Additional evidence on the economic benefits of full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. of investment was recently published in the American Economic Journal: Economic Policy. Two new studies exploit changes in the UK and Chinese taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. codes and observe that movement towards a system of full, immediate expensing grows the economy and fosters a more productive business environment.
At present, businesses in the United States are able to deduct the cost of most assets in full from taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. in the year they were purchased. This was not the case before the Tax Cuts and Jobs Act (TCJA)The Tax Cuts and Jobs Act in 2017 overhauled the federal tax code by reforming individual and business taxes. It was pro-growth reform, significantly lowering marginal tax rates and cost of capital. We estimated it reduced federal revenue by .47 trillion over 10 years before accounting for economic growth. , and, according to present law, will not be the case after TCJA changes expire in 2026. Previously, businesses would depreciate an asset over a set window of time (dependent on asset type), meaning they would deduct a predetermined percentage of the cost of an asset from taxable income annually.
The tax treatment of capital can directly impact the profitability of investments by changing the overall cost of capital. The cost of capital is, in essence, the revenue an investment will need to raise in order for a business to break even on an investment. Nontax components of the cost of capital include the cost of borrowing, or the interest rate.
The first study, conducted by economists Giorgia Maffini, Jing Xing, and Michael P. Devereux, observes the effect of shortened depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. schedules in the UK. As a result of these accelerated depreciation schedules, “the investment rate of qualifying companies increased 2.1-2.5 percentage points relative to those that did not qualify.” This shift is significant, especially given that the change merely allowed companies to depreciate assets by a greater amount in the year purchased, but did not allow for full, immediate expensing.
A change to full expensing would likely result in a larger increase, as characterized by a second new study. Economists Yongzheng Liu and Jie Mao prove this by examining the effects of a shift from a nationwide production-based VAT to a consumption-based VAT in China from 2004-2008. One of the major impacts of this shift is that purchases for most capital are now deductible from a company’s tax liability in the year purchased. They found that “the reform raised investment and productivity of the treated firms relative to the control firms by 38.4 percent and 8.9 percent, respectively.” This effect was higher on average for smaller firms with more constrained access to funding for new projects, meaning that they face somewhat higher interest rates and therefore a higher cost of capital.
Notably, increases in productivity are a key driver for overall wage growth. This means that the benefits of full expensing are not only felt by business owners and shareholders, but also by the workers who use new capital to produce more of a product or service in the same amount of time.
Reducing the tax impact on the cost of capital can increase long-term economic growth, specifically by increasing productivity. According to previous Tax Foundation analysis of the recent U.S. tax reform, “permanent 100 percent bonus depreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings, in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs. produces about 4.5 times more GDP growth per dollar of revenue than making individual TCJA provisions permanent.”
There are two primary drivers as to why depreciation increases the cost of capital: the time value of money and inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. . The time value of money is an economic term for the preference to consume now, rather than consume later—most people (if not all) prefer $100 today over $100 a year from today. The same goes for businesses, as fully deducting the cost of capital now is better for cash flow (as they receive the benefit of the deduction in that year) compared to depreciating the asset over time.
Additionally, expensing an asset in the year it was purchased rather than over time prevents inflation from affecting the real value of deductions. As the impact of inflation on the cost of capital is not included in depreciation schedules, businesses are not able to deduct the full amount of an investment in real terms. The table below demonstrates how different rates of inflation affect the real value of deductions for businesses over time.
Assumes half-year convention, 3 percent real discount rate, plus inflation. Source: Erica York, “Cost Recovery Treatment Short of Full Expensing Creates A Drag on Economic Growth,” Tax Foundation, Sept. 17, 2018.
|5-year asset||15-year asset||20-year asset|
|MACRS at 0% inflation||$92.97||$78.64||$75.50|
|MACRS at 2% inflation||$88.75||$69.32||$63.87|
|MACRS at 3% inflation||$86.77||$66.69||$59.07|
Another way to achieve a similar policy result would be to adopt neutral cost recovery. Rather than allowing full and immediate expensing, neutral cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages. allows businesses to depreciate their asset over time while adjusting for the time value of money. Instead of seeing their deduction erode over time, neutral cost recovery would allow businesses to deduct the full value of their investments in terms of present value.
As with most policy provisions, the positive effects of full expensing of investment will only last if they are permanent and apply to as broad a base as possible. This means that, on top of making the full expensing provisions in the TCJA permanent, they should be expanded to all large capital investments, including structures. Without permanency and universality, the U.S. leaves significant potential for growth on the table.
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