RALEIGH — North Carolina lawmakers should take aim at the state’s current system of depreciation, as they look for more ways to improve the tax code. A new John Locke Foundation Spotlight report recommends replacing state depreciation schedules with single-year “expensing.”
“Using a system of depreciation for writing off asset costs distorts investment decisions,” said report author Dr. Roy Cordato, John Locke Foundation Vice President for Research and Resident Scholar. “It creates a bias against making investments in ‘longer-lived’ capital and businesses that require such investment. It creates a bias in favor of ‘shorter-lived’ capital investments and industries that rely more heavily on these kinds of investments.”
In contrast, a system based on “expensing” allows businesses to deduct the full cost of a capital asset from business taxes in the year the purchase is made, Cordato said. “Expensing eliminates the bias tied to depreciation by treating all asset investments equally,” he said. “It would ensure that the tax value of all such investments is equal to the full cost of making the investment.”
There’s another benefit, Cordato adds. “Ultimately, it would put North Carolina in a good position for making and attracting new investments by lowering the cost for almost all capital investments.”
The switch from depreciation to expensing would fit well with the “positive” and “dramatic” restructuring of North Carolina’s tax code under way since 2013, Cordato said. Lowering and flattening the personal and corporate income tax rates have “created a more efficient and fair tax code.”
Now lawmakers ought to focus on getting the income tax base right, Cordato said. “Going forward, the primary task of tax reform should be to eliminate the bias that exists against saving, investment, and entrepreneurship,” he said. “The current tax code penalizes saving and investment by double taxing interest, dividends, and capital gains.”
Alongside this focus on the tax base, the state should re-examine the way it treats business investments in capital equipment and real property, Cordato said. “This is where the switch from depreciation to expensing comes into play.”
It’s universally recognized that business expenses tied to producing goods and services for sale should be deductible from taxation, Cordato said. But the federal government and most states permit deductions linked to land, office equipment, machinery, buildings, and other assets only over a period of time and at specified rates.
This approach, called depreciation or amortization, is based on the presumed durability of the investment. A “longer-lived” asset has a longer depreciation period, such as 27.5 years for investment in land for an apartment complex versus five years for an office computer.
“While this approach might seem to make sense, it has several serious defects from an economic perspective,” Cordato said. “First, a piece of equipment’s useful life has more to do with market conditions and alternative technology than the equipment’s physical characteristics.”
A “deeper and more systemic problem” is the distortion of investment decisions, Cordato adds. “The bias against ‘longer-lived’ capital and in favor of ‘shorter-lived’ capital creates problems even if the write-off period is consistent with the asset’s true economic lifespan.”
Under a system of depreciation, the value of a tax deduction turns out to be less than the full cost of the capital asset, Cordato said. “This is because a dollar is worth more to someone now than at any time in the future,” he said. “This is why lenders charge interest and borrowers agree to pay interest.”
Under immediate expensing, a construction company that buys a $100,000 bulldozer can write off the full $100,000 from this year’s pretax income. “That means the full cost gets deducted,” Cordato said. “On the other hand, a six-year depreciation period means the total value of the deduction will be less than the full cost of the investment. The longer the depreciation period, the less the deduction will be worth.”
“Depreciation creates an incentive for substituting, where possible, shorter-lived assets for longer-lived assets,” he added. “This is true for decisions within individual companies. It’s also true for those making decisions about the kind of businesses to invest in. There’s a bias against investment in companies requiring use of more longer-lived assets.”
Scrapping depreciation for expensing would require North Carolina to break away, or “decouple,” from the federal tax code. But that would not make tax filing at the state level any more complicated for N.C. businesses, Cordato said.
“We’re not talking about substituting a different set of depreciation schedules for the federal set,” he said. “Businesses would simply deduct the full amount of their asset purchases during the year from their pretax income in one lump sum.”
Any tax reform should pursue a goal of not interfering with business decisions, Cordato said. “To the extent possible, such decisions should be made based on market conditions of supply and demand. They should not be guided in any direction by the tax code.”
“In examining future changes to North Carolina’s tax code, the overall goal should be what economists call ‘tax neutrality,’ which implies treating all business and consumption activities equally.”
Dr. Roy Cordato’s Spotlight report, “More To Do on Tax Reform: Changing how business expenses are deducted,” is available at the JLF website. For more information, please contact Cordato at (919) 828-3876 or [email protected]. To arrange an interview, contact Mitch Kokai at (919) 306-8736 or [email protected].