When calculating their taxable income, companies can deduct the expenses they incurred when producing tangible goods or providing services for sale, including depreciation—the drop in the value of a productive asset over time. The tax code sets the number of years, or service life, over which the value of different types of investments can be deducted from taxable income.
In recent years, the tax code has permitted firms to accelerate depreciation deductions for equipment. Firms were allowed to expense—that is, immediately deduct from taxable income—100 percent of the costs of investment in equipment made between September 8, 2010, and December 31, 2011. For equipment acquired between January 1, 2012, and December 31, 2013, firms were able to immediately deduct 50 percent of the cost. After 2013, current tax law will revert to the typical rules, which allow no expensing (except in limited cases) and generally require firms to deduct their investments in equipment over a number of years.
This option would extend the lifetime of equipment and certain structures placed into service after December 31, 2013, for purposes of tax depreciation. Specifically, where the tax code currently stipulates a lifetime of 3, 5, 7, 10, 15, or 20 years for a given type of equipment, this option would increase those lifespans to 4, 7, 9, 13, 20, or 25 years, respectively. If implemented, those changes would increase revenues by $272 billion over the 2014–2023 period, the staff of the Joint Committee on Taxation estimates.
An argument in favor of this option is that the current rates of tax depreciation overstate the decline in the economic value of assets because they do not accurately reflect the rate of inflation that is likely to occur over an asset’s lifetime. Because rates of depreciation are set by the tax code and depreciation deductions are not adjusted, or indexed, for inflation, the real (inflation-adjusted) value of the depreciation allowed by tax law depends on the rate of inflation.
Most rates of depreciation in the tax code today were set in the Tax Reform Act of 1986 and, if the average rate of inflation since that time was 5.0 percent, they would approximate the rate of economic depreciation (the decline in an asset’s economic value, including the impact of inflation over time). The Congressional Budget Office estimates, however, that inflation over the next decade will average about 2.3 percent annually. That difference of nearly 3 percentage points means that, if those rates of depreciation stay the same, businesses will be able to deduct larger amounts of depreciation from taxable income—and thus have a lower tax liability—than they could if the deduction accurately measured economic depreciation.
Another argument in favor of this option is that it would equalize effective tax rates on the income generated by different types of investment. (Effective tax rates measure the impact of statutory tax rates and other features of the tax code in the form of a single tax rate that applies over the life of an investment.) Equipment and structures are two of the main types of tangible capital for which businesses take depreciation deductions, and the effective tax rates are currently quite different. Under the law currently in effect for 2014, if inflation was 2.3 percent and the real discount rate (which adjusts for the change in the value of a dollar over time) for businesses was 6.2 percent, the average effective tax rates on income from corporate investment would be 26.4 percent for equipment and 29.4 percent for structures. In contrast, under this option, those rates would be 30.1 percent for equipment and 30.4 percent for structures. That near parity would mitigate the incentive that exists in the tax code for companies to invest more in equipment and less in structures than they might if investment decisions were based on economic returns.
Those effective tax rates would differ if inflation was different, however. If the rate of inflation was a percentage point lower, the effective tax rate under this option would be 28.1 percent for equipment and 29.2 percent for structures. Conversely, if inflation was a percentage point higher, the rates for equipment and structures would be 31.9 percent and 31.4 percent, respectively. Therefore, if inflation differed from CBO’s expectations, new distortions between investment in equipment and structures would emerge over the long run.
An argument against this option is that low tax rates on income generated by capital would encourage investment. From that perspective, effective tax rates might best be equalized by easing taxation on all forms of capital rather than by raising the effective tax rate all capital or on a type of capital that is now favored. Moreover, by raising effective tax rates on business investment, this option would exacerbate the current tax bias in favor of owner-occupied housing relative to business investment.
|(Billions of dollars)||2014||2015||2016||2017||2018||2019||2020||2021||2022||2023||2014-2018||2014-2023|
|Change in Revenues||6||18||28||33||37||39||35||29||25||23||122||272|
Source: Staff of the Joint Committee on Taxation.
Note: This option would take effect in January 2014.