Cost Recovery Treatment Short of Full Expensing Creates A Drag on Economic Growth

September 17, 2018

The Tax Cuts and Jobs Act (TCJA) made significant progress in improving the cost recovery treatment of business investment by enacting 100 percent bonus depreciation. Full expensing, or the immediate write-off of all business investment, is a key driver of future economic growth, and can have a larger pro-growth effect per dollar of revenue forgone than cutting tax rates. However, the TCJA expensing provision will only be in effect for five years before it begins phasing down; as lawmakers continue efforts to reform the tax code, permanence for full expensing should be on their radar.

Full expensing is a powerful, pro-growth provision because it alleviates a bias in the tax code that discourages investment in the United States.

Generally, when businesses calculate their income for tax purposes, they subtract business costs. This makes sense because the corporate income tax is a tax on business profits, or generally, revenues minus costs. However, businesses are not always allowed to subtract the amount they spend on capital investments, such as when businesses purchase equipment, machinery, and buildings. Typically, when businesses incur these sorts of costs, they must deduct them over several years according to preset depreciation schedules, instead of deducting them immediately in the year the investment occurs.

This is problematic because, due to inflation and the time value of money, a dollar in the future is worth less than a dollar today. So, delaying deductions for the cost of business investments means that the actual value of the deductions is less than the original cost. The table below illustrates what this looks like for a variety of assets at different rates of inflation.

The Present Value of Delayed Deductions Is Smaller Than the Original Cost
  5-year asset 15-year asset 20-year asset

Source: Author’s calculations. Assumes half-year convention, 3 percent real discount rate, plus inflation.

Expensing $100.00 $100.00 $100.00
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

Ultimately, this treatment means that the corporate income tax is biased against investment in capital assets to the extent that it makes the investor wait years or decades to claim the cost of machines, equipment, or factories on their tax returns. This results in less capital formation, lower productivity and wages, and less output.

The Tax Cuts and Jobs Act significantly improved the ability of businesses to recover the costs of their investments by enacting 100 percent bonus depreciation for assets with cost recovery periods of 20 years or less. Through 2022, businesses can immediately deduct the full cost of eligible investments, such as machinery and equipment, just as they would with any other business expense, rather than stretching deductions over many years. But after 2022, the provision will begin phasing down, which is why the provision doesn’t contribute to long-run economic growth. And, if Congress doesn’t make the provision permanent, it would result in an increase in the cost of investing in machinery and equipment in the United States.

In our recent paper, we estimate that making the 100 percent bonus depreciation provision in the Tax Cuts and Jobs Act permanent would increase the size of the capital stock by 2.2 percent and long-run GDP by 0.9 percent; the larger economy would result in a 0.8 percent increase in wages and 172,300 full-time equivalent jobs. And it would improve the economy in a cost-efficient manner. We’ve estimated that permanence for the TCJA expensing provision generates about 4.5 times more economic growth per dollar of revenue cost than permanence for the TCJA’s individual provisions.

Permanence for TCJA Expensing Would Generate Long-Run Economic Growth

Source: Taxes and Growth Model, April 2018

GDP +0.9%
Wage Rate +0.8%
Private Business Capital Stock +2.2%
FTE Jobs 172,300

As lawmakers continue efforts to improve the tax code like Tax Reform 2.0, they ought to explore ways to make the TCJA 100 percent bonus depreciation provision permanent well before it expires.

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A 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.

Inflation 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.

Full 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.

Depreciation 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.

Bonus 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.