Key Issues in Tax Reform: The Business Interest Deduction and Capital Expensing

Key Issues in Tax Reform: The Business Interest Deduction and Capital Expensing

Updated September 27, 2017
Key Issues in Tax Reform: The Business Interest Deduction and
Capital Expensing
Two policy changes that have appeared in the recent tax
More complicated methods exist under the declining-
reform discussions are (1) disallowing business deductions
balance approach which allows for larger depreciation
of interest payments and (2) allowing expensing of capital
deductions in the earlier years of an asset’s life. Because
investments. While the discussions are typically framed in
assets are deprecated more quickly under the declining-
terms of trading one policy for the other policy, the analysis
balance method, this approach is often referred to as
presented here attempts to separate the two options where
“accelerated” depreciation.
possible, given that each policy change could be enacted
independent of the other.
The tax code provides two exceptions to MACRS known as
“179 expensing” and “bonus” depreciation. These
Brief Summary of Current Law
exceptions allow for more generous capital cost recovery.
Currently, businesses are generally allowed to deduct
For more information, see CRS Report R43432, Bonus
interest costs incurred when borrowing money to finance
Depreciation: Economic and Budgetary Issues, by Jane G.
business activities. The rules and limitations for the
Gravelle; and CRS Report RL31852, The Section 179 and
deduction are detailed in Section 163 of the Internal
Bonus Depreciation Expensing Allowances: Current Law
Revenue Code (IRC). Business interest has been deductible
and Issues for the 114th Congress, by Gary Guenther.
since the enactment of the modern federal income tax code
in 1913. The deduction is consistent with traditional
Recent Proposals
theories of income taxation which call for the deduction of
The Unified Framework for Fixing Our Broken Tax Code,
expenses incurred in the generation of income.
issued by the Office of the Speaker on September 27, 2017,
would allow businesses to expense new investments made
Businesses are also allowed to claim a deduction for the
within at least the next five years. Structures would not be
cost of their investments in physical assets wearing out (i.e.,
eligible for expensing. The Unified Framework also states
depreciating). Like the interest deduction, the depreciation
that the deduction for net interest would be “partially
deduction is a feature of an income tax and has been
limited” for C corporations, and that consideration would
available in some form since the enactment of the modern
be given to the appropriate treatment for non-corporate
tax code. The general idea is that since physical assets
businesses.
generate income over time, the deduction of their cost
should be spread out over time to match the generation of
The House “Better Way” tax reform blueprint proposed
income. The Modified Accelerated Cost Recovery System
prohibiting businesses from deducting net interest while
(MACRS) has been used to depreciate most investments
simultaneously allowing them to expense the cost of
made after 1986. The intricacies of MACRS and the
investments in the year capital is purchased. Not allowing a
exceptions to it are governed by various sections of the tax
deduction for interest while allowing full expensing is a
code (e.g., Sections 167, 168, 179, etc.).
fundamental feature of a business cash-flow tax, but not an
income tax. Interest expenses could offset interest income,
The current depreciation system can be understood along
but could not offset non-interest income.
two dimensions. The first dimension is the length (or life)
over which a business may depreciate an asset. Most
In the 113th Congress, former Ways and Means Chairman
equipment is depreciated over 5 to 7 years, although some
Dave Camp’s Tax Reform Act of 2014 (H.R. 1) would have
may be depreciated over as short as 3 years or as long as 20
allowed businesses to continue to deduct interest, but would
years. Residential buildings are depreciated over 27.5 years,
have slowed depreciation for most businesses by extending
while commercial buildings are depreciated over 39 years.
the time period over which the deductions were claimed
Land may not be depreciated.
and requiring the use of the straight-line method. Small
businesses, however, would have been eligible for more
The second dimension is the method used to determine how
generous depreciation than is allowed under the current
much depreciation can be deducted each year. Under
system.
MACRS, the simplest method is the straight-line method
which allows for equal amounts to be deducted each year
Budgetary and Economic Issues
over the relevant life of an asset. For example, under the
straight-line method if a machine costs $1 million and has a
Budgetary Issues
depreciable life of 10 years, a business would be permitted
Disallowing the deduction for net interest and allowing
to deduct $100,000 from its income each year for 10 years.
businesses to expense their investments would have
opposing revenue effects. The Joint Committee on Taxation
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Key Issues in Tax Reform: The Business Interest Deduction and Capital Expensing
(JCT) would be assigned the task of providing official
associated with existing debt that is refinanced after the
revenue estimates of both changes were legislation to be
policy change.
introduced. As of the date of this writing, only outside
estimates are available.
Allowing firms to expense their capital investment would
likely stimulate investment in the short run. Fully deducting
The Tax Foundation estimates that allowing expensing
the cost of capital expenditures would reduce the marginal
would result in a revenue loss of approximately $2.2 trillion
tax rate on investment and therefore the after tax return.
in the first decade, whereas disallowing the deduction of
Increases in the capital stock should translate into increased
interest would increase revenue by $1.2 trillion, for a
growth in the short run as the economy transitions under the
combined revenue loss of approximately $1 trillion. The
new policy. The effect of expensing within a broader tax
Tax Policy Center (TPC) estimated the combined revenue
reform, however, is likely to be smaller than if the proposal
effect of allowing expensing and disallowing the deduction
were enacted as a stand-alone provision. Most tax reform
of interest and found that the changes would result in a $1.1
proposals would also lower tax rates on business income,
trillion revenue loss over the first 10 years. However, the
which would lessen the value of expensing.
TPC found that the combined changes would increase
revenue by $1.1 trillion in the second decade following the
The longer-run effect on the capital stock and economy as a
reform.
result of expensing is less clear, particularly if expensing
leads to increased deficits. Increased deficits may lead to
The reversal in revenue effects in the first and second
higher future interest rates, or possibly higher tax rates if
decades following reform are due to a timing effect. The
policymakers grow concerned over the sustainability of the
expensing of capital investment will have a large negative
deficits. A rise in interest rates or taxes could curtail or
revenue effect in earlier years which will be offset in later
offset any positive effect expensing has on investment
years because firms will not be claiming depreciation
incentives. If the proposal is part of a larger reform
deductions. Also, the estimates assume that interest on
package, the revenue effects of the reform, as well as tax
existing loans will still be deductible and the revenue gain
rates set in the reform, would also influence the impact of
will grow over time as those loans mature.
the expensing provision.
Economic Issues
Full expensing of capital expenditures would simplify the
Currently, the tax code tends to encourage the use of more
tax system. The current depreciation system is generally
debt than otherwise would occur because interest payments
recognized to be complex, requiring companies to incur
are deductible while equity earnings (e.g., dividends paid)
administrative costs when investing in capital equipment
are not. There is concern that the tax-induced preference for
and structures. Since expensing would allow the full cost of
debt financing distorts the allocation of capital and
an investment to be written off in the first year, this option
introduces undue risk in the economy. Removing the
avoids many of the complexities and costs of the current
deduction for interest would create parity in the tax
system.
treatment of debt financing and equity financing.
As with disallowing a deduction for interest, transitioning
Disallowing the interest deduction would negatively impact
to expensing will require careful consideration.
businesses that rely on debt financing. There is concern that
Policymakers will have to decide if any existing capital
smaller business could be disproportionally impacted since
stock is eligible for expensing after the change is enacted. If
they may not be able to access equity financing as easily as
not, immediate expensing could create a disparity in the tax
larger firms. There is also concern over businesses that rely
treatment of new and old capital, especially investments
on bridge loans such as farmers who must cover costs
made in the year immediately preceding the change. If so, it
between planting and harvest, or contractors and developers
would create tax parity in the tax treatment of new and old
who may need to finance the purchase of materials or
capital, but at an extremely high revenue cost given the size
payroll several months in advance of a project’s
of the existing depreciable capital stock. It would also
completion. One option would be to continue to allow
produce a windfall gain for past investments. Relatedly,
certain taxpayers deductions for interest, although this
there is the question of whether to allow used assets that are
would reduce the revenue generated from removing the
acquired after the policy change to be expensed.
deduction. Allowing some taxpayers a deduction for
interest, while denying it to others, could create

administrative complexity and potentially introduce new
tax-induced distortions.
This In Focus is part of a series of short CRS products on
tax reform. For more information, visit the "Taxes, Budget,
If Congress chooses to modify the treatment of business
& the Economy" Issue Area Page at www.crs.gov.
interest, it will need to carefully consider how to transition
to the new policy. For businesses that secured loans before
Mark P. Keightley, Specialist in Economics
the policy change, policymakers would have to decide if
interest payments on debt secured before the policy change
IF10696
would continue to be deductible. Additionally, Congress
would have to decide how to treat interest payments
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Key Issues in Tax Reform: The Business Interest Deduction and Capital Expensing

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