Continuing my series on tax expenditures, this week I want to discuss accelerated depreciation for business investments in machinery and equipment, the eighth-largest tax expenditure, which will reduce federal revenues by $274 billion over the next five years, according to the Treasury Department. There is an additional tax expenditure of $15 billion over five years for accelerated depreciation on rental housing.

Depreciation is an allowance for the decline in value of a long-lived capital asset. In theory, it should equal the cost of replacement when the asset ceases to have value. Accelerated deprecation represents that which is written off faster than the useful life of an asset.

Historically, depreciation wasn’t something businessmen bothered with. They tended to operate strictly on a cash basis, treating capital outlays and current operating expenses the same way. But two developments changed this historical practice.

First was the rise of the modern corporation in the early 19th century, which required improvements in accounting. Investors not involved in management needed accurate accounts to determine whether they were making money or not and to keep managers honest.

The second factor was the railroad, which required more private capital than had ever been assembled before in history. Previously, capital investments on such a scale had exclusively been governmental undertakings.

If the railroads treated capital expenditures the same way that operating expenses were treated, they would have huge losses for many years that would discourage investors. So the idea of depreciation was born – writing off capital investments over time. Ideally, the depreciation period would correspond to the useful life of an asset – 10 percent a year for an asset that would last 10 years, 5 percent a year for an asset that would last 20 years, and so on.

At the time the railroads were being built in the United States, taxes did not enter into the calculation because the corporate income tax did not come into existence until 1909. The concept of depreciation was developed for purely business purposes and was strongly influenced by engineers who needed to know the useful life of machinery for their own purposes.

By the time the corporate income tax came into existence, accounting for depreciation was still in its infancy. It was based mainly on a literal wearing out of a piece of equipment. Today, economists recognize that obsolescence is far more important in determining the value of capital equipment.

The Internal Revenue Service and Congress long struggled to determine the proper role of depreciation. (See this 1989 Treasury Department study: “A History of Federal Tax Depreciation Policy.”) In general, the I.R.S. pushed for longer depreciation schedules, preferably along a straight line – a fixed percentage each year over the useful life of an asset, which was determined by the Treasury in a publication called “Bulletin F.”

Businesses, of course, preferred faster depreciation rates because they saved taxes and recovered their investments more quickly. Many economists have long argued in favor of “expensing” – allowing businesses to deduct capital investments immediately just as they deduct current operating expenses.

Two factors strengthened the argument for expensing. First was inflation, which eroded the value of depreciation allowances because they are based on historical cost – the original purchase price of an asset – rather than replacement cost. Many economists concluded that the inadequacy of capital consumption allowances in the 1970s reduced capital investment and hence reduced productivity and economic growth.

The second factor was the increasing importance of investments in high-tech equipment such as computers that never really wear out in a physical sense; they just become obsolete and at an increasingly rapid rate.

The solution to both these problems was to permit expensing, many economists asserted. One option that was widely discussed in the 1980s was put forward by the economists Alan J. Auerbach and Dale W. Jorgenson in the September-October issue of Harvard Business Review. They suggested continuing to allow businesses to depreciate assets over time, but to increase the size of annual depreciation allowances by the rate of interest so that businesses got the real present value of depreciation. That would be the economic equivalent of expensing, they said.

As time went by, both Congress and the White House have become less interested in treating depreciation in some theoretically proper or consistent manner than in using it as a tool to encourage additional investment by businesses without reducing revenues too much or creating distortions in business investment.

In 1981, President Reagan proposed and Congress adopted the “10-5-3” deprecation plan, whereby most structures could be depreciated over 10 years, machinery and equipment over 5 years and vehicles over 3 years.

But it quickly became apparent that such tax treatment, when combined with the investment tax credit, which gave businesses a 10 percent tax credit for investments in machinery and equipment, was excessively generous. Rather than spur productivity-enhancing investments, it created opportunities for tax shelters – investments driven solely by the potential for tax savings without regard to economic merit.

The Tax Equity and Fiscal Responsibility Act of 1982 and other legislation in the 1980s sharply curtailed the 10-5-3 system, both for revenue-raising purposes and to restrict tax shelters. The investment tax credit was abolished in the Tax Reform Act of 1986, which also lowered the corporate tax rate to 34 percent from 46 percent.

In recent years, Congress instituted a temporary increase in depreciation allowances purely as a short-run stimulus measure. “Bonus depreciation” was supported by both the George W. Bush administration and the Obama administration. (For details, see this 2012 report from Congress’s Joint Committee on Taxation: “Background and Present Law Relating to Cost Recovery and Domestic Production Facilities.”)

The possibility that Congress will take up tax reform in the near future guarantees that there will be further changes in depreciation policy. As the largest corporate tax expenditure, accelerated depreciation will almost certainly be on the chopping block to finance another reduction in the corporate tax rate.

It is hard to see how this could be done in such a way that the cost of capital won’t increase. (See “Reducing Depreciation Allowances to Finance a Lower Corporate Tax Rate” by the Congressional Research Service economist Jane Gravelle.) But leaving accelerated deprecation off the table means that a reduction in the corporate tax rate will have to be financed either by raising taxes on individuals or with some new revenue source. That is because there aren’t enough corporate tax expenditures to finance a reduction in the corporate rate to 25 percent from 35 percent in a revenue-neutral manner, a goal with bipartisan support.

Whatever is done with depreciation, it would be desirable to establish a stable system and cease using it as a short-run stimulus measure.


Bruce Bartlett held senior policy roles in the Reagan and George H.W. Bush administrations and served on the staffs of Representatives Jack Kemp and Ron Paul. He is the author of “The Benefit and the Burden: Tax Reform – Why We Need It and What It Will Take.”