Few issues in public finance generate as much controversy among policy-makers and the business community as the question of the “appropriate” taxation of corporate income. The vigor and the persistence of the controversy arise from two sources: 1) There is disagreement regarding the normative objectives of corporate tax policy, i.e., what objective should tax policy be designed to achieve?; and 2) Even among those discussants who agree as to the propriety of tax policy objectives, there is divergence of opinion as to the practical means of achieving those objectives.

Most economists agree that in any mature industrialized economy, such as that of the United States, a main engine of economic growth is investment by businesses in plant and equipment. One of the important characteristics of those kinds of capital goods is that they depreciate over time. It logically follows that any corporate tax policy which discourages investment in depreciable plant and equipment will, ipso facto, impede economic growth. 

What is not widely recognized is that the tax treatment of allowable depreciation has an especially inhibiting effect on economic growth when businesses expect a period of sustained inflation during the life of the depreciable assets.

A fundamental proposition in corporate finance states that the incentive (or disincentive) to invest in a capital good is determined by the firm’s expectation of the risk-adjusted discounted value of the after-tax net income ascribed to the investment. A tax policy that has the effect of diminishing the discounted value of after-tax net income generated by the asset diminishes the incentive to acquire that asset. This is an area where current methods of depreciation allowed by the IRS Code inhibit investment in long-lived capital goods. 

As a general proposition, it is well understood that the purpose of the depreciation charge allowed by the taxing authority is to write off the cost of a depreciable asset that is used up in producing the income of the business. Even if wear, tear and obsolescence of equipment could be measured accurately, the funds accumulated in a depreciation reserve based on the asset’s historical cost would not be adequate to replace the value of the capital stock during periods of rising prices.

In a period of sustained inflation the cost of replacing expensive capital equipment will be greater, sometimes much greater, than the historical cost of acquiring it. The result of depreciation based on the asset’s historical cost is an overstatement of profits and, thus, some tax on the capital itself. 

That consequence cannot help but affect incentives for investment in long-lived capital goods in a period of inflation. If the taxing authority requires depreciation charges to be based on the fixed cost of the capital good acquisition, the marginal incentive to undertake new investment in capital goods will diminish if the firm expects inflation to increase in the foreseeable future.  

A tax policy designed to avoid the biasing effect of depreciation based on historical costs would allow firms to calculate depreciation charges after adjusting the historical costs for the increase(s) in the average of all prices. The result of the policy is that gains and losses on depreciable assets exceeding those that reflect changes in the general price level are included in income as they accrue. 

An innovative idea of adjusting the system of tax depreciation for inflation is to allow an immediate deduction for the present value of the future economic depreciation that firms could claim if there were zero inflation. No adjustment for inflation would ever be needed because the depreciation charge would be taken in the same year in which the asset was purchased. 

The result of this approach is consistent with the result for inflation-adjusted historical cost depreciation because gains from changes in the relative prices of depreciable assets would be included in income.

Mantell, Ph.D., professor of Finance and Economics at Pace University’s Lubin School of Business in New York, is author of the new study, “Inflation Expectations, Business Taxation and the Incentive to Invest in Depreciable Capital Goods.”