Three Reasons Why Full Cost Recovery Is Right Even if Assets Increase in Value

August 5, 2021

Critics of depreciation deductions for business expenses in the tax code occasionally argue that assets that can go up in value, like structures or sports teams, should not receive the same depreciation deductions as assets that decline in value. That criticism is driven by a deeper dispute over whether businesses should be taxed on the change in their net worth or their cash flow—we argue that taxing cash flow is superior because it is the simpler, less arbitrary, and more economically efficient method to tax businesses.

The federal income tax code is currently a mix of the two approaches. It establishes depreciation deductions that attempt to mirror changes in net worth for some types of capital investments but also provides bonus depreciation and full expensing for other asset types and smaller businesses.

When a business makes a capital investment, the value of the cash spent on that investment is transferred to the value of the physical asset. For example, if a farming operation spends $500,000 on a new combine harvester, it transfers $500,000 in value from cash to the harvester, and the operation’s net worth remains the same.

Advocates of the net worth approach argue that because the operation’s net worth remains unchanged, they should not receive an immediate depreciation deduction for the investment. Instead, the operation should wait to take depreciation deductions in the future as the combine harvester’s value declines to match their tax deductions with their change in net worth.

Under the cash flow approach, however, what matters is the amount of cash earned and spent each year by the firm. Capital investments, like other business costs including employee wages and utility bills, are fully and immediately deductible when they are made. Instead of depreciating the $500,000 combine harvester over time, the operation would take a tax deduction for the entire $500,000 the year it was purchased to fully recover its costs.

The cash flow approach of providing full cost recovery for all forms of capital investment comes with at least three advantages.

First, taxing cash flow is simpler because the same tax treatment applies if the asset wears out, becomes obsolete, or increases in value. While proponents of matching depreciation deductions to a business’ net worth argue there should be no depreciation deductions in cases where the asset increases in value, from a cash flow perspective it makes no difference. A full and immediate deduction for an asset is the proper tax treatment because it is a real expense like any other cost of doing business, regardless of how its value may change in the future.

For example, imagine the combine harvester increases in value to $525,000 one year after purchase due to a shortage of semiconductor chips placed in new harvesters. Advocates of the net worth approach would need to revalue the harvester and deny a depreciation deduction. Under full expensing, however, the $500,000 purchase price was already fully deducted, which is a simpler process for businesses and the IRS.

Second, determining scientifically accurate depreciation time frames is a nearly impossible feat, resulting in somewhat arbitrary classifications. Consider that under current depreciation rules, assets must be classified into one of nine different asset classes with depreciation schedules ranging from three years to 39 years. But as explained in a previous Tax Foundation post, economists have not reached a consensus on the complexities of economic depreciation:

A 2006 study estimated the [depreciation] rate for transportation equipment used for research and development to be 17 percent, but this recent study finds the depreciation rate on the same sort of capital goods is at least 56 percent. [emphasis added] With such wildly differing estimates of devaluation rates, basing entire aspects of our tax system on economic depreciation can be incredibly arbitrary.

The combine harvester in our example would be classified as seven-year property, regardless of the practical or real useful life used in the operation.

Third, it is more economically efficient to provide a full and immediate deduction for all investments.

Requiring businesses to wait to take their deductions erodes the real value of the deductions due to inflation and the time value of money—it means businesses never fully recover their capital investment costs and thus biases the tax code against capital investment. For example, if the firm had to take depreciation deductions for its $500,000 combine harvester over seven years, at 2 percent inflation and a 3 percent real discount rate, the real value of the deductions would be $422,849. The delay in taking the depreciation deductions understates the real costs the operation incurred and overstates its profits and tax liability.

The ideal treatment is to match the tax code to a firm’s cash flow—allow immediate deductions for all expenses, including all forms of investment, while taxing the resulting returns from the investments. Depreciation deductions are an important part of the tax code to determine business income regardless of the future value of the underlying assets. We should consider providing full and immediate deductions for all business expenses, which would simplify the tax code and increase economic output by allowing all costs to be fully recovered.

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A tax deduction is a provision that reduces taxable income. A standard deduction is a single deduction at a fixed amount. Itemized deductions are popular among higher-income taxpayers who often have significant deductible expenses, such as state/local taxes paid, mortgage interest, and charitable contributions.

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.

Cost 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.