Contract with America: neutral costrecovery system.
proposed depreciation changes
Although the proposed capital gains tax cut in the House Republican Contract with America has received much attention, a less noticed item in the contract could garner major tax savings for capital-intensive businesses. The proposed neutral cost recovery system (NCRS) aims to increase the value of depreciation deductions for much personal property so their benefit is equal in present value to immediate expensing of investment, and, for other depreciable property, to prevent the erosion of these deductions by inflation.
Although the structure of the proposal would increase revenues in the short run, over the long run there would be a significant reduction in the business tax burden. The current version of the NCRS proposal is in Section 2001 of H.R. 9, introduced in the House of Representatives in January 1995 (The original version in the Contract with America had additional features, which are noted in the text.)
MACRS as we know it
Under the current modified accelerated cost recovery system (MACRS), assets in the three-year, five-year, seven-year and 10-year classes are depreciated using the 200% declining-balance method. Assets in the 15-year and 20-year classes use the 150% declining-balance method. Assets in higher classes must use the straight-line method.
Under the double-declining balance method, a rate equal to two divided by the tax life is applied to the undepreciated basis. For example, for a five-year class asset, 40% (2/5) is deducted in the first year, 24% (40% of 60%, the remaining undepreciated balance) is deducted in the second year, and so forth. Since the arithmetic of declining-balance methods would never fully depreciate an asset's cost, a business will switch to straight-line accounting at a point in the asset's life that will maximize the tax deduction for depreciation.
Neutral cost recovery system
For short-lived equipment, the objective of the NCRS proposal is to provide purchasers of equipment and structures with cost recovery deductions that have a cumulative value equal to immediate expensing of the asset. This objective would not be implemented by allowing immediate expensing (which would be very costly); rather, any deductions not allowed until a year later than the year the property is placed in service would be augmented by an interest factor that would compensate for the delay. For structures and other equipment, the objective of NCRS is to prevent erosion of depreciation deductions by inflation. Although this could have been achieved with an immediate deduction for a portion of the cost of the property, the cost of such a method would have been much larger than allowing additional deductions in future years.
Specifically, the NCRS proposal changes the capital cost recovery system for depreciable assets (equipment and structures) by:
1. Adopting a slower method of depreciation for most equipment by shifting from double declining balance to 150% declining balance,and
2. Increasing deductions allowable after the first year by a factor equal to
-the percentage increase in the price level (the gross national product deflator) since the property was placed in service (computed on a quarterly basis), and
-for property with a depreciation life less,than 15 years (other than property used in a farming business or to which the straight-line method applies), an interest factor of 3.5 % per year since the property was placed in service. (The original Contract with America proposal applied the interest factor to both short- and long-lived property.)
The adjustment factor in (2) applies to minimum tax depreciation and is not taken into account in computing basis or recapture. (The original proposal also eliminated the ACE depreciation adjustment for all property.) As proposed, NCRS would be effective for property placed in service in tax years beginning after Dec. 31, 1994.
Effects on depreciation
In the short run, the shift from double declining balance to 150% declining balance for short-lived equipment reduces deductions. in contrast, adjusting depreciation deductions by the rate of inflation, and the additional 3.5 % factor, increases the size of the deductions, with the increase compounding over time. As a result, NCRS reduces the depreciation deduction from current law in the early years of an asset's life, but increases it in later years. The net effect is a significant increase in the total of depreciation deduction allowed over the asset's life. Unlike previous depreciation systems, NCRS would allow total deductions in excess of cost. However, assuming that the inflation and interest factors above produce a reasonable discount rate, the present value of the total deductions equals the asset's cost.
Exhibit 1, top right, shows an example of how NCRS deductions would be computed for $1,000 of five-year property if the inflation rate were 3% each year. The figures in the first column result from computing depreciation according to a conventional 150% declining-balance method, with switching to straight line. The next three columns show the adjustment factors that increase each year's deductions. The adjustment is larger in years furthest from the year in which the property is placed in service.
Column (5) shows the actual NCRS deductions, which total $1,156, 15.6% more than the property's cost. Finally, column (6) shows that the sum of the year 1 present values of each year's deductions totals $1,000. Since the adjustment factor in column (4) is defined to be equivalent to a discount factor equal to 3.5 % plus the inflation rate, the discounting offsets exactly the increase in the deductions beyond the original column (1) figures.
Exhibit 2, above, compares the depreciation deductions allowed under present law with NCRS for equipment of various property classes. For a $1,000 piece of equipment with a five-year life, a firm can deduct $200 in the first year under current law, but only $150 under NCRS. This reflects the shift to the slower method of depreciation. By year 3, the depreciat ion deduction under NCRS is higher than current law ($203 versus $192), and by the final year it is doubled. The total deduction for the five-year period rises from $1,000 to $1,156.
A similar pattern is seen in the other asset classes, with short-run declines being offset by long-run increases in deductions, with the total exceeding the original value of the asset.
For longer-lived assets, the effects on total deductions are even more dramatic. Commercial and industrial structures, with asset lives of 40 years, are already subject to straight-line depreciation and thus unaffected by the movement away from the double-declining balance. As shown in Exhibit 3, above, however, because of the effect of the inflation adjustment, the depreciation deductions for a $1,000 asset total $1,917 over 40 years. (Note that the interest factor does not apply to property with lives of 15 years or more.)
Capital cost recovery deductions equivalent to expensing are a significant policy objective for those who believe that additional investment incentives should be added to the tax code. Expensing of capital assets effectively eliminates any tax on return on investments.
The expensing deduction reduces the after-tax cost of the assets by the same percentage as the taxation of the income from the asset reduces the income flows from the asset. The relative relationship between cost and income (and thus the rate of return) is left unchanged. Although actual expensing would be simpler than NCRS, as noted, it would have a very large near-term revenue cost.
NCRS probably would result in near-term increases in tax revenues, but potentially large declines in later years. On February 1, 1995, the joint Committee on Taxation released an estimate that the proposal would increase revenue by $16.7 billion in the first five years. This is close to a previous Treasury Department estimate that revenue would increase by $18.4 billion. These gains stem from the shift from the double-declining balance method.
In later years, the revenue effects would reverse. For the second five years, Treasury projects the proposal would lose $138.8 billion in revenue.
A reply to this revenue-cost criticism already surfacing in press reports is that NCRS will generate significantly more economic activity and growth. Proponents argue that this extra activity would generate additional tax revenue, offsetting the effects described above. This issue of dynamic scorekeeping of revenues has been fully aired in discussions of the revenue effects of lower capital gains tax rates and will be debated yet again as Congress considers the Contract with America.
Tax planning implications and
If enacted as proposed, NCRS would create a substantial increase in cost recovery deductions for equipment and structures. If it is not. costly to delay placing in service planned investment until after the effective date of the proposal, it may be beneficial for taxpayers to do so.
There are a number of reasons Congress ultimately may not approve the proposal. First, concern over long-term revenue costs may doom the proposal. Second, the business community may split between capital intensive and labor intensive sectors and deny the provision needed uniformity in business support. Third, would-be supporters may be wary of signing on to a short-term cost in the form of 150% declining-balance depreciation in return for a promise of inflation adjustments in years to come. Many may imagine future revenue options based on cutbacks in the adjustments. Among tax proposals in the House Republican Contract, this is among the least likely to be enacted.
Even if some form of NCRS is enacted, the effective date could be changed during the legislative process or the proposal could be significantly scaled back (e.g., structures could be totally eliminated from the proposal).
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|Publication:||The Tax Adviser|
|Date:||Mar 1, 1995|
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