Expensing

Originally published in the NTA Encyclopedia of Taxation and Tax Policy, Second Edition, edited by Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle. The encyclopedia is available in paperback from the Urban Institute Press. Order online at www.uipress.org or call toll-free 1-877-847-7377

Raquel Meyer Alexander
University of North Carolina at Wilmington

System that allows a taxpayer to deduct - expense - the costs of acquiring a depreciable capital asset as soon as these costs are incurred, rather than take a stream of depreciation deductions over the useful life of the asset.

Schemes that allow business firms to write off assets faster than true economic depreciation are referred to as accelerated depreciation. At the extreme of accelerated depreciation, the firm expenses-that is, deducts from taxable income the assets’ full cost of acquisition. The result can be a dramatic reduction in tax liability (Rosen 2005).

The financial effects of allowing investment costs to be expensed are illustrated in table 1 below. In this example, the asset is assumed to have a purchase price of $8,000 and to provide a stream of economic returns of $3,800 in the first year, $3,000 in the second year, and $2,000 in the third year. At the end of the third year, the asset is assumed to have exhausted its useful economic life, providing no further return and having no scrap or salvage value.

If the tax rate is assumed to be 50 percent and the investment is expensed for tax purposes, the government receives the stream of tax payments shown in column 2 and the investor realizes the stream of after-tax cash flows shown in column 3. In the year in which the asset is acquired, its full cost is deducted in computing taxable income, reducing the investor’s tax liability by $4,000. In effect, the government provides the investor with a tax rebate equal to the tax rate multiplied by the cost of the asset. In subsequent years, no further deductions are taken, and the full amounts of the cash flows produced by the asset are taxed.

Using standard techniques for evaluating investments, it is easily shown that with expensing, the asset has an after-tax return of 5.5 percent, the same as the before-tax return. In this case, the marginal effective tax rate on the investment is zero.

This occurs because expensing reduces after-tax returns and costs by the same proportion, determined by the tax rate. If the tax rate is 50 percent, the result under expensing is financially equivalent to one in which the government becomes a 50 percent partner in the investment. Through the tax system, the government shares 50 percent of the initial costs of the investment by allowing a deduction to be taken immediately, and then shares in 50 percent of the investment’s proceeds. In other words, through the tax system, the investor keeps only 50 percent of the investment’s returns, but also bears only 50 percent of the costs. As a result, per dollar invested, the investor earns the same return from the investment after taxes as before taxes.

The Internal Revenue Code (IRC) includes two provisions that allow certain taxpayers to immediately expense qualified purchases rather than take depreciation deductions over the asset’s life. Under IRC §179, taxpayers may elect to immediately expense up to $100,000 of qualified purchases. IRC §168(k) allows taxpayers to immediately expense 30 or 50 percent of the cost of new property placed into service ("bonus depreciation").

IRC §179

IRC §179 allows taxpayers (other than estates and trusts) to deduct immediately the cost of qualifying depreciable property. To stimulate the economy in the short run, the Jobs and Growth Relief Reconciliation Act of 2003 (PL 108-27) increased the maximum deduction to $100,000 annually for tax years beginning in 2003. The §179 inflation-adjusted expense increases to $102,000 in 2004. In 2006, the maximum deduction reverts to $25,000. This deduction is applicable for purchases of new or used tangible depreciable property acquired for trade or business use. Only for tax years ending 2003, 2004, and 2005 does off-the-shelf computer software qualify for §179 purposes. Most states conform to the federal income tax treatment, although the enactment dates vary; California and Michigan do not allow the §179 expense election.

The §179 expense is subject to an investment limitation and a taxable income limitation. The investment limitation is calculated first and reduces the amount of §179 expense when the cost of qualifying property placed in service in the tax year exceeds $200,000 on a dollar-for-dollar basis. For tax years 2003 through 2005, this threshold is increased to $400,000 but reverts to $200,000 thereafter. The inflation-adjusted investment limit is $410,000 for 2004. For example, taxpayers who place $450,000 of qualified property into service in 2004 must reduce the §179 expense by $40,000, the amount by which the qualified purchases exceed the $410,000 threshold. Because of this investment limitation, §179 favors small businesses. The second limitation, based on the taxable income, disallows deductions that exceed the taxable income derived by the taxpayer from business income. Thus, taxpayers must have at least $102,000 of taxable business income to take the maximum §179 deduction in 2004. Any amount disallowed because of the income limitation may be carried forward indefinitely.

Bonus depreciation

Bonus depreciation was created by the Job Creation and Worker Assistance Act of 2002 (PL 107-147) and provides an additional first-year 30 percent depreciation allowance for qualified property purchased after September 10, 2001, and before May 5, 2006. Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, bonus depreciation increases to 50 percent for purchases after May 5, 2003, and before January 1, 2005. Taxpayers may elect by property class to claim the 30 percent bonus rather than the 50 percent bonus depreciation. Currently, only 12 states allow bonus depreciation for state income tax purposes, and the remaining states that impose a general corporate income tax vary in their treatment. Qualified property for bonus depreciation includes the following categories: off-the-shelf software, water utility property, qualified leasehold improvements, and property accounted for under the modified accelerated cost recovery system (MACRS) that is no more than 20 years old.

Some taxpayers may not qualify for both the §179 deduction and the bonus depreciation due to property types, investment limitations, or income limitations. For taxpayers eligible for both, the §179 deduction is taken first. Bonus depreciation is then calculated for the property as reduced by the §179 allowance. Any remaining depreciable basis may be deducted through the MACRS.

Example

A new five-year property was purchased in January 2004 for $250,000. The taxpayer makes no other purchases during the year. Assume the taxpayer expenses $102,000 under §179. The depreciable basis is reduced to $148,000 ($250,000 - 102,000), and bonus depreciation would be $74,000 ($148,000 × 50 percent). Regular MACRS depreciation is based upon the unrecovered basis of $74,000 ($148,000 - $74,000).

Policy implications

Because expensing exempts the normal or competitive return on capital assets from taxation, the method of capital cost recovery is appropriate if the objective is to tax consumption instead of income. Thus, recent proposals for replacing the income tax with a consumption-based flat tax have allowed outlays for new capital to be expensed. Similarly, a consumption value-added tax would allow outlays for new capital to be deducted when computing taxable value added.

If, however, the objective is to tax income instead of consumption, the appropriate method is to require the taxpayer to spread out deductions for the cost of the asset, based on the rate at which the asset depreciates in value over its useful lifetime (its economic depreciation). Under an income tax, allowing expensing of assets thus becomes a form of tax preference or tax expenditure because it allows the competitive investment return of assets to go untaxed. In this case, opportunities for tax arbitrage can arise if taxpayers are allowed to expense the cost of assets, while at the same time deducting the interest on the debt incurred to acquire these assets.

The economic effects of the two expensing provisions of the IRC are disputed. Supporters of the §179 expense expansion and bonus depreciation believe that because these provisions lower the cost of capital and increase cash flow, capital formation and employment rates would increase and provide a short run stimulus to the economy (Guether 2003). Further, more small business owners would benefit from the expanded expensing incentives as the §179 investment limitation increases. Finally, accounting would be simplified as businesses could maintain fewer tax depreciation records (Guether 2003).

Opponents note that equipment investment incentives lead to substituting capital for labor and may result in increased national productivity without employment growth (Guether 2003). Opponents also stress that during times of slow economic growth, temporary incentives are more effective than permanent ones. Business executives will accelerate capital acquisitions only if they believe that the §179 expansion and bonus deprecation will expire. So long as doubt exists, the incentives’ efficacy as economic stimuli is unclear. If made permanent, the economic inefficiencies introduced by favoring investments in equipment relative to structures would increase (Gravelle 2003). In addition, the credibility of other "temporary" measures will be questioned and thereby undermine future fiscal policy (Gravelle 2003).

ADDITIONAL READING

• Gravelle, Jane G. "Effects of the 1981 Depreciation Revision on the Taxation of Income from Business Capital." National Tax Journal 35 (March 1982).
• ---. "Capital Income Tax Revisions and Effective Tax Rates." CRS Report RL32099. Washington, DC: Congressional Research Service, 2003.
• Guether, Gary. "Small Business Expensing Allowance under the Jobs and Growth Tax Relief Reconciliation Act of 2003: Changes and Likely Economic Effects." CRS Report RL31852. Washington, DC: Congressional Research Service, 2003.
• Holtz-Eakin, Douglas. "Should Small Businesses Be Tax Favored?" National Tax Journal 48 (September 1995): 387-95.
• Rosen, Harvey. Public Finance, 7th ed. New York: McGraw-Hill, 2005.