Republicans will soon release an economic package that addresses a number of significant tax changes that have already or are scheduled to increase taxes on American businesses. Reporting indicates that a central component of the pro-growth package is the extension of full business expensing for R&D, equipment, and machinery.

In a recent Cato brief, I explain why maintaining and expanding full expensing is critical for American workers, especially when economic growth is weak, and inflation remains high.

What is Full Expensing?

Businesses of all sizes make capital investments in tools, buildings, and research, allowing workers to produce new goods and services and earn higher incomes. However, the normal income tax rules for deducting investments from revenues increase effective tax rates, making new investments more expensive.

Recovering the cost of an investment over multiple years decreases the after-tax return on the investment because the real value of the deduction decreases each year due to inflation and the opportunity cost of passed time. For example, if a farmer buys a new combine and can only use one-fifth of what he paid to offset revenues this year, he will have artificially high profits and thus pay higher taxes. The higher taxes will cut into his ability to make other investments in his farm, reducing his productivity and business growth.

The 2017 Tax Cuts and Jobs Act temporarily fixed this problem by allowing businesses to fully deduct the cost of new investments in the year they are made, called full expensing or 100 percent bonus depreciation. Beginning in 2022, companies started amortizing research expenses over five years, and beginning in 2023, equipment and other short-lived investments lose 20 percent of their expensing deduction each year through 2026.

Forcing taxpayers to carry investment deductions into future years—as many as 39 years for many buildings—means that the write-off’s value is eroded by inflation and time. I estimate that the loss of full expensing and five-year amortization of research expenses will deny businesses as much as 28 percent of the real value of their investment deductions. Losing more than a quarter of the real cost of investment tax deductions will make new investments that primarily benefit American workers more costly.

The Tax Code Increases Inflation Costs

A largely forgotten cost of high inflation in the 1970s was the resulting decrease in business investment due partly to the tax code’s treatment of depreciation and not allowing full expensing.

In 1979, Martin Feldstein and Lawrence Summers estimated that inflation increased the total effective tax rate on capital income by 23 percentage points, from 43 percent to 66 percent. They concluded that inflation raises effective tax rates because, without expensing, the delayed write-offs overstate taxable profits and reduce after-tax returns.

The high costs of inflation helped motivate cost recovery reforms that shortened asset lives in the 1980s. Facing high inflation again, the U.S. tax code is set to begin denying businesses the full investment deduction. By requiring long and variable depreciation deductions, the tax code will again accelerate the adverse effects of inflation on investment and economic growth. The Republican tax package would keep the worst of these effects from coming to pass.

An Economic Package for American Workers

The Republican economic tax package will likely be referred to as a package of business tax breaks, insinuating that expensing and other reforms leave families and workers behind. This misleading narrative forgets that most American workers are employed by businesses that must make new investments in technologies and tools to compete with similar producers worldwide. The American worker can’t compete for higher wages and new opportunities without new business investment.

A robust economic literature shows that businesses invest more when after-tax investment returns are higher, and the resulting larger capital stock (the accumulation of investments) increases labor demand and raises wages. The full Cato brief summarizes a more specific body of research showing that past expensing policies in the U.S. and around the world boosted investment and increased employment.

Allowing full first-year expensing to phase out will depress new investment and exacerbate the already heightened risk of recession. Congress should permanently restore full expensing for R&D and short-lived assets. Congress should also expand expensing to longer-lived structures by allowing the same immediate deduction or implementing a “neutral cost-recovery system,” which provides a similar economic benefit as expensing by enabling businesses to index their write-offs for inflation.

Congress has many important deadlines looming as major components of the 2017 tax cuts begin to expire; none is more immediately important than making full expensing permanent.