Adam N. Michel
As Congress searches for policies to meet our current economic challenges, maintaining full expensing—which has begun to phase out—should be top of the list. Full expensing protects business investment from the costs of inflation and supports economic growth by reducing barriers to new investments.
Expensing (also called 100 percent bonus depreciation) allows businesses to deduct the full cost of new investments in the year they are made. Without expensing, investment costs must be deducted over time. For example, if a farmer buys a new combine and can only use one-fifth of what he paid to offset revenues this year, he will have artificially high profits and thus pay higher taxes. The higher taxes will cut into his ability to make other investments in his farm. Expensing makes it easier to invest in new equipment.
Workers of all types benefit from investments in tools, buildings, and research that allow us to produce new goods and services and earn higher incomes for our work. By lowering the cost of new investments made in the United States, expensing is a powerful incentive to boost wages and create jobs. It also removes unnecessary tax barriers for firms trying to re-shore supply chains and increase domestic manufacturing.
What is expensing?
Businesses pay income taxes on their profits: revenues minus costs. Expenses such as employee salaries, power bills, and rent are all deductible in the year they are paid. And until 2022, research expenses had been fully deductible since the 1950s. However, different rules have historically applied to longer-lived capital investments, such as equipment and structures. Without full expensing, businesses are forced to deduct the cost of their physical investments over several years, according to depreciation schedules usually ranging from three years to 39 years.
For reporting profitability to shareholders, it may make sense to spread out big one-time costs so that profits do not swing up and down from year to year. However, when applied to the tax code, this system of spreading out the deductions over time makes investments more costly because the real value of the deduction decreases every year due to inflation and the opportunity cost of passed time.
The Tax Cuts and Jobs Act (TCJA) temporarily changed depreciation rules so that short-lived investments (class lives of less than twenty years) are fully deductible in the year those investments are made. However, starting in 2023, the 100 percent deduction is reduced by twenty percent each year through 2026, after which the bonus deduction is entirely phased out. Since the beginning of 2022, research expenses have had to be deducted over five years.
The high cost of waiting
The loss of full expensing is most economically costly during times of high inflation because inflation erodes the deduction’s value. At two percent inflation, a new building’s present value tax deduction is only worth 45 cents of each dollar invested. If inflation is five percent, the write-off value falls to 32 cents on the dollar.
Following persistent high inflation in the 1970s, inflation was relatively low and stable for almost forty years. In the decade before the 2020 pandemic, the average annual inflation rate was 2.2 percent as measured by the Consumer Price Index. Since the beginning of 2021, the inflation rate has remained at a stubbornly high average rate of 6.3 percent, and in March inflation was five percent over the last 12 months. Even if inflation continues to retreat from its post-pandemic highs, there is substantial risk that it will remain above the historical average for some time.
Businesses and their investors make decisions about future investments based on the project’s projected after-tax rate of return compared to its alternatives. The normal depreciation system lowers after-tax returns because the value of the investment deduction declines over time as inflation and time erode its real present value. By effectively only recognizing a portion of the investment’s actual cost, the tax system raises effective tax rates by artificially increasing business profits (by reducing the real value of its allowable expenses).
At two percent inflation, Table 1 shows that a $1 investment depreciated over seven years under the general depreciation system (without expensing) is only worth 90 cents to the business in present value. At five percent inflation, it is only worth 85 cents in present value. Under full expensing, the business can write off the full investment immediately, recovering the entire cost.
A $1 investment in a non-residential structure, depreciated over 39 years, has a present value of 45 cents at two percent inflation and 32 cents at five percent inflation. While it is unlikely that inflation will stay above five percent for the next three decades, even low inflation levels over long periods erode the real value of investment tax deductions. Over the next few years, expensing will phase out and leave most new U.S. business investments facing the depreciation system described in Table 1.
Expensing and economic growth
New equipment and buildings complement workers who can be more efficient and innovative when using the latest tools. Through these productivity increases, investment is an important driver of economic growth. Allowing expensing to phase out will depress new business investment and exacerbate rising recessionary pressures.
The economics of full expensing is more than just theoretical. Denying the full research deduction has left research-intensive small businesses with tax bills they are struggling to pay. One manufacturer told The Wall Street Journal that the new write-off rules will “prohibit me from growing any more the next three years” because the change artificially raised his tax rate from twelve percent in 2021 to 171 percent in 2022. Beginning this year, businesses in even more industries will face similar (although likely not as large) tax increases as they slowly lose the full first-year deduction they have benefited from since the end of 2017.
The Tax Foundation estimates that making the 2017 expensing reforms permanent would increase GDP by 0.9 percent. Expanding expensing to all investments (including structures that are not eligible under TCJA) would boost investment, wages, and growth even further. The combined effect of these reforms is projected to increase GDP by four percent, the capital stock by ten percent, wages by more than three percent, and will add more than 800,000 new full-time equivalent jobs. Past reforms in the United States and the United Kingdom have consistently shown that expensing boosts investment, job creation, and wages.
By removing policy distortions that make domestic investments less attractive, Congress could make America a more attractive investment location by simply extending and expanding the expensing policies passed in 2017.
Expanded, permanent expensing
Congress should permanently restore full expensing and expand its availability to longer-lived structures by allowing an immediate deduction or implementing a “neutral cost-recovery system,” which allows businesses to index their write-offs for inflation.
There is bipartisan support in Congress for reversing the changes that deny businesses their full research investment deduction. The American Innovation and Jobs Act has close to equal Republican and Democrat cosponsors to reinstate full expensing for research and experimental expenditures.
The most complete set of proposed expensing reforms is in the CREATE JOBS Act, which makes full expensing permanent for research costs and shorter-lived investments and allows longer-lived structures to use neutral cost recovery. The ALIGN Act makes the expensing rules for short-lived assets permanent.
Congress has many important deadlines looming as significant components of the 2017 tax cuts begin to expire; none is more immediately important than making full expensing permanent.