Depreciation Allowance

A depreciation allowance is the amount of depreciation that a firm may deduct from its taxable income in a given period, under the tax rules that apply to the treatment of capital assets. The allowance reduces taxable profit and thereby reduces the tax liability of the firm.

Purpose

The purpose of the depreciation allowance is to recognise that capital assets are used up in production and that the cost of acquiring them should be deducted from income over their useful life. In the absence of such an allowance, the tax base would overstate income, because it would not account for the consumption of capital.

The allowance also serves an economic purpose, by aligning the tax treatment of different assets and by affecting the incentive to invest. The generosity of depreciation allowances influences the cost of capital, and therefore the level and the composition of investment.

Methods

Depreciation allowances are calculated according to rules that specify the cost that may be deducted and the timing of the deductions. The simplest method is straight-line depreciation, in which the cost is spread evenly over the life of the asset. Accelerated depreciation allows larger deductions in the early years.

The rules may also provide for immediate expensing, in which the full cost is deducted in the year of acquisition. Expensing is the most generous treatment, since it allows the full cost to be deducted immediately, and it is equivalent to a cash-flow tax on the investment.

The rules specify the asset lives and the depreciation rates that apply to different categories of assets. These rates are set by tax authorities and reflect estimates of the useful lives of the assets.

Economic Effects

The generosity of depreciation allowances affects the cost of capital and therefore the incentive to invest. More generous allowances reduce the after-tax cost of capital, raising investment. The effect is larger for assets that benefit disproportionately from the allowances.

The design of the allowances affects the allocation of investment across assets and across sectors. When the allowances are more generous for some assets than for others, investment is tilted towards those assets. This can distort the allocation of capital and reduce the efficiency of investment.

The allowances also affect the timing of investment, since firms may accelerate investment to take advantage of generous allowances before they expire. This can create cycles in investment and in tax revenues.

International Aspects

In an open economy, the treatment of depreciation affects the attractiveness of the country as a location for investment. Countries compete for investment, and the tax treatment of capital is one dimension of that competition. Differences in the treatment of depreciation across countries can influence the location of investment and the structure of multinational firms.

The treatment of depreciation in the tax system also interacts with the treatment of foreign-source income and with the rules for the allocation of profits among jurisdictions. These interactions are relevant to the debate about international tax competition and about the reform of corporate taxation.

Accelerated Depreciation as Stimulus

Accelerated depreciation is often used as a stimulus measure during downturns. By allowing firms to deduct the cost of investment more rapidly, it reduces the after-tax cost of capital and encourages investment. The measure is temporary, and the incentive to invest before it expires can bring forward investment that would otherwise have occurred.

The design of accelerated depreciation affects its effectiveness. A provision that allows immediate expensing of investment is the most generous, since it eliminates the tax on the normal return to capital. A provision that shortens asset lives is less generous but still reduces the cost of capital.

The evidence on the effectiveness of accelerated depreciation as a stimulus is mixed. Studies suggest that it can raise investment in the short run, but that the effect is smaller than the theoretical maximum, because firms discount the future benefit and because the provision may mainly shift the timing of investment rather than increase its level.

Interaction with the Tax Rate

The effect of depreciation allowances depends on the corporate tax rate. A given allowance is worth more when the tax rate is higher, since the deduction reduces a larger tax liability. Changes in the tax rate and in the allowances therefore interact, and a reduction in the rate reduces the value of the allowances.

This interaction matters for the design of tax reform. A reform that lowers the statutory rate and broadens the base, by reducing allowances, changes the effective tax burden in a way that depends on the composition of investment. The distributional effects across assets and sectors are therefore an important consideration.

The international dimension of this interaction is also significant. In a world of mobile capital, the effective tax rate on investment influences the location decisions of multinational firms, and the treatment of depreciation is one of the elements that determines the effective rate.

Accounting and Economic Depreciation

The depreciation allowance in the tax system is based on accounting conventions rather than on economic depreciation. Accounting depreciation follows rules that specify the asset life and the pattern of deductions, while economic depreciation is the actual decline in the value of the asset over time.

The two can diverge substantially. An asset may lose value more quickly or more slowly than the accounting rules assume, and the pattern of decline may differ from the straight-line or accelerated patterns used for tax purposes. The divergence affects the measurement of taxable income and the incentives that the tax system creates.

The relationship between accounting and economic depreciation is relevant to the measurement of the tax burden on capital and to the analysis of the neutrality of the tax system. A tax system that taxes the normal return to capital creates a distortion, and the treatment of depreciation is one of the factors that determine whether the return is taxed.

Summary

Depreciation allowances are a central element of the taxation of capital, and their design affects the cost of capital, the allocation of investment, and the international competitiveness of the tax system. Their analysis requires attention to the interaction with the tax rate and to the difference between accounting and economic depreciation.

See also

• Tax Base
• Cost Accounting
• Investment Bank