Tax System’s Reliance on Economic Depreciation Hinders Growth
August 11, 2016
Last month, the National Bureau of Economic Research (NBER) released a paper presenting findings that research and development depreciation rates for capital in large, high-tech industries in the United States are generally greater than previously understood. Such a finding highlights the complexities and arbitrariness in depreciation schedules used by the Internal Revenue Service (IRS), with negative consequences for the economy.
First of all, what is depreciation? In economics, depreciation is the decrease in the value of capital as time goes on. This occurs as machinery and other types of capital goods wear out, become obsolete, or fall out of demand.
This becomes an issue due to how the federal government defines income, a necessity for direct income taxation. As my colleague Alan Cole highlights in his most recent paper, “Corporate and Individual Tax Expenditures 2016,” the federal income tax system is based on the Haig-Simons definition of income, developed almost a century ago, that defines an individual’s income as the sum of his or her consumption plus the change in net worth. When it comes to capital, since its value declines with time as the asset depreciates, the government attempts to account for changes in net worth by allowing businesses to write off part of their capital investment each tax period. Because devaluation takes time, these depreciation schedules can stretch years, or even decades.
The NBER paper highlights the complexity of economic depreciation, and how economists may not know as much about it as previously thought. Prior estimates of depreciation rates for research and development capital were around 15 percent, but these new findings show this as a generally significant underestimate. For example, a 2006 study estimated the 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.
With such wildly differing estimates of devaluation rates, basing entire aspects of our tax system on economic depreciation can be incredibly arbitrary. Luckily, capital investment for research and development is currently fully expensed, meaning businesses may immediately deduct the full value of such purchases from their taxes. With full expensing, depreciation schedules that are perhaps poorly estimated do not have to be used. However, this expensing does not extend to other types of physical capital, leading to damaging economic effects.
Full expensing greatly improves simplicity by adopting one simple rule, rather than a collection of depreciation schedules: the deduction for capital investment is immediate and equal to what is spent on said investment. Moreover, this ensures that the full value of the capital investment can be deducted. In contrast, current depreciation schedules allow business to deduct only 87.14 percent of their investment costs, according to a Tax Foundation paper, “Cost Recovery for New Corporate Investments in 2012.”
This can have serious repercussions for the economy, as it discourages physical capital investment. Such investment drives economic growth, and previous studies have shown that faster depreciation schedules increase the capital stock, leading to job creation and higher wages. In fact, if full expensing were expanded to all capital investment, and not just for research and development, we would see long-run GDP expansion of more than 5.4%, the creation of more than a million jobs, and after-tax income gains across the board, according to our book Options for Reforming America’s Tax Code.
The NBER’s paper demonstrates that estimates of economic depreciation are unreliable. Basing write-offs in our tax system on such estimates subjects the capital investment necessary for greater growth and higher incomes to damaging arbitrariness. If the United States government wants to see real growth, it should abandon its tax system’s dependence on haphazard economic depreciation, and adopt full expensing of capital investment.