Effectiveness and Economic Impact of Tax Incentives in the SADC ...

5-6 EFFECTIVENESS AND IMPACT OF TAX INCENTIVES IN THE SADC REGION
Capital Recovery Incentives--Accelerated Depreciation and Initial Capital
Allowances
Accelerated depreciation front-loads the capital allowance for tax purposes, relative to the
economic rate of capital consumption. The true pattern and rate of depreciation is not
generally known, so any designated depreciation schedule is somewhat arbitrary. The most
common form is straight-line (SL) depreciation over a plausible number of years for each class
of assets. Hussey and Lubick (1996) propose the declining balance method (DBM) as the
standard in their model tax code, at annual rates ranging from 5−25 percent. 67 A write-off
faster than the DBM can be regarded as an incentive, albeit a moderate one because it affects
only the timing of cost-recovery, not the amount.
Initial capital allowances (ICAs) are special capital write-offs that enhance cost-recovery at the
start of a project. The ICA is a percentage of the asset cost that can be written off in the first
year (or the first few years). Sometimes the initial write-off involves a corresponding
reduction in the basis for depreciation. In other systems the ICA is an extra or additional
allowance, over and above full depreciation of the capital asset. This case is equivalent to a
subsidy on the purchase price of the capital.
The value of an incentive in the form of a capital allowance depends how the exact
specification of the tax provision, other aspects of the tax law, and characteristics of each
investment. For example, this type of benefit has little value to an investment that would
show large tax losses anyway in the early years, unless the losses can be used to offset income
from other related sources. Capital allowances therefore favor projects undertaken by existing
businesses. Nonetheless, generous investment allowances can strongly reduce the METR on
new investments. In particular, an initial allowance of 100 percent—full expensing—can
reduce the METR to zero for an equity-financed investment, and less than zero for a debt-
financed project, if interest payments are deductible. 68
For most capital-recovery incentives the revenue cost is fairly moderate. Under full expensing,
the revenue loss is the tax rate times the difference between the allowable capital cost and the
present discounted value of normal depreciation allowances. For large projects this can
represent a significant amount of tax money, but it is nonetheless a limited amount of
exposure for the Treasury.
Capital recovery incentives are relatively simple to administer. However, serious problems
can arise if companies abuse the incentives through sham sale and re-purchase of assets, or
channeling asset purchases through qualifying companies on behalf of non-qualifying
67 Specifically, they propose annual capital consumption allowances of 5 percent for buildings and structures;
25 percent for automobiles and light trucks, office equipment and computer systems; and 15 percent for all
other tangible property.
68 A negative METR means that the after-tax return is higher than the before-tax return. In the case cited here,
full expensing reduces the METR to zero and the interest deduction provides a further advantage by lowering
the cost of borrowed funds.