Inefficiencies Created by the Tax System’s Dependence on Economic Depreciation

June 12, 2020

One idea that would help the nation’s economic recovery during the coronavirus crisis would be moving to full expensing of capital investment. The depreciation debate might seem confusing, so the question at hand is: how, when, and by what amount can businesses recognize (or recover) the cost of a capital investment, like a piece of equipment or a new warehouse, on their income tax return?

  • Should capital investment costs be fully deducted as an expense when the asset is purchased (full expensing)?
  • Or, should the cost be spread out over the assumed economic life of the asset by some formula (depreciation)?

We argue that full expensing, rather than economic depreciation, is the appropriate tax treatment of capital investment. Reliance on economic depreciation ignores key issues of timing and opportunity cost, and is highly complex and hinders economic growth.

Income is a net concept—revenue minus the cost incurred to produce the revenue. So to measure income accurately, the timing and amount of deductions for capital investment need to be correct. The federal income tax system, however, is built on a definition of income defined as the sum of consumption and the change in net worth, or the change in the ability to consume, known as the Haig-Simons definition of income.

Under this definition, because the value of a capital investment declines over time, the tax code allows businesses to deduct part of their capital investment each tax year. Devaluation of capital investment takes time, so depreciation schedules can stretch out for decades for some assets, ignoring how a dollar today is worth more than a dollar tomorrow.

To illustrate this, suppose a business makes a $500 capital expenditure. If the business were required to use straight-line depreciation deductions, the present discounted value of the deductions to the business would total to $462, less than the $500 expenditure. Under full expensing, the firm could immediately deduct the full $500, receiving a deduction equal to the expenditure in present value terms.

  Year 1 Year 2 Year 3 Year 4 Year 5 Total

Straight Line Depreciation

$100 $100 $100 $100 $100 $500

Present Value

$100 $96 $92 $89 $85 $463
 

Full Expensing

$500 $0 $0 $0 $0 $500

Present Value

$500 $0 $0 $0 $0 $500

Source: Author calculations. Assumes a 4 percent discount rate.

The problem is that because of the time value of money and inflation, delayed write-offs have a lower present value than the original cost. If the business is required to deduct its cost over a longer period, the real value of the deductions would fall further. This means that in real terms, business costs are understated and business profits are overstated, leading to a tax penalty on investment.

In addition to increasing the cost of making investments, another shortcoming of depreciation is how the schedules are defined. Economic depreciation attempts to track changes in the value of the assets that a business owns and the amount a business might realize if it were to sell the assets. This rationale is rooted in the Haig-Simons definition of income. The Tax Foundation’s Stephen Entin explains why this is problematic:

Of course, businesses do not normally sell their assets every year to engage in consumption. Their money remains locked up in their production assets as long as they are economically useful. Employing economic depreciation for tax purposes ignores the time value of money and the opportunity cost of these funds. If economic depreciation could be calculated and employed in a perfectly uniform manner, it would still lead to an understatement of cost and an overstatement of income compared to expensing, imposing a penalty for saving and investing instead of consuming one’s income.

In practice, economic depreciation is difficult, if not impossible, to set rules for and predict. For example, if a business purchases an automobile, it is classified as 5-year property. That categorization does not allow nuance for how frequently or where a business is using the automobile nor the differences in quality between the make/model of an automobile, all of which affect the time it takes for the automobile to wear out.

The current tax code contains a mix of cost recovery policies, some of which attempt to provide an “allowance for the wear and tear, deterioration, or obsolescence of the property” and others that accelerate the depreciation process. For example, the straight line method under the Alternative Depreciation System (which has longer asset lives than the General Depreciation System) is the closest approximation of economic depreciation under current law, while 100 percent bonus depreciation for some assets is the closest approximation of full expensing.

It’s also important to recognize different purposes for which businesses calculate their income, such as income taxes and financial statements. While it may seem that these two purposes should be similar, they serve different functions and have varying definitions. Firms report their book income to shareholders via their publicly available financial statements, which is dictated by accounting standards that generally follow the idea of depreciation. On the other hand, Congress sets the rules for how businesses calculate their taxable income, often with factors other than accounting principles in mind, so tax and book income and depreciation can and do differ.

The accounting profession tends to say that the difference between methods of depreciation comes down to timing:

Generally, the difference between book depreciation and tax depreciation involves the “timing” of when the cost of an asset will appear as depreciation expense on a company’s financial statements versus the depreciation expense on the company’s income tax return. Hence, the depreciation expense in each year will likely be different, but the total of all of the years’ depreciation expense for an asset will likely add up to the same total.

However, the timing of costs matters, as illustrated above. The time value of money and the opportunity cost of having funds tied up in a capital investment affect the decision to make an investment, as delays in depreciation deductions reduce the real value of the deductions.

Further, as stated in a previous Tax Foundation post, economists have not reached a consensus on the complexities of economic depreciation: “A 2006 study estimated the [depreciation] 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.”

Even if it were realistic to perfectly calculate and apply economic depreciation, such a system would still understate business costs, overstate business income, and bias the tax code against capital investment compared to full expensing. Any delay in taking deductions ignores the time value of money, distorts the cost of capital, and reduces economic output.

Economic depreciation is not economically efficient or ideal; only expensing (or a close economic equivalent, like neutral cost recovery) can provide an unbiased and economically efficient method of cost recovery for tax purposes.

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