What is Depreciation?

Instead of deducting the cost of capital expenses like regular business costs, the Modified Accelerated Cost Recovery System (MACRS) requires businesses to take depreciation deductions over long periods of time. Delaying, rather than immediately subtracting, reduces the value of the deductions to the business below the original cost. 

How Does Depreciation Work?

In the United States, business income taxes generally include four steps.

  • Step 1: Add up revenues (total income)
  • Step 2: Subtract expenses (deductions)
  • Step 3: Report the difference (taxable income)
  • Step 4: Multiply taxable income by tax rate to calculate total tax

Depreciation falls under Step 2. In general, businesses are allowed to deduct most ordinary business costs, such as wages, salaries, maintenance, advertising, etc. However, certain categories of expenses are not allowed to be deducted immediately—businesses cannot take an immediate deduction for the cost of their capital expenses. This category of expenses includes any business purchase that is expected to be useful for a long time: machinery, furniture, computers, buildings, etc.

Instead, businesses are required to deduct the cost of their capital expenses over long periods of time, according to a set of depreciation schedules under the MACRS. These gradual deductions for the cost of capital expenses are known as “depreciation deductions,” and they have been a feature of the federal income tax since its enactment.

What Is the Effect of Delayed Deductions?

Stretching deductions out over time reduces the present-value of the deductions, which means companies are unable to fully recover the cost of their investment in real terms, even when the deductions nominally add up to the investment cost. This treatment understates business costs, overstates profits, and increases the tax burden on investment.

By increasing the tax burden on investment (or increasing the cost of capital), the tax code discourages businesses from investing, which results in less capital formation, lower productivity and wages, and less output.

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