Why Neutral Cost Recovery Matters

The debate over the 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 and Jobs Act (TCJA) expirations is usually focused on which tax cuts to preserve. However, one policy ultimately excluded from the TCJA should make its way back into the renewed tax policy debate: 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. (NCR) for structures. A new bill introduced by Rep. Kevin Hern (R-OK), the Renewing Investment in American Workers and Supply Chains Act, does just that, and by adopting neutral cost recovery, it would significantly boost investment incentives in the US and grow economic output, wages, and jobs.

The bill would shorten the cost recovery schedules for both residential and nonresidential structures to 20 years and apply 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 opportunity cost adjustments to deductions each year. The inflation adjustment would vary each year according to actual inflation, while the opportunity cost adjustment would be fixed at 3 percent.

The adjustments would remove the current tax penalty for investment in structures, driving additional capital investment and growing economic output and wages. Tax Foundation’s model estimates the Hern proposal would increase the capital stock by 2.3 percent, GDP by 1.3 percent, wages by 1.0 percent, and hours worked by 276,000 full-time equivalent (FTE) jobs. American incomes, as measured by GNP, would rise by 1.1 percent. The 2.3 percent capital stock would, in 2024 dollars, amount to a $1.8 trillion increase in the long-run level of productive assets in the economy. We estimate how the increase in FTE employment and capital stock would be distributed across the states and DC in the maps below.

Over the 10-year budget window, revenue would drop by $257 billion by accelerating 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. deductions and providing the inflation and opportunity cost adjustments. On a dynamic basis, which incorporates the revenue feedback from higher wages and more hours worked, revenue would increase by $344 billion.

Estimated Revenue and Long-Run Economic Effects of Renewing Investment in American Workers and Supply Chains Act

Source: Tax Foundation General Equilibrium Model, August 2024.

To understand the purpose of neutral cost recovery, one must understand the structure of today’s corporate tax. 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. is a tax on profits, namely revenues minus costs. Ideally, companies would be able to deduct the full cost of their capital investments, just as they can deduct the cost of their operating expenses like wages, salaries, and other costs of goods sold.

However, at least in real terms, they cannot. Companies must spread deductions for capital investments out over several years.

Through the combination of inflation and the opportunity cost of delaying the deduction, businesses cannot fully deduct (recover the cost) of their capital investment. The number of years over which companies must spread deductions varies by investment class. Different types of equipment and machinery must be deducted over between 3 and 20 years, while residential buildings must be deducted over 27.5 years and nonresidential buildings over 39 years. The goal of the current tax treatment is to approximate the economic life of structures, but even under that standard, structures are overly penalized; research indicates that on average buildings wear out after around 19 years, once the cost of maintenance is factored in.

The TCJA improved cost recovery for some types of investment by introducing 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 short-lived assets—allowing investment in machinery and equipment to be deducted immediately. However, it has begun to phase out: this year, companies can deduct 60 percent of their machinery and equipment investment immediately and must spread the remaining deductions out over time. Structures, meanwhile, did not see a significant improvement in tax treatment, temporary or otherwise.

Stopping short of full deductibility of investment creates a tax penalty for investment. Consider an investment of $500 made in 2019. For simplicity’s sake, we’ll assume it is deducted over five years using straight-line depreciation. Factoring in a 3 percent discount rate and actual inflation rates over the past five years, the company would be able to deduct just over 87 percent of its investment. Under a 21 percent corporate tax, this translates to an additional $13.40 tax on the investment—representing a tax penalty that increases the cost of making an investment.

Simple Example: 5-Year Straight-Line Depreciation Lets Business Deduct 88.5 Percent of Cost

Note: Stylized example ignores half-year convention. Present value calculations use actual annual inflation from 2019-2023 and a 3 percent discount rate.
Source: Authors’ calculations.

If instead, businesses could fully deduct the cost of their investment in the year they actually make it, they wouldn’t face an inflation or opportunity cost penalty under the tax code

Expensing Example: Deduction Up Front

Note: Stylized example ignores half-year convention. Present value calculations use actual annual inflation from 2019-2023 and a 3 percent discount rate.
Source: Authors’ calculations

Moving to expensing for structures creates fiscal challenges and practical challenges, namely a large upfront transition cost to the federal budget and the risk that companies wouldn’t be able to fully use a deduction for the entire cost of a new structure. Going from, say, spreading deductions out over five years to taking them immediately for an investment in a new aircraft is one thing, but bringing deductions that were originally spread over several decades to a single year is another.

Neutral cost recovery for structures (NCRS) overcomes both challenges. Neutral cost recovery for structures maintains longer depreciation schedules, but it adjusts the deductions over time to keep up with inflation and the opportunity cost of delays. This way, Neutral cost recovery for structures allows businesses to deduct the full real cost of investment without creating an immediate tax revenue loss or too large of a deduction to use up front.

Neutral Cost Recovery Adjustments Are Equal to Expensing in Present Value

Note: Stylized example ignores half-year convention. Present value calculations use actual annual inflation from 2019-2023 and a 3 percent discount rate.
Source: Authors’ calculations.

These simple examples understate the extent to which the current system penalizes investment in residential and nonresidential structures. Deductions for residential structures are spread over 27.5 years, and deductions for nonresidential structures are spread over 39 years. Assuming a 3 percent discount rate and a 2 percent inflation rate, companies are only able to deduct around 47 percent of their investment in residential structures and 44 percent of their investment in nonresidential structures.

Allowing full deductibility of commercial structures would make possible major projects previously considered unviable. Neutral cost recovery for structures could be particularly beneficial for greenfield development (i.e., new facilities being built from scratch). If a company is mostly upgrading its existing operations, such as by retooling or upgrading equipment, most of its costs would be in equipment. However, if a company is debating whether to build a new factory, the structure itself would make up a larger share of the investment cost, meaning improved cost recovery would be especially beneficial.

Allowing full deductibility of residential structures would mean more housing construction, particularly multifamily housing—a practical solution to address housing affordability challenges. The Tax Reform Act of 1986 extended the cost recovery schedule for residential housing from 19 years to 27.5 years, and it eliminated the use of declining balance depreciation for the asset class (declining balance allowed taxpayers to take larger deductions in earlier years and smaller deductions in later years, in effect allowing them to deduct more of their investment in present value terms). In the aftermath of the 1986 tax reform, multifamily housing construction collapsed, and apartment building starts have not recovered to pre-1986 levels since. Neutral cost recovery adjustments would restore full cost recovery to these investments, again acting as a powerful incentive to increase investment in the housing sector.

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