RDP 9012: Some Calculations on Inflation and Corporate Taxation in Australia 2. Depreciation

Depreciation arises from the fact that fixed assets used in income production, such as plant, equipment and buildings, commonly last for longer than one accounting period, but not forever. Accounting principles dictate that income and expenses be matched year by year. This requires that the expense (depreciation) associated with the use of capital be assessed yearly, regardless of actual capital expenditure that year. Because it is not directly observable, depreciation presents a fundamental measurement problem. In the Australian National Accounts, aggregate national depreciation is estimated indirectly using data on annual capital expenditure and assumptions about asset lifetimes and decay rates.^[2]

At the company level, true economic depreciation may differ widely for a given asset depending on its actual circumstances, but tax laws require standardised rules for calculating depreciation allowances, for obvious reasons. As in most other countries, the Australian tax system allows companies to deduct a certain portion of the original purchase price of the asset each year, that portion based on a statutory effective lifetime for the particular type of asset and a depreciation formula. Companies may elect to use one of two formulas in calculating the annual depreciation allowance. The “straight-line” or “prime-cost” method provides a series of equal annual deductions. Thus for an asset of purchase price K and lifetime L, L annual deductions of K/L are allowed. The alternative “diminishing-balance” formula applies a rate equal to 150% of the straight-line rate (1.5/L) to the net value of the asset each year; any remaining portion of the original price of the asset can be deducted in the last year of the asset's statutory lifetime.

Under these original-cost depreciation rules, the real value of tax allowances falls below actual depreciation in inflationary periods. This occurs because inflation increases the replacement cost of new plant, equipment and buildings, but depreciation allowances are fixed (or declining) in nominal terms, and so decline in real terms over time. Put more simply, under original-cost accounting, the real value of the stream of tax allowances is much less than the original cost of the asset. As a result, and most disturbing to businesses, profits measured at original cost will be overstated, thus increasing the income tax liability.

The effect of inflation on depreciation allowances can be demonstrated with a simple formula. Assuming a straight-line pattern for tax purposes and for actual economic depreciation, the real value of tax allowances A, for an asset of purchase price K with a statutory lifetime of L years under inflation of π, can be expressed by the following formula:

It is quite easy to see that if inflation is greater than zero, A will be less than K; furthermore, A will decrease as the inflation rate and the life of the asset increase.^[3] In reality, this calculation is not so simple when factors such as accelerated depreciation, investment allowances and formulas other than the straight-line method are considered.

Table 1 illustrates how different depreciation rules affect the real value of depreciation allowances for assets of different lifetimes and under different rates of inflation. The four plant and equipment cases reflect actual rules that have existed in Australia and are shown in roughly chronological order.

The first case (1) of simple straight-line depreciation, which prevailed for most of the 1960s and 1970s, relies on the simple formula shown above. (Depreciation was not allowed on most buildings in this period.)

“Accelerated” depreciation, which allowed plant and equipment to be amortised over a shorter than effective lifetime, was introduced in 1980. An additional acceleration provision became available for assets ordered after 19 July, 1982. The so-called “5/3” system, the second case (2) shown, allowed equipment with a statutory lifetime longer than five years to be amortised at 20% per year, and those with shorter lifetimes were depreciated over three years or less.

In case 3, an 18% investment allowance available between 1981 and 1988 is added to the 5/3 allowances. Some form of investment tax allowance for new plant and equipment had been in effect since the early 1960s, and intermittently in the 1970s. This allowance, intended as an investment incentive, was very similar to the depreciation allowance, in that it provided an additional, immediate write-off of a fraction of plant and equipment expenditure.

Case 4 shows the real value of depreciation allowances for new plant and equipment in the current (post-1988) Australian system. Tax reforms in 1985 and 1988 terminated most of the investment allowance and accelerated depreciation provisions. For plant and equipment installed after 26 May, 1988, depreciation allowances must be calculated according to standard effective lifetimes (either straight-line or 150% diminishing-balance method) with a 20% “loading”^[4] on these rates. (Note that plant and equipment installed before that date continue to be eligible for the 5/3 treatment and the investment allowance.)

Only one case is shown for non-residential buildings; this is the law effective for buildings constructed between July 1982 and August 1984 and since September 1987. Depreciation is allowed at a rate of 2.5% of original construction costs over 40 years. As Table 1 indicates, this rule implies that the real value of allowances per dollar invested will be equal for all buildings for a given inflation rate. Buildings that last less than 40 years, however, cannot claim the full value of these allowances except in the case of demolition or destruction, when a balancing deduction equal to unclaimed depreciation is allowed. (Residential properties, not shown here, are eligible for annual deductions of 2.5% if owned for investment purposes and constructed after 1987.)

These simple calculations highlight the difference in inflationary bias to depreciation allowances across assets of different expected lifetimes. A comparison of case (4) with case (3) indicates that the current depreciation rules provide a considerably smaller total write-off of plant and equipment than under the system that existed until 1988, for longer-lived assets in particular. For example, under current law, the real value of depreciation allowances for equipment with a 20-year lifetime and inflation of 10% per year amounts to only one-half of the actual cost of the asset.

Some other features of the current Australian depreciation provisions highlight additional uneven tax treatment of different assets. Research and development expenditures can be amortised at 150% of cost over three years, while patents and copyrights must be amortised over their “useful” life. Depreciation of automobiles is restricted. Other less tangible capital expenditures, such as staff training and advertising, can be written off immediately, as can expenditures on certain favoured activities, notably mining exploration and production of Australian films.

Aggregate data for the non-financial corporate sector provide another view of the adequacy of depreciation allowances over the last two decades. Specifically, a comparison of total tax allowances claimed on company tax returns with an estimate of actual economic depreciation at replacement cost indicates the extent to which depreciation allowances were or were not adequate.

Data on corporate tax allowances are readily available from aggregate taxation statistics. The data used here for actual depreciation at replacement and original cost are calculated by the ABS, but should be treated with caution as they are quite sensitive to the assumptions used to construct them.

According to the ABS data, economic depreciation of equipment and buildings at replacement cost has significantly exceeded tax allowances for the last 20 years. In 1987–88, for example, replacement-cost depreciation of $15 billion was almost $5 billion greater than tax allowances. This discrepancy can be divided into two components: the excess of replacement-cost over original-cost depreciation; and the difference between original-cost depreciation and tax allowances.

The relative importance of these two components is illustrated in Table 2, over the period 1966–1988. Column 1 shows the ratio of original-cost to replacement-cost depreciation estimates; this represents the cumulative effect of inflation on fixed-capital values. In the 1960s, this ratio was close to one, as replacement costs did not differ markedly from book values. As inflation accelerated in the 1970s, an increasing shortfall emerged in depreciation calculated at original prices. By the late 1970s, inflation had pushed the replacement cost of existing capital to nearly 200% of its original cost. As inflation abated somewhat in the mid-1980s, this ratio recovered slightly, but because the effects of inflation are cumulative over the lifetime of an asset, the effects of late 1970s inflation on much of the capital stock are still being felt in increased replacement-cost depreciation.

The ratio of tax allowances to original-cost depreciation is shown in Column 2. Given that tax allowances are based on original prices, one would expect this difference to be negligible. In fact, the discrepancy was often quite large, but there are a number of plausible explanations for this finding. First, changes in the tax rules clearly contributed to changes in this ratio. Accelerated depreciation, in particular, boosted total depreciation allowances claimed on company tax returns. The tax allowance/original-cost depreciation ratio increased steadily after the introduction of accelerated depreciation in the early 1980s. By 1987–88, tax allowances significantly exceeded original-cost depreciation.

Second, prior to 1982, buildings were not covered by depreciation rules. As a result, actual depreciation would tend to be increasingly understated by tax allowances as buildings increased as a fraction of the capital stock. Third, the data are affected by changes in the composition of the capital stock which may have reduced its average life. Finally, inaccuracies in the ABS estimates may also be a factor, considering the inevitably inexact nature of their construction.^[5]

The ratio of tax depreciation allowances to replacement-cost depreciation is shown in column 3 (= column 1 × column 2). The inflationary effect on replacement costs (column 1) typically accounts for all of the shortfall in tax allowances. In column 4, the ratio of both depreciation and investment allowances to replacement-cost depreciation provides an estimate of the extent to which the tax system overall allowed adequate deductions for capital consumption.

Total deductions fell from nearly 100% of estimated real economic depreciation in the 1960s to less than 70% in 1987–88. Note that the ratios in columns 3 and 4 can be thought of as aggregations across assets (of different types, lifetimes and ages) of the real value calculations shown in Table 1. However, direct comparisons would be misleading. In 1987–88, for example, Table 2 shows aggregate depreciation allowances well below replacement-cost depreciation, despite the quite generous tax treatment of plant and equipment in that year. Note, however, that the capital stock in 1987–88 contained many assets purchased prior to 1982 which were not eligible for the 5/3 provision, and which would have been subject to the high inflation of the late 1970s. The figures in Table 1 also indicate that as the acceleration provisions are phased out over the next few years, the ratio of tax allowances to actual depreciation can be expected to decline, particularly if inflation remains fairly high.

Footnotes

Prior to 1986, the ABS used depreciation allowances reported on tax returns in the National Accounts, but now estimate actual economic depreciation to obtain a capital consumption measure consistent with national accounting principles. [2]

To be consistent with replacement-cost valuation, the inflation rate used should be specific to the type of asset considered. Also note that this calculation ignores the real financing costs (the time value of money) that would be included in a standard present-value calculation. It is assumed that these costs are not relevant to an assessment of the real income tax base. [3]

Plant and equipment purchased after May 1988 can be written off at a rate 20 per cent faster than implied by the assessed asset life. [4]

One source of error is the industry coverage of the ABS estimates and the taxation data. It is difficult to disagggregate the taxation data into the private, non-financial, corporate trading enterprise sector used in the National Accounts. Leasing activities by financial enterprises, for example, could introduce inconsistencies between the two sources. [5]