The Tax Treatment of Capital Assets and Its Effect on Growth: Expensing, Depreciation, and the Concept of Cost Recovery in the Tax System

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Introduction

Congress is debating major reforms of the corporate and individual income taxes. One expressed goal of the exercise is to promote economic growth while lowering the deficit. Growth is key. Without it, employment and incomes will suffer, and the hoped-for tax revenue will not appear. Proper tax treatment of the cost of plant, equipment, and buildings is an important and underappreciated prerequisite for a pro-growth tax system. This paper seeks to explain the nature of capital cost recovery as it is currently treated by business planners, accountants, and the tax code, and to describe the reforms needed to produce the best economic and budget outcomes.

In the early days of the corporate income tax, businesses were allowed to report the costs of their assets to any schedule they chose. Later, efforts were made to set rational guidelines for such reporting based on the expected lives of the assets. The accounting profession chose a few methods for financial statements. The Congress and the IRS chose different methods for tax purposes (and changed them again and again). These efforts were hardly scientific. (Why is the Empire State Building like a telegraph pole? See below!) Worse, they focus on fundamentally unknowable asset lives instead of on the relatively clear issue of what is best for the economy.

This is a significant issue. How capital assets are accounted for in the tax code dramatically affects what is defined as taxable income and, thereby, directly influences the cost of capital. The higher the cost, the less capital is formed, and the slower the economy will grow. The lower the cost, the bigger the economy will be, and with it the number of jobs and the level of wages. Getting cost recovery right is immensely important for the well-being of the population. Economic growth, not budgetary convenience, should be the determining factor in crafting cost recovery in tax reform.

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