Information Regarding the Depreciation of Assets

Report
November 21, 2013

Letter to the Honorable Max Baucus

This letter responds to a request by the committee staff that CBO, in consultation with the staff of the Joint Committee on Taxation, provide information regarding the depreciation of tangible assets (the rate at which assets wear out or become obsolete). The current tax code contains a schedule of depreciation rates, with different rates assigned to different types of assets. Taxpayers use those rates to compute a depreciation deduction—that is, the dollar amount of asset depreciation that can be subtracted from their gross income—and thus reduce the amount of taxes they owe. Those tax depreciation rates, however, often differ from the rate of actual (or “economic”) depreciation.

The first item requested by the committee staff was a categorization into five groups of the asset classes specified by the Internal Revenue Service (in Revenue Procedures 87-56 and 88-22). Four of the groups (referred to as “pools” in the request) were defined by the committee staff largely in terms of a specified range of economic depreciation rates; the fifth group consists of real property, such as buildings, land, and certain other structures. In a few cases, the committee staff assigned certain types of assets to specific pools regardless of their economic depreciation rate. CBO computed the weighted average economic depreciation rate within each of the four pools. The list of asset classes in each group and the weighted average economic depreciation rates for the four pools are shown in Table 1 in the complete document.

The committee staff also asked CBO to make the following two adjustments to the weighted average rates of economic depreciation in each pool:

  • The first was an adjustment for inflation. The average economic depreciation rates shown in Table 1 account for the decline in asset values over time in the absence of inflation. Over time, however, rising prices boost the nominal value of an asset—and thus the amount of its economic depreciation. Without an adjustment for inflation, the annual deduction would understate the nominal decline in the value of an asset during a tax year. When making this adjustment, CBO used a projected rate of inflation of 2.18 percent per year.
  • The second was an adjustment to reflect a “half-year convention”—that is, an assumption that assets are, on average, placed in service on July 1. The rates shown in Table 1 reflect an assumption that all assets are placed in service on January 1. Accounting for the half-year convention, therefore, required a downward adjustment—the equivalent of disallowing six months of depreciation deductions during the first year of service.

The results of the two adjustments are shown in Table 2 in the complete document. On balance, the adjusted recovery rates derived by CBO are higher than the weighted average rates of economic depreciation. CBO estimates that the adjusted recovery rates for the four pools would be as follows:

Table 1

The adjusted recovery rate for Pool 3 exceeds the maximum economic depreciation rate for machinery and equipment in that pool because of the adjustment for inflation and the inclusion of personal property with no class life (that is, property that is not explicitly addressed by the Treasury Department’s regulations governing depreciation deductions).

The third item requested by the committee staff concerns the depreciation schedule for real property (the fifth group). Real property is typically depreciated for tax purposes using a straight-line approach—that is, the difference between the initial cost of an asset and its scrap value at the end of its useful life, divided equally among the years in that period. CBO was asked to estimate the length of the period under the straight-line approach that would generate the same value of depreciation deductions for real property as would applying the average economic depreciation rate after adjusting for inflation. CBO estimates that period to be 43 years.