Immediate deduction of the full cost of business investments (“expensing”) is an integral part of a consumption tax. Expensing, however, is not consistent with an income tax. Expensing creates major economic distortions within an income tax.
Measuring economic depreciation, similar to any valuation procedure, is specific to the facts and circumstances of the particular investment, and is not easy. So tax depreciation has used rules of thumb in the trade-off between administrability, simplicity and economic efficiency. Expensing would be simple, but results in significant erosion of the tax on capital income, particularly if expensed investments can be debt financed with deductible interest.
Economists calculate that expensing results in a zero marginal effective tax rate (METR) on the marginal (last dollar) zero-profit investment. Since the vast majority of investment is not marginal, nor earns the minimum required return of the investor, expensing only reduces businesses’ average effective tax rate on investment. But the tax benefit can be quite large, particularly for long-lived assets and risky borrowers.
Expensing accelerates the timing of tax deductions compared to economic depreciation. Investors benefit from having more cash (less tax paid) when they take the deduction, but repay the cash (more taxes paid) later since they don’t have the future deductions they would have had with economic depreciation. This is the equivalent of the Federal government giving investors an interest-free loan.
The Federal Credit Reform Act (FCRA) of 1990 requires calculation of Federal interest subsidies through below-market interest rates, guarantees or loan forgiveness. Zero-interest loans from accelerated tax depreciation and other tax deferral provisions aren’t covered under the FCRA.
Zero-interest loans from tax expensing vary by the life of the capital investment and the riskiness of the investor (borrower) as shown in the table below. Corporate bond interest rates vary from 2.9% for AAA borrowers to over 10% for CCC or below rated borrowers. The table below shows how the benefit of zero-interest rate loans from expensing vary, from 5% of the cost of the investment for a 5-year asset by AAA borrower to 53% for a 20-year investment by a high-risk borrower.
Historically, the US tax code has tried to provide more incentive for shorter-lived equipment rather than longer-lived assets. This would be reversed with expensing. Subsidizing high-risk borrowers or risky investments should be done directly through programs, such as the Small Business Administration programs, rather than hidden in tax provisions.
Considering tax expensing as a zero-interest lending program is helpful in understanding the real economic effects of such a proposal. Reducing the tax rates on business income would provide an investment incentive in a uniform way to all types of investments and investors.