The Section 179 and Section 168(k) Expensing Allowances: Current Law, Economic Effects, and Selected Policy Issues

Summary

Expensing is the most accelerated form of depreciation. Section 179 of the Internal Revenue Code allows a taxpayer to expense (or deduct as a current rather than a capital expense) up to $500,000 of the total cost of new and used qualified depreciable assets it buys and places in service in 2016, within certain limits. Firms unable to claim this allowance may recover the cost of qualified assets over longer periods, using the depreciation schedules from Sections 167 or 168. While the Section 179 expensing allowance is not targeted at smaller firms, the limits on its use effectively confine its benefits to such firms.

Section 168(k), which provides a so-called bonus depreciation allowance, allows taxpayers to expense 50% of the cost of qualified assets bought and placed in service in 2016. Taxpayers have the option of forgoing the bonus depreciation allowance and instead claiming unused alternative minimum tax credits, within certain limits; taxpayers choosing this option are required to recover the cost of the assets over longer periods using the straight-line method of depreciation.

Since 2002, the two allowances have been used primarily as tax incentives for stimulating the U.S. economy. Several studies have examined the economic effects of the 30% and 50% bonus depreciation allowances from 2002 to 2004 and from 2008 to 2010. Their findings indicated that accelerated depreciation is a relatively ineffective tool for stimulating the U.S. economy during periods of weak or negative growth.

Available evidence also suggests that the expensing allowances may have a minor effect at best on the level and composition of business investment and its allocation among industries, the distribution of the federal tax burden among different income groups, and the cost of tax compliance for smaller firms. The allowances have advantages and disadvantages. On the one hand, an expensing allowance simplifies tax accounting, and a temporary allowance has the potential to stimulate 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. On the other hand, depending on its design, an expensing allowance may interfere with the efficient allocation of capital among investment opportunities by diverting capital away from more productive uses.

In December 2015, the House and the Senate agreed on a measure (H.R. 2029, Protecting Americans from Tax Hikes Act of 2015, or PATH Act, P.L. 114-113) to extend more than 90 business and individual tax preferences.

A number of the provisions were permanently extended, including the enhanced Section 179 expensing allowance that was available from 2010 to 2014. As a result, the maximum allowance is set at $500,000, and the phaseout threshold at $2 million, beginning in 2015 and thereafter. Both amounts are indexed for inflation starting in 2016. The act also removed the $250,000 annual cap on expenditures for leasehold, retail, and restaurant property improvements that could be expensed under Section 179 and permanently added off-the-shelf software for business use to the roster of qualified property.

In addition, the PATH Act extended the bonus depreciation allowance from 2015 to 2019. From 2015 to 2017, the allowance is equal to 50% of the cost of qualified property acquired and placed in service during that period; the share drops to 40% for assets acquired and placed in service in 2018, and then to 30% for assets acquired and placed in service in 2019. No allowance may be claimed after 2019. The act retained the option to claim unused alternative minimum tax credits as a refundable credit in lieu of bonus depreciation and removed the dollar limit on the amount of the credit that may be claimed in a tax year. Finally, the act extended the bonus depreciation allowance to the cost of planting or grafting certain trees, vines, and plants that bear fruits or nuts.

Introduction

Source: Internal Revenue Service, revenue procedures dating back to 1987.

Besides the Section 179 expensing allowance, businesses may also claim an additional first-year (or bonus) depreciation allowance under Section 168(k) for eligible property acquired and placed in service in 2016. The allowance is equal to 50% of the cost of qualified property acquired and placed in service that year. Under current law, the bonus depreciation rate is to remain at 50% in 2017 and then drop to 40% in 2018 and to 30% in 2019. No bonus depreciation may be claimed for tax years beginning in 2020 and thereafter.

This added allowance accelerates the depreciation of qualified property, lowering the cost of capital for investment in those assets and increasing the cash flow of businesses making such investments. Congress created the allowance, and later enhanced it, mainly to spur increased business investment during periods of negative or sluggish economic growth, such as the severe recession that lasted from late 2007 to mid-2009 and the relatively weak recovery that persisted into early 2014.

The initial bonus depreciation allowance was enacted in 2002 and was equal to 30% of the cost of property eligible for depreciation under the MACRS with recovery periods of 20 or fewer years, water utility property, off-the-shelf computer software, and qualified leasehold property. The property had to be acquired and placed in service between September 12, 2001, and December 31, 2004. (Eligible property with relatively long production times and certain non-commercial aircraft could be placed in service in 2005 and still qualify for the allowance.) Taxpayers claiming the allowance had to be the original user of the property. In addition, the allowance could be applied against the AMT with no adjustment.

In 2003, Congress raised the bonus depreciation allowance to 50% of the cost of qualified property acquired and placed in service in 2003 to 2005. It expired at the end of 2005. Congress reinstated it in 2007 for property acquired and placed in service in 2008 (or 2009 for property with long production times and certain aircraft). Owing to several subsequent extensions and enhancements, a bonus depreciation allowance of 50% or 100% was available for property acquired and placed in service in 2009 to 2015 (with an extension to 2016 for property with relatively long production times and qualified aircraft.)

Moreover, from 2016 to 2019, C and S corporations only are allowed to claim a refundable and accelerated AMT credit under Section 168(k)(4), instead of taking bonus depreciation for qualified property they acquire and place in service during that period. The method for calculating the credit is complicated, and the rules for electing it may vary for taxpayers in different circumstances. Taxpayers taking the credit are required to recover the cost of their bonus depreciation property using the straight-line method over the regular MACRS recovery period. The amount of the credit is equal to a taxpayer's "bonus depreciation amount (BDA)," which in turn is equal to 20% of the difference between the regular and bonus depreciation the company could claim in the year the property is placed in service and the total depreciation the company could claim that year without bonus depreciation. A company's BDA cannot exceed its "maximum increase amount (MIA)," which is the lower of (1) 50% of the firm's minimum tax credit under Section 53(b) for the first tax year ending after December 31, 2015, or (2) its minimum tax credit for the current year, as determined by the company's adjusted net minimum tax (as defined in Section 53(d)) for tax years ending before January 1, 2016.

There is a simple rationale for the credit: for companies that invest in bonus depreciation property, it is intended to provide roughly the same net tax benefit to a profitable corporation that pays the AMT as it does to a corporation with an NOL.

A somewhat different set of rules governed use of the accelerated credit in tax years that began before 2016. For tax years beginning on or after April 1, 2008 and before January 1, 2016, C corporations had the option under Section 168(k)(4) of cashing in some or all of their alternative minimum tax (AMT) and research tax credits carried over from tax years before 2006, in lieu of taking the bonus depreciation allowance. Corporations choosing the accelerated credit also had to use the straight-line method over MACRS recovery period for the bonus depreciation property to recover its cost. The credit was refundable and limited to a corporation's BDA. This amount was also equal to 20% of the difference between the bonus and regular depreciation a company could claim for the tax year the property was placed in service and the depreciation it could claim without bonus depreciation. And a taxpayer's BDA could not exceed its MIA. From 2008 to 2010, the MIA was the lower of (1) 6% of the sum of its carried-forward (or unused) AMT and research tax credits from tax years before 2006, or (2) $30 million. For bonus depreciation property placed in service from 2011 to 2015, corporations could claim the accelerated credit for unused AMT credits from tax years before 2006 only. The credit was provided indirectly through an increase in the limitations on the use of the AMT credit (under Section 53(c)) and the research tax credit (under Section 38(c)); the increase was treated as a refundable overpayment of tax.

A corporation was most likely to claim the initial version of the credit if it was both cash-strapped and at risk of incurring a net operating loss if it were to claim bonus depreciation. Since the maximum credit a corporation could take in tax years beginning on or after April 1, 2008 and before January 1, 2016 was $30 million, it had to place in service in a tax year $150 million in bonus depreciation property to equal that amount (20% of $150 million = $30 million). The corporation also needed $500 million in unused AMT and research tax credits from tax years beginning before 2006 to reach the $30 million ceiling (6% of $500 million = $30 million).

In the case of assets that are eligible for both expensing allowances, a company must recover their cost in a prescribed order. The Section 179 expensing allowance has to be taken first, lowering the company's basis in the asset by that amount. The taxpayer then may apply the bonus depreciation allowance to the remaining basis amount, further reducing the company's basis in the property. Finally, the company is allowed to claim a depreciation allowance under the MACRS for any remaining basis, using the double declining balance method.

A simple example explains how this process works. Assume that the only investment a company makes in 2016 is the acquisition of 10 new machine tools at a total cost of $700,000. Such a purchase qualifies for both the Section 179 expensing and bonus depreciation allowances for that year. Therefore, it may recover that cost for federal tax purposes as follows:

• First, the company claims a Section 179 expensing allowance of $500,000 on its federal tax return for that year, lowering its basis in the property to $200,000 ($700,000 - $500,000).
• Then it claims a bonus depreciation allowance of $100,000 ($200,000 x 0.5), further lowering its basis to $100,000 ($200,000 - $100,000).
• Next, the company is allowed a deduction for depreciation under the MACRS on the remaining $100,000. Given that the MACRS recovery period for machine tools is five years and five-year property is depreciated using the double-declining-balance method, the company could claim an additional depreciation allowance equal to 20% of $100,000, or $20,000, under the half-year convention.
• The company then recovers the remaining basis of $80,000 ($100,000 - $20,000) by 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.
• As a result, the company may deduct for the 2016 tax year nearly 89% of the purchase price of the machine tools it buys and places in service that year.

The Section 179 expensing allowance has been a permanent provision of the federal tax code since September 1958. It started out as a first-year depreciation allowance that Congress included in the Small Business Tax Revision Act of 1958 (P.L. 85-866). Its purpose was no different from its purpose today: to reduce the tax burden on small business owners, stimulate 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 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 a gradual increase in the allowance to $10,000 by 1986. In spite of the 150% increase in the allowance for single filers, 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 investment tax 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 outweighed the tax savings from a combination of the credit and the allowance.

Nearly one year later, Congress again extended the enhanced allowance from tax years beginning in 2012 and 2013. As a result of the Protecting Americans from Tax Hikes Act of 2015 (PATH Act, P.L. 114-113), the Section 179 expensing allowance is permanently set at $500,000, and the phaseout threshold at $2 million, starting in 2015. Both amounts are indexed for inflation beginning in 2016. Off-the-shelf computer software and leasehold, restaurant, and retail property improvements are permanently eligible for the allowance. And there no longer is a dollar limit on the amount of those improvements that can be expensed in a tax year.

In December 2015, Congress passed the Protecting Americans from Tax Hikes Act of 2015 (PATH Act, P.L. 114-113). Among other things, it extended the bonus depreciation allowance from 2014 through 2019. In 2015 to 2017, the allowance is equal to 50% of the acquisition cost of qualified property placed in service during that period; the rate is scheduled to drop to 40% in 2018, and then to 30% in 2019. No allowance is available for qualified property acquired and placed in service in 2020 and thereafter. The act also extended through 2019 the optional refundable credit. Unlike the credit that was available from 2008 to 2015, there is no upper dollar limit on the amount that can be claimed in lieu of the bonus depreciation allowance. The credit a corporation may claim is equal to its bonus depreciation amount; this amount, in turn, cannot exceed the lower of 50% of the corporation's AMT credit under Section 53(b) for its first tax year ending in 2016, or the AMT credit for the current tax year calculated by taking into account only the adjusted new minimum tax (as defined in Section 53(d)) for tax years ending before January 1, 2016. In addition, the PATH Act extended the bonus depreciation allowance to domestic planted or grafted trees or vines that bear fruits or nuts and have a pre-production period of over two years from the time of planting or grafting to the time of bearing fruits or nuts.

Many lawmakers have viewed the Section 179 expensing and bonus depreciation allowances as effective policy tools for promoting the growth of small firms and stimulating the economy during periods of slow or negative growth. And many business owners think of the allowances as a valuable and desirable instrument for increasing their cash flow and simplifying tax accounting.

But many economists take a more balanced view of those allowances. In their view, the disadvantages of the allowances outweigh their advantages. Specifically, they maintain that the allowances have the potential to promote an inefficient allocation of capital among domestic industries and alter the distribution of the federal tax burden among income classes. At the same time, many economists acknowledge that expensing can reduce the cost of tax compliance, especially for smaller firms. These effects correspond to three traditional criteria used by economists to evaluate actual or proposed tax policies: efficiency, equity, and simplicity.

Each effect is examined below. The discussion begins with a review of what is known about the effectiveness of the Section 179 expensing and bonus depreciation allowances as a policy instrument for economic stimulus.

Since 2003, Congress has passed eight bills that either temporarily enhanced the Section 179 expensing allowance and its phaseout threshold or included a temporary or permanent extension of an already enhanced allowance. And since 2002, nine bills have been enacted that extend or enhance the bonus depreciation allowance. In both cases, each extension or enhancement was largely intended to spark increases in business investment. When Congress first took these steps in the early 2000s, many assumed these measures would boost short-term business investment in qualified assets. This expectation rested on the understanding that expensing lowered the user cost of capital for investment in qualified property and expanded the cash flow of companies making such investments.

The user cost (or rental price) of capital influences business investment decisions. It combines the opportunity cost of an investment (i.e., the highest pre-tax rate of return a company could earn by investing in a low-risk asset like a U.S. Treasury bond) with its direct costs, such as depreciation, the actual cost of the asset, and income taxes.² In effect, the user cost of capital determines the after-tax rate of return an investment must earn in order to be profitable—and thus worth undertaking. In general, the larger the user cost of capital, the fewer projects companies can profitably undertake, and the lower their desired capital stock. In theory, when a change in tax law decreases the user cost of capital, businesses can be expected to increase the amount of capital they wish to own, boosting business investment in the short run, all other things being equal.

How does expensing affect the user cost of capital? As the most accelerated form of depreciation, expensing lowers this cost by reducing the tax burden on the returns to an eligible investment. This reduction can be considerable.³ Expensing 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 studies have indicated that investment in equipment is somewhat sensitive to changes in the user cost of capital. Estimates of the price elasticity of demand for equipment (which measures the percentage change in spending on equipment divided by the percentage change in its user cost of capital) range from -0.25 to -0.66; some economists argue that the elasticity is probably close to -0.50,⁴ though a 2014 study of the impact of bonus depreciation that took into effect frictions in the financing of investment came up with a much larger elasticity estimate: 1.6.⁵ An elasticity of that size means that a 10% decline in the user cost of capital should result in a 16% rise in business spending on equipment in the short run, all other things being equal.

Another significant influence on the investment behavior of firms is cash flow.⁶ There are several reasons why a company may prefer to finance new investments from retained earnings. It may wish to limit the company's exposure to external debt and the risk of default it carries. Or the company may have little or no choice but to rely on retained earnings since it has limited access to debt and equity markets. Younger firms investing in the development of new technologies may encounter difficulty raising needed capital in debt or equity markets when the owners know more about the potential growth in demand for their services and products than investors and lenders do. For companies in such a situation, the cost of internal funds would be lower than the cost of external funds; so they would be better off financing new investments out of retained earnings. Expensing can increase a profitable 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 when they are placed in service, reducing its tax liability.

In the case of cash flow's importance as a driver of business investment, however, what makes sense in theory has proven difficult to measure or verify in practice. The actual contribution of an increase in cash flow to business investment (especially small business investment) remains unclear. Some studies have found a significant positive correlation between changes in a firm's net worth and its investment spending.⁷ This correlation was strongest for firms with limited or no access to debt and equity markets. Yet these findings do not prove that firms with relatively high amounts of retained earnings invest more than firms with relatively low or negative amounts. A strong correlation between two factors does not necessarily mean that one caused the other. In the case of cash flow and business investment, a plausible explanation for the correlation was that firms with relatively high cash flows invested more, on average, than firms with relatively low cash flows for reasons that have nothing to do with the relative cost of internal and external funds.⁸ What can be said with certainty is that the relationship between cash flow and business investment is complicated, and that additional research is needed to assess the effects of the former on the latter.

So in theory, expensing should boost business investment in qualified assets relative to a baseline scenario with no expensing. This raises the question of how effective and cost-effective the enhanced Section 179 and bonus depreciation allowances have been in stimulating business investment, especially during the severe recession of 2007 to 2009.

Several studies have looked at the effect of the allowances on business investment. Their findings indicate that the allowances did spur a rise in business investment in equipment and standardized software. But the findings differ over the extent of this increase, among other things.

According to the results of a 2005 study by Matt Knittel from the Department of the Treasury, small businesses did not increase their use of the Section 179 expensing allowance and the bonus depreciation allowance after both were made more generous in 2003.⁹ Specifically, Knittel found that the share of small firms claiming the Section 179 allowance changed little from 2001 or 2002 to 2003, when it rose from $25,000 to $100,000. Similarly, 39% of non-corporate business owners and 54% of small corporations claimed bonus depreciation in 2002, but these share decreased to 33% for passthrough business owners and 49% for small corporations in 2003, even though the bonus depreciation allowance rose from 20% of the cost of qualified assets in 2002 to 30% in 2003.

A 2006 study by Darrel Cohen and Jason Cummings found that although over half of all C and S corporations claimed bonus depreciation in 2002 to 2004, no more than 10% of those companies deemed the allowances an important consideration in determining the timing or amount of qualifying investments.¹⁰ These findings raised the possibility that many of the investments that benefited from bonus depreciation would have been undertaken without it. In addition, the study showed that bonus depreciation had no effect on investment in short-lived assets, such as computer hardware and software.

In another 2006 study, Christopher House and Matthew Shapiro estimated that bonus depreciation had a minor impact on gross domestic product and employment in 2002 and 2003. According to their findings, bonus depreciation probably led to a cumulative increase in GDP of 0.07% to 0.14%, and in total employment of 100,000 to 200,000 workers, in that period.¹¹ House and Shapiro also found that the allowance had its largest impact on investment in long-lived equipment.

In another study, which was published in 2007, Knittel found that the take-up rate for the bonus depreciation allowance from 2002 to 2004 was substantially below 100% among corporations.¹² The take-up rate measures the share of eligible investment for which the allowance was claimed. According to the results of the study, the take-up rate ranged from 54% in 2002 to 61% in 2004 for C corporations and from 65% in 2002 to 70% in 2004 for S corporations. Though the analysis did not investigate why such so many corporations opted to forgo bonus depreciation when they could have taken it, Knittel cited two possible reasons. First, a large number of corporations had net operating losses from 2002 to 2004, and bonus depreciation would have offered little or no immediate benefit to companies with such losses, or to companies that had loss or credit carryforwards or claimed new credits. Second, many states disallowed bonus depreciation allowances for the purpose of computing state income tax liability, and that may have deterred some companies from claiming it. Knittel also found that the take-up rate was highest for industries where a small number of companies accounted for most of the investment in long-lived assets, such as telecommunications.

But a 2014 study of the impact of bonus depreciation on business investment by Eric Zwick and James Mahon came up with strikingly different results.¹³ Using a model that accounted for "frictions" or imperfections in capital markets, they estimated that the allowance increased investment in qualifying assets by 10.4% from 2001 to 2004, and by 16.9% from 2008 to 2010. These estimates are much greater than the results of other studies of bonus depreciation and its impact on business investment. Zwick and Mahon noted that their analysis produced higher estimates of the effects of the allowance because it allowed for financial frictions, which cause firms to "sharply discount future deductions, making bonus depreciation more appealing. The study also found that small firms were much more responsive to bonus depreciation than larger firms, and that firms facing cash constraints were more responsive to the incentive than firms that had adequate access to capital to finance new investments in bonus depreciation property.

There are several reasons why the allowances are likely to have had a modest impact on the U.S. economy as a whole over the past 12 or 13 years.

First, the design of each allowance limits their impact on the level of overall economic activity. Neither allowance applies to investments in inventory, structures, and land. And the Section 179 allowance phases out once a company's total investment in qualified assets in a tax year exceeds a specified dollar amount ($2 million in 2016).

Second, spending on the assets eligible for the two expensing allowances tends to account for a relatively small slice of U.S. business investment. One measure of this relationship is the value of depreciation allowances claimed by businesses in a tax year. According to IRS data, corporations claimed a total of $609.8 billion in depreciation allowances in 2009. Of that amount, Section 179 allowances amounted to $7.8 billion (or 1.3% of the total amount) and bonus depreciation allowances to $137.4 billion (or 22.5% of the total amount).¹⁴ In total, the two allowances represented less than 24% of total corporate depreciation allowances that year.

Third, expensing is likely to generate less of a stimulus when an economy is mired in a recession than when it is expanding. This is because business investment generally is driven more by current economic conditions and the short-term outlook for sales and earnings than it is by tax considerations. An increase in an expensing allowance when the economy is contracting and many companies are burdened with excess capacity may affect the timing of some planned investments, but is unlikely to spur a permanent increase in the capital stock. Some companies may accelerate planned investments to take advantage of a temporary investment tax subsidy like expensing, but that does not mean that any short-term increase in net investment would reflect an increase in the desired capital stock of the many companies experiencing declines in profits or financial losses.

Fourth, an investment tax subsidy like expensing offers no immediate benefit to companies suffering net operating losses. In this case, accelerated depreciation simply enlarges the loss for the current tax year.

Fifth, the benefit from the Section 179 expensing and bonus depreciation allowances depends on the length of a qualified asset's recovery period. The House-Shapiro study found that the bonus depreciation allowances enacted for 2002 and 2003 boosted business investment, but the increase was concentrated among long-lived equipment. And the Cohen-Cummins study concluded that the same provisions had no effect on investment in eligible short-lived assets. This difference in effect stems from the fact that the net present value of the tax benefit was proportional to the recovery period of qualified assets.

The forces constraining the potential stimulus from Section 179 expensing and bonus depreciation affected its cost-effectiveness as a means of boosting economic activity between 2002 and 2015. Other approaches might have produced better results, especially those that would have quickly put more money in the hands of the unemployed. A 2010 analysis by the Congressional Budget Office (CBO) supported this notion. It estimated that increasing financial aid to the unemployed would have increased 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 have raised GDP from $0.20 to $1.00 for each $1.00 of budgetary cost.¹⁵

Efficiency lies at the core of economic theory and analysis. It refers to the allocation of resources in an economy and how that allocation affects the welfare of consumers and of producers. An allocation of resources is considered efficient when it yields the greatest possible economic surplus (which is the total value to consumers of the goods and services they purchase minus the total cost to sellers of providing the goods and services), given existing constraints on the supply of labor and capital and the productivity of that capital. But when the allocation turns inefficient, some of the possible gains from exchanges among buyers and sellers are not realized. For example, an allocation of resources is deemed 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 any economic surplus.

Expensing is equivalent to exempting from taxation the normal returns on investment. As such, it would be the preferred method of capital cost recovery under a 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 those normal returns 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 expensing and bonus depreciation allowances have the potential to distort the allocation of resources in an economy by driving a wedge between the return on investment in favored assets and the return on investment in all other assets. Other things being equal, expensing increases the after-tax rates of return for favored assets relative to the after-tax rates of return for all other assets. As a result, it could encourage inefficient levels of investment in favored assets, at least in the short run, depriving more productive investments, but with lower after-tax rates of return, of needed capital.

In general, how beneficial is expensing to companies? 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, the pre-tax and after-tax rates of return are the same for the investment, which means that expensing produces a marginal effective tax rate of 0%.

This equivalence between pre- and after-tax rates of return reflects a key effect of expensing: it reduces the total after-tax return over the life of an eligible asset and its total cost by the same factor: an investor's marginal tax rate.¹⁶ For example, if a non-corporate 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. By the same token, 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.

Is there evidence that the two Section 179 expensing and bonus depreciation allowances have caused 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 either allowance on capital formation in the period they have been available. Given that the expensing allowance lowers the cost of capital and can boost the cash flow of firms claiming it, and that investment in many of the assets eligible for the allowance seems at least somewhat sensitive to changes in the cost of capital, it would be reasonable to conclude that the allowance may have caused domestic investment in those assets to be greater than it otherwise would have been.¹⁷

But it can also be argued that much of this additional investment would have taken place in any event, and that the main effect of expensing is to accelerate the timing of those investments so the firms making them can take advantage of the tax subsidy.¹⁸ Most economists would agree that investment in the assets eligible for the Section 179 expensing allowance is driven more by expectations for future growth in sales and profits by firms that purchase these assets, the nature of the assets, and conditions in debt and equity markets than by tax considerations.¹⁹ This view finds some support in the 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.²⁰

When seen through the lens of economic theory, expensing 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 tax-favored ones. According to standard economic theory, in an economy devoid of significant market failures and ruled by competitive markets, a policy of neutral or uniform taxation of capital income minimizes the efficiency losses associated with business income taxation. But the Section 179 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, expensing distorts the incentives to expand facing companies. Like any subsidy targeted at firms of a certain size, the Section 179 allowance gives smaller firms an incentive to limit their growth so they can continue to benefit from the allowance. Such an unintended effect is the result of the steady rise in the marginal effective tax rate on the income earned by qualified assets over the allowance's phaseout range ($500,000 to $2 million in 2016).²¹ Douglas Holtz-Eakin, a former director of the Congressional Budget Office, has called this incentive effect a "tax on growth by small firms."²²

Equity is another basic concept in economic analysis. It generally refers to the distribution of income among the individuals or households.

In the field of public finance, equity usually denotes the distribution of after-tax household income among individuals ranked by income. Economists who analyze the equity effects of income taxes focus on two kinds of equity: horizontal equity and vertical equity. A tax is horizontally equitable if it imposes similar burdens on individuals with similar incomes or living standards. And a tax system is 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 intellectual 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 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 existing tax preferences (e.g., deductions, preferential rates, deferrals, exclusions, exemptions, and credits), 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?

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Footnotes

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.

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, 6^th Ed (New York: McGraw-Hill/Irwin, 2002), pp. 407-409.

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.

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 [author name scrubbed] and [author name scrubbed].

Eric Zwik and James Mahorn, Tax Policy and Heterogeneous Investment Behavior, working paper 21876, National Bureau of Economic Research (Cambridge, MA: Jan. 2016), p. 32.

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.

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.

Harvey S. Rosen and Ted Gayer, Public Finance, 8^th edition (New York: McGraw-Hill Irwin: 2008), p. 448.

Matthew Knittel, "Small Business Utilization of Accelerated Tax Depreciation: Section 179 Expensing and Bonus Depreciation," National Tax Journal Proceedings-2005, 98^th Annual Conference, 2005, pp. 273-286.

Darrel S. Cohen and Jason Cummins, A Retrospective Evaluation of the Effects of Temporary Partial Expensing, 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.

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.

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.

Eric Zwick and James Mahom, Tax Policy and Heterogeneous Investment Behavior, NBER working paper 21876.

See http://www.irs.gov/uac/SOI-Tax-Stats-Corporation-Depreciation-Data.

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.

Raquel Meyer Alexander, "Expensing," in The Encyclopedia of Taxation and Tax Policy, Joseph J. Cords, Robert D. Ebel, and [author name scrubbed], eds. (Washington: Urban Institute Press, 2005), p. 129.

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 [author name scrubbed].

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.

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.

Various data on business claims for the expensing allowance were obtained via email from the Statistics of Income Division at IRS on March 21, 2006.

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.

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

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.