Depreciation 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.
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 can deduct most ordinary business costs, such as wages, salaries, maintenance, advertising, etc. However, certain categories of expenses are not allowed to be deducted immediately, like 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, a system called the Modified Accelerated Cost Recovery System (MACRS) in the U.S. These gradual deductions for the cost of capital expenses are known as “depreciation deductions,” and have been a feature of the federal income tax since its enactment in 1913.
What Is the Effect of Delayed Deductions?
Stretching deductions over time reduces their present value, 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), this part of the tax code discourages businesses from investing, which results in less capital formation, lower productivity and wages, and less output.Share