President’s Advisory Panel on Federal Tax Reform

Capital Cost Recovery: Why it matters for tax reform

Andrew B. LyonPricewaterhouseCoopers LLPApril 18, 2005

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Capital Cost Recovery Allowance is Main Difference Between an Income Tax and a Consumption Tax

• A pure income tax includes a tax on the return to a capital investment. - Achieved by permitting a deduction only for the actual decline in

value of an asset (economic depreciation)

• A cash-flow consumption tax (e.g., VAT, flat tax) exempts the ordinary return (or opportunity cost) to a capital investment.- Achieved by permitting an immediate deduction for the entire cost

of an asset (expensing)- For a marginal investment, the immediate deduction for the

asset’s cost is equal in present value to the tax paid on the return to the investment

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Capital Cost Recovery under an Income Tax

• An income tax provides a deduction for the costs associated with earning income: tax applies to income not receipts

- Expenditures that do not give rise to a future benefit are deducted currently

- In contrast, capital expenditures are generally recovered over time through depreciation allowances

• The decline in an asset’s value over time is depreciation

- Physical wear and tear may reduce the remaining productive period of an asset or reduce its current output

- Obsolescence may cause a decline in value

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Depreciation is Quantitatively Important

• In 2002, gross corporate depreciable and amortizable assets were valued at $10 trillion (historical cost)

• In 2002, corporate depreciation and amortization deductions totaled $825 billion

- By comparison, 2002 corporate income, net of deductions except depreciation and amortization, was $1.4 trillion

- In late 1990s, depreciation and amortization were more than 40 percent of corporate income before this deduction

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Investment Incentives Vary with Permitted Depreciation

For a particular equity-financed investment, rate of tax paid on the return varies with the permitted depreciation deduction:

expensing

0%

Statutory rate (35%)

economic depreciation w/inflation indexing

accelerated depreciation

Marginal Effective Tax Rate

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Depreciation Affects the Efficient Allocation of Capital Stock

• For any overall level of capital investment, the efficient allocation of capital requires that investment be taxed equally—neutral investment incentives across all assets

• For equity-financed investments:

- Economic depreciation is neutral

- Expensing is neutral

- Combinations of partial expensing and partial economic depreciation are neutral (Bradford, 1981)

- If tax depreciation is not neutral, capital will be allocated inefficiently. The cost of an inefficient allocation of capital is fewer goods and services being produced than is otherwise achievable.

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Capital Cost Recovery Rules under the Tax CodePlant and Equipment

Depreciation rules specify a recovery period and a recovery method- Asset classification systems date back to 1962 and earlier- Specific recovery periods last established in 1986 Act

Equipment: assigned one of seven recovery periods, ranging from 3 years to 25 years

- Most equipment investment recovered over 5 or 7 years

- Recovery methods range from double declining balance to straight line

Buildings: 27.5 years (residential), 39 years (nonresidential)

- Straight-line recovery method

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Capital Cost Recovery Rules under the Tax Code

Special items

• Historical cost: no adjustment for inflation

• Bonus depreciation (partial expensing): property with a 20-year or less recovery period (9/11/01-12/31/04)

• Section 179 expensing for equipment investments by small business: $105,000 in 2005 (indexed) ($25,000 indexed after 2007)

• Alternative minimum tax: requires a second set of depreciation calculations and records for most assets− For most equipment, a slower recovery method is used, but same

recovery period

• Pre-1986: Investment tax credit of up to 10% of cost of equipment

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Capital Cost Recovery Rules under the Tax CodeIntangible Capital

• Most investments in self-created intangible capital are expensed (e.g., research and development and advertising)

- Credit up to 20% applies to increase in R&D over base (expires after 2005)

- Certain intangible investments capitalized

• Purchased intangibles generally amortized over 15 years (e.g., goodwill, customer lists)

Land

• Costs generally not recoverable

Inventory

• Costs of producing inventory recovered when inventory sold

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Is There a Need for Change?2000 Treasury Study:

• “The current depreciation system is dated. The asset class lives that serve as the primary basis for the assignment of recovery periods have remained largely unchanged since 1981, and most class lives date back at least to 1962.”

• “Entirely new industries have developed in the interim, and the manufacturing processes in traditional industries have changed. These developments are not reflected in the current cost recovery system, which does not provide for updating depreciation rules to reflect new assets, new activities, and new production technologies.”

• “…we do not know with any degree of certainty what economic depreciation rates should be, even on average, for aggregated classes of investments”

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Is There a Need for Change?

• System is antiquated: Estimates of economic depreciation in use at time of 1986 Act date back to studies in late 1970s commissioned by Treasury, preceded significant growth in new types of technological investments- 1970s researchers used prices of surplus government

typewriters to determine depreciation rate for computing equipment (Hulten and Wykoff, 1981)

- More recent estimates by researchers suggest personal computers depreciate twice as fast (Dunn, Doms, Oliner, and Sichel, 2004)

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Is There a Need for Change?• System is arbitrary: Identical asset treated differently depending on the

industry of the company that owns it

Example:

- Natural gas gathering lines owned by pipeline companies argued by IRS to be recovered over 15 years; if owned by gas producer recovered over 7 years

• Difficult to get correct: continuous technological change; differences across uses; limited active markets to observe prices of used productive assets- Treasury authority to update asset classifications provided under 1986

Act was revoked by legislation in 1988

• Creates inefficiency: Varying investment incentives across assets results in an inefficient allocation of capital and less production than is possible

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Thoughts on Reform Several possible goals: Efficient allocation of capital; administrative

ease; overall rate of tax applying to capital investments

• Efficient allocation of capital requires either expensing or tax depreciation that is related to economic depreciation (or combination of both)- If desire a system related to economic depreciation, the difficulty of

ascertaining true economic depreciation requires extensive initial study and constant monitoring

- Expensing requires fewer factual determinations

• Administrative ease, for example a single recovery period of x years, can conflict with efficient allocation of capital

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Thoughts on Reform• Overall rate of tax can be lowered either through partial

expensing or by reducing the statutory tax rate- Movements toward expensing encourage new investment

without reducing tax rates on existing investments - Transition effects of expensing may reduce value of

existing capital - Statutory rate reductions reward both new and old

investments; but rate reductions may have a more significant impact on internationally mobile and highly profitable investments

- Both changes can promote efficient allocation of capital

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Selected ReferencesBradford, David F., 1981. “Issues in the Design of Savings and Investment Incentives.” In Depreciation, Inflation,

and the Taxation of Income from Capital, ed. Charles R. Hulten, Washington: Urban Institute.

Brazell, David, Lowell Dworin, and Michael Walsh, 1989. “A History of Tax Depreciation Policy.” Office of Tax Analysis Paper no. 64. U.S. Treasury Department.

Brazell, David and James B. Mackie III, 2000. “Depreciation Lives and Methods: Current Issues in the U.S. Capital Cost Recovery System.” National Tax Journal, v. 53, no. 3, pp. 531-62.

Dunn, Wendy, Mark Doms, Stephen Oliner, and Daniel Sichel, 2004. “How Fast Do Personal Computers Depreciate? Concepts and New Estimates.” National Bureau of Economic Research, working paper no. 10521.

Gentry, William and R. Glenn Hubbard, 1996. “Distributional Implications of Introducing a Broad-Based Consumption Tax.” National Bureau of Economic Research, working paper no. 5832.

Hulten, Charles R. and Frank Wykoff, 1981. “The Measurement of Economic Depreciation.” In Depreciation, Inflation, and the Taxation of Income from Capital, ed. Charles R. Hulten, Washington: Urban Institute.

Lyon, Andrew B., 1992. “Tax Neutrality under Parallel Tax Systems.” Public Finance Quarterly, v. 20, no. 3, pp. 338-58.

Lyon, Andrew B. and Peter Merrill, 2001. “Asset Price Effects of Fundamental Tax Reform.” In Transition Costs of Fundamental Tax Reform, eds. Kevin Hassett and R. Glenn Hubbard, Washington: American Enterprise Institute.

U.S. Department of the Treasury, 2000. Report to the Congress on Depreciation Recovery Periods and Methods.