I

n 2013 the state of North Carolina dramatically

restructured its tax code. In large part, the changes
were positive and made a great deal of sense from
an economics perspective. They moved the tax system
in a direction that is already having, and will continue to
have, a positive impact on efficient resource allocation
and economic growth. This was done by lowering and
flattening the income tax rate for all taxpayers and
by dramatically reducing the negative effects of the
corporate income tax through almost halving the rate and
eliminating most of its exemptions. The personal income
tax rate structure has gone from having 3 tiers topping
out at 7.75% to, after a second round of reductions this
past legislative session, a flat rate of 5.49% in 2017.
Furthermore the corporate rate has gone from 6.9 percent
to 4 percent starting in January 2016 and could fall to 3
percent in 2017 if certain revenue targets are met. These
are big steps toward what should be the ultimate goal of
eliminating the corporate tax entirely. All these changes
have created a more efficient and fair tax code.

Going forward the primary task of

tax reform should be to eliminate
the bias that exists against savings,
investment, and entrepreneurship.
In legislative sessions to come, it will be important
to focus on getting the income tax base right. Going
forward the primary task of tax reform should be to
eliminate the bias that exists against savings, investment,
and entrepreneurship. As has been explained by this
author in several previous John Locke Foundation
publications, North Carolinas tax code penalizes
savings and investment by double taxing their returns
specifically interest, dividends, and capital gains. These
biases can only be eliminated by removing savings and
investment from the tax base,1 or by eliminating the
returns to saving; for example abolishing the taxation
of capital gains.2
In addition to these changes, the state should reexamine
the way it treats business investments on capital
equipment and real property. While for most of us this
is a rather obscure and arcane topic, which we would
rather leave to tax accountants, the way investment in
plant, equipment, and property is treated by the tax code
can be quite important to businesses who are deciding
what to invest in or whether to invest at all.
Spotlight #473: More To Do On Tax Reform

Depreciation, Expensing, and the Federal Tax Code

A principle of taxation that is universally recognized in

both the federal and state tax codes is that, for businesses,
all expenses that are meant to produce goods and services
for sale, i.e. generate income, should be deductible. At
the present time, the rules for doing this are established
through the federal tax code and generally replicated by
North Carolina law, with some exceptions.
The approach taken by the federal government and
adopted by most states, including NC, is to allow
companies to deduct investment in company assets like
land, office equipment, machinery, buildings, etc. over a
specified period of time and at a specified rate, depending
on the classification of the investment in question. This
approach is called depreciation or amortization and is
based on the presumed durability of the investment. The
more durable or longer lived the asset, the longer the
tax deduction period is. So, for example, an investment in
land for an apartment complex would be written off of a
businesss taxes over a period of 27.5 years while the cost
of a computer is written off over a 5-year period (see table
pg.3).
While this approach, i.e., writing off an investment over a
period that coincides with its useful life, would seem to
make sense, from an economics perspective it has several
serious defects. First, and probably most obvious, is that
the useful life of a piece of equipment has little to do
with the assets physical characteristics. It is instead a
function of alternative technology and market conditions.
For example, a computer that is purchased today will
have a tax write off period of 5 years, but in fact, it is
not unimaginable that in one year new technology could
come along that would render that computer obsolete in
terms of keeping the businesses operations efficient and
competitive. So while in a physical sense it might last
for 5 or more years, in an economic sense its useful life
may be much shorter. During a period of quickly changing
technology this is likely to be true for all kinds of assets.
But beyond this, using a system of depreciation for writing
off asset costs creates an even deeper and more systemic
problem that distorts investment decisions. It creates a
bias against making investments in longer lived capital
and businesses that require such investments and in favor
of shorter lived capital investments and industries that
rely more heavily on these kinds of investments. This is

the case even if the write-off period is consistent with the benefits can be compared directly to the current system
assets true economic life span.
of depreciation.

How a system of depreciation biases against Under a system of depreciation, where the business can
take the deduction for an assets purchase only over
longer lasting capital
As already noted, it is a generally agreed upon principle
of taxation that the cost of any income generating asset
should be deductible to the business that incurs it. To
a business the full cost of any asset, which is what
should be deducted from the companys income, is
the price paid for the asset at the time it is purchased.
So in order to realize the full cost in the tax deduction
it should be written off of the businesss taxes in the
year it is incurred regardless of how long lived the
asset is. This is what is known as expensing and its

a period of time, the real value of the deduction will

actually be less than its full cost. This is because a dollar
is worth more to someone now than at any time in the
future. And the further into the future a person must
wait to receive a dollar, the less that dollar will be worth.
The evidence is that people need to be paid interest in
order to be induced to save, and they are willing to
incur interest costs in order to have access to a dollar
now rather than wait until some future point when they
have earned that dollar or saved it from past earnings.
A simple example is the savings vehicle known as a

MACRS GDS property classes table

Type
Property Class
Description
Special handling devices for food and beverage manufacture.
Special tools for the manufacture of finished plastic products, fabricated
3-year property
metal products, and motor vehicles
Property with ADR class life of 4 years or less
Information Systems; Computers / Peripherals
Aircraft and parts (of non-air-transport companies)
Computers
5-year property
Petroleum drilling equipment
Property with ADR class life of more than 4 years and less than 10 years
Certain geothermal, solar, and wind energy properties.
All other property not assigned to another class
Personal class
7-year property
Office furniture, fixtures, and equipment
Property with ADR class life of more than 10 years and less than 16 years
Assets used in petroleum refining and certain food products
10-year property Vessels and water transportation equipment
Property with ADR class life of 16 years or more and less than 20 years
Telephone distribution plants
15-year property Municipal sewage treatment plants
Property with ADR class life of 20 years or more and less than 25 years
Municipal sewers
20-year property
Property with ADR class life of 25 years or more
27.5-year property Residential rental property (does not include hotels and motels)
Real property
39-year property Non-residential real property
MACRS is the Modified Accelerated Cost Recovery System. For further discussion of the technicalities of the federal system, see
en.wikipedia.org/wiki/MACRS
Spotlight #473: More To Do On Tax Reform

certificate of deposit (CD). A CD that is issued for a

longer period of time typically pays a higher interest
rate than one that is issued for a shorter period. This is
because the saver/lender requires a higher interest rate
to put aside use of his money for a longer period and the
bank/barrower is willing to pay a higher interest rate in
order to defer having to pay it back.

Conclusion: A move to expensing

As noted, expensing would eliminate this bias by treating

all asset investments equally. It would also insure that
the tax value of any such investment is equal to the full
cost of making the investment. Ultimately it would put
North Carolina in a good position for attracting new
investment by lowering the cost for almost all capital
If a construction company purchases a bulldozer for investment.
$100,000 this year, immediate expensing, writing off
Lastly, it should be pointed out that unlike other possible
the $100,000 from this years pre-tax income, insures
decoupling from the federal tax code, this would not
that the full cost, $100,000, is what is being deducted.
make tax filing for businesses at the state level any
If that investment can only be recovered over, for
more complicated than it is now. While businesses, at
example, a 6-year period, then it will be worth less
the state level, would no longer be invoking the same
than the full cost of the investment. The longer the
depreciation schedules used in filing their federal taxes,
depreciation period the less the deduction will be
there would not be a new set of depreciation schedules
worth and the greater the difference between the assets
to follow. They instead would simply deduct the full
full cost and the value of the deduction. In a system
amount of their asset purchases during the year from
such as we currently have, where the asset costs are
their pretax incomes in one lump sum. It would involve
depreciated for tax purposes rather than expensed in
no additional calculations. In other words, from the
the year they are incurred, an incentive will be created
perspective of businesses filing in North Carolina, there
for substituting, where possible, shorter lived assets for
would be no downside to making this change.
longer lived assets.
In examining future changes to North Carolinas tax
This would be the case both for choosing between
code these are the kinds of reforms that should be
specific types of investments within a company and for
considered. The goal should be what economists call
making decisions about the kind of businesses to invest
tax neutrality, which implies treating all business and
in. The current depreciation system creates a tax system
consumption activities equally. Along with eliminating
bias against assets that are classified as longer lived
or reducing the states capital gains tax3, restructuring
under NC and US tax code and investment generally
the way business deductions are taken along the lines
in those industries that use such assets more intensely.
suggested here should also be a high priority.
This might include the construction industry and
investments that would involve the use of a good deal
of real estate (see table below).
Roy Cordato is Vice President for Research and
The goal of any tax reform needs to be non-interference
in business decisions. To the extent possible such
decisions should be made based on market conditions of
supply and demand and not be guided in any direction
by the tax code.

Resident Scholar at the John Locke Foundation.

Endnotes
1. Roy Cordato The Consumed Income Tax: Efficient
and Fair Tax Reform for North Carolina The John
Locke Foundation Spotlight, April 3rd, 2012. Found at
johnlocke.org/research/show/spotlights/271.
2. Roy
Cordato
North
Carolinas
Capital
Gains
Tax: Its Time to Consider a Change
John Locke
Foundation Spotlight, September 15, 2014. Found at
johnlocke.org/research/show/spotlights/311
3. Ibid.

Spotlight #473: More To Do On Tax Reform

Spotlight #473: More To Do On Tax Reform