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Improved Cost Recovery Is A Wide-Ranging Policy Solution

By: Erica York

Investment comes in a variety of forms—be it private or public investments ranging from rural broadband and 5G to health care infrastructure and innovation. But not all investment is equal in terms of its effects on productivity and economic growth. While the common perception tends to be that public infrastructure is more productive than private infrastructure, research from the Congressional Budget Office suggests that returns to federal investment are only half the returns to private investment. This suggests that lawmakers could receive more bang for their buck by pursuing 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. policy improvements that drive additional private investment.

Amid the discussions for Phase 4 of economic relief legislation, many lawmakers are proposing industry-specific tax policy changes to induce an increase in investment, sometimes on a temporary basis. For example, providing shorter asset lives and bonus depreciation or immediate expensing to medical supply and pharmaceutical companies that move from foreign countries. Other proposals would expand the Research and Development tax credit for new small- and medium-sized businesses and additional activities.

These proposals center on a key idea: tax policy under current law can hinder private investment and thus create a drag on innovation, productivity, employment, and economic growth. Specifically this drag occurs because of the way the tax code treats (or is soon scheduled to treat) cost recovery of capital investments:

  1. 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. for investment in machinery and equipment will phase down after 2022
  2. The 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.  treatment of R&D is scheduled to worsen after 2022
  3. The current treatment of capital investment in buildings and structures prevents full cost recovery in real terms

The policy proposals mentioned above would chip away at the tax code’s bias against investment in certain sectors by improving the incentives for capital investment related to medical supplies and pharmaceuticals—a key component of the public health response to the pandemic. However, stopping at these key sectors would retain the bias against capital investment in other sectors at a time when increased investment is necessary for an economic recovery.

Public health investment is crucial for the pandemic response, and so too is investment across other technologies and industries as economic activity is reallocated to adapt to the new normal.

Rather than limit improvements to certain sectors, lawmakers could pursue a broader policy 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. for all capital investment and neutral cost recovery for structures and clear the tax policy hurdles that currently stand in the way of private investment. Further, improving cost recovery treatment across all sectors and all investments would be easier to administer and more neutral than trying to apply the policy in a piecemeal fashion across selected industries or types of investment.

The Tax Foundation General Equilibrium Model estimates that enacting a policy of neutral cost recovery for buildings and structures and full expensing for all other capital investments, including machinery, equipment, and R&D expenses, and would increase the long-run level of gross domestic product (GDP) by 5.1 percent. The capital stock would expand by 13 percent, wages increase by 4.3 percent, and employment grow by more than 1 million full-time equivalent jobs.

Long-Run Economic Effect of Full Expensing

Gross Domestic Product

5.1%

Capital Stock

13.0%

Wage Rate

4.3%

Full-Time Equivalent Jobs

1.02 million

Source: Tax Foundation General Equilibrium Model, November 2019

Strong private sector investment can help build strong infrastructure and increase employment, the capital stock, and economic output. Full expensing and neutral cost recovery are wide-ranging policy solutions that will help clear the tax policy hurdles standing in the way of investment and economic recovery.

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