Bonus Depreciation is a Bonus, but Full Expensing is Ideal

July 08, 2014

This week the House will take up a bill that will permanently extend what is called “bonus depreciation,” or 50 percent expensing. 50 percent expensing was one of the over 50 “extender” tax provisions that expired at the end of last year.

50 percent expensing allows businesses to immediately write off, or expense, 50 percent of an investment in new equipment or short-lived structures. It does not apply to commercial or residential buildings or factories.

We find that permanently extending this provision would boost GDP by over 1 percent, wages be 1 percent, and create 212,000 new jobs due to its effects on the cost of capital. It would also increase federal tax revenues by $23 billion after taking into account the increases wages and incomes caused by making bonus expensing permanent.

While these things are certainly good, calling the provision a bonus is a little misleading. It is a bonus compared to current law. Businesses can write off more of their investment sooner and the economy as a whole will see more investment and growth compared to current law; however, bonus depreciation more accurately represents only a partial move to a more neutral tax base. An ideal, neutral tax code (a tax code that treats saving and investment equally) would allow businesses 100 percent expensing on all capital investments rather than 50 percent expensing on some investments.

Under current law, when a business makes a capital investment (purchases a machine, building, or office equipment), it must write off, or deduct these costs from taxable income in stages over several years or decades.

For example, suppose a pizza shop purchases an oven for $100. Under the current cost recovery system, an oven is deducted in stages over 7 years according to a depreciation schedule. Each year’s deduction is a percent of the total initial cost (table, below). Over the expected life of the investment, each year’s deductions add up to the initial nominal cost of $100 when the oven was purchased.

However, in present-value terms, this isn’t the case. If we take into account the time-value of money and inflation, the pizza shop will actually not be able to deduct the initial cost of the investment over seven years. In fact, the pizza shop will only be able to deduct $83.63 in present-value terms over the life of the investment. For the business this means their taxable income over the seven years is inflated related to what is should have been. For the economy as a whole, this means an increase in the cost of capital, reduced investment, and slower economic growth.

Depreciation Schedule of a 7-year Asset (MACRS)

Year

Write-off

Present Value Write-off

0

 $  14.29

 $ 14.29

1

 $  24.49

 $ 22.78

2

 $ 17.49

 $ 15.13

3

 $ 12.49

 $ 10.05

4

 $ 8.93

 $ 6.69

5

 $ 8.92

 $ 6.21

6

 $ 8.93

 $ 5.79

7

 $ 4.46

 $ 2.69

Total:

 $ 100.00

 $ 83.63

Note: 5 percent real discount rate and 2.5 percent inflation

50 percent expensing is an improvement over current law. This provision allows a business to immediately deduct 50 percent of the initial cost before using the above depreciation schedule. For the pizza shop, this means a $57 deduction for the oven on the first year. This also means that because a larger deduction was taken in the first year, the pizza shop will be able to recovery more of the initial cost of the investment over the 7 years ($91.82 with bonus depreciation vs. $83.63 without bonus depreciation) after we take into account the time value of money and inflation. This represents a reduction in the cost of capital in contrast with current law. This is why our analysis finds a boost to GDP, wages, and employment.

Depreciation Schedule of a 7-year Asset (MACRS) with 50% Expensing

Year

Write-off

Present Value Write-off

0

 $ 57.15

 $ 57.15

1

 $ 12.25

 $ 11.39

2

 $ 8.75

 $ 7.57

3

 $ 6.25

 $ 5.03

4

 $ 4.47

 $ 3.34

5

 $ 4.46

 $ 3.11

6

 $ 4.47

 $ 2.89

7

 $ 2.23

 $ 1.34

Total:

 $ 100.00

 $ 91.82

Note: 5 percent real discount rate and 2.5 percent inflation

However, $91.82 in present-value terms is still not $100. So even with 50 percent expensing, we are not at the ideal in which a business can recover the full cost of an investment.

An Ideal tax code would allow the full $100 cost of the oven to be deducted in the year in which it was purchased. Allowing businesses to expense, or deduct the full cost of an investment immediately, would lower the cost of capital and increase investment even more.

We found that full expensing will increase GDP by 5.21 percent, wages by 4.42 percent, and federal revenue by $96 billion. A benefit to GDP five times greater than a permanent bonus expensing provision.

So yes, bonus depreciation is a bonus compared to current law and a step in the right direction towards a neutral, pro-growth tax system, but full expensing is still the ideal.

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