Reviewing the Economic and Revenue Implications of Cost Recovery Options

April 28, 2020

Removing tax policy barriers can help businesses and individuals invest, work, create jobs, and lift the economy during a post-pandemic recovery without requiring lawmakers to create new spending programs. One of the most cost-efficient options available to lawmakers is to make permanent and expand the full expensing of capital investment.

We have used the Tax Foundation General Equilibrium Model to analyze different ways lawmakers could improve the cost recovery treatment of capital investment in order to incentivize new investment and boost economic output.

Background on Capital Cost Recovery

Improving capital cost recovery will be crucial to the post-pandemic effort to increase investment and economic growth. Under the U.S. tax code, businesses can generally deduct their ordinary business costs when figuring their income for tax purposes. However, this is not always the case for the costs of capital investments, such as when businesses purchase 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.

Delaying deductions means the present value of the write-offs (adjusted for inflation and the time value of money) is less than the original cost—how much less valuable depends on the rate of inflation and the discount rate. Thus, this system of tax depreciation, rather than full expensing, is highly unfavorable and increases the after-tax cost of making investments, leading to a lower level of investment and economic growth.

The current cost recovery system permits immediate 100 percent bonus depreciation deductions for investments in short-lived assets like machinery and equipment thanks to a temporary policy of full expensing for some assets enacted in the Tax Cuts and Jobs Act (TCJA) of 2017. This policy is scheduled to phase down beginning in 2022 and fully expire by 2026. Investments that do not qualify for this temporary provision face much harsher treatment. For example, when a business purchases a structure, it has to deduct the cost over a period of up to 27.5 years (for residential buildings) or 39 years (for nonresidential buildings). The tax treatment of structures is important because structures comprise more than three-quarters of the private capital stock.

Additionally, the tax treatment of expenses for research and development (R&D) will be important for lawmakers to address. Since 1954, companies have been permitted to immediately deduct their R&D costs from their taxable income in the year the costs occur, but beginning in 2022, companies will be required to amortize their R&D costs over five years. This change will raise the cost of investment, discourage R&D, and reduce the level of economic output.

Rather than allow the temporary 100 percent bonus depreciation deductions to expire, increase the tax on R&D, and maintain the current biased treatment against investment in other asset types, full expensing for all capital investment provides an opportunity to improve capital cost recovery and boost long-run economic output, wages, and jobs.

Full Expensing for All Capital Investment

We estimate that enacting a policy of full expensing for all capital investments, including machinery, equipment, buildings, structures, and R&D expenses, would increase the long-run level of gross domestic product (GDP) by 5.1 percent. The capital stock would expand by 13 percent, wages increase by 4.3 percent, and employment grow by more than 1 million full-time equivalent jobs.

Table 1. Long-Run Economic Effect of Full Expensing

Gross Domestic Product

5.1%

Capital Stock

13.0%

Wage Rate

4.3%

Full-Time Equivalent Jobs

1.02 million

Source: Tax Foundation General Equilibrium Model, November 2019

We estimate that on a conventional basis, enacting full expensing would reduce federal revenue by $1.64 trillion from 2021 through 2030. On a dynamic basis, accounting for the economic growth from the policy change, the 10-year cost falls to $809 billion.

A large component of the 10-year revenue cost of full expensing is transitory; investments made before the policy change are still being written off, while new investments are fully and immediately written off. The combination of legacy write-offs from old investments and 100 percent write-offs for new investments makes the upfront cost huge for switching to full expensing. As legacy write-offs are used up, the cost of the policy will fall.

Table 2. 10-Year Revenue Effect of Full Expensing
  2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2021-2030

Conventional (billions)

-$62 -$130 -$149 -$170 -$191 -$204 -$212 -$191 -$172 -$156 -$1,637

Dynamic (billions)

-$44 -$102 -$109 -$117 -$124 -$117 -$102 -$60 -$18 -$16 -$809

Source: Tax Foundation General Equilibrium Model, November 2019

We estimate that the long-run annual cost of full expensing is $61 billion on a conventional basis (in 2020 dollars).

The transition costs of moving to full expensing for all assets may deter lawmakers from pursuing the policy. However, this treatment can be expanded to buildings and structures in a way that lowers the upfront cost while providing nearly equivalent economic benefit.

Neutral Cost Recovery for Structures to Address Budgetary Concerns

An alternative to full expensing for structures is a neutral cost recovery system (NCRS). A NCRS would have a similar economic effect as full expensing but would decrease the cost over the 10-year budget window, reducing the initial cost of improving the tax treatment of structures.

A NCRS would provide nearly the same economic benefit as full expensing because businesses would get the full present value of the write-offs they would receive under full expensing. To achieve this, the current depreciation schedules for residential and nonresidential buildings, 27.5 years and 39 years, respectively, would remain, but deductions would be adjusted to compensate for the delay by accounting for inflation and the time value of money.

This adjustment equalizes the present value of the delayed deduction to the value the company would receive from an immediate deduction and provides businesses with the same economic incentive to invest as they would have under full expensing. This also prevents the government from facing higher upfront costs. Table 3 illustrates how normal depreciation deductions lose value over time and how this is remedied by expensing and a NCRS system.

Table 3. Comparing the Present Value of Depreciation Deductions under Different Cost Recovery Systems
Year 1 2 3 4 5 Total

Straight-line Depreciation Deductions

$100.00 $100.00 $100.00 $100.00 $100.00 $500.00

   Present Value

$100.00 $96.15 $92.46 $88.90 $85.48 $462.99

Expensing

$500.00 $0.00 $0.00 $0.00 $0.00 $500.00

   Present Value

$500.00 $0.00 $0.00 $0.00 $0.00 $500.00

Neutral Cost Recovery

$100.00 $104.00 $108.16 $112.49 $116.99 $541.63

   Present Value

$100.00 $100.00 $100.00 $100.00 $100.00 $500.00

Source: Author calculations. Assumes a 4 percent discount rate.

Using the Tax Foundation General Equilibrium Model, in Table 4 we estimate the effect of a NCRS system for investments in 27.5-year and 39-year structures (residential and nonresidential, respectively) and a policy of full expensing for all other assets.

Table 4. Long-Run Economic Effect of NCRS for Buildings and Structures and Full Expensing for All Other Assets
  NCRS for 27.5- and 39-Year Structures Full Expensing for All Other Assets Combined Effect

Gross Domestic Product

2.8% 2.3% 5.1%

Capital Stock

7.0% 6% 13.0%

Wage Rate

2.4% 1.9% 4.3%

Full-Time Equivalent Jobs

569,000 451,000 1.02 million

Source: Tax Foundation General Equilibrium Model, November 2019

The benefit of a NCRS is that it reduces the upfront transition cost in the short term when compared to full expensing while delivering the same economic benefit. We estimate that in the 10 years between 2021 and 2030, this policy change would reduce federal revenues by $1.26 trillion on a conventional basis, reducing the 10-year cost by $376 billion compared to full expensing for all assets. On a dynamic basis, the 10-year cost of a NCRS for structures and full expensing for all other assets falls to $386 billion.  

Table 5. 10-Year Revenue Effect of NCRS for Buildings and Structures and Full Expensing for All Other Assets
  2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2021-2030

Conventional Revenue (billions)

-$21 -$94 -$111 -$131 -$152 -$165 -$176 -$153 -$133 -$126 -$1,261

Dynamic Revenue (billions)

-$3 -$65 -$70 -$77 -$83 -$77 -$63 -$18 $25 $46 -$386

Source: Tax Foundation General Equilibrium Model, November 2019

Write-offs under a NCRS are low initially and rise over time. Companies would not start taking significantly larger deductions until later years, so while the cost within the first 10-year budget window is low, the cost in later years would be higher. There are some economic imperfections with this approach: discount rates may differ by firm, which would not be accounted for under a NCRS, and firms might experience uncertainty that the policy would hold over the long term.

We estimate that the long-run annual cost of neutral cost recovery for structures and full expensing for all other assets is $61 billion on a conventional basis (in 2020 dollars).

Addressing the Scheduled Increase on Research and Development Costs

While full expensing for all types of investments would result in the largest boost in investment and economic growth, at the very least, scheduled tax increases on capital investment should not be allowed to occur. This includes the upcoming amortization of R&D expenses scheduled to take place in 2022.

Using the Tax Foundation General Equilibrium model, we previously estimated that on its own, removing R&D amortization in favor of full expensing would increase the size of the economy by 0.15 percent, increase the size of the capital stock by 0.26 percent, and boost employment by 30,600 full-time equivalent jobs, in the long run.

Table 6. Long-Run Economic Effect of Canceling R&D Amortization
Gross Domestic Product (GDP) 0.15%
Wage Rate 0.12%
Capital Stock 0.26%
Full-Time Equivalent Jobs 30,600

Source: Tax Foundation General Equilibrium Model, December 2018

According to the Tax Foundation General Equilibrium Model, canceling the amortization of R&D would reduce federal revenue by $133 billion on a conventional basis between 2021 through 2030. Additional economic output over the budget window (due to the larger capital stock) would reduce the cost of canceling R&D amortization. On a dynamic basis, we estimate the change would reduce federal revenue by $102 billion between 2021 and 2030.

Table 7. 10-Year Revenue Effect of Canceling R&D Amortization
  2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 2021-2030

Conventional Revenue

$0 -$40 -$26 -$20 -$15 -$8 -$4 -$7 -$7 -$7 -$133

Dynamic Revenue

$0 -$40 -$25 -$18 -$12 -$4 $1 -$1 -$1 -$1 -$102

Source: Tax Foundation General Equilibrium Model, December 2018

Conclusion

Permanent full expensing for all types of investment is an effective policy change lawmakers can use to encourage additional investment and economic growth. We estimate that full expensing for all capital investments would boost economic output by 5.1 percent, wages by 4.3 percent, and create more than 1 million full-time equivalent jobs over the long run. To reduce the short-term cost of full expensing for structures, lawmakers could use a neutral cost recovery system (NCRS), which would provide a nearly equivalent economic effect at a lower initial cost, pushing the greater costs to the outyears.

Additionally, lawmakers should prevent upcoming increases to capital investment that are scheduled to take place, such as the expiration of 100 percent bonus depreciation and the amortization of R&D expenses. Allowing these policy changes to occur would undermine the economic recovery.

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