The most powerful fiscal measure the government could take to ensure continuing vigorous growth of the economy is eliminating the overstatement of business income by moving from depreciation to expensing of assets.

Business income is now overstated because the tax code requires that businesses write off -- depreciate -- their investment outlays over a period of time instead of deducting the entire cost at once. However, a business must buy an entire machine or building all at once, tying up funds that otherwise would be available to earn income.

The longer lived the asset and the higher the rate of inflation, the lower the present value of the capital consumption allowance, the greater the overstatement of business income and the less the value of taxes saved.

• With expensing, the asset life doesn't matter when calculating current income because the full amount invested is written off in the first year.

• At 5 percent inflation, the allowable write-off for a building with a 39-year asset life has a present value of less than 30 cents per dollar of cost.

Taxes are a part of the cost of capital. The higher the tax rate and the cost of capital, the fewer investment projects that businesses can justify as affordable to undertake, and the smaller the stock of capital.

Falling inflation has eased the tax burden on capital and encouraged the development of a larger capital stock, giving strength to economic expansion. But the resulting boost lasts only until the added capital made profitable by the drop in inflation is put into service.

A switch to expensing would involve some short-run revenue loss to the Treasury, but the additional investment resulting from the lower cost of capital would boost gross domestic product and the tax base, and would recover a significant portion of the lost revenue.

Source: James R. Kee, "Preserving Growth through Sensible Tax Reductions," IRET Policy Bulletin No. 73, October 20, 1998, Institute for Research on the Economics of Taxation, 1300 19th Street, N.W., Suite 240, Washington, D.C. 20036, (202) 463-1400.