President

1
Presidents Advisory Panel on Federal Tax Reform

• Capital Cost Recovery
• Why it matters for tax reform
• Andrew B. Lyon
• PricewaterhouseCoopers LLP
• April 18, 2005

2
Capital Cost Recovery Allowance is Main
Difference Between an Income Tax and a
Consumption Tax

• A pure income tax includes a tax on the return to
  a capital investment.
• Achieved by permitting a deduction only for the
  actual decline in value of an asset (economic
  depreciation)
• A cash-flow consumption tax (e.g., VAT, flat tax)
  exempts the ordinary return (or opportunity cost)
  to a capital investment.
• Achieved by permitting an immediate deduction for
  the entire cost of an asset (expensing)
• For a marginal investment, the immediate
  deduction for the assets cost is equal in
  present value to the tax paid on the return to
  the investment

3
Capital Cost Recovery under an Income Tax

• An income tax provides a deduction for the costs
  associated with earning income tax applies to
  income not receipts
• - 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
• The decline in an assets value over time is
  depreciation
• - 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

4
Depreciation is Quantitatively Important

• In 2002, gross corporate depreciable and
  amortizable assets were valued at 10 trillion
  (historical cost)
• In 2002, corporate depreciation and amortization
  deductions totaled 825 billion
• - 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

5
Investment Incentives Vary with Permitted
Depreciation

• 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)
0
expensing
economic depreciation w/inflation indexing
accelerated depreciation
6
Depreciation Affects the Efficient Allocation of
Capital Stock

• For any overall level of capital investment, the
  efficient allocation of capital requires that
  investment be taxed equallyneutral investment
  incentives across all assets
• For equity-financed investments
• - 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.

7
Capital Cost Recovery Rules under the Tax Code

• Plant and Equipment
• Depreciation rules specify a recovery period
  and a recovery method
• Asset classification systems date back to 1962
  and earlier
• Specific recovery periods last established in
  1986 Act
• 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

8
Capital Cost Recovery Rules under the Tax Code

• Special items
• Historical cost no adjustment for inflation
• Bonus depreciation (partial expensing) property
  with a 20-year or less recovery period
  (9/11/01-12/31/04)
• Section 179 expensing for equipment investments
  by small business 105,000 in 2005 (indexed)
  (25,000 indexed after 2007)
• Alternative minimum tax requires a second set of
  depreciation calculations and records for most
  assets
• For most equipment, a slower recovery method is
  used, but same recovery period
• Pre-1986 Investment tax credit of up to 10 of
  cost of equipment

9
Capital Cost Recovery Rules under the Tax Code

• Intangible Capital
• Most investments in self-created intangible
  capital are expensed (e.g., research and
  development and advertising)
• - Credit up to 20 applies to increase in RD
  over base (expires after 2005)
• - Certain intangible investments capitalized
• Purchased intangibles generally amortized over 15
  years (e.g., goodwill, customer lists)
• Land
• Costs generally not recoverable
• Inventory
• Costs of producing inventory recovered when
  inventory sold

10
Is There a Need for Change?

• 2000 Treasury Study
• The current depreciation system is dated. The
  asset class lives that serve as the primary basis
  for the assignment of recovery periods have
  remained largely unchanged since 1981, and most
  class lives date back at least to 1962.
• Entirely new industries have developed in the
  interim, and the manufacturing processes in
  traditional industries have changed. These
  developments are not reflected in the current
  cost recovery system, which does not provide for
  updating depreciation rules to reflect new
  assets, new activities, and new production
  technologies.
• we do not know with any degree of certainty
  what economic depreciation rates should be, even
  on average, for aggregated classes of
  investments

11
Is There a Need for Change?

• System is antiquated Estimates of economic
  depreciation in use at time of 1986 Act date back
  to studies in late 1970s commissioned by
  Treasury, preceded significant growth in new
  types of technological investments
• 1970s researchers used prices of surplus
  government typewriters to determine depreciation
  rate for computing equipment (Hulten and Wykoff,
  1981)
• More recent estimates by researchers suggest
  personal computers depreciate twice as fast
  (Dunn, Doms, Oliner, and Sichel, 2004)

12
Is There a Need for Change?

• System is arbitrary Identical asset treated
  differently depending on the industry of the
  company that owns it
• Example
• - 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
• Difficult to get correct continuous
  technological change differences across uses
  limited active markets to observe prices of used
  productive assets
• Treasury authority to update asset
  classifications provided under 1986 Act was
  revoked by legislation in 1988
• Creates inefficiency Varying investment
  incentives across assets results in an
  inefficient allocation of capital and less
  production than is possible

13
Thoughts on Reform

• Several possible goals Efficient allocation
  of capital administrative ease overall rate of
  tax applying to capital investments
• Efficient allocation of capital requires either
  expensing or tax depreciation that is related to
  economic depreciation (or combination of both)
• If desire a system related to economic
  depreciation, the difficulty of ascertaining true
  economic depreciation requires extensive initial
  study and constant monitoring
• Expensing requires fewer factual determinations
• Administrative ease, for example a single
  recovery period of x years, can conflict with
  efficient allocation of capital

14
Thoughts on Reform

• Overall rate of tax can be lowered either through
  partial expensing or by reducing the statutory
  tax rate
• Movements toward expensing encourage new
  investment without reducing tax rates on existing
  investments
• Transition effects of expensing may reduce value
  of existing capital
• Statutory rate reductions reward both new and old
  investments but rate reductions may have a more
  significant impact on internationally mobile and
  highly profitable investments
• Both changes can promote efficient allocation of
  capital

15
Selected References

• 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.