The whole notion of “profit” is fundamental to the capitalist system, because profits and the effort to achieve them are what drives work, investment and, ultimately, economic growth and well-being. At its simplest level, profit arises when someone can sell something for more than what it cost them to produce it. Thus, the question of what is a “cost” is inextricably intertwined with that of profit.
Although labor is the largest component of the cost of producing almost everything, it is not the only factor. There is the cost of raw materials, machinery and equipment, and interest on money borrowed for working capital, among other things.
Obviously, farmers cannot grow crops unless they first buy land, tractors, fertilizer and seed. These factors of production must be deducted from the gross sales of harvested grains or other produce in order to determine profit and loss. So, too, with all other business endeavors.
There is an important anomaly in this seemingly straightforward calculation, however, and that has to do with capital. Unlike outlays for labor or raw materials, expenditures on plant and equipment are not deducted directly from sales to determine profit. Instead of being written off immediately, capital must be depreciated over time. Only a percentage of the cost of equipment may be deducted in a given year, rather than the whole cost, as is the case with other production expenses.
The rationale for this is that labor and raw materials are used up in the production process immediately, while capital equipment may be used again in future years. But the outlay for capital equipment is made all at once by producers. The IRS may assume that the cost is spread out over several years, but the seller of the equipment is not going to wait until a business has sales before getting paid. Thus, while the return to capital may come over time, the cost of acquiring it comes upfront.
For many years, the IRS took the view that it was up to the firm to decide how to allocate the cost of capital in calculating profit and loss. But over time, law and practice have put all equipment into rigid deprecation categories, where they are written off between three and 20 years, depending on the asset.
The problem is that $1 written off in year 20 is worth a lot less than $1 deducted in year one. This is true even in the absence of inflation. To see why this is true, just ask yourself whether you would be willing to accept the same pay now for work today or get paid three to 20 years in the future? Obviously not. Money in the future is clearly worth less than money today. Interest is the price society charges for the time value of money.
However, the time value of money does not apply to depreciation. Firms do not get interest on unused depreciation, even though it is worth less each year that goes by. At a 10 percent interest rate, $1 of depreciation in year 20 is only worth about 16 cents.
The result of this depreciation policy is to bias investment against long-lived assets. It also biases investment against equipment that becomes obsolete, and hence worthless, faster than depreciation schedules allow it to be written off. The result is less investment than the economy needs, and misallocation of the investment it gets.
The way around this, in the view of many economists, is to allow all capital equipment to be deducted immediately, known as expensing, the same way labor and raw materials are treated now. This would eliminate the tax bias against capital and certain types of capital relative to others. These economists take the view that until a business has recovered all its production costs, including outlays for capital, it really cannot say it has earned a profit.
Yesterday two congressmen, Richard Neal, Massachusetts Democrat and Phil English, Pennsylvania Republican, introduced legislation to shorten depreciation schedules for new investments in technology equipment. Called the “High Productivity Investment Act,” this bill would allow high-tech equipment, such as computers and software, to be written off immediately, rather than depreciated. Although it applies only to high-tech equipment, because such equipment now accounts for more than half of total private fixed investment, it is a significant movement toward expensing all capital equipment.
It is too soon to say if the administration will endorse the Neal-English bill, but George W. Bush’s chief economic adviser, Lawrence Lindsey, recently said, “The more and more I look, I think depreciation schedules are too long.” With bipartisan congressional support, administration backing and an investment-led economic slowdown, this legislation could move quickly.