This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
This week we’re looking at “accelerated depreciation,” the IRS rule allowing businesses to write off the costs of investments faster than they actually wear out.
What is accelerated depreciation?
Accelerated depreciation is the set of IRS rules that allow businesses to deduct from their taxable income the declining value of business-related investments, such as equipment and machinery, faster than the value of those assets actually declines.
Consider the following example of how accelerated depreciation works: A delivery business purchases a new truck to expand its business and thus increase its revenues each year. But the truck is only expected to last several years before it breaks down. It is a “depreciating” asset.
Keep in mind that our income tax system is intended to tax only business profits, or gross revenues minus costs. That means businesses are allowed to take deductions for costs, including long-term investments. The business in our example is therefore allowed to deduct from its income the cost of the truck—but the deduction must be spread out over the several years that the truck is expected to be used in the business.
In theory, the annual deduction should reflect how much the property has depreciated that year. Our tax system is actually more generous than that.
According to existing rules, the delivery business can “write off” or take depreciation deductions equivalent to more than half of the truck’s cost in the first two years it is used in the business. The rest of the truck’s cost would be deducted more gradually over the remainder of the depreciation period.[1]
In reality, the truck will probably wear out slower and last longer than the tax code assumes. That’s why we say the depreciation deduction is “accelerated.”
In general, the tax code’s depreciation methods allow taxpayers to take bigger deductions sooner than they would if the tax deduction tracked actual or “economic” depreciation.[2]
Why is accelerated depreciation a “tax expenditure”?
Special tax breaks are considered “tax expenditures” because they are essentially government spending programs that give out tax breaks instead of direct payments.
How much does it cost?
According to estimates by the Treasury Department, accelerated depreciation of machinery and equipment will cost the federal government $24.5 billion in fiscal year 2012, and $270 billion over the next five years.
Those estimates likely do not take into effect the additional cost of recent legislation. Under legislation passed by Congress in December and signed by President Barack Obama, businesses are allowed to “expense” new longer-term investments in 2011. That means they can deduct the entire cost of new investment purchases this year. This special rule is intended to jumpstart business investment, which had been lagging.
The same legislation also extended “bonus depreciation” through 2012. Bonus depreciation is a kind of extra-accelerated depreciation that allows businesses to immediately deduct 50 percent of an investment’s cost, with the rest of the costs deducted in later years under the regular accelerated depreciation rules.
Who benefits?
Accelerated depreciation is one of the largest corporate subsidies in the tax code. It allows taxpayers to take bigger deductions, and therefore pay smaller tax bills, in the earlier years of an investment. Accelerated depreciation therefore subsidizes business investments.
According to the Congressional Research Service, the direct benefits of accelerated depreciation “accrue to owners of assets and particularly to corporations. . . . Benefits to capital income tend to concentrate in the higher-income classes.”[3]
There are specific depreciation rules for each kind of business property, so some investments are subsidized more than others. A 2000 report by the Treasury Department found that the tax subsidy is particularly high for investments in equipment, public utility property, and so-called intangibles, such as intellectual property.[4]
Moreover, some industries have succeeded in carving out special depreciation rules. A tax rule inserted into the 2008 farm bill, for example, allows horse breeders to write off the cost of their investments (horses) over three years, though a Treasury report found that racehorses actually have a much longer useful life.[5]
What’s the downside of accelerated depreciation?
Depreciation rules create incentives to shift business investment toward the areas that have the most favorable tax consequences, even if they are not always the best investments.
Another concern is that investments made with borrowed money allow taxpayers to combine depreciation deductions with those for interest expense to achieve extremely low, or even negative, tax rates on their investments. According to the Congressional Budget Office, “[A]ccelerated depreciation and interest payments generate tax deductions in excess of taxable income, which leads to corporate tax refunds.”[6]
One thing that can be said in favor of accelerated depreciation is that it provides more favorable rules for domestic investment than for foreign investment; in this sense, the depreciation rules counteract the other, substantial tax incentives for companies to invest offshore. The new focus on corporate tax reform is an opportunity to reduce unjustified loopholes and rebalance incentives toward job creation in the United States.
Accelerated depreciation in general should be thought of as a multibillion-dollar federal spending program that subsidizes business investments. And when they single out specific industries for special benefit, depreciation rules are akin to spending “earmarks.” The only difference is they come in the form of tax breaks rather than direct spending programs.
Accelerated depreciation rules should therefore be subject to the same level of scrutiny as direct spending programs of similar magnitude.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions.
Endnotes
[1] Under a “straight-line” depreciation system, the business would be allowed to deduct an equal amount per year over the cost-recovery period. But our tax code allows the business the option of taking bigger deductions at the beginning of the period using an alternative method called the “double declining balance” method. Types of property classified as having longer useful lives are eligible for a 150-percent declining balance method, under which deductions in early years are more than under a straight-line method but less than under the double declining balance method. The depreciation deductions would actually span six different tax years; the year the property is first used in the business is counted as a half-year, and another half-year is added at the end of the recovery period. A separate, related rule (section 179) allows small businesses to “expense” (deduct immediately) investments up to a certain limit.
[2] This is especially true when inflation is relatively low, as it has been. See Department of the Treasury, “Report to The Congress on Depreciation Recovery Periods and Methods” (2000), p. 2, available at http://www.treasury.gov/resource-center/tax-policy/Documents/depreci8.pdf.
[3] Congressional Research Service, “Tax Expenditures: Compendium of Background Material on Individual Provisions” (2010), p. 437.
[4] Many of the expenses that go into producing intangible assets, like research and advertising, can be deducted immediately.
[5] Department of the Treasury, “Report to Congress on the Depreciation of Horses” (1990), available at http://www.treasury.gov/resource-center/tax-policy/Documents/depreci8study_horses.pdf.
[6] Congressional Budget Office, “Taxing Capital Income: Effective Rates and Approaches to Reform” (2005), p. 8. For further discussion, see Michael P. Ettlinger, “Our Bucket is Leaking,” in Bad Breaks All Around, (Washington: The Century Foundation, 2002), p. 119.