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Expensing of Machinery and Equipment Should Be Made Permanent

By: Stephen J. Entin

Investment spending has dropped for two consecutive quarters as the Federal Reserve has tightened credit and raised interest rates. Meanwhile, 100 percent expensing, temporarily extended by 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. of 2017 to allow businesses to immediately deduct the full cost of machinery and equipment instead of depreciating it over time, has begun phasing out. Making expensing permanent would be ideal, but it is especially important to extend it now, when the economy is threatened with a recessionA recession is a significant and sustained decline in the economy. Typically, a recession lasts longer than six months, but recovery from a recession can take a few years. 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. remains high.

The government has two primary economic targets: growth of real output and employment, and low inflation. And to hit these targets, the government has two policy arrows: monetary policy and fiscal policy. The former maintains price stability while the latter promotes real growth.

Monetary policy has its primary long-term effect on prices, not on real activity. (It can disrupt real activity in the short run, but the effect wears off as people begin to expect the altered level of prices generated by the monetary policy shift.) Fiscal policy (federal spending and 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, as well as regulatory policy that affects production costs and resource allocation) primarily influences real activity.

Since World War II, the Federal Reserve has placed too much emphasis on targeting real activity and neglected its primary responsibility to keep inflation low and the dollar sound. The result: periodic bouts of inflation and a reduction in the growth of real output as Federal Reserve policy has swung from easing to tightening and back again. The attempts to dampen every short-run swing in economic activity have too often led the Federal Reserve to indulge in excessive money creation.

The resulting inflation interacts with the tax system to raise marginal and effective tax rates on investment, reducing capital formation, employment, and wages—the exact opposite of the Federal Reserve’s goals. Subsequent efforts to contain inflation by tightening monetary policy make the damage to investment and employment worse until price stability is restored. Meanwhile, Congress has failed to adopt a tax regime that allows for optimal capital formation, productivity growth, and higher wages.

Getting each of these policy arrows aimed at the right targets would permit faster growth with stable prices.

The best policy the Federal Reserve can adopt to keep unemployment low and both economic output and wages high is to keep inflation low and steady. That requires a steady rate of expansion in the supply of money and credit consistent with the long-term growth of the economy’s capacity, not stop-and-go countercyclical swings or manipulation of interest rates. The Federal Reserve seems to be clinging to the old “Phillips Curve” idea that one can achieve a permanent reduction in unemployment by accepting a bit more inflation. That theory was discredited over 50 years ago. It is high time for it to be dropped from the Federal Reserve’s modeling and thought process.

Congress can protect the real economy from Federal Reserve policy errors by reducing the sensitivity of the tax system to inflation. It largely did so with the 1981 Economic Recovery Tax Act, which provided for the adjustment of income tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s, the standard deductionThe standard deduction reduces a taxpayer’s taxable income by a set amount determined by the government. It was nearly doubled for all classes of filers by the 2017 Tax Cuts and Jobs Act as an incentive for taxpayers not to itemize deductions when filing their federal income taxes. , and the erstwhile personal exemptions for inflation since 1985. This has prevented a recurrence of “bracket creepBracket creep occurs when inflation pushes taxpayers into higher income tax brackets or reduces the value of credits, deductions, and exemptions. Bracket creep results in an increase in income taxes without an increase in real income. Many tax provisions—both at the federal and state level—are adjusted for inflation. ” in the personal income tax, which contributed to stagflation in the 1970s.

Unfortunately, inflation continues to damage investment by eroding the value of the 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, which raises the after-tax cost of investment. The present value of $100 in depreciation deductions for a 7-year machine is $89 at zero inflation, $81 at 3 percent inflation, and $76 at 5 percent inflation. In contrast, expensing protects write-offs from inflation.

Letting expensing expire and returning to depreciation now would be horrible timing. It would sharply raise the after-tax cost of machinery and equipment. Less capital would be formed, which would depress economic output, productivity, wages, and employment, falling particularly hard on workers in the form of lower wages. Consumers would see fewer goods and services. Savers and retirees would earn lower returns on investment.

Expensing is not just a counter-cyclical tool to head off a recession, only to be removed during good times. Business costs should always be fully deductible when incurred.

Tax Foundation estimates permanent expensing would add 0.2 percent to GDP by the end of the budget window and 0.4 percent over time. Hours worked would increase by the equivalent of 72,600 full-time jobs, and wages would be 0.3 percent higher. The private sector capital stock would be 0.7 percent higher, or about $400 billion in added investment.

Economic Effect of Permanent 100 Percent Expensing
Gross Domestic Product (GDP) +0.4%
Gross National Product (GNP) +0.3%
Capital Stock +0.7%
Wages +0.3%
Full-Time Equivalent (FTE) Jobs +72,600
Source: Tax Foundation General Equilibrium Model.

Workers, savers, and consumers would not be the only losers if expensing were to end. Ironically, the government would lose too, because expensing is one of the very few tax reductions that boost economic activity enough to result in higher revenues down the road. After the 10-year budget window, permanent expensing would lift tax revenues above the baseline due to higher wages and employment.

Tax Foundation estimates permanence would reduce revenues by $431 billion over the 2024-2033 budget window on a conventional basis. Allowing for expected gains in GDP, the revenue loss would fall to $316 billion on a dynamic basis. One-third of the 10-year conventional revenue loss would be recovered due to higher output and incomes over the budget window.

The losses would diminish rapidly and be a scant $1.8 billion in 2033 (on a dynamic basis), with revenue gains in the next decade and beyond rising over time.

Revenue and Short-Term Economic Effects of Permanent 100 Percent Bonus Depreciation
2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 2024 – 2033
Conventional -$37.2 -$49.1 -$60.5 -$71.1 -$55.2 -$43.3 -$35.0 -$29.4 -$25.9 -$24.0 -$430.6
Dynamic -$37.0 -$48.2 -$55.3 -$62.0 -$44.1 -$29.9 -$19.4 -$11.6 -$6.2 -$1.8 -$315.6
GDP Effect in the 10-Year Window 0.01% 0.04% 0.07% 0.11% 0.13% 0.15% 0.17% 0.19% 0.21% 0.22%
Source: Tax Foundation General Equilibrium Model.

Lawmakers should prioritize additional 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.  improvements too.

Businesses with low current income, such as start-ups or firms in a loss position, may not be able to use the entire deduction provided by expensing immediately. Businesses can carry forward unused write-offs to a later date, but delays reduce their value. The value of deferred deductions could be preserved by increasing them each year by 3.5 percent (to reflect the real cost of capital) plus the rate of inflation. Doing so would level the tax playing field between start-ups and established businesses.

Structures comprise over one-third of the capital stock subject to capital cost recovery, but they are excluded from the expensing provision. This omission is serious, because structures are the assets most hurt by delays in deducting their costs, due to their long write-off periods. The present value of $100 in depreciation deductions for a 39-year building is $37 at 3 percent inflation and $30 at 5 percent inflation. Buildings require superior earnings to jump that tax hurdle.

Expensing of structures would be ideal, but transitioning to expensing for structures would involve a large initial revenue drop due to the combination of full write-offs for new buildings and remaining write-offs for old buildings. The revenue loss would gradually disappear as old buildings use up their write-offs, but it would take decades. Expensing would favor new buildings over existing buildings, which could lead to resales and churning. Also, some businesses might not be able to use the entire deduction immediately, because the deduction for a large building project might exceed current earnings, resulting in a loss carry-forward.

A neutral cost recovery system (NCRS), is an alternative means of providing full-value cost recovery that avoids these issues. Under NCRS, firms would continue to deduct the cost of assets over time, but with an adjustment for inflation and a real return, equal in present value to immediate expensing. Economic gains from neutral cost treatment of structures would be about twice those of expensing for equipment. It would be wise to keep old structures competitive by raising their remaining deductions annually in the same manner. Extension of inflation protection to depreciation deductions through expensing of equipment, and dealing with the same issues regarding structures, would keep inflation from depressing economic growth and reduce the pain of fighting inflation when it recurs.

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