types of intangible assets, will experience an increase in the ETR, from −14 percent to 11 percent. The largest drop will be for investments in purchased software, from 41 percent to 28 percent.
Those results cannot be generalized to investments financed by debt or undertaken by businesses not subject to the corporate income tax.