Senator Max Baucus (D-Mont.) today released his cost recovery tax reform draft.  In short, it would create a regime where business investments are never fully accounted for and capital investment takes a massive hit.  When capital investment suffers, so does everything else in an economy: wage growth, job creation, and growing nest eggs.

The conservative answer on cost recovery questions is very simple: all business inputs (including business investment purchases) should be eligible for immediate first-year expensing.  It should not matter whether a business buys a pencil, pays a wage, acquires a building, or purchases a computer.  All of those represent cash flow expenditures of the business, and should be deducted out of the business’ tax base the year they are spent.  This sane and common sense tax treatment is common to all major tax reform plans, including but not limited to: the flat tax, the FAIR Tax, the USA Tax, the Bradford-x Tax, the progressive consumption tax, and all kinds of value-added taxes (VATs).  This basic consumption-base, business cash-flow arrangement is the norm in academic tax literature.  Bizarre alternatives are only found in Washington, DC political back rooms.

Before getting into the many problems with the Baucus draft, there are three areas where it gets it right:

Small business expensing.  The draft makes “Section 179” permanent at $1 million of assets invested (with a phaseout between $2 million and $3 million of assets deployed).  That’s a very good change to the tax code that’s long overdue.

Treasury updates of cost recovery speed.  The Treasury Department is given power to update cost recovery periods to account for changing economic conditions.  This is a power they had under the 1986 Tax Reform Act, but Congress stripped them of it 2 years later.  This would allow a more pro-growth administration to speed up cost recovery, for example.

Deduction of inventory costs.  For taxpayers using the cash method of accounting, inventory costs would be deductible.  This is a big step in the right direction of a business cash flow model (unfortunately overwhelmed by what is done on depreciation and amortization).

Below are the major problems with the Baucus cost recovery draft:

Depreciation that never ends.  Emulating the tax treatment of business assets seen in European tax plans (which would explain how Senator Baucus got the idea from Senator John Kerry, a known Europhile), the Baucus draft would end the current depreciation rules for business tangible property.

Under current law, when a business purchases an asset, it usually must be slowly-deducted (“depreciated”) over several years.  The draft replaces this with a new four-tiered system of “asset pooling.”  Under asset pooling, businesses keep track of different classes of assets on their books.  The pool is increased by new asset purchases, and decreased by assets taken out of service and the deduction regime described below.  The asset pools can claim a deduction every year that ranges from 38 percent down to 5 percent of the value of the pool.

To use a common business purchase, computers are in “Pool 1,” which allows for a 38 percent deduction of the pool’s value every year.  Each year, a company can claim a deduction equal to 38 percent of their cost basis in all the computers they own (less any prior year deductions they have already claimed).

Hopefully, the problem here is obvious.  The company can only deduct 38 percent of each new computer’s purchase in the first year, and only 38 percent of the old computers’ remaining value (which declines every year, but never to zero).  The older computers’ cost is never recovered in full before obsolescence assuming the company continues to make capital investments.   It’s a dog chasing its tail.


A company purchases a computer in Year A for $1000.  This is a “Pool 1” asset, so a deduction is taken at a 0.38 rate.  This $380 deduction reduces Pool 1’s value to $620.

In Year B, the company purchases another $1000 computer.  This is added to the pool’s value, which increases to $1620.  A 0.38 rate deduction is claimed on this, or $616.  This reduces the pool’s value to $1004.

In Year C, the company purchases yet another $1000 computer.  This is added to the pool’s value, which increases to $2004.  A 0.38 rate deduction is claimed on this, or $762.  This reduces the pool’s value to $1242.

The real estate that time forgot.  There’s one area where the Baucus draft retains depreciation–real estate investments.  Under current law, real estate is depreciated over 330 months (27.5 years) for residential real estate, 468 months (39 years) for non-residential real estate, and 480 months (40 years) for overseas property and property subject to the corporate AMT.

The Baucus draft replaces all of these with a new and arbitrary 516 month (43 year) property depreciation for real estate.  This means that real estate purchased for business use faces a ridiculous amount of time before the cost is ever recovered—and thanks to inflation, the real cost is not anywhere near recovered.

Lifetime cap on business use of personal vehicle.  The draft imposes a $45,000 lifetime cap on depreciation deductions for business use of a personal vehicle.  This is a big tax increase on small business owners who use their cars a lot for business (think realtors, salesmen and even clergy).

“Mad Men haircut.”  The draft imposes an arbitrary restriction on advertising expenses.  Half of an annual expense can be deducted in the year paid, with the remaining half ratably amortized over 60 months (5 years).  For companies that advertise regularly, this means they effectively can never catch up.

Why advertising?  Why not business travel?  Why not supplies?  Picking on one ordinary and necessary business expense is arbitrary and a clear case of the tax code picking winners and losers.

Higher taxes on research and experimentation, and on energy.  The draft requires research and experimentation expenses, intangible drilling costs, and other energy extraction costs to be amortized over 60 months (5 years).  This would have a devastating impact on America’s energy production, which in turn will make energy more expensive for working families.

Other intangibles are forced to be amortized over 240 months (20 years), up from today’s 180 months (15 years).

LIFO repeal.  Under the draft, the “last in, first out” method of accounting for inventory is repealed.  Going forward, all inventory must be done in a “first in, first out” (FIFO) manner.  However, companies will have to pay taxes on their “LIFO inventory” (the aggregate net annual advantage in claiming LIFO instead of FIFO for the life of the business).  Businesses have eight years to pay this tax.

This is very unfair.  Some companies are decades old, and have been claiming LIFO that whole time (in accordance with tax law).  To retroactively repeal that legal tax treatment now is unfair, and is a retroactive tax increase.  The LIFO tax does not reflect actual income today, and is nothing more than a pure power grab. 

Green energy tax credits given a pass.  In the “Unaddressed Issues and Requests for Comment” section, the committee staff say that they haven’t made a decision on what to do with green energy tax credits set to expire at the end of 2013.  This just shows how backwards the committee’s work has been.  They are considering potentially making these ridiculous tax credits permanent, while arbitrarily increasing taxes on productive energy companies and manufacturers.