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CRS FINDS NEUTRAL COST RECOVERY SYSTEM WOULD BE REVENUE-LOSER.

JAN. 18, 1995

95-161 E

DATED JAN. 18, 1995
DOCUMENT ATTRIBUTES
  • Authors
    Brumbaugh, David L.
    Gravelle, Jane G.
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Index Terms
    carryovers, NOL, limits
    carryovers, limits on credits, taxes and losses
    depreciation, indexation
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-3171
  • Tax Analysts Electronic Citation
    95 TNT 57-49
Citations: 95-161 E

           THE NEUTRAL COST RECOVERY SYSTEM AND THE HOUSE

 

                         REPUBLICAN CONTRACT

 

 

                         David L. Brumbaugh

 

                    Specialist in Public Finance

 

                         Economics Division

 

 

                          Jane G. Gravelle

 

                Senior Specialist in Economic Policy

 

                    Office of Senior Specialists

 

 

SUMMARY

An important part of the House Republican Contract with America is its tax proposals for saving and investment. Prominent among these, in turn, is a proposed change in tax depreciation rules embodied in what the plan calls the "Neutral Cost Recovery System (NCRS)." NCRS would provide more generous tax depreciation allowances by indexing depreciation for inflation and increasing depreciation deductions by an additional flat percentage rate. The plan would reduce the tax burden on depreciable assets; its effect on achieving a more efficient allocation of resources is not clear. NCRS would also lose tax revenue in the long run.

TAX DEPRECIATION IN GENERAL

When a business purchases a tangible asset, it is not incurring a cost; it is simply exchanging one asset -- for example, cash -- for another. The full purchase price of an asset is therefore usually not tax deductible in the year it is bought. Assets do, however, decline in value as they age or become outmoded; that decline in value (depreciation) IS a cost. And because assets gradually depreciate until they are worthless, the tax code permits firms to gradually deduct the full acquisition cost of an asset over a number of years.

The tax code contains a set of rules that govern the rate at which depreciation deductions can be claimed. The rules determine the tax depreciation rate by specifying a RECOVERY PERIOD and a DEPRECIATION METHOD for different types of assets. An asset's recovery period is the number of years over which deductions for the asset's full cost must be spread; the applicable depreciation method determines how depreciation deductions are distributed among the different years of the recovery period.

Most nonresidential buildings are depreciated over 39 years under a "straight-line" method, with an equal share deducted in each year. Most equipment assets are depreciated over five or seven years, with a much faster method (double-declining balance) which allows twice as much as the "straight-line" method in the first year. Longer-lived equipment and public utilities are depreciated over longer periods, with a slower method (150% declining balance, where first-year deductions are 50 percent larger than straight-line). 1

A tax deduction of a given dollar amount is worth more to a business the sooner it can be claimed because -- to quote Ben Franklin -- time is money; the sooner a tax deduction can be claimed, the sooner the tax savings it generates can be invested and earn a return. It follows that the tax rules governing when depreciation deductions can be claimed are quite important to businesses. If depreciation deductions can be claimed before an asset actually declines in value, a tax benefit exists; if, on the other hand, depreciation deductions can be claimed more slowly than the corresponding asset actually depreciates, a tax penalty occurs. Only if depreciation deductions are claimed at the rate an asset actually depreciates do taxes confer neither a tax benefit nor a tax penalty.

Since the true rate at which assets decay is not known with certainty, the impact of current depreciation rules is also not known with absolute precision. It is likely, however, that current tax depreciation is more rapid than economic depreciation for both equipment and -- to a lesser extent -- structures.

Part of the NCRS proposal is devoted to offsetting the effects of inflation. Inflation reduces the value of depreciation allowances, and current law's rules would confer a larger tax benefit if it were not for the impact of rising prices. When inflation occurs over the lifetime of an asset, recovery of just the purchase price is not sufficient to recoup the full purchasing power of the funds originally spent on the asset. Because inflation erodes the value of funds, a firm must recover the acquisition cost of the asset plus enough revenue to compensate for inflation's erosive effect.

The tax code's depreciation rules do not take inflation into account. Under current law, the total amount of deductions allowed for any single asset is frozen at the acquisition cost of the asset, regardless of any inflation that occurs over the asset's lifetime. As a result, depreciation deductions do not include compensation for the decline in the purchasing power of investment dollars.

MECHANICS OF THE NEUTRAL COST RECOVERY SYSTEM

NCRS's liberalization of depreciation contains two principal elements that would apply to both equipment and structures: an indexation of annual depreciation deductions; and an additional increase in annual depreciation by a specified percentage rate. This latter increase is applied only to property depreciated over periods in excess of ten years, primarily structures.

NCRS' indexation would be accomplished by inflating each years' deduction by increases in the general price level. More precisely, each year's depreciation deduction would be increased by the ratio of the Gross Domestic Product (GDP) for the tax year for which depreciation is being calculated to the the deflator for the tax year the asset was placed in service. The second element of NCRS, applying to most equipment, would increase each year's depreciation deduction by multiplying the year's deduction by 1.035 raised to the nth power, where n is generally the number of years the asset has been in service. 2

Both these changes increase the value of depreciation deductions in a straightforward way: they increase the dollar amount of depreciation deductions that can be claimed over an asset's lifetime. But NCRS also includes one change that works in the opposite direction: for equipment (but not structures), it requires firms to use a slower depreciation method than that which is currently permitted. Under the proposal, equipment now eligible for double- declining balance depreciation would be written off using the slower 150-percent declining-balance method. The depreciation method for other assets would stay the same.

As we shall see, the switch to the slower method is not sufficient to offset NCRS' other changes and the net effect of NCRS would be to increase the value of depreciation allowances and reduce the tax burden on depreciable assets.

The proposal also applies to depreciation under the Alternative Minimum Tax (AMT). Under current law, firms are generally required to pay either their regular tax or their minimum tax, whichever is higher; the two amounts ordinarily differ because the AMT tax rate is relatively low, while its definition of taxable income is relatively broad. Its depreciation rules, for example, are less generous than those of the regular tax. Under the proposal, AMT depreciation deductions would be increased by the same percentage as regular tax depreciation. If NCRS were not to extend to the AMT, the proposal would probably increase the number of firms subject to the AMT rather than the regular tax.

These are the basic mechanics of the proposal. We should note, however, that a thorough analysis of how these provisions might interact with rules contained in other parts of the tax code is beyond the scope of this report. These interactions may present additional issues, particular regarding the sale of depreciable assets. For example, would how would the new NCRS depreciation interact with the capital gains provisions contained in other parts of the House Republican Contract with America? Would the NCRS rules encourage "churning," or the sale and repurchase of depreciable assets? Would the passive loss restrictions that were enacted by the 1986 Tax Reform Act limit the applicablility of the NCRS?

IMPACT OF THE NCRS ON TAX REVENUES

The Neutral Cost Recovery System would raise revenue within the normal budget planning horizon of five years (the Senate uses a ten- year period for some purposes), but would lose large amounts of revenue in the future. For example, with an effective date of 1995, the proposal would increase taxable income by $93 billion in its first five calendar years. In the long run (after the longest depreciation period of 39 years), at the same income levels, the proposal would REDUCE taxable income by $495 billion -- an amount in the opposite direction that is over six times as large. With effects this large it is very difficult to predict changes in tax liability since some firms would probably more than exhaust their existing taxable income in depreciation deductions.

This revenue-loss pattern -- a short-run gain followed by a substantial long-run loss -- occurs because of the proposal's slower depreciation method on the one hand and its indexation and 3.5 percent exemption on the other. Taken alone, the shift to 150 percent declining-balance depreciation method has the effect of shifting deductions from the near term towards the future; taxable income thus shifts from the future towards the near term, which increases tax revenue in the proposal's first few years. As inflation occurs, however, NCRS' indexation provision gradually increases the size of depreciation deductions that firms can take; the additional 3.5 percentage point exemption increases depreciation deductions further. After the first few years of the proposal, the increases in deductions outweigh the impact of the slower depreciation method. The revenue loss from inflated depreciation deductions eventually dwarfs the initial revenue gain. Note that if it were possible to predict the discount rate with certainty and use that rate to increase depreciation deductions, one could raise virtually any amount of revenue in the budget horizon, without altering the effective tax burden on most equipment, since slowing depreciation automatically induces an offsetting increase in future deductions.

The time path of the revenue base changes is shown in figure 1; these effects are calculated at constant 1994 levels of income. What begins as an approximately $20 billion increase in taxable income becomes a $67 billion decrease after ten years, and eventually (after 40 years) becomes a $99 billion decrease. 3

FIGURE 1: CHANGES IN TAXABLE INCOME: NEUTRAL COST RECOVERY PROPOSAL (1995 Income Levels)

[graph omitted]

IMPACT ON TAX BURDENS

The tax burden on income from particular investments is determined by the statutory tax rate that applies to taxable income, whether any investment tax incentives are available, and the pattern of depreciation deductions allowed. As noted above, depreciation deductions produce a tax benefit if they are allowed more quickly than the true economic depreciation of the asset. At the same time, depreciation deductions are not currently indexed for inflation, which raises the real tax burden.

One way of expressing this tax burden is to calculate a marginal effective tax rate. Basically, the marginal effective tax rate measure is a way of capturing in a single number all of the factors that affect tax burden; it is the percentage difference between the before- and after-tax return to investment. Another way of looking at it is as a number that indicates what statutory rate would be applied to economic income to give the taxpayer the same burden as the combination of all tax benefits and penalties.

If the discount rate of the firm were 3.5 percent, NCRS would reduce the effective tax rate (at the firm level) to zero for most equipment regardless of useful life or depreciation method because the system effectively pays interest on deferred depreciation. 4 Such a method makes the depreciation system the equivalent of expensing (writing off all costs in the first year). Expensing results in a consumption tax treatment for new investment, or a zero tax rate. Note, however, that unlike a true shift to a consumption tax, NCRS would continue to allow depreciation on existing capital assets and would not eliminate the deductibility of interest (or require loans to be included in income).

At currently prevailing inflation rates, and assuming a somewhat higher real discount rate, NCRS would cut the tax burden on depreciable assets roughly in half. As noted above, while depreciation is not indexed, it is slightly accelerated under current law. At the present inflation rate, this results in marginal effective tax rates that are slightly lower than the current 35 percent statutory corporate tax rate. For new investment that is financed with a combination of debt and equity and given currently prevailing economic conditions, the marginal effective tax rate (at the firm level) is 28 percent for equipment and 32 percent for structures. 5 Under NCRS, however the marginal effective tax rates would be 13 percent for equipment and 27 percent for structures.

This firm level tax rate does not take into account the deduction for interest by the firm and the taxation of interest to individuals. Because nominal interest is deducted and taxed, there is likely to be a negative tax rate on debt financed equipment investment overall. Equity investment is subject to additional taxes at the personal level (on dividends and capital gains).

A closer look at NCRS' probable impact on tax burdens suggests the proposal's effect on allocative efficiency is uncertain, although it is likely to be beneficial. NCRS would reduce current law's preferential treatment of owner-occupied housing compared to business investment and of non-corporate business compared to corporate business. On the other hand, the system would expand the current favorable treatment of depreciable assets compared to inventories, and of equipment relative to structures.

 

FOOTNOTES

 

 

1 Under declining balance methods, depreciation deductions become smaller each year; the taxpayer switches at some point to a straight-line method on the remaining undepreciated balance for the remaining years.

2 The proposal's inflation adjustment would actually be made based on changes in the GDP deflator since the calendar quarter the asset is placed in service. Also, the proposal would never reduce depreciation deductions, even during periods of falling prices; it provides that the "neutral cost recovery ratio" -- the ratio consisting of both the inflation adjustment and the flat percentage increase -- will never be less than one.

3 This chart is taken from an earlier CRS memorandum, "Background Information on the Neutral Cost Recovery Proposal," by Jane G. Gravelle, March 8, 1994.

4 As used here, the term "discount rate" is the cost of funds to the firm: the real rate of return, after taxes, that individual savers require of their investments in the corporate sector.

5 These rates were calculated assuming 1/3 debt-finance, 3 percent inflation, a 9 percent nominal interest rate, a 7 percent real return to equity.

 

END OF FOOTNOTES
DOCUMENT ATTRIBUTES
  • Authors
    Brumbaugh, David L.
    Gravelle, Jane G.
  • Institutional Authors
    Congressional Research Service
  • Subject Area/Tax Topics
  • Index Terms
    carryovers, NOL, limits
    carryovers, limits on credits, taxes and losses
    depreciation, indexation
  • Jurisdictions
  • Language
    English
  • Tax Analysts Document Number
    Doc 95-3171
  • Tax Analysts Electronic Citation
    95 TNT 57-49
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