Taking a Look at Capital Consumption Allowances

December 5, 2013

Must of the focus on the corporate tax code has centered on the fact that the United States has the highest corporate tax rate among industrialized nations. However, the United States also has one of the worst capital allowance systems, which significantly impacts investment and wages, says Kyle Pomerleau, an economist at the Tax Foundation.

In order to determine their taxable income, companies take their revenue and subtract their costs (such as state and local taxes, wages paid to employees, raw materials, etc.). But the calculation is slightly more complicated when a business has made a capital investment (such as purchasing machines, buildings or equipment).

  • When a business purchases something large, like a building, the United States does not allow them to deduct that cost immediately.
  • Instead, they write that investment off over a number of years.
  • Depreciation schedules estimate the life of an asset.
  • If a company purchases a machine that is estimated to last seven years, then the company will follow the depreciation schedule and deduct part of the cost of that machine over the course of seven years, ultimately adding up to the initial cost of the asset.

But due to the fact that the value of money changes over time, write-offs in year seven are not as valuable as write-offs in year one. Because corporations are not actually able to deduct the full present value of the cost of the investment, actual business costs are understated while their taxable income is overstated. This effect only becomes more pronounced as the rate of inflation increases and the depreciation schedule lengthens.

A capital allowance, therefore, is the percent of a business's investment that can be recovered through the tax code.

  • A 100 percent capital allowance means that a business can deduct the full cost of an investment over its life.
  • The lower the capital allowance, the more a business's taxable income is inflated (and therefore its tax bill is overstated).
  • The average net present value of capital allowances in the United States is only 62.4 percent, meaning that depreciation schedules in the United States allow businesses to recover only 62.4 percent of the present value of their investments, on average. This is less than the Organization for Economic Cooperation and Development average of 66.5 percent.

Low capital allowances mean that higher taxes are paid by businesses and capital costs increase. This leads businesses to invest more slowly while reducing productivity, employment and wages.

Source: Kyle Pomerleau, "Capital Cost Recovery across the OECD," Tax Foundation, November 19, 2013.

 

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