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Abstract - In part because of concerns that the tax depreciation system may be dated and may not properly measure income, Congress directed that the Treasury study the current tax depreciation system. This paper is derived from the staff work for the Treasury Study. The paper first discusses the rationale for a depreciation allowance. It next describes the current tax depreciation system. Using the cost of capital, the paper evaluates the current tax depreciation system. It then discusses several comprehensive reforms of the tax depreciation system, and calculates the effects of these reforms on the cost of capital. The final section discusses several practical problems with the current tax depreciation system.
INTRODUCTION
The U.S. capital cost recovery system has remained largely unchanged since 1986. Moreover, it is based on an asset classification system that dates to 1962 and was last modified in 1981. Since 1981 entirely new industries have developed, and manufacturing processes in traditional industries have changed dramatically. Because the current system is dated, some have recently called for its modification. In response to these concerns, Congress has directed that the Treasury study the system's recovery periods and depreciation methods.1 This paper is derived from the preliminary staff work for the forthcoming Treasury Study. 2
Following this introduction, the paper briefly discusses the rationale for a depreciation allowance under an income tax. It next describes the current cost recovery or depreciation system. Using the cost of capital, the fourth section evaluates current law's depreciation system relative to the standard of economic depreciation. The fifth section discusses several comprehensive reforms of the current cost recovery system, and illustrates the effects of these reforms on investment incentives using the cost of capital. The final section discusses several practical problems with the current depreciation system.
DEPRECIATION AND INCOME MEASUREMENT
A tax system based on income generally does not allow a deduction for the cost of a new asset in the year the asset is purchased. Instead, it spreads out the deduction over an estimate of the asset's useful lifetime. The amount allowed as an annual deduction reflects (however roughly) the reduction in the value of the capital asset as it ages, and is called depreciation.
A depreciation deduction is justified under the standard provided by economic...