Ask Hans

In an effort to help stabilize the economy, the federal government has extended tax incentives that encourage energy efficiency. These incentives have a dual purpose: to protect the environment through more efficient use of energy, and to increase capital investment to counter the economic recession. My comments will focus on the latter.

In the interest of the HVAC industry, two particular tax incentives deserve attention. The first tax incentive targets energy-efficient equipment installed in commercial buildings. To receive the deduction, energy savings must be accomplished through energy and power cost reductions for the building’s heating, cooling, ventilation, hot water, and interior lighting systems. The amount deductible is up to $1.80/sq ft of building floor area for buildings achieving a 50% energy savings target.

The economic effectiveness of any business tax incentive is measured by the additional capital investment that takes place because of the credit. In economic parlance, the incentive is effective if, and only if, a measurable amount of capital investment occurs that would not take place but for the incentive. In the absence of data to analyze, a priori statement of the incentive’s effectiveness can be made based on economic theory and knowledge of the tax code.

Assume for instance that a firm is trying to decide whether to make a capital investment in expanding manufacturing capacity. Let’s also assume that as part of the plant expansion, the firm wishes to revamp the existing HVAC system. If efficiency targets are hit, the firm may receive a tax deduction. In deciding whether to invest, the firm considers direct costs such as taxes and depreciation as well as the opportunity cost of forgoing an alternative investment.nstance, the incentive aimed at commercial energy efficiency is a deduction rather than a credit. Deductions have a lesser impact in reducing taxable income because the subtraction is made before the tax rate is applied in the calculation. The firm will only receive an actual reduction in the tax bill, and thus a reduction in its user cost of capital of 65 cents/sq ft of building floor area, not the $1.80 deduction.

Beyond the microeconomic theory, current macroeconomic conditions and the pre-existing corporate income tax structure must be considered. According to the Bureau of Economic Analysis, corporate profits before taxes declined 17.6% in 2008.4Even though profits show signs of recovery in 2009, many firms have accumulated significant net operating losses (NOLs) that can be carried forward to reduce future tax liabilities. Firms hardest hit by the economic downturn, such as those in the construction industry, are the ones most likely to accumulate NOLs. If a firm’s future tax liability is reduced to zero or a de minimis level under the existing code, additional tax incentives fail to achieve meaningful reductions in the user cost of capital and thus stimulate very little additional investment.

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