A couple of weeks ago, I argued that North Carolina’s legislature should “one-up” Congress and the Trump administration when it comes to tax reform by abolishing the state’s capital gains tax. Despite all of the good changes made to the tax treatment of investment and business income, lawmakers chose not to make any changes to the tax treatment of capital gains.
This week, I’d like to argue that there is another important area of taxation where N.C. can improve on federal reforms – the treatment of deductions for expenditures on capital assets.
In the recent tax reforms made at the federal level, an important and significant change was made to the way investment in new plants and equipment is treated. The feds moved from a system based primarily on what is called depreciation to one based on expensing. If expenditures on plant and equipment are depreciated for tax purposes, this means that the cost incurred for the purchases have to be written off by a company over a statutorily specified period. Under a system of expensing, the entire expenditure can be written off from a business’ income in the year that it incurred, regardless of the asset purchased. Unfortunately, North Carolina, will not be adopting the federal changes and will maintain its current system, which is based on writing off depreciated costs over time.
While the federal government has taken an important step in the right direction, the problem is that the changes in this area will expire after five years and the tax code will revert to the system of depreciation that existed before the reform. North Carolina should take a leadership role vis-à-vis the federal government and other states by moving completely to a system of expensing making it a permanent feature of our tax code.
The argument typically given for using a system of depreciation is that the timing of the tax write-off should coincide with an investment’s “useful life.” At first blush, this would seem to make sense. But from an economic perspective, the whole notion of “useful life,” as somehow being related to how long it would take for an asset to physically wear out, doesn’t make much sense. Probably the most obvious problem with the concept is that the useful life of a piece of equipment has little to do with the asset’s physical characteristics or how long it can be expected to last in some physical sense. It is, instead, a function of alternative technology and market conditions.
For example, a computer purchased under the Fed’s previous system of depreciation would have a tax write-off period of five years. But in fact, it is not unimaginable that in one year a new technology could come along that would render that computer obsolete in terms of keeping the businesses operations efficient and competitive. So, while in a physical sense the computer might “last” for five or more years, in an economic sense, its useful life may be much shorter. During a period of quickly changing technology and market conditions more generally, this is likely to be true for all kinds of assets.
But using a system of depreciation for writing off asset costs creates an even deeper and more systemic problem that distorts investment decisions. It creates a bias against making investments in “longer-lived” capital and businesses that require such investments and in favor of “shorter-lived” capital investments and industries that rely more heavily on these kinds of investments. This is the case even if the write-off period is consistent with the asset’s “useful life.”
Under a system of depreciation, where the business can take the deduction for an asset’s purchase only over a period, the real value of the deduction will actually be less than its full cost. This is because a dollar is worth more to someone now than at any time in the future. And the further into the future a person must wait to receive that dollar, the less it will be worth. This is why people need to be paid interest to be induced to save and the longer their money is committed to those savings, the higher the interest rate has to be. It explains why a 10-year certificate of deposit pays a higher interest rate than a five-year CD.
For example, if a construction company purchases a bulldozer for $100,000 this year, immediate expensing, that is, writing off the $100,000 from this year’s pre-tax income ensures that $100,000 is deducted. If the cost of that investment can only be recovered over, for example, a six-year period, then it will be worth less than the full cost of the investment. The longer the depreciation period, the less the deduction will be worth and the greater the difference between the asset’s full cost and the value of the deduction will be. In a system where the asset costs are depreciated for tax purposes, rather than expensed in the year they are incurred, an incentive is created for substituting, where possible, assets with a shorter depreciation period, i.e., shorter-lived assets, for assets with a longer depreciation period or longer-lived assets.
This would be the case both for choosing between specific types of investments within a company and for making decisions about the kind of businesses to invest in the first place. Because the depreciation system creates a tax bias against assets that are classified as “longer-lived,” it also biases against investment in those industries that use longer-lived assets more intensely. This might include the construction industry and other industries that would involve the use of a good deal of heavy equipment and real estate.
The North Carolina General Assembly can take a bold step by leapfrogging over the federal government. It should adopt a system of complete expensing with no expiration date. This would send a clear message to other states, Washington, and, most importantly, businesses and investors from around the world that North Carolina is serious about truly rewarding capital investment and entrepreneurship.