5263
ANALYSIS OF THE TAX IMPLICATIONS
OF RAPID AMORTIZATION
Environmental Protection Agency
Office of Planning and Evaluation
Economic Analysis Division
April 1977
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ANALYSIS OF THE TAX IMPLICATIONS OF RAPID AMORTIZATION
TAX REFORM ACT OF 1976
Section 2112 of the Tax Reform Act of 1976 (P.L. 94-455), signed
into law October 4, introduces some significant changes affecting tax
treatment of certain pollution control facilities. Prior to 1976, a
firm investing in pollution control equipment for an existing plant
could elect one of two options: rapid amortization o£ normal deprecia- .
tion practice, called here standard amortization. If rapid amortization
was chosen then the first 15 years of depreciable life could be amortized
-.over a 5 year period. However, by so doing the firm had to forego the
investment tax credit.
The provisions of 26 U.S.C. 169 which authorized the rapid amorti-
zation of pollution control equipment expired as to facilities installed
after December 31, 1975. But the new legislation restored rapid
amortization as a permanent provision for facilities installed after
December 31, 1975 in plants in operation before January 1, 1976.
Further, for those facilities installed after December 31, 1976, the
new law permits the concurrent use of rapid amortization and the invest-
ment tax credit; however, if the tax credit is used in conjunction with
rapid amortization only one-half of the currently allowable investment
credit may be claimed.
In restoring rapid amortization, Congress left the rules governing
eligibility for certification essentially unchanged, since process
changes to accommodate cleaner production methods remain ineligible.!/
However, the Code has been modified to allow the certification of
processes that prevent the creation of contaminants (e.g., fuel
desulfurization equipment if the fuel is burned on-site) when installed
in an existing plant.
These revisions were precipitated by the fact that, after the rein-
statement of the investment tax credit in 1971, 26 USC 169 was used
only infrequently because the standard investment tax credit plus
standard amortization practice provided greater tax benefits. The
concurrent use of the investment tax credit and rapid amortization
now authorized appears to make the rapid amortization option more
attractive to the investor in pollution control equipment.
I/Section 2112 excludes from eligibility equipment which increases
output or capacity by more than 5 percent, extends the useful life,
or reduces the total operating cost of the plant. Further, rapid
amortization can only be applied to facilities with a depreciable
life greater than 5 years. For a more precise definition of facilities
which may be certified for rapid amortization the reader should refer
to 40 CFR, Part 20, Certification of Facilities.
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ANALYSIS OF THE TAX BENEFITS UNDER THE NEW LAW
The present value of the flow of tax benefits resulting from
a capital investment is determined by a basic relationship between
four principal variables: (1) the discount rate, 2/ (2) the asset
life, (3) the method of depreciation, and (4) the investment tax
credit. The first two variables have the largest effect on the
value of the flow of tax benefits. And, within certain distinct
limits, it can be said that higher discount rates tend to make
rapid amortization more attractive to the investor, as do relatively
long asset lives. By contrast, the choice of depreciation method
has relatively little effect on the value of the tax benefits.
In fact, the sum-of-years digits method is always preferred over
other depreciation formulas if asset life is more than 5 to 6
years. 3/ Finally, the size of the investment tax credit has
a measurable impact on the desirability of rapid amortization.
If the firm is eligible for a relatively large credit in relation
to the investment, the attractiveness of rapid amortization will
be diminished.
Past changes in the investment tax credit have also significantly
altered the benefits provided by rapid amortization. When 25 USC 169
was originally enacted in 1969, the investment tax credit was repealed.
Later, in 19?I, Congress reinstated the 7 percent credit and many firms
found that rapid amortization no longer provided tax advantages,
particularly those installing equipment with short to moderately long
asset lives. The subsequent increase in the investment tax credit to
10 percent under the Tax Reduction Act of 1975 eliminated the benefits
of rapid amortization for almost all investors.
The following analysis of the tax implications of the new law was
performed based upon some key simplifying assumptions. Hence, the con-
clusions, while providing a satisfactory order of magnitude assessment
for the general case, may be imprecise when applied to specific situations.
First, a corporate tax rate of 48 percent and a state income tax rate of
4.8 percent were used, the latter representing a typical rate for most states.
2/The discount rate is rate used to determine the value today of a
future stream of cash flows.
3/The magnitude of tax benefit provided by rapid amortization over standard
amortization practice is influenced by the method of calculating depreciation
selected by the investor, an effect separate from the one attributable to the
decision to use rapid amortization. This analysis was performed using the two
accelerated depreciation methods utilized by most investors: sum-of-years
digits and double declining balance. If standard amortization practice is
used, it was found that for equipment with depreciable lives more than 5 to 6
years, sum-of-years digits provided the greatest tax advantages. And, if
rapid amortization were selected double declining balance was never uniquely
preferable to sum-of-years digits (for that portion of depreciable life which
exceeds 15 years).
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In practice, the marginal rats iray vary from the assumed total of
52.8 percent. 4/ However, this will not effect the decision to select
rapid amortization; it will only change the present value of tax benefits.
Second, the actual size of the investment tax credit can vary significantly.
This analysis is based on a graduated credit, with the full credit applicable
only when the useful equipment life is greater than or equal to 7 years.
If the credit realized by the firm is less than assumed here then, other
things being equal, rapid amortization will be attractive for equipment
with slightly shorter life than this analysis would indicate.
Benefits Provided by Rapid Amortization
In the range of discount rates which are applicable to most firms
(greater than 8 percent) we find that rapid amortization under the new
law is attractive for pollution control equipment with depreciable lives
longer than 11 to 12 years. For equipment with shorter lives, standard
amortization yields greater tax savings. Exhibit I depicts this relationship.
It is interesting to note that under the new law the point of
indifference between rapid amortization and standard amortization practice
does not change significantly for discount rates roughly above 14 percent.
This is due to the fact that at high discount rates the immediate cash
flow emanating from the investment tax credit is so highly valued that
future benefits resulting from rapid amortization are outweighed.
The magnitude of the potential tax benefits provided by the new
tax law over standard amortization practice varies as a function of
discount rate and depreciable equipment life. For illustrative
purposes, Exhibit II plots the tax benefits against depreciable
life based on a discount rate of 12 percent. Assuming a depreciable
equipment life of 14 years the rapid amortization provision yields an
additional tax•advantage of about 5 percent in real terms over standard
depreciation methods (a present value of tax benefits of $431 per $1,000
investment as opposed to $409 per $1,000 investment).
Benefits Provided by the New Law Over the Previous Law
The new tax law also provides significant tax benefits beyond
those allowed under the old provisions of 26 USC 169. These increased
advantages result from the fact that the new tax law permits investors
to take one-half of the investment tax credit in addition to rapid
amortization, whereas prior to the new law, firms were not allowed
4/The investment decision should be analyzed as a commitment of funds
at the margin. Hence, the appropriate corporate tax rate for this
analysis is the marginal rate and not the effective rate. Although
effective corporate tax rates are substantially lower than 52,8 percent,
we believe that this figure is representative of the marginal rate.
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to take advantage of both. As Exhibit I indicates, the point where
rapid amortization becomes attractive now has shifted to the left
(forward). At a discount rate of 10 percent, rapid amortization
under the new law provides tax advantages for equipment with a
depreciable life of 12 years. By contrast, during 1975, the former
26 USC 169 would only have been beneficial for pollution control
equipment with lives longer than 18 years.
An additional insight can be gained^by adding broader perspective
to the analysis. When 26 USC 169 was originally enact3d in 1969,
it provided attractive benefits to almost all investors. However,
the reinstatement of a 7 percent investment tax credit in 1971 had
the effect of making standard amortization practice attractive
to firms installing equipment of short to moderate life - that is
less than 14 to 15 years. Increasing the investment tax credit to
10 percent shifted the point of indifference by 3 to 4 years, further
reducing taxpayer interest in rapid amortization. Hence, a key benefit
of the Tax Reform Act of 1976 is to make rapid amortization desirable
for shorter-lived equipment once again, while increasing the present
value of tax benefits for users of rapid amortization.
»
The actual size of the advantage created by the new law over
former 26 USC 169 will change depending on depreciable life and
discount rate. But based on an investment in pollution control
equipment having a depreciable life of 20 years, the new law could
provide an additional tax advantage of 10 percent over what was
previously allowed under Section 169 during 1975, assuming a
discount rate of 12 percent (Exhibit III).
The remaining question is how much pollution control equipment
will have depreciable lives greater than 11 to 12 years. Unfortunately,
there is no straightforward answer. Since much pollution control
equipment will be depreciated under the same guidelines as the productive
equipment to which it is attached, the same kind of pollution control
facility could be depreciated at different rates depending on the
industry.
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EXHIBIT II
TAX REFORM ACT OF 1976
PRESENT VALUE OF TAX BENEFITS
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10 14 20
ASSET LIFE-YEARS
NOTES:
1. FOR EACH SET OF CURVES (RAPID AND STANDARD AMORTIZATION), THE
HIGHER VALUES RESULT FROM THE USE OF SUM-OF-YEARS DIGITS AND
LOWER VALUES FROM THE DOUBLE DECLINING BALANCE METHOD.
I PRESENT VALUE OF TAX BENEFITS WERE CALCULATED USING A DISCOUNT
RATE OF 12%.
3. THE INITIAL DIP IN THE CURVES IS CAUSED BY THE FACT THAT
EQUIPMENT WITH AN ASStT LIFE OF LESS THAN 7 YEARS IS
NOT ELIGIBLE FOR THE FULL INVESTMENT TAX CREDIT.
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EXHIBIT III
COMPARISON OF BENEFITS
TAX REFORM ACT OF 1976 AND FORMER 26 USC159
DOLLARS
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1376 ACT
FORMER
26 USC 169
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ASSET LIFE-YEARS
! RAPID
AMORTIZATION
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AMORTIZATION
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NOTE:
PRESENT VALUES WERE CALCULATED USING SUM-OF-YEARS
DEPRECIATION METHOD. A DISCOUNT RATE OF 12%, AND A
1054 IN VESTMENT TAX CREDIT.
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