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.
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Capital Cost Recovery:
Why it matters for tax reform
Andrew B. Lyon
April 18, 2005
- 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
- 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
- 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
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%)
economic depreciation w/inflation indexing
- 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.
Plant and Equipment
Depreciation rules specify a recovery period and a recovery method
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
- Credit up to 20% applies to increase in R&D over base (expires after 2005)
- Certain intangible investments capitalized
2000 Treasury Study:
- 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
Several possible goals: Efficient allocation of capital; administrative ease; overall rate of tax applying to capital investments
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 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.