Capital cost recovery and tax reform (Spoiler alert: Tax nerd moment)


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Eakinomics: Capital cost recovery and tax reform (Spoiler alert: Tax nerd moment)

There is a lot of talk about the potential for tax reform this year, and some news reports that the White House, House and Senate negotiate a single compromise plan that will be released after the August recess. According to Axios, “One of the most difficult disputes that remains is whether to start letting companies immediately write off the cost of equipment (known as ‘full expense’). It would be extremely expensive, so some Conservatives are opposed to it. But House Leadership argues it would boost economic growth in the short term. “

The question revolves around what are called depreciation allowances. These are deductions that the tax code allows companies that make capital investments. In full expensing, if a business spends $ 100 on a new machine, they deduct $ 100 (the total cost) in the year of the investment. Under traditional depreciation regimes, deductions would be spread over the expected life of the machine. For example, with an expected life of 2 years, the business would deduct $ 50 in each of the first two years. So-called “accelerated” depreciation approaches prefigure deductions, but spread them all the same over the life of the investment. In this example, deducting $ 75 in the first year and $ 25 in the second year would be a form of accelerated depreciation. From this point of view, the full charge is only an extreme form of accelerated depreciation.

In short, the problem is simple. The shift from expensing to accelerated depreciation broadens the short-term tax base; the switch to straight-line damping does it even more. A larger base allows lower rates to increase the same income. The broader base, however, means that instead of having a $ 100 deduction to free up money to invest, the business only has $ 75 or less. This makes the tax system more expensive and decreases the incentives. (Another point is that if some investments get expedited processing and others get straight-line depreciation, then the tax code is non-neutral and starts to distort investment choices. Expense avoids this entirely. .)

You might think that’s it. Tax policymakers simply have a difficult choice between lower rates and better investment incentives. But not so fast. It is possible to compensate companies for the cost of immobilizing their funds; it is the rate of return lost on the investment that has been lost. In practice, this amounts to paying interest on future depreciation deductions. In my simple example, at current rates, the depreciation would be $ 50 in the first year, but $ 51.18 in the second year. (Some readers may recognize that this makes the present value of capital cost allowance exactly the same as the expense, $ 1.)

So ! A wider base, lower rates and good investment incentives.

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