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Depreciation, Expensing and Taxes

By: Andrew Lundeen

Bruce Bartlett wrote an article with a nice breakdown of the history of 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. in the United States. An interesting point he makes is that depreciation was initially an accounting gimmick:

If the railroads treated capital expenditures the same way that operating expenses were treated, they would have huge losses for many years that would discourage investors. So the idea of depreciation was born – writing off capital investments over time.

Maybe that helped businesses sell projects to investors, but the addition of the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. in 1909 made depreciation rules important for 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. es, too.

In the article, Bartlett lays out two common economic arguments why depreciation rules can be bad for tax purposes.

The first argument is that under current depreciation rules, 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. erodes the value of the tax right off. These types of depreciation rules understate the cost of the equipment to business, overstate the profit, and lead to higher taxes for the business.

The second argument is that as technology changes more rapidly, high-tech equipment becomes irrelevant sooner than it physically wears out.

Expensing solves both these issues and offers other benefits of its own – namely, increased investment and economic growth.

Expensing is effective in increasing investment, because it lowers the cost of capital. As the Tax Foundation’s Steve Entin wrote in a recent report:

The rules for how quickly a company can write off investments in plants, equipment, and buildings directly impact the cost of doing business. The higher those costs are, the slower the economy will grow. The lower the cost, the bigger the economy will be, and with it the number of jobs and the level of wages.

But it’s important for long-term economic growth that expensing not just be used as a short-term solution to stimulate investment, as it has been used in the past.

As Bartlett points out, for depreciation policy, policymakers need to “establish a stable system and cease using it as a short-run stimulus measure.”

To maximize economic growth and let businesses make investments based on their timeframe instead of due to taxes, that policy should move towards expensing.

For tax purposes, it would be nice if we still saw depreciation rules as merely a gimmick and allowed businesses to expense the full cost of capital investments instead.