Require Half of Advertising Expenses to Be Amortized Over 5 or 10 Years

Background

Business expenses can generally be categorized as either investments, which create assets whose value persists over a multiyear period, or current expenses, which go toward goods or services and do not generate any assets because the value of those goods or services dissipates during the first year after they are purchased. For example, the cost of a new piece of equipment is an investment, but routine maintenance of that equipment is a current expense. Investments and current expenses are often treated differently for tax purposes. For example, current expenses can be deducted from income in the year they are incurred, but some investment costs, such as the cost of constructing buildings, must be deducted over a multiyear period. The deductibility of many other investments is scheduled to change over the next decade under current law. For example, research and development costs incurred before 2022 are immediately deductible, but such costs incurred in 2022 and beyond must be amortized (that is, deducted in equal amounts) over five years. In addition, equipment costs are immediately deductible through 2022, but increasing shares of such costs will revert to multiyear recovery periods from 2022 through 2027, when immediate deductions will be limited to companies investing amounts below a specific threshold.

Advertising is treated by the tax system as a current expense and can therefore be immediately deducted. However, the intent of advertising varies. Some types of advertising are designed to move inventory over the short term (for example, by publicizing a sale that will last one week) and, like other current expenses, do not create longer-term value. Advertising can also create and enhance brand image—an intangible asset that retains value over a multiyear period. That type of advertising expense is more similar to an investment.

To the extent that advertising creates an intangible asset, the ability to deduct the cost immediately makes the effective tax rate on income from the investment lower than that for assets with multiyear cost-recovery periods. (Effective tax rates measure the impact of statutory tax rates and other features of the tax code in the form of a single rate that applies over the life of an investment.) The Congressional Budget Office has estimated that the effective tax rate on income from equity-financed purchases of brand-building advertising by businesses subject to the corporate income tax will be 8 percent for the foreseeable future. Once the temporary provisions of the 2017 tax act have expired, that rate will be lower than the effective tax rate on any other type of investment.

According to the Internal Revenue Service, in 2013, corporations deducted $285 billion in advertising expenses, or a little more than 1 percent of their business receipts. Since 2001, advertising expenses have been growing slightly slower than gross domestic product (GDP).

Option

This option consists of two alternatives. Both would recognize half of advertising expenses as current expenses, which can be immediately deducted. The other half would be treated as an investment in brand image and would be amortized over a period of years. Under the first alternative, that period of amortization would be 5 years; under the second alternative, it would be 10 years.

Effects on the Budget

The first alternative would increase revenues by $63 billion from 2019 through 2028, the staff of the Joint Committee on Taxation estimates. The second alternative would increase revenues by $132 billion over the same period.

The pattern of the revenue effects is quite different for the two alternatives. Under the first alternative, the vast majority of the revenue increase would occur in the first five years. In the first year, businesses would claim 60 percent of the advertising expenses they incurred that year (the 50 percent not subject to amortization plus an additional 10 percent representing one-fifth of the 50 percent subject to amortization). By the sixth year, the businesses would still claim 60 percent of the current-year expenses but, in addition, would claim 10 percent of expenses incurred in each of the prior four years. If advertising expenses did not grow each year, the amount claimed in the sixth year would equal the amount they can deduct under current law; as a result, there would be no revenue effect after the fifth year. However, because advertising expenses do grow each year, the projected revenue effects from 2024 on reflect that growth.

Under the second alternative, the initial amount of deductible expenses would be 55 percent of the current-year expense. For each of the next nine years, the deductible expense would ratchet up to account for 5 percent of expenses incurred in each of the prior years. The equilibrium reached in the sixth year under the first alternative would not be reached until the 11th year (2029) under the second alternative. After that, any positive effect on revenues would be due to the growth in advertising expenses.

The estimates for this option are uncertain for two key reasons. First, the estimates rely on CBO's projections of GDP and taxable corporate profits over the next decade under current law, which are uncertain. Second, accounting for how taxpayers might adjust their advertising expenses in response to the option introduces additional uncertainty.

Other Effects

An argument in favor of this option is that it would, once the temporary cost-recovery provisions of the 2017 tax act have expired, result in a more uniform treatment of different types of investments. A portion of advertising expenses serve to develop brand image and therefore more closely resemble investments than current expenses. What that portion is, however, has proved difficult to identify—the option's 50 percent rule mirrors other proposals that have been made. (Descriptions of those proposals can be found in Joint Committee on Taxation 2014; Senate Committee on Finance 2013.) By amortizing half of advertising expenses, the option would treat investments in brand image similarly to investments in other types of assets whose costs must be deducted over time. Treating investments similarly improves economic efficiency because it encourages businesses to choose investments on the basis of how they will improve productivity instead of how they will reduce a business's tax liability.

An argument against the option is that treating exactly 50 percent of advertising expenses as an investment ignores differences in how businesses utilize advertising. Retailers that primarily use advertising to inform consumers of sales would be required to amortize expenses that are not true investments. That would effectively raise the cost of short-term advertising, thereby hindering their ability to reduce their inventory. By contrast, manufacturers who mainly use advertising to build brand image would still be able to immediately deduct some of those investments. Furthermore, most research finds that the value of brand image typically declines more rapidly than implied by either the 5- or the 10-year amortization schedules. Particularly in the case of 10-year amortization, that could make the effective tax rate for brand-building advertising higher than the rate for other types of assets, which would undercut the uniformity argument. The option would also add to businesses' reporting burdens: In their financial statements, publicly traded corporations typically report the costs of advertising as a current expense, in accordance with generally accepted accounting principles.

Another effect of the option would be to reduce the amount businesses spend on advertising. That would hinder economic efficiency to the extent that advertising by businesses provides useful information to consumers. However, to the extent that the content of such advertising is misleading, reducing its volume could improve economic efficiency. Furthermore, if businesses spent less on advertising, the price of advertising would decline, and nonbusiness entities would probably spend more on it. Such advertising would have both positive and negative effects on economic efficiency, depending on the usefulness and accuracy of its content.