A tax proposal released on Thursday by the chairman of the Senate Finance Committee, Max Baucus, addresses a topic that tends to make my students’ eyes glaze over: cost recovery.
Cost recovery is a technical topic but one that may shape our economic future, since it affects the calculations of every business manager making a decision about what projects to pursue and what assets to buy.
Under current law, cost recovery (better known as depreciation) is accelerated, meaning that the value of assets can be written off for tax purposes faster than the assets actually decline in value in economic terms.
Accelerated depreciation has a long history rooted in the goals of the 20th century manufacturing economy. Facing the rising threat of world war, Congress introduced accelerated cost recovery in 1940 to encourage investment in property considered necessary for the national defense. (Before acquiring property that would benefit from accelerated depreciation rules, taxpayers had to seek a certificate of necessity from the War Production Board.) Liberal depreciation allowances were expanded with the enactment of the 1954 Internal Revenue Code. The current accelerated depreciation system was in place by the 1980s, and revised in the 1990s, again with an eye toward encouraging investment in productive machinery, equipment and other tangible assets.
But it is no longer clear that we should use the tax system to encourage investment in tangible assets. After all, a system that encourages investment in tangible assets makes investments in other assets â€" intangible assets and human capital â€" look worse by comparison. The Baucus proposal aims to make the tax system match economic reality, removing the tax distortions from the equation. It would group tangible assets into just four different pools, with a fixed percentage of cost recovery applied to the tax basis of each pool each year, ranging from 38 percent for short-lived assets to 5 percent for certain long-lived assets.
This policy change is more important than it sounds. Imagine three types of assets a business might invest in: (1) tangible assets, like office furniture, livestock and manufacturing equipment; (2) intangible assets, like patents, technology licenses, customer lists and marketing rights; and (3) human capital in the form of salaries and training for employees. If the goal is to improve our long-term economic growth and prosperity, which type of investment is most important?
It would be hard to make the case for giving the priority to tangible assets, and yet that is precisely what current law does by allowing rapid depreciation. At a minimum, the tax depreciation system should strive for neutrality and not discourage investment in intangibles and human capital. If we want to give incentives to a particular activity that generates positive effects beyond the company making the investment â€" an argument often made in favor of subsidizing research and development â€" then refundable tax credits, scientific grant programs or other indirect government expenditures are better approaches.
Cost recovery provides an uneven benefit to taxpayers, making it an especially weak instrument to subsidize activities that we want to encourage. For companies that pay little income tax, like many start-ups, accelerated depreciation offers little benefit. While net operating losses increase through the use of accelerated depreciation, the value of those losses is deferred and often lost because of limitations that kick in when the company is acquired or goes public. And yet these start-ups are often the companies that engage in the innovative research and development that can build a healthier economy in the long run.
As with Senator Baucus’s international tax proposal, revenue raised from modernizing cost recovery would be used to pay for a reduction in corporate tax rates. Industries that benefit from the current rules, like the oil and gas industry, are expected to denounce the change. While the prospects of the legislation moving forward are uncertain in the short term, the proposal shifts the burden onto old economy companies to explain why their industries should be subsidized at everyone else’s expense.
Victor Fleischer is a professor of law at the University of San Diego, where he teaches classes on corporate tax, tax policy, and venture capital and serves as the director of research for the Graduate Tax Program. His research focuses on how tax affects the structuring of venture capital, private equity, and corporate transactions. Twitter: @vicfleischer
