As lawmakers work through the reconciliation process, permanently enacting improvements to deductions for capital investment and research and development (R&D) costs will create an economically powerful package. On the other hand, if lawmakers give in to budgetary pressures and only make temporary improvements to cost recoveryCost recovery is the ability of businesses to recover (deduct) the costs of their investments. It plays an important role in defining a business’ tax base and can impact investment decisions. When businesses cannot fully deduct capital expenditures, they spend less on capital, which reduces worker’s productivity and wages.
, it will undercut what would otherwise be a powerful economic incentive to invest in the United States.
The corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.
applies to profits—revenues minus costs—but defining costs isn’t always straightforward, especially for major capital investments. One view, favored by accountants, suggests investment costs should be depreciated over an asset’s useful life to match revenues with costs.
While useful in accounting, the matching approach has flaws as economic policy. Spreading deductions over time penalizes capital investment since future deductions lose value due to inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power.
and opportunity costs. For assets like nonresidential structures, depreciated over 39 years, businesses often deduct less than half their costs in present value terms.
Consider deductions for a $10,000 investment depreciated over 10 years. Assuming a conservative 3 percent real discount rate and a 2 percent inflation rate, a company recovers less than 80 percent of its costs when it is required to stretch deductions out over time, as illustrated in the table below.
Not being able to fully deduct the cost of investment means companies effectively end up paying taxes on profits that do not exist. In the 10-year asset example, depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment.
prevents the company from deducting more than 20 percent of its real costs. Multiplying the disallowed deductions by the corporate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities.
rate of 21 percent shows the company must pay 4.4 percent of the investment cost in taxes. In the case of a $10 million investment, that translates to almost half a million dollars in added tax costs.
Expensing offers a solution. Under expensing, businesses deduct capital costs immediately just as they do operating costs instead of spreading deductions out over time as they do under depreciation. Expensing lowers the cost of capital, spurring investment and expanding the capital stock by enabling projects previously unviable under depreciation rules. It also eases cash flow issues for businesses investing in expensive capital, fostering economic growth and efficiency.
Returning to the example above, if, instead of stretching deductions for the $10,000 investment out over 10 years, the firm immediately deducts the full $10,000 expenditure, then the tax system no longer artificially distorts the real value of the deductions. Under depreciation and expensing, firms deduct the same nominal investment costs, but, in real terms, immediate expensing is the only treatment that allows full cost recovery.
Transitioning from a tax system that relies on stretched-out depreciation deductions to immediate expensing will result in an upfront revenue loss from the perspective of the federal government budget. For example, if the government expected depreciation deductions for new investment to amount to $1 per year for 10 years, but instead depreciation deductions amounted to $10 in year 1 and $0 for the following years, the budgetary cost in year 1 would be $9 as deductions under the new policy are much larger than under the old policy. Over time, however, the upfront transition cost to faster cost recovery fades. For this reason, moving to full expensingFull expensing allows businesses to immediately deduct the full cost of certain investments in new or improved technology, equipment, or buildings. It alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs.
for capital investment costs less than one might initially assume by looking at the revenue estimate for the first few years of the new policy alone.
Full, immediate deductions also reduce tax distortions across industries, assets, and business models. Consider two companies with slightly different cost structures. Each has revenues of $110 million and total costs of $100 million. However, Company B has higher capital costs ($10 million) than Company A ($5 million).
With depreciation for capital investment in place, say each company can only deduct 80 percent of the real value of the cost of their capital investments. As a result, Company B pays a higher tax. Expensing, meanwhile, aligns the tax calculations with the actual revenues and costs of the two companies. The taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income.
is consistent with their cash flow, and Company B faces no tax penalty for being more capital-intensive than Company A.
If enacted permanently, expensing eliminates a structural tax bias against capital investment, building the foundation for long-term growth. Some proposals, though, call for expensing to be enacted temporarily. Temporary expensing would make investment fully deductible only for a narrow timeframe, leaving the structural bias of depreciation unresolved.
The 2017 tax reform initially proposed permanent full expensing for all capital investments but was scaled back during the legislative process as lawmakers worked to achieve fiscal targets and balance political trade-offs.
The Tax Cuts and Jobs Act (TCJA) introduced 100 percent bonus depreciationBonus depreciation allows firms to deduct a larger portion of certain “short-lived” investments in new or improved technology, equipment, or buildings in the first year. Allowing businesses to write off more investments partially alleviates a bias in the tax code and incentivizes companies to invest more, which, in the long run, raises worker productivity, boosts wages, and creates more jobs.
for short-lived assets, like equipment and machinery, from September 27, 2017, through January 1, 2023. Starting in 2023, bonus depreciation decreases by 20 percentage points annually, phasing out completely by 2027.
However, the TCJA also worsened the tax treatment of R&D investment by introducing R&D amortization in 2022. Previously, companies could fully deduct R&D costs in the year incurred. Under the new law, domestic R&D costs must be deducted over five years and foreign R&D over 15 years, significantly reducing the real value of the deduction due to inflation and the time value of money and creating cash flow problems for smaller and cash-constrained firms.
The economic literature on the TCJA to date has shown the reforms did grow capital investment. A paper by Gabriel Chodorow-Reich, Matthew Smith, Eric Zwick, and Owen Zidar found increased capital investment using Treasury tax return data. Another study exploited variation in tax treatment between C corporations and S corporations and found significant increases in investment. A paper by Steven Crawford and Garen Markarian in the Journal of Corporate Finance found corporate capital investment increased post-TCJA by comparing financial statement data in the United States and Canada.
These results are consistent with a larger body of literature on bonus depreciation. Eric Zwick and James Mahon studied the introduction of temporary bonus depreciation in the US in the early 2000s and found a powerful effect on eligible investment, as did Christopher House and Matthew Shapiro. Further research using state-level variation in bonus depreciation policy showed bonus depreciation drove investment growth in manufacturing industries. Similar results have been found in other countries, such as the United Kingdom.
Limiting expensing to certain assets or periods, as done in the TCJA, reduces fiscal costs but sacrifices long-term economic growth as temporary policies create uncertainty and may lead to investment declines when they expire. Permanent reforms are more effective but come with higher revenue costs during the 10-year budget window.
We modeled five different cost recovery improvements for three categories of investment expenses: short-lived assets (machinery and equipment), R&D, and long-lived assets (commercial and residential structures). To illustrate the trade-off between economic efficiency and revenue impact within the budget window, we illustrate the revenue and economic effects of permanent versus five-year designs for each policy.
Temporary improvements initially lead to more investment and economic growth, but when they expire, the benefits drop off and the economy returns to its baseline level, as illustrated in the chart below. Permanent improvements to investment incentives will deliver permanent improvements to the level of investment and output in the United States.
Permanent 100 percent bonus depreciation would reduce federal revenue by $432.4 billion over a decade ($242.7 billion dynamically) but boost long-run GDP by 0.4 percent. Temporary 100 percent bonus depreciation for five years has no long-term GDP effect but reduces revenue by $62.8 billion conventionally ($8.7 billion dynamically). Over the first years, temporary extension has the same revenue and economic results as enacting the policy permanently, but once the policy expires, investment would drop off and the policy change would raise revenue relative to the baseline in later years. This temporary surge in revenue under expiration would decline just as the temporary upfront revenue losses under permanence would decline.
Reducing bonus depreciation to 80 percent permanently cuts the revenue loss to $306.1 billion ($153.8 billion dynamically) with a 0.3 percent GDP gain. Temporary 80 percent bonus depreciation yields no GDP growth and reduces revenue by $51.2 billion conventionally.
Permanent R&D expensing lowers revenue by $181.3 billion conventionally ($139.6 billion dynamically) with a 0.1 percent GDP gain. Temporary R&D expensing raises revenue slightly but has no permanent GDP effect.
Permanent full expensing for structures would reduce revenue by $527.3 billion conventionally (increase it by $73.1 billion dynamically) over the 10-year budget window, while increasing long-run GDP by 1.3 percent. A temporary extension would reduce revenue by $230.5 billion conventionally ($48.1 billion dynamically), with no effect on GDP growth. Accelerated depreciation for structures (20-year lives using the 200 percent declining balance method) also shows significant economic benefits when enacted permanently.
The best way to boost investment incentives with a lower revenue loss is to offset full, permanent cost recovery with other reforms to the tax code. If offsets aren’t feasible, a smaller permanent improvement is better than a temporary measure. Another option to improve the cost recovery treatment of structures is neutral cost recovery (NCR): NCR would retain the current 39- and 27.5-year schedules but augment the deductions with adjustments for inflation and the time value of money. The adjustments would make companies whole for waiting, providing equivalent treatment as expensing but with a significantly smaller upfront cost (though the nominal cost would grow outside the budget window).
Lawmakers should not compromise on the most pro-growth tax reform available, and instead ought to prioritize enduring, broad-based cost recovery improvements over short-term patches.
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