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Small Business Expensing Allowance: Current
Status, Legislative Proposals, and Economic
Section 179 and Bonus Depreciation
Expensing Allowances:
Current Law, Legislative Proposals in the
112th Congress, and Economic Effects
Gary Guenther
Analyst in Public Finance
March 18, 2009August 14, 2012
Congressional Research Service
7-5700
www.crs.gov
RL31852
CRS Report for Congress
Prepared for Members and Committees of Congress
c11173008
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Small Business Expensing Allowance
Summary
Under the American Recovery and Reinvestment Act of 2009 (ARRA, P.L. 111-5), business
taxpayers may
Section 179 and Bonus Depreciation Expensing Allowances
Summary
Expensing is the most accelerated form of depreciation for tax purposes. Section 179 of the
Internal Revenue Code (IRC) allows a taxpayer to expense (or deduct as a current expense rather
than a capital expense) up to $125) up to $250,000 of the total cost of certain
depreciable assets placed in service in 2009, within certain limits. One limit is a phaseout
threshold, which is set at $800,000 in 2009. The act also allows business taxpayers to claim a socalled bonus depreciation allowance in 2009 that is equal to 50% of the cost of qualified assets
placed in service that year. Firms unable to use either option for accelerated depreciation have to
write off that cost over a longer period, using current depreciation schedules. The rules governing
the use of the allowance confine most of its benefits to relatively small firms.
This report focuses on the economic effects of what is referred to as the small business expensing
allowance. It begins by explaining how the allowance works, then summarizes its legislative
history and describes legislation in the 111th Congress to modify the allowance, and concludes
with a discussion of the allowance’s implications for economic efficiency, equity, and tax
administration. The report will be updated as necessary.
There was strong bipartisan support for enhancing the expensing allowance in recent Congresses,
and there are some early signs that this support has not waned in the 111th Congress. Several bills
to extend the enhanced allowance that was in effect in 2008 through 2009 or 2010 have been
introduced, capped by H.R. 1, the American Recovery and Reinvestment Act of 2009. The
version of H.R. 1 signed by President Obama contains a provision that would allow firms to claim
the same enhanced expensing allowance in 2009 that was available in 2008. The act also extends
through 2009 the 50% bonus depreciation allowance that applied to the purchase of qualified
assets in 2008.
The expensing allowance appears to have a 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 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 and increasing the
cash flow of firms that use the allowance, it can also harm economic efficiency by encouraging
greater investment in activities with relatively low pre-tax rates of return. At the same time, the
allowance appears to have no measurable impact on the distribution of the federal tax burden
among income groups, but it simplifies tax accounting for firms claiming it.
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Contents
Current Expensing Allowance .....................................................................................................1
Maximum Expensing Allowance...........................................................................................1
Qualified Property.................................................................................................................2
Limitations on the Use of the Expensing Allowance ..............................................................2
Bonus Depreciation Allowance .............................................................................................3
Legislative History of the Expensing Allowance..........................................................................4
Legislative Initiatives in the 111th Congress .................................................................................5
Economic Effects of the Expensing Allowance............................................................................6
Efficiency Effects..................................................................................................................6
Equity Effects ..................................................................................................................... 10
Tax Administration.............................................................................................................. 10
Contacts
Author Contact Information ...................................................................................................... 11
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rovided certain conditions are met, firms may expense (or deduct as a current expense) up
to $250,000 of the total cost of qualified assets they purchase and place in service in 2009.
Some refer to this option for capital cost recovery as the small business expensing
allowance, as the rules governing its use confine the allowance’s benefits mainly to firms that are
relatively small in asset, employment, or revenue size. Generally, firms that cannot use the
expensing allowance may recover the cost of the same assets over longer periods by claiming
allowable depreciation deductions. The expensing allowance represents a significant tax subsidy
for small business investment, as it reduces the marginal effective rate at which the returns to
investment in qualified assets are taxed.
The 111th Congress has already passed a bill (H.R. 1, the American Recovery and Reinvestment
Act of 2009 or ARRA, P.L. 111-5) that extends through 2009 an enhanced version of the
allowance that was available in 2008. It is hoped that such an investment tax subsidy will spur
many small firms to spend more on new equipment in 2009 than they otherwise would.
This report examines the current status of the small business expensing allowance, initiatives in
the 111th Congress to modify it, and its main economic effects The report begins by describing the
allowance’s design and summarizing its legislative history. It then discusses proposals in the
current Congress to modify the current allowance. The report concludes with an assessment of the
allowance’s implications for economic efficiency, equity, and tax administration.
Current Expensing Allowance
Under section 179 of the Internal Revenue Code (IRC), firms in all lines of business have the
option of expensing the cost of qualified assets (or property) they acquire in the year when the
assets are placed in service, within certain limits. In general, business taxpayers that are unable or
unwilling to take advantage of the expensing allowance may recover this cost over longer periods
by using allowable depreciation deductions.
Maximum Expensing Allowance
The maximum expensing allowance is $250,000 for qualified assets placed in service in 2009 by
firms located outside so-called enterprise and empowerment zones (EZs), renewal communities
(RCs), and presidentially declared disaster areas (PDDAs). 1 (For the sake of clarity, this
allowance is henceforth referred to as the regular allowance.) For firms operating within all
special areas except PDDAs, the maximum allowance for qualified assets placed in service in
2009 is $285,000. For firms located in PDDAs, the maximum allowance for qualified assets
placed in service in 2009 is $350,000.
In 2010, the regular allowance is scheduled to drop to $125,000, before adjustment for inflation;
it will be $160,000 for firms located in special areas other than PDDAs, and $225,000 for PDDA
firms; both amounts are indexed for inflation. Assuming no change in current law, the regular
allowance is scheduled in 2011 and beyond to drop to $25,000, its amount before the enactment
1
The allowance is indexed for inflation in 2004 through 2010. In 2003, it was $100,000; in 2004, $102,000; in 2005,
$105,000; in 2006, $108,000; in 2007, $125,000; and in 2008, $250,000. The large increase in 2008 was temporary and
resulted from a provision in the Economic Stimulus Act of 2008.
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of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), with no adjustment for
inflation. Beginning in 2011, the allowance will fall to $60,000 for firms operating in all special
areas except PDDAs.
Qualified Property
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 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 (including heavy-duty sport utility vehicles) is considered qualified property, but
not heating and air conditioning units. In addition, the cost of packaged computer software
acquired for business use may be expensed through 2009. Most buildings and their structural
components do not qualify for the regular allowance, but research and bulk storage facilities do
qualify.
The expensing allowance does not apply to qualified property placed in service in the following
kinds of establishments located in EZs, RCs, and PDDAs: 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.
Limitations on the Use of the Expensing Allowance
The maximum amount of qualified property that may be expensed in a single tax year under IRC
Section 179 is subject to two explicit limitations: a dollar limitation and an income limitation.
Under the dollar limitation, the regular expensing allowance is reduced, dollar for dollar, by the
amount by which the total cost of qualified property placed in service during the year exceeds a
phaseout threshold. For firms operating in EZs, RCs, and the NYLZ, the expensing allowance is
reduced by half of the amount by which the total cost of qualified property placed in service in a
tax year exceeds the threshold. The threshold is set at $800,000 in 2009 for all firms except those
operating in PDDAs, which face a threshold of $1,400,000.2 As a result, a business taxpayer
located outside the special areas may expense none of the cost of qualified property it places in
service in 2009 when the total cost equals or exceeds $1,050,000. This means, for example, that if
such a firm were to place in service in 2009 qualified property whose total cost came to $550,000,
it could deduct the entire amount under IRC Section 179.
The phaseout threshold for the regular allowance is scheduled to fall to $500,000 in 2010, with an
adjustment for inflation. Assuming no change in current law, the threshold is scheduled to revert
to its pre-JGTRRA level of $200,000 (with no indexation for inflation) in 2011 and beyond.
Under the income limitation, the expensing allowance a firm claims cannot exceed its taxable
income (including wages and salaries) from the active conduct of the trade or business in which
2
Like the maximum expensing allowance, the phase-out threshold is indexed for inflation in 2004 through 2010. In
2003, the threshold was $400,000; in 2004, $410,000; in 2005, $420,000; in 2006, $430,000; in 2007, $500,000; and in
2008, $800,000.
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the qualified assets are employed. For example, if the firm in the above example were to have
taxable income in 2009 of $25,000 from the business in which the qualified property is used, it
would be able to claim an expensing allowance of no more than $25,000. While business
taxpayers are not allowed to carry forward any expensing allowance lost because of the dollar
limitation, they may carry forward indefinitely any allowance denied because of the income
limitation.
Business taxpayers can also expect to face a new restriction on their ability to take advantage of
the expensing option in 2011. Under Internal Revenue Service (IRS) Regulation 1.179-5,
taxpayers currently may make or revoke an election under IRC Section 179 for property placed in
service through 2010 without the consent of the IRS Commissioner by submitting an amended tax
return for the tax year in question. For tax years beginning in 2011, however, an expensing
election may be revoked only with the consent of the Commissioner.
Bonus Depreciation Allowance
In addition to the expensing allowance, business taxpayers were able to 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 deductions were commonly
referred to as bonus depreciation allowances and operated as partial expensing allowances. They
applied to new (but not used) property eligible for depreciation under the modified accelerated
cost recovery system (MACRS) and having a depreciation life of less than 20 years. Qualified
property acquired between September 11, 2001 and December 31, 2004, and placed in service
before January 1, 2005, was eligible for the 30% depreciation deduction. The 50% deduction
applied to qualified property bought between May 6, 2003 and January 1, 2005, and placed in
service by January 1, 2006. Since there was an overlap of nearly 19 months between the two
options for accelerated depreciation, business taxpayers were allowed to claim only one of them.
The Economic Stimulus Act of 2008 (P.L. 110-185) reinstated the 50% first-year bonus
depreciation allowance that expired at the end of 2006. It applies to the same set of depreciable
assets targeted by the earlier deduction. To benefit from this allowance, a firm had to buy
qualified assets and place them in service between January 1, 2008, and December 31, 2008; an
exception was made for assets with relatively long production schedules, such as aircraft. The
allowance expired at the end of 2008.
As a result of the ARRA, the bonus depreciation allowance that was available in 2008 has been
extended through 2009.
For property that is eligible for both the expensing and special depreciation allowances, a firm is
required to write off the property’s cost in a prescribed order. The expensing allowance must be
taken first, an act that reduces a taxpayer’s basis in the property by the amount of the allowance.
Then the taxpayer may apply the 50% first-year bonus depreciation allowance to any remaining
basis, further reducing the taxpayer’s basis in the property. Finally, the taxpayer is allowed to
claim a depreciation allowance under the MACRS on any remaining basis, using the double
declining balance method. Firms using all three allowances realize a significant reduction in their
cost of capital for investment in qualified property, as will be discussed below in some detail.
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Legislative History of the Expensing Allowance
The expensing allowance under IRC Section 179 originated as a special first-year 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 owners, stimulate small business investment,
and simplify tax accounting for smaller firms. The deduction was limited to $2,000 (or $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 effect 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 laid down a timetable for gradually increasing the allowance to $10,000 by 1986.
Despite these enhancements, few firms took advantage of the new allowance. Some analysts
ascribed the tepid response to the limitations on the use of the investment tax credit that was also
established by ERTA. A business taxpayer claiming the credit for the acquisition of an asset that
also was eligible for the expensing allowance could claim the credit only for the portion of the
cost that was not expensed; so the full credit could be used only if no expensing allowance was
claimed. For many firms, the tax savings from the credit only evidently outweighed the tax
savings from a combination of the credit and the allowance.
In a bid to counter the growing federal budget deficits of the early 1980s, Congress passed the
Deficit Reduction Act of 1984 (P.L. 98-369). One of its provisions postponed from 1986 to 1990
the scheduled increase in the maximum expensing allowance to $10,000. Use of 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 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. One of these
benefits was an expensing allowance for qualified assets placed in service in an EZ that was
$20,000 greater than the regular allowance, with a phaseout threshold twice as large as the
phaseout threshold for the regular allowance. To be designated as an EZ, an area had to meet 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. 104-188), the regular
allowance embarked on yet another upward path. The act raised the maximum allowance to
$18,000 in 1997, $18,500 in 1998, $19,000 in 1999, $20,000 in 2000, $24,000 in 2001 and 2002,
and $25,000 in 2003 and thereafter.
Under the Community Renewal Tax Relief Act of 2000 (P.L. 106-544), Congress expanded the
list of special areas to include renewal communities 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 all special areas
(including RCs) to $35,000 above the regular allowance.
In response to the economic effects of 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
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area as the New York “Liberty Zone.” Among the tax benefits offered to firms investing in the
zone was the same enhanced expensing allowance available for qualified investments in EZs and
RCs.
The regular allowance remained on the upward path set down by the Small Business Jobs
Protection Act until the adoption of JGTRRA. Under JGTRRA, the maximum regular allowance
rose four-fold to $100,000 as of May 6, 2003 and was supposed to stay at that amount in 2004
and 2005, before returning to its amount before the enactment of JGTRRA ($25,000) in 2006 and
thereafter. JGTRRA also raised the phaseout 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-theshelf software for business use to the list of depreciable assets eligible for expensing from May 6,
2003 through December 31, 2005.
The American Jobs Creation Act of 2004 (AJCA, P.L. 108-357) extended the changes in the
allowance made by JGTRRA through the end of 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 the GOZ, including
an enhanced expensing allowance for qualified assets purchased on or after August 28, 2005, and
placed in service by December 31, 2007. This allowance could be as much as $100,000 above the
regular allowance. In addition, it began to phase out when the total cost of qualified assets placed
in service in a tax year exceeded a threshold that was $600,000 above the phaseout threshold for
the regular allowance. Finally, more assets were eligible for the enhanced allowance than for 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.
Under 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 yet again
(through 2010), raised the maximum allowance to $125,000 and the phaseout threshold to
$500,000 from 2007 through 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.
In a bid to boost business investment in the midst of an accelerating downturn in economic
activity, Congress increased the allowance to $250,000 and the phaseout threshold to $800,000
for 2008 only through the Economic Stimulus Act of 2008 (P.L. 110-185). Those amounts return
to $125,000 and $500,000 (both amounts adjusted for inflation) in 2009 and 2010.
The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) extended the enhanced
allowance created by the Economic Stimulus Act of 2008 through 2009.
Legislative Initiatives in the 111th Congress
There are some early signs that congressional interest in enhancing the expensing allowance to
boost small business investment remains as robust as ever in the 111th Congress. Several bills to
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extend through 2009 or 2010 the enhanced allowance that was available in 2008 have been
introduced, capped by H.R. 1(ARRA, P.L. 111-5). The version of H.R. 1 signed by President
Obama contains a provision that allows firms to claim a maximum expensing allowance of
$250,000, with a phaseout threshold of $800,000, for qualified assets placed in service in 2009.
The act also extends through 2009 the 50-percent bonus depreciation allowance that applied to
the purchase of qualified assets in 2008.
Economic Effects of the Expensing Allowance
For many lawmakers, the expensing allowance represents a desirable policy tool for lowering the
tax burden on small business owners and stimulating business investment at the same time. And
for many small business owners, the allowance represents a desirable tax benefit. But for most
public finance economists, the allowance generates economic effects that go beyond its impact on
the tax burden of small business owners. In their view, the allowance could 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 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 traditional economic theory and analysis. It refers to the allocation
of resources in an economy and how that allocation shapes the welfare of consumers and
producers. When the allocation of resources produces the greatest possible economic surplus—
defined as the total value to buyers of the goods and services they consume minus the total cost to
sellers of providing these goods and services—the allocation is said to be efficient. But when the
allocation is less than efficient, some of the possible gains from exchange among buyers and
sellers are not realized. For example, economists deem an allocation of resources inefficient when
most suppliers of a good fail to produce it at the lowest marginal cost allowed by existing
technologies. In this case, a shift in sources of supply from relatively high-cost producers to
relatively low-cost producers, driven perhaps by an unleashing of consumer demand, would lower
the total economic cost of providing the good, thereby raising the overall economic surplus.
A 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 economic outcomes
because they sway the decisions of consumers and producers in ways that leave one group or the
other—or both—worse off. Non-lump-sum taxes have this effect because they inevitably distort
the economic choices facing individual and business taxpayers, leading them more often than not
to allocate resources on the basis of how taxes affect the cost and benefit of the goods and
services they buy and sell, rather than according to their actual costs and benefits. Such a
distortion entails what economists call a deadweight loss, which is a condition where the amount
of revenue raised by a tax is less than the loss of economic welfare it engenders.
The expensing allowance could affect the allocation of resources in an economy by encouraging
firms to invest in assets that qualify for the allowance, possibly at the expense of other, more
productive assets. There are two channels through which the allowance can produce such an
inefficient outcome. One channel is a reduction in the user cost of capital for investment in
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qualified assets relative to investment in all other assets. A second channel is a temporary increase
in the cash flow or retained earnings of firms that acquire qualified assets. Restraining the
allowance’s influence on the allocation of resources is its phaseout threshold, which effectively
confines the benefits of the allowance to relatively small firms.3
Not surprisingly, the user cost of capital plays a major role in a firm’s investment decisions. This
cost embraces both the opportunity cost of an investment and its direct costs, such as
depreciation, the actual cost of the asset, and income taxes. In effect, the user cost of capital
establishes 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 fewer projects a firm can
profitably undertake, and the lower its desired capital stock. When a change in tax policy
decreases the user cost of capital, it is reasonable to expect many firms to respond by increasing
the amount of capital they wish to own, boosting overall business investment in the short run.
So 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 written off in its first year of use,
regardless of the asset’s economic or useful life. Allowing a firm to expense its acquisition of an
asset is akin to the U.S. Treasury providing the firm 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 particular after-tax rate
of return. 4 Expensing yields the largest possible reduction in the user cost of capital from
accelerated depreciation. As some studies have shown, this reduction can be considerable.5
How beneficial is expensing? One way to illustrate the tax benefit from expensing is to assess
how it affects the marginal effective tax rate on the returns to investment in an asset whose cost is
expensed. Expensing has the effect of taxing the stream of income earned by an asset over its
lifetime at a marginal effective rate of zero. 6 This is because expensing reduces the after-tax
3
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%.
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)]/(1-t). 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.
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, September 1995, p. 389.
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.
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return and cost for an investment by the same factor, which is 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 the cost
of a depreciable asset he or she buys is recovered through expensing, 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 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.7 This equivalence implies that expensing results in an effective
marginal tax rate of 0.
Expensing could also spur a rise in business investment by augmenting the cash flow of firms that
rely heavily on retained earnings to finance their investments.8 Expensing can increase a firm’s
cash flow in the short run because it allows the firm to deduct the full cost of qualified assets in
the tax year the firm places them into service. There are several reasons why a firm’s investments
could depend on its cash flow. One is that the firm’s owners or senior managers want to limit their
exposure to external debt and the risk of default it entails. Another reason is that the firm has
limited or virtually no access to debt and equity markets, because potential investors and lenders
lack sufficient information about the firm’s products and competitive strategies. For firms in such
a position, the cost of internal funds could be lower than the cost of external funds, in which case
the firm clearly would be better off financing its investments out of retained earnings.
Nevertheless, the impact of increases in cash flow on business investment remains uncertain.
Some studies found a significant positive correlation between changes in a firm’s net worth and
its investment spending.9 This correlation was strongest for firms that had very limited access to
debt and equity markets. Yet it would be a mistake to interpret these findings as proof that firms
with relatively high cash flows invest more than firms with relatively low or negative cash flows.
After all, a strong correlation between two factors does not prove the existence of a cause-andeffect 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 relationship between cash
flow and business investment is complicated, and further research is needed to clarify it.
Has the expensing allowance made significant contributions 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, largely because there are no studies analyzing the impact of the
allowance on capital formation over time, and available empirical evidence is incomplete. Given
that the expensing allowance lowers the cost of capital and may boost cash flow for firms using it,
and that investment in many of the assets eligible for the allowance seems somewhat sensitive to
changes in the cost of capital, one might be justified in concluding that the allowance has caused
7
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.
8
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.
9
For a review of the recent literature on this topic, see R. Glenn Hubbard, “Capital Market Imperfections and
Investment,” Journal of Economic Literature, vol. 36, March 1998, pp. 193-225.
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Small Business Expensing Allowance
domestic investment in those assets to be greater than it otherwise would have been. 10 But there
are some compelling reasons to argue that much of this investment would have taken place
without the expensing allowance.11 Most economists would be likely to agree that investment in
assets eligible for the expensing allowance is driven more by expectations for future growth in
sales by firms that purchase these assets, the nature of the assets, and conditions in debt and
equity markets than by tax considerations. 12 This view finds some support 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 Section 179 property placed in service
in that period was equal to only 5% of domestic gross investment in equipment and computer
software.13
When seen through the lens of conventional economic theory, the expensing allowance has
efficiency effects 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 is likely to lure some capital away from highly profitable uses and into
tax-favored uses. Conventional economic theory holds that in an economy free of significant
market failures and dominated by competitive markets, a policy of neutral or uniform taxation of
capital income minimizes the efficiency losses associated with income taxation. But the
expensing allowance 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 pre-tax rates of return.
In addition, the expensing allowance gives smaller firms an incentive to limit their growth. This
unintended effect stems from the rise in marginal effective tax rates on the income earned by an
asset eligible for the allowance in the allowance’s phaseout range ($530,000 to $663,000 in
2009).14 Douglas Holtz-Eakin, a former Director of the Congressional Budget Office, has called
this incentive effect a “tax on growth by small firms.”15
10
Two studies from the 1990s found that a 1% decline in the user cost of capital was associated with a rise in business
equipment spending of 0.25% to 0.66%. See CRS Report RL31134, Using Business Tax Cuts to Stimulate the
Economy, coordinated by Jane G. Gravelle, p. 4.
11
There is some anecdotal evidence to support this supposition. At a recent hearing held by the House Small Business
Subcommittee on Tax, Finance, and Exports, Leslie Shapiro of the Padgett Business Services Foundation stated that
expensing “may be an incentive in making decisions to buy new equipment, but it’s not the dominant force.” His firm
provides tax and accounting services to over 15,000 small business owners. See Heidi Glenn, “Small Business
Subcommittee Weighs Bush’s Expensing Boost,” Tax Notes, April 7, 2003, p. 17.
12
See Roger W. Ferguson, Jr., “Factors Influencing Business Investment,” speech delivered on October 26, 2004,
available at http://www.federalreserve.gov/boarddocs/speeches/2004/20041026/default.htm.
13
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.
14
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.
15
U.S. Congress, Senate Committee on Finance, Small Business Tax Incentives, hearings on S. 105, S. 161, S. 628, S.
692, S. 867, and H.R. 1215, 104th Cong., 1st sess., June 7, 1995 (Washington: GPO, 1995), pp. 11-12.
Congressional Research Service
9
.
Small Business Expensing Allowance
Equity Effects
Equity is another basic concept in conventional economic analysis. It generally refers to the
distribution of income among the individuals or households in a particular geographic area.
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 kinds of equity: horizontal equity and vertical equity. A tax is said to
be horizontally equitable if it imposes similar burdens on individuals with similar incomes or
living standards. 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 lays the
foundation for a progressive income tax system. Under such a system, an individual’s tax liability,
measured as a fraction of income, rises with income.
The current federal income tax system arguably leans more in the direction of vertical equity than
horizontal equity. Many individuals with similar incomes before taxes end up being taxed at the
same marginal rate. But because so many tax preferences in the form of deductions, preferential
rates, deferrals, exclusions, exemptions, and credits have been enacted in recent decades, a
significant share of individuals with similar before-tax incomes end up being taxed at different
rates. At the same time, those with relatively high pre-tax incomes are generally taxed at higher
rates than those with relatively low pre-tax incomes.
How does the expensing allowance affect vertical and horizontal equity?
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 from the allowance is a reduction in the marginal effective tax rate on the
income earned by assets eligible for expensing. How much of a reduction depends critically on
the proportion of an asset’s cost that is expensed. As was noted earlier, if the entire cost is
expensed, then the marginal effective rate falls to zero. Yet the allowance does not change the
actual marginal rates at which this income is taxed. This is because accelerated depreciation does
not reduce the total amount of taxes (measured in current dollars) owed on the stream of income
earned by an asset over its useful life. Rather, accelerated depreciation simply moves forward the
timing of depreciation deductions in a way that substantially raises the present discounted value
of the tax savings from depreciation deductions.
Most of the assets eligible for the allowance are held by smaller firms. Therefore, it seems
reasonable to conclude that most of the tax savings attributable to the allowance ends up in the
pockets of small business owners. But such a conclusion is somewhat misleading, as the
allowance does not alter the income tax rates that apply to the income earned by small business
owners—and thus has no direct effect on the distribution of the federal income tax burden among
income groups. Nonetheless, the allowance does lower the tax burden on the returns to a portion
of small business investment, which means that the allowance may indirectly violate the principle
of vertical equity by decreasing the effective tax rate on income earned by small business owners.
Tax Administration
Yet another policy question raised by the expensing allowance concerns its impact on the cost of
tax compliance for business taxpayers.
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10
.
Small Business Expensing Allowance
Most public finance economists agree that a desirable income tax system is one that imposes
relatively low costs for administration and compliance. Research indicates that the administrative
cost of a tax system 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.
Most public finance economists also agree that the current federal income tax system fails this
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 growing complexity of the federal tax code.
Many small business owners have long complained about the costs imposed on them by the
record keeping and filings required by the federal income tax.
The expensing allowance addresses this concern by simplifying tax accounting for the firms that
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 writing off that cost over a longer period using allowable
depreciation schedules. At the same time, the rules governing the use of the regular allowance and
the use of the allowance in special areas like EZs and RCs add a layer of complexity to the
administration of the tax code by the IRS.
Tax simplification is a longstanding policy objective for a majority of small business owners. A
primary motivation for this quest is the relatively high costs small firms evidently bear in
complying with federal tax laws. These costs were the main focus of a 2001 study prepared for
the Office of Advocacy at the Small Business Administration. The study found that the cost per
U.S. employee for tax compliance in 2000 was an estimated $665 for all firms, $1,202 for firms
with fewer than 20 employees, $625 for firms with 20 to 499 employees, and $562 for firms with
500 or more employees. 16 This finding appears to lend further support to what is regarded as a
well-established truth about the costs to firms of tax compliance: namely, that these costs are17
regressive to firm size in that “as a fraction of any of a number of size indicators, the costs are
lower for larger companies.”
Author Contact Information
Gary Guenther
Analyst in Public Finance
gguenther@crs.loc.gov, 7-7742
16
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.
17
Joel Slemrod, “Small Business and the Tax System,” in The Crisis in Tax Administration, Henry J. Aaron and Joel
Slemrod, eds. (Washington: Brookings Institution Press, 2004), p. 81.
Congressional Research Service
11new and used qualified depreciable
assets it buys and places in service in 2012, within certain limits. Firms unable to take advantage
of the Section 179 expensing allowance may recover the cost of qualified assets over longer
periods, using the appropriate depreciation schedules. While the Section 179 expensing allowance
is not targeted at firms that are relatively small in employment, asset, or receipt size, the rules
governing its use limit its benefits to such firms, for the most part.
In addition, Section 168(k), which provides a so-called bonus depreciation allowance, generally
allows taxpayers to expense half the cost of qualified assets bought and placed in service in 2012.
Taxpayers that can claim the allowance have the option of monetizing any unused alternative
minimum tax credits they have accumulated from tax years before 2006, within certain limits, and
writing off the cost of the assets that qualify for the allowance over a longer period.
This report examines the current status, legislative history, and economic effects of the two
expensing allowances. It also discusses initiatives in the 112th Congress to modify them. The
report will be updated as legislative activity warrants.
The two expensing allowances have enjoyed broad bipartisan support in recent Congresses, and
there is no reason to believe this consensus has frayed in the 112th Congress. The House passed a
measure (H.R. 8) on August 1, 2012, that would raise the maximum Section 179 allowance to
$100,000 and the phaseout threshold to $400,000 for the 2013 tax year, index both amounts for
inflation, and allow purchases of off-the-shelf computer software eligible for the allowance
through the 2014 tax year, among other things. A day later (August 2), the Senate Finance
Committee reported a bill (the Family and Business Tax Cut Certainty Act of 2012, no bill
number yet) that would raise the maximum Section 179 allowance to $500,000 and the phaseout
threshold to $2 million in 2012 and 2013 and allow taxpayers to expense up to $250,000 of the
cost of qualified leasehold property improvements in those years.
Since 2002, the allowances have served as one of several tax incentives for stimulating growth in
the U.S. economy. This raises the question of their effectiveness. Though there are no studies that
address the economic effects of the enhanced Section 179 allowances that were enacted in the
previous eight years, several studies have examined the economic effects of the 30% and 50%
bonus depreciation allowances that were available from 2002 to 2004. The two allowances
applied to nearly the same property. Basically, the studies concluded that accelerated depreciation
in general is a relatively ineffective tool for stimulating the economy.
Available evidence, as incomplete as it is, indicates that the expensing allowances probably have
no more than a minor effect on the level, composition, and allocation among industries of
business investment; the distribution of the federal tax burden among income groups; and the cost
of tax compliance for smaller firms. On the one hand, an expensing allowance has the potential to
spur increased small business investment in favored assets in the short run by reducing the user
cost of capital and increasing the cash flow of investing firms. It also has the advantage of
simplifying tax accounting for depreciation for firms that take the expensing allowance. On the
other hand, an expensing allowance could interfere with the allocation of economic resources by
diverting capital flows away from investments with more productive outcomes.
Congressional Research Service
Section 179 and Bonus Depreciation Expensing Allowances
Contents
Introduction...................................................................................................................................... 1
Current Expensing Allowances........................................................................................................ 1
Section 179 ................................................................................................................................ 1
Maximum Expensing Allowance ........................................................................................ 1
Qualified Property............................................................................................................... 1
Limitations on Use of the Section 179 Allowance .............................................................. 2
Claiming the Allowance ...................................................................................................... 2
Bonus Depreciation Allowance ................................................................................................. 3
Interaction with Other Depreciation Allowances, Including the
Section 179 Allowance..................................................................................................... 4
Legislative History of the Two Expensing Allowances ................................................................... 4
Section 179 ................................................................................................................................ 4
Bonus Depreciation Allowance ................................................................................................. 7
Legislative Initiatives to Modify the Two Expensing Allowances in the 112th Congress................ 8
Section 179 Expensing Allowance ............................................................................................ 8
House Bills .......................................................................................................................... 8
Senate Bills.......................................................................................................................... 9
President’s Budget Request for FY2013 ............................................................................. 9
Bonus Depreciation Allowance ............................................................................................... 10
House Bills ........................................................................................................................ 10
Senate Bills........................................................................................................................ 10
President’s Budget Request for FY2013 ........................................................................... 10
Economic Effects of the Section 179 and Bonus Depreciation Allowances.................................. 11
The Allowances as Tools for Economic Stimulus ................................................................... 11
Efficiency Effects .................................................................................................................... 14
Equity Effects .......................................................................................................................... 17
Tax Administration .................................................................................................................. 18
Tables
Table 1. Maximum Expensing Allowance and Investment Limitation from 1987 to 2013............. 3
Contacts
Author Contact Information........................................................................................................... 18
Congressional Research Service
Section 179 and Bonus Depreciation Expensing Allowances
Introduction
Under current tax law, firms may expense (or deduct as a current rather than a capital expense) up
to $125,000 of the total cost of new and used qualified assets they purchase and place in service
in 2012 under Section 179 of the federal tax code. They also have the option under Section 168(k)
of expensing half of the cost of qualified assets they buy and place in service the same year. Many
assets qualify for both allowances.
Expensing is the most accelerated form of depreciation. As a result, it has the potential to
stimulate business investment by reducing the cost of capital for favored investments and
increasing the cash flow of firms making such investments. This explains why economists view
the two allowances as a significant investment tax subsidy.
The 112th Congress has passed no legislation changing the status of either allowance, though a
number of bills have been introduced that would extend one allowance or the other by one or
more years, or permanently. In contrast, the 111th Congress passed four bills that enhanced the
allowances, partly as a countercyclical measure: the American Recovery and Reinvestment Act of
2009 (ARRA; P.L. 111-5); the Hiring Incentives to Restore Employment Act of 2010 (HIRE Act;
P.L. 111-147); the Small Business Jobs Act of 2010 (SBJA; P.L. 111-240); and the Tax Relief,
Unemployment Compensation Reauthorization, and Job Creation Act of 2010 (TRUCA;
P.L. 111-312).
This report examines the current status, legislative history, and main economic effects (including
their efficacy as an economic stimulus tool) of the Section 179 and bonus depreciation
allowances. It also identifies legislative initiatives to extend them beyond 2012.
Current Expensing Allowances
Section 179
Under Section 179 of the Internal Revenue Code (IRC), firms in all lines of business and all sizes
have the option, within certain limits, of expensing part or all of the cost of new and used
qualified property (or assets) they acquire in the year when the assets are placed in service.
Business taxpayers that cannot or choose not to claim the allowance may recover capital costs
over longer periods by claiming the appropriate depreciation deductions under the MACRS or
ADS.
Maximum Expensing Allowance
The maximum Section 179 expensing allowance is set at $125,000 for qualified assets bought and
placed in service in 2012. Assuming no change in current law, the allowance will drop to $25,000
in 2013 and thereafter.
Qualified Property
Current law defines property that qualifies for the allowance as new and used tangible property—
as specified in IRC Section 1245(a)(3)—that is depreciable under IRC Section 168 (which holds
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Section 179 and Bonus Depreciation Expensing Allowances
the MACRS) and acquired for use in the active conduct of a trade or business. With a few
exceptions, this property consists of machines and equipment used in manufacturing, mining,
transportation, communications, the generation and transmission of electricity, gas and water
distribution, and sewage disposal. Most buildings and their structural components (including
heating and air conditioning units and lodging facilities) do not qualify for the allowance. But an
exception was made for 2010 and 2011 only: taxpayers may expense up to $250,000 of the cost
of qualified leasehold improvements, qualified retail improvement property, and qualified
restaurant improvement property. Research and bulk storage facilities do qualify for the
allowance, as do single-purpose agricultural structures, storage facilities for petroleum products,
and railroad grading and tunnel bores. In addition, the cost of off-the-shelf computer software that
is depreciable in three years and placed in service from 2003 to 2012 may be expensed under
Section 179.
Limitations on Use of the Section 179 Allowance
Use of the allowance is subject to two limitations: an investment (or dollar) limitation and an
income limitation.
Under the dollar limitation, the maximum allowance is reduced, dollar for dollar but not below
zero, by the amount by which the aggregate cost of qualified property a firm buys and places in
service during a tax year exceeds what is often referred to as a phaseout threshold. The threshold
is set at $500,000 in 2012 and is scheduled to fall to $200,000 in 2013 and thereafter. (See Table
1 for the amounts in tax years before 2011.) As a result, a taxpayer may claim no Section 179
expensing allowance for the cost of qualified property it acquires and places in service in 2012
when the cumulative cost is $625,000 or more.
The income limitation bars a taxpayer from claiming an allowance greater than its taxable income
(including wages and salaries) from the active conduct of a trade or business. It is determined
after the application of the investment limitation. So if a firm has $25,000 in taxable income from
a business but may claim a Section 179 allowance no larger than $20,000 after applying the
investment limitation, it could expense no more than $20,000 of the cost of qualified property and
depreciate the remainder under the MACRS, if applicable. Though taxpayers cannot carry
forward any allowance that is denied because of the investment limitation, they may carry
forward indefinitely any allowance that is denied because of the income limitation.
Claiming the Allowance
Historically, an election to claim the Section 179 allowance could be revoked only with the
consent of the Internal Revenue Service (IRS). But this rule has been suspended for tax years
beginning in 2003 through 2012. During this time, a taxpayer may revoke any portion of an
election to expense qualified property without the IRS’s consent, regardless of whether the
election was made on an original or an amended return (IRS regulation 1.179-5). A revocation is
made by submitting an amended tax return for the tax year in question. To claim the allowance, a
taxpayer must specify on Form 4562 the items to which the election applies and the portion of the
cost of each item that is to be deducted immediately.
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Section 179 and Bonus Depreciation Expensing Allowances
Table 1. Maximum Expensing Allowance and Investment Limitation
from 1987 to 2013
Year
Maximum Expensing Allowance
Investment Limitation
1987-1992
$10,000
$200,000
1993-1996
$17,500
$200,000
1997
$18,000
$200,000
1998
$18,500
$200,000
1999
$19,000
$200,000
2000
$20,000
$200,000
2001 and 2002
$24,000
$200,000
2003
$100,000
$400,000
2004
$102,000a
$410,000a
2005
$105,000a
$420,000a
2006
$108,000a
$430,000a
2007
$125,000
$500,000
2008 and 2009
$250,000
$800,000
2010 and 2011
$500,000
$2,000,000
2012
$125,000
$500,000
$25,000
$200,000
2013 and beyond
Source: Internal Revenue Service, revenue procedures dating back to 1987
a.
The $100,000 figure for the maximum allowance and the $400,000 figure for the investment limitation were
both indexed for inflation from 2004 to 2006.
Bonus Depreciation Allowance
Besides the Section 179 expensing allowance, taxpayers have had in recent years the option of
claiming an additional first-year (or bonus) depreciation allowance that entered the tax code
(§68(k)) in 2002 and is scheduled to last through 2012, under current law. The allowance speeds
up the depreciation of qualified property, increasing the present value of the tax savings from
depreciation. As such, it is intended to stimulate higher levels of business investment in the short
run than otherwise would occur.
The initial bonus depreciation allowance was a temporary 30% first-year depreciation deduction
included in the Job Creation and Worker Assistance Act of 2002 (P.L. 107-147). It applied to
property that was eligible for depreciation under the MACRS with recovery periods of 20 years
or less, water utility property, off-the-shelf computer software, and qualified leasehold property.
This property had to be acquired between September 12, 2001, and December 31, 2004, and
placed in service before January 1, 2005. Taxpayers claiming the allowance had to be the original
user of the property. They could apply it against the regular income tax and the AMT with no
adjustments.
Under current law, a 50% bonus depreciation allowance is available for the same property
acquired and placed in service in 2012. It is scheduled to expire on December 31 of this year.
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Section 179 and Bonus Depreciation Expensing Allowances
Corporations have the option under Section 168(k)(4) to claim a portion of their unused
alternative minimum tax (AMT) credits from tax years before 2006, in lieu of any bonus
depreciation allowance they could take in 2012. The accelerated credit is refundable and limited
to a corporation’s bonus depreciation amount for the tax year. This amount cannot exceed what is
known as the “maximum increase amount,” which is the lesser of 6% of the sum of the
corporation’s unused AMT credits from tax years before 2006 or $30 million. In 2008, 2009, and
2010, a corporation was allowed to claim unused AMT and research credits from tax years before
2006, in lieu of any bonus depreciation allowance it could take.
Interaction with Other Depreciation Allowances, Including the
Section 179 Allowance
In the case of assets that are eligible for both expensing allowances, a taxpayer is required to
recover their cost in a prescribed order. The expensing allowance must be taken first, lowering the
taxpayer’s basis in the asset by the amount that is expensed. If there is a remaining basis, the
taxpayer then may apply the bonus depreciation allowance to that amount, further reducing her
basis in the property. Finally, the taxpayer is allowed to claim a depreciation allowance under the
MACRS for any basis left after the first two adjustments, using the double declining balance
method.
A simple example can illustrate how this three-step process is supposed to work. Assume the only
investment a company made in 2009 involved the acquisition of 10 new machine tools at a total
cost of $700,000. Such a purchase qualified for both the expensing and bonus depreciation
allowances that were available that year. Consequently, the company took an expensing
allowance of $250,000 on its federal tax return for that year, lowering its basis in the property to
$450,000 ($700,000 - $250,000). It then claimed a bonus depreciation allowance of $225,000
($450,000 x 0.5), further lowering its basis to $225,000 ($450,000 - $225,000). Finally, the
company was allowed to take a deduction for depreciation under the MACRS on the remaining
$225,000. Given that the MACRS recovery period for machine tools is five years, and that fiveyear property is depreciated with the double-declining-balance method, it took an additional
depreciation deduction equal to 20% of $225,000, or $45,000, using the half-year convention.
The company may recover the remaining basis of $180,000 ($225,000 - $45,000) through taking
MACRS depreciation deductions over each of the next five years at rates of 32%, 19.2%, 11.52%,
11.52%, and 5.76%, respectively. Thus, the company may write off 74% of the cost of the
machine tools in the year they were bought and placed in service: 2009. If the transaction had
taken place in 2010 or 2011, the taxpayer would have been able to deduct the full cost of the
equipment by taking the 100% bonus depreciation allowance.
Legislative History of the Two
Expensing Allowances
Section 179
The Section 179 expensing allowance originated as a special first-year depreciation allowance
that Congress included in the Small Business Tax Revision Act of 1958 (P.L. 85-866). Its purpose
was the same as the current allowance: reduce the tax burden on small business owners, stimulate
Congressional Research Service
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Section 179 and Bonus Depreciation Expensing Allowances
small business investment, and simplify tax accounting for smaller firms. The original deduction
was limited to $2,000 (or $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 tax life of six or more years.
No change was made in the special allowance until the enactment of the Economic Recovery Tax
Act of 1981 (ERTA; P.L. 97-34). ERTA raised the expensing allowance to $5,000 and laid down a
timetable for gradually increasing the allowance to $10,000 by 1986. In spite of the substantial
increase in the allowance, few firms took advantage of it. Some attributed the tepid response to
the limitations on the use of an investment tax credit that ERTA established. A business taxpayer
could claim the credit only for the portion of an eligible asset’s cost that was not expensed; so the
full credit could be used only if the company claimed no expensing allowance. For many firms,
the tax savings from the credit alone reportedly outweighed the tax savings from combining the
credit with the allowance.
In an effort to stop the growth in the federal budget deficit in the early 1980s, Congress passed
the Deficit Reduction Act of 1984 (P.L. 98-369). Among other things, the act postponed from
1986 to 1990 the scheduled increase in the expensing allowance to $10,000. Use of the allowance
rose markedly following the repeal of the investment tax credit by the Tax Reform Act of 1986.
With the backing of Congress, the allowance rose to $10,000 in 1990, as scheduled, and remained
at that level until the passage of the Omnibus Budget Reconciliation Act of 1993 (OBRA93; P.L.
103-66). OBRA93 increased the allowance to $17,500 (as of January 1, 1993) and created a
variety of tax benefits for impoverished areas designated as enterprise zones and empowerment
zones. The benefits included an enhanced expensing allowance for qualified assets placed in
service in an EZ.1 To be designated as an EZ, an area had to meet a variety of eligibility criteria
relating to population, poverty rate, and geographic size.
With the enactment of the Small Business Job Protection Act of 1996 (P.L. 104-188), the regular
allowance again moved upward but with a difference: scheduled annual (with one exception)
increases over six years. Specifically, the act raised the maximum allowance to $18,000 in 1997,
$18,500 in 1998, $19,000 in 1999, $20,000 in 2000, $24,000 in 2001 and 2002, and $25,000 in
2003 and thereafter.
The Community Renewal Tax Relief Act of 2000 (P.L. 106-554) added so-called renewal
communities (RCs) to the list of special areas and granted them the same tax benefits available to
businesses in EZs, including the enhanced expensing allowance. In addition, it increased the
premium for the allowance for qualified assets placed in service in special areas (including RCs)
to $35,000 above the regular allowance.
In response to the economic losses associated with 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 aerial attacks on the World Trade Center.
The act designated this area as the New York “Liberty Zone.” Among the tax benefits offered to
1
Firms placing qualified assets in service in an EZ were allowed to claim a maximum allowance that was $20,000
greater than the allowance available in other areas, with a phaseout threshold that was twice as large as that available in
other areas.
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Section 179 and Bonus Depreciation Expensing Allowances
firms operating in the zone was the same enhanced expensing allowance for qualified investments
in EZs and RCs.
After the enactment of the Small Business Jobs Protection Act, no change was made in the
allowance until the passage of JGTRRA. Under the act, the allowance rose four-fold to $100,000
(as of May 6, 2003), was to stay at that amount in 2004 and 2005, and then reset in 2006 and
beyond at its level before JGTRRA ($25,000). JGTRRA also raised the phaseout threshold to
$400,000 from May 2003 to the end of 2005, indexed the regular allowance and the threshold for
inflation in 2004 and 2005, and added off-the-shelf software for business use to the list of
depreciable assets eligible for expensing in the same period.
The American Jobs Creation Act of 2004 (AJCA; P.L. 108-357) extended the changes made by
JGTRRA through the end of 2007.
In an effort to aid economic recovery in the areas of Louisiana, Mississippi, and Alabama
devastated by Hurricane Katrina in 2005, Congress passed the Gulf Opportunity Zone Act of
2005 (P.L. 109-135). Among other things, the act created what was known as a Gulf Opportunity
Zone (GOZ) in those areas and offered a variety of tax incentives for business investment in the
GOZ, including an enhanced expensing allowance for qualified assets purchased on or after
August 28, 2005, and placed in service by December 31, 2007. This allowance could be as much
as $100,000 above the regular allowance, with a phaseout threshold that was $600,000 greater
than that for the regular allowance. And the enhanced GOZ allowance applied to more assets than
the regular allowance.
The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) extended the changes
in the allowance under JGTRRA through 2009.
Under the U.S. Troop Readiness, Veterans’ Care, Katrina Recovery, and Iraq Appropriations Act,
2007 (P.L. 110-28), Congress further extended the changes in the allowance made by JGTRRA
through 2010, raised the maximum allowance to $125,000 and the phaseout threshold to
$500,000 for 2007 to 2010, and indexed both amounts for inflation in that period. The act also
extended through 2008 the special GOZ allowance.
In an effort to boost business investment in the midst of an accelerating economic downturn,
Congress increased the allowance to $250,000 and the phaseout threshold to $800,000 in 2008
only, by passing the Economic Stimulus Act of 2008 (ESA; P.L. 110-185). Those amounts were
supposed to reset at $125,000 and $500,000 in 2009 and 2010, with adjustments for inflation.
During the 111th Congress, the American Recovery and Reinvestment Act of 2009 (P.L. 111-5)
extended the enhanced allowance created by ESA through 2009, and the Hiring Incentives to
Restore Employment Act of 2010 (P.L. 111-147) extended it through 2010.
Under the Small Business Jobs Act of 2010 (P.L. 111-240), the maximum amount a taxpayer can
expense was increased to $500,000, and the phaseout threshold was raised to $2 million, for tax
years beginning in 2010 and 2011.
The Tax Relief, Unemployment Compensation Reauthorization, and Job Creation Act of 2010
raised the maximum expensing allowance to $125,000 and the phaseout threshold to $500,000 for
the 2012 tax year, indexed those amounts for inflation, set the maximum allowance at $25,000
and the phaseout threshold at $200,000 for the 2013 tax year and each tax year thereafter, and
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extended through 2012 the rule allowing off-the-shelf computer software to qualify for the
allowance.
Bonus Depreciation Allowance
The Job Creation and Worker Assistance Act of 2002 (P.L. 107-147) created the initial bonus
depreciation allowance. It was equal to 30% of the adjusted basis of new qualified property
acquired after September 11, 2001, and placed in service no later than December 31, 2004. A oneyear extension of the placed-in-service deadline was available for certain property with a
MACRS recovery period of 10 or more years and for transportation equipment.
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27), the allowance
became 50% for the same qualified property acquired after May 5, 2003, and placed in service
before January 1, 2006. A one-year extension of that deadline was available for the same qualified
property.
Congress passed the Economic Stimulus Act of 2008 in response to the financial crisis that
emerged with devastating effects in the late summer and early fall of that year. Included in the act
was a reinstatement of the 50% bonus depreciation allowance that expired at the end of 2005. To
claim the allowance, a taxpayer had to acquire qualified property after December 31, 2007, and
place it in service before January 1, 2009.
Later the same year, Congress passed a measure (the Housing Assistance Tax Act of 2008)
intended to ease the impact of the financial crisis on the domestic housing market. It included a
provision that gave corporations the option of trading any bonus depreciation allowance they
could claim for eligible property they acquired between April 1 and December 31, 2008, for a
refundable tax credit equal to the lesser of $30 million or 6% of the sum of any research and
AMT credits that could be carried forward from tax years before 2006. Corporations choosing the
option were required to depreciate the property that qualified for the allowance under the
MACRS using the straight-line method; no AMT adjustment for depreciation was required.
The American Recovery and Reinvestment Act of 2009 (P.L. 111-5) extended the deadlines by
one year, to the end of 2009, for both the 50% bonus depreciation allowance and for the option of
monetizing a portion of unused research and AMT credits from tax years before 2006.
Congress extended the 50% allowance so that it and the option to exchange it for an accelerated
research and AMT credit applied to qualified property acquired and placed in service in 2010 by
passing the Small Business Jobs Act of 2010 (P.L. 111-240).
Under the Tax Relief, Unemployment Compensation Reauthorization, and Job Creation Act of
2010 (P.L. 111-312), the bonus depreciation allowance increased to 100% for qualified property
acquired after September 8, 2010, and placed in service before January 1, 2012. The act also
established a 50% allowance for property acquired and placed in service in 2012. And it allowed
corporations to claim a refundable credit for unused AMT credits (but not unused research
credits) from tax years before 2006 in lieu of a bonus depreciation allowance for qualified
property they acquired between January 1, 2011, and December 31, 2012.
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Legislative Initiatives to Modify the Two Expensing
Allowances in the 112th Congress
Support in the current Congress for retaining or enhancing the Section 179 and bonus
depreciation allowances seems as robust as ever. But growing concerns over current and projected
federal budget deficits and sharp disagreements between Democratic and Republican leaders in
the House and Senate over what steps to take to lower or eliminate future budget deficits and
federal debt may hinder efforts in the 112th Congress to pass legislation extending the current
allowances.
Section 179 Expensing Allowance
Several bills have been introduced in the House and Senate to extend an enhanced allowance
beyond 2011. Each bill is briefly described below.
House Bills
H.R. 15 would raise the maximum allowance to $250,000 and the phaseout threshold to $800,000
for 2013 only. It would also extend through 2013 the period during which purchases of qualified
computer software are eligible for Section 179 expensing. The House passed the bill on
H.R. 8, which the House passed on August 1, 2012, would increase the maximum allowance to
$100,000 and the phaseout threshold to $400,00 in the 2013 tax year, index both amounts for
inflation, and allow purchases of off-the-shelf computer software to qualify for the allowance
through the 2014 tax year.
H.R. 158 would remove all limits on the Section 179 expensing allowance, effectively converting
it into a permanent 100% bonus depreciation allowance.
H.R. 206 would permanently set the maximum allowance at $125,000, and the phaseout
threshold at $500,000, starting in the 2012 tax year. It would also permanently index those
amounts for inflation beginning in the 2013 tax year, permanently extend the rule allowing offthe-shelf computer software eligibility for the expensing allowance, and permanently allow
taxpayers to revoke claims for the allowance without the permission of the IRS.
H.R. 1773 would permanently set the maximum allowance at $250,000, and the phaseout
threshold at $800,000, for tax years beginning in 2012.
H.R. 1792 would make automated fire sprinkler systems permanently eligible for expensing
under Section 179.
H.R. 3302 would permanently extend the allowance at the amount of $500,000 and the phaseout
threshold at the amount of $2 million and make eligible computer software a permanent part of
Section 179 property.
H.R. 3476 would extend the current expensing allowance and dollar limitation through 2014 and
the inflation adjustment for both amounts through 2015; it would also continue the treatment of
off-the-shelf computer software as qualified property through 2016.
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Senate Bills
S. 12 would permanently extend the $500,000 maximum allowance and the $2 million phase out
threshold for tax years beginning in 2011. It would also permanently extend the rules allowing
off-the-shelf computer software to qualify for Section 179 expensing and taxpayers to revoke an
election for Section 179 expensing for any property without the permission of the IRS.
S. 727 would permanently grant qualified small companies an unlimited expensing allowance for
qualified property, under Section 179. A company would qualify for this treatment if its average
annual gross receipts did not exceed $1 million in the three previous tax years.
S. 1801 would extend the current expensing allowance and dollar limitation through 2012, the
inflation adjustment for both amounts through 2013, and the eligibility of computer software for
the allowance through 2014.
S. 1866 would make the same changes in the Section 179 allowance as H.R. 3476.
S. 1873 would make the same changes in the allowance as S. 1801 would make.
S. 2050 would extend the generous expensing allowance that was available in 2011 through 2012.
S. 3401 would extend the $500,000 maximum expensing allowance that was available in the 2010
or 2011 tax years to include 2012 and 2013. It would also extend the $2 million phaseout
threshold that was available in 2010 or 2011 to include 2012. Starting in 2013 and for each
subsequent tax year, the maximum allowance would be set at $25,000 and the phaseout threshold
at $200,000. In addition, the bill would extend the eligibility of computer software and certain
leasehold property for the expensing allowance through the 2013 tax year.
S. 3412 would make the same changes in the Section 179 allowance as H.R. 15.
S. 3442 would increase the maximum expensing allowance to $500,000 and the phaseout
threshold to $2 million for the 2013 tax year. Starting in 2014 and for each subsequent tax year,
the maximum allowance would be set at $25,000 and the phaseout threshold at $200,000. The bill
would also extend the eligibility of computer software and certain leasehold property for the
expensing allowance to include the 2013 tax year.
The Family and Business Tax Cut Certainty Act of 2012 (no bill number yet), as reported by the
Senate Finance Committee on August 2, 2012, would raise the maximum allowance to $500,000
and the phaseout threshold to $2 million in 2012 and 2013. It would also allow taxpayers to
expense up to $250,000 of the cost of qualified leasehold property improvements made in those
years.
President’s Budget Request for FY2013
There is no provision in President Obama’s budget request for FY2013 that would further
enhance the Section 179 allowance in tax years beyond 2012.
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Bonus Depreciation Allowance
Several bills to extend the current 100% bonus depreciation allowance have been introduced in
the House and Senate. Each is briefly described below.
House Bills
H.R. 12 would extend the 100% allowance through 2012 and allow firms to claim a 50%
allowance for qualified property acquired and placed in service in 2013.
H.R. 660 would extend through 2013 both the 100% allowance and the option to monetize
unused AMT credits from tax years before 2006.
H.R. 3476 would extend through 2014 both the 100% allowance and the option to exchange
unused AMT credits from tax years before 2006 for any bonus depreciation allowance that could
be claimed in the current tax year.
H.R. 3630 (as passed by the House) would extend through 2012 both the 100% bonus
depreciation allowance and the option to claim a refundable credit for unused AMT credits
instead of a bonus depreciation allowance. In addition, it would modify the limit on the
refundable credit a corporate taxpayer may take in a tax year so that it is equal to the lesser of
50% of a taxpayer’s AMT credit for the first tax year after 2011 or the current-year ATM credit
taking into account “only the adjusted minimum tax for taxable years ending before January 1,
2012 (determined by treating credits as allowed on a first-in, first-out basis).”
H.R. 4196 would extend the 100% allowance through 2012.
Senate Bills
S. 1801 would extend through 2012 both the 100% bonus depreciation allowance and the option
to monetize unused AMT credits from tax years starting before 2006.
S. 1866 would make the same changes in the allowance as H.R. 3476.
S. 1873 would make the same changes as S. 1801 would make.
S. 2237 would reinstate the 100% allowance for qualified property acquired and placed in service
in 2012 and allow a 50% allowance for 2013.
S. 2240 would make the same changes in the allowance as H.R. 3630.
President’s Budget Request for FY2013
The Obama Administration supports an extension of the 100% bonus depreciation allowance for
one year, through 2012.
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Economic Effects of the Section 179 and Bonus
Depreciation Allowances
For many lawmakers, the expensing allowance represents a desirable policy tool for promoting
the growth of small firms and stimulating the economy. For many small business owners, the
allowance represents a desirable tax benefit in that it raises after-tax rates of return on investments
in qualified property and simplifies tax accounting. But for most public finance economists and
some other analysts, the allowance represents a source of inefficiency in the use of resources
within the U.S. economy. In their view, the allowance has the potential to affect the allocation of
capital within the economy, the distribution of the federal tax burden among income classes, and
the cost of tax compliance for smaller firms in ways that might produce inefficient or less
equitable outcomes. These effects correspond to three traditional criteria for evaluating tax policy:
efficiency, equity, and simplicity. Each is discussed below, following a review of what is known
about the effectiveness of the Section 179 and bonus depreciation expensing allowances as a
policy tool for economic stimulus.
The Allowances as Tools for Economic Stimulus
Since 2003, five bills have been enacted that included either a temporary enhancement of the
Section 179 expensing allowance and the phaseout threshold, or a temporary extension of an
already enhanced allowance: JGTRRA, the Economic Stimulus Act of 2008, ARRA, SBJA, and
TRUCA. Since 2002, six bills have been enacted to extend or enhance the bonus depreciation
allowance. Each of these bills was intended, in part, to spark an increase in small business
investment, as part of a broader government effort to stimulate the economy. It is reasonable to
expect that an enhanced allowance might have this effect, since it lowers the user cost of capital
for investment in qualified property and expands the short-term cash flow of companies that
claim it.
The user cost of capital plays a significant role in a firm’s investment decisions. This cost
comprises the opportunity cost of an investment (i.e., the highest pre-tax rate of return a company
could earn by investing the same amount in a low-risk asset like a Treasury bond) and its direct
costs, such as depreciation, the actual cost of the asset, and income taxes.2 In effect, the user cost
of capital establishes 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 fewer
projects a firm can profitably undertake, and the lower its desired capital stock. When a change in
tax policy decreases the user cost of capital, in theory, many firms would respond by increasing
the amount of capital they wish to own, boosting business investment in the short run.
2
The user cost of capital is the real rate of return an investment project must earn to break even. In theory, a firm will
undertake an investment provided the after-tax rate of return exceeds the user cost of capital. Rosen has expressed this
cost in terms of a simple equation. Let C stand for the user cost of capital, a for the purchase price of an asset, r for the
after-tax rate of return, d for the economic rate of depreciation, t for the corporate tax rate, z for the present value of
depreciation deductions flowing from a $1 investment, and k for the investment tax credit rate. Then C = a x [(r +d) x
(1-(t x z)-k)]/(1-t). Under expensing, z is equal to one. By inserting assumed values for each variable in 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.
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So how does expensing affect the user cost of capital? As the most accelerated form of
depreciation, expensing lowers the cost of capital by reducing the tax burden on the returns to an
investment. This reduction can be considerable.3 Allowing a firm to expense the cost of an asset is
equivalent to the U.S. Treasury providing the firm with a tax rebate equal to the firm’s marginal
tax rate multiplied by the cost of the asset. Several recent studies have shown that investment in
equipment is somewhat sensitive to changes in the user cost (or rental price) of capital. Estimates
of the price elasticity of demand for equipment (which is the percentage change in spending on
equipment divided by the percentage change in the user cost of capital) range from -0.25 to -0.66,
with some economists maintaining the elasticity is probably close to -0.50.4 An elasticity of that
size means that a 10% decline in the user cost of capital should result in a 5% rise in business
spending on equipment, all other things being equal.
Cash flow can also affect the investment behavior of firms.5 A firm’s owners or senior managers
may prefer to finance new investment from retained earnings in order to limit their exposure to
external debt and the risk of default it entails. Or retained earnings may be the only feasible
option for financing new investment in the case of firms that have limited or no access to debt and
equity markets because the owners know more about their products and potential for growth than
investors and lenders, including banks. For firms in this position, the cost of internal funds is
probably lower than the cost of external funds, which means they would be better off financing
new investments out of retained earnings.
Expensing can increase a firm’s cash flow in the short run because it allows the firm to deduct the
full cost of qualified assets in the tax year the firm places them into service. Nevertheless, the
impact of increases in cash flow on business investment remains uncertain. Some studies have
found a significant positive correlation between changes in a firm’s net worth and its investment
spending.6 This correlation was strongest for firms with very limited access to debt and equity
markets. Yet it would be a mistake to interpret these findings as conclusive proof that firms with
relatively high cash flows invest more than firms with relatively low or negative cash flows. After
all, a strong correlation between two factors does not necessarily mean that one is a primary cause
of the other. 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
3
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, September 1995, p. 389.
4
See Jonathan Gruber, Public Finance and Public Policy (New York: Worth Publishers, 2005), p. 675; and CRS
Report R41034, Business Investment and Employment Tax Incentives to Stimulate the Economy, by Thomas L.
Hungerford and Jane G. Gravelle.
5
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.
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.
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relative cost of internal and external funds.7 The relationship between cash flow and business
investment is complicated, and further research is needed to clarify it.
While these considerations suggest that an enhanced Section 179 or generous bonus depreciation
expensing allowance has the potential to boost small business investment, they say little about
their actual efficacy as a policy tool for economic stimulus. How effective might these forms of
accelerated depreciation be in boosting economic output and employment in the short run?
There are several reasons why an enhanced Section 179 allowance would likely have no more
than a modest effect on the economy during a downturn or a period of stagnation. The design of
the allowance, especially the phaseout range, sharply limits its potential to affect economic
activity. The allowance offers little or no tax benefit for investments in inventory, structures, and
land. And among qualified assets, it provides a greater tax benefit for investment in longer-lived
items (such as machine tools) than it does for investment in shorter-lived ones (such as computer
systems). Consequently, spending on assets eligible for the allowance tends to account for a small
slice of overall investment in those assets: the total value of Section 179 property placed in
service from 1999 to 2003 accounted for 5% of total investment in equipment and software in that
period. Spending on Section 179 assets makes an even smaller contribution to overall economic
activity: the total value of Section 179 property placed in service between 1999 and 2003
represented 0.4% of cumulative gross domestic product, measured in current dollars.
In addition, enhanced versions of either allowance are likely to have less of a stimulative effect
when an economy is mired in a recession or growing too slowly to reduce the unemployment rate
than when it is in the midst of a robust expansion. This is because business investment in general
is driven more by the outlook for sales and economic growth than it is by temporary tax
incentives. So an increase in the expensing allowance when the economy is contracting and more
and more companies, large and small, have excess capacity is more likely to affect the timing of
planned qualifying investments than the amount of those investments. Companies may be able to
accelerate the timing of some planned investments to take advantage of an enhancement in an
expensing allowance, but little new investment would be likely to occur while the short-term
sales and profit outlook for most companies remains bleak, despite the availability of a relatively
generous but temporary expensing allowance.
Three studies, two from 2006 and the other from 2007, provide additional support for the view
that temporary accelerated depreciation is largely ineffective as a policy tool for economic
stimulus. In one study, Matthew Knittel of the Office of Tax Analysis at the Treasury Department
found that take-up rates for the bonus depreciation allowances available in the 2002 to 2004 tax
years ranged from 54% to 61% for C corporations and from 65% to 70% for S corporations.8
Knittel attributes the surprisingly low take-up rates to firms that had relatively large stocks of
accumulated net operating losses and the many states that elected not to conform their tax codes
to the bonus depreciation allowances. The second study noted that though over half of all C and S
corporations claimed bonus depreciation in the 2002-2004 tax years, a variety of surveys
indicated that no more than 10% of companies deemed the allowances an important consideration
in determining the timing or level of qualifying investments.9 This suggests that many of the
7
Harvey S. Rosen and Ted Gayer, Public Finance, 8th edition (New York: McGraw-Hill Irwin: 2008), p. 448.
Matthew Knittel, Corporate Response to Accelerated Depreciation: Bonus Depreciation for Tax Years 2002-2004,
Department of the Treasury, Office of Tax Analysis, Working Paper 98 (Washington: May 2007),
http://www.treasury.gov/resource-center/tax-policy/tax-analysis/Documents/ota98.pdf.
9
Darrel S. Cohen and Jason Cummins, A Retrospective Evaluation of the Effects of Temporary Partial Expensing,
(continued...)
8
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investments in that period that benefited from bonus depreciation would have been made without
it. Another study found that although the impact of bonus depreciation on gross domestic product
and employment may have been modest, it might have had a substantial impact on the
composition of business investment, boosting demand for qualified assets. The researchers,
Christopher House and Matthew Shapiro, estimated that bonus depreciation may have resulted in
a cumulative increase in GDP between 0.07% and 0.14%, and in overall employment between
100,000 and 200,000, in 2002 and 2003.10
There is anecdotal evidence that the current bonus depreciation allowance has made little or no
difference in the investment plans of some companies, while moving forward the timing of
planned investments for other companies to take advantage of the tax savings.11 In either case, it
can be argued that the tax subsidy is not laying the groundwork for sustained increases in
business investment in software and equipment, the vast share of the assets that are eligible for
the bonus depreciation allowance. Some experts worry that the subsidy will be made permanent.
The forces constraining the stimulative potential of accelerated depreciation, particularly in a
weak economy, suggest that the two expensing allowances examined here would have relatively
little bang for the buck as a means of boosting economic activity. Other approaches may produce
better results, especially those that would quickly put more money in the hands of the
unemployed. A recent analysis by the Congressional Budget Office (CBO) lends some credence
to this notion. It estimated that increasing financial aid to the unemployed would increase GDP
from $0.70 to $1.90 for each $1.00 of budgetary cost from 2010 to 2015; by contrast, allowing
full or partial expensing of investment costs would raise GDP from $0.20 to $1.00 for each $1.00
of budgetary cost.12
Efficiency Effects
Efficiency lies at the core of economic theory and analysis. In essence, it refers to the allocation
of resources in an economy and how that allocation simultaneously affects the welfare of
consumers and producers. When the allocation of resources yields the greatest possible economic
surplus—which is defined as the total value to consumers of the goods and services they purchase
minus the total cost to sellers of providing the goods and services—the allocation is said to be
efficient. But when the allocation is inefficient, some of the possible gains from exchanges among
buyers and sellers are not realized. For example, economists deem an allocation of resources
inefficient when most suppliers of a good fail to produce it at the lowest marginal cost permitted
by current technology. In this case, a shift in supply from high-cost producers to low-cost
producers, driven by consumers seeking greater value, would lower the economic cost of
providing the good, perhaps increasing the economic surplus.
(...continued)
Federal Reserve Board, Finance and Economics Discussion Series, Working Paper No. 2006-19 (Washington: April
2006), http://www.federalreserve.gov/pubs/feds/2006/200619/200619pap.pdf.
10
Christopher House and Matthew D. Shapiro, Temporary Investment Tax Incentives: Theory with Evidence from
Bonus Depreciation, National Bureau of Economic Research, working paper no. 12514 (Cambridge, MA: September
2006), p. 2. http://www.nber.org/papers/w12514.
11
Binyamin Applebaum, “Tax Break Increases Deficit, but May Have a Silver Lining,” New York Times, February 3,
2012.
12
Congressional Budget Office, Policies for Increasing Economic Growth and Employment in the Short Term,
Statement of Douglas W. Elmendorf, Director, before the Joint Economic Committee, February 9, 2010, table 1, p. 11.
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Expensing is equivalent to exempting from taxation the normal returns on investment. As such, it
would be the preferred option for capital cost recovery under some kind of consumption tax, such
as a flat tax or a value-added tax. But under an income tax, expensing becomes a tax preference
or benefit because it allows the normal returns on investment to go untaxed. When this happens,
new opportunities for tax arbitrage open up. Expensing allows taxpayers to borrow funds to
purchase new depreciable assets, deduct the full cost of those assets in the year they are placed in
service, and deduct interest payments on the debt incurred to acquire the assets.
How does the expensing allowance affect the allocation of capital within an economy? In theory,
all taxes, except lump-sum taxes, generate inefficient economic outcomes, because they influence
the decisions of consumers and producers in ways that leave one group or the other, or both,
worse off. Non-lump-sum taxes have this effect because they distort the economic choices facing
individual and business taxpayers, leading them to allocate resources on the basis of how taxes
affect the costs and benefits of the goods and services they buy and sell, rather than according to
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 is less than the loss of economic welfare
associated with it.
The Section 179 and bonus depreciation expensing allowances have the potential to distort the
allocation of resources in an economy by driving a wedge between favored assets and all other
assets regarding their profitability. In theory, expensing increases the after-tax rates of return for
favored assets, relative to the after-tax rates of return for all other assets. Thus, it could encourage
inefficient levels of investment in favored assets, at least in the short run, depriving more
productive investments with lower after-tax rates of return of needed capital.
In general, how beneficial is expensing? One way to illustrate its potential tax benefit is to show
how expensing affects the marginal effective tax rate on the returns to an investment. This rate
encapsulates the tax provisions that affect the returns on an investment and is calculated by
subtracting the expected after-tax rate of return on a new investment from the expected pre-tax
rate of return and dividing by the pre-tax rate of return. Under expensing, it can be shown that the
pre-tax and after-tax rates of return are the same for the investment, which means that full
expensing produces a marginal effective tax rate of 0%.
This equivalence between pre- and after-tax rates of return reflects a critical aspect of expensing:
it reduces the total after-tax return and total cost for an investment by the same factor: an
investor’s marginal tax rate.13 For example, if a small business owner’s income is taxed at a rate
of 35%, and the entire cost of a depreciable asset is expensed, the federal government effectively
becomes a partner in the investment with a 35% interest. 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 use, but it shares in 35% of the income earned by the investment in subsequent years,
assuming no change in the owner’s tax rate. At the same time, expensing allows the small
business owner to receive 65% of the returns from the investment over its lifetime 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 he does before taxes.
13
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.
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Is there evidence that the expensing allowance has contributed to shifts in the size and
composition of the domestic capital stock in recent decades? This question is difficult to answer,
largely because no studies have been done that assess the impact of the allowance on capital
formation over time. Given that the expensing allowance lowers the cost of capital and boosts the
cash flow of firms using it, and that investment in many of the assets eligible for the allowance
seems somewhat sensitive to changes in the cost of capital, one might be justified in concluding
that the allowance has caused domestic investment in those assets to be greater than it otherwise
would have been.14 But it can also be argued that much of this investment would have taken place
in any event.15 Most economists would agree that investment in the assets eligible for the
expensing allowance is driven more by expectations for future growth in sales and profits by
firms that use these assets, the nature of the assets, and conditions in debt and equity markets than
by tax considerations.16 This view finds some support 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 Section 179 property placed in service was equal to 5% of
gross domestic investment in equipment and computer software.17
When seen through the lens of economic theory, the expensing allowance has efficiency effects
that may worsen the deadweight loss associated with 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 is likely to divert some capital away from relatively productive uses and into taxfavored ones. Standard economic theory holds that in an economy devoid of significant market
failures and dominated by competitive markets, a policy of neutral or uniform taxation of capital
income minimizes the efficiency losses associated with income taxation. But the expensing
allowance encourages investment in a specific set of assets by relatively small firms. As such, it
represents a departure from the norm of neutral taxation.
In addition, an expensing allowance, like any subsidy targeted at firms of a certain size, gives
smaller firms an incentive to limit their growth by restricting investments to take advantage of the
allowance. This unintended effect stems from the steady increase in the marginal effective tax
rates on the income earned by qualified assets in the allowance’s phaseout range ($500,000 to $2
million 2011).18 Douglas Holtz-Eakin, a former director of the Congressional Budget Office, has
labeled this incentive effect a “tax on growth by small firms.”19
14
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.
15
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.
16
See Roger W. Ferguson, Jr., “Factors Influencing Business Investment,” speech delivered on October 26, 2004,
available at http://www.federalreserve.gov/boarddocs/speeches/2004/20041026/default.htm.
17
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.
18
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.
19
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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Section 179 and Bonus Depreciation Expensing Allowances
Equity Effects
Equity is another basic concept in economic analysis. It generally refers to the distribution of
income among the individuals or households in a particular geographic area.
In the context of income taxation, equity usually denotes the distribution of after-tax household
incomes among individuals grouped by income. Economists who analyze the equity effects of
income taxes tend to focus on two kinds of equity: horizontal equity and vertical equity. A tax is
said to be horizontally equitable if it imposes similar burdens on individuals with similar incomes
or living standards. 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 basis for a progressive income tax system. Under such a system, an individual’s tax
liability, measured as a fraction of income, rises with income.
The current federal income tax system may lean more in the direction of vertical equity than
horizontal equity. Many individuals with similar incomes before taxes end up in the same tax
bracket. But because of the tax preferences (e.g., deductions, preferential rates, deferrals,
exclusions, exemptions, and credits) that have been enacted in recent decades, a substantial
number of individuals with similar before-tax incomes end up being taxed at different effective
rates. At the same time, the income received by those with relatively high pre-tax incomes is
generally taxed at higher rates than the incomes of those with relatively low pre-tax incomes.
How does the expensing allowance affect vertical and horizontal equity?
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 burden. The
main tax benefit from the allowance is a reduction in the marginal effective tax rate on the
income earned by assets eligible for expensing. How much of a reduction depends critically on
the proportion of an asset’s cost that is expensed. As was noted earlier, if the entire cost is
expensed, then the marginal effective rate on the returns falls to zero.
Yet the allowance does not change the actual marginal rates at which this income is taxed.
Accelerated depreciation, such as the Section 179 expensing allowance, does not reduce the
federal taxes paid on the stream of income earned by an asset over its useful life. Rather, it allows
firms to take a larger share of depreciation deductions for an asset in its first year or two of use
than would be possible under the MACRS. This forward shift or acceleration in depreciation
allowances raises the present discounted value of the tax savings from depreciation.
Most of the assets eligible for the allowance are held by smaller firms. Therefore, whatever gains
in profits can be attributed to the allowance end up in the hands of small business owners. Since
the tax benefits associated with capital income tend to concentrate in upper-income households, it
might be argued that the expensing allowance tilts the federal income tax away from vertical
equity. The allowance lowers the effective tax burden on small business income relative to other
sources of income. While this effect makes investment in qualified assets more attractive, it does
not change the fact that the allowance has no effect on the taxes paid by small business owners
over time on the income that can be attributed to the affected assets. Over the useful life of such
an asset, the amount of taxes paid on income from it is the same, regardless of whether its cost is
expensed or not. As a result, it seems fair to conclude that the allowance has no discernible effect
on the distribution of after-tax incomes.
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Section 179 and Bonus Depreciation Expensing Allowances
Tax Administration
Yet another policy issue raised by the expensing allowance concerns its impact on the cost of tax
compliance for business taxpayers.
Most public finance economists would agree that one of the key elements of a desirable income
tax system is relatively low costs for administration and compliance. Research indicates that the
administrative cost of a tax system 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.
Most public finance economists would also agree that the current federal income tax system fails
this test on all counts. 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 growing
complexity of the federal tax code. Many small business owners have long complained about the
costs imposed on them by the record keeping and filings required by the federal income tax.
The expensing allowance addresses this concern by simplifying tax accounting for depreciation.
Less time and paperwork are expended in writing off the entire cost of a depreciable asset in its
first year of use than in writing off that cost over a longer period using the appropriate
depreciation schedules. At the same time, it cannot be denied that the rules governing the use of
the allowance add a layer of complexity to the tasks of administering and complying with the tax
code.
Tax simplification is a long-standing policy objective for small business owners. A primary
motivation for pursuing this goal is the relatively high costs small firms evidently bear in
complying with federal tax laws. These costs were the main focus of a 2001 study prepared for
the Office of Advocacy at the Small Business Administration. The study estimated that the cost
per U.S. employee for tax compliance in 2000 was $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.20 This finding underscores a well-established truth about the costs to firms of
tax compliance: namely, these costs are21 regressive to firm size in that, “as a fraction of any of a
number of size indicators, the costs are lower for larger companies.”
Author Contact Information
Gary Guenther
Analyst in Public Finance
gguenther@crs.loc.gov, 7-7742
20
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.
21
Joel Slemrod, “Small Business and the Tax System,” in The Crisis in Tax Administration, Henry J. Aaron and Joel
Slemrod, eds. (Washington: Brookings Institution Press, 2004), p. 81.
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