CRS Report Takes Negative View on Bonus Depreciation

by Akin Gump Strauss Hauer & Feld LLP

The Congressional Research Service (CRS) has issued a report analyzing the economic effects of bonus depreciation. CRS has very little to say that is positive about bonus depreciation. CRS views it as neither an effective economic stimulus nor as a means of promoting a level playing field for economic growth among various sectors of the American economy.  The report is available here

Below are key excerpts from the report.

 Excerpts from Report’s Executive Summary

  • The Tax Extenders Act of 2013 (S. 1859), which would extend expiring tax provisions for a year, includes bonus depreciation and H.R. 4718 proposes to make bonus depreciation permanent. The temporary provisions enacted in the past for only a year or two and extended multiple times are generally referred to collectively as the "extenders.” Historically, bonus depreciation has not been a traditional "extender."
  • Bonus depreciation allows half of equipment investment to be deducted immediately rather than depreciated over a period of time. Bonus depreciation was enacted for a specific, short-term purpose: to provide an economic stimulus during the recession. Most stimulus provisions have expired. Bonus depreciation has been in place six years (2008-2013), contrasted with an earlier use of bonus depreciation in place for three years.
  • A temporary investment subsidy was expected to be more effective than a permanent one for short-term stimulus, encouraging firms to invest while the benefit was in place. Its temporary nature is critical to its effectiveness. However, research suggests that bonus depreciation was not very effective, and probably less effective than the tax cuts or spending increases that have now lapsed
  • Compared to a statutory corporate tax rate of 35%, bonus depreciation lowers the effective tax rate for equipment from an estimated 26% rate to a 15% rate.
  • Moving to permanent bonus depreciation is inconsistent with tax reform proposals made by the Wyden-Coats bill, the Senate Finance Committee Staff discussion draft and Chairman Camp's proposal.  All of these proposals would reduce the current accelerated depreciation for equipment.
  • The usual extenders cost a fraction of the cost of permanent provisions in a 10-year budget window, but bonus depreciation is a smaller fraction because it is a timing provision. A one-year extension costs $5 billion for FY2014-FY2024, less than 2% of the cost of $263 billion for a permanent provision.

Historical Development of Bonus Depreciation

  • When depreciation rules were set in the Tax Reform Act of 1986 (P.L. 99-514), they allowed for accelerated deductions to offset the lack of indexing for inflation, so that the discounted present value of tax depreciation deductions was roughly equal to the discounted present value of economic depreciation.
  • Since that time, inflation has declined and caused the value of tax depreciation to be more beneficial than economic depreciation. For non-residential buildings, the inflation effect has been offset by an increase in tax lives. For equipment, with costs deducted over relatively short periods of time and under accelerated declining balance methods, tax depreciation is more generous than economic depreciation.
  • Bonus depreciation was first enacted in the Job Creation and Worker Assistance Act of 2002 (P.L. 107-147) at a 30% rate, for three years, with the purpose of stimulating investment during an economic slowdown. Concerns about the economy had come in the aftermath of the 2001 terrorist attacks.  Although the bonus depreciation rate was increased by the Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27) to 50% in the following year and extended for a year, it expired at the end of 2005.
  • With the financial distress and recession that began in 2007, the Economic Stimulus Act of 2008 (P.L. 110-185) was enacted to stimulate the economy, including a single year of bonus depreciation at 50%. Bonus depreciation was not the centerpiece of the stimulus; the major tax cut, much larger than bonus depreciation, was an individual tax rebate.
  • As the recession continued, a much larger stimulus measure was adopted in 2009 (the American Recovery and Reinvestment Act, P.L. 111-5). It extended bonus depreciation for an additional year, through 2009. Bonus depreciation was only a minor part of a larger package that included a two-year individual tax credit aimed at low-income individuals (the Making Work Pay Credit) and spending increases that were much larger than the tax reductions.
  • Bonus depreciation has continued to be extended. It expired in 2010 but was extended retroactively through 2010 by the Small Business Jobs Act of 2010 (P.L. 111-240), enacted at the end of September 2010.
  • Most of the extension of bonus depreciation was retroactive (three quarters of the year had passed when the bill was adopted). Thus, the extension provided a windfall to firms for that period, rather than a stimulus.
  • The Tax Relief, Unemployment Compensation Reauthorization, and Job Creation Act of 2010 (P.L. 111-312) extended the Bush tax cuts and the 2009 provisions relating to education, the child credit and the earned income credit for two years and retroactively extended the extenders for two years (through 2011). It increased bonus depreciation to 100% for the period from September 8, 2010, through 2011, and then allowed it at 50% through 2012.
  • The American Taxpayer Relief Act of 2012 (P.L. 112-240), which was adopted in early January 2013, made most of the Bush tax cuts permanent and extended bonus depreciation for another year, among other things.
  • The proposal to include bonus depreciation in a standard extenders bill separates the provision from a fiscal stimulus objective. This inclusion creates uncertainty about the expected future of bonus depreciation and suggests an analysis of it either as a temporary stimulus or a permanent provision.

Effectiveness as a Temporary Fiscal Stimulus

  • Some evidence suggests that the temporary bonus depreciation enacted in 2002 had little or no effect on business investment. A study of the effect of temporary expensing by Cohen and Cummins at the Federal Reserve Board found little support for a significant effect.  They suggested several potential reasons for a small effect. One possibility was that firms without taxable income could not benefit from the timing advantage. In a Treasury study, Knittel confirmed that firms did not elect bonus depreciation for about 40% of eligible investment, and speculated that the existence of losses and loss carry-overs may have made the investment subsidy ineffective for many firms, although there were clearly some firms that were profitable that did not use the provision.
  • Cohen and Cummins also suggested that the incentive effect was quite small (largely because depreciation already occurs relatively quickly for most equipment), reducing the user cost of capital by only about 3%,  and that planning periods may have been too long to adjust investment across time. Knittel also suggests that firms may have found the provision costly to comply with, particularly because most states did not allow bonus depreciation.
  • Cohen and Cummins also reported the results of several surveys of firms, which showed that between two-thirds and more than 90% of respondents indicated bonus depreciation had no effect on the timing of investment spending.
  • Forecasters vary in the multipliers they assign different tax and spending provisions.  (A multiplier estimates the amount of economic output resulting from a certain amount of stimulus.) For example, the Congressional Budget Office, during discussion of the fiscal cliff, indicated a multiplier of 0.15 for business tax cuts in general, and a multiplier of 0.6 for expensing. The latter suggests a dollar of budgetary cost spending induces a 60-cent increase in output. The dollar of cost was measured as the present value of bonus depreciation. This multiplier was among the smaller ones, with payroll taxes having a multiplier of 0.9 and unemployment insurance a multiplier of 1.1. Zandi had similar multipliers for these latter provisions but assigned a multiplier of 0.2 for bonus depreciation, measuring the provision as the first-year tax saving (a larger number than present value).
  • Overall, bonus depreciation did not appear to be very effective in providing short-term economic stimulus compared to alternatives.
  • There are also concerns about the effectiveness of bonus depreciation when the extension is retroactive.  When bonus depreciation is extended retroactively, the benefit is a windfall which cannot affect investment.

Bonus Depreciation as a Permanent Provision

  • If bonus depreciation is permanent, it affects the size and allocation of the capital stock. In particular, it lowers the tax rate on equipment relative to other depreciable assets.

Effective Tax Rates

[Editor’s note:  When CRS refers to “effective tax rates” it does not use the term in the financial accounting sense.  Specifically, CRS considers bonus depreciation to reduce the present value of tax liabilities and thus a factor in CRS’s effective rate calculations.  In contrast, a financial statement preparer would consider bonus depreciation to have no effective tax rate benefit as it is only a more accelerated cost recovery for tax purposes than is available for financial accounting purposes (i.e., a mere “timing” benefit that results in a “deferred tax liability”).]

  • If bonus depreciation is permanent, estimates of U.S. effective tax rates reflecting concerns that the U.S. rate is higher than that of other countries overstate the effective U.S. corporate tax rate; U.S. effective tax rates on equipment would be significantly lower than the Organization for Economic Cooperation and Development average. 
  • Prominent tax reform proposals would reduce accelerated depreciation. Making bonus depreciation a permanent provision would significantly increase its budgetary cost.
  • If tax depreciation is equal to economic depreciation in present value, the effective tax rate for the firm (the difference between the before-tax rate of return on the investment and the firm's after-tax return, divided by the before-tax return) is equal to the statutory rate for an equity investment. (Rates are higher for equity investment when shareholder taxes are imposed, but may be negative for debt-financed investment.)  If depreciation has a greater present value than economic depreciation the effective tax rate falls below the statutory rate for firm-level taxes on equity investment; if all of the cost is immediately deducted the effective tax rate is zero.
  • The standard way to measure the effect of depreciation rules on tax burdens is to consider the influence of the provision on the required return to a new investment. This approach requires an estimate of the required internal pre-tax rate of return for an investment to break even (i.e., the pre-tax rate of return needed to earn a required after-tax return).  The effective tax rate is measured as the pre-tax return minus the after-tax return, divided by the pre-tax return. In other words, it measures the share of the investments earnings that is paid in tax.
  • Because nominal interest is deducted, however, effective tax rates with debt finance can be negative. For equity assets taxed at an effective rate of 35%, the effective tax rate on debt-financed investment is a negative 5%. The rate on equipment without bonus depreciation is minus 19%; with bonus depreciation it is minus 37%.
  • Equipment assets generally have favorable tax depreciation rules, even without bonus depreciation, with effective tax rates falling as low as 17% but generally around the mid-twenties, well below the 35% statutory rate. Public utility structures and farm structures are treated as equipment in the Tax Code and also have lower tax rates. Non-residential buildings (commercial, industrial and other) tend to be taxed at or above the statutory rate.  Residential buildings, not shown, are taxed at around 32%. Bonus depreciation benefits equipment, already favored by the Tax Code, producing effective tax rates that range from 9% to 21%, with most around the mid-teens.

Bonus Depreciation and Revenues

  • Some have suggested that the traditional extenders have been repeatedly enacted on a temporary basis because the revenue cost is much smaller for a single years extension compared to a permanent extension with the 10-year budget horizon.  Without growth, one would expect a standard provision to cost only 10% of the permanent 10-year cost; with growth it would be somewhat less because each years cost would be slightly larger than the year before.
  • Bonus depreciation and Section 179 expensing cost even less compared to their cost in the 10-year budget horizon because most of the initial revenue loss is recovered during the budget horizon.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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