Academic journal article Review of Business & Finance Studies

Use of Depreciation as a Tax Policy Device to Control Inflation

Academic journal article Review of Business & Finance Studies

Use of Depreciation as a Tax Policy Device to Control Inflation

Article excerpt


The United States Internal Revenue Code contains many provisions for credits, deductions, and other tax advantages intended to achieve various economic goals considered desirable by the U.S. Congress. The depreciation allowance is one such deduction, frequently used to compensate taxpayers for the effects of inflation and to promote economic growth. The government uses it extensively as a part of tax-incentive programs based on the theory that tax benefits stemming from depreciation reduce the cost of doing business, and thus stimulate capital formation by allowing tax-free recovery of capital by businesses. Capital formation increases productive capacity by providing resources to those companies that can use them to expand business operations. The expected increase in productivity would result in more goods and services in the economy, which in turn would act to keep prices down and help suppress inflation. Congress has realized the importance of capital formation to control inflation and thus, over time, has extended significant tax advantages to businesses through depreciation. This paper examines the effectiveness of depreciation as a means of stimulating capital formation and of controlling inflation.

JEL: H2, H4, H8

KEYWORDS: Depreciation, Tax Policy Device, Inflation, U.S. Congress, Capital Formation, Internal Revenue Code


Depreciation is a deduction from the taxable income of a business for exhaustion, wear and tear, and obsolescence of property used in the course of that entity's income-producing activities. Due to these factors, physical plants, machinery, equipment and other types of physical assets lose their value with the passage of time. Consequently, the Internal Revenue Code allows a deduction for the depreciation of physical assets used in a business (I.R.C. § 167 and 168, 1986). The amount of depreciation allowed for tax purposes is a product of the acquisition cost of the assets, their estimated useful life, and (if required) their salvage value. The annual depreciation deduction is determined by allocating the acquisition cost of the assets over their service life by means of a systematic allocation method. One may assume that depreciation deduction is intended to provide funds to replace such property at the end of its useful life (United States v. Ludey, 1925). However, as a practical matter, depreciation is not an objectively determinable figure; it is an estimate based upon individual judgments or market data. The amount allowed for depreciation by the Code may not be equal to the actual decrease in an asset's market value (Portland General Elec. Co. v. U.S., 1969). In reality, depreciation is determined legislatively based on the policies adopted by the Congress, which has used depreciation frequently, in various forms, over a span of decades to stimulate investment and economic growth. It is not, therefore, possible to estimate the true rate of depreciation of every asset in the actual economy (Congressional Budget Office, 1985).

Depreciation is one of the most important factors considered in business and regulatory accounting in order to determine taxable business income, and to measure the growth of the economy. Accurate measures of income are necessary in order for government to accurately gauge the success of economic and financial programs, including the control of inflation. Several studies have indicated that Congress has not always been successful in its attempts to promote investment and to control inflation through depreciation allowance (Barry P. Bosworth, 1985). Rather, frequent changes in depreciation methods have widened the gap between tax depreciation and economic depreciation, or the real loss in the value of physical assets. The original intention of Congress was to allow taxpayers a reasonable allowance for depreciation. Historically, an asset's depreciable life was set equal to its estimated economic life.

However, the Internal Revenue Code, 1954 Section 167(b) provides that, for assets purchased after 1953, the term "reasonable allowance" shall include an allowance computed under certain specified methods. …

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