Capital Cost Recovery and
Fundamental Tax Reform
President’s Advisory Panel on Federal Tax Reform
Kevin A. Hassett
AEI
Overview of Testimony
Four Issues
 Where do the depreciation rules fit into the
theory of tax reform?
 How big are the distortions associated with
current law?
 What do we know about the effect of
depreciation rules on economic activity?
 Given the importance of neutrality, is the
current research credit good tax policy?
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Depreciation Rules and the
Theory of Tax Reform
 Tax reform proposals are motivated by two
insights from the literature on the optimal design of
a tax system:
– A tax system should not favor one type of input over
another. If it does, then economic inefficiency results.
(Diamond and Mirlees)
– A tax system should not tax capital income, as taxes on
capital income impose distortions that explode over
time. (Chamley, Judd)
 Current depreciation rules violate both principles.
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Depreciation Rules and the
Theory of Tax Reform (cont.)
 Depreciation rules and economic distortions
– Tax depreciation rules create economic distortions when
the depreciation allowance differs from true economic
depreciation. This leads firms to substitute tax-favored
types of equipment for other types of equipment.
– Current depreciation rules introduce a non-optimal tax on
capital because firms do not receive the full benefit of
depreciation in the year that they purchase an asset. With
expensing, a dollar spent on a machine, for example,
would generate a deduction worth one dollar. When a
deduction is spread out over many years, the present
value of the deduction declines sharply.
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Depreciation Rules and the
Theory of Tax Reform (cont.)
 Estimates suggest that the economic cost resulting from the
differential tax treatment of capital goods is relatively
inconsequential. (Auerbach)
 However, the tax on capital income, which includes the
corporate and individual income taxes on capital income, likely
has very large efficiency effects. Recent studies of the gains
from a wholesale switch to a consumption tax suggest that
output could increase enormously, with a healthy share of the
gain attributable to lower taxes on capital income. (Altig et al.)
 Accordingly, almost all of the benefit from revising depreciation
rules would come from the associated reduction of the tax on
capital income if depreciation allowances were expanded in
the direction of expensing and not from an improved allocation
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of business investment across assets.
How Big Is the Distortion?
 Current law gives firms deductions that are lower
in present value than what they could take with
expensing.
– For 7-year tax life assets, each dollar of equipment
spending is allowed a deduction worth only 84 cents in
present value. With expensing, firms could deduct the
full dollar of spending.
– For 5-year equipment, the current deduction is worth 88
cents.
– For 3 year equipment, the current deduction is worth 94
cents. (Cohen, Hansen and Hassett)
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Depreciation Rules and the
Cost of New Investment
 Since the value of the deduction is lower than
under expensing, the cost of investing is higher.
This drives down investment and reduces
economic activity.
 Assuming a 42% corporate tax rate (35% federal
statutory tax rate plus an average 7% state and
local tax rate), the cost of new investment under
current law relative to expensing is:
– 11.5 percent higher for 7-year equipment
– 8.7 percent higher for 5-year equipment
– 4.3 percent higher for 3-year equipment
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The Effect of Depreciation Rules on
Economic Activity
 A large literature exists that has found a strong and
statistically significant link between taxes that affect the cost
of investment and investment activity. (Hassett and Hubbard)
– The basic investment model can take many different forms. The
implied responsiveness of investment to tax policy is remarkably
similar across specifications and data sets.
 A recently updated study found results that reinforced these
findings, suggesting that the effects of tax policy on
investment may be even larger. (Desai and Goolsbee)
 While the economic science is an uncertain one, the link
between tax policy and investment is one of the betterdocumented and least-disputed results in the literature on
the effects of taxation on economic activity.
 Tax reforms that reduce the tax on investment activity will
almost certainly significantly spur investment.
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Is it Ever Appropriate to Favor
Certain Types of Investment?
 Economic theory tells us that under some conditions it is
optimal for the government to subsidize particular types of
capital.
– For example, monopolists tend to increase profit by reducing output.
The result is an inefficiently low level of output. Subsidizing the
capital expenditures of monopolies, although politically infeasible, can
move the economy toward a better outcome by inducing them to
produce more output.
– More interestingly, some activities may have positive external effects.
Chief among these are research and development expenditures.
Since research discoveries often lead to additional discoveries, the
social benefit from research is greater than the private benefit, with
some estimates suggesting the benefit to society is double the private
benefit. Accordingly, in theory, it may be beneficial to provide special
subsidies for research.
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The Current Research Credit
is Terrible Tax Design
 Designing an efficient subsidy to encourage new research expenditures
is difficult (who should be undertaking the research, how much research
should be undertaken, etc.).
 Credits to encourage research activity through the tax code may be
even more difficult to structure.
– Requires not only picking the appropriate research activities to subsidize,
but also ensuring that the firms who should be undertaking the beneficial
research are the firms receiving the subsidy. (Does research into new types
of potato chips qualify?)
– Credits that attempt to reward incremental expenditures can be extremely
complicated and of questionable effectiveness. (Altshuler)
– Moreover, Section 382 limitations often eliminate tax benefits for small
innovative firms. Equity issuance can count as an ownership change and
essentially eliminate benefits that are carried forward. Unless credits are
refundable, it may be difficult to provide a tax benefit to the most innovative
start-up firms.(Hassett)
 While in theory a credit to encourage additional research may be
appropriate, in practice it is has been impossible to get right.
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References
 Altig, David, et al. (2001). “Simulating Fundamental Tax Reform in the
United States,” American Economic Review 91(3): 574-595.
 Altshuler, Rosanne (1988). “A Dynamic Analysis of the Research and
Experimentation Credit,” National Tax Journal 41(4): 453-466.
 Auerbach, Alan J. (1989). “The Deadweight Loss from ‘Nonneutral’
Capital Income Taxation,” Journal of Public Economics 40(1): 1-36.
 Chamley, Christophe P. (1986). “Optimal Taxation of Capital Income in
General Equilibrium with Infinite Lives,” Econometrica 54 (3): 607-22.
 Cohen, Darrel S., Dorthe-Pernille Hansen, and Kevin A. Hassett
(2002). “The Effects of Temporary Partial Expensing on Investment
Incentives in the United States,” National Tax Journal 55(3): 457-466.
 Desai, Mihir and Austan Goolsbee (2004). “Investment, Overhang, and
Tax Policy,” Brookings Papers on Economic Activity 2: 285-338.
 Diamond, Peter A. and James A. Mirrlees (1971). “Optimal Taxation
and Public Production,” American Economic Review 61: 8-27, 261-278.
 Judd, Kenneth L. (1985). “Redistributive Taxation in a Simple Perfect
Foresight Model,” Journal of Public Economics 28 (1): 59-83.
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References (cont.)
 Hassett, Kevin A. (2003). “Taxation and the Incentive to Invest in the
Biotech Industry,” White Paper, Biotechnology Industry Organization.
 Hassett, Kevin, and R. Glenn Hubbard (2002). “Tax Policy and
Business Investment,” in Handbook of Public Economics Vol. III, edited
by Auerbach and Feldstein. Amsterdam: Elsevier Science B.V., 12931343.
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