HENDERSON: The U.S. Tax Rate on Capital is Rising

By David R. Henderson, Hoover Institution at Stanford University

One of the best features of the 2017 Tax Cuts and Jobs Act was the introduction of “expensing” for capital investments. Translation: Corporations that made capital investments could deduct (i.e., expense) those costs from taxable income in the year they made those expenditures. The only condition for expensing was that the asset had to have a “life” of 20 years or less and had to be purchased after September 27, 2017, but before January 1, 2023.
 
Unfortunately, starting this year, the 2017 law also phases out the ability to expense. The phaseout will be complete on January 1, 2027.  As expensing phases out, the effective tax rate on capital will rise substantially. That, in turn, will lead to less investment. With less investment, the capital stock won’t grow as quickly as it would have. That means that worker productivity won’t grow as much, which means that real wages won’t grow as much.
 
The advantage of being able to expense capital is that the corporation gets the full deduction. What were the rules before the 2017 tax cut? Most capital investments had to be “depreciated,” that is, deducted in stages over a certain number of years that was related to the life of the asset.
 
The idea of depreciating over multiple years might sound reasonable, but two facts make it not so reasonable. First, even with zero inflation, a dollar a few years from now is worth less than a dollar today. If you don't believe that, please, even if inflation falls to zero, lend me $1,000 for 10 years at a zero interest rate.
 
Second, any inflation, but especially the kind of high inflation we are likely to have for the next few years, makes the future deductions for capital purchased today even less valuable. For both reasons, the effective tax rate on capital will be higher than otherwise.
 
In a June 2023 study, economist Adam N. Michel, director of tax policy studies at the Cato Institute, points out that a “delayed deduction is a partially denied deduction that artificially increases taxable profits and decreases investment returns.” Michel has also done the math. He points out, for example, that if an asset with a life of 10 years is depreciated over 10 years, then, even with zero inflation and assuming a real interest rate of 3 percent, the present value of the deduction is 91 percent of the amount invested. If the inflation rate for the next 10 years were 5 percent, admittedly a likely worst case, the present value of the deduction would be only 78 percent of the amount invested.
 
A 2020 study by the Tax Foundation finds that making the 2017 expensing reforms permanent would increase the capital stock by 2.2 percent, real wages by 0.8 percent, and gross domestic product by 0.9 percent. That sounds like a good idea.

Today's TaxByte was written by David R. Henderson, a research fellow with the Hoover Institution at Stanford University.