Democratic presidential candidates Senators Warren (D-MA) and Sanders (I-VT) have proposals to end 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. and lengthen 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 and the New York Times in a recent article analyzes the size of 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. cuts, including the effect of full expensing, and the size of investments made by companies.
While it is encouraging to see such an important part of tax policy (depreciation of capital investments) receiving attention, it is unfortunate that most aren’t getting it quite right. As we scrutinize tax policy, whether it be changes made in the past or plans for future changes, it is crucial to have a proper understanding of how and why the changes are expected to affect economic output, productivity, and wages. Without this understanding, it is all too easy to reach the wrong conclusion about how provisions work and how to improve the tax code.
When it comes to full expensing, this is the policy question that must be answered: For tax purposes, should capital investments be counted as costs immediately when they are bought, or should the costs be stretched over many years? We argue that costs should be immediately deductible when assets are bought (the policy know as full expensing), because this policy recognizes opportunity cost and the time value of money. This makes the tax code neutral toward investment, rather than discouraging it.
Importantly, we expect investment will increase under full expensing, holding all else equal, because it lowers the cost of capital and removes the tax bias that discourages investment.
Companies do not make new investments or increase workers’ wages simply because they have more cash available to spend or have received a “big tax cut.” Instead, full expensing boosts long-run productivity, economic output, and incomes by lowering the cost of capital. Investments that were not profitable to undertake under depreciation become profitable under full expensing, due to this reduction.
Before deciding to make an investment, a business will complete a cost-benefit analysis. What will this investment cost—including taxes—and how much revenue will it generate? By delaying deductions for capital investments, as opposed to allowing an immediate and full deduction, the tax code disallows recovery for part of the cost of production. In other words, the present-value of the write-offs allowed under depreciation is smaller than the original cost of the investment due to 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. and the time value of money.
For example, when a business spends $100 to purchase a new piece of equipment, that $100 is immediately gone. The business cannot use it to purchase a different piece of equipment or to pay bills. So from a simple cash-flow perspective, it makes sense to allow an immediate deduction, as the tax code does for labor costs. But, if the company is not allowed to deduct the full $100 cost that same year, it instead takes deductions over a number of years going forward; this is problematic because, due to inflation and the time value of money, a dollar in the future is not worth as much today. When given the option of receiving $100 today or $100 a year from now, no one would view these as equivalent. The same can be said of taking deductions over a number of years in the future rather than immediately expensing investments—the real value of the deductions over time is less than the original cost. For examples, see the table below.
Note: Assumes straight line depreciation, 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|
In summary, depreciation understates actual costs and overstates profits, and by doing so, increases the cost of capital. As such, the approach of delayed deductions does not make sense for tax calculation purposes and further, it discourages capital investment, which lowers productivity, output, and incomes.
This context matters when we analyze proposals to stretch deductions over longer periods of time, such as those from Senators Warren (D-MA) and Sanders (I-VT). Doing so would increase the cost of capital, bias the tax code against investment, and lead to less capital accumulation and lower productivity, output, and wages. It’s also important for evaluating claims in the news, like this recent New York Times article, which compared the size of a company’s tax cut to the size of their investment. The size of tax cut, (having extra, or unexpected, cash on hand), is not the channel through which we would anticipate an increase in investment from a business tax change.
Understanding the channel through which a tax policy change is expected to affect the economy is crucial. Absent this understanding, we are likely to reach the wrong conclusions on what sound tax policy looks like and what changes would improve the tax code.
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