CRS Updates Report on Small Business Expensing Allowance

Under current federal tax law, business taxpayers are allowed to deduct (or expense) no less than $100,000 of the total cost of qualified assets placed in service in a tax year from 2005 through 2007, within certain limits. In the absence of such a provision, firms would have to recover the cost over a longer period under allowable depreciation schedules. The rules governing the use of the allowance largely confine its benefits to relatively small firms.

This report focuses on the economic effects of the small business expensing allowance. It begins by explaining how the allowance works and concludes with an assessment of its implications for economic efficiency, and equity and tax administration. It will be updated to reflect significant legislative activity in the 109th Congress.

In recent Congresses, there was broad bipartisan support for enhancing the allowance as a means of both stimulating increased business investment and aiding small business owners. By all indications, this support has not diminished in the 109th Congress. A number of bills to extend or modify the current allowance have been introduced in the 109th Congress. In the House, H.R. 1091 would permanently extend and enhance the current allowance; H.R. 1388 and H.R. 3841 would permanently extend the current allowance; H.R. 1678 would extend the current allowance through 2009; and H.R. 4297, a tax reconciliation bill passed by the House on December 8, 2005, would extend the current allowance through 2009. In the Senate, S. 1523 would permanently extend the current allowance, and a tax reconciliation bill (S. 2020) passed by the Senate on November 18 would also extend the current allowance through 2009. The Bush Administration has indicated that it would support a permanent extension of the existing allowance.

In addition, the House and Senate passed a bill (H.R. 4440) in December 2005 that, among other things, established an enhanced expensing allowance for qualified assets purchased on or after August 28, 2005, and placed in service by December 31, 2007, in the areas devastated by Hurricane Katrina.

The expensing allowance may have important implications for the allocation of business investment, the distribution of the federal tax burden among income groups, and the cost of tax compliance for smaller firms. These effects loosely correspond to the three traditional criteria for evaluating the effects of tax policy: efficiency, equity, and simplicity. While the allowance seeks to stimulate small business investment by reducing the user cost of capital for eligible assets and increasing the cash flow of firms able to claim it, the allowance nonetheless can serve as a drain on economic efficiency by encouraging an increased flow of capital into uses that may not be as productive as others. Moreover, since the allowance does not directly alter the income tax rates applied to the income of owners of firms that benefit from it, the allowance has no discernible impact on the distribution of the federal tax burden among income groups. At the same time, the allowance offers the benefit of simplifying tax accounting for firms able to claim it.

                            Contents

This report examines the economic effects of the small business expensing allowance and initiatives in Congress to modify it. It begins by explaining how the allowance works and summarizing its legislative history. The report then discusses proposals in the 109th Congress to alter the current allowance. It concludes with an assessment of the allowance's likely economic effects, focusing on its implications for economic efficiency, equity, and tax administration.

Firms in all lines of business may claim the regular expensing allowance. The same is true of the enhanced expensing allowance available to firms operating in the special areas, with certain exceptions. Specifically, this allowance may not be claimed for qualified investments in the following establishments located in EZs, RCs, and the newly created GOZ: private or commercial golf courses, country clubs, massage parlors, hot-tub and suntan facilities, stores whose principal business is the sale of alcoholic beverages, racetracks, and facilities used for gambling.

Qualified property is defined as certain new and used depreciable assets -- as specified in IRC section 1245(a)(3) -- acquired for use in the active conduct of a trade or business. With a few notable exceptions, this property consists of business machines and equipment used in connection with manufacturing or production, extraction, transportation, communications, electricity, gas, water, and sewage disposal. Transportation equipment with an unloaded gross weight of more than 6,000 pounds may be expensed, but not heating and air conditioning units. In addition, packaged computer software for business use may be expensed through 2007. Most buildings and their structural components do not qualify for the regular allowance, but research and bulk storage facilities do qualify. In the case of the enhanced expensing allowance for firms operating in the GOZ, however, certain residential and commercial properties do qualify.

The maximum amount of qualified property that may be expensed in a tax year under IRC section 179 is subject to two limitations: a dollar limitation and an income limitation.

Under the dollar limitation, the maximum expensing allowance for many firms is reduced, dollar for dollar, by the amount by which the total cost of all qualified property placed in service during the year exceeds a phase-out threshold. But in the case of firms operating in EZs, RCs, and the NYLZ, the maximum expensing allowance is reduced by $0.50 for each dollar by which the cost of qualified property placed in service in a tax year exceeds the phase-out threshold. In 2005, the threshold is set at $420,000 for all firms except those operating in the GOZ, where the threshold is $1,020,000.² As a result of the dollar limitation for the regular allowance, none of the cost of qualified property placed in service in 2005 may be expensed once its total cost reaches $525,000 or more. For example, if a firm operating outside the special areas were to place in service qualified property whose total cost in 2005 came to $500,000, the firm could expense no more than $25,000 of that amount, and the remaining $475,000 would be written off under existing tax depreciation schedules. The threshold for the regular allowance is indexed for inflation in 2005 through 2007. In 2008 and thereafter, it is scheduled to revert to its pre-JGTRRA level of $200,000.

Under the income limitation, the expensing allowance a firm claims cannot exceed the taxable income it earns from the active conduct of the trade or business in which the qualified assets are used. Although business taxpayers may not carry forward any expensing allowances denied because of the dollar limitation, they may carry forward allowances denied because of the income limitation.

In addition to the regular expensing allowance, business taxpayers were able to claim in recent tax years a temporary 30% first-year depreciation deduction under the Job Creation and Worker Assistance Act of 2002 (P.L. 107-147) or a temporary 50% first-year depreciation deduction under Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA, P.L. 108-26). Both allowances applied to new (but not used) property depreciable under the modified accelerated cost recovery system (MACRS) and having a recovery period of less than 20 years. Qualified property acquired between September 11, 2001, and December 31, 2004, and placed in service before January 1, 2005, was eligible for the special 30% depreciation allowance. The 50% depreciation allowance could be claimed for qualified property bought between May 6, 2003, and January 1, 2005, and placed in service by January 1, 2006. Business taxpayers were permitted to claim either the 30% or 50% first-year depreciation allowance, but not both. For property eligible for both the expensing and special depreciation allowances, a firm had to recover its cost for tax purposes in the following sequence: the expensing allowance was claimed first, followed by the temporary first-year depreciation allowance on any remaining basis in the property and then the regular depreciation allowance under the MACRS on any remaining basis.

This allowance remained in force until the enactment of the Economic Recovery Tax Act of 1981 (ERTA, P.L. 97-34). ERTA replaced the special deduction with a maximum expensing allowance of $5,000 and laid down a timetable for gradually increasing the upper limit of the allowance to $10,000 by 1986. Despite these changes, few firms took advantage of the new allowance. Such a tepid response was due mainly to the limitations on the use of the investment tax credit also established by ERTA. Any business taxpayer claiming the credit for the purchase of an asset also eligible for the expensing allowance could claim the credit only for the portion of the asset's cost that was not expensed. Evidently for many firms, the potential tax savings from claiming the credit alone outweighed the potential tax savings from claiming both the credit and the allowance.

Faced with large and growing federal budget deficits in the early 1980s, Congress passed the Deficit Reduction Act of 1984 (P.L. 98-369), which, among other things, postponed from 1986 to 1990 the scheduled increase in the maximum expensing allowance to $10,000. Claims for the allowance rose markedly following the repeal of the investment tax credit by the Tax Reform Act of 1986.

The maximum allowance reached $10,000 in 1990, as scheduled, and remained there until the passage of the Omnibus Budget Reconciliation Act of 1993 (OBRA93, P.L. 103-66), which retroactively boosted the maximum allowance to $17,500 as of January 1, 1993. OBRA93 also created a variety of tax benefits for special areas known as enterprise zones and empowerment zones (EZs). One benefit was an enhanced expensing allowance of up to $20,000 above the regular maximum allowance, whose phase-out threshold was effectively twice as large as the phase-out threshold for the regular allowance. To be designated as an EZ, an area had to satisfy eligibility criteria relating to population, poverty rate, and geographic size.

Under the Small Business Job Protection Act of 1996 (P.L. 104- 188), the regular allowance embarked on a path marked by periodic ascents. The act raised the maximum allowance to $18,000 in 1997, $18,500 in 1998, $19,000 in 1999, $20,000 in 2000, $24,000 in 2001 and 2002, and $25,000 in 2003 and thereafter.

With the enactment of the Community Renewal Tax Relief Act of 2000 (P.L. 106-544), Congress enlarged the list of special areas to include so-called "renewal communities" (RCs) and endowed them with many of the same tax benefits available to EZs, including an enhanced expensing allowance. The act also increased the maximum allowance for qualified assets placed in service in a tax year in the special areas (including RCs) to $35,000 above the regular allowance.

In response to the terrorist attacks of September 11, 2001, Congress established a variety of tax benefits through a provision of the Job Creation and Worker Assistance Act of 2002 (P.L. 107-147) to encourage new business investment in the part of lower Manhattan in New York City that was directly affected by the attack on the World Trade Center. The act designated this area as the New York "Liberty Zone." Among those tax benefits was the same enhanced expensing allowance available to firms located in EZs and RCs.

The regular allowance remained on the path created by the Small Business Jobs Protection Act until the passage of JGTRRA in 2003. Under JGTRRA, the maximum regular allowance jumped to $100,000 in May 2003 and was to remain at that amount in 2004 and 2005 before returning to $25,000 in 2006 and thereafter. JGTRRA also raised the phase-out threshold to $400,000 for the same period, indexed both the maximum regular allowance and threshold for inflation in 2004 and 2005, and made purchases of off-the-shelf software for business use eligible for expensing in 2003 through 2005.

Under the American Jobs Creation Act of 2004 (AJCA, P.L. 108- 357), the changes in the allowance made by JGTRRA were extended by another two years, or through 2007.

In an effort to spur economic recovery in the areas of Louisiana, Mississippi, and Alabama devastated by Hurricane Katrina, Congress passed the Gulf Opportunity Zone Act of 2005 (P.L. 109-135). The act offered a variety of tax incentives for new business investment in these areas, including an enhanced expensing allowance for qualified assets purchased on or after August 28, 2005, and placed in service by December 31, 2007. The expensing allowance for firms located in the zone can be as much as $100,000 above the regular allowance; it begins to phase out when the total cost of qualified assets placed in service in a tax year exceeds an amount that is $600,000 above the phase-out threshold for the regular allowance. In addition, the range of assets eligible for the enhanced allowance is greater than that for the regular allowance.

Legislative initiatives in the 109th Congress that would modify the existing expensing allowance can be divided into two categories: (1) those that would extend or further enhance the regular allowance, and (2) those that would offer an enhanced expensing allowance to firms making qualified investments in designated geographic areas characterized by relatively high levels of poverty or economic distress.

Bills to extend most or all of the enhancements in the regular allowance made by JGTRRA have been introduced in both houses.

In the House, H.R. 1091 (introduced by Representative Phil English on March 3, 2005) would keep the regular allowance from falling below $100,000 after 2007, raise its phase-out threshold to a minimum of $500,000 on January 1, 2006, and allow both amounts to be indexed for inflation beyond 2007. Two other measures (H.R. 1388, introduced by Representative Wally Herger on March 17, 2005, and H.R. 3841, introduced by Representative Donald Manzullo on September 21, 2005) would establish permanent floors for the regular allowance of $100,000 and for its phase-out threshold of $400,000 and allow both amounts to be indexed for inflation beyond 2007. None of the three bills would allow business taxpayers to expense purchases of off-the- shelf software for business use under IRC Section 179 beyond 2007. In addition, a bill (H.R. 1678) introduced by Representative Marilyn Musgrave on April 19, 2005, would extend the current regular allowance through 2009.

In the Senate, S. 1523, introduced by Senator Olympia Snowe on July 28, 2005, would make the same changes in the regular allowance as H.R. 1388 and H.R. 3841, but it would also permanently add off- the-shelf-software for business use to the pool of qualified assets.

More important, the House and Senate have approved differing tax reconciliation bills, both of which include a provision that would extend the existing regular allowance another two years, or through 2009: H.R. 4297 and S. 2020. The differences between the bills will have to be reconciled in a conference committee. Given that some of the differences are contentious, there is no certainty that a conference agreement likely to win approval in both houses will emerge anytime soon.³

Any of these proposed changes in the expensing allowance is likely to have the support of the President. In its budget request for FY2006, the Bush Administration favors permanently extending all the enhancements in the expensing allowance made by JGTRRA.

On December 16, 2005, the House and Senate passed a bill (H.R. 4440, P.L. 109-135) that, among other things, established a variety of tax incentives to spur economic recovery in the areas devastated by Hurricane Katrina in late August 2005. Among the incentives were an enhanced expensing allowance for qualified assets purchased on or after August 25, 2005, and placed in service no later than December 31, 2007, in a so-called "Gulf Opportunity Zone." The allowance can be as much as $100,000 above the regular allowance, and it begins to phase out at an amount that is $600,000 above the phase-out threshold for the regular allowance. In addition, unlike the regular allowance, the enhanced allowance applies to commercial real estate and residential rental property.

Efficiency Effects

Efficiency is both a central concept and guiding principle in economic analysis. It refers to the impact of the allocation of resources in an economy on the welfare of consumers and producers. When such an allocation leads to the greatest possible economic surplus -- calculated as the total value to buyers of the goods and services they consume, as measured by their willingness to pay, minus the total cost to sellers of providing these goods and services -- the allocation is said to be efficient. If an allocation is less than efficient, then some of the possible gains from exchange among buyers and sellers are not being realized. For example, an allocation is deemed inefficient when a good is not produced by sellers with the lowest marginal costs. In this case, a shift in production from high-cost producers to low-cost producers, driven perhaps by an unleashing of previously restrained market forces, would lower the total cost of providing the good, thereby raising the total economic surplus.

One important policy issue raised by the small business expensing allowance concerns its effect on the allocation of resources in general and the allocation of business investment in particular. In theory, all taxes except lump-sum taxes have adverse efficiency effects because they influence the decisions of consumers and producers in ways that leave one group or the other -- or perhaps both -- worse off. Taxes do this because they distort the incentives facing taxpayers, leading them to allocate resources according to the effects of taxes on the costs and benefits of the goods and services they buy and sell rather than their actual costs and benefits. Such a distortion entails what economists call a deadweight loss, or a condition where the amount of revenue raised by a tax falls short of the loss of the economic welfare of taxpayers it causes.

The allowance affects the allocation of resources in the U.S. economy by encouraging firms to invest in assets that qualify for the allowance at the expense of other assets, tangible and intangible. There are two channels through which the allowance can exert such an influence. The more important of the two is thought to be a reduction in the user cost of capital for investment in qualified assets relative to all other assets. A second channel is an increase in the cash flow or internal funds of firms that tend to finance investment mainly out of retained earnings for the simple reason that their cost of internal funds is significantly lower than their cost of external funds. It is important to note that the overall effect of the allowance on the domestic allocation of resources is limited because of the phase-out threshold for the allowance, which has the effect of restricting the pool of firms able to take advantage of the allowance to those that are relatively small in asset size.⁴

The user cost of capital strongly influences a firm's decision to invest. It encompasses both the opportunity cost of undertaking an investment and the direct costs of that investment, such as depreciation, the cost of the asset, and income taxes. In effect, the user cost of capital determines the after-tax rate of return an investment project must earn in order to be profitable -- and thus worth undertaking. In general, the higher the user cost of capital, the lower the number of profitable projects a firm can undertake -- and the lower its desired capital stock. When a change in tax policy leads to a decrease in the user cost of capital, firms may respond by increasing the amount of capital they wish to own, boosting business investment in the short run.

How does expensing reduce the user cost of capital? In essence, expensing is the most accelerated form of depreciation because the entire cost of an asset is written off in its first year of use, regardless of the asset's actual or useful life. Allowing a firm to expense is equivalent to the U.S. Treasury providing the firm (or its owners) with a tax rebate equal to the tax rate multiplied by the cost of the asset. Accelerated depreciation -- along with other investment tax subsides such as an investment tax credit -- can reduce the user cost of capital by decreasing the pre-tax return a firm must earn in order to attain a given after-tax return.⁵ This reduction expands as the period over which the asset's cost is written off contracts, and as the proportion of the cost that is written off in the beginning of that period increases. Expensing yields the largest possible reduction in the user cost of capital attributable to depreciation. The reduction can be considerable.⁶

How beneficial is expensing? One way to illuminate the tax benefits from expensing is to explain how it affects the marginal effective tax rate on the returns to a new investment. Expensing has the effect of taxing the stream of income earned by an asset over its lifetime at a marginal effective rate of zero.⁷ This means that if the entire cost of an investment is expensed, the after-tax rate of return on the investment becomes equal to its before-tax rate of return.⁸ This convergence occurs because expensing reduces after-tax returns and costs for eligible investments by the same factor: namely, the investor's marginal tax rate (whether the investor is a corporation or an individual acting as a small business owner). So, for example, if the tax rate is 35% and the cost of the investment is expensed, then the government bears 35% of the cost of the investment. By contrast, if the cost of the same investment were recovered at a rate reflecting the actual decline over time in the economic value of the underlying assets and no tax preferences for depreciation were available, then the returns would be taxed at current statutory rates. As a result of JGTRRA, the maximum federal corporate and individual income tax rate is 35% in 2005.

Some argue that expensing can also spur new business investment by augmenting the cash flow of firms, especially those that rely heavily on internal funds or retained earnings to finance new investment. In the world of business finance, the term "cash flow" does not necessarily have a universal meaning. Nevertheless, cash flow can be thought of as the difference between a firm's revenue and its payments for all factors or inputs used to generate its output, including capital equipment.

All other things being equal, expensing increases a firm's cash flow more than other allowable depreciation methods. A firm's ability to invest could hinge on its cash flow if it has limited or no access to debt and equity markets mainly because of insufficient information on the part of potential lenders or investors. In this case, the cost of internal funds would be lower than the cost of external funds, making it reasonable and even imperative for the firm to attempt to finance most of its new investment out of retained earnings. Some studies have found a significant positive correlation between changes in a firm's net worth or supply of internal funds and its investment spending.⁹ What is more, this correlation has been strongest for firms facing serious obstacles to raising funds in debt and equity markets because of insufficient information on the part of investors or lenders. At the same time, it would be erroneous to interpret these findings as conclusive evidence that firms with relatively high cash flows invest more than firms with relatively low or negative cash flows. After all, a positive or negative correlation offers no firm proof of the existence of a cause-and-effect relationship between two or more variables. It may be the case that firms with relatively high cash flows invest more, on average, than firms with relatively low cash flows for reasons that have little or nothing to do with the relative cost of internal and external funds. The connection between cash flow and business investment seems complicated, and further research is needed to clarify them.

To what extent has the expensing allowance contributed to shifts in the size and composition of the domestic capital stock in the 24 years it has existed in its present form? There appear to be no studies analyzing these effects. Considering the effect of expensing on the cost of capital and cash flow among small firms and available evidence suggesting that investment in many of the assets that qualify for the allowance is somewhat sensitive to reductions in its cost of capital, it is entirely possible that the allowance has caused domestic investment in qualified assets to be greater than it otherwise would have been.¹⁰ But it is also possible that much of this investment would have taken place without the expensing allowance.¹¹ In analyzing the efficacy of investment tax incentives such as the expensing allowance, it is useful to keep in mind that the decisions by business managers and owners to invest in assets eligible for the IRC section 179 expensing allowance tend to be driven more by their expectations for future sales growth, the nature of the capital goods themselves, and financing conditions than by tax considerations.¹²

Unpublished federal tax return data made available by the Internal Revenue Service (IRS) suggest that the allowance may play a significant role in trends in business investment in equipment. Between 1997 and 1999, 23% of corporations filing federal tax returns claimed the allowance, and the total value of IRC section 179 deductions claimed by corporations accounted for 2% of total corporate deductions for depreciation reported on those tax returns.¹³ In the same period, the total value of IRC section 179 property placed in service equaled 14% of domestic gross investment in equipment, according to data released by the U.S. Commerce Department.

When filtered through the lens of conventional economic theory, the expensing allowance acts like a drain on efficiency that may worsen the deadweight loss caused by the current federal tax code. Under the plausible assumption that the amount of capital in the economy is fixed in the short run, a tax subsidy like the allowance has the potential to lure capital away from more productive uses and into tax-favored investments. Conventional economic theory holds that in an economy free of significant market failures and ruled by competitive markets, a policy of neutral or uniform taxation of capital income would minimize the efficiency losses brought on by income taxation. The expensing allowance, however, encourages investment in specific assets by relatively small firms. Such a subsidy can retard the flow of financial capital to its most profitable uses by making it possible for business owners to earn higher after-tax rates of return on new investment in assets eligible for expensing than on new investment in other assets with higher expected pre-tax rates of return. In addition, the expensing allowance arguably gives firms able to claim it a significant incentive to restrain their growth. This unintended but logical outcome stems from the rise in marginal effective tax rates on the returns to investment in the allowance's phase-out range (presently, $400,000 to $500,000).¹⁴ Douglas Holtz-Eakin, the current Director of the Congressional Budget Office, has labeled this incentive effect a "tax on growth by small firms."¹⁵

Equity Effects

Equity is another important fundamental concept and guiding principle in economic analysis. In general, it refers to the distribution of economic welfare (as measured by income) among the individuals or households in a country. In the case of income taxation, equity denotes the distribution of the tax burden among taxpayers organized by income groups. Economists who analyze the equity effects of income taxes tend to focus on two distinct concepts of fairness: horizontal equity and vertical equity. Some individuals earn similar incomes. A tax system is said to be horizontally equitable if it imposes similar burdens on such individuals. At the same time, some individuals earn more than others. A tax system is said to be vertically equitable if the burdens it imposes vary according to an individual's ability to pay. The principle of vertical equity provides the foundation for a progressive income tax system. Under such a system, an individual's total tax liability, measured as a fraction of income, rises with income.

The federal income tax system incorporates both concepts. Income is used to measure an individual's ability to pay. Individuals filing singly or jointly or as heads of household in the same income group are taxed at the same marginal rate. At the same time, those in higher income groups are taxed at higher rates than those in lower income groups. Obviously, a key issue in assessing the fairness of the distribution of the federal income tax burden is the measurement of income. Because of various tax preferences in the form of deductions, deferrals, exclusions, exemptions, and credits enacted over many years, the definition of income under the federal tax code can be elastic. As a result, individuals earning the same income can end up paying different amounts in taxes.

The expensing allowance constitutes a tax preference, albeit for investment in certain tangible business assets. How does it affect vertical and horizontal equity?

To answer this question, it is necessary to understand what tax benefits derive from the expensing allowance, who receives them, and how they affect the recipients' federal income tax liabilities. The main tax benefit generated by the allowance is a reduction in the marginal effective tax rate on the returns to new investment in qualified assets. How much of a reduction depends largely on the proportion of the asset's acquisition cost that is subject to expensing. As was noted earlier, if the entire cost is expensed, then the marginal effective rate falls to zero. Nevertheless, the allowance does not change the marginal rates at which these returns are taxed. This is because an acceleration in the depreciation rate does not, in theory, reduce the amount of taxes that will be paid on an asset's expected stream of income over its useful life. Rather, accelerated depreciation changes the timing of tax payments in ways that are advantageous for business owners or shareholders. Most assets eligible for the allowance are owned by smaller firms. As a result, it is fair to assume that most of the tax benefit generated by the allowance is captured by small business owners. A recent analysis of federal income tax return data for individuals by William Gale of the Tax Policy Center found that few small business owners faced the highest marginal income tax rates, and that more than two-thirds of tax returns reporting small business income were in the lowest two tax brackets.¹⁶

Because the allowance does not alter income tax rates, it has no direct effect on the distribution of the federal income tax burden among income groups. And because the allowance leaves the distributional effects of the income tax unchanged, it can have no impact on vertical or horizontal equity.

Tax Administration

Yet another interesting policy question raised by the expensing allowance concerns its impact on the cost of tax compliance for business taxpayers.

Many public finance experts would agree that one of the critical features of a desirable income tax system is that it impose relatively low costs for administration and compliance. Research has shown that the administrative cost of a tax system varies according to numerous factors. The primary ones are the records that must be kept in order to comply with tax laws, the complexity of those laws, and the types of income subject to taxation.

Many public finance experts would also agree that the current federal income tax system fails the test of having relatively low costs for administration and compliance. In their view, the costs of collecting income taxes and enforcing compliance with the tax laws are needlessly high, and the primary cause is the complexity of the federal tax code. Many small business owners in particular have long complained bitterly about the costly burdens imposed on them by the record keeping and filings required by the federal income tax.

The expensing allowance addresses this concern by simplifying tax accounting for firms able to claim it. Less time and paperwork are involved in writing off the entire cost of a depreciable asset in its first year of use than in recovering its cost over a longer period under current depreciation schedules. Tax simplification has long been a primary policy objective for most small business owners, largely because of the relatively high costs they must bear in complying with federal tax laws. These costs were examined in a 2001 study prepared for the Office of Advocacy of the Small Business Administration. According to the study, the cost per employee for tax compliance in 2000 was an estimated $665 for all firms, $1,202 for firms with fewer than 20 employees, $625 for firms with 20 to 499 employees, and $562 for firms with 500 or more employees.¹⁷

² Like the maximum expensing allowance, the phase-out threshold is indexed for inflation in 2004 through 2007. In 2003, the threshold was $400,000, and in 2004, $410,000. The threshold for 2006 is likely to be higher than it is in 2005.

³ See Wesley Elmore, "Further Movement on Tax Cuts Unlikely as Session Winds Down," Tax Notes, Dec. 26, 2005, p. 1624.

⁴ This point is difficult to substantiate because of a paucity of reliable, publicly available data on capital spending by firm size. One way around this difficulty is to use depreciation allowances as a proxy for capital spending. Such an assumption appears reasonable because of the strong correlation over time between industry asset size, capital outlays, and depreciation allowances for tax purposes. According to IRS data, the average depreciation deduction for corporations with assets of $250 million and over in 1999 was $4.1 million; by comparison, the average depreciation deduction for corporations with less than $250 million in assets came to $32.5 thousand, or 0.8% of the average for the larger corporations.

⁵ The user cost of capital is the real rate of return an investment project must earn to be profitable. In theory, a firm will undertake an investment provided the after-tax rate of return exceeds or at least equals the user cost of capital. Rosen has expressed this cost in terms of a simple equation. Let C stand for the user cost of capital, a for the purchase price of an asset, r for the after-tax rate of return, d for the economic rate of depreciation, t for the corporate tax rate, z for the present value of depreciation deductions flowing from a $1 investment, and k for the investment tax credit rate. Then C = a x [(r +d) x (1-(t x z)-k)]/(1-t). Under expensing, z is equal to one. By plugging assumed values for each variable into the equation, it becomes clear that C increases as z gets smaller. Thus, of all possible methods of depreciation, expensing yields the lowest user cost of capital. For more details, see Harvey S. Rosen, Public Finance, 6th ed (New York: McGraw-Hill/Irwin, 2002), pp. 407-409.

⁶ In a 1995 study, Douglas Holtz-Eakin compared the cost of capital for an investment under two scenarios for cost recovery. In one, the corporation making the investment used expensing to recover the cost of the investment; and in the other, the cost was recovered under the schedules and methods permitted by the modified accelerated cost recovery system. He further assumed that the interest rate was 9%, the inflation rate 3%, and the rate of economic depreciation for the asset acquired through the investment 13.3%. Not only did expensing substantially reduce the cost of capital, its benefit was proportional to the firm's marginal tax rate. Specifically, Holtz-Eakin found that at a tax rate of 15%, expensing lowered the cost of capital by 11%; at a tax rate of 25%, the reduction was 19%; and at a tax rate of 35%, the cost of capital was 28% lower. See Douglas Holtz-Eakin, "Should Small Businesses Be Tax-Favored?," National Tax Journal, Sept. 1995, p. 389.

⁷ For a discussion of the economic logic behind such an outcome, see Jane G. Gravelle, "Effects of the 1981 Depreciation Revisions on the Taxation of Income from Business Capital," National Tax Journal, March 1982, p. 5.

⁸ For an example, see Joseph J. Cordes, "Expensing," in The Encyclopedia of Taxation and Tax Policy, Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington: Urban Institute Press, 1999), p. 114.

⁹ For a review of the recent literature on this topic, see R. Glenn Hubbard, "Capital Market Imperfections and Investment," Journal of Economic Literature, vol. 36, March 1998, pp. 193-225.

¹⁰ Two studies from the 1990s found that a 1% decline in the user cost of capital was associated with a rise in business equipment spending of 0.25% to 0.66%. See CRS Report RL31134, Using Business Tax Cuts to Stimulate the Economy, by Jane G. Gravelle, p. 4.

¹¹ There is some anecdotal evidence to support this supposition. At a recent hearing held by the House Small Business Subcommittee on Tax, Finance, and Exports, Leslie Shapiro of the Padgett Business Services Foundation stated that expensing "may be an incentive in making decisions to buy new equipment, but it's not the dominant force." His firm provides tax and accounting services to over 15,000 small business owners. See Heidi Glenn, "Small Business Subcommittee Weights Bush's Expensing Boost," Tax Notes, April 7, 2003, p. 17.

¹² See Roger W. Ferguson, Jr., "Factors Influencing Business Investment," speech delivered on Oct. 26, 2004, available at [http://www.federalreserve.gov/boarddocs/speeches/2004/ 20041026/default.htm].

¹³ Data on business claims for the expensing allowance were obtained via e-mail from Nina Shumofsky of the Statistics of Income Division at IRS on March 27, 2003.

¹⁴ Jane Gravelle of CRS estimated that, assuming a corporate tax rate of 28% and a rate of inflation of 3%, in the phase-out range for the expensing allowance the marginal effective tax rate on the returns to favored assets is 36%, compared to a rate of 0% for each dollar of investment up to $200,000 and a rate of 22% for all corporations.

¹⁵ U.S. Congress, Senate Committee on Finance, Small Business Tax Incentives, hearings on S. 105, S. 161, S. 628, S. 692, S. 867, and H.R. 1215, 104th Cong., 1st sess., June 7, 1995 (Washington: GPO, 1995), pp. 11-12.

¹⁶ William G. Gale, "Small Businesses and Marginal Income Tax Rates," Tax Notes, April 26, 2004, p. 471.

¹⁷ W. Mark Crain and Thomas D. Hopkins, The Impact of Regulatory Costs on Small Firms (Washington: Office of Advocacy, Small Business Administration, 2001), p. 32.