Order Code RL3185 2RL31852
CRS Report for Congres s
Congress
Received through the CRS Web
Small Business Expensing Allowance Under th e
Jobs and Growth Tax Relief Reconciliation Act o f
2003 : Changes and Likely Economic Effect s
Updated June 24, 2003
Gary Guenthe r:
Current Status, Legislative Proposals,
and Economic Effects
Updated May 9, 2005
Gary Guenther
Analyst in Business Taxation and Financ eFinance
Government and Finance Divisio nDivision
Congressional Research Service v˜ The Library of Congress
Small Business Expensing Allowance Under the Job s
and Growth Tax Relief Reconciliation Act of 2003 :
Changes and Likely Economic Effect s
Summar y: Current Status,
Legislative Proposals, and Economic Effects
Summary
Under current federal tax law, business taxpayers are allowed to deduct (or
expense) up to $100at least $102,000 of the total cost of qualified assets placed in service in a
in a single tax year from 2005 through 2007. In . In
the absence of such a provision, firms
would have to recover the cost over a longer
period under allowable depreciation schedules . The accelerated write-off under what
is known as the expensing allowance represents a significant tax benefit because i t
reduces the tax burden on the returns to investment in qualified assets . Certain rule s
governing the use of the allowance effectively confine its benefits to relatively smal l
firms .
In early January 2003, President Bush publicly endorsed a package of measure s
to stimulate the economy which included a substantial expansion of the expensin g
allowance . On May 9, 2003, the House passed H .R. 2, which would have raised th e
allowance from $25,000 to $100,000 and the phase-out threshold from $200,000 t o
$400,000 in 2003 through 2007, indexed both amounts for inflation, and adde d
packaged software to the depreciable assets eligible for expensing, among other
things. The amended version of H .R . 2 passed by the Senate on May 15, 2003 woul d
have made the same changes in the allowance . Under a conference agreement passe d
by both houses on May 23, 2003 and signed into law by President Bush on May 28 ,
2003 (the Jobs and Growth Tax Relief Reconciliation Act of 2003 or JGTRRA, P .L.
108-26), the allowance is set at $100,000 and the phase-out threshold at $400,000 in
2003 through 2005 ; both amounts are indexed for inflation in 2004 and 2005 ; and
packaged software qualifies for expensing in 2003 through 2005 .
Proponents of expanding the allowance in the manner of JGTRRA hav e
maintained that such a step should impart a significant boost to small busines s
investment . To substantiate this expectation, they note that the expansion reduce s
the user cost of capital for a broader pool of possible small business investmen t
projects, is likely to increase the cash flow of many small firms in the next thre e
years, is temporary, increases the number of firms able to benefit from expensing ,
and adds packaged software to the array of depreciable assets eligible for expensing .
But some analysts are convinced that the temporary expansion will have muc h
smaller impact on small business investment . In their view, the expansion is unlikel y
to make much of a difference in a domestic business investment climate marked b y
excess capacity and widespread pessimism among business executives over-futur e
growth in sales and profits . In addition, they say that most small business owners ar e
unlikely to speed up the timing of planned future investments to take advantage o f
the temporary expansion because they believe that Congress will extend th e
expansion before it expires . The sceptics also note that there is a lack of empirica l
evidence that investment tax incentives spur significant increases in busines s
investment in the short run .
This report will not be updated .
Content s
Current Expensing Allowance
1
Legislative History of the Expensing Allowance
3
Main Economic Effects of the Expensing Allowance
Efficiency Effects
Equity Effects
Tax Administration
3
4
7
8
Proposals in the 108 th Congress to Expand the Expensing Allowance
8
Likely Short-Term Economic Effects of the Temporary Expansion o f
the Expensing Allowance
9
Small Business Expensing Allowanc e
Under the Jobs and Growth Tax Relie f
Reconciliation Act of 2003 : Changes an d
Likely Economic Effect s
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA :
H.R. 2, P .L .108-27), firms may deduct (or expense) up to $100,000 of the cost of
qualified depreciable assets placed in service in a single tax year between 2003 an d
2005 . Before the enactment of JGTRRA, the maximum allowance was $25,000 in
2003 and thereafter . In the absence of such a provision, firms would have to recover
this cost over longer periods through allowable depreciation deductions . The
expensing allowance represents a significant tax subsidy for business investmen t
because it has the potential to eliminate or greatly reduce the tax burden on th e
returns to investment in qualified assets . Certain rules governing the use of th e
allowance effectively confine its benefits to relatively small firms .
This report examines the likely short-term economic effects of the large bu t
temporary expansion of the expensing allowance enacted as part of JGTRRA . It
begins with an explanation of how the allowance works and a brief description of it s
legislative history . The report concludes with a discussion of the allowance's likel y
short-term economic effects .
Current Expensing Allowanc e
Under section 179 of the Internal Revenue Code (IRC), business taxpayer s
purchasing qualified property (or assets) may deduct (or expense) some or all of it s
cost (depending on the amount) in the year in which it is placed into service ,
provided certain conditions are met . The alternative to expensing is to recover the
cost over longer periods through depreciation deductions intended to approximate th e
rate at which these assets lose value . Between 2003 and 2005, the maximum
expensing allowance is $100,000 for firms operating outside empowerment zones .
For firms conducting all their trade or business within these zones, the maximu m
allowance in that period is the lesser of $35,000 or the cost of qualified property . In
2006, the maximum allowance for non-empowerment zone firms falls to $25,000 ,
its level before the enactment of JGTRRA .
Qualified property is defined as certain new and used depreciable assets - a s
specified in IRC section 1245(a)(3) - acquired for use in the active conduct of a trad e
or business . With a few exceptions, it consists of business machines and equipmen t
used in connection with manufacturing or production, extraction, transportation ,
communications, electricity, gas, water, and sewage disposal. Transportation
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equipment with a gross, unloaded weight of more than 6,000 pounds may b e
expensed, but heating and air conditioning units are not eligible for the allowance .
Most buildings and their structural components are ineligible for the allowance, bu t
research and bulk storage facilities related to these commercial activities do qualify .
In addition, under JGTRRA, purchases of off-the-shelf, packaged computer softwar e
may be expensed from 2003 through 2005 .
Business taxpayers may also claim a temporary 30% first-year depreciatio n
deduction under the Job Creation and Worker Assistance Act of 2002 (P .L. 107-147)
for new (but not used) property depreciable under the modified accelerated cost
recovery system (MACRS) and having a recovery period of less than 20 years .
Under the act, qualified property acquired between September 11, 2001 an d
September 11, 2004 and placed in service before January 1, 2005 is eligible for th e
bonus depreciation, as well as regular depreciation deductions and the expensing
allowance under IRC section 179 . JGTRRA extends the deadline for acquirin g
qualified property to December 31, 2004 . For property eligible for both th e
expensing and the bonus depreciation allowances, a firm must claim its depreciation
deductions in the following order : expensing allowance, the bonus depreciation o n
the remaining basis in the property (if any), and the MACRS depreciation on th e
remaining basis (if any) . JGTRRA adds a separate 50% first-year depreciation
deduction for purchases of the same property between May 6, 2003 and January 1 ,
2005 ; the property must be placed in service by January 1, 2006 . Business taxpayers
may claim either the 30% or 50% first-year depreciation allowance, but not both .
The amount that a business taxpayer may deduct in a single tax year unde r
section 179 is subject to two important limitations : a dollar limitation and a taxable income limitation . Under the dollar limitation, the maximum expensing allowanc e
is reduced, dollar for dollar, by the amount by which the cost of all qualified propert y
placed in service during the year exceeds $400,000 (an amount that sometimes i s
referred to as the phase-out threshold) in 2003 through 2005 . This limit applies to
either the entire cost or a portion of the cost of one or more qualified assets . In 2006
and thereafter, the limit falls back to its pre-JGTRRA level of $200,000 . As a result ,
none of the cost of qualified property placed in service in a single year from 200 3
through 2005 may be expensed if this cost reaches $500,000 or more, since the ca p
on the allowance is $100,000 in that period . Under the taxable-income limitation ,
the expensing allowance cannot exceed the taxable income a taxpayer earns from th e
active conduct of a trade or business . No deduction disallowed under the dolla r
limitation may be carried forward, but deductions disallowed under the income
limitation may be carried forward .
Under JGTRRA, both the maximum expensing allowance and the phase-ou t
threshold are indexed for inflation in 2004 and 2005 .
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Legislative History of the Expensing Allowanc e
The expensing allowance under 1RC section 179 originated as an added first year depreciation deduction enacted as part of the Small Business Tax Revision Ac t
of 1958 (P .L. 85-866) . It was intended to reduce the tax burden on small busines s
owners, stimulate small business investment, and simplify their tax accounting . The
deduction was equal to $2,000 ($4,000 in the case of a married couple filing a join t
return) of the cost of new and used business machines and equipment with a recover y
period for tax purposes of six years or more .
This allowance remained in force until the enactment of the Economic Recover y
Tax Act of 1981 (ERTA, P .L . 97-34), which replaced the additional deduction with
a maximum expensing allowance of $5,000 and put in place a timetable for graduall y
increasing the allowance to $10,000 by 1986 . Despite the increase in the maximu m
deduction under ERTA, few firms took advantage of it because of a rule denying th e
investment tax credit established by ERTA to the portion of an asset's cost that wa s
expensed.
Faced with large and growing federal budget deficits, Congress passed th e
Deficit Reduction Act of 1984 (P .L. 98-369), which, among other things, postpone d
the scheduled increase in the allowance to $10,000 from 1986 until 1990 . Claims fo r
the allowance rose markedly following the repeal of the investment tax credit by th e
Tax Reform Act of 1986 .
The maximum allowance remained at $10,000 from 1990 until the enactmen t
of the Omnibus Budget Reconciliation Act of 1993 (P .L . 103-66), which increase d
it to $17,500 as of January 1, 1993 . With the passage of the Small Business Jo b
Protection Act of 1996 (P .L. 104-188), the allowance embarked on a path o f
staggered ascents . Under the Act, the maximum allowance rose to $18,000 in 1997 ,
$18,500 in 1998, $19,000 in 1999, $20,000 in 2000, $24,000 in 2001 and 2002, an d
$25,000 in 2003 and thereafter .
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (P .L. 108 27), the allowance jumps to $100,000 in 2003, 2004, and 2005, before dropping bac k
to $25,000 in 2006 and thereafter . The Act also raises the phase-out threshold to
$400,000 in the same period, indexes both amounts for inflation in 2004 and 2005 ,
and makes purchases of off-the-shelf software eligible for expensing in 2003 throug h
2005 .
Main Economic Effects of the Expensing Allowanc e
Although many small business owners may view the expensing allowanc e
chiefly as a vehicle for delivering what they regard as welcome tax relief, its
economic effects go beyond the impact on the tax liabilities of small busines s
owners . The allowance has implications for the allocation of business fixe d
investment, the distribution of the federal tax burden among income groups, and th e
cost of tax administration . These effects loosely correspond to the three classic
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criteria for evaluating tax systems : efficiency, equity, and simplicity . Each i s
examined below.
Efficiency Effects
One important economic effect of the expensing allowance is that it affects (t o
an unknown extent) the allocation of resources in the U .S. economy by encouragin g
firms to invest in qualified assets at the expense of other assets . According t o
economists who study the forces driving business investment, the allowance does s o
in two ways . One is by reducing the user cost of capital for investment in these asset s
relative to other assets . A second channel through which the allowance encourage s
investment in qualified assets is by increasing the cash flow or internal funds of firm s
whose cost of internal funds is significantly lower than the cost of external funds .
Owing to the phase-out threshold for the allowance, most of the firms takin g
advantage of it are likely to be relatively small in asset size . '
The user cost of capital is a key factor in a firm's decision to invest as it
embraces both the opportunity cost of forgoing other investments and the direct cost s
of an investment such as depreciation and income taxes . In essence, the user cost o f
capital specifies the after-tax rate of return an investment project must achieve i n
order to be profitable, and thus worth undertaking . In general, the higher the use r
cost of capital, the lower the number of profitable projects that might be undertaken ,
and the lower a firm's desired capital stock . When a change in tax policy reduces th e
user cost of capital, the reduction may increase the amount of capital that firms wis h
to hold, boosting business fixed investment in the short run .
How does expensing reduce the user cost of capital for favored assets ?
Basically, expensing is the most accelerated form of depreciation in that the entir e
cost of an asset is written off in its first year of use, regardless of the asset's actual
economic or useful life . Expensing can be viewed as equivalent to the U .S. Treasury
providing the investor with a tax rebate equal to the tax rate multiplied by the cost o f
the asset . Depreciation allowances effectively reduce the user cost of capital b y
decreasing the pre-tax return a firm must earn in order to attain a given after-ta x
return .2 This cost reduction increases as the period over which the asset's cost i s
' This point is difficult to substantiate because of a paucity of reliable data on capita l
spending by firm size . One way to circumvent this difficulty is to use depreciation
allowances as a proxy for capital spending . Such an assumption is reasonable because o f
the strong correlation over time between industry asset size, capital outlays, and depreciatio n
deductions for tax purposes . According to IRS data, in 1999, the average depreciation
deduction for corporations with assets of $250 million and over was $4 .1 million; by
comparison, the average depreciation deduction for corporations with less than $250 millio n
in assets came to $32 .5 thousand, or 0 .8% of the average for the larger corporations .
2 The user cost of capital is the real rate of return an investment project must earn to b e
profitable . In theory, a firm will undertake an investment provided the after-tax rate o f
return exceeds or at least equals the user cost of capital . Rosen has expressed this cost i n
terms of a simple equation . Let C stand for the user cost of capital, a for the purchase pric e
of an asset, r for the after-tax rate of return, d for the economic rate of depreciation, t for th e
corporate tax rate, z for the present value of depreciation deductions flowing from a $ 1
(continued. . .)
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written off contracts, and as the proportion of the cost that is written off in th e
beginning of that period expands . Expensing yields the largest possible reduction i n
the user cost of capital attributable to depreciation . The reduction can be
considerable.'
How beneficial to firms is expensing? One way to illustrate the tax benefit s
from expensing is to assess how it affects the marginal effective tax rate on th e
returns to an investment. Expensing is equivalent to taxing the stream of income
earned by an asset over its lifetime at a marginal effective rate of zero .4 In other
words, under expensing, the after-tax rate of return on an investment becomes equa l
to its before-tax rate of return . 5 This occurs because expensing reduces after-ta x
returns and costs by the same factor : namely, the investor's marginal tax rate
(whether the investor is a corporation or an individual) . 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 its rat e
of economic depreciation and no tax preferences were available, then the returns
would be taxed at existing statutory rates . As a result of JGTRRA, the maximum
federal corporate and individual income tax rate is 35% in 2003 .
Some maintain that expensing can also stimulate business investment b y
augmenting the cash flow of firms that rely heavily on internal funds or retaine d
earnings to finance new investment . Cash flow can be thought of as the differenc e
between a firm's revenue and payments for inputs, including capital equipment . All
other things being equal, expensing increases a firm's cash flow more than othe r
allowable depreciation methods . One reason why a firm's capacity to invest coul d
Z (. ..continued)
investment, and k for the investment tax credit rate. Then C = a x [(r +d) x (1-(t x z)-k)]I(1 t). Under expensing, z is equal to one . By plugging assumed values for each variable int o
the equation, it becomes clear that C increases as z gets smaller . Thus, of all possibl e
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 .
407409.
In a 1995 study, Douglas Holtz-Eakin compared the cost of capital for an investment unde r
two scenarios for cost recovery . In one, the corporation making the investment use d
expensing to recover the cost of the investment ; and in the other, the cost was recovere d
under the schedules and methods permitted by the modified accelerated cost recover y
system . He further assumed that the interest rate was 9%, the inflation rate 3%, and the rat e
of economic depreciation for the asset acquired through the investment 13 .3%. Not only di d
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%, expensin g
lowered the cost of capital by 11% ; at a tax rate of 25%, the reduction was 19% ; and-0 a tax
rate of 35%, the cost of capital was 28% lower . See Douglas Holtz-Eakin, "Should Smal l
Businesses Be Tax-Favored?," National Tax Journal, Sept. 1995, p . 389 .
4 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 Busines s
Capital," National Tax Journal, March 1982, p . 5.
s
For an example, see Joseph J. Cordes, "Expensing," in The Encyclopedia of Taxation an d
Tax Policy, Joseph J . Cordes, Robert D . Ebel, and Jane G . Gravelle, eds . (Washington :
Urban Institute Press, 1999), p. 114 .
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depend critically on its cash flow is that it has limited or no access to debt and equit y
markets because of insufficient information on the part of lenders or investors . In
this case, the cost of internal funds would be lower than the cost of external funds ;
so most investment would be financed out of the firm's cash flow . Some studie s
have found a significant positive correlation between changes in a firm's net wort h
or internal funds and its investment spending .' In addition, this correlation i s
strongest for firms facing obstacles in raising funds in debt and equity market s
because of information problems . But it would be incorrect to construe thes e
findings as conclusive evidence that firms with relatively high cash flows invest mor e
than firms with relatively low or negative cash flows . The links between cash flo w
and business investment are a topic of further research among economists .
To what extent has the expensing allowance contributed to shifts in the size an d
composition of the domestic capital stock in the twenty-two or so years it has existe d
in its present form? No one seems to know, largely because there appear to be n o
studies analyzing this impact . Nonetheless, considering expensing's impact on th e
cost of capital and available empirical evidence that investment in assets eligible fo r
the allowance is somewhat sensitive to reductions in its cost of capital ', it is
reasonable to assume that the allowance has caused domestic investment in qualifie d
assets to be greater than it otherwise would have been . But it is also reasonable t o
assume that a significant proportion of investment in IRC section 179 property woul d
have taken place without the expensing allowance .' Federal tax return data made
available by the Internal Revenue Service (IRS) indicate that the allowance ma y
account for a significant share of business investment in equipment . In 2000, 5 .4
million sole proprietorships, partnerships, and corporations claimed the deductio n
under IRC section 179, and the total cost of IRC section 179 property placed i n
service came to $89 .1 billion. Between 1997 and 1999, 23% of corporations filin g
federal tax returns claimed a deduction under section 179 ; the total value of sectio n
179 deductions claimed by corporations averaged 2% of total corporate deduction s
for depreciation reported on those tax returns .9 In the same period, the total value o f
section 179 property placed in service averaged 14% of domestic gross investmen t
in equipment, according to data released by the U .S. Commerce Department .
6
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 .
' Two studies from the 1990s found that a 1% decline in the user cost of capital wa s
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.
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 o f
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 .
9
Data on business claims for the expensing allowance were obtained via e-mail from Nin a
Shumofsky of the Statistics of Income Division at IRS on March 27, 2003 .
CRS- 7
When viewed through the lens of economic theory, however, the expensin g
allowance takes on the appearance of a drain on economic efficiency . Assuming the
amount of capital in the economy is fixed in the short run, a tax subsidy like th e
allowance has the potential to draw capital away from more productive uses . Theory
holds that in an economy free of significant market failures and dominated b y
competitive markets, neutral or uniform taxation of capital income is the tax polic y
best suited to foster an efficient allocation of resources . The expensing allowance ,
however, encourages investment in specific assets by firms of a certain size . In
theory, such a subsidy can prevent capital from migrating to its most economicall y
valuable applications . Moreover, the allowance may give eligible firms an incentiv e
restrain their growth . This unintended incentive flows from the rise in margina l
effective tax rates on the returns to investment in the allowance's phase-out rang e
(presently, $400,000 to $500,000) . 10 Douglas Holtz-Eakin has described thi s
perverse effect as a "tax on growth by small firms.""
Equity Effects
Another important economic effect of the expensing allowance is its impact o n
the distribution of the federal tax burden among income groups . The current federal
income tax system is built on the principle of progressivity . Under such a principle ,
an individual's tax burden depends on his or her taxable income, and those wit h
higher taxable incomes bear larger shares of the overall burden . How does the
allowance affect the progressivity of the federal income tax ?
The allowance reduces the tax burden on a portion of capital income : namely,
the returns on investment earned by firms able to claim the allowance . Most studie s
of the taxation of capital income leave the impression that any such tax is likely t o
be borne by all owners of capital in the short run, given reasonable and defensibl e
behavioral assumptions . Research shows that capital income is heavily concentrate d
in upper-income groups : in a 1998 report, the Congressional Budget Offic e
estimated that in 1999, 40% of capital income would be received by the top 1% o f
households ranked by cash income, 60% would be received by the top 5%, and 67 %
would be received by the top 10% .'2 Available data indicate that the typical smal l
business owner has a relatively high income and net worth .' These findings sugges t
10 Jane Gravelle estimated that, assuming a corporate tax rate of 28% and a rate of inflatio n
of 3%, in the phase-out range for the expensing allowance the marginal effective tax rate o n
the returns to favored assets is 36%, compared to a rate of 0% for each dollar of investmen t
up to $200,000 and a rate of 22% for all corporations .
" 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, 104 th Cong., 1 5' sess ., June 7, - 199 5
(Washington : GPO, 1995), pp . 11-12 .
j2 U.S. Congressional Budget Office, Estimates ofFederal Tax Liabilities for Individual s
and Families by Income Category and Family Type for 1995 and 1999, memorandum
(Washington : May 1998), p. 30 .
13 Surprisingly few studies examine the incomes and wealth of small business owners . A
recent study, funded in part by the Small Business Administration (SBA), compared th e
mean and median income and wealth of families with and without small business owner s
(continued. ..)
CRS-8
(but do not prove) that relatively high-income households capture most of the tax
benefits generated by the allowance, and that the allowance lessens (to an unknown
but probably minor extent) the progressivity of the federal income tax system .
Tax Administratio n
Another notable economic effect of the expensing allowance is that it simplifie s
tax accounting for firms able to claim it . Less time and paperwork are involved i n
writing off the entire cost of a depreciable asset in its first year of use than i n
recovering the cost over a longer period . Tax simplification has long been an
important policy objective for most small business owners, largely because of th e
relatively high costs they must bear in complying with federal tax laws . According
to a 2001 study prepared for the Office of Advocacy of the Small Busines s
Administration, in 2000, the cost per employee for tax compliance was an estimate d
$665 for all firms, $1,202 for firms with fewer than 20 employees, $625 for firm s
with 20 to 499 employees, and $562 for firms with 500 or more employees . ? 4
Proposals in the 108 th Congress to Expand th e
Expensing Allowanc e
Recent actions by the 108th Congress indicate there is bipartisan support fo r
bolstering the expensing allowance in order to both stimulate the economy and ai d
small business owners . In early January 2003, President Bush endorsed a packag e
of measures designed in part to accelerate the pace of short-term economic growth .
One of the measures called for a permanent expansion of the expensing allowance .
Specifically, the President proposed that, effective January 1, 2003, the allowance b e
increased from $25,000 to $75,000, the phase-out threshold be raised from $200,00 0
to $325,000, and purchases of off-the-shelf computer software qualify for th e
allowance ; he also recommended that the allowance and threshold be indexed fo r
inflation as of January 1, 2004.
Since the start of the 108 th Congress, at Ieast 11 bills to enhance the allowanc e
have been introduced . 15 Two played critical roles in the enactment of JGTRRA :
13 (. . .continued )
from 1989 to 1998, using data on consumer finances obtained from the Federal Reserv e
Board. It found that in 1998, households with no business owners had a mean income o f
$43,999 ; by contrast, households with small business owners had a mean income that wa s
$101,563, or 2 .3 times greater . Similarly, in 1998, the mean net worth of households
without business owners was $171,904, or about one-fifth the mean net worth of households
with small business owners, which came to $832,514 . See George W. Haynes, Wealth and
Income: How Did Small Businesses Fare from 1989 to 1998?, May 16, 2001, pp . 24 and
27, available from the SBA's Office of Advocacy website : www.sba .govladvo .
Fa W
. Mark Crain and Thomas D . Hopkins, The Impact ofRegulatory Costs on Small Firm s
(Washington : Office of Advocacy, Small Business Administration, 2001), p . 32 .
15 The bills are H.R . 2, H .R . 22, H .R . 179, H .R. 224, H .R. 1079, H.R. 1126, S. 2 (identical
(continued...)
CRS-9
H.R. 2 and S . 2 . H .R. 2, as passed by the House on May 9, 2003, would have raise d
the expensing allowance to $100,000 and the phase-out threshold to $400,000 an d
index both for inflation from 2003 through 2007 . It would also have made purchases
of off-the-shelf computer software eligible for expensing in the same period . By
contrast, S . 2, as reported by the Senate Finance Committee on May 8, 2003, woul d
have implemented the President's proposal in the period from 2003 through 2012 .
During floor consideration of S . 2, the Senate incorporated the language of S . 105 4
into H .R . 2 as an amendment and approved the amended version on May 15, 2003 .
The Senate amendment would have made the same changes in the expensin g
allowance as the House-passed version of H .R. 2 . Under the conference agreement
for H.R. 2 (H .Rept . 108-26) approved by the House and Senate on May 23, 2003, th e
allowance rises to $100,000 and the phase-out threshold to $400,000 in 2003 to 2005 ;
off-the-shelf computer software becomes eligible for expensing in 2003 to 2005 ; and
the amounts of the allowance and phase-out threshold are indexed for inflation i n
2004 and 2005 . Starting in 2006, the allowance is to return to its status before the
enactment of JGTRRA .
Likely Short-Term Economic Effects of th e
Temporary Expansion of the Expensing Allowanc e
In the debate preceding the enactment of JGTRRA, those favoring a substantia l
increase in the IRC section 179 expensing allowance pointed to the potentia l
economic benefits as the primary reason for taking such a step . Two such benefit s
were paramount, in their view . First, they said that a more generous allowance woul d
generate greater rates of capital formation and employment growth among smal l
firms in the short run by Iowering their cost of capital for investment in qualifie d
assets and by increasing their cash flow . Second, they maintained that an enhance d
allowance would reduce their compliance burden by simplifying their tax accountin g
for depreciation . Public comments in support of President Bush's proposal to expan d
the expensing allowance made by Chad Moutray, the chief economist at the Smal l
Business Administration's Office of Advocacy, and Gregory F . Jenner, the Deput y
Assistant Secretary for Tax Policy at the Treasury Department, exemplified this lin e
of reasoning .' Such an argument raises the question of how much of new investment
and how many new jobs are likely to arise from the large but temporary expansio n
of the allowance under JGTRRA .
In light of what is known about the main economic effects of the allowance, thi s
much seems clear . First, there are reasons to believe that the temporary expansio n
15 (. ..continued)
to H.R. 2), S . 106, S . 158 (identical to H .R. 179), S . 414, and S . 513 .
16 See Chad Moutray, "President's Plan Means Jobs and Growth for Small Business," The
Small Business Advocate (Washington : Small Business Administration, Feb . 2002), p . 5 ; an d
statement by Gregory F . Jenner before a hearing of the House Small Business Subcommitte e
on Tax, Finance, and Exports held on April 3, 2003 and entitled "Small Business Expensing :
Increasing Incentives for Small Companies to Grow and Invest in Their Businesses, "
available from www .nexis.com.
CRS-1 0
could trigger a significant increase in small business investment in the short run . It
reduces the user cost of capital for investment in qualified assets ; the reduction is
proportional to the share of an asset's cost that is expensed . The expansion also add s
computer software to the pool of assets eligible for the allowance for thre e
consecutive years . In addition, it would increase the number of firms able to take
advantage of expensing . And by reducing a small business taxpayer's current ta x
liability relative to what it otherwise would be, the expansion increases the amoun t
of internal funds available for investment (or other purposes, including payin g
dividends or retiring outstanding debt) by small firms claiming the allowance in th e
next three years . Finally, because the expansion is temporary, it increases a firm' s
incentive to invest in qualified assets in the next three years relative to future periods .
Rising investment in turn would create some new employment opportunities .
Second, the temporary expansion of the expensing allowance would also lesse n
to an unknown (but probably minor) extent the progressivity of the federal incom e
tax system by increasing the number of small business owners who benefit fro m
expensing.
And third, expanding the allowance as provided in JGTRRA should also hav e
the benefit of simplifying tax accounting for an increased number of small firms .
Nonetheless, some seriously doubt that the expansion of the expensing
allowance will impart as strong a boost to small business investment and employmen t
in the short run as proponents have maintained . They cite several reasons for thi s
scepticism .
First, sceptics note that economic context and timing are critical to the efficac y
of fiscal policy as a tool for stimulating the economy . In their view, investment tax
incentives like an investment tax credit or expensing are likely to be most effectiv e
when an economy is growing, most industries are operating at relatively high rate s
of capacity utilization, and the vast share of business executives are optimistic abou t
future growth in sales and profits . Yet U.S . business investment and industrial
operating rates remain significantly below the levels they reached when the econom y
was growing robustly in the late 1990s, despite relatively low interest and inflatio n
rates in the past two years and the enactment of a temporary 30% first-yea r
depreciation deduction in 2002 ." Some argue that the temporary expansion of th e
" According to figures released by the Commerce Department, real domestic investment i n
non-residential fixed investment (seasonally adjusted at annual rates) fell steadily from it s
most recent peak of $1,340 .7 billion (1996 dollars) in the third quarter of 2000 to $1,178 . 7
billion in the third quarter of 2002, before rising to $1,185 .3 billion in the fourth quarter o f
2002 . This investment accounted for 12 .5% of real gross domestic product (GDP) in 200 2
and was the primary reason that real GDP declined in each of the first three quarters o f
2001 . And according to figures released by the Federal Reserve Board, the capacit y
utilization rate for all U .S . industries dropped from 84 .2% in the fourth quarter of 1997 to
75 .1% in the fourth quarter of 2001 and the first quarter of 2002, before rising to 75 .4
percent in the fourth quarter of 2002 .
CRS-1 1
allowance under JGTRRA is likely to exert little stimulus in the current domesti c
climate for business investment .18
Second, sceptics contend that it would lead to the creation of fewer jobs than
proponents of the expansion of the allowance under JGTRRA have argued . They
point out that such a measure would lower the cost of a unit of eligible capita l
relative to a unit of labor among small firms able to claim the allowance, all othe r
things being equal . According to mainstream economic theory, such a shift i n
relative costs would give those firms an incentive to substitute capital for labor i n
their operations, where feasible. Assuming constant levels of output, the net resul t
would be an increase in labor productivity and perhaps profits, but a decline in tota l
employment, among those firms . Many economists attribute the weak rebound i n
employment from the economic downturn in 2001 largely to robust gains i n
productivity in recent years . 19
Third, sceptics note that temporary investment incentives typically pack a
stronger stimulative punch in periods of sluggish or negative economic growth tha n
permanent ones .20 Although the expansion of the allowance under JGTRRA i s
temporary in that it will be effective from 2003 to 2005, they argue that its short-ter m
impact on small business investment depends in part on how many busines s
executives expect that Congress will allow the expansion to expire at the end o f
2005 . Some believe that so many executives and small business owners will com e
to expect Congress to extend (and perhaps even further increase) the expansio n
before 2006 that it may induce relatively few firms to move forward planned futur e
investments.
Finally, sceptics say that the existing literature on the efficacy of investment ta x
incentives offers little empirical support for the belief that the expansion of th e
allowance under JGTRRA will spur a significant increase in small busines s
investment. They point to recent studies that found a very low response o f
investment in equipment to declines in the user cost of capital and no correlation
between the internal funds of firms and their investment spending .'
See William G . Gale, "The President's Tax Proposal : First Impressions," Tax Notes, Jan.
13, 2003, p . 269 ; and Joseph E . Stiglitz, "Bush's Tax Plan - The Dangers," New York
Review of Books, March 13, 2003, p . 13 .
18
See James C . Cooper and Kathleen Madigan, "Why Cutting Unemployment Will B-e On e
Tough Job," Business Week, Dec. 23, 2002, p . 25 .
20 Gravelle, Using Business Tax Cuts to Stimulate the Economy, pp . 6-7 .
2' See Robert S . Chirinko, Steven M . Fazzarri, and Andrew P. Meyer, " How Responsive i s
Business Capital Formation to Its User Cost? An Exploration With Micro Data?," Journa l
of Public Economics, vol . 74, 1999, pp. 53-80 ; and Jason G . Cummins, Kevin A . Hassett ,
and Stephen D . Oliner, "Investment Behavior, Observable Expectations, and Interna l
Funds," working paper, Board of Governors of the Federal Reserve, Sept . 2002, availabl e
through [http ://www.federalreserve .gov] period under allowable depreciation
schedules. Certain rules governing the use of the allowance confine its benefits to
relatively small firms.
The main focus of this report is the economic effects of the small business
expensing allowance. It begins with an explanation of how the allowance works and
a brief summary of its legislative history. The report then describes current
legislative initiatives to modify the current allowance 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.
Legislative action in the 108th Congress indicated broad bipartisan support for
enhancing the allowance both as a means of stimulating increased business
investment and aiding small business owners. Under the Jobs and Growth Tax Relief
Reconciliation Act of 2003 (JGTRRA), the maximum allowance was raised from
$25,000 to $100,000 and the phase-out threshold from $200,000 to $400,000 in 2003
through 2005; both amounts were indexed for inflation in 2004 and 2005; and
packaged software qualified for expensing in 2003 through 2005. The American
Jobs Creation Act of 2004 (P.L. 108-357) extended the enhancements made by
JGTRRA through 2007.
Two bills to extend permanently most of the enhancements in the allowance
made by JGTRRA have been introduced in the 109th Congress: H.R. 1091 and H.R.
1388. The only difference between the two proposals is that H.R. 1091 would
increase the phase-out threshold to $500,000 from its current level of $400,00, as of
January 1, 2006. Neither bill would allow the expensing of off-the-shelf software for
business use beyond 2007. In addition, another bill (H.R. 1678) would extend the
changes in the allowance made by JGTRRA through 2009. President Bush supports
the permanent extension of these changes in his budget request for FY2006.
To most economists, the small business 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 tax policy: efficiency, equity, and simplicity. When seen through the lens
of conventional economic theory, the allowance takes on the appearance of a drain
on economic efficiency that may worsen the deadweight loss associated with the
current federal income tax. At the same time, because the allowance does not alter
marginal income tax rates, it has no discernible impact on the distribution of the
federal tax burden among income groups. In addition, the allowance has the benefit
of simplifying tax accounting for firms able to claim it.
Contents
Current Expensing Allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Legislative History of the Expensing Allowance . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Legislative Initiatives in the 109th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Economic Effects of the Expensing Allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Efficiency Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Equity Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Tax Administration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Small Business Expensing Allowance:
Current Status, Legislative Proposals,
and Economic Effects
Under certain circumstances, firms may deduct (or expense) more than
$100,000 of the cost of qualified depreciable assets placed in service in a tax year
between 2005 and 2007. This option for depreciation is known as the small business
expensing allowance because certain rules governing the use of the allowance restrict
its benefits to relatively small firms. In the absence of the expensing allowance,
firms would have to recover the cost of qualified depreciable assets over longer
periods through allowable depreciation deductions. The expensing allowance
represents a significant tax subsidy for business investment because it has the
potential to reduce substantially or even nullify the tax burden on the returns to
investment in qualified assets.
This report examines the economic effects of the small business expensing
allowance. It begins with an explanation of how the allowance works and a brief
summary of its legislative history. The report moves on to describe proposals in the
109th Congress to modify the allowance. It concludes with a discussion of the
allowance’s likely economic effects, focusing in particular on its implications for
economic efficiency, equity, and tax administration and its impact on business
investment since the enactment of the Jobs and Growth Tax Relief Reconciliation
Act of 2003.
Current Expensing Allowance
Under section 179 of the Internal Revenue Code (IRC), business taxpayers
purchasing qualified property (or assets) may deduct (or expense) some or all of its
cost (depending on the amount) in the year in which it is placed into service,
provided certain conditions are met. As an alternative to expensing, business
taxpayers may elect to recover the cost over longer periods through allowable
depreciation deductions. Between 2005 and 2007, the maximum expensing
allowance is at least $102,000 for firms operating outside empowerment zones.1 For
firms conducting their trade or business within these zones, the maximum allowance
in that period is the lesser of $137,000 or the cost of qualified property. In 2008, the
maximum allowance is set to drop to $25,000 for firms operating outside
empowerment zones and $60,000 for firms operating within the zones, their amounts
1
The allowance is indexed for inflation in 2004 through 2007. In 2003, it was $100,000.
In 2004, it was $102,000. The final amount for 2005 has not been determined yet.
CRS-2
before the enactment of Jobs and Growth Tax Relief Reconciliation Act of 2003
(JGTRRA, P.L. 108-26).
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 exceptions, this property embraces business machines
and equipment used in connection with manufacturing or production, extraction,
transportation, communications, electricity, gas, water, and sewage disposal.
Transportation equipment with a gross, unloaded weight of more than 6,000 pounds
may be expensed, but heating and air conditioning units are not eligible for the
allowance. Most buildings and their structural components do not qualify for the
allowance, but research and bulk storage facilities related to these commercial
activities do qualify. In addition, purchases of off-the-shelf, packaged computer
software for business use may be expensed from 2003 through 2007.
In assessing the impact of the expensing allowance on business investment, one
should keep in mind that business taxpayers were also able to claim a temporary 30%
first-year depreciation deduction under the Job Creation and Worker Assistance Act
of 2002 (P.L. 107-147) for new (but not used) property depreciable under the
modified accelerated cost recovery system (MACRS) and having a recovery period
of less than 20 years. Under the act, qualified property acquired between September
11, 2001 and September 11, 2004 and placed in service before January 1, 2005 was
eligible for the special 30% depreciation allowance, as well as regular depreciation
deductions and the expensing allowance under IRC section 179. JGTRRA extended
the deadline for acquiring qualified property to December 31, 2004. More important,
it added a separate 50% first-year depreciation deduction for purchases of the same
property between May 6, 2003 and January 1, 2005; the property must be 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 is claimed first;
then the special first-year depreciation allowance on the remaining basis in the
property (if any) may be claimed; finally, the regular depreciation allowance under
the MACRS on the remaining basis (if any) may be claimed.
The amount that a business taxpayer may deduct in a single tax year under
section 179 is subject to two limitations: a dollar limitation and an income
limitation. Under the dollar limitation, the maximum expensing allowance 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 of at least
$410,000 in 2005 through 2007.2 In 2008 and thereafter, the threshold will revert to
its pre-JGTRRA level of $200,000. As a result, none of the cost of qualified property
placed in service in a single tax year from 2005 through 2007 may be expensed once
this cost reaches $512,000 or more. Under the income limitation, the expensing
allowance cannot exceed the taxable income a taxpayer earns from the active conduct
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. In 2004, it was $410,000. The
final amount for 20005 has not been determined yet.
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of the trade or business in which qualified assets are used. Although no deductions
disallowed under the dollar limitation may be carried forward, deductions disallowed
under the income limitation may be carried forward.
In addition, both the maximum expensing allowance and the phase-out threshold
are indexed for inflation in 2004 through 2007.
Legislative History of the Expensing Allowance
The expensing allowance under IRC section 179 originated as a special firstyear depreciation allowance enacted as part of the Small Business Tax Revision Act
of 1958 (P.L. 85-866). It was intended to reduce the tax burden on small business
owners, stimulate small business investment, and simplify tax accounting for smaller
firms. The deduction was equal to $2,000 ($4,000 in the case of a married couple
filing a joint return) of the cost of new and used business machines and equipment
placed in service with a depreciation life of six or more years.
This allowance remained in force until the enactment of the Economic Recovery
Tax Act of 1981 (ERTA, P.L. 97-34), which replaced the special deduction with a
maximum expensing allowance of $5,000 and established a timetable for gradually
increasing the allowance to $10,000 by 1986. Despite the changes made by ERTA,
few firms took advantage of the allowance. Much of this tepid response could be
blamed on a rule preventing business taxpayers from claiming the investment tax
credit established by ERTA for the share of an asset’s cost that was expensed.
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 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 enactment of the Omnibus Budget Reconciliation Act of 1993 (P.L.
103-66), which boosted the maximum allowance to $17,500 on January 1, 1993.
With the passage of the Small Business Job Protection Act of 1996 (P.L. 104188), the allowance embarked on a path punctuated by staggered ascents. Under the
Act, the maximum allowance rose 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.
The allowance followed this path until the passage of JGTRRA. Under the Act,
the allowance immediately rose to $100,000 in 2003; it was to remain there in 2004
and 2005 and return to $25,000 in 2006 and thereafter. JGTRRA also raised the
phase-out threshold to $400,000 for the same period, indexed both amounts for
inflation in 2004 and 2005, and made purchases of off-the-shelf software for business
use eligible for expensing in 2003 through 2005.
CRS-4
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.
Legislative Initiatives in the 109th Congress
Legislative action in the 108th Congress revealed broad bipartisan support for
enhancing the allowance both as a means of stimulating increased business
investment and aiding small business owners. On May 28, 2003, President Bush
signed into law a version of H.R. 2 (the Jobs and Growth Tax Relief Reconciliation
Act of 2003) that was passed by both houses a few days earlier. Under the act, the
maximum allowance was raised from $25,000 to $100,000 and the phase-out
threshold from $200,000 to $400,000 in 2003 through 2005; both amounts were
indexed for inflation in 2004 and 2005; and packaged software qualified for
expensing in 2003 through 2005. The American Jobs Creation Act of 2004 (P.L.
108-357), which the President signed on October 22, 2004, extended the
enhancements made by JGTRRA through 2007.
Two bills to extend permanently all but one of the enhancements in the
allowance made by JGTRRA have been introduced in the 109th Congress. H.R.
1091, introduced by Representative Phil English on March 3, 2005, would keep the
maximum expensing allowance at $100,000 after 2007, raise the phase-out threshold
to $500,000 on January 1, 2006, and allow both amounts to be indexed for inflation
beyond 2007. H.R. 1388, introduced by Representative Wally Herger on March 17,
2005, would keep the maximum expensing allowance at $100,000 and the phase-out
threshold at $400,000 and allow both amounts to be indexed for inflation beyond
2007. Neither bill would allow business taxpayers to expense purchases of off-theshelf software for business use under IRC Section 179 beyond 2007.
In addition, a bill introduced by Representative Marilyn Musgrave on April 19,
2005 would extend the changes in the allowance made by JGTRRA through 2009.
If either measure were to pass both houses of Congress intact, it is likely that the
President would sign it. In his budget request for FY2006, President Bush is
proposing to extend permanently all the enhancements in the expensing allowance
under JGTRRA.
Economic Effects of the Expensing Allowance
To many policymakers, the expensing allowance represents a desirable policy
tool for aiding small business and stimulating the economy at the same time. And
to many small business owners, the allowance represents a prized vehicle for
delivering a desirable tax benefit. But to most economists, the allowance has effects
that extend beyond its direct impact on the tax burden of small business owners. In
their view, the allowance may have important implications for the allocation of
business investment, the distribution of the federal tax burden among major income
groups, and the cost of tax compliance for smaller firms. These effects loosely
CRS-5
correspond to the three traditional criteria for evaluating tax policy: efficiency,
equity, and simplicity. Each is examined below.
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
total economic surplus — or 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 — it is said to be efficient. If an allocation is less
than efficient, then some of the possible gains from trade among buyers and sellers
are not being realized. For example, an allocation is inefficient when a good is not
being produced by sellers with the lowest cost. 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 to sellers of providing
the good, 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 affect 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, inducing them to
allocate resources according to the impact 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, a condition where the
amount of revenue raised by a tax falls short of the reduction in the economic welfare
of taxpayers.
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 has this effect. The more important of the two is a reduction in the user
cost of capital for investment in qualified assets relative to other assets. A second
channel is an increase in the cash flow or internal funds of firms whose cost of
internal funds is significantly lower than the cost of external funds. Because of the
phase-out threshold for the allowance, most of the firms taking advantage of it are
likely to be relatively small in asset size.3
3
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, in 1999, the average
depreciation deduction for corporations with assets of $250 million and over 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.
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The user cost of capital exerts a significant influence on a firm’s decision to
invest, because 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 is 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 that a firm might undertake, and the lower its desired capital stock.
When a change in tax policy reduces the user cost of capital, the reduction may
increase the amount of capital that firms wish to hold, boosting business investment
in the short run.
How does expensing reduce the user cost of capital for affected assets? 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
economic 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.4 This reduction gets larger 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 expands. Expensing yields the largest possible reduction in
the user cost of capital attributable to depreciation. The reduction can be
considerable.5
4
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)]/(1t). 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.
5
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.
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How beneficial is expensing? One way to illustrate 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 the affected asset over its lifetime at a marginal effective rate of zero.6 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.7 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). 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 2004 and 2005.
Some argue that expensing can also spur 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. 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 major reason why a firm’s ability to invest
could hinge on its cash flow is that 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 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.8 What is more, this correlation is strongest for firms facing
serious barriers to raising funds in debt and equity markets because of insufficient
information on the part of investors or lenders. Nevertheless, it would be erroneous
to construe these findings as providing conclusive evidence that firms with relatively
high cash flows invest more than firms with relatively low or negative cash flows.
A correlation offers no proof of the existence of a cause-and-effect relationship
between two 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
6
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.
7
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.
8
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.
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have little or nothing to do with the relative cost of internal and external funds. The
links between cash flow and business investment are complex, 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 23 years it has existed in its present
form? There appear to be no studies analyzing these effects. Nonetheless,
considering the effect of expensing on the cost of capital and cash flow among small
firms and available evidence that investment in many of the assets eligible for the
allowance is somewhat sensitive to reductions in its cost of capital, it is possible that
the allowance has caused domestic investment in qualified assets to be greater than
it otherwise would have been.9 At the same time, it is possible that much of this
investment would have taken place without the expensing allowance.10 In analyzing
the efficacy of investment tax incentives such as the expensing allowance, one should
keep in mind that the decisions by business managers and owners to invest in
equipment and software tend to be driven more by their assessments of future sales
prospects, the nature of the capital goods themselves, and financing conditions than
by tax considerations.11
Unpublished federal tax return data made available by the Internal Revenue
Service (IRS) suggest that the allowance may influence a significant share of
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.12 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 seen through the lens of conventional economic theory, the expensing
allowance takes on the appearance of a drain on efficiency that may worsen the
deadweight loss associated with 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 draw capital away from more
9
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.
10
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.
11
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].
12
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.
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productive uses. Conventional economic theory leads to the conclusion that in an
economy free of market failures and dominated by competitive markets, a policy of
neutral or uniform taxation of capital income would minimize the efficiency losses
associated with income taxation. The expensing allowance, however, subsidizes
investment in specific assets by relatively small firms. Such a subsidy can prevent
financial capital from migrating to its economically most valuable applications 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
appears to give firms able to claim it a significant incentive to restrain their growth.
This unintended 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).13 Douglas Holtz-Eakin has labeled this incentive effect a “tax on growth
by small firms.”14
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 signifies 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, 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 somewhat elastic. As a result, individuals earning the same
income can end up paying different amounts in taxes.
13
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.
14
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.
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The expensing allowance constitutes a tax preference, albeit for investment in
certain tangible business assets. How does it affect vertical and horizontal equity?
In order 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 expensed. 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 accelerated depreciation in and of itself does not
reduce the amount of taxes that are paid on the stream of income earned by an asset
over its useful life. Rather, accelerated depreciation changes the timing of tax
payments in ways that are advantageous for business owners. 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 finds that few small business owners face the
highest marginal income tax rates, and that more than two-thirds of tax returns
reporting small business income are in the lowest two tax brackets.15
Because the allowance does not alter marginal 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 tax untouched, it
can have no impact on vertical and horizontal equity.
Tax Administration
Yet another interesting policy question raised by the expensing allowance
concerns its impact on the cost of tax compliance.
Many would agree that one of the desirable characteristics of any 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 would also agree that the 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 bitterly complained about the
costly burdens imposed on them by the record keeping and filings required by the
federal income tax.
15
William G. Gale, “Small Businesses and Marginal Income Tax Rates,” Tax Notes, April
26, 2004, p. 471.
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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. 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 addressed in a 2001 study
prepared for the Office of Advocacy of the Small Business Administration.
According to the study, in 2000, the cost per employee for tax compliance 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.