Cost Recovery

What is Cost Recovery?

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. 

Cost Recovery’s Role in the Tax Base 

Business taxes usually apply to net income, which is revenues minus costs. Imagine a store owner who spends $1 million on inventory, $500,000 in renovations, and another $500,000 on salaries in a year. Revenues for that year are $2.2 million. The store would have an income of $200,000 based on the cash value of its costs. However, the tax code does not always look at the cash value of costs. 

However, various tax rules can limit the amount of costs a business can deduct. Deductions for inventory are defined using last-in-first-out (LIFO) accounting measures, and the store owner’s renovation costs may not be eligible for immediate deductions. Wage costs are deductible in the first year. 

When taxable income is calculated using measures of costs that do not reflect economic reality, the tax base is inflated. 

Inventory Cost Recovery 

Deductions for inventory costs can also be limited by tax rules. The rules usually vary among first-in-first-out (FIFO), average cost, and last-in-first-out (LIFO) methods.  

If a store owner is constantly buying and selling inventory, FIFO would require the owner to value the cost of their inventory based on the price of the first-acquired products. In the context of inflation, FIFO leads to profits being overstated relative to the cost of the inventory being sold. LIFO, on the other hand, allows a business to deduct the cost of inventory based on the most recently acquired inventory. The average cost method would require the owner to average their inventory cost over recently acquired and older inventory. 

Capital Cost Recovery 

For large expenses like constructing a new building, buying expensive machinery, or a major renovation, the tax code can create a bias against investment by inflating the tax base for businesses. Capital cost recovery rules rarely reflect the economic cost of an investment and require businesses to deduct investment costs over multiple years. This biases the tax code against new investment and can create a drag on economic growth 

Some countries provide full expensing, or immediate cost recovery, for some assets. The U.S. has a temporary policy that allows businesses to deduct the full cost of investments in short-life assets like equipment and machinery. After 2022, the policy will begin phasing out until it fully expires at the end of 2026. However, proponents of a long-term stable policy of full expensing have been arguing for this policy to be made permanent. 

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