A really bad idea: Attacking the tax deduction on ads

Representative Dave Camp

FORTUNE — On April 2, Rep. Dave Camp (R-Mich.), chairman of the House Ways and Means Committee, released his eagerly awaited vision of tax reform, a draft bill 979 pages in length that’s taken three years to prepare. Camp’s stated goal is to make today’s fiendishly complex tax code simpler and fairer. But one of his major reforms, a radical change in treatment of advertising spending, contradicts his objective by imposing an extra layer of accounting clutter, shrinking legitimate deductions by delaying them, and punishing a whole class of companies that rely on TV spots, billboards, and magazine spreads to sell their shoes, cosmetics, and soft drinks, not to mention the players that sell those ads.

Camp’s objective of broadening the tax base as a platform for lowering the top corporate rate seems laudable. But the proposal on advertising presents a stern warning: His approach is likely to cancel the benefits of lower rates by imposing even more costly accounting entanglements on corporate America. “This proposal is totally idiotic and misguided,” says Chris Edwards, an economist with the conservative Cato Institute. “Tax reform is supposed to be about simplicity. His idea of broadening brings on more complexity, not less.”

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Today, companies can deduct every dollar they spend on advertising. Those dollars are considered “ordinary and recurring expenses for carrying on a trade or business” under the tax regulations, just like salaries or components. On pages 363 to 365, “The Tax Reform Act of 2014” proposes reducing the deduction to just 50% of what’s spent on advertising in the current year. The other half would be capitalized, then amortized over the following 10 years, at a flat rate of one-tenth per annum. The new regulations would phase in over the next four years and apply to “any communication to the general public intended to promote the taxpayer’s business.” That means absolutely all advertising — TV, digital, print, you name it.

The new measure would include the pay for employees who work on ad campaigns. It would also eliminate a special exemption that allows consumer goods companies to expense the costs of designing their packaging immediately. Those costs are a big item for purveyors of cosmetics, sweets, and snacks. Under the new rules, the design bill would be added to the cost of each candy bar or flask of perfume when it’s sold, regardless of when the design budget was actually spent. It’s still another complication: The rule would require companies to allocate design costs to every item they sell, and since it’s impossible to know in advance how many will be sold, more time and expense will go to bookkeeping rather than making things.

The bill is unlikely to pass this year. House Speaker John Boehner states that he has no intention of bringing a tax reform bill to a vote in this Congress, and both Senate Minority Leader Mitch McConnell and Majority Leader Harry Reid display a similar lack of enthusiasm in the Senate. Still, the lobby for advertisers is rightly worried. The alleged advertising loophole threatens to remain a pillar of tax reform in future bills.

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The reason is simple: Targeting advertisers would raise lots of cash. Camp claims the provision would generate revenues of $169 billion from 2014 to 2023. Those extra taxes are necessary to achieving Camp’s target of lowering the top corporate rate from 35% to 25%. In other words, companies that advertise a lot would face higher taxes, other corporate categories would benefit from lower levies, and the total tax take would stay about the same — even at the lower rate, courtesy of the cancelled deductions for the advertisers, and other losers in the new regime.

In theory, the proposal does follow a certain economic logic. The idea is that spending generating revenues over a long period should be expensed as those revenues flow in. That bookkeeping practice applies to capital expenditures for plants or buildings that generate sales in future years; the cash goes out right away, the “expense” comes in the form of depreciation for years into the future.

“The idea is not completely crazy,” says Baruch Lev, an accounting professor at NYU’s Stern School. “It’s been shown that the benefits of advertising stretch over two to three years.” But Lev insists that assuming they last a decade has no economic rationale. “I’d recommend perhaps writing off half in the first year, and half in year two, so all the ad spend from year one is expensed by the end of year two,” he says. “Ten years is extreme.”

It’s highly questionable whether the same logic that applies to building factories should govern ad spending. “Companies do hundreds of things that have a lasting effect, from staff retreats, to team building, to training — the benefits of those all last a number of years, yet they aren’t amortized,” says Edwards. It’s extremely difficult for a company to quantify how much of its ad budget is spent on building the brand, and how much on selling cars or skin creams right now. Most spending contributes to some combination of both.

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The Camp bill simply attributes an arbitrary 50% of the total spend to brand-building and securing customer loyalty. Besides the basic issue of whether advertising should be treated as a capital expenditure, the proposal has two main drawbacks. First, it makes the corporate code more complex, and less fair. Second, it penalizes big advertisers to make the numbers work, and would substantially lower their market value.

To understand why, let’s take the following, imaginary example of a consumer goods company with a big ad budget. Say the Boppity Boots Corp. has revenues of $10 billion and expenses of $9 billion, of which $3 billion is advertising. That one-third share of total ad spend to expenses isn’t unusual for mass or luxury goods marketers. Today, it’s garnering $1 billion in pre-tax income and paying $350 million a year in taxes.

Now let’s imagine that the Camp bill becomes law. Boppity Boots is limited to expensing $1.5 billion of its ad spend. Hence, its pre-tax income for tax purposes swells by $1.5 billion to $2.5 billion. Keep in mind that its tax rate would drop from 35% to 25%, supposedly a big benefit of the Camp measure. So its new tax bill is 25% of $2.5 billion, or $625 million, a $275 million, or 79% increase. Let’s say its current cash flow is equal to its net income. Its cash flow will drop from $650 million to $380 million. As a result, its market cap could shrink by billions of dollars.

That’s an example of how Camp intends to pay for lower rates.

The unfairness issue arises from the delay in booking deductions. It’s true that Boppity would recoup part of its lost deductions in future years. But far from the full amount, or the benefit it’s getting now. A dollar in tax deductions today is worth a lot more than the same dollar in deductions in five or 10 years. Yet the law doesn’t index the amounts to amortize over the following decade to an interest rate or cost of capital that would make the taxpayer whole. Hence, the value of the deductions is gigantically reduced by spreading them over 10 years.

It’s interesting that the Camp bill at least proved consistent in targeting, and given the ground rules, a more appropriate corporate expense: research and development. His bill would replace immediate expensing of R&D with a requirement to amortize those costs over five years. “R&D has far longer-lasting benefits than advertising. In the pharmaceutical industry, it can extend 10 years,” says Lev. “But people are often dismissive about advertising, calling it a waste. Camp knows that it’s easier to attack advertising than R&D.” Hence, it is remarkable that Camp is also confronting this formerly untouchable issue.

Adds another accounting expert, Jack Ciesielski, author of the prominent newsletter to money managers The Analyst’s Accounting Observer, “The big spenders on R&D have a much more powerful lobby. Targeting R&D would get the whole West Coast against you.” The bill is bound to face far tougher opposition from tech companies than from the advertising lobby.

Ciesielski also notes that the big ad spenders probably won’t react by running fewer spots, or changing the networks and publications where they advertise. They’ll want cheaper ads. “It’s speculation, but I bet the big advertisers would put lots of price pressure on the media companies and publishers that depend on adverting.”

In the current system, companies spend the cash on advertising and deduct the same cash amount from their taxable income that year. It is simple. It works. Imposing accruals, making companies that spend the cash now but build bigger balance sheet entries that amortize over a decade, is complex. For taxes, it’s far better to expense this year what you paid in cash this year. Camp is going in the opposite direction. For taxes, simple should always win.

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