Order Code RL31852
CRS Report for Congress
Received through the CRS Web
Small Business Expensing Allowance:
Current Status, Legislative Proposals,
and Economic Effects
Updated April 12, 2006September 8, 2008
Gary Guenther
Analyst in Business Taxation and Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress
Small Business Expensing Allowance: Current Status,
Legislative Proposals, and Economic Effects
Summary
Under current federal tax law, business taxpayers are allowed tomay deduct (or
expense) $108up
to $250,000 of the total cost of certain assets placed in service in 2006, within
certain limits. In the absence of2008, within certain
limits. Without such an option, firms would have to recover the cost
over a longer period under allowable
period, using current depreciation schedules. The rules governing
the use of the
allowance confinelimit most of its benefits to relatively small firms.
This report focuses on the economic effects of the small business expensing
allowance and legislation in the 109th Congress to modify the 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. The report
will be updated to reflect significant legislative activity in the current Congress.
In recent Congresses, there was broad bipartisan support for enhancing the
allowance as a means of 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 S. 2020/H.R.
4297, the tax reconciliation bill passed by the Senate on November 18, would also
extend the current allowance through 2009.
In its budget request for FY2007, the Bush Administration is asking Congress
to extend permanently the temporary features of the existing allowance, raise the
allowance to $200,000 and its phase-out threshold to $800,000, and index both
amounts for inflation. Companion bills introduced in the House (H.R. 4790) and the
Senate (S. 2287) would implement these proposed changes.
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 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 the allowance, it can also 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, because the allowance does not directly alter the income tax
rates faced by 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 reduces the compliance burden for business taxpayers by
simplifying tax accounting for firms able to claim. It begins by explaining how the allowance works; moves on to
summarize its legislative history and describe legislation in the 110th Congress to
modify the allowance; and concludes with a discussion of the allowance’s
implications for economic efficiency, the distributional effects of the federal income
tax, and tax administration. The report will be updated to reflect significant
legislative activity.
There has been substantial bipartisan support for enhancing the expensing
allowance in the 110th Congress. In May 2007, the House and Senate passed a bill
(H.R. 2206, P.L. 110-28) that included an increase in the expensing allowance to
$125,000 and the phaseout threshold for the allowance to $500,000 in 2007, indexing
both amounts for inflation from 2008 to 2010, and extending through 2008 the
enhanced expensing allowance for qualified property used in the Gulf Opportunity
Zone.
Then in February 2008, the House and Senate approved an economic stimulus
bill (H.R. 5140, P.L. 110-185) that boosted the allowance to $250,000 and the
phaseout threshold to $800,00 in 2008 only. Under current law, the allowance will
revert to $125,000 and the threshold to $500,000 in 2009 and 2010.
Several other bills would permanently enhance the allowance or extend its
reach, including S. 3119, S. 3162, and H.R. 6611. Companion bills in the House
(H.R. 6587) and Senate (S. 3322) would greatly increase the expensing allowance
and phaseout threshold for qualified assets placed in service in 2008 in areas of the
Midwest that were declared presidential disaster areas in the summer of 2008.
The expensing allowance has a seemingly minor effect on the composition and
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. While the allowance has the potential to spur
increased small business investment by reducing the user cost of capital for eligible
assets and increasing the cash flow of firms that claim the allowance, it can impair
economic efficiency by encouraging higher investment in activities yielding relatively
low pre-tax returns. At the same time, the allowance appears to have no measurable
impact on the distribution of the federal tax burden among income groups. In
addition, it has the advantage of lessening the burden of tax compliance by
simplifying tax accounting for firms claiming it.
Contents
Current Expensing Allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Legislative History of the Expensing Allowance . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Legislative Initiatives in the 109th110th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Initiatives to Extend or Enhance the Current Allowance . . . . . . . . . . . . . . . . 6
Initiatives to Create an Enhanced Allowance for Firms Making
Qualified Investments in Designated Geographic Areas . . . . . . . . . . . . 76
Economic Effects of the Expensing Allowance . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
Efficiency Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 87
Equity Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Tax Administration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Small Business Expensing Allowance:
Current Status, Legislative Proposals,
and Economic Effects
UnderProvided certain conditions, current federal tax law allows are met, firms tomay expense (or
deduct) up to $108
$250,000 of the cost of qualified assets placedthey place in service in 2006.1
2008. Some refer to
this option for capital cost recovery as the small business expensing
allowance allowance
because the rules governing its use effectively limitrestrict the option’s benefits
mainly to firms that
are relatively small in asset, employment, or revenue size. Firms unable
to claim the
expensing allowance maycan recover the cost of the same assets over longer
periods through periods
through claiming allowable depreciation deductions. The expensing allowance
represents a significant tax subsidy for small business investment because it has the
potential to reduce substantiallycan
reduce the marginal effective rate at which the returns to
investment in qualified
assets are taxed.
This report examines the current status of the small business expensing
allowance, its main economic effects, and initiatives in Congress to modify it. The
report begins by explaining how the allowance works’s design and summarizing its legislative
history. It then discusses proposals in the 109th110th Congress to alter the current
allowance. The report concludes with an assessment of the allowance’s likely
economic effects, focusing on its implications implications
for economic efficiency, equity, and
tax administration.
Current Expensing Allowance
Under section 179 of the Internal Revenue Code (IRC), business taxpayers have
the option of deducting (or expensing) the full cost of qualified assets (or property) they
they purchase in the year when the assets are placed in service, within certain limits.
Business taxpayers that are unable or unwilling to take advantage of this option for capital
capital cost recovery may recover thethis cost over longer periods throughby claiming allowable
depreciation deductions. In 2006
In 2008, the maximum expensing allowance is $108250,000
for firms operating
outside so-called enterprise and empowerment zones (EZs),
renewal communities
(RCs), and the areas devastatedaffected the most by Hurricane Katrina (also known
as the Gulf
Opportunity Zone, or GOZ), and the portion of lower Manhattan directly
affected by the terrorist attacks of September 11, 2001 (also known as the New York
Liberty Zone, or NYLZ).2 (For the sake of clarity, this allowance is henceforth
1
2
See Internal Revenue Service Revenue Procedure 2005-70..1 (For the sake of clarity, this allowance is henceforth
referred to as the regular allowance.) For firms operating within all the special areas
except the GOZ, the maximum allowance in 2008 is $285,000. For firms located in
1
The allowance is indexed for inflation in 2004 through 2007. In 2003, it was $100,000,
and it was set at $102,000 for 2004. Given that the rate of inflation as measured by the
(continued...)
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referred to as the regular allowance.) For firms operating within all the special areas
except the GOZ, the maximum allowance in 2006 is $143,000. For firms located in2010. In 2003, it was $100,000;
in 2004, $102,000; in 2005, $105,000; in 2006, $108,000; and in 2007, $125,000.
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the GOZ, the maximum allowance in 20062008 for qualified assets purchased on or after
August 28, 2005, and placed in service by December 31, 20072008, is $208350,000. The
The regular allowance is indexed for inflation in 2005 through 2007. Unless current law
is changed, it is scheduled to drop to $25,000 beginning in 2008 and thereafter for
firms operating outside the special areas;$60,000 for firms operating in all the special
areas except the GOZ; and scheduled to fall back to $125,000 in 2009 and 2010,
with each amount indexed for inflation. Assuming no change in current law, it is
scheduled to revert to $25,000 (its level before the enactment of the Jobs and Growth
Tax Relief Reconciliation Act of 2003, or JGTRRA) in 2011 and each year thereafter
for firms operating outside the special areas. In the same period, the allowance will
fall to $60,000 for firms operating in all the special areas except the GOZ, and to
$125,000 for firms operating in the GOZ.
Business taxpayers choose the expensing option underby following rules set forth by the
the Internal Revenue Service (IRS). Under IRS Regulation 1.179-5, these taxpayers are
allowed to
may make or revoke an election under IRC sectionSection 179 for property placed in
service from 2003 service
through 20072010 without the consent of the IRS Commissioner by
submitting an
amended tax return for the tax year in question. For tax years
beginning in 20082011, an
expensing election may be revoked only with the consent of
the Commissioner.
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. More specifically, the allowance does not
apply to qualified property placed in service 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 sectionSection 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 acquired for business use may be expensed through
2007
through 2009. Most buildings and their structural components do not qualify for the regular
regular allowance, butalthough research and bulk storage facilities do qualify. In the
case of firms
operating located in the GOZ, however, certain residential and commercial
properties do
qualify.
The maximum amount of qualified property that may be expensed in a single
tax year under IRC sectionSection 179 is subject to two limitations: a dollar limitation and
an income limitation.
2
(...continued)
consumer price index for items consumed by urban consumers has been higher in the first
seven months of 2005 compared to the same period in 2004, the maximum allowance in
2006 is likely to be higher than it is in 2005.
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Under the dollar limitation, the regular expensing allowance is reduced, dollar
for dollar, by the 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 expensing allowance is reduced by $0.50
for each dollarhalf of the amount by which the
cost of qualified property placed in service in a tax year
exceeds the phase-out threshold. In 2006, the threshold. The
threshold is set at $430,000 for all
800,000 in 2008 for all firms except those operating in the GOZ, where the
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which face a threshold isof $1,030400,000.3 As a
result, a business taxpayer may expense none of 2 As a result of this dollar limitation, a business
taxpayer operating outside the GOZ and the other special areas may expense none of
the cost of qualified property placed
in service in 2006 in areas outside the GOZ once its total cost reaches or exceeds
$538,000. For example, if a firm operating outside the special areas were to place
in it places in service in 2008 when the total cost of that
property equals or exceeds $1,050,000. For example, if such a firm were to place in
service qualified property whose total cost in 2006 was $500,000, the firm could
expense $38,000 of that amount, and the remaining $462,000 would be recovered
under the regular tax depreciation rules. 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 $200,0002008 were to come to $750,000, it
would be allowed to deduct the entire amount under IRC Section 179.
The threshold for the regular allowance is scheduled to fall back to $500,000 in
2009 and 2010; it is indexed for inflation in both years. Assuming no change in
current law, the threshold is scheduled to revert to its pre-JGTRRA level of $200,000
in 2011 and each year thereafter.
Under the income limitation, the expensing allowance a firm claims cannot
exceed the taxable income (including wages and salaries) it earns from the active
conduct of the trade or business in which the qualified assets are used. For example,
if the firm in the above example hadwere to have taxable income in 2008 of $25,000 in
the business in
which the qualified property was used, then the expensing allowance it could claim
would be $25,000 instead of the $38,000 that it was eligible to claim. Although
is used, it would be able to claim a
maximum expensing allowance of $25,000, instead of the $750,000 it otherwise
would be entitled to claim. Although business taxpayers may not carry forward any
expensing allowancesallowance lost because of
the dollar limitation, they may carry forward allowancesan
allowance denied because of the
income limitation.
In addition to the regular expensing allowance, business taxpayers were able to
claim in recent tax years claim
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 allowancesdeductions applied to new (but not used)
property property
depreciable under the modified accelerated cost recovery system (MACRS)
and and
having a recovery period of less than 20 years. Qualified property acquired
between between
September 11, 2001, and December 31, 2004, and placed in service before
January January
1, 2005, was eligible for the special 30% depreciation allowance. The 50%
depreciation allowance could be claimeddeduction. The 50% deduction was
available 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 the 50% deduction, but not both.
The Economic Stimulus Act of 2008 (P.L. 110-185) reinstated the temporary
50% first-year depreciation deduction that expired at the end of 2006. It applies to
the same set of depreciable assets targeted by the earlier deduction. To benefit from
the partial expensing allowance, a firm must buy qualified assets and place them in
service between January 1, 2008, and December 31, 2008; an exception is made for
certain assets (e.g., aircraft) with relatively long production periods. The allowance
expires at the end of 2008.
For property eligible for both the expensing and special depreciation allowances,
a firm is required to recover the property’s cost in a prescribed order. The expensing
250% first-year depreciation
allowance, but not both.
For property eligible for both the expensing and special depreciation allowances,
a firm was required to recover the property’s cost in a prescribed order. The
expensing allowance was claimed first, reducing the taxpayer’s basis in the property
by the amount of the allowance. Then the taxpayer applied the temporary 30% or
50% first-year depreciation allowance to any remaining basis, further reducing the
3
Like the maximum expensing allowance, the phase-out threshold is indexed for inflation
in 2004 through 20072010. 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.
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taxpayer’s basis in the property. Finally, the taxpayer could claim a depreciation
allowance under the ; in 2004, $410,000; in 2005,
$420,000; in 2006, $430,000; and in 2007, $500,000.
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allowance must be claimed first, reducing the taxpayer’s basis in the property by the
amount of the allowance. Then the taxpayer may apply the 50% first-year
depreciation allowance to any remaining basis, further reducing the taxpayer’s basis
in the property. Finally, the taxpayer may claim a depreciation allowance under the
MACRS on any remaining basis, using the most advantageous
depreciation method:,
which is the double declining balance method.
Legislative History of the Expensing Allowance
The expensing allowance under IRC sectionSection 179 originated as a special firstyear depreciation allowance that was included in the Small Business Tax Revision
Act of
1958 (P.L. 85-866). It was intended to reduce the tax burden on small
business business
owners, stimulate small business investment, and simplify tax accounting
for smaller
firms. The deduction was limited 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
with a depreciation life of six or more years.
This allowance remained in force until the passage 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 set forthspecified a timetable for gradually
increasing the allowance to $10,000 by 1986. Despite these changes, few firms took
advantage of the new allowance. Some analysts ascribed such a tepid response to the
limitations on the use of the investment tax credit also established by ERTA. AnyA
business taxpayer claiming the credit for the purchase of an asset that also was
eligible for the expensing allowance could claim the credit only for the portion of the
asset’s cost that was not expensed. For many firms, the potential tax savings from
claiming the credit evidently 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
at that amount until the passage of the Omnibus Budget Reconciliation Act of 1993
(OBRA93, P.L. 103-66). OBRA93 retroactively raised the maximum allowance to
$17,500 (as of January 1, 1993) and added a variety of tax benefits for special areas
known as enterprise zones and empowerment zones (EZs). One of these benefits was
an enhanced expensing allowance for qualified assets placed in service in a special
area ofthat
was $20,000 above the regular allowance, paired with a phase-out threshold twice
as large
as the phase-out threshold for the regular allowance. To be designated as an
EZ, an
area had to satisfy a variety of eligibility criteria relating to population,
poverty rate,
and geographic size.
With the passage of the Small Business Job Protection Act of 1996 (P.L. 104188), the regular allowance embarked on another upward path: the. The act raised the
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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.
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Through the Community Renewal Tax Relief Act of 2000 (P.L. 106-544),
Congress expanded the list of special areas to include so-called “renewal
communities” (RCs) and granted them 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 the Job Creation and Worker Assistance Act of 2002
(P.L. 107-147) to encourage new business investment in the section of lower
Manhattan in New York City that bore the brunt of the attacks on the World Trade
Center. The act designated this area as the New York “Liberty Zone.” Among the
tax tax
benefits offered to firms located in the zone was the same enhanced expensing
allowance available for qualified investments in EZs and RCs.
The regular allowance remained on the ascendingupward path laid down by the Small
Business Jobs Protection Act until JGTRRA was enacted in 2003the adoption of JGTRRA. Under JGTRRA,
the the
maximum regular allowance rose four-fold to $100,000 in May 2003 and was to
stay stay
at that lofty amount in 2004 and 2005, before returning to $25,000 in 2006 and
thereafter.
JGTRRA also raised the phase-out threshold to $400,000 over the same
period,
indexed both the regular allowance and the threshold for inflation in 2004 and
2005,
and added off-the-shelf software for business use to the poollist of depreciable
assets assets
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 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). Among other things, the act designated these areas
as the Gulf Opportunity Zone (GOZ), and offered a variety of
tax incentives for new
business investment in these areasthe GOA, 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 can be as much
as $100,000 above
the regular allowance. In addition, it begins to phase out when
the total cost of
qualified assets placed in service by a business taxpayer in a tax year
exceeds a
threshold that is $600,000 above the phase-out threshold for the regular
allowance.
Finally, the range of assets eligible for the enhanced allowance is greater
than that for the regular allowance.
Legislative Initiatives in the 109th Congress
Legislative activity in recent Congresses showed there was broad bipartisan
support for enhancing the expensing allowance as a means of simultaneously
spurring increased business investment and aiding small business owners. By all
indications, support for the current allowance appears undiminished in the current
Congress.
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For the sake of exposition, 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 specific geographic areas characterized by relatively high levels of
poverty or other kinds of economic distress.
Initiatives to Extend or Enhance the Current Allowance
Bills to further 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 versions of a tax
reconciliation bill (H.R. 4297), both of which include a provision that would extend
the existing regular allowance another two years. A conference committee has been
formed to reconcile the differences between the two versions. 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.4
There is little doubt that the Bush Administration would back any of these
legislative initiatives. Its budget request for FY2007 calls for the permanent
extension of all the temporary features of the current allowance, including the
eligibility of off-the-shelf computer software for the allowance.5 But the
Administration also favors taking the added step of significantly enhancing the
allowance to encourage increased business investment and entrepreneurship. The
same budget proposal asks Congress to enact legislation that would increase the
4
See Wesley Elmore, “Further Movement on Tax Cuts Unlikely as Session Winds Down,”
Tax Notes, Dec. 26, 2005, p. 1624.
5
U.S. Office of Management and Budget, Analytical Perspectives, Budget of the United
States Government, Fiscal Year 2007 (Washington: GPO, 2006), p. 252.
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expensing allowance to $200,000 and the phase-out threshold for the allowance to
$800,000 for qualified property placed in service in 2007 and thereafter, and would
index these amounts for inflation for tax years starting in 2008.6 According to an
estimate by the Treasury Department, the Administration’s proposed enhancement
of the expensing allowance, including the permanent extension of its temporary
features, would result in a revenue loss of $12.4 billion from FY2007 through
FY2011.7
Companion bills to implement the Administration’s proposed changes in the
expensing allowance have been introduced in the House (H.R. 4790) and the Senate
(S. 2287). Each bill would raise the expensing allowance to $200,000 and the phaseout threshold for the allowance to $800,000 starting in 2007 and thereafter, index
these amounts for inflation starting in 2008 and thereafter, allow taxpayers to make
or revoke expensing elections without the consent of the IRS Commissioner, and
permanently add off-the-shelf computer software to the pool of depreciable assets
eligible for the expensing allowance.
Initiatives to Create an Enhanced Allowance for Firms Making
Qualified Investments in Designated Geographic Areas
Bills to enhance the current allowance would also increase the allowance for
qualified property placed in service in the special areas, such as EZs and RCs.
In addition, the current Congress has established a new special area with an
enhanced expensing allowance. On December 16, 2005, the House and Senate
passed a bill (H.R. 4440, P.L. 109-135) that, among other things, created a variety of
tax incentives to foster economic recovery in the areas devastated by Hurricane
Katrina in late August 2005. Among the incentives was 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; it begins to
phase out at an amount $600,000 above the phase-out threshold for the regular
allowance. Unlike the regular allowance, the enhanced allowance applies to
commercial real estate and residential rental property.
Economic Effects of the Expensing Allowance
To many lawmakers, the expensing allowance represents a desirable policy tool
for aiding small business owners and stimulating the economy at the same time. To
many small business owners, the allowance represents a desirable vehicle for
delivering a generous tax benefit. But to most public finance economists, the
allowance has effects that go beyond its direct impact on the tax burden of small
business owners. In their view, the allowance is likely to have important implications
6
7
Ibid., p. 254.
U.S. Department of the Treasury, General Explanations of the Administration’s Fiscal
Year 2007 Revenue Proposals (Washington: Feb. 2006), p. 20.
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for the allocation of investment capital within the private sector, the distribution of
the federal tax burden among major 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. Each is discussed below.
Efficiency Effects
Efficiency is a cornerstone of economic theory and analysis. It refers to the
allocation of resources in an economy and how it affects the welfare of consumers
and producers. When such an allocation leads to the greatest possible economic
surplus — defined as the total value to buyers of the goods and services they
the regular allowance.
The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222)
extended the changes in the allowance made by JGTRRA through 2009.
Finally, in passing the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery,
and Iraq Appropriations Act, 2007 (P.L. 110-28), Congress extended the changes in
the allowance made by JGTRRA through 2010, raised the maximum allowance to
CRS-6
$125,000 and the phaseout threshold to $500,000 in 2007 to 2010, and indexed both
amounts for inflation from 2008 through 2010. The act also extended through 2008
the enhanced expensing allowance for qualified assets placed in service in the GOZ.
Congress boosted the allowance to $250,000 and the phaseout threshold to
$800,000 in 2008 only by passing the Economic Stimulus Act of 2008 (P.L. 110185). Those amounts revert back to $125,000 and $500,000 in 2009 and 2010,
respectively.
Legislative Initiatives in the 110th Congress
Legislative activity in recent Congresses demonstrated that there was broad
bipartisan support for enhancing the expensing allowance, as a means of both
spurring increased business investment and funneling aid to small business owners.
By all accounts, this support remains as robust as ever in the current Congress.
Bills to extend the enhancements in the regular allowance made by JGTRRA and to
enhance temporarily the current allowance as a way to spur faster domestic economic
growth have been enacted. Other bills to further enhance the allowance on a
permanent basis have been introduced.
Between late March and mid-May 2007, the House and Senate passed two bills
(H.R. 1591 and H.R. 2206) that included further enhancements of the expensing
allowance. Specifically, each measure would have raised the maximum allowance
to $125,000 and the phaseout threshold to $500,000 from 2007 through 2010,
indexed both amounts for inflation in 2008 to 2010, extended through 2010 all other
features of the allowance that are set to expire in 2009, and extended through 2008
the enhanced expensing allowance under IRC Section 1400(N) for qualified property
placed in service in the GOZ. President Bush vetoed H.R. 1591 on May 1, 2007, but
he signed H.R. 2206 (P.L. 110-28) on May 25.
Faced with mounting evidence of a pronounced slowdown in domestic
economic activity, Congress showed a renewed interest in using the allowance as a
tool for stimulating faster economic growth in early 2008. On January 24, the leaders
of the House and the Bush Administration announced they had reached an agreement
on an economic stimulus package that included an increase in the allowance to
$250,000 and in the threshold to $800,000 in 2008 only. Five days later, the House
passed a measure (H.R. 5140) incorporating the terms of that agreement. The Senate
did likewise on February 7. President Bush signed the legislation on February 13.
Under the law, the allowance and threshold will revert to preexisting law in 2009 and
beyond.
There are some indications that this interest has not abated a good deal in the
months since the enactment of the stimulus legislation. Several bills to enhance
permanently the allowance and its phaseout threshold have been introduced in recent
months. S. 3119 would permanently raise the maximum allowance to $128,000 and
the phaseout threshold to $500,000 in 2009 and beyond and adjust both amounts for
inflation. S. 3162 would permanently set the maximum allowance at $125,000 and
CRS-7
the phaseout threshold at $500,000 in 2009 and thereafter, adjust both amounts for
inflation, and make purchases of off-the-shelf computer software for business use
permanently eligible for the expensing allowance; and H.R. 6611 would permanently
increase allowance to $250,000 and the phaseout threshold to $800,000 and adjust
both for inflation, starting in 2009.
In addition, companion bills in the House (H.R. 6587) and Senate (S. 3322)
would offer temporary tax relief for taxpayers located in areas of certain Midwestern
states that were declared presidential disaster areas as a result of severe storms,
flooding, and tornados that occurred early in the summer of 2008. Each bill contains
a provision that would raise the expensing allowance to $350,000 and the phaseout
threshold to $1.4 million for qualified assets placed in service in 2008 in any of the
disaster areas. To qualify for this treatment, an asset would have to be eligible for
the Section 179 expensing allowance and meet the definition of qualified Gulf
Opportunity Zone property under IRC Section 1400N(d)(2).
The Bush Administration has signaled that it would back a further enhancement
of the expensing allowance. Its budget request for FY2009 includes a permanent
increase in the maximum allowance to $200,000 and the phase-out threshold
allowance to $800,000 and a permanent indexation of these amounts for inflation,
starting in 2009.3 According to the Treasury Department, these changes in the
allowance would result in an estimated revenue loss of $7.6 billion from FY2009 to
FY2018.4
Economic Effects of the Expensing Allowance
To many lawmakers, the expensing allowance represents a desirable policy tool
for aiding small business owners and stimulating the economy at the same time. To
many small business owners, the allowance represents a desirable tax benefit. But
to most public finance economists, the allowance has economic effects that extend
beyond its implications for the tax burden of small business owners. In their view,
the allowance may affect the allocation of investment capital within the private
sector, the distribution of the federal tax burden among major 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.
Each is discussed below.
Efficiency Effects
Efficiency lies at the heart of economic theory and analysis. It refers to the
allocation of resources in an economy and how it shapes the welfare of consumers
and producers. When such an allocation generates the greatest possible economic
surplus — defined as the total value to buyers of the goods and services they
3
U.S. Department of the Treasury, General Explanations of the Administration’s Fiscal
Year 2009 Revenue Proposals (Washington: Feb. 2008), pp. 17-18.
4
Ibid., p. 18.
CRS-8
consume minus the total cost to sellers of providing these goods and services — the
allocation is said to be efficient. But when an allocation is less than efficient, some
of the possible gains from exchange among buyers and sellers are not being realized.
For example, an allocation is deemed inefficient when most suppliers of a good fail
to produce it at the lowest marginal cost underpermitted by existing technologies. In this
case, a
shift in productionsupply from relatively high-cost producers to relatively low-cost
producers, driven perhaps by an unleashing of market forces, would lower the total
economic cost of providing the good, thereby raising the overall 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
investment capital within the private sector in particular. In theory, all taxes except
lump-sum taxes lead to inefficient outcomes because they influence the decisions of
consumers and producers in ways that leave one group or the other — or perhaps
both —
worse off. Non-lump-sum taxes have this effect because they inevitably
distort the
incentives facing individual and business taxpayers, leading them to
allocate allocate
resources according to the effects of the taxes on the costs and benefits of the
goods goods
and services they buy and sell rather than their actual costs and benefits. Such
a a
distortion entails what economists call a deadweight loss, orwhich is a condition where the
the amount of revenue raised by a tax is less than the loss of economic welfare it
engenders.
The expensing allowance affectshas the potential to affect the allocation of resources
in the U.S. economy
by encouraging firms able to claim it to invest in assets that
qualify for the allowance,
possibly at the expense of other more productive assets.
assets. There are two channels through which the
allowance can have such an effect. 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 ana
temporary increase in the cash flow or internal funds
available to firms that purchase
qualified assets. Restraining the allowance’s
influence over the allocation of
resources is its phase-out threshold, which effectively
confines the benefits of the
allowance to firms that are relatively small in asset size.8
8
According to unpublished IRS estimates, a total of $55.161 billion in assets eligible for the
IRC section 179 expensing allowance were placed in service in 2003. Firms with assets of
$10 billion or less accounted for 49% of this investment, whereas firms with assets of $100
billion or more accounted for 16%.
CRS-9
The5
As one would expect, the user cost of capital plays a major role in a firm’s decision to invest. This
investment decisions. This cost encompasses both the opportunity cost of 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
must earn in order to be profitable, — and thus worth
undertaking. In general, the
higher the user cost of capital, the lower the number offewer profitable
projects a firm can
undertake, and the lower its desired capital stock. When a change
in tax policy
decreases the user cost of capital, many firms can be expected to
respond by
increasing the amount of capital they wish to own, perhaps boosting overall business
investment in the short run.
How does expensing affect the user cost of capital? Unlimited expensing is the
most
business investment in the short run.
5
According to unpublished IRS estimates, a total of $55.161 billion in assets eligible for the
IRC Section 179 expensing allowance were placed in service in 2003. Firms with assets of
$10 billion or less accounted for 49% of this investment, whereas firms with assets of $100
billion or more accounted for 16%.
CRS-9
How does expensing affect the user cost of capital? Expensing is the most
accelerated form of depreciation: under expensing, the entire cost of an asset
is is
written off in its first year of use, regardless of the asset’s actual or useful life.
Allowing a firm to expense its acquisition of an asset is equivalent to the U.S.
Treasury providing the firm (or its owners) with a tax rebate equal to the firm’s
marginal tax rate multiplied by the cost of the asset. Accelerated depreciation —
along with other investment tax subsidies such as an investment tax credit — reduces
the user cost of capital by lowering the pre-tax rate of return on investment a firm
must earn in order to realize a desired after-tax rate of return.96 Expensing yields the
largest possible reduction in the user cost of capital from accelerated depreciation.
This reduction can be considerable.107
How beneficial is expensing? One way to illustrate the tax benefit from
expensing is to show how it affects the marginal effective tax rate on the returns to
investment in an asset that is expensed for tax purposes. Expensing has the effect of
taxing the stream of income earned by an asset over its lifetime at a marginal
9
effective rate of zero.8 This is because expensing reduces the after-tax returns and
costs for eligible investments by the same factor: an investor’s marginal tax rate.
For example, if the income received by a small business owner is taxed at a rate of
35% and a depreciable asset he or she buys is expensed, then the federal government
effectively becomes a partner in the investment with an interest of 35%. Through the
tax code, the federal government assumes 35% of the cost of the asset by allowing
its entire cost to be deducted in the first year of the asset’s use, and it receives 35%
of the income earned by the investment in subsequent years. Conversely, expensing
6
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, one sees 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.
107
In a 1995 study, Douglas Holtz-Eakin compared the cost of capital for an investment
under 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.
CRS-10
effective rate of zero.11 This is because expensing reduces after-tax returns and costs
for eligible investments by the same factor: an investor’s marginal tax rate (whether
the investor is a corporation or a small business owner). For example, if the tax rate
faced by a small business owner is 35% and a depreciable asset he or she buys is
expensed, then the federal government effectively becomes a partner in the
investment with an interest of 35%. Through the tax code, the federal government
assumes 35% of the cost of the asset by allowing its entire cost to be deducted in the
first year of the asset’s use, and it receives 35% of the income earned by the
investment in subsequent years. By the same token, because of expensing, the small
business owner receives 65% of the returns from the investment but bears only 65%
September 1995, p. 389.
8
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.
CRS-10
allows the small business owner to receive 65% of the returns from the investment
but to bear only 65% of the cost. Such an outcome implies that for each dollar spent
on the asset, the
owner earns the same rate of return after taxes as before taxes.129
Expensing could also stimulate what might be described as a self-reinforcing
support a sustained rise in business investment by
augmenting the cash flow of firms that rely heavily on internal
funds or retained
earnings to finance the bulk of their investments and have positive
tax liabilities.13 net incomes.10
Expensing can increase a firm’s cash flow in the short run because
it allows it the firm
to deduct the full cost of qualified assets it purchases in the tax year when
they are
placed into service. There are a variety of reasons why a firm’s investments
could could
hinge on its cash flow. One is that the firm’s owners or senior managers wish
to want to
limit their exposure to external debt and the risks it entails. Another reason is that
the firm has restrictedlimited or no access to debt and equity markets, mainly because of a
lack lack
of accurate information on its assets, strategies, andor prospects for achieving
relatively relatively
high rates of return on equity. For a firm in such a position, the cost of
internal funds
could be lower than the cost of external funds, in which case the firm
and its owners
would be better off if the firm were to finance most of its investments
out of retained
earnings.
What is unclear is the extent to whichhow increases in cash flow in the aggregate
boost overall affect overall
business investment. Some studies have found a significant positive
correlation correlation
between changes in a firm’s net worth (or supply of internal funds) and its
investment investment
spending.1411 What is more, this correlation was strongest for firms facing
serious serious
obstacles to raising funds in debt and equity markets because of insufficient
information on the part of investors or lenders. Nevertheless, it would be a mistake
to interpret these findings as providing conclusive evidence that firms with relatively
high cash
flows invest more than firms with relatively low or negative cash flows.
11
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.
12 After all,
a strong correlation between two variable factors does not prove the existence of a
cause-and-effect relationship between them. 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 link between cash flow and business investment is
complicated; further research is needed to clarify it.
Is there reason to believe that the expensing allowance has contributed to shifts
in the size and composition of the domestic capital stock in the 25 years the
allowance has existed in its present form? This question is difficult to answer
because there are no studies analyzing the impact of the allowance on capital
formation over time, and empirical evidence is incomplete. Given that the expensing
9
Raquel Meyer Alexander, “Expensing,” in The Encyclopedia of Taxation and Tax Policy,
Joseph J. Cordes, Robert D. Ebel, and Jane G. Gravelle, eds. (Washington: Urban Institute
Press, 2005), p. 129.
1310
In the realm of business finance, the term “cash flow” can take on different meanings.
Here it denotes the difference between a firm’s revenue and its payments for all the factors
or inputs used to generate its output, including capital equipment.
1411
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.
CRS-11
After all, a strong correlation between two variable factors does not prove the
existence of a cause-and-effect relationship between them. 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 link between cash flow and business
investment is complex, and further research is needed to clarify it.
To what extent has the expensing allowance contributed to shifts in the size and
composition of the domestic capital stock in the 25 years the allowance has existed
in its present form? This question is difficult to answer because there are no studies
analyzing the effects of the allowance on capital formation over time, and relevant
empirical evidence is incomplete. Given that the expensing allowance lowers the
cost of capital and raisesallowance lowers the cost of capital and may boost cash flow for many firms able to
claim it, and that there is
some evidence that investment in many of the assets eligible for the allowance isseems
somewhat sensitive to reductions in the cost of capital, one might be justified in
thinkingconcluding that the allowance has caused domestic investment in those assets to be
greater than it otherwise would have been.1512 Yet there are equally compelling
reasons to thinkinfer that much of this investment would have taken place without the
expensing allowance.1613 Most economists would probably agree that investment in
assets eligible for
the expensing allowance tendsis likely to be driven more by business
expectations for future
growth in sales, the nature of the capital goods themselves,
and conditions in debt
and equity markets than by tax considerations.1714 This view gains
finds some support from
in available data on use of the expensing allowance: although
22% of corporations
filing federal tax returns claimed the allowance from 1999
through 2003, the total
value of IRC sectionSection 179 property placed in service was equal
to only 5% of domestic
gross investment in equipment and computer software.1815
When filteredseen 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 federal tax code. Under the reasonable 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 some capital away from morehighly profitable productive uses and into
tax-favored
investments uses. Conventional economic theory holds that in an economy free of
significant market failures and ruled mostlydominated by competitive markets, a policy of
15 neutral
or uniform taxation of capital income would minimize the efficiency losses brought
on by income taxation. The expensing allowance, however, subtly encourages
investment in specific assets by relatively small firms. Such a subsidy can interfere
with 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 investment in assets
eligible for the allowance than on investment in other assets with higher expected
pre-tax rates of return.
In addition, the expensing allowance gives firms able to claim it an incentive to
restrain their growth. This unintended incentive stems from the rise in marginal
effective tax rates on the income earned by an asset eligible for the allowance in the
12
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.
1613
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 Weighs Bush’s Expensing Boost,” Tax Notes, April 7, 2003, p. 17.
1714
See Roger W. Ferguson, Jr., “Factors Influencing Business Investment,” speech delivered
on Oct.October 26, 2004, available at [http://www.federalreserve.gov/boarddocs/speeches/2004/
20041026/default.htm].
1815
Various data on business claims for the expensing allowance were obtained via e-mail
from the Statistics of Income Division at IRS on March 21, 2006.
CRS-12
neutral or uniform taxation of capital income would minimize the efficiency losses
brought on by income taxation. The expensing allowance, however, fosters
investment in specific assets by relatively small firms. Such a subsidy can interfere
with 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 investment in assets
eligible for the allowance than on investment in other assets with higher expected
pre-tax rates of return. In addition, the expensing allowance gives firms able to claim
it an incentive to restrain their growth. This unintended incentive stems from the rise
in marginal effective tax rates on the income earned by an asset eligible for the
allowance in the allowance’s phase-out range ($430,000 to $538,000 in 2006).19
Douglas Holtz-Eakinallowance’s phase-out range ($500,000 to $625,000 in 2007).16 Douglas HoltzEakin, the former Director of the Congressional Budget Office, has
labeled this
incentive effect a “tax on growth by small firms.”2017
Equity Effects
Equity is a key principle of economic analysis. In general, itanother basic concept in economic analysis. It generally refers to the
distribution of income among the individuals or households in a geographic unit. In
the casearea.
In the context of income taxation, equity usually denotes the distribution of the
tax burden
among taxpayers divided into income groups. Economists who analyze
the equity
effects of income taxes tend to focus on two distinct conceptskinds of equity: horizontal
horizontal equity and vertical equity. A tax system is said to be horizontally
equitable if it
imposes similar burdens on individuals with similar incomes or
standards of living. And a tax system is
said to be vertically equitable if the burdens
it imposes vary according to an
individual’s or household’s ability to pay. The
principle of vertical equity provides the foundation
for aany progressive income tax
system. Under such a system, an individual’s total tax
liability, measured as a
fraction of income, rises with income.
The current federal income tax system seems to lean more in the direction of vertical
vertical equity than horizontal equity. Individuals with theMany individuals with similar incomes before
taxes can
end up being taxed at the same marginal rate. But because of various tax preferences
preferences in the form of deductions, preferential rates, deferrals, exclusions,
exemptions, and
credits enacted over many years, individuals a significant share of individuals
with similar before-tax incomes can also
also end up being taxed at significantly different
rates. At the same time, those with
relatively high pre-tax incomes are almost uniformly generally
taxed at significantly higher
rates than those with relatively low pre-tax incomes.
The expensing allowance constitutes a tax preference, albeit for investment in
certain businessone targeted at
business investment in certain assets. How does it affect vertical and horizontal
equity?
19
To answer this question, it is necessary to consider the tax benefits associated
with the expensing allowance, who receives them, and how they affect the recipients’
federal income tax burdens. The main tax benefit generated by the allowance is a
reduction in the marginal effective tax rate on the income earned by assets eligible
for the allowance. How much of a reduction depends critically on the proportion of
the asset’s 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
16
Jane Gravelle of CRS has estimated that, with a corporate tax rate of 28% and a rate of
inflation of 3%, the marginal effective tax rate on the income earned by assets eligible for
the expensing allowance is 36% in the phase-out range for the allowance. By contrast,
under the same assumptions, the marginal effective tax rate on the income earned by
qualified assets is 0% for each dollar of investment in those assets up to $430,000.
2017
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.
CRS-13
To answer this question, it is necessary to consider 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 income earned by assets eligible
for the allowance. 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 actual marginal rates at which this income is taxed. This is
because change the actual marginal rates at which this income is taxed. This is because
accelerated depreciation does not, in theory, reduce the taxes that will be
total amount of taxes
(measured in current dollars) that will be paid on an asset’s expected stream of
income over its useful life. Rather, accelerated
depreciation simply changes the
timing of depreciation deductions in ways that are
advantageous for business owners or shareholders. Mostsubstantially boost the present
discounted value of the tax savings from depreciation allowances.
Most of the assets eligible for the
allowance are owned by smaller firms. As a
result, it iswould be reasonable to assume that
most of the tax benefit associated with the allowance falls into the hands of small
business owners. This benefit does not involve a reduction in their marginal tax
rates.
Becausesavings generated by the
allowance end up in the pockets of small business owners. But such an inference is
implausible, since the allowance does not alter the income tax rates facing small business
owners, it
business owners — and thus has no direct effect on the distribution of the federal
income tax burden
among income groups. And becauseAs the allowance leaves the distributional effects
effects of the income tax unchanged, it can havehas 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.
Most public finance expertseconomists would agree that a desirable income tax system is
is one that imposes 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 hinges on three factors: (1) the
records that must be kept in order to comply with
tax laws, (2) the complexity of
those laws, and (3) the types of income subject to taxation.
Many public finance expertseconomists would also likely agree that the current federal
income tax system fails this crucial test. 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
have long complained bitterly about the costly burdens imposed on them by the
record 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
that cost
over a longer period underapplying complicated depreciation schedules. At the same time,
the rules governing the use of the credit in and out of specially designated areas add
a layer of complexity to the administration of the allowance by the IRS.
Tax simplification has long been a key 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
CRS-14
for firms with fewer than 20 employees, $625 for firms with 20 to 499 employees,
and $562 for firms with 500 or more employees.21
crsphpgw
2118
18
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.