Understanding Depreciation and Taxes for Entrepreneurs – Pizza Shop Example

Note: If you want to be an entrepreneur in the USA, you need to know this stuff “cold” and be able to have a sound and reasonable opinion on it.

In recent weeks the US House of Representatives are working on a bill that will permanently extend what is called “bonus depreciation,” or 50 percent expensing. 50 percent expensing was one of the over 50 “extender” tax provisions that expired at the end of last year.

This means that 50 percent expensing allows businesses to immediately write off, or expense, 50 percent of an investment in new equipment or short-lived structures. It does not apply to commercial or residential buildings or factories.

Washington DC-based Tax Foundation writes that permanently extending this provision would boost GDP by over 1 percent, wages be 1 percent, and create 212,000 new jobs due to its effects on the cost of capital. It would also increase federal tax revenues by $23 billion after taking into account the increases wages and incomes caused by making bonus expensing permanent.

While these things are certainly good, calling the provision a bonus is a little misleading. It is a bonus compared to current law. Businesses can write off more of their investment sooner and the economy as a whole will see more investment and growth compared to current law; however, bonus depreciation more accurately represents only a partial move to a more neutral tax base. An ideal, neutral tax code (a tax code that treats saving and investment equally) would allow businesses 100 percent expensing on all capital investments rather than 50 percent expensing on some investments.

Under current law, when a business makes a capital investment (purchases a machine, building, or office equipment), it must write off, or deduct these costs from taxable income in stages over several years or decades.

For example, suppose a pizza shop purchases an oven for $100. Under the current cost recovery system, an oven is deducted in stages over 7 years according to a depreciation schedule. Each year’s deduction is a percent of the total initial cost (table, below). Over the expected life of the investment, each year’s deductions add up to the initial nominal cost of $100 when the oven was purchased.

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SOURCE: TaxFoundation.org