What Should Capital Cost Recovery Ideally Look Like?

Senate Finance Committee Chairman Max Baucus (D-MT) has unveiled a tax reform proposal in draft form. (See links for the international the international and cost recovery discussion papers.) His plan emphasizes business taxation. House Ways and Means Committee Chairman Dave Camp (R-MI) is also crafting a tax reform plan. Many of its provisions are expected to deal with business taxes.

It is generally agreed that the corporate income tax rate needs to come down. The federal statutory rate is 35 percent, and the combined federal-state rate, at 39.1 percent, is higher than in any other developed nation. The average among OECD nations is about 25 percent.

A more contentious issue, but also a key one, is how quickly the tax code should let businesses claim deductions for their capital costs. (Capital mainly refers to equipment, structures, and intangibles. Tax write-offs are usually called depreciation for physical capital and amortization for intangibles.)

Businesses’ capital costs need to be written off when computing taxes because income is a net concept. Rather than being gross revenue, income is revenue minus the costs of producing the revenue. Moreover, to measure income accurately, the timing of the write-offs needs to be correct.

A short thought experiment helps explain why timing is so important. Suppose someone asks to borrow $1,000 from you today, offers enough collateral to remove any default risk, and promises to repay exactly $1,000, at a rate of $200 a year over the next 5 years. Is this an attractive deal for you? Of course not. First, because of inflation, the repayments will have less real value than the original $1,000. Second, because of basic human nature, people prefer the present over the future and require a reward for waiting. Accordingly, payments of $200 made over the next 5 years are inferior to $1,000 today due to the time value of money. This explains why lenders typically demand interest on loans and borrowers are willing to pay.

The example is relevant when thinking about capital cost recovery allowances because the tax system’s standard way of treating a capital cost incurred one year is to stretch out the write-off over a number of subsequent years. Although capital costs can sometimes be deducted immediately (e.g., section 179 and this year’s temporary 50 percent bonus depreciation), that is the exception, not the rule.

The problem is that because of the time value of money, delayed write-offs have a smaller present discounted value than the original cost. For instance, suppose investors in a business buy a $1,000 piece of equipment. If they have, say, a discount rate of 5 percent and if cost recovery allowances are spread out over the 5-year schedule described in the above example, the present value of the cost recovery allowances will be only $865.90. In present value terms, that falls $134.10 short of what the investment cost. Because costs are understated, income in present value terms—and the tax due on the income—will be overstated.

The result of the overtaxation will be a bias against capital formation and less investment. That will hurt economic growth, depressing people’s incomes and opportunities.

To measure investment costs accurately, the proper capital cost recovery system is expensing (first-year write-off). Expensing is more economically efficient than current law and, in addition, much simpler. A more complicated method for achieving the same result is to delay the write-offs but increase their nominal amounts by inflation and the time value of money so the delayed write-offs have the same present value as what the investments cost. (See link for a discussion of this method, which is known as neutral cost recovery.)

Some economists claim the ideal capital cost recovery system would be what is known as economic depreciation. Under economic depreciation, capital costs cannot be claimed when the costs are incurred; they can only be taken at the rate at which the assets lose economic value. Economic depreciation is the wrong approach because, like the would-be borrower who asks for $1,000 today in return for $200 yearly over the next 5 years, it ignores the time value of money.

A secondary problem is a data limitation. The rate of economic decay depends on the specific asset, industry, and firm and usually varies over time. Congress and the Treasury do not have enough information to take more than crude guesses at assets’ rates of economic depreciation. (For a more detailed discussion of why expensing is superior to economic depreciation, see here.)

Senator Baucus’s proposal would sharply lengthen cost recovery periods for many assets and move toward economic depreciation. The plan would be better if it shortened cost recovery periods and moved in the direction of expensing.