The art of depreciation

Posted: Jun 21, 2001 12:00 AM
In the near future, investors are going to start to hear a great deal more about depreciation. It's a tax deduction businesses get for the wearing out of structures, machinery and equipment, so that they can be replaced when their useful lives are over. It is very likely that the next major piece of tax legislation considered by Congress will substantially alter the treatment of depreciation, with important implications for investors and the economy as a whole. The very notion of depreciation is actually a fairly recent phenomenon. Until the 19th century, it really didn't exist. Accounting concepts did not differentiate between outlays for capital and operating expenses. However, the very large investments that were being made in railroads led managers to realize that they needed to account for depreciation in some way. They recognized that when they built railroad tracks, they were building something that would last a long time, but not forever. No matter how much was spent on repair and maintenance, at some point the rails would have to be replaced. This needed to be accounted for in profit and loss statements, lest profits be overstated, putting excessive pressure on managers to pay out dividends, when they knew that funds needed to be set aside for capital replacement. From this, accountants developed the notion of depreciation. It was a charge against current earnings that did not involve a direct cash outlay, but was designed to account for the declining value of existing capital. In theory, depreciation allowances would equal the cost of replacing locomotives, rails and such when the time came that they could no longer be repaired profitably and had to be replaced altogether. The concept of depreciation, therefore, developed well before there were any tax considerations involved. Its purpose was to give investors an accurate picture of true profit and loss, not distorted by the distinction between outlays for long-term capital and short-term operating expenses. Unfortunately, thinking on the subject was not well advanced when a federal income tax was imposed on corporations in 1909 and on individuals in 1913. The first tax laws allowed a deduction from gross income for depreciation. At this point, a concept that was developed solely to give investors a clearer understanding of the true profitability of their investments had important tax consequences, as well. From the beginning, the Internal Revenue Service has had a strong preference for what accountants call "straight line" depreciation. If a piece of machinery is thought to have a useful life of, say, 10 years, then a business should be allowed to deduct 10 percent of the original purchase price for 10 years. After that, the machine is assumed to be worthless. For years, the IRS has expended enormous resources trying to figure out exactly what is the useful life of various capital assets. It has also waged virtual war with the business community about what is capital, which must be depreciated, and what is an operating expense, which can be deducted all at once. In the "Old Economy" of lathes, drill presses and such, it may have been possible to apply the traditional notion of depreciation as a literal "wearing out" of capital, over and above maintenance. But, increasingly, in the "New Economy" of software and the Internet, the concept is worthless. Software, for example, never "wears out" in any meaningful sense. There is nothing to wear out. It is nothing but a bunch of numbers embedded in a program. It never really wears out the way a piece of machinery does; it just becomes obsolete. This distinction is leading many tax theorists to conclude that the old notion of depreciation as a physical wearing out over time has lost its meaning. Obsolescence, rather than depreciation, is more relevant for judging the decline in value of capital investment. And, as anyone who has bought a computer or software in recent years knows, obsolescence happens very quickly. Yet the tax laws are still based on the old fashioned notion of capital physically wearing out. The result is that investments in such things as computers and software are excessively taxed, because they cannot be depreciated quickly enough to compensate for their obsolescence. In coming months, there is going to be a major effort in Congress, likely supported by the Bush administration, to overhaul depreciation policy. Investments in high-tech equipment, such as computers, will be allowed to be written off immediately, rather than depreciated. This will significantly lower the tax burden on high-tech investment, which will raise labor productivity, increase economic growth and give a big boost to computer and software stocks.