President’s Advisory Panel on Federal Tax Reform
Capital Cost Recovery:
Why it matters for tax reform
Andrew B. Lyon
PricewaterhouseCoopers LLP
April 18, 2005
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:
Marginal Effective Tax Rate
Statutory
rate
(35%)
0%
expensing
accelerated
depreciation
economic
depreciation
w/inflation
indexing
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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 Code
Plant 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 Code
Intangible 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 References
Bradford, 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 BroadBased 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.
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