The next major tax legislation considered by Congress will likely substantially alter the treatment of depreciation, with important implications for investors and the economy as a whole.

Depreciation is the tax deduction businesses get for the wearing out of structures, machinery and equipment, so they can be replaced when their useful lives are over.

For years, the IRS has expended enormous resources trying to figure out exactly what is the useful life of various capital assets. It has also waged virtual war with the business community about what is capital, which must be depreciated, and what is an operating expense, which can be deducted all at once.

In the "Old Economy" of lathes, drill presses and such, it may have been possible to apply the traditional notion of depreciation as a literal "wearing out" of capital, over and above maintenance. But, increasingly, in the "New Economy" of software and the Internet, the concept is worthless. Software and computers are an increasing share of fixed investment (see figure). And software, for example, never "wears out," it just becomes obsolete.

Many tax theorists conclude that obsolescence, rather than depreciation, is more relevant for judging the decline in value of capital investment.

Yet because of the tax laws, investments in such things as computers and software are excessively taxed, because they cannot be depreciated quickly enough to compensate for their obsolescence.

In coming months, there will be a major effort in Congress, likely supported by the Bush Administration, to overhaul depreciation policy. Investments in high-tech equipment, such as computers, will be allowed to be written off immediately, rather than depreciated. This will significantly lower the tax burden on high-tech investment, raising labor productivity, increasing economic growth and giving a big boost to computer and software stocks.

Source: Bruce Bartlett, senior fellow, National Center for Policy Analysis, June 25, 2001.

For text http://www.ncpa.org/oped/bartlett/bartlett01.html