Extend the Period for Depreciating the Cost of Certain Investments

CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.

Billions of Dollars 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2017-2021 2017-2026
Change in Revenues 4.5 13.9 21.3 26.4 32.0 35.2 33.7 30.7 27.9 25.6 98.1 251.2

Source: Staff of the Joint Committee on Taxation.

This option would take effect in January 2017.

When calculating their taxable income, businesses can deduct the expenses they incurred when producing tangible goods or providing services for sale. One of those deductions is for depreciation—the drop in the value of a productive asset over time as a result of wear and tear or obsolescence. The tax code sets the number of years, or recovery period, over which the value of different types of investments can be deducted from taxable income and specifies what percentage of the cost can be deducted in each year of the period.

Equipment and structures are the two main types of tangible assets for which businesses take depreciation deductions. The tax code generally specifies recovery periods for equipment of between 3 and 20 years (with 5 years being the most common) and permits firms to accelerate the associated depreciation deductions so that those claimed early in the period are larger than those claimed later. Most structures have recovery periods longer than 20 years (with 39 years being the most common). The cost of structures with recovery periods in excess of 20 years must be recovered by deducting equal amounts in each year over that period.

The ability to accelerate depreciation deductions reduces the effective tax rate on income from investment in equipment relative to that on income from investment in structures. (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.) The Congressional Budget Office estimates that businesses subject to the corporate income tax face an effective tax rate for equipment of 23.4 percent—9.6 percentage points less than the rate would be if deductions were limited to the actual decline in value (that is, economic depreciation). The corresponding effective tax rate for structures is 29.5 percent, which is 3.8 percentage points lower than if deductions were limited to economic depreciation.

This option would extend the recovery periods of assets placed into service after December 31, 2016, if those assets currently have recovery periods of 20 years or less. Specifically, where the tax code currently stipulates recovery periods of 3, 5, 7, 10, 15, or 20 years for a given type of asset, this option would increase those recovery periods to 4, 7, 9, 13, 20, or 25 years, respectively. If the current recovery period is greater than 20 years, it would not change under the option. Furthermore, the recovery periods for intangible assets, including computer software, would remain the same as under current law. Any asset that currently qualifies for accelerated depreciation would continue to qualify. If implemented, the option would increase revenues by $251 billion over the 2017–2026 period, the staff of the Joint Committee on Taxation estimates. (Because of the temporary expensing provisions that continue through 2019, the revenue gains would be smaller in the earlier years and greater in the later years than they would be in the absence of expensing.)

An argument in favor of this option is that it would make tax depreciation for equipment align more closely with economic depreciation. That, in turn, would make the effective tax rates on the income generated by different types of investment more equal. Under this option, the effective tax rates for businesses subject to the corporate income tax would be 28.2 percent for equipment and 29.9 percent for structures—reducing the gap between equipment and structures from 6.2 percentage points to 1.7 percentage points. That narrowing of the gap 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 solely on economic returns.

An argument against this option is that its higher effective tax rates on income generated by capital would discourage investment. From that perspective, effective tax rates might best be equalized by easing taxation on less favored forms of capital rather than by raising the effective tax rate on a type of capital that is now favored. For example, the economic efficiencies gained by bringing the effective tax rates of equipment and structures closer together could be achieved by shortening the recovery periods of structures instead of by lengthening the recovery periods of equipment. However, that approach would reduce revenues. Another argument against this option is that 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.