When calculating their taxable income, companies can deduct the expenses they incurred when producing goods or services for sale, including depreciation (the drop in the value of a productive asset over time). The tax code sets the number of years over which the value of different types of investments can be deducted from taxable income.
This option would extend the lifetime of equipment and certain structures placed into service after December 31, 2012, for purposes of tax depreciation. Specifically, where the tax code currently stipulates a lifetime of 3, 5, 7, 10, 15, or 20 years, this option would raise the lifetime to 4, 8, 11, 20, 30, or 39 years, respectively.1 Those changes would increase revenues by a total of $79 billion from 2012 through 2016 and by $241 billion over the 2012- 2021 period.
An argument in favor of this option is that the current rates of tax depreciation overstate the decline in the economic value of assets because they do not accurately reflect the rate of inflation that is likely to occur over the asset's lifetime. Because rates of depreciation are set by the tax code and depreciation deductions are not indexed for inflation, the real (inflation-adjusted) value of the depreciation allowed by tax law depends on the rate of inflation.
Most rates of depreciation in the tax code today were set in the Tax Reform Act of 1986 and would approximate economic depreciation (the decline in an asset's economic value, including the impact of inflation over time) if the average rate of inflation had been 5 percent during that 25-year period. The Congressional Budget Office estimates, however, that inflation over the next decade will average about 2 percent annually. That difference of about 3 percentage points means businesses can deduct larger amounts of depreciation from taxable income-- and thus have a lower tax liability--than they could if the deduction accurately measured economic depreciation.
Another argument in favor of this option is that it would equalize effective tax rates--the total amount of tax liability divided by income--on the income from different types of investment. Equipment and structures are two of the main types of tangible capital for which businesses take depreciation deductions, and the effective tax rates are currently quite different. Deductions for equipment generally contribute more to the understatement of taxable income than do deductions for structures; equipment has a shorter service life (the time over which depreciation deductions can be taken), so changes in inflation have a greater effect on deductions for equipment. Since 1986, policymakers have extended the useful lifetime of some kinds of structures for calculating depreciation.
In contrast, recent legislation allows firms to accelerate depreciation deductions for equipment. The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Public Law 111-312) allows firms to expense--that is, immediately deduct from taxable income--100 percent of the costs of investment in equipment made between September 8, 2010, and December 31, 2011. For equipment acquired between January 1, 2012, and December 31, 2012, firms will be able to immediately deduct 50 percent of the cost. After 2012, current tax law will revert to the typical rules, which allow no expensing (except in limited cases) and generally require firms to deduct their equipment investment over a number of years.
Under the law currently in effect for 2013, if inflation remained at 2 percent and the real discount rate (which adjusts for the change in the value of a dollar over time) for businesses was 5 percent, the average effective tax rates on income from corporate investment would be 25 percent for equipment and 30 percent for structures. In contrast, under this option, those rates would be 33 percent for equipment and 32 percent for structures. That near parity 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 on economic returns. Such an incentive distorts choices between investing in equipment and investing in structures, thus reducing economic efficiency.
Those average tax rates would differ if inflation was different, however. If the rate of inflation was a percentage point lower, the average effective tax rate under this option would be 30 percent for equipment and
31 percent for structures. Conversely, if inflation was a percentage point higher, the rates for equipment and structures would be 35 percent and 33 percent, respectively. Therefore, if inflation differed from CBO's expectations, new distortions between investment in equipment and structures would emerge over the long run.
An argument against this option is that low tax rates on capital may encourage investment. From that perspective, the current tax treatment could be equalized by easing taxation on all forms of capital rather than by raising the effective tax rate on a type of capital that is now favored. In addition, under this option, there would continue to be substantial variation in the effective tax rates for equipment with different service lives.