Daniel Bunn President and CEO at Tax Foundation | Twitter Website
Lawmakers are currently deliberating on the reconciliation process, with a focus on making permanent improvements to deductions for capital investment and research and development (R&D) costs. These changes could form a significant economic package. However, temporary enhancements to cost recovery might undermine the potential benefits of these incentives.
The corporate income tax applies to profits, which are calculated as revenues minus costs. Defining costs can be complex, particularly for major capital investments. One approach suggests depreciating investment costs over an asset's useful life to align revenues with costs. While this method is beneficial in accounting, it has limitations as economic policy because spreading deductions over time reduces their value due to inflation and opportunity costs.
For instance, a $10,000 investment depreciated over 10 years results in less than 80 percent cost recovery when considering a conservative 3 percent real discount rate and a 2 percent inflation rate. This means companies effectively pay taxes on non-existent profits.
Expensing offers an alternative by allowing businesses to deduct capital costs immediately, similar to operating costs. This method lowers the cost of capital and encourages investment by enabling projects that were previously unviable under depreciation rules.
Transitioning from depreciation deductions to immediate expensing may result in an initial revenue loss for the federal government budget. However, over time, this upfront transition cost diminishes. Permanent full expensing could reduce tax distortions across industries and eliminate structural tax biases against capital investment.
The Tax Cuts and Jobs Act (TCJA) introduced 100 percent bonus depreciation for short-lived assets from September 27, 2017, through January 1, 2023. Starting in 2023, bonus depreciation decreases annually until it phases out completely by 2027. The TCJA also altered R&D investment tax treatment by introducing amortization in 2022.
Research indicates that the TCJA reforms have increased capital investment. Studies using Treasury tax return data and financial statement comparisons between the United States and Canada support these findings.
Limiting expensing to certain assets or periods reduces fiscal costs but sacrifices long-term economic growth due to uncertainty created by temporary policies. Permanent reforms are more effective but entail higher revenue costs within the budget window.
Permanent improvements to investment incentives will deliver lasting benefits to U.S. investment levels and output compared to temporary measures that only provide short-term gains before reverting back upon expiration.
###
