At a moment when we are seeing clear weaknesses in supply chains and needs for gearing production toward more environmentally friendly approaches, capital investment is critical. Policymakers have an opportunity to change a coming decline in investment incentives by adopting permanent policies to support growth.
Expiring tax policies in major economies could create a setback for business investment in coming years.
When businesses make investments in physical assets, they consider how profitable a new production facility or machine might be. One factor that impacts profitability is the tax treatment of investment costs. If investment costs can be immediately deducted, the business is able to make the investment without worrying about inflation eroding their costs. However, most countries require businesses to deduct costs over time—in some cases decades—which raises the after-tax cost of making an investment by eroding the value of deductions.
The rules that specify how much of an investment can be deducted each year are called depreciation schedules, and the amount available to be deducted is called a capital allowance.
Last week we published a report on capital allowances in developed countries. It showed that on average, the 38 countries in the Organisation for Economic Co-operation and Development (OECD) provide businesses with the ability to deduct 70.7 percent of their investment costs over time. The calculation accounts for the time value of money, which is impacted by inflation.
On average, it means 29.3 percent of investment costs are not deductible in OECD countries.
Some countries have provisions to allow businesses to deduct the full costs of investment, including Chile, Estonia, and Latvia. Other countries, including Canada, the United Kingdom, and the United States, provide full deductions for certain investments in equipment.
Unfortunately, the policies are not all permanent.
As the policies expire, the after-tax cost of investment will rise. In fact, over the course of 2022 through 2026 the amount of investment costs that businesses can deduct is expected to fall from the 2021 level of 70.7 percent to 68.4 percent. When weighting the data by GDP, the decline is from 68.7 percent to 65.1 percent.
In Canada, a policy that provides immediate deductions for investments in equipment will begin phasing out in 2024 until it fully expires after 2027. The policy was first put in place in 2018.
In the United Kingdom, a temporary super-deduction of 130 percent for equipment will expire at the end of March 2023. The corporate tax rate is also scheduled to rise from 19 percent to 25 percent at that time. The super-deduction was just recently put in place in 2021.
In the United States, bonus depreciation, which was adopted in 2017, will begin phasing out in 2023. By 2027, the treatment of business investment will return to a much less generous policy.
While a permanent expansion of capital allowances would support business investment, capital formation, and economic growth over the long term, temporary expansions have much more limited impacts. Businesses may accelerate some investment decisions they had already planned, but that just changes the timing for when investments happen rather than increasing the level of investment overall.
The policies in Canada, the United Kingdom, and the United States are particularly important. In 2019, the three countries accounted for 20 percent of worldwide private investment. If their policies are not geared toward investment, it will put a drag on worldwide investment and economic output.
Rather than adopt temporary policies that phase out and expire, policymakers should focus their efforts on long-term reforms to support investment. In fact, Canada, the U.S., and the UK should aim to permanently provide immediate deductions for investments in machinery and equipment, and for all other capital investments provide adjustments for inflation and the time value of money.