Senate Finance Committee Chairman Max Baucus (D-MT) has released a detailed proposal for capital 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. , which we summarized last week.
Currently, our cost recovery system overstates business income, ranks poorly by international standards, and is exceedingly complex.
Unfortunately, Senator Baucus’s plan does not seriously address these issues. In order to “pay for” an unspecified lower corporate tax rate, his plan moves in the opposite direction on cost recovery. Although the expansion and extension of Section 179 is a positive move, it worsens the treatment of capital assets and retroactively taxes businesses.
Extension and Expansion of Section 179
Under current law, businesses are allowed to expense up to $500,000 in capital investments, rather than depreciating them over time. Section 179 rules are set to expire and revert to a $25,000 limit. Senator Baucus’s draft proposes to make permanent the Section 179 rules. In addition he would increase the amount small businesses can expense to $1,000,000 per year, and increase this amount by inflation each year.
Senator Baucus recognizes that extending the ability for small businesses to deduct the entire cost of a capital asset the year it was purchased is beneficial. Therefore his plan increases the ability for them to do so. However, he misses the general point that the ability to expense would be beneficial for all businesses, big and small.
Rather than making special benefits for some businesses, it would be better to just allow all businesses to expense their capital assets.
It Worsens the Treatment of Capital Assets
When a business is calculating its taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. for the IRS, it takes its revenue and subtracts its costs (such as wages, raw materials, and state and local taxes). However, with capital investments (buildings, machines, and other equipment) the calculation is much more complicated. Businesses in the U.S. are generally not allowed to immediately count the cost of their capital investments. Instead, they are required to write them off over several years or even decades through depreciation schedules set by the IRS. Currently there are dozens of defined assets and assets lives used by the IRS.
Senator Baucus will eliminate the long list of 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. schedules for individual assets and replace them with four “asset pools” and another category for structures. Each of these pools will include a set of capital assets. Businesses will need to place each asset into one of these pools, sum the total value of all assets in the pool and depreciate them at one set rate.
Although these pools reduce the number of asset lives businesses have to keep track of from dozens to five, many assets will be treated poorly under this system. Businesses will not be able to deduct the full present value of a capital asset. According to our calculations (table, below), assets in pool one will only be able to write off 90 percent of the full present value of the asset. Businesses would only be able to recover 80 percent of pool 2 assets, 72 percent in pool three, and 48.6 percent in pool four. Structures that are written off will only be able to recover 41.8 percent of their present value.
This of course is all compared to expensing, which would allow businesses to recover the full cost of their capital assets and thus properly define their taxable income.
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The Present Values of Cost Recovery Allowances Under Expensing and the Baucus Draft Proposal |
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Assume 5 Percent Discount Rate |
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Present Value |
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Expensing (First-Year Write-Off) |
100% |
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Baucus Draft Proposal |
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Pool 1 |
90.6% |
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Pool 2 |
80.2% |
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Pool 3 |
72.0% |
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Pool 4 |
48.6% |
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43-Year Straight Line |
41.8% |
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. Foundation calculations.
It also worsens the treatment of intangible assets by making businesses amortize them over 20 years rather than the current 15. His plan also disallows businesses from deducting the full cost of advertisement in the year in which the investment is made. Instead, 50 percent is deducted in the first year, after which the remainder is amortized over five years. Both of these proposals head farther from a neutral tax base.
The plan also targets the oil and natural gas for tax increases by repealing intangible drilling costs and percentage depletion.
Retroactively Taxes Businesses
The other major problem with the cost recovery plan that Baucus released is that some of its changes create retroactive tax increases. In other words, they tax businesses on past activity that they made under past rules. Imagine an income tax increase that applied to income you made five years ago.
The first retroactive tax increase is through the new depreciation system. Under this system, not only will future assets need to be placed in one of these five “asset pools,” but also existing assets. If this existing asset is treated worse under Senator Baucus’s proposed plan, the business will end up receiving a smaller deduction than they first assumed when making the investment and thus will be paying a higher tax than they previous assumed.
We estimate that this would raise around $500 and $750 billion over ten years.
It also retroactively taxes businesses through its repeal of LIFO (Last-in, First-out) accounting of inventory. Senator Baucus’s plan would repeal this provision and force all businesses to use FIFO (First-in, First-out). This will reduce business’ reported inventory costs, and increase their taxable income. As with the depreciation system, the change in inventory accounting will also be retroactive. Businesses will have to revalue all current LIFO inventory and pay the resulting tax increase on past activity. Businesses would then have eight years to pay the additional tax they owe on existing inventory.
This will result in more than $82 billion in additional tax revenue solely from existing inventory.
Overall this plan will end up costing businesses more, but this was the point. This cost recovery plan is supposed to help raise money in order to lower the corporate tax rate. However, the damage that the Baucus plan will do to the economy through higher costs of capital, lower productivity, and lower wages, overwhelms the positive benefits of the modest rate cuts that Baucus is pursuing.
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