The concept of depreciation arises because physical capital wears out. Each year, a business, in effect, consumes a portion of its capital in producing that year's income. Thus, to match properly a business' costs and income over time, and therefore have a correct figure for profits, it must count as a current cost the value of the capital it consumes each year. As a cost, depreciation lowers profits and, therefore, tax liabilities.
The Accelerated Cost Recovery System (ACRS) was proposed and passed in 1981 to offset the way in which inflation, under the then-current rules, was causing businesses to pay taxes on phantom profits. Prior to ACRS, businesses had to take these charges against income over a period of years roughly equal to the actual expected life of each type of asset involved. The amount of depreciation claimed was tied to the original cost of the asset, though a variety of "accelerated" methods were permitted to allow businesses to take more of the total write-off during the early part of the asset's useful life.
But depreciation also is supposed to provide a business with enough cash flow to allow it to replace assets as they wear out. In a period of very high inflation, it did not work that way. Because depreciation was based on the original cost of the asset, whose replacement cost had soared, businesses were not able to deduct the true cost of the capital they were consuming year by year. That meant their true profits were overstated, and so were their tax liabilities.
ACRS was intended to correct all this. The link between an asset's expected useful life and the period of write-off was dropped. On average, the allowed write-offs were set to compensate for an annual inflation of about 8 percent in the cost of business equipment and structures.
The 1981 law set a write-off period of three years for vehicles and some types of equipment, five years for most equipment, 10 years for some kinds of utility property and 15 years for most real estate. The real estate period was lengthened to 18 years in 1984.
The Treasury Department's tax simplification proposal would replace ACRS and the investment tax credit with write-off periods more closely approximating the actual life of the investment. The value of the asset would be indexed to the inflation rate. Treasury officials say they are willing to change the specifics of their proposal, with one calling it a "first cut" at depreciation reform.
The principal Democratic tax-simplification plan, sponsored by Sen. Bill Bradley (D-N.J.) and Rep. Richard Gephardt (D-Mo.), also would do away with the investment tax credit and lengthen depreciation periods to up to 40 years, but without indexation for inflation. Acceleration would be permitted, but not to the extent now allowed.
A third measure, sponsored by Rep. Jack Kemp (R-N.Y.) and Sen. Bob Kasten (R-Wis.), would replace ACRS and the tax credit with what Kemp calls the economic equivalent of a one-year write-off. The write-off periods would be as long as 25 years, but firms would be able to deduct more than the actual purchase price over time to make up for inflation.