Bonus Expensing Moves the Tax Code Closer to the Ideal

September 17, 2015

This week, the House Ways and Means Committee took up a bill that would permanently extend what is called “Bonus Expensing” or 50 percent expensing. 50 percent bonus expensing is one of the over 50 “extender” tax provisions that expires at the end of each year.

50 percent expensing allows businesses to immediately write off, or expense, 50 percent of an investment in new equipment or short-lived structures. It does not apply to commercial or residential buildings or factories.

Our Taxes and Growth (TAG) model finds that permanently extending this provision would boost GDP by 1.1 percent, increase the capital stock by 3.3 percent, wages by 1 percent, and create 214,000 new jobs. On a static basis, a permanent bonus depreciation would reduce federal revenues by $336 billion over the next ten years, but due to the growth in wages and incomes, the ultimate cost to the treasury over ten years would be $74 billion, which is less than a quarter of the revenue impact without growth.

The reason why bonus depreciation has such a positive impact on the economy is that is reduces the cost of capital, or the cost of investment for businesses. It does this by allowing businesses to recover more of the upfront cost of each investment. It moves closer to what is called “full expensing,” which allows businesses to fully deduct the cost of all business expenses including capital investments.

Under current law, when a business makes a capital investment (purchases a machine, building, or office equipment), it must write off, or deduct these costs from taxable income in stages over several years or decades.

Take for example a pizza shop that purchases an oven for $100. Under the current cost recovery system, an oven is deducted in stages over 7 years according to a depreciation schedule. Each year’s deduction is a percent of the total initial cost (table, below). Over the expected life of the investment, each year’s deductions add up to the initial nominal cost of $100 when the oven was purchased.

However, in present-value terms, this isn’t the case. If we take into account the time-value of money and inflation, the pizza shop will not be able to deduct the initial cost of the investment over seven years. In fact, the pizza shop will only be able to deduct $83.63 in present-value terms over the life of the investment. For the business this means their taxable income over the seven years is inflated related to what is should have been. For the economy as a whole, this means an increase in the cost of capital, reduced investment, and slower economic growth.

Depreciation Schedule of a 7-year Asset (MACRS)

Year

Write-off

Present Value Write-off

0

$ 14.29

$ 14.29

1

$ 24.49

$ 22.78

2

$ 17.49

$ 15.13

3

$ 12.49

$ 10.05

4

$ 8.93

$ 6.69

5

$ 8.92

$ 6.21

6

$ 8.93

$ 5.79

7

$ 4.46

$ 2.69

Total:

$ 100.00

$ 83.63

Note: 5 percent real discount rate and 2.5 percent inflation

50 percent expensing is an improvement over current law. This provision allows a business to immediately deduct 50 percent of the initial cost before using the above depreciation schedule. For the pizza shop, this means a $57 deduction for the oven on the first year. This also means that because a larger deduction was taken in the first year, the pizza shop will be able to recovery more of the initial cost of the investment over the 7 years ($91.82 with bonus depreciation vs. $83.63 without bonus depreciation) after we take into account the time value of money and inflation. This represents a reduction in the cost of capital in contrast with current law. This is why our analysis finds a boost to GDP, wages, and employment.

Depreciation Schedule of a 7-year Asset (MACRS) with 50% Expensing

Year

Write-off

Present Value Write-off

0

$ 57.15

$ 57.15

1

$ 12.25

$ 11.39

2

$ 8.75

$ 7.57

3

$ 6.25

$ 5.03

4

$ 4.47

$ 3.34

5

$ 4.46

$ 3.11

6

$ 4.47

$ 2.89

7

$ 2.23

$ 1.34

Total:

$ 100.00

$ 91.82

Note: 5 percent real discount rate and 2.5 percent inflation

Permanent bonus expensing would represent an important step toward full expensing, which economists recognize to be ideal for investment and economic growth.

Read more about Bonus Expensing here.


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