Report to The Congress on Depreciation Recovery Periods and Methods Department of the Treasury July 2000 July 282000 The Honorable Bill Archer Chairman Committee on Ways and Means House of Representatives Washington, DC 205 15 Dear Mr. Chairman: Section 2022 of P.L. 105-277, the Tax and Trade Relief Extension Act of 1998 (the 1998 Act), directed the Secretary of the Treasury to conduct a comprehensive study of the recovery periods and depreciation methods under section 168 of the Internal Revenue Code and to provide recommendations for determining those periods in a more rational manner. The 1998 Act directed the Secretary to submit the results of the study and recommendations to the House Committee on Ways and Means and the Senate Finance Committee by March 3 1,200O. Pursuant to that directive, I hereby submit the “Report to the Congress on Depreciation Recovery Periods and Methods.” I am sending a similar letter to Senator William V. Roth, Jr., Chairman of the Committee on Finance, Senator Daniel P. Moynihan, and Representative Charles B. Rangel. Sincerely, Jonathan Talisman Acting Assistant Secretary Tax Policy Encl.osure L July 28,200O The Honorable William V. Roth, Jr. Chairman Committee on Finance United States Senate Washington, DC 205 10 Dear Mr. Chairman: Section 2022 of P.L. 105-277, the Tax and Trade Relief Extension Act of 1998 (the 1998 Act), directed the Secretary of the Treasury to conduct a comprehensive study of the recovery periods and depreciation methods under section 168 of the Internal Revenue Code and to provide recommendations for determining those periods in a more rational manner. The 1998 Act directed the Secretary to submit the results of the study and recommendations to the House Committee on Ways and Means and the Senate Finance Committee by March 3 1,200O. Pursuant to that directive, I hereby submit the “Report to the Congress on Depreciation Recovery Periods and Methods.” I am sending a similar letter to Representative Bill Archer, Chairman of the Committee on Ways and Means, Senator Daniel P. Moynihan, and Representative Charles B. Rangel. Sincerely, Jonathan Talisman Acting Assistant Secretary Tax Policy Enclosure TABLE OF CONTENTS Chapters 1. INTRODUCTION AND SUMMARY ................................................................................... 1 A. Purpose of the Study................................................................................................... 1 B. Solicitation of Public Comments................................................................................ 1 C. Organization of the Report ......................................................................................... 2 D. Principal Issues and Findings Related to the Current Depreciation System .............. 2 E. Policy Options............................................................................................................. 3 2. DEPRECIATION AND INCOME MEASUREMENT.......................................................... 5 A. Introduction ................................................................................................................ 5 B. Depreciation Defined.................................................................................................. 5 C. Depreciation Versus Current Expenses ...................................................................... 6 D. Why Do Capital Assets Depreciate? .......................................................................... 6 E. Inflation, Real Changes in Asset Values, and Depreciation....................................... 7 F. Four Characteristics of Economic Depreciation ......................................................... 8 G. Why Is Depreciation Important? .................................................................................9 H. Cost Recovery for Assets Other than Equipment and Structures................................9 3. CAPITAL COST RECOVERY UNDER CURRENT LAW.................................................11 A. Introduction ...............................................................................................................11 B. Description of Current Law.......................................................................................11 4. EVALUATION OF THE CURRENT COST RECOVERY SYSTEM.................................27 A. Introduction ...............................................................................................................27 B. Income Measurement: General Issues......................................................................27 C. Income Measurement: Empirical Evaluation of Current Law’s Capital Cost Recovery System................................................................................31 D. Rationales for General And Selective Investment Incentives...................................38 5. COMPREHENSIVE REFORM.............................................................................................43 A. Introduction ...............................................................................................................43 B. Switch to Economic Depreciation .............................................................................43 C. Indexing Depreciation for Inflation...........................................................................49 D. Introduce a Mark-to-Market Regime ........................................................................57 E. Conform Tax Depreciation to Financial (Book) Depreciation..................................58 F. Allow Depreciation Based on Taxpayer Facts and Circumstances ...........................59 G. Expensing of Business Investments ..........................................................................60 6. CURRENT ISSUES IN TAX DEPRECIATION ..................................................................63 A. Introduction ...............................................................................................................63 B. The Classification of Depreciable Assets..................................................................63 C. Keeping the System Current......................................................................................90 D. Other Issues ...............................................................................................................95 -i- 7. SUMMARY OF ISSUES IN TAX DEPRECIATION ........................................................101 A. Introduction .............................................................................................................101 B. Economic Depreciation and Alternatives................................................................101 C. A Revised Asset Classification System...................................................................104 D. Create a New Process to Establish and Amend Class Lives ...................................107 E. MACRS Recovery Periods and Methods ................................................................108 F. Treatment of Asset Retirements...............................................................................109 Appendices 1. EVALUATING THE HULTEN-WYKOFF ESTIMATES.................................................111 A. Introduction .............................................................................................................111 B. The Hulten-Wykoff Depreciation Rates..................................................................111 C. The Used-Asset Price Approach to Measuring Economic Depreciation ................111 D. Limitations of the Hulten-Wykoff Study ................................................................113 E. Other Depreciation Studies......................................................................................115 2. EXPERIENCE OF THE DEPRECIATION ANALYSIS DIVISION (DAD).....................119 A. History of DAD.......................................................................................................119 B. Absence of a Used Asset Market.............................................................................120 C. The Problem of Technological Obsolescence .........................................................121 D. Summary of DAD Reports......................................................................................123 References .................................................................................................................................125 -ii- LIST OF TABLES AND CHARTS Table 1 MACRS Investment in 1997...........................................................................................15 2 200-Percent Declining Balance Depreciation with an Optimal Switch to Straight-Line and Half-Year Convention........................................................................17 3 Corporate AMT Adjustments and Preferences ...............................................................19 4 A Comparison of Tax Allowances with Economic Depreciation at Various Inflation Rates .................................................................................................................32 5 Cost of Capital and Marginal Effective Tax Rates under Current Law..........................37 6 Effect of Economic Depreciation on the Cost of Capital and the Marginal Effective Tax Rate...........................................................................................47 7 Effect of Indexing Depreciation on the Cost of Capital at Selected Inflation Rates.......52 8 Present Value of MACRS Depreciation Allowances......................................................82