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6 INVESTMENT ALLOCATION AND GROWTH 

UNDER THE TAX REFORM ACT OF 1986 

Don Fullerton, Yolanda K. Henderson. and James Mackie 

I. INTRODUCTION 

Investment incentives and economic efficiency have been important issues in 

the debate preceding passage of the Tax Reform Act of 1986. The final version 

of tax reform changes the taxation of capital, and hence investment incentives, in several important ways. Cost recovery allowances are tightened as a 

result of longer lives for depreciation and repeal of the investment tax 

credit. At the same time, however, the corporate statutory rate has fallen 

from 46 percent to 34 percent. In addition, tax reform lowers individual tax 

rates on interest, dividends, and noncorporate income, but raises the rate on 

capital gains. 

The paper by Fullerton, Gillette, and Mackie ( 1987, this volume) analyzes 

the effect of tax reform on investment incentives. Their cost of capital 

analysis suggests that overall investment and savings incentives might be 

reduced by tax reform. Thus tax reform could reduce capital formation and 

growth. At the same time, however, they point out that tax reform will 

improve the allocation of a given stock of capital. Thus, the net welfare 

effect of the capital taxation provisions of the Tax Reform Act of 1986 is 

ambiguous. It depends on the sensitivity of total investment to the overall 

net rate of return, as· compared to the sensitivity of capital allocation to 

differential returns across assets. Analysis of the cost of capital by itself 

can only point out incentives for behavioral changes. It cannot assess the 

magnitudes of such changes. 

Fullerton and Henderson ( 1986a) have developed a general equilibrium model 

that can analyze the effects of changes in investment incentives on savings, 

investment, allocation, output, and welfare. Their model incorporates the 

cost of capital model of Fullerton and Henderson ( 1984) into the general 

equilibrium model developed by Fullerton. Shoven. and Whalley ( 1978. 1983). 

The authors thank Donna Harrell, Geraldine Huggins. Barbara Parsons. and Dolores Perticari for 

assistance in the preparation of tire manuscript and rabl~s. 

173 
114 Don Fullerton/Yolanda K. Henderson/James Mackie 

As a consequence, the Fullerton-Henderson general equilibrium model facilitates analysis of the tax-induced welfare effects of changes in interasset, 

intersectoral, and intertemporal distortions of the type associated with tax 

reform. 

FuUerton and Henderson (1986b) have used their disaggregate general 

equilibrium model to evaluate the capital taxation provisions of the Treasury 

proposal of 1984 and the President's proposal of 1985. We use this model to 

analyze the Tax Reform Act of 1986. We find that tax reform improves welfare 

under a wide variety of assumptions concerning the relative importance of 

interasset, intersectoral, and intertemporal effects. Thus, the reforminduced reduction of interasset distortions generally offsets the effects of 

increases in intersectoral and intertemporal distortions. Only when saving is 

very sensitive to the net rate of return, or when investment allocation is 

very insensitive to differential asset taxation, does tax reform fail to 

stimulate improvements in output and welfare. 

The paper is organized as follows. In section l we measure the impact of 

tax reform on investment incentives using a cost of capital model. In section 

II we describe the general equilibrium model of Fullerton and Henderson in 

more detail. Section Ill presents our simulation results. We conclude in 

section IV with a summary of our findings. 

II. THE EFFECf OF TAX LAW ON INCENTIVES 

The Tax Reform Act of 1986 incorporates pervasive changes to the tax code, 

but this paper concentrates on provisions that would affect taxes on income 

from capital. These include the reduction of the top corporate rate from 46 

to 34 percent and the reduction of personal rates to two brackets of 15 and 28 

percent

1

, as well as revised capital cost recovery provisions, including the 

repeal of the investment tax credit. 

This section measures the investment incentives arising from these changes 

and compares them to incentives under prior law. The model of investment 

incentives is based on Fullerton and Henderson ( 1984), as updated in Henderson 

(1986) and Fullerton (1987). In order to use these costs of capital as inputs 

for the general equilibrium model, we omit the further disaggregation of 

capital stocks and other refinements of Fullerton, Gillette, and Mackie (1987. 

this volume). 

A. A Model of Investment Incentives 

We measure investment incentives using the cost of capital approach of Hall 

and Jorgensen ( J 967). Consider a perfectly competitive corporate finn 

contemplating a new investment in a world with no uncertainty. Assume the 

firm has sufficient tax liability to take associated credits and deductions, 

and that it does not resell the asset. 

2 Investment receives a tax credit at 

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Investment Allocation and Growth Under Tax Refonn 175 

rate k. The rental return increases at the constant inflation rate n, and 

decreases because of constant exponential depreciation of the asset at rate o . Local property tax at rate w is paid on the asset's value at any point in 

time, and the return net of property tax is subject to the corporate income 

tax at statutory rate u. These net returns are discounted at the firm's 

nominal after-tax discount rate r. The present value of depreciation allowances per dollar of marginal investment is z. 

3 In equilibrium, the real 

social return in the corporate sector, gross of tax but net of depreciation, c b . p , may e wntten as: 

c r-n +o 

p = l-u (1-k-uz) + w- o . (6.1) 

In calculations below, common values are used for r, n, and u, but each asset 

has a specific value for o, k, z, and w. Similar expressions may be derived 

for the real social return in the noncorporate business sector and owneroccupied housing sector. See Fullerton, Gillette, and Mackie (1987, this 

4 volume). 

To compute the discount rate, we assume that individuals hold debt and 

equity issued by all three sectors, and that they arbitrage away any differences in net rates of retum.

5 Suppose i is the nominal interest rate and 'Td 

is the debtholder's personal marginal tax rate. Then, under our arbitrage 

assumption, all assets must provide the real net return that individuals could 

earn on their debt holdings: 

(6.2) 

Here, s represents the net-of-all-tax return in the corporate, noncorporate, 

and owner-occupied housing sectors. In our computations, we start with an 

assumption on s and use equation (6.2) to calculate i for all sectors as 

(s + n )/(1-'Td ). 

The computation of discount rates th(!n involves examining separately each 

sector and source of finance-debt, retained earnings, and new share issuesassuming that the financial decision is exogenous. We focus our discussion on 

the corporate sector, but similar expressions are derived for the non corporate 

business and owner-occupied housing sectors. The corporation's discount rate 

for debt is simply the rate of return net of corporate income tax: r = i(l-u). 

For retained earnings, the individual's nominal net return must match i(J -'Td ). 

The investment earns a nominal net-of-corporate-tax return rand the resulting 

share appreciation is taxed at the accrued personal capital gains rate -r . r• 

The return r must be such that r( 1-'T ) = i( 1-'Td). The solution for r re 

provides the requisite discount rate. Finally, new shares provide a return 

net of corporate taxes that can be paid as dividends and taxed at personal 

rate 'T05 , so r(I -'T08 ) = i(l-'Td). The corporation's single discount rate is a 
176 Don Fullerton/Yolanda K. Henderson/James Mackie 

weighted average of these three discount rates: 

[ cd . l 1(1-u) + c [i(l--rd) l + c [i(l--rd) l re (l-'T ) ne (l-'T ) r• , na 

(6.3) 

where cd, cr , and c are the proportions of new investment fmanced by debt, e Dll 6 

retained earnings, and new shares, respectively. 

Investment incentives are properly measured by the marginal product of 

capital, p, but we present many of our results in terms of marginal effective 

total tax rates. These tax rates (t) are the difference between the pre- and 

post-tax rates of return, as a proportion of the pre-tax rate of return. 

Because s is the return net of all taxes, this effective rate reflects the 

combined impact of corporate taxes, property taxes, and .personal taxes. It 

shows the portion of capital costs attributable to taxes. The reason for 

looking at effective tax rates is that they are easily interpreted. For 

example, the effective rate can be compared with the statutory corporate rate, 

or with the zero rate that would apply in the case of a consumption tax. With 

s constant throughout the economy, t varies with p in such a way that assets, 

industries, or sectors with higher effective tax rates also face higher 

required pre-tax rates of return for investment. 

B. The Two Tax Regimes 

The above framework is useful to sort out the net impact of statutory tax 

rates, cost recovery provisions, and other rules affecting interest, dividends, and capital gains. This section proceeds to discuss values for the 

parameters 11ecessary to implement that framework, for prior law and for the 

Tax Reform Act of 1986. 

1 . Statutory tax rates 

For prior law, we use the top federal statutory rate of .46 for marginal 

corporate income. The weighted average of states' top-bracket rates has been 

estimated to be .0655 by King and Fullerton (1984, p. 204). Accounting for 

the deductibility of state taxes at the federal level, the appropriate value 

for u is .46+ .0655(1-.46), which equals 49.5 percent. Tax reform sets a top 

federal rate of . 34 and maintains the deductibility of state corporate taxes. 

For this reform, u is thus 38.3 percent. 

We also require marginal tax rates at the personal level. To measure 

corporate investment incentives. we need marginal rates on dividend income 

(-rna) and capital gains (-r r.). For noncorporate business. we require a 

marginal rate on entrepreneurial income ( "l'" c: ). which enters the noncorporate 

cost of capital in a manner analogous to the effect of u on the corporate cost 

of capital. Similarly, we require a rate for interest and property tax 

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Investment Allocation and Growth Under Tax Reform 177 

deductions of home-owners (-rh) in order to measure incentives for investment 

in owner-occupied housing. Finally. to include the effect of debt finance, we 

need a marginal tax rate for interest income (-rd). 

The marginal investment under consideration is an equiproportionate 

increase in all capital stocks, with an equiproportionate increase in the 

holdings of all investors. Additional debt and interest income, for example, 

would be distributed among debtholders in proportion to their current debt and 

interest income. The appropriate marginal tax rate is thus the average of all 

debtholders' marginal rates, weighted by their interest income. We include 

both federal and state taxes. Furthermore, these rates must reflect the 

proportions of income received directly by households and the proportions 

received indirectly through institutions such as nonprofit organizations and 

life insurance companies. 

For households, federal tax rates were calculated by James Cilke, using the 

Treasury Individual Tax Model. 8 The computed rate for housing interest 

deductions under prior law is 20.9 percent. The rate for interest recipients 

(25.5 percent) and rate for dividend recipients (32.9 percent) indicate that 

they are on average in higher brackets than homeowners. The 41.0 percent 

capital gains rate reflects the full taxation of realized gains, and the 25.0 

percent noncorporate rate reflects the low brackets of many proprietors and 

partners with losses for tax purposes. All of these personal tax rates would 

be reduced by tax reform. The newly calculated marginal rates are: housing 

deductions, 17.5 percent; interest received, 21.6 percent; dividends, 25. 8 

percent; capital gains, 26.7 percent; and noncorporate income, 21.0 percent. 

In order to include state income taxes, 5 percentage points are added to 

each of these federal rates.

9 This percentage reflects the weighted average 

of the different states' rates, and the deductibility of state taxes at the 

federal level for those who itemize. 

The personal rate on interest is then adjusted to account for the taxation 

of banks, as described in King and Fullerton (1984, pages 223-226). The 

resulting rate for households must then be averaged with a zero rate for the 

interest income of nonprofit institutions, and another rate for the interest 

income of life insurance companies .

1 0 The final estimate for -r d, as shown in 

Table 6.1, is 21.9 percent for prior law and 19.4 percent for tax reform. 

Table 6.1 Tax Rate Paramete.rs 

Type of Income 

Interest Received 

Dividends Received 

Capital Gains 

Noncorporate Income 

Housing Deductions 

Prior Law 

.219 

.285 

.074 

.300 

.259 

Tax Reform Act of 1986 

. 194 

.232 

. 125 

.260 

.225 
178 Don Fullerton/Yolanda K. Henderson/James Mackie 

The household rate on dividends is similarly raised to account for state 

taxes and reduced to account for the dividends received by tax-exempt institutions and insurance companies.11 The resulting value for -r is .285 under n• 

current law and .232 under tax reform. The noncorporate rate is raised by 

state taxes, but not reduced by any holdings of institutions. It is .300 and 

. 260 under prior law and tax reform, respectively. 

Under prior law, only 40 percent of realized long term capital gains were 

subject to federal income taxation. Adding 5 percent to account for state 

taxes, and adjusting for exclusion brings the rate down to 18.4 percent. The 

advantage of deferral cuts the effective rate of tax approximately by half.12 

Taking into account insurance companies (taxed at a 28 percent rate) and tax 

exempts yields an effective rate on accrued capital gains of 7.4 percent. Tax 

reform eliminates the 60 percent exclusion on long term capital gains. Thus, 

we do not reduce the 26.7 percent rate to account for special treatment of 

capital gains income. However, we do account for state taxes, tax exempts, 

insurance companies, and deferral. Under tax reform, our overall effective 

rate on accrued capital gains is 12.5 percent. 

The prior law weighted-average rate for mortgage interest deductions ('t'h) 

is raised to .259 to account for state taxes. Tax reform lowers this rate to 

.225. In measuring incentives to invest in owner-occupied housing, we recognize that only a fraction of homeowners take advantage of the deductibility of 

property taxes by itemizing their deductions. The Treasury Individual Tax 

model indicates that only 48 percent of household real property taxes were 

deducted by itemizers (>. = .48). Tax reform would reduce this fraction to 4 1 

percent. 

2. Capital cost recovery 

Potential for nonneutralities arises because different assets depreciate at 

many different rates, while tax codes tend to simplify by grouping assets into 

a few categories for depreciation allowances. In order to capture these 

nonneutralities, it is important to include many diverse assets in the model. 

Table 6.2 lists the 35 depreciable assets used in this study, including 20 

kinds of equipment and 15 types of structures. The economic depreciation 

rates 6 are estimated by Hulten and Wykoff ( 1981) and shown in the first 

column of Table 6.2. These range from a high of .333 for autos to a low of 

.015 for residential buildings. We also include inventories and land in our 

study. These are assumed not to depreciate, and they do not receive any 

depreciation allowances. 

· The second column of Table 6.2 shows the recovery periods available under 

the Accelerated Cost Recovery System (ACRS) of prior law. Autos are depreciated over 3 years, other equipment over 5 years, public utility structures 

over 10 or 15 years, and other structures over 19 years. Allowances over 

these lifetimes can be read from tables in the law. In effect, equipment and 

public utilities receive allowances based on 150 percent of declining balance 

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I Investment Allocation and Growth Under Tax Refonn 179 

Table 6.2 Tax Parameters for Each Asset 

I Economic Recovery Period Prior Law 

Depreciation Prior Law Tax Reform Investment 

I Rate• (ACRS) Act of 1986 Tax Credit 

1 Furniture and Fixtures .110 5 7 .10 

I 2 Fabricated Metal Products .092 5 7 .10 

3 Engines and Turbines .079 5 7 .10 

4 Tractors .163 5 5 .10 

5 Agricultural Machinery .097 5 7 .10 

I 6 Construction Machinery .172 5 7 .10 

7 Mining and Oil Field Machinery . 165 5 5 .10 

8 Metalworking Machinery .123 5 7 .10 

I 9 Special Industry Machinery .103 5 7 .10 

I 0 General Industrial Equipment .123 5 7 .10 

1 1 Office and Computing Machinery .273 5 7 .10 

I 

12 Service Industry Machinery .165 5 7 .10 

13 Electrical Machinery .118 5 7 .10 

14 Trucks, Buses. and Trailers .254 5 5 .10 

15 Autos .333 3 5 .06 

I 16 Aircraft .183 5 5 .10 

17 Ships and Boats .075 5 10 .10 

18 Railroad Equipment .066 5 7 .10 

I 19 Instruments .150 5 7 .10 

20 Other Equipment .150 5 7 .10 

21 Industrial Buildings .036 19 31.5 .00 

22 Commercial Buildings .025 19 31.5 .00 

I 23 Religious Buildings .019 19 31.5 .00 

24 Educational Buildings .019 19 31.5 .00 

25 Hospital Buildings .023 19 31.5 .00 

I 26 Other Nonfarm Buildings .045 19 31.5 .00 

27 Railroads .018 15 20.0 .10 

28 Telephone and Telegraph .033 15 20.0 . 10 

.I 29 Electrical Light and Power .030 15 20.0 .10 

30 Gas Facilities .030 10 15.0 .10 

31 Other Public Utilities .045 10 15.0 .10 

32 Farm Structures .024 19 20.0 .00 

I 33 Mining. Shafts and Wells .056 5 5.0 .00 

34 Other Nonbuildlng Facilities .029 19 31.5 .00 

35 Residential Structures .015 19 27.5 .00 

I •Economic depreciation rates come from H ulten and Wykoff ( 1981 ) and Jorgenson and 

I 

Sullivan (1981). 

with a switch at the optimal time to straight line. The depreciation basis is 

reduced by half the investment tax. credit. Other structures receive allowI ances based on 175 percent of declining balance with an optimal switch to 

straight line. 

I 

At zero inflation, these allowances are high relative to economic depreciation. They are fixed in nominal tenns, however, so that at moderate inflation 

I 
180 Don Fullerton/Yolanda K. Henderson/ James Mackie 

rates, their real present value may be less than that of economic depreciation. We use a nominal discount rate in calculating z to account for the fact 

that allowances are based on historical cost. The exact formula is shown in 

King and Fullerton (1984, page 211). 

Tax reform modifies depreciation allowances in several important ways. It 

expands the number of recovery classes from 5 to 8, and it generally lengthens 

recovery periods. Personal property is now depreciated over periods ranging 

from 3 to 20 years. In the 3, 5, 7, or 10 year class, personal property 

receives allowances based on 200 percent declining balance with an optimal 

switch to straight line. Personal property in the 15 and 20 year class 

receives 150 percent declining balance. Real nonresidential property is 

depreciated over a 31.5 year period, and residential real property is depreciated over a 27.5 year period, both based on the straight line method. Tax 

reform recovery periods for each of our 35 types of depreciable property are 

shown in the third column of Table 6.2. 

The other aspect of capital cost recovery is the investment tax credit. 

Current law provides a 6 percent credit for automobiles, a I 0 percent credit 

for other equipment, a 10 percent credit for public utility structures, and no 

credit for buildings. These rates are shown in the fourth column of Table 

6.2. The Tax Reform Act of 1986 repeals these credits. 

3. Other parameters 

For local property tax rates (w), we use the same parameters under both tax 

regimes. Assuming that new investments will pay the same property tax on 

average as existing investments, data in Fullerton and Henderson ( 1984} 

indicate rates of .00768 for equipment and inventories, .01126 for business 

land and structures, .01550 for public utilities, and .01837 for residential 

land and structures. 

We assume that marginal investments in all three sectors are financed using 

one-third debt and two-thirds equity (Fullerton and Henderson, 1984}. However, we consider two alternative assumptions for the division of corporate 

equity between retained earnings and new share issues. 

One scenario is based on the financing of existing corporate capital. 

Under this first scenario. we follow King and Fullerton (1984) in assuming 

that our marginal corporate investment is financed 61 percent through retentions, 34 percent through debt, and 5 percent through new share issues. This 

assumption is important because equation (6.3) indicates that the dividend tax 

(reduced by tax reform) affects investment financed through new share issues. 

while the capital gains tax (increased by tax reform) is relevant for investment fmanced by retained eamings.13 The small 5 percent weight on new share 

issues in this scenario is thus consistent with the "new view" of dividend 

taxation (Auerbach. 1979, Bradford, 1981, and King, 1977) which holds that the 

taxation of dividends does not provide a serious disincentive to marginal 

investment in the corporate sector. 

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Investment Allocation and Growth Under Tax Reform J 81 

A competing tradition, however, is the "old view" which holds that dividend 

payout rates affect the cost of capital, and that there is significant double 

taxation of corporations because profits are taxed once at the finn level and 

again when distributed as dividends (McLure. 1979). Under this alternative 

theory. the reduction in the taxation of dividends would tend significantly to 

lower the effective tax rate for corporate investments, because firms are 

observed to distribute a sizable fraction of their earnings to shareholders.

14 

Thus for our second financing assumption. we construct a scenario that is 

consistent with the findings under the old view, for a payout rate of 50 

percent. Al.though existing investments are financed 61 percent by retained 

earnings, it may not be possible as easily to finance additional new investments from that same source. If corporations have a limited supply of 

retained earnings and must increase their reliance on new shares to finance 

marginal investments, then equation (6.3) may be modified such that equity 

finance is divided evenly between retained earnings and new shares (ere= .3315 

and ens= .3315, with cd still equal to .337). Under this alternative, the 

dividend tax reduction has a more substantial impact, and the capital gains 

tax increase has a less substantial impact. 

Finally. we set both the inflation rate, n, and the baseline net-of-all-tax 

rate of return, s, to 4 percent. Solving equation (6.2) with these assumptions and 'td = .2 19, we find that i for prior law equals 10.2 percent. If s did 

not change under the Tax Reform Act of 1986, i would be 9. 9 percent. The 

general equilibrium model below allows endogenous determination of the net 

rate of return s, but the next subsection first looks at incentives with a 

fixed net rate of return. 

C. Effective Tax Rate Results 

This section first concentrates on incentives to invest in different 

assets. These detailed results are reported only for the "new view" financing 

assumptions because similar results are obtained for the old view. We next 

aggregate assets to reflect investment incentives at the sector and industry 

levels. These aggregate incentives are reported for both the new and old 

views of dividend taxation. 

Table 6.3 shows the present value of depreciation allowances and marginal 

effective total tax rates for 36 assets in the corporate sector based on new 

view financing assumptions.

15 Under prior law, the first 20 types of equipment have very low tax rates or could even be subsidized. These effective tax 

rates range from 0 percent to +6 percent, despite the fact that we are including taxation at both the personal and corporate levels.16 Equipment has 

these low effective tax rates because of investment tax credits and because of 

depreciation allowances in excess of economic depreciation. Structures 

(assets 21-26, 32-34) face considerably higher tax rates, between 33 and 50 

percent, because they are not eligible for the investment tax credit and 

because of their less generous depreciation allowances. Public utility 
182 Don Fullerton/Yolanda K. Henderson/ James Mackie 

Table 6. 3 Investment Incentives for Each Asset 

in the Corporate Sector* 

Present Value of Marginal Effective 

'=A~II~ow_a;;;.;n.;.;;ce~s~(z~) --=---Total Tax Rate 

Prior Tax Reform Prior Tax Reform 

Law Act of 1986 Law Act of 1986 

1 Furniture and Fixtures .810 

2 Fabricated Metal Products 

3 Engines and Turbines 

4 Tractors 

5 Agricultural Machinery 

6 Construction Machinery 

7 Mining and Oil Field Machinery 

8 Metalworking Machinery 

9 Special Industry Machinery 

10 General Industrial Equipment 

11 Office and Computing Machinery 

12 Service Industry Machinery 

13 Electrical Machinery 

14 Trucks. Buses. and Trailers + 

15 Autos .888 

16 Aircraft .810 

17 Ships and Boats 

I 8 Railroad Equipment 

19 Instruments 

20 Other Equipment + 

2 I Industrial Buildings .589 

22 Commercial Buildings 

23 Religious Buildings 

24 Educational Buildings 

25 Hospital Buildings 

26 Other Nonfarm Buildings + 

27 Railroads .602 

28 Telephone and Telegraph I 

29 Electric Light and Power + 

30 Gas Facilities .696 

31 Other Public Utilities + 

32 Farm Structures .589 

33 Mining. Shafts and Wells .863 

34 Other Nonbuilding Facilities .589 

35 Inventories 

36 Land 

.816 

.816 

.816 

.866 

.816 

.816 

.866 

.816 

.816 

.816 

.816 

.816 

.816 

.866 

.866 

.866 

.749 

.816 

.816 

.816 

.369 

+ 

.529 

.529 

.529 

.609 

.609 

.529 

.840 

.366 

.045 

.050 

.054 

.031 

.049 

.028 

.030 

.042 

.047 

.042 

-.001 

.030 

.043 

.004 

.010 

.025 

.055 

.057 

.034 

.034 

.476 

.442 

.423 

.423 

.438 

.500 

.353 

.383 

.377 

.311 

.328 

.439 

.329 

.455 

.493 

.515 

.402 

.383 

.368 

.400 

.389 

.460 

.401 

.415 

.395 

.415 

.532 

.454 

.410 

.460 

.505 

.414 

.410 

.354 

.441 

.441 

.523 

.496 

.481 

.481 

.492 

.543 

.465 

.496 

.490 

.465 

.490 

.447 

.364 

.506 

.471 

.495 

*Calculations use " new-view" financing assumptions (with 4 percent inflation and a 4 percent 

net rate of return). 

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Investment Allocation and Growth Under Tax Refonn 183 

structures (assets 2 7-31) have tax rates that are not quite as high as those 

for most other structures, since they receive a I 0 percent investment tax 

credit. Land and inventories receive neither credits nor accelerated depreciation allowances. Consequently, they face relatively high effective tax 

rates of 52 and 49 percent. respectively. 

Tax refonn reduces disparities in tax rates among assets, mostly as a 

result of rescinding the investment tax credit for equipment and public 

utility property. Effective tax rates for assets used in the corporate sector 

lie between 35 and 54 percent. The generally higher level of these rates is 

due in part to the changes in capital cost recovery provisions, but also to 

changes in the treatment of interest and capital gains. Currently, investments financed by debt are subsidized in that interest payments are deducted 

by corporations at a 49.5 percent rate, but included in taxable income of 

debtholders at an average marginal rate of only 21.9 percent. The difference 

between 49.5 percent and 21.9 percent is a 27.6 percentage-point subsidy. 

This subsidy is lowered by the Tax Refonn Act to J 8.9 percentage points, since 

interest deductions are made at a 38.3 percent rate while interest income is 

taxed at a 19.4 percent rate. Effective tax rates in the corporate sector 

also rise because capital gains on corporate retentions are taxed as ordinary 

income, thus raising the effective rate on accrued gains from 7.4 percent to 

12.5 percent. 

Table 6.4 presents user costs and effective tax rates under the new view 

for the corporate, noncorporate, and owner-occupied housing sectors. Summary 

measures of investment incentives also are presented for several aggregated 

assets: equipment, residential and nonresidential structures, public utility 

structures, inventories, and residential and nonresidential land. Investment 

incentives for each asset were aggregated using estimates of the 1984 stock of 

h . h 11 eac asset m eac sector. 

Under prior law, accelerated cost recovery provisions combine with nominal 

interest deductions to generate a total tax rate in the corporate sector that 

is below the statutory corporate rate. The overall effective tax rate in the 

corporate sector is 38.8 percent, only 3.6 percentage points higher than the 

35.2 percent effective rate in the noncorporate sector, but 12 points higher 

than the 26.9 percent rate on owner-occupied housing (attributable to local 

property taxes). Tax refonn actually increases the spread between the overall 

tax rate in the corporate sector and the overall rates in the other sectors. 

Less generous capital cost recovery and capital gains provisions overcome the 

effect of rate reduction to raise the rate in the corporate sector by 7. 6 

percentage points. The effect of less generous cost recovery provisions is 

offset to a large degree in the noncorporate sector by the 4 percentage point 

reduction in the tax rate of proprietors and partners. For housing, the 

effective tax rate rises slightly. reflecting reduced numbers of itemizers as 

well as reduced personal rates for interest deductions. Table 6.4 also 

indicates that tax reform would cut the capital-weighted standard deviation 

of all of these costs of capital. from .012 to .009. 
184 Don Fullerton/Yolanda K. Henderson/ James Mackie 

Table 6.4 lnvestment lncentives With 

New View of Dividend Taxes 

Prior Law Tax Reform Act of 1986 

Co~r~te Sector 

u1pment .042 

Nonresidential Structures .072 

Public Utility Structures .063 

Inventories .079 

Land .083 

Total .065 

Noncorporate Business Sector 

Equtpment .033 

Nonresidential Structures .059 

Public Utili~ Structures .054 

Residential tructures .065 

Inventories .061 

Nonresidential Land .064 

Residential Land .072 

Total .062 

Owner-Occupied Housing .055 

Average Overall Cost of Capital 

Standard Deviation 

Average Overall Tax Rate 

Interest Rate 

Table 6.5 lnvestment lncentives With 

Old View of Dividend Taxes 

p t 

.038 .069 .422 

.441 .078 .489 .361 .078 .484 

.493 .076 .471 .515 .079 .495 .388 .075 .464 

-.201 .056 .289 .323 .061 .348 .260 .064 .373 .383 .067 .401 .343 .059 .319 .379 .062 .358 .441 .069 .424 .352 .063 .360 

.269 .056 .281 

.061 .065 

.012 .009 

.347 .387 

.102 .099 

Prior Law Tax Reform Act of 1986 .;:,;,;=-=.;,;_t -- p 

Cor~r~te Sector 

u1pment .051 .212 

Nonresidential Structures .083 .518 .074 .459 .084 .522 

Public Utility Structures .073 .449 

Inventories .093 .571 

.083 .516 .081 .509 

Land .097 .587 .085 .529 

Total .077 .482 .080 .500 

Noncorporate Business Sector* .062 .352 .063 .360 

Owner-Occupied Housing .055 .269 .056 .281 

Average Overall Cost of Capital .066 

Standard Deviation .015 .067 

.Oil 

Average Overall Tax Rate .391 .405 

Interest Rate .102 .099 

*The choice between the old and new view of dividend taxes does not affect the noncorporate 

sector. owner-occupied housing. or the overall interest rates. 

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Investment Allocation and Growth Under Tax Reform 185 

Table 6.5 shows summary measures of investment incentives under the old 

view. Tax reform in this case has only a small effect on corporate and 

overall investment incentives. The lower tax on dividends helps offset both 

the higher tax on retentions and the less generous depreciation allowances. 

Thus, the effective tax rate in the corporate sector rises only slightly (by 

1.8 percentage points) as a result of tax reform. The modest rise in the 

corporate sector cost of capital and effective tax rate, combined with a 

nearly constant cost of capital in the noncorporate sector means that, under 

the old view, tax reform does not markedly worsen distortions at the corporate/noncorporate margin. In addition, since the cost of capital for owneroccupied housing still rises slightly as a result of tax reform, distortions 

between noncorporate investment and owner-occupied housing are reduced. For 

these reasons, tax reform reduces the standard deviation of the cost of 

capital under the old view more than it does under the new view. 

Next, Table 6.6 shows marginal effective tax rates by industry for both of 

our financing assumptions. Under prior law, and using new view financing 

assumptions, these industry effective rates range from 25.4 percent in the 

services industry to 44.3 percent in the transportation equipment industry. 

The services industry has a low effective tax rate because it is more than 

one-half nonco.rporate. Generally, manufacturing industries, including 

transportation equipment, face above average effective tax rates because they 

are largely corporate, Utilities face a relatively low effective tax rate. 

Table 6.6 Marginal Effective Total Tax Rates for Each Industry 

New View OICJ View 

Prior Tax Reform Prior Tax Reform 

Industry Law Act of 1986 Law Act of 1986 

I Agriculture. Forestry and Fisheries .361 .354 .366 .356 

2 Mining .310 .442 .392 .469 

3 Crude Petroleum and Gas .358 .399 .424 .427 

4 Construction .378 .427 .448 .455 

5 Food and Tobacco .469 .469 .500 .504 

6 Textiles, Apparel and Leather .400 .457 .488 .492 

7 Paper and Printing .355 .454 .450 .489 

8 Petroleum Refining .429 .484 .514 .518 

Chemicals and Rubber .346 .453 .447 .489 

I 0 Lumber. Furniture. Stone. Clay 

& Glass .379 .458 .468 .492 

11 Metals and Machinery .409 .467 .499 .502 

12 Transportation Equipment .443 .473 .527 .509 

13 Motor Vehicles .365 .466 .466 .502 

14 Transportation, Communication 

& Utilities .210 .443 .370 .475 

15 Trade .422 .433 .487 .462 

16 Finance and Insurance .364 .386 .384 .394 

17 Real Estate .303 .314 .303 .314 

18 Services .254 .403 .313 .422 

Total .347 .387 .391 .405 
186 Don Fullerton!Yolanda K. Henderson/James Mackie 

even though they are mostly corporate, because they could make extensive use 

of the investment tax credit. 

Tax reform changes the relative treatment of industries, and generally 

raises effective tax rates under these assumptions. Agriculture and real 

estate are now the low-tax industries, reflecting the benefit of rate reduction for nondepreciable land.18 Transportation equipment remains the high-tax 

industry, due largely to repeal of the investment tax credit. Services face 

an above-average effective tax rate because of repeal of the investment tax 

credit and the longer recovery period for real property. Utilities also face 

an above-average effective tax rate, again due largely to repeal of the 

investment tax credit. 

Industry effective tax rates for both prior law and tax reform are generally higher under the old view than under the new view. The ranking of 

industries by effective tax rate is also changed, reflecting the higher 

effective tax rates in the corporate sector under the old view. However, low 

tax industries are stiU largely noncorporate industries such as real estate 

and services. Tax reform has a smaller effect on industry investment incentives under the old view because effective tax rates in the corporate sector 

are not much changed from prior law. 

III. The General Equilibrium Model 

The investment incentives measured in the previous section are used as 

inputs into the general equilibrium model developed in Fullerton and Henderson 

(1986a). This model is capable of simulating the effects of tax reform on 

production by different industries, as well as on aggregate output. Furthermore, because of the detail on capital formation, it can trace the flow of 

capital simultaneously among different assets and sectors. 

A. A Description of the Model 

The consumption side of the model is taken directly from the general 

equilibrium model of Fullerton, Shoven, and Whalley (FSW, 1978, 1983), as 

fully described in Ballard, Fullerton, Shoven, and Whalley ( 1985). Twelve 

income-differentiated households have initial endowments of labor and capital 

that can be sold for use in production. As indicated in the top part of 

Figure 6.1, these households each maximize a nested constant elasticity of 

substitution (CES) utility function by making an initial allocation of 

resources between present consumption and saving. The elasticity of substi-

tution between present and future consumption is based on an exogenously 

specified aggregate estimate for n, the uncompensated savings elasticity with 

respect to the net rate of return. We examine alternative savings etas- . • • 19 

ttcrtaes. 

In evaluating any tax reform the model simulates a sequence of equilibria 

in which the capitaJ stock increases as a result of saving in the previous 

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Investment Allocation and Growth Under Tax Reform 187 

Figure 6.1 A Diagrammatic Summary of the Model 

u 

H 

Utility U Is a CES function of present 

consumption H and future consumption CF' 

CF 

Present consumption H is a CES function 

leisure L and a composite good X. 

Consumer Goods (m · 1,15) Xm 

X is a Cobb-Douglas composite of the 15 

consumer Qoods Xm. 

Producer Goods (j - 1,19) Q

1 

Each consumer good Xm (e.g., appliances) is a 

fixed coefficient mix of the 19 producer goods 

Ql (e.g., metals, transportation, and trade). 

L 

I 

VA 

I 

Each producer good Qj uses fixed proport1ons 

of value added VAl and intermediate inputs Ar 

Intermediate inputs are the 19 producer 

goods. in fixed proportions for each Industry. 

Value added VA; is a CES function of 

labor L; and capital i<1

• 

Capital Kl In each industry Is a CES function .1/ 

of corporate capital Kc and noncorporate 

Kc Knc capital K~c . 1 

~ ~ ~"of oop;"t to oo<h ""o' "• CES II I I \\\ /1 II \ ~ function of the 38 asset types. 

Kc I• 1.38) If Knc I• 1 381 'I 

Y In the houstng tnduslly. capllal IS a CES function of 

owner-occup1ed housong and noncorpora&e rental houstng 
188 Don Fullerton/Yolanda 

K. Henderson/ James Mackie 

period. Domestic saving is the only vehicle by which investment can be 

affected, since the model is not open to international capital flows. The 

model is open to balanced trade in commodities, but there is no scope for 

saving by foreigners to finance domestic capital formation. 

With present resources, as indicated in the next level of Figure 6. I, a 

household can choose to buy some of its own labor endowment for leisure. The 

elasticity of substitution between consumption and leisure is based on an 

aggregate estimate of 0.15 for the uncompensated labor supply elasticity with 

respect to the net-of-tax wage. Present consumption expenditures are then 

divided among 15 consumer goods according to a Cobb-Douglas subutiHty nest. 

Each consumer good is a fixed-coefficient combination of outputs of the 18 

industries. The model includes the entire spectrum of federal, state, and 

local taxes. These are typically modeled as ad valorem tax rates on purchases 20 -

of appropriate products or factors. 

The Fullerton-Henderson amendments to this model come in the specification 

of production decisions. It is a generalized equilibrium model with endogenous allocation of capital across industries, sectors, and assets. 

The structure of production is displayed in the bottom half of Figure 6.1, 

where each industry determines its use of factors in a sequence of stages. 

The first two stages are similar to the FSW model. First, producers have 

fixed requirements of intermediate inputs and value-added per unit of output. 

Second, they can substitute between labor and capital in a CES value-added 

function. The elasticity of substitution between labor and capital in each 

industry is chosen from an average of econometric estimates in the literature. 

These average elasticity estimates vary from 

0. 7 to 1.0 across the 18 private 

industries. However, this stage differs from the FSW model which constructs 

capital costs from observed tax payments. Instead, a HaJI

-Jorgenson ( 1967) 

type cost-of-capital formula determines the demand for composite capitaiKj in 

each of the 18 private industries, emphasizing investment incentives at the 

margin. 

The new model also adds a third and fourth stage to production decisions. 

In the third stage, for each industry j, producers decide how to allocate the 

composite capital good between the corporate sector and the noncorporate 

sector. 

21 This allocation is made on the basis of the CES function: 

[ 

I o- 1 I o- 1 l o 

K = (13 f (i(c;a- + (l-13 )

0 (Kc)U aT j j j j j 

(6.4) 

The parameter o is the elasticity of substitution between corporate and 

noncorporate capital. It measures the ease with which capital may be switched 

from one sector to the other. The parameter 

a. measures the relative impor-

tance of the noncorporate sector in industry 

J. while K~ and ~c are the 

corporate and noncorporate capital stocks in the jth industry. respectively. 

The industry's demands for capital of each type are determined by cost 

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Investment Allocation and Growth Under .Tax Refonn 189 

minimizing behavior using p; and p "; , composite corporate and noncorporate 

costs of capital within each industry. The Lagrangian multiplier from this 

minimization provides the composite cost of capital for the industry, mentioned above. 

In the fourth stage of production decisions, finns in each sector of each 

industry allocate their composite capital among depreciable assets, land, and 

inventories, according to a CES function. For corporate finns, the function 

is written as: 

(6.5) 

The parameter t is the elasticity of substitution among assets, assumed 

constant across assets, industries, and sectors. The parameter ex: :l shows the 

importance of asset type i in the corporate sector of industry j. The stock 

K; :l is the amount of capital of the ith asset type in corporate sector of the 

jth industry. The disaggregate capital demands K: :l are obtained through cost 

minimizing behavior based on individual assets' costs of capital from equation 

(6.1 ). The Lagrangian multiplier from this minimization provides p;, the 

composite corporate cost of capital for the jth industry. A similar equation 

is minimized to obtain demands for capital in the noncorporate sector of each 

industry. and to obtain p ;c, the composite noncorporate cost of capital. 

Econometric estimates are not available for the key parameters u, t, cx1 j , and 

a1 j. As a consequence, the values of a and t are specified exogenously (but 

results for alternative specifications are reported below). The other key 

capital allocation parameters, cxij and aij. are determined from the initial 

set of capital costs and the observed allocation of capital in the baseline 

case (prior law). Once a and t are specified, we solve backwards for the cx1 j 

and a1 that must have pertained if producers actualJy had the observed 

demands while facing the initial costs of capital. This calibration allows 

the model to find the observed or "benchmark" equilibrium as a solution for 

the model when producers face initial capital costs. Once calibrated in this 

manner, cxq and a1 j remain constant across tax policy changes. 

For a gaven set of technological parameters, the allocation of capital 

depends ultimately on user costs for individual asset types. As described 

above. these are built up from infonnation on statutory tax rates, credit 

rates, tax lifetimes, and other statutory specifications. These costs also 

depend endogenously on the real after-tax rate of return. s, detennined in 

equilibrium. These disaggregate asset costs are used directly for each sector 

to determine allocations among assets in the last stage of Figure 6. 1. A 

composite of those capital costs is calculated for the corporate sector and 

for the noncorporate sector of each industry. in order to determine the 

allocation between sectors in the next-to-last stage of Figure 6. 1. Finally, 

an additional composite of the two sectors is calculated for each industry. in 
190 Don Fullerton/Yolanda K. Henderson/James Mackie 

order to determine the allocation of capital among industries. Thus, each 

industry has a different mix of assets in each sector, as well as a different 

mix of sectors, all determined endogenously. When the total use of capital 

equals the total available supply, we have equilibrium in the capital market; 

when other markets clear as well, we have a general equilibrium. 

An important advantage of this model is that it is not limited to a unitary 

elasticity of substitution among assets, as implied by the Cobb-Douglas 

functional form common in previous studies. Instead, the elasticity of substitution among assets ( £) and among sectors (a) may be specified exogenously. 

These generalizations are important because the choices of £ and a, as well as 

of n, have much bearing on the relative size of different distortions and 

therefore on the net effect of tax reform. If £ is high, for example, then 

the change in the relative tax treatment of different assets will result in a 

more significant change in the finn's production technology. A high value for 

t will therefore imply relatively high welfare gains from the more uniform tax 

treatment of different assets. If a is high, then the sectoral allocation of 

capital is more sensitive to changes in the relative tax treatment of corporations, noncorporate business, and owner-occupied housing. High values of a 

would be associated with high welfare gains from more uniform tax treatment of 

sectors. Finally, the choice of n, the savings elasticity, matters for 

aggregate capital accumulation. If n is high, then any change in the overall 

taxation of the return to income from capital would result in a higher saving 

response. As this assumed elasticity rises, any tax wedge between the gross 

and net return to saving results in a greater measured efficiency loss. 

B. Simulation and Sensitivity 

Before presenting the results themselves, it is necessary to describe our 

simulations. We simulate a sequence of 6 equilibria that are 10 years apart, 

so our total simulation interval is 50 years. AJJ our simulations assume an 

adjustment in lump-sum taxes (positive or negative as appropriate) in order to 

restore the revenue yield of the baseline. We perform the simulations for 

each view of dividend taxes under several alternative sets of parameters. 

We consider values of E: and a between 

0. 15 and 2.5, and values of n between 

0 and 0.6. As stressed in Fullerton and Henderson, (J986a) existing econometric work on substitution elasticities does not consider the number of 

assets included in this model. Neither does it attempt specifically to measure a sectoral substitution elasticity. There remains considerable uncertainty about these parameter values. For the savings elasticity, our lower 

bound of zero is consistent with the estimate of Howrey and Hymans ( 1978). and 

our upper bound of . 6 is in the upper range of estimates in Boskin ( 1978). 

Under the new view of dividend taxation. tax reform increases distortions 

between present and future consumption. for which n is important. Under the 

old view, this effect is similar but smaller. Under both views, tax reform 

reduces distortions in the choice among assets, for which £ is important. 

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Investment Allocation and Growth Under Tax Reform 19 J 

Thus, assessment of the overall efficiency effects of tax reform depends on 

the relative sizes of £ and tl. The effect of tax reform on intersect oral 

distortions is slightly more complicated. Under both the new and old views, 

corporate/noncorporate distortions are magnified while noncorporate/owneroccupied housing distortions are reduced. ff we adopt the new view so that 

the corporate/noncorporate distortion is more greatly affected by tax reform. 

then it seems likely that increases in a will reduce any efficiency gains 

bought on by reduction in interasset distortions. In contrast, if we adopt 

the old view, the corporate/noncorporate distortion is only slightly increased 

by tax reform. Thus, increases in a might increase or decrease efficiency 

gains, depending on whether the improvement in the margin between noncorporate rental housing and owner-occupied housing more than offsets the effect of 

the margin in other industries between the corporate sector and the noncorporate sector. 

C. Interpretation of Simulations 

Simulation analysis such as we perform here can provide highly detailed 

results. It is always necessary to bear in mind, however, the limitations of 

such studies. We would like to mention three types of issues: the quantification of tax reform measures~ the specification of economic behavior; and 

the usefulness of our results for policy decisions. 

First, although our simulations take into account major elements of the tax 

reform proposals as they pertain to capital formation, they do not take into 

account all aspects of fundamental tax reform. For example, while we capture 

the effect of capital gains changes on the overall incentive to invest, we do 

not capture their effect on holding periods or realizations. We do not 

capture the effect of tax reform on incentives to chum assets, to merge with 

other firms, to increase compliance, or to join the labor force. We omit the 

alternative minimum tax and the passive loss rules. In addition, we do not 

capture new features that could have sizable influences on particular industries. Examples include special features that relate to energy and to 

accounting for multi period production. 2 2 

Second, any simulation model necessarily simplifies some aspects of 

economic decisionmaking. One example relevant to our model is the specification of financial choices. Tax reform raises the cost of debt finance for 

corporations, yet we do not alter firms· debt -equity ratios to reflect this 

change. Also, we have made specific choices with respect to capital allocation decisions. Our use of the t parameter implies that firms view all assets 

as substitutes for one another in production; we omit the possibility that 

some assets are complements. Our use of the a parameter attempts to capture 

the impact of capital costs on incorporation decisions, but we do not explicitly model the effect on these decisions of providing limited liability or 

access to national financial markets. 

Finally, it should be emphasized that we do not consider the effects of tax 

reform on "fairness" or "simplicity, " concepts that were important throughout 
192 Don Fullerton

/Yolanda K. Henderson/James Mackie 

the development of the tax reform process. Any changes in the achievement of 

these other goals would be additional criteria by which to assess tax reform. 

In summary, the various results found in the next section must necessarily be 

interpreted with caution. Any overall evaluation of tax reform should use 

appropriate additional information and judgment. 

IV. General Equilibrium Results 

A. The Net Effect on Economic Well-being 

Previous literature provides very little guidance in the selection of 

values for our three key elasticity parameters. Therefore our strategy here 

is to select one set of parameters for a starting point and then to vary each 

parameter systematically. The starting point is taken to be the case where 

£ = I, a = 1, and n = .4, so that asset and sectoral combinations are Cobb-Douglas 

and savings are moderately responsive to net returns. 

Under the "new view," with these parameters, the net effect of tax reform 

is a $54 billion present value welfare gain, measured by the sum of equivalent 

variations over the twelve consumers, in 1984 dollars. This gain is 

0.04 

percent of the present value of real income in the baseline. The increase in 

economic well-being is achieved despite the reduction of investment incentives. That is, the greater efficiency of investment more than compensates 

for a lower total. The capital stock is still growing, of course, but after 

50 years it is 1. 9 percent lower than it would have been under prior law. 

Under the "old view, " with the same elasticity parameters, the net effect of 

tax reform is a $302 billion present value welfare gain (0.2 percent of 

baseline income). The overall cost of capital does not rise as much in this 

case, so increases in allocation efficiency are offset to a lesser degree. 

This more-efficient capital stock is only 0.6 percent lower than in the 

baseline after 50 years. 

The next three figures display the net effects of varying the three 

elasticity parameters one at a time. 

Figure 6.2 shows the effect of alternative savings elasticities. The 

vertical axis measures the present value change in welfare, and the horizontal 

axis shows values of n ranging from 0 to .6 (while t =a= l). As expected. 

welfare gains fall as n increases. However, for both views of dividend tax

-

ation, welfare gains are positive for all values of n that we consider. Under 

the old view welfare gains range from $337 billion to $286 billion. Under the 

new view, welfare gains are smaller. ranging from $141 billion to $13 billion. 

Welfare gains are larger for the old view because di

vidend tax reductions are 

more important. As indicated in Tabl

es 6.5 and 6.6. tax reform in this case 

causes a smaller increase in overall effective tax rate

s. a larger improvement 

in interasset neutrality. and a smaller increase in the intersectoral distor

-

tions. Because tax reform raises effective tax rat

es more sharply under the 

new view. the slope of the curve for the new view is steeper. 

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Investment Allocation and Growth Under Tax Reform 193 

Figure 6.2 Savings Elasticity and the Welfare Gain 

from the Tax Reform Act of 1986• 

400 Old View 

\ 

200 

New View 

oC:::::::::::::d\~--n .2 

-200 

- 400 

• Calculations assume a ""' t • I . 

bin billions of 1984 dollars. 

.4 

Figure 6.3 Asset Substitution and the Welfare Gain 

from the Tax Reform Act of 1986• 

-200 

- 400 

• Calculations assume a = I and l1 = .4. 

bin billions of 1984 dollars. 

.6 
194 Don Fullerton/Yolanda K. Henderson/James Mackie 

Figure 6.4 Sectoral Substitution and the Welfare Gain 

from the Tax Reform Act of 1986• 

Old View 

200 

New View 

\ 

0 

.5 1 

•calculations assume £ = I and t) = .4. 

bin billions of 1984 dollars. 

1.5 2 

0 

2.5 

Figure 6.3 plots the relationship between tax reform's welfare effects and 

£. the elasticity of substitution across assets (while a= I and n = .4). Because 

tax reform improves interasset neutrality, welfare gains rise with t and reach 

a maximum of $733 billion under the old view when t =2.5. However, with very 

low substitutability a.rnong assets, tax reform can actually reduce welfare: 

adverse effects on savings and the intersectoral allocation of capital offset 

the sma11er favorable effects on interasset neutrality. As in Figure 6. 2, tax 

reform has more favorable effects on welfare under the old view than under the 

new view. 

Figure 6.4 illustrates the relationship between the economic benefits of 

tax reform and a, the parameter for intersectoral substitution possibilities 

(while t =I and n = .4). For all values of a between 0.15 and 2.5 , our simulations indicate positive welfare effects under both the new and old views of 

dividend taxation. Because of the increase in all intersectoral distortions 

under the new view, welfare improvements faJI as a rises. The fact that they 

remain positive shows that asset substitution effects dominate sectoral substitution effects even when a rises to 2.5. Under the old view. tax reform 

generates improvements in welfare that rise as a rises. The positive slope 

reflects the smaller increase in corporate/noncorporate distortions under the 

old view. As in Figures 6.2 and 6.3. tax reform stimulates larger improvements in welfare when the reduction in dividend taxation has a larger effect 

and the increase in capital gains tax has a smaller effect. 

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Investment Allocation and Growth Under Tax Reform 195 

B. Allocation of Capital Among Assets and Sectors 

Under prior law, investment in equipment is tax-favored as a result of the 

investment tax credit and very short lifetimes for depreciation. At the other 

extreme, returns to investments in inventories and land face statutory tax 

rates. 

Tax reform narrows the differences in these tax treatments. As a result, 

firms alter their relative demands for these assets. Table 6. 7 illustrates 

this reallocation for the corporate sector, for the case where a = 1, & = l, and 

n = .4, with both the "new view" and the "old view." Similar reallocations 

take place in the noncorporate business sector. Under our 1984 baseline data, 

29 .. 5 percent of the corporate capitaJ stock is in the form of equipment. 

Under the new view, with tax reform, this share would drop to 20.5 percent. 

The percentage for inventories would increase from 34.2 to 41.2 percent under 

tax reform. The use of land and structures in the corporate sector would also 

increase. The corporate sector would use a smaller share of public utility 

property. Results for the old view are similar. In the simulations with a 

higher value of t (not shown), these reallocations are in the same direction 

but larger in magnitude. As the asset elasticity parameter increases, 

corporations change their production processes more sharply in reaction to 

changes in relative user costs for different assets. 

Because it changes relative investment incentives. tax reform redistributes 

capitaJ across the three sectors of the economy. Table 6.8 shows the results 

of this redistribution. Under the new view of dividend taxation, the corporate sector cost of capital rises by 15 percent, from .065 to .075, while the 

costs of capital in the noncorporate and owner-occupied housing sectors are 

largely unchanged. After 50 years, this 15 percent increase in the cost of 

capital in the corporate sector leads to an 8 percent reduction in the 

fraction of capital employed in the corporate sector. The capitaJ flowing out 

of the corporate sector goes largely into the noncorporate sector. Owneroccupied housing is only slightly increased as a percentage of the overall 

stock of capital. Table 6.8 also shows results for the old view of dividend 

taxation. Under this alternative assumption capital shares ~re less sensitive 

to tax reform. This reflects smaller effect of tax reform on intersect oral 

investment incentives when dividend taxation is more important and capital 

gains are less important. The changes in shares, however, follow the same 

pattern as under the new view. 

C. Results for Industries 

As was indicated in Table 6. 7. tax reform encourages the use of nondepreciable assets such as land and inventories. It also expands the noncorporate 

and owner-occupied housing sectors relative to the corporate sector. especially under the new view of dividend taxation. Thus. we would expect that 

noncorporate industries using reJatively large amounts of land and inventories 

would expand relative to other industries as a result of tax reform. 
I 96 Don Fullerton/Yolanda K. Henderson/James Mackie 

Table 6. 7 Eventual Allocation of Corporate 

Capital Across Asset Types* 

Tax Reform Act of 1986 

Prior Law New View 

(After fifty years. as proportion of total) 

Equipment .295 

Nonresidential Structures . 149 

Public Utility Structures . I 12 

Inventories .342 

Land . 101 

*Calculations assume a - £ - I . and I') = .4 

Table 6.8 Eventual Allocation of Capital 

Across Sectors* 

.205 

. 156 

. 105 

.411 

.122 

Old View 

.213 

.154 

. 104 

.409 

.120 

Tax Refonn Act of 1986 

Prior Law New View 

(After 50 years as a proportion of total) 

Corporate 

Non corporate 

Owner-occupied Housing 

.373 

.371 

.257 

.343 

.394 

.263 

*Calculations assume a=£= I . and l1 = .4 

Old View 

.364 

.378 

.258 

Table 6.9 shows the induced changes in output and capital in each of 18 

private industries. We start with the new view of dividend taxation . 

Agriculture. which is largely noncorporate and uses a large proportion of 

land, experiences the largest percentage increase in output and capital. No 

industry other than agriculture experiences increases in output or capital of 

larger than 3 percent. Utilities and mining experience the largest contraction of output and capital as a result of tax refonn. Overall . under the new 

view, tax refonn causes a .4 percent reduction in output and a I . 9 percent 

reduction in capital. 

Under the old view, in general. induced changes in output and capital are 

proportionally smaller. Capital falls by .6 percent. Output. however. rises 

by .2 percent. Agriculture again experiences the largest percentage increase 

in output, and utilities still experience the largest percentage reduction in 

output. However, the transportation equipment industry now experiences the 

largest percentage increase in capital . followed by agriculture. Capital in 

the utility industry continues to contract the most under the old view. 

The treatment of dividend taxation also can affect the sign of changes in 

output and capital for certain industries. The metal and machinery industry. 

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Investment Allocation and Growth Under Tax Reform J 97 

Table 6.9 Eventual Output and Capital Stock by Industry• 

Baseline after 

fifty years b (billions of Tax Reform Act of J 986 

1984 dollars2 New view Old view 

Industry Output Capital Output Capital Output Capital 

I Agriculture, Forestry & Fisheries 794 6,255 8.9% 9.0% 5.5% 5.4% 

2 Mining 94 204 -5.3% -17.6% -3.2% -12.3% 

3 Crude Petroleum and Gas 106 917 -3.8% -4.3% -.9% -.8% 

4 Construction 659 708 -1.5% -5.9% -.4% -1.3% 

5 Food and Tobacco 960 454 2.2% -2.9% 2.1% 1.1% 

6 Textiles, Apparel & Leather 472 179 -.4% -6.1% .6% .0% 

7 Paper and Printing 352 347 -.9% -12.1% .0% -5.8% 

8 Petroleum Refining 234 252 -1.7% -5.6% .4% -.8% 

9 Chemicals and Rubber 519 586 -2.1% -14.0% -.8% -7.2% 

10 Lumber, Furniture. Stone. 

Clay & Glass 357 296 -.8% -9.8% -.0% -3.4% 

11 Metals and Machinery 1,545 2,025 -2.0% -7.3% .4% -.5% 

12 Transportation Equipment 147 246 .7% -1 .2% 3.0% 6.5% 

13 Motor Vehicles '430 280 -2.1% -13.2% -.5% -5.7% 

14 Transportation, Communiction 

& Utilities 1.085 3,308 -5.0% -20.2% -3.8% -14.7% 

15 Trade 1.641 4,438 -.2% .8% .7% 4.8% 

16 Finance and Insurance 594 572 -.5% -.5% -.2% .7% 

17 Real Estate I , 139 10,897 .6% .7% .I% .0% 

18 Services 1.707 887 -.8% -16.8% -.4% -14.3% 

Totalc 12,836 32,855 -.4% -1.9% .2% -.6% 

•calculations assume a,.,£= I and l1,., .4. 

bPercent change from the baseline. 

cDetail may not add to total due to rounding. 

for example, experiences a 2 percent reduction in output under the new view. 

but a .4 percent increase in output under the old view. The food and tobacco 

industry experiences almost a 3 percent reduction in capital under the new 

view, but over a 1 percent increase under the old view. 

V. Summary 

We have used the disaggregate general equilibrium model developed in 

Fullerton and Henderson (l986a, b) to analyze the Tax Reform Act of 1986. 

This model focuses on measuring changes in the taxation of income from real 

capital assets. It is capable of measuring the net effects of changes in 

statutory rates, credits. and depreciation allowances on the allocation . of 

capital among assets, sectors, and industries. It also captures the effect on 

total savings and investment of changes in overall incentives. 
198 Don Fullerton/Yolanda K. Henderson/ James Mackie 

We find that under a wide variety of parameter values, refonn of capital 

taxation results in net improvements in welfare. This result holds even 

though in many instances both output and capital formation fall slightly as a 

result of tax refonn. The provisions of tax refonn that affect capital tend 

to stimulate production in industries such as agriculture that employ large 

amounts of nondepreciable assets fully benefiting from statutory rate reduction. We also find that results are sensitive to the relative importance of 

dividend and capital gains taxation. If dividend taxes are a significant 

source of distortion in the allocation of capital, then tax refonn compares 

more favorably with prior law than if dividend taxation is unimportant. 

FOOTNOTES 

1 This paper does not consider the effects of these rate cuts on labor income and labor 

supf.ly. We concentrate exclusively on their effects on capital. 

The effects of uncertainty and imperfect loss offsets are investigated in Auerbach ( 1986) 

and Auerbach and Poterba ( 1987). 3 For a variety of reasons not captured here, firms may not always minimize their taxes by 

taking the earliest possible deductions. In order to concentrate on the tax wedge and to insure 

comparability across taJt regimes. however. calculations here assume tax minimizing behavior. 

Similarly. firms pay unnecessary taJtes by using FIFO inventory accounting. so calculations here 

assume LIFO methods. The effect of FIFO inventory accounting is shown in Fullerton ( 1987). 4 For the social rate of return in the noncorporate sector. p Dc . we use an expression analogous 

to 6. 1 where u is replaced by 't'Dc. the marginal rate on noncorporate business income, and r is 

replacedbythecorrespondingnoncorporatediscountrate. Sinceowner-occupiedhousingreceives 

no credit or depreciation allowances, the analogous expression in that sector is 

ph =r-n + ( 1-A 'th)w, where 'tb is the marginal rate at which interest and property taxes are 

deducted and A is the fraction of property taxes deducted by homeowners. 

5

If individuals earn the same rate of return net of all taxes from debt and equity, then the 

firm must earn a higher marginal product on a project financed by equity than on the same 

project financed by debt. In a context of perfect certainty, this can be justified only if for 

some reason firms must use a given mix of finance. Here, we do not model the role of 

uncertainty or institutional restrictions that influence observed financing choices. These 

choices are taken to be exogenous. An alternative assumption might be that firms, rather than 

individuals, arbitrage between debt and equity. The effects of firm arbitrage on measured taJt 

rates are explored in Fullerton and Henderson (1984), and Fullerton ( 1987) as well as Fullerton. 

Gillette and Mackie (1987, this volume). This alternative view would be supported in the 

perfect certainty framework only if individuals in different income groups specialize in 

different assets, as in Miller (1917). 6

In thenoncorporatesector, the discount rate is ndi(l-'tDc) + n. i(l-'td). wherend and n. are 

the fractions of noncorporate investment financed by debt and equity. respectively. The rate 

't is the marginal rate on noncorporate business income, and 'td is the marginal rate on DC 

interest income. In the owner-occupied housing sector, the discount rate is b i( 1-'th) + 

h• i(l-'t d). where hd and h• are the fractions of owner-occupied housing investment f.nanced by 

debt and equity, respectively. and 'th is the marginal rate at which homeowners deduct interest 

payments and property taxes. 

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Investment Allocation and Growth Under Tax Refonn 199 

7 Total effective tax rates are meaningful in our model with no international capital flows, 

because all taxes on capital affect total savings and investment. They may not be as meaningful 

in a more open economy where corporate taxes affect primarily investment and personal taxes 

affect primarily savings. 8 See Cilke and Wyscarver (1987, this volume) for further description of this model. 

9 See page 221 of King and Fullerton (J 984). 10 The adjusted rate for households is .267 under prior law and .232 under Tax Reform. The 

weights for households, tax-exempts, and insurance companies are .609, .153, and .238 

respectively. Under prior law, a special 20 percent deduction reduced the rate on insurance 

companies from 46 to 36.8 percent. The Tax Reform Act repeals this special deduction and leaves 

them with the same 34 percent rate as other corporations. 11 For dividends and capital gains, we use weights given by the holdings of corporate stock: 

. 7 43 for households, . 216 for tax -exempt institutions. and . 041 for insurance companies. The 

dividend rate of insurance companies was .069 under prior Jaw and .068 under tax reform, 

accounting for the intercorporate dividend deduction. 12See King and Fullerton (1984, pages 221-222). 13 Consider first a firm that wishes to invest $1 more by issuing $1 of new shares. The asset 

earns a return r, net of corporate tax, which the firm pays out as a dividend. The ultimate 

return to the new shareholder is this (1-"tn• )r. Alternatively, consider a firm that wishes to 

invest in $1 more of capital by retaining an additional dollar of earnings. To retain an extra 

dollar. the firm must necessarily reduce dividend payments. The $1 dividend foregone represents 

$(1-'t'n•) net of personal tax. In the following period the asset earns a return r net of 

corporate tax and (1-"t • )r net of personal tax. The return to shareholders relative to 

dividends foregone in the first period is just r. This return is independent of the parameter 

'tn• since it affects identically the numerator and denominator in the calculation of the rate of 

return. 14 The new view receives empirical support in a study by Auerbach (1984), but the old view is 

found more compatible with historical evidence in Poterba and Summers ( 1983, 1985). Poterba 

and Summers ( 1985) also explain some conceptual problems associated with each theory. 15Starting from the 35 depreciable assets listed in Table 6 .2, the corporate sector in this 

model excludes residential structures but includes land and inventories. 16 A subsidy, or negative effective tax rate, means that tax credits and depreciation allowances are so generous that they outweigh the effects of taxes on net income and property values. 

Undfr a subsidy, to earn s-.04 after tax, the required value of p is lower than 4 percent. 1 From the July 1985 Survey of Current Business, we obtain 1981 data for corporate 

equipment, corporate structures, noncorporate equipment, and noncorporate structures. We 

also obtain data for total depreciable capital stocks by 18 industries. We project each of 

these 22 capital stock figures to 1984 by using an econometric estimate of the relationship 

between economic growth and capital formation. We then use an RAS procedure with these 1984 

targets to adjust an unpublished 1977 matrix from Dale Jorgenson, showing each of these four 

types of asset used in each of the 18 industries. Finally, we obtain the finer capital 

allocations for all 20 types of equipment and 15 types of structures, by using disaggregate 

proportions in the Jorgenson data. These data also form the basis for our 1984 projections of 

the values of land and inventories in each of our industries. 

18This model considers fully taxable firms and infinite holding periods. It thus omits 

changes in the alternative minimum tax, passive loss rules, and the churning of tax shelter 

assets such as those in real estate. Also, we assume the same financing shares for all assets 

in all industries. 

19 Our model assumes that households' expectations of the rate of return are myopic . Ballard 

and Goulder (1985) examine the effect of incorporating perfect foresight into the FullertonShoven-Whalley model. 20The model also requires that government run a balanced budget. Therefore, when our 

simulations raise (lower) national output and income, we must offset the resulting revenue gains 
200 Don Fullerton/Yolanda K. Henderson/ James Mackie 

(losses) by cutting (increasing) some other tax. We do this by changing income taxes in a lumpsum manner. We thus abstract from changes in personal taxation of labor income. 

21 ln the housing industry, producers instead allocate the composite capital good between 

owner-occupied housing and noncorporate rental housing. 2 2 See FuUerton, Gillette and Mackie (1987, this volume) for additional work in this area. 

They find that these cost of capital measures are relatively unaffected by accounting changes, 

cost capitalization. and other provisions that are not modelled here. These provisions affect 

the timing of revenue more than they affect the present value of tax on marginal Investment. 

Indeed, it is because tax revenue is often a poor guide to investment incentives that we turn to 

the concept of the cost of capital. Still. because the cost of capital cannot account for every 

feature of the tax code, it may omit important effects on incentives. 

REFERENCES 

Auerbach, Alan J. "Wealth Maximization and the Cost of Capital." Quarterly Journal of 

Economics 93 (1979), pp. 433-46. 

Auerbach, Alan J. "Taxes, Firm Financial Policy, and the Cost of Capital: An Empirical 

Analysis. " Journal of Public Economics 23 (1984), pp. 27-57. 

Auerbach, Alan J. "The Dynamic Effects of Tax Law Asymmetries. " Review of Economic 

Studies 53 (1986). pp. 205-25. 

Auerbach, Alan J. and James M. Poterba. "Tax Loss Carryforwards and Corporate Tax 

Incentives." In M . Feldstein (Ed.), Taxation and Capital Formation. Chicago: 

University of Chicago Press. 1987. 

Ballard, Charles L. and Lawrence H . Goulder. "Consumption Taxes, Foresight, and 

Welfare: A Computable General Equilibrium Analysis. " In John Piggott and John 

Whalley (Eds.), New Developments in Applied General Equilbrium Analysis. 

New York: Cambridge University Press, 1985. 

Ballard, Charles L., Don Fullerton, John B. Shaven, and John Whalley. A General Equilibrium Model for Tax Policy Evaluation. Chicago: University of Chicago Press, 1985. 

Bosk..in, Michael 1. "Taxation, Saving, and the Rate of Interest. " Journal of Political 

Economy 86 (1978), pp. S3-S27. 

Bradford, David F . "The Incidenceand Allocation Effects of a Tax on Corporate Distributions." 

Journal of Public Economics 15 (1981), pp. J -23. 

Bradford, David F . and Don Fullerton. "Pitfalls in the Construction and Use of Effective Tax 

Rates. " In C.R. Hulten (Ed.), Depreciatio11, Inflation , and the Taxation of Income from 

Capital. Washington, D.C.: The Urban Institute Press. 1981. 

Cilke. James and Roy Wyscarver. "The Individual Income Tax Simulation Model. " Chapter 2 

in this volume. 

Feldstein, Martin, Louis Dicks-Mireaux and James Poterba. "The Effective Tax Rate and the 

Pretax Rate of Return. " Journal of Public Economics 21 (1983). pp. 129-58. 

Fullerton. Don. "The Indexation oflnterest. Depreciation. and Capital Gains and Tax Reform 

in the United States." Journal of Public Economics 32 (1987). February. pp. 25-51 . 

Fullerton, Don, Robert Gillette and James Mackie. "Investment Incentives Under the Tax 

Reform Act of 1986." Chapter 5 in this volume. 

Fullerton, Don and Yolanda Kodrzycki Henderson. " Incentive Effects of Taxes on Income from 

Capital: Alternative Policies in the 1980's. " In C.R. Hulten and I.V. Sawhill (Eds.). 

The Legacy ofReagallomics: Prospects for Lo11g-Tenn Growth. Washington. D.C.: The Urban 

Institute Press. 1984. 

Fullerton. Don and Yolanda Kodrzyck.i Henderson. "Long-run Effects of the Accelerated Cost 

Recovery System. " The Revitw of Economics and Statistics 61 (1985). pp. 363-72 . 

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Investment AJiocation and Growth Under Tax Reform 201 

Fullerton, Don and Yolanda Kodrzycki Henderson. "A Disaggregate Equilibrium Model of 

the Tax Distortions Among Assets, Sectors, and Industries. " Working Paper No. 1905 

(1986a). Cambridge, MA: National Bureau of Economic Research. 

Fullerton. Don and Yolanda Kodrzycki Henderson. "The Impact of Fundamental Tax Reform 

on the Allocation of Resources." Working Paper No. 1904 (1986b). Cambridge, MA: 

National Bureau of Economic Research. 

Fullerton, Don, John B. Shoven, and John Whalley. "General Equilibrium Analysts of U.S. 

Taxation Policy." In 1978 Compendium ofTa>.· Research. Washington, D.C.: Government 

Printing Office, 1978 . 

Fullerton, Don, John B. Shoven , and John Whalley. "Replacing the U.S. Income Tax with a 

Progressive Consumption Tax." Journal of Public Economics 20 (1983), pp. 3~23. 

Gravelle, Jane G. "Effects of the 1981 Depreciation Revisions on the Taxation oflncome from 

Business Capital." National Ta>.· Journal 35 (1982), pp. 1-20. 

Hall, Robert and Dale W. Jorgenson. "Tax Policy and Investment Behavior." Americon 

Economic Review 51 (1967), pp. 391-414. 

Harberger, Arnold C. "Efficiency Effects of Taxes On Income From Capital." In M. Krzyzaniak 

(Ed.), Effects of Corporation Income Tax. Detroit: Wayne State University Press. 1966. 

Henderson, Yolanda, K. "Lessons from Federal Reform of Business Taxes." N~ England 

Economic Revi~. November/December 1986. 

Howry, E. Philip and Saul H. Hymans. "The Measurement and Determination of Loanable 

Funds Saving." Brookings Papers on Economic Activity (1978), pp. 655-685. 

Hulten, Charles R. and Frank C. Wykoff. "The Measurement of Economic Depreciation." In 

C.R. Hulten (Ed.), Depreciation, Inflation, and the Taxation of Income from Capital, 

Washington, D.C.: The Urban Institute Press. 1981. 

Jorgenson, Dale W. and Martin A. Sullivan. "Inflation and Corporate Capital Recovery." In 

C.R. Hulten (Ed.), Depreciation, Inflation, and the Taxation of Income from CapitQ/. 

Washington, D.C. : The Urban Institute Press. 1981. 

King, Mervyn A. Public Policy and the Corporation. London: Chapman and Hall, 1977. 

King, Mervyn A. and Don Fullerton (Eds.). The Taxation of Income from Capital: A Comparativ~ Study of the U.S. , U.K., Sweden, and West Germany. Chicago: The University of 

Chicago Press, 1984. 

Lindsey, Lawrence B. and John F. Navratil. "Rate Reductions and Revenue Responses: Evidence 

from 1982." mimeo, Harvard University. 1985. 

McLure, Charles E .• Jr. Must Corporate Income b~ Taxed Twice?. Washington, D .C.: Brookings 

Institution. 1979. 

McLure, Charles E., Jr. "Rationale U nderJying the Treasury Proposals." In Federal Reserve 

Bank of Boston Conference Series No. 29. Economic Consequences of Tax Simplification, 

1986. 

Miller, Merton. "Debt and Taxes." Journal of Finance 32 (1977), pp. 261-75. 

Poterba, James M. and Lawrence H. Summers. "Dividend Taxes, Corporate Investment, and 

'Q'." Journal of Public Economics 22 (1983). pp. 135-67. 

Poterba, James M. and Lawrence H. Summers. "The Economic Effects of Dividend Taxation." 

In Edward I. Altman and Marti G. Subrahmanyam (Eds.), Recent Advances in Corporate 

Finance. Homewood, IL: Richard D. Irwin. 1985. 

Slemrod, Joel. "The Impact of Tax Reform on Households." In Federal Reserve Bank of Boston 

Conference Series No. 29. Economic Consequences of Tax Simplification, 1986. 

U.S. Department of the Treasury. Ta>.· Reform for Fairness, Simplicity. and Economic Growth. 

Washington, D.C.: Government Printing Office. 1984. 

The White House. The President 's Tax Proposals to the Congress for Fairness, Growth, and 

Simplicity. Washington . D.C.: Government Printing Office, 1985. 
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7 THE TREASURY DEPRECIATION MODEL 

Geraldine Gerardi, Hudson Milner, Leslie Whitaker, 

and Roy Wyscarver 

I. INTRODUCI10N 

Depreciation refonn was a controversial issue during the tax refonn debate 

with numerous depreciation systems proposed. The debate over depreciation 

concentrated primarily on the proper balance between lower statutory rates and 

greater depreciation allowances, and secondarily on improvements in the measurement of income through both more realistic measures of depreciation and 

adjustments for inflation. The principal model the Office of Tax Analysis 

used to evaluate the revenue consequences of depreciation proposals was the 

Treasury Depreciation Model. 

For any proposed tax system the depreciation model calculates depreciation 

deductions based on investment estimates by type of asset within a set of 

industries. These estimates enable the model to operate between the micro 

level of the finn, where investment is difficult to forecast, and the macro 

level, where detail is inadequate to evaluate alternative tax proposals. The 

investment estimates are derived primarily from data on investment by industry 

and type of asset for 1970 through 1985 from the Bureau of Economic Analysis 

(BEA). The BEA data are modified for use in the depreciation model to exclude 

investment that is not eligible for depreciation, to extrapolate investment to 

1992, to allocate investment to depreciation categories, and to allocate 

investment to the corporate and non-corporate sectors. The model currently 

considers 72 assets in 55 industries. 

Although these investment estimates provide the basic data to the model, 

they must be supplemented by other data to calculate changes in deductions and 

tax revenues. For example, tax return data from the IRS Statistics of Income 

are used to estimate the amount of investment depreciated by each depreciation 

method and the amount of tentative depreciation and investment credit changes 

carried back or forward as a result of inadequate taxable income. 

The authors wouJd like to express their appreciation to Donna Harrell for preparation of the 

manuscript and tables. 

203 
204 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

To compute total changes in calendar year tax liabilities as a result of 

alternative depreciation proposals, the model calculates the change in depreciation claimed in the current year by adding to the tentative current change 

the carryforward deductions from prior years, subtracting the amounts not 

usable in the current year and adding the amounts carried back to prior years. 

Calendar year tax liabilities are then computed by multiplying the change in 

deductions for the year by each sector's effective tax rate (calculated from 

both statutory tax rates and simulations of the Treasury's corporate tax 

model) to determine the relationship between depreciation deductions and 

taxable income. The depreciation model also computes the investment tax 

credit (lTC) claimed for each year in the simulation period, including the 

interaction of depreciation deductions and lTC carrybacks and carryforwards. 

The depreciation model was used to estimate the revenue effect of the 

changes in the lTC and depreciation provisions under the Tax Reform Act of 

1986. The Act generally repealed the lTC for equipment. which under prior law 

generally was 10 percent of qualified investment. In addition to repealing 

the lTC. the Act reduced the amount of tax credits that could be carried over 

to future years. The Act changed the provisions governing depreciation allowances by replacing the six recovery period classes under prior law with eight 

classes-six for personal property and two for real estate. The Act also 

modified expensing provisions. 

Based on the Administration's August 1986 investment forecast, the mod~l 

shows that the changes in the lTC and depreciation would increase calendar 

year tax liabilities by approximately $256 billion through 1992. After 

certain "off model" adjustments, the estimates were approximately $260 billion 

over this calendar year period and about $23 I billion over the fiscal year 

period ending with fiscal year 1992. 

The results described in this paper illustrate one use of the depreciation 

model-estimating the revenue effect of a change in the tax law over a certain 

period of years. The model is also used to devise depreciation proposals with 

a targeted revenue cost, which may then be evaluated for their reduction in 

the cost of capital (see Chapter 5). Alternatively. a proposal that meets a 

given cost of capital objective can be evaluated for its revenue consequences. 

Finally, a joint goal for the cost of capital and revenue cost could be 

specified and depreciation proposals devised to achieve that goal. 

The remainder of this paper is organized as follows. Section II describes 

the changes in the investment tax credit and depreciation provisions under the 

Tax Reform Act of 1986. Section III continues with a description of the data 

used by the depreciation modeling system: section IV addresses the actual 

model in some detail. Finally. section V presents the model's estimated 

revenue effects from simulating the tax reform changes in depreciation allowances and investment tax credits and discusses the results. 

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The Treasury Depreciation Model 205 

II. A DESCRIPTION OF lTC AND DEPRECIATION CHANGES 

This section describes the changes in the investment credit and depreciation provisions under the Tax Reform Act of 1986 that were evaluated in part 

by the use of the depreciation model. Each change is discussed in the order 

it was evaluated by the model: (l) repeal of the lTC for equipment; (2) reduction of carryforwards of investment tax credits; (3) changes in expensing; and 

(4) changes in the depreciation provisions. 

Prior to the Tax Reform Act a 10 percent lTC was generally allowed for 

investment in new equipment (and used equipment up to $125,000). Short-lived 

equipment in the 3 year Accelerated Cost Recovery System (ACRS) depreciation 

class was permitted a 6 percent credit. Assets that took more than one year 

to construct could receive credits on qualified progress expenditures (QPE's) 

made during the period of construction before the asset was completed and 

placed in service. After 1982 the basis against which depreciation allowances 

were permitted was adjusted down by one-half of the investment credit earned 

unless the credit percentage was reduced by two percentage points. Investment 

in buildings was not allowed an investment credit. 

The Tax Reform Act of 1 986 abolished the lTC after December 3 1 , 1985. 

unless transition rules apply. Some property will continue to receive the 

investment credit for various periods through 1 990 depending upon the asset 

depreciation range (ADR) life of the asset, provided it satisfies certain 

binding contract criteria or was specifically identified in the Act as transition property. The depreciable basis of assets that qualify for transition 

treatment are reduced by the full amount of the credit and continue to use 

pre-reform depreciation schedules. 

Accompanying repeal of the investment credit is the elimination of basis 

adjustments to depreciable assets associated with investment credits and the 

reduction of carryforwards of investment credits. Under prior law, investment 

credits not usable in the current year because of inadequate tax liability 

were carried back 3 years and forward 15 years. Under the Tax Reform Act, tax 

credits carried forward from prior years and newly earned credits are allowed 

in full for 1986, but are reduced by 17.5 percent in 1987 and by 35 percent 

after 1987. 

The Tax Reform Act also changed expensing provisions. Under prior law 

$5,000 of investment could be directly expensed (i.e., deducted in full) in 

1986. This amount was scheduled to increase to $7,500 in 1988 and to $10,000 

in 1990 and thereafter. The new law expands the amount eligible for expensing 

to $10,000 in 1987. subject to certain restrictions. The restrictions generally limit the amount expensed to taxable income derived from any trade or 

business. Thus, expensing deductions cannot be used to offset income from 

other sources. Also. the $10.000 deduction is reduced dollar for dollar as 

the amount of annual investment exceeds $200.000. 
206 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

The Tax Reform Act also replaced the prior ACRS depreciation system with a 

new depreciation system. The prior ACRS system depreciated assets over 3, 5, 

10. 15 and 19 years. Assets in 3, 5. 10 and 15 year classes were depreciated 

by a method similar to 1 SO percent declining balance (DB) with an switch to 

straight line to maximize depreciation allowances. Low-income housing and 

assets in the 19 year class were depreciated at 200 percent and 175 percent 

DB. respectively, with a switch to the straight-line method to maximize the 

present value of depreciation deductions. 

The new depreciation system uses 200 percent DB for assets in the 3, 5. 7 

and 10 year classes and 150 percent DB for assets in the 15 and 20 year 

classes with an optimum switch to straight line to maximize depreciation 

allowances. Real estate is depreciated using the straight-line method over 

2 7. 5 years for residential real estate and over 31.5 years for other real 

estate. The new system applies in I 987, but is optional for assets placed in 

service between July 31 and the end of 1986. The ADR midpoint life primarily 

determines the assignment of property to a class as follows: 

New Ufe 

3 

5 

7 

10 

15 

20 

For ADR Uves 

4 or less 

4.5 to 9.5 

10 to 15.5 

16 to 19.5 

20 to 24.5 

25 or more 

However, certain equipment is treated differently. Autos and light trucks. 

research and experimentation property, and certain technological property are 

placed in the 5 year class. Other assets are assigned new ADR lives by 

statute. Assets without ADR midpoint lives are treated as 12 year ADR midpoint life assets. The Appendix contains a more detailed comparison of prereform and reform depreciation systems according to ADR midpoint life and 

asset type or industry where applicable. 

The Tax Reform Act of 1986 provides an alternative depreciation system for 

property used predominantly outside the United States, for determining the 

proportion of property financed by tax-exempt bonds, and for computing earnings and profits and depreciation for minimum tax purposes. The alternative 

depreciation system uses the ADR midpoint life and is 40 years for structures 

and 27.5 years for low-income housing financed with tax-exempt bonds and the 

straight -line method (except for purposes of the minimum tax). The minimum 

tax allows the 150 percent declining balance method switching to the straightline method for property other than real property. which continues to use the 

straight-line method. 

Under prior law several alternative tax systems applied. The minimum tax 

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The Treasury Depreciation Model 207 

did not apply to depreciation on ACRS personal property. However, for real 

property straight-line depreciati.on was required for minimum tax purposes over 

the applicable ACRS life of 15, 18 or 19 years. Leased property was required 

to use the straight-line method over the somewhat longer tax lives of S , 8, IS 

and 22 years for personal property and 40 years for real property except low 

income housing which used 18 years. Property placed in service abroad was 

able to use the double declining balance depreciation method with an optimum 

switch to the straight-line method over the ADR midpoint life for equipment. 

Real property placed in service abroad was limited to 150 percent declining 

balance with a switch to straight line over 35 years. For computing earnings 

and profits the straight-line method applied to the longer tax lives of 5, 12, 

25 and 35 years for equipment and 40 years for real property. 

Ul. A DESCRIPTION OF THE DATA 

This section discusses the data inputs for the depreciation model. The 

model processes: (a) investment data disaggregated by industry. asset type. 

and asset depreciation range (ADR) and (b) other data which supplements the 

investment data to enable calculation of revenue effects. 

A. The Investment Data File 

The investment data file is the basic data for the depreciation model. The 

Office of Tax Analysis (OT A) created this file from investment data supplied 

by Bureau of Economic Analysis (BEA). This process consisted of four steps: 

(a) adjusting the investment data to investment allowed tax depreciation. (b) 

extrapolating the data through 1992. (c) mapping the BEA industries and asset 

classes into OTA industries and asset classes, and (d) splitting the data file 

into a corporate and non-corporate sector. The subsections below provide 

background about the BEA data file and describe each step of the process used 

to create the investment data file. A detailed discussion of BEA's estimation 

procedure is contained in Gorman, et.al. ( 1985). 

B. The BEA Data 

The BEA investment estimates by industry were obtained from three major 

sources. The first data source, BEA 's plant and equipment expenditure survey. 

provides annual data on investment in nonresidential capital by nonfarm industries. These data are classified on a company basis and provide a two-way 

split by type of asset: total equipment and total structures. The second 

source of information is on investment in structures and durable equipment by 

sector (mining. construction. manufacturing. etc.). which is collected by the 

Census Bureau. These data are available every five years. The third source of 

data is the capital flow tables prepared by BEA from input-output tables for 
208 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

1963, 1967, and 1972, which provide distributions of investment by asset for 

each industry. In those instances where data were nonexistent, adjustments 

were made using interpolation and extrapolation procedures calibrated to 

established benchmarks. 

The investment flows were derived for investment in new capital by type of 

asset for each industry and for transfers of used assets between private 

business and other types of owners. The flows for each industry for investment in new and used assets were distributed by legal form of organization. 

The BEA data provides estimates of investment by industry and by type of 

asset for 1970 through 1985. For years following 1985, investment was calculated from detailed industry growth rates obtained from long-term forecasts by 

Data Resources, Inc. (DRI). 

C. The Data Adjustment Process 

In order to use the BEA data to compute tax depreciation, several adjustments were required. In order to concentrate on depreciation deductions of 

taxable firms, all tax-exempt co-operatives were removed (rural electric 

power, telephone and wholesale trade). Similarly, all investments of nonprofit institutions were removed from the real estate industry. (BEA classified these investments in the real estate industry in order to maintain 

consistency with the National Income and Product Accounts, NIPA). Non~ 

depreciable oil wells, gas wells, and mine shafts were removed from their 

corresponding industries. The assets of Federal Reserve Banks are also 

removed since they do not pay income tax. 

A time series for used investment was created using basic scrap equations 

found in Winfrey ( 1935). Adjustments were made for replacement railroad 

tracks and major structural improvements. Special purpose agriculture structures. railroad tank cars. public utilities, coal fired burners, and other 

asset types were also adjusted to achieve benchmark targets. 

These adjustments to the BEA data produced the basic data for the 

depreciation model. 

D. Extrapolation 

The BEA data file provides data for the years 1970 through 1985. Since the 

depreciation model must simulate proposals for 1981 through 1992, the years 

beyond 1985 were extrapolated in two steps: (a) investment was grown from 

19.86 through 1992 based on estimated growth rates for each industry from DRI. 

and (b) the data was subsequently scaled to conform with the Administration's 

forecast for gross private domestic investment in producers durable equipment. 

residential structures. and non-residential structures. This extrapolation 

procedure provides a consistent basic data set that covers the years for which 

revenue estimates are calculated. 

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The Treasury Depreciation Model 209 

E. Mapping 

Mapping of industries and asset classifications is required because BEA 

industries and asset classifications are not the same as those used by OT A. 

Since BEA uses more detailed industries than OTA, the 61 BEA industries were 

mapped into 55 industry classifications used by OTA. ADR mapping also is 

necessary because not all of the investment attributed to each of BEA 's 65 

asset types corresponds to one and only one ADR classification. Consequently, 

the investment in certain asset types are allocated among several different 

ADR classes depending on the asset type and industry. Investment in other 

asset types are allocable to one and only one ADR class. 

F. The Corporate/Individual Split 

The investment data file was split into two separate data fLles, for the 

corporate and individual (non-corporate) sectors, so that revenue estimates 

could be calculated for each sector. The investment data file was split by 

computing the percentage of total investment by industry that is non-corporate 

and applying that percentage to the investment in each asset within the industry. This percentage is the weighted sum of the percentage of non-corporate 

investment in equipment and structures obtained from statistics of income 

data. 

G. Other Data Inputs 

Although the adjusted investment data file provides the basic infonnation 

needed for the computation of tax depreciation, it is incomplete and must be 

supplemented by data from other sources. For example, it does not contain the 

amount of investment that received straight line depreciation or sum of the 

years digits, or the amount of depreciation deductions claimed for the current 

year or deductions carried forward to future years. The corporate tax model 

with published corporate statistics of income (SOl) data was used . either to 

extract, or where necessary, generate the additional data in a fonn that could 

be used with the investment data. These data include: 

o Percent of corporate and non-corporate investment qualifying for bonus 

depreciation by industry. These amounts are used to determine the 

amount of corporate and non-corporate investment that is expensed, 

respectively. 

o Growth factors to inflate or deflate expensing and bonus depreciation. 

These data are used to estimate real growth in the number of businesses 

by industry and year. 

o Depreciation deductions on structures "in place" as of 1981 estimated 

through 1992 for each industry. These amounts are added to new depreciation to yield total depreciation. 
210 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

o Depreciation deductions on equipment "in place" as of 1981 estimated 

through 1992 for each industry. These amounts are added to new depreciation to yield total depreciation. 

o Interpolation parameters (by percent change in depreciation) by industry for the a) effective tax rate; b) percentage of depreciation 

deductions in net operating losses (NOL); and c) ratio of tentative lTC 

to claimed lTC. 

o Percentage of carryback and carryforward that apply to the ITC computations. 

o Percentage of NOLs carried back and forward that apply to the depreciation computations. 

These additional data complete the input data used in the current version 

of the depreciation model. 

IV. A DESCRIPTION OF THE SIMULATION MODEL 

This section summarizes the operation of the depreciation model program. 

The fll'st subsection highlights the functional operation of the model. A 

subsection follows that provides a more detailed explanation of selected 

computations. The last subsection illustrates how the depreciation model is . 

used with other modeling systems to expand the capabilities of those systems. 

A. The Simulation Process 

The data for each asset in each industry is processed for each year in the 

simulation for present law (Plan X) and proposed law (Plan Y). For each plan. 

the model computes by year an investment tax credit and depreciation deductions by proceeding through the following steps: 

o The asset tax classification is determined. 

o Transition rules are applied. if applicable. 

o Expensing is computed and. if appropriate, the expensed amount is 

subtracted from the cost of property to obtain the adjusted basis. 

o The allowable investment tax credit is computed and. if appropriate, 

the adjusted basis is modified again. 0 Regular depreciation deductions are computed for investment that does 

not receive straight line. 

o Straight-line depreciation deductions are computed for investment that 

is eligible for and chooses to use straight Jine. 

The results are summed for each industry across all asset classifications 

to obtain total investment. total depreciation. and total "tentative" investment tax credit for the industry by year. 

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The Treasury Depreciation Model 211 

Next, the difference between present law and proposed law depreciation 

deductions and lTC and the corresponding difference in calendar year tax 

liabilities and fiscaJ year receipts are computed. (These computations are 

described in greater detail later in the subsection on credit computations.) 

The industry results are available for the corporate sector, non-corporate 

sector, and both sectors combined. 

B. Explanations of Selected Computations 

This section provides detailed explanations of the model's computations for 

expensing. qualified progress expenditures, tax liability, and tax credits. 

J • Expensing 

A finn can elect to deduct the cost of property up to some maximum in the 

year the property is placed into service in lieu of recovering the cost under 

the depreciation rules currently in effect. Only personal property is eligible for expensing. Because the investment data was collected by industry and 

expensing rules apply to the firm, a procedure was developed to estimate expensing on a industry basis for both the corporate and non-corporate sectors. 

Corporate tax model simulations were perfonned to determine, by industry, 

the percentage of cumulative investment less than or equal to expensing limits 

in $5,000 increments up to $50,000. Similar simulations were also performed 

using the sole proprietorship file to obtain percentages for the non-corporate 

sector. These percentages, applied to the investment across an industry in a 

given sector for a specific expensing limit. yield an estimate of expensing. 

Based on the results of regressions, allowances were made to expensing for the 

growth in the number of business over time. 

2. Qualified Progress Expenditures 

Qualified progress expenditures (QPE) are calculated so that their associated lTC can be computed. By looking ahead in the time series. the amount of 

investment that will be put in place in the future is distributed backwards 

through time (the construction period) according to an industry-specific 

pattern. The industries that are affected by qualified progress expenditures 

rules are chemical and petroleum refining equipment, coal and non-nuclear 

power plants, and nuclear power plants. 

Table 7.1 provides an example of this estimation method for QPEs for 

chemical and refining equipment. It is assumed that QPEs in the current year 

are 34 percent of total investment and that this amount was actually spent 

over the prior 4 years of the construction period. The pattern of this distribution assumes that 7 percent of the cost occurred one year ago. 20 percent 

two years ago, 48 percent three years ago. and 25 percent in the first year of 

the construction (four years ago). Once these computations hav.e been completed. the qualified progress expenditures for each year of the simulation 
212 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

Table 7. I Assumptions Underlying Qualified Progress Expenditures 

Number Chemical Coal and Nuclear 

of Years Refining Non-Nuclear Power 

Past Equipment • • b Power Plants Plants 

Construction period 4 .00 7.00 1 I .00 

Total QPE as a percent of 

current year investment 34.00 30.28 30.28 

I 7.00 4.00 16.00 

2 20.00 14.00 14.00 

3 48.00 33.00 12.00 

4 25.00 34.00 12.00 

5 11 .00 I I .00 

6 3.00 11 .00 

7 1.00 12 .00 

8 6 .00 

9 4 .00 

10 1.00 

II 1.00 

•coNCEPT-S. Oak Ridge National Laboratories. Phase VI Update (1983) Report for the 

Energy Economic Data Base Program. EEDB-VI. September. 1984. 

bBased on Energy Information Form 254 and Federal Energy Regulatory Commission 

Form I. The data are based on a specific 1120 megawatt pressurized-water reactor unit that 

is considered to be representative of nuclear units. 

are summed so that the series wiU be available for the computation of the 

investment tax credit. 

The same procedure is applied to the other eligible industries. Since the 

construction period for nuclear power plants is 11 years, the computations 

cover the period 1971 (1982. when QPE rules were enacted, minus II years) to 

2006 (1995, the last year the model estimates, plus II years). In years where 

no actual investment data exists. data was generated by assuming that investment continues to grow at the same rate exhibited by the last two periods of 

actual data. 

3. Tax Computations 

For each industry the depreciation model computes the following changes for 

each year in the simulation: 

0 Tentative total depreciation. 

o Tentat.ive current year depreciation. 0 Tentative deductions carried back. 

o Tentative deductions carried forward . 

o Claimed total depreciation. 

o Claimed current year depreciation and deductions carried back, 

o Claimed deductions carried forward. 

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The Treasury Depreciation Model 213 

o Outstanding carryforward (NOL). 

o Calendar year tax liability, and 

o Fiscal year receipts. 

To compute these changes. summations are required for total depreciation 

deductions under present law (Plan X) and under proposed law (Plan Y). The 

tax calculator begins by computing the tentative change in depreciation as the 

difference between Plan Y and Plan X depreciation deductions. In-place depreciation for equipment and structures is added to present law depreciation to 

yield total present law depreciation. 

Next, the model computes the percentage change in depreciation deductions 

with respect to total present law depreciation. Both the percentage change in 

depreciation deductions and industry classification are used to determine 

three exogenous tax parameters: (a) the effective corporate tax rate for 

depreciation deductions. (b) the percent of total depreciation deductions in 

NOL.s, and (c) the ratio of claimed lTC to tentative lTC (used in the computation of tax credits). These tax parameters are used to calculate the change 

in current year depreciation deductions and to allocate the total depreciation 

change between current year deductions and additions to carryback and carryforward deductions. Tentative changes are computed in four steps. 

First, the tentative change in current year taxable income is computed by 

multiplying the total change in depreciation deductions by one minus the percent of total depreciation deductions in NOLs. Second. the tentative change 

in carryback deductions is computed by multiplying the tentative change in 

N 0 Ls by the percentage of N 0 Ls carried back (obtained from data extracted from 

the corporate SOl). Third, the tentative change in carryforward deductions is 

a residual obtained by subtracting the tentative change in carryback deductions from the tentative change in NOLs. 

The change in current year taxable income is computed as the sum of the 

tentative change due to current year depreciation deductions, the tentative 

change in carryback deductions, and the claimed change in carryforwards from 

prior years (accumulated during prior years of the simulation). For each year 

remaining in the simulation, the claimed change in carryforward deductions is 

computed by multiplying the tentative change in NOLs by the percentage ofNOLs 

carried forward. These carryforwards are accumulated for each year remaining 

in the simulation so that claimed carryforwards will already be computed when 

the simulation reaches a future year. 

Calendar year tax liabilities are computed by sector because effective tax 

rates differ by sector. The effective corporate tax rates are adjusted for 

the rate reductions enacted in the Tax Refonn Act of 1986 by simple proportional adjustment. Thus, the corporate tax rate (derived from corporate tax 

model simulations) is multiplied by (0.40/0.46) for 1987 and by (0.34/0.46) 

for 1988 and the years that follow. The individual tax rates are computed as 

a base rate adjusted to reflect bracket creep that existed prior to indexing 

enacted under the Deficit Reduction Act. In addition, the individual tax 
214 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

rates were adjusted further to capture the rate reductions enacted by the 

Economic Recovery Tax Act. Changes in tax liabilities are then computed by 

multiplying the change in deductions claimed by the effective tax rate for the 

appropriate sector. 

4. Credit Computations 

Following the tax computations. the depreciation model computes the lTC for 

each year in the simulation. The model computes the following changes: 

o Tentative total lTC, 

o Tentative current year lTC, 

o Tentative lTC carried back, 

o Tentative lTC carried forward. 

o Claimed total lTC, 

o Claimed current year and carryback lTC, 

o Claimed ITC carried forward , 

o Outstanding carryforward. 

o Calendar year tax liability. and 

o Fiscal year receipts. 

The procedure for these calculations is similar to that for the tax 

computations for changes in depreciation. Consequently. it will not be 

discussed further here except to note two differences. First, the allocation 

of tentative total lTC to carryforward and carryback credits is more complicated than the same computation for depreciation deductions because the model 

must account for the fact that a change in gross tax will change lTC carried 

back or forward. In other words, if the lTC does not change between present 

and proposed law but depreciation deductions do change, then more or less lTC 

will be carried back or forward . Second. the tax liability computation is 

different because ITCs are applied directly against tax. 

C. Relationship to Other Models 

I . Corporate Model 

The depreciation model is used to supply three categories of data to assist 

simulations made with the corporate model: (a) estimates that adjust depreciation deductions by industry on the corporate SOl file. (b) computations of 

preference amounts that are allocated to corporate returns for computing the 

alternative minimum tax. and (c) estimates that are used to construct an earnings and profit (E&P> net depreciation adjustment for 1990 and beyond. 

For the regular tax. depreciation in the corporate tax model is recomputed 

by multiplying the base year depreciation by an adjustment ratio. This 

ratio is the target depreciation. as estimated by the depreciation model. 

divided by the total base year depreciation on the corporate data base. 

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The Treasury Depreciation Model 215 

For the alternative minimum tax under the Tax Refonn Act (TRA), two 

simulations using the depreciation model are required to produce the appropriate estimates. The first simulation yields depreci~tion claimed under the 

TRA for assets put in place after the law becomes effective; the second simulation produces the minimum depreciation generated by these assets. 

The adjustment for earnings and profit depreciation requires a series of 

depreciation model simulations to capture the nuances of the interactions of 

book income and taxable income within the depreciation system. 

2. Supplemental Model 

The results of the depreciation model are adjusted using a supplemental 

model to take into account changes in the tax treatment of research and development property. The adjustment provided by this model is described in detail 

in section V.B. 

V. RESULTS OF SIMULATING THE EFFECTS OF TAX REFORM 

This section discusses one use of the depreciation model: detennining the 

revenue effects of changes in depreciation allowances and investment tax 

credits in the Tax Refonn Act of 1986. 

A. Simulation Results 

The depreciation model evaluated refonn proposals in the following order: 

repeal of the investment tax credit, reduction in existing investment credits, 

changes in expensing. and changes in depreciation. The order of consideration 

affects the revenue estimate for a particular provision. For example, the 

revenue estimate for changes in expensing is different if it is considered 

before rather than after depreciation provisions. The "stacking order" 

followed for the Tax Refonn Act estimates was statutory tax rate reduction 

frrst, followed by investment credit repeal, reduction in existing credits. 

increase in expensing, and depreciation changes. Stacking order issues are 

discussed in Nester "Interpreting Revenue Estimates: Macro-Static MicroDynamic" in Chapter I of this volume. The effect of general rate reduction, 

which is considered before depreciation and investment credit provisions for 

revenue estimating purposes. is not discussed here. In addition. the effect 

of other provisions which were stacked later. such as the minimum tax, are not 

described here. 

l. Summary 

The revenue estimates produced by the depreciation model after adjustments 

are summarized in Table 7.2. The tax refonn changes in the lTC and depreciation increase calender year tax liabilities by $260 billion through 
2 J 6 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

Table 7.2 Revenue Changes From The Capital Cost Recovery Provisions 

in The Tax Reform Act of 1986, 1986- 1992. 

1986 1987 1988 1989 1990 1991 1992 1986-1992 

($ Millions) 

Individual 3,320 3,1102 5.332 6,729 9,0110 11 .807 13,138 53,208 

Corporate 10.533 15,069 22.408 29,452 36.880 254 46,3511 206.954 

Total 13,853 18 ,1170 27 .741 36.1111 45.961 SII.062 S9.496 260,163 

*These estimates may differ from other published estimates, because they are based on a 

different economic forecast and include only selected capital cost recovery provisions. 

calendar 1992. Calendar year liabilities increase from $13.9 billion in 1986 

to $59.5 billion in 1992 as transition provisions phase out, the economy 

grows, and a larger fraction of investment becomes eligible for the new 

depreciation schedules. 

The change considered first, investment credit repeal, provides revenue 

increases roughly proportional to investment in equipment. The changes considered second and third, the reduction in existing credits and increases in 

expensing. have relatively small effects concentrated in the early years. 

Depreciation provisions. which were considered last, first reduce and then 

increase revenue after a few years as the revenue increase from the less rapid 

depreciation schedules for structures overtakes the revenue loss from the more 

rapid depreciation schedules for equi.pment. 

Results of the depreciation model are adjusted to produce the final set of 

revenue estimates. These adjustments take into account current data for the 

35 percent cutback of ITCs, the elective 15 year carryback for certain taxpayers, the treatment of R&D property. and recapture provisions for auto and 

truck leasing. These adjustments are necessary to produce a fmal set of 

revenue estimates for the tax reform proposals. Several adjustments made 

using the supplemental model are described in section B. 

2. Investment Credit Repeal 

The first change evaluated by the model is repeal of the investment tax 

credit. Tentative investment credits before reform are calculated according 

to the classification of the asset. Three-year property receives a 6 percent 

investment credit and longer lived personal property receives a lO percent 

credit unless the property is expensed. 

The translation of tentative credit changes to actual tax changes requires 

adjustments for the interaction of credits with depreciation and adjustments 

for restrictions on the use of credits and deductions. The computation of 

revenue changes associated with repeal of the investment credit is described 

in more detail below. 

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The Treasury Depreciation Model 217 

The baseline investment series for 3. 5, 10, and 15 year personal property 

eligible for the credit under prior law for calendar years 1986 through 1992 

is shown on Table 7.3. Within each asset class the amount of investment is 

shown that is adjusted in basis for investment credits, is expensed, is 

allowed ACRS depreciation, and selects straight-line depreciation. Investment 

expenditures fall primarily in the 5 and 19 year classes. For 1986, $284 

billion or 49 percent of investment was accounted for by 5 year equipment. 

Buildings, which received a 19 year depreciation period, accounted for $153 

billion or 27 percent of total investment. Based on the estimates of investment shown on Table 7.3, the model calculates tentative depreciation deductions before repeal of the investment credit. These estimates for calendar 

years 1986 through 1992 are shown on Table 7.4. 

Table 7.5 summarizes the computation of actual tax changes from repeal of 

the investment credit and shows the total change in calender year liabilities 

and fiscal year receipts. These totals include various interactions between 

credit~. depreciation allowances and the other tax provisions shown on the 

table. After a presentation of total investment for reference in lines 1 to 3 

of Table 7.5 and total tentative depreciation deductions in the base and 

revised cases in lines 4 and 5, respectively. the differences in tentative 

depreciation deductions from repeal of the lTC are presented in line 6. 

Tentative depreciation deductions increase by approXimately $16 billion per 

year by 1992 from the elimination of the basis adjustment. 

Based on simulations of the corporate tax model, the tentative depreciation 

allowance change is divided into three parts: the portion used in the current 

year, the portion carried back to one of the previous three tax years, and the 

portion carried forward to future years. Because some deductions not usable 

against current year tax liability (carrybacks) are assumed to reduce tax liability for a prior year, any pennissible reduction in prior year tax liability 

from the carryback is a reduction in tax liability affecting Federal government revenue for the current year. These current and carryback deductions 

from Jines 7 and 8 are totaled in line II. The third portion of depreciation 

deductions, the position that cannot be used currently or carried back to a 

prior year due to inadequate tax liability. is carried forward to a future 

year. perhaps to be usable later as a carryforward (line 9). 

Line 12 takes into account the stock of net operating loss carryforwards 

that some finns have from the past that are usable in the current year. Thus. 

the current year change shown in line 10 is the sum of current and carryback 

use of currently earned tentative depreciation deductions plus the amount of 

carryforwards from previous years used in the current year. The change in the 

stock of outstanding carryforwards of net operating losses maintained by the 

model is presented in Jjne 13. 

The "bottom line" effect on tax receipts of depreciation related changes 

induced by repeal of the investment credit is presented in line 14 by calendar 

year and in line 15 by fiscal year. The tax rate applicable to depreciation 

allowances is calculated by the model from the basic statutory rates of 40 
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21 8 

Geraldine Gerardi/Hudson Milner/leslie Whitaker/ o~ W~scarver I 

Table 7.3 

Total Investment by ACRS Depreciation O ass I 

Before TRA 86, 1986-1992 

I ACRS Class 1986 1987 1988 1989 1990 1991 1992 

(S Millions) 

3 Year Personal Property 

Buls Adjustment 1,319 1,460 

1.638 1,9211 2,156 2.341 2.546 I 

Expensing 1.606 1,616 2,466 

2,6S2 3.268 3.273 3.288 

Regular 63.187 69.711 78.161 91

,889 102,739 111

,542 121,2S2 I Straight Line 2,292 2,5211 2.83S 3.333 3 ,726 4.046 4,3911 

S Year Personal Property 

I Basis AdjuStment 7.834 8.807 9,934 11.634 13,071 14,353 15,282 

Expensing 6,039 6.187 9,461 10

,144 12

,596 12

,843 13,129 

Rqular 260

,463 292,510 329.779 387

.067 436

,020 480,215 529.839 

Straight Line 

9,447 10

,609 11

.961 14.039 15.814 17,417 19,217 

I 10 'Veer Personal Propeny 

Basis Adjustment 296 328 366 412 4SI 489 207 

E•penslng 10 10 IS 16 19 19 20 

I Regular 11.012 11.801 12.784 14,037 JS, l74 16,352 18.099 

Straight Line 399 428 46S S09 S50 S93 656 

IS Year Penonal Property 

I Basis Adjustment 813 908 1,011 1,160 1,282 1,378 959 

EJtpensing 12 

12 19 20 24 24 2S 

Reautar 27

,426 30,033 33

,240 38,090 42,068 45,238 49.6

17 

Stralaht line 99S 

1,089 1,206 

1,382 

1,526 1,641 

1.800 

I 5 Year Real Property I 

EJtcept Low Income 

Basis Adjustment 9S 0 0 0 0 0 0 I EJtpensing 0 0 0 0 0 0 0 

Regular 

11.967 0 0 0 0 0 0 

Straight Une 8.974 0 0 0 0 0 0 

lS Year Real Propeny 

Low Income I 

Basis Adjustment 0 0 0 0 0 0 0 

E•pensing 0 0 0 0 0 0 0 I Reaular 6.737 7,4113 11 .282 9,015 9 ,701< 10,5112 11.520 

Straiaht Line 237 264 292 318 342 373 406 

19 Yur Real Property 

Basis Adjustment 0 0 0 0 0 0 0 I 

Expensing 0 0 0 0 0 0 0 

Rqular 1111

.335 110,392 122 ,23• 133.177 144,435 157.944 172,574 I Straight Une 64.758 80.633 119.173 97.077 105,453 115.342 126.089 

Total 514,254 636.809 

715,320 817,898 910.419 996.004 

1.090.932 

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Table 7.4 Total Deductions by ACRS Depredation Class 

Before TRA 86, 1986-1992 

ACRS Class 1986 1987 1988 1989 1990 1991 1992 

($ Millions) 

3 Year Personal Propeny 56,162 57.518 62.340 70,327 80,411 89.722 97.899 

S Year Personal Property 242,233 257.821 28S,SS9 315,311 354,163 399,006 447,296 

10 Year Personal Property 5,899 7,077 8,335 9,730 11 .250 12,100 13,144 

IS Year Personal Property 10,146 12,2SS 14S75 17,206 20,200 23.392 26,841 

15 Year Real Property 

E11cept Low lncome 37 ~ 35,259 32,505 30,301 28.679 27,084 25,121 

IS Year Real Properly 

Low Income 2,669 3.222 3,793 4,402 5 ,033 5.699 6,416 

19 Year Real Property 15,614 27,554 40,859 54.700 68.996 83,878 99,617 

Total 370,290 400,706 447 ,966 501,977 568,732 640,881 716,933 

percent in 1987 and 34 percent thereafter with adjustments to these statutory 

tax rates calculated within the model based on the results of simulations of 

the corporate model. Fiscal year receipts are calculated from the calendar 

year figures from a rule of thumb division of calendar year liabilities 

between fiscal years. All amounts are calculated for the corporate and noncorporate sectors separately and aggregated to the totals presented. A 

similar set of calculations is then performed by the model for investment 

credit changes, shown starting on line 16. The difference between baseline 

and tax reform tentative investment credits in lines 16 and 17 is presented in 

line 18 as the tentative change. The portions of the tentative change used in 

the current year or carried back to one of the previous three years shown in 

lines 19 and 20 are summed in line 23. The portion of the outstanding investment credit carried forward from previous years shown in line 24 is added to 

determine the actual change in line 22. The stock of outstanding carryforward 

is adjusted for the difference between past carryforward used or lost and 

current year additions to the carryforward in line 25. Changes in fiscal year 

receipts in line 27 are calculated from calendar year receipts in line 26. 

The total change in line 28 is the sum of depreciation induced changes in 

tax liability in line 14 and investment credit changes in tax liability in 

line 26. Similar sums are calculated for fiscal year receipts in lines 15, 

27. and 29. The total tentative ~evenue change in investment credits through 

t 992 of $337 billion becomes a $230 billion dollar change after carryforwards. 

carrybacks and associated depreciation adjustments. These are the amounts 

associated with repeal of the investment credit before the reduction in 

investment credits that will be discussed next. 

3. Reduction in Investment Credits 

The second set of tax reform changes evaluated by the depreciation model is 

the reduction in investment credits allowed. Investment credits allowed under 
Table 7.5 Summary of the Effects of the Proposal to Repeal the ,~ Investment Tax Credit of TRA 86, 1986-1992* 0 

n 

198() 1987 1988 1989 1990 1991 1992 !. 

($ Millions) Q. ... Investment ;:) 

I Total .574,254 636,809 71.5.320 817,898 910,419 996,004 1.090.932 n 

2 New 494.894 .5.51.343 618,800 707.067 783.012 849.83.5 924.278 0 

3 Used 79.360 8.5.466 96 • .520 110.831 127.407 146,170 166.6.53 n 

2 Depreciation Q. 

4 Tentative Plan X (ACRS) 370.290 400,706 447.966 501,977 .568.733 640.881 716.933 -· -. s Tentative Plan Y (Re.pea.l) 371.940 404,797 4.54,406 .510.939 .580,.531 6.54.83.5 732.674 ::c 

6 Tenlative Change L.650 4.091 6 ,440 8 .962 11.799 13.9.54 1.5,742 c: 7 Current Year 966 2.466 3.974 .5,624 7,473 8.939 10.144 Q. 

II C11rryb~t k 18.5 439 666 9012 1. 168 1.354 I.Sll ~ 9 Carryforward 499 1,186 1.800 2.437 .1,1.58 3.661 <4 ,086 ;:) 

10 Actual Change 1.1.51 2.939 4 ,7S6 6.763 9 .047 10,91.5 12 • .528 

I I Current Year + C11rryback 1.1.51 2,90.5 4,640 6 • .52.5 8,641 10.293 11,65.5 ~ IZ Carryforv.anl u,aJ 0 34 11.5 239 406 622 873 5" 

13 Ot.ll,tanding Carry1orward (NOLl 499 1.6.51 3.336 .5 . .534 8 ,286 11.32.5 14,538 n 

14 Calender Year Tu Liability -408 -9.57 -1.3.52 -1,872 -2 . .514 -3 .046 -3 • .506 .., 

........ 

IS Fiscal Year ReceiptS -218 -699 · 1, 168 - 1.6<43 · 2.222 · 2.806 -3 .197 fi' 

Investment Tu Credit 

16 Tentative lTC Plan 36.114 40,40.5 4.5,3.53 .52.63.5 .58,873 6<4 . .508 63,368 c;· 

11 

II! 

Tt:ntatl

Tent11tlve 

ve 

Change 

lTC Plan 

-24

12

.

.

013 

110 

-34

6

.

.

348 

0.57 

-41

3,608 

,746 -.51.313 

1.322 

-51,154 

1,119 

-64.508 

0 

~3.368 

0 ~ ::T 

19 Current Year ·IS. ISS -21 .824 -26.791 ·33,219 -37,486 -42.222 · 41 . 110 --· 20 

21 

C

C.trrytorward 

arryhuck 

-8.41.5 

-443 

-11.898 

·626 - 14,

-

207 

748 

- 17,

-

189 

90.5 

· 19

- 1.013 

.2.5.5 · 21,171 

-1, 114 

· 21

-1.113 

,14.5 ~ n 

22 Actual Change · 1.5 . .598 -24,66.5 -32 • .530 -41.201 -47,874 · 54 . .578 -.5.5.034 .., 

-. 23 Current Year + Carryback - 1.5,.598 -22.4.50 -27,.539 -34.124 -38.499 -43.336 ·42,223 , 

24 Carrytorward Used 0 · 2.21.5 -4,991 -7 .077 ·9.374 · II ,242 · 12.811 0 

2S Outsusnding Carryforward (lTC) -8,41.5 - 18.098 -27,314 -37,426 -47,306 -.57.23.5 ~.5 . .569 

26 Cah:nder Year Tall Liability 14 ,.540 23.021 29.671 36.734 42.694 48,766 48,641 

27 Fistal Year Receipt~ 7 ,937 19.194 26,196 3 ,747 40.0.5.5 46.110 48,484 

Total Change 

2M Calender Year Tax Liability 14,132 22.06<4 28.319 34.862 40.181 4.5.720 4.5, 13.5 

29 Fi-cal Vt!ar ReceirtS 0 26.213 2S.623 32. 103 37.833 43 . .304 4.5.187 

*These estimates may differ from other published estimates because they are based on a different economic forecast. 

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transition rules or carried forward from previous years could be used in full 

in 1986. but were scaled back 17.5 percent for 1987 and 35 percent for 1988 

and thereafter. Marginal revenue changes from this provision are calculated 

by taking the difference between depreciation model runs that add the investment credit cutback provision to the investment credit repeal provision 

discussed above and the depreciation model run for investment credit repeal 

alone. This difference is concentrated in calendar years 1987 through 1990 

when unused credits are their maximum and some investment credits are being 

earned on transition property. 

4. Increase in Expensing 

The Tax Refonn Act of 1986 increases expensing of personal property to 

$10,000 in 1987; under pre-refonn Jaw the increase phases in over a 4 year 

period. The Act also limits the amount eligible to be expensed to taxable 

income derived fonn the active trade or business in which the property is used 

and phases out the ceiling dollar for dollar on taxpayer investment in excess 

of $200,000. The revenue cost of this provision totals about $5 billion as 

shown in Table 7.6. concentrated in the early years when current law allows 

expensing of only $5,000 or $7,500. 

Because limitations on expensing take place at the firm rather than industry level. adjustments to the depreciation model for these changes are based 

on simulations of the corporate tax model to obtain "rules of thumb" cutbacks 

to apply to expensing. 

5. Depreciation Changes 

As described in Section 11, TRA completely changed the tax treatment of 

depreciable assets. The ADR system classified assets by their average useful 

Table 7.6 Revenue Estimates for Expensing Provision Changes in TRA86• 

1987 1988 1989 1990 1.991 1992 1986-1992 

Calendar Year Liability 

Individual -1.16 I -586 -393 -123 5 -48 -2,306 

Corporate -1,386 -641 -487 -148 7 -62 -2 .717 

Total -2.547 - 1.227 -880 -270 12 -110 -5 .023 

Fiscal Year Receipts 

Individual -436 -946 -514 -292 -75 -15 -2.276 

Corporate -831 -939 -549 -283 -55 -35 -2.692 

Total -1.267 - 1.885 -1.062 -575 -130 -49 -4.968 

*These estimates may differ from other published estimates because they are based on a 

different economic forecast. 
222 Ge.raJdine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

life in the hands of the purchaser. Most equipment was classified as 5-year 

ACRS property under pre-reform law. The Tax Reform Act moves this property 

primarily into the 5 and 7 year double declining balance classes. Thus, most 

personal property obtains approximately equal or more rapid depreciation from 

the tax change because 5-year ACRS depreciation is approximately equivalent to 

150 percent declining balance (all with an optimum switch to the straight-line 

method). The depreciation lives of structures are lengthened from 19 to 27.5 

or 31.5 years and their depreciation is reduced from the 175 percent declining 

balance method to straight line. 

The amount of investment in each of the eight new classes is given in Table 

7. 7 for calendar years 1986 through 1992 using the Administration's August 

1986 forecast. The distribution of investment by the new depreciation 

categories is most clearly seen in 1991 and 1992 when transition treatments 

have ended. (Transition property is shown as an aggregate rather than by 

class at the bottom of Table 7. 7.) The largest class is 5 year property. The 

next two largest classes are the real property classes for residential and 

nonresidential building followed by the 7 year personal property class as the 

fourth largest investment category. 

Total deductions for each class by calendar year are presented in Table 

7. 8. These deductions when adjusted and converted to tax changes are compared 

with pre-reform law to obtain the summary of differences in Table 7. 9 for the 

depreciation changes alone. 

Table 7. 9 shows the effect of two factors on revenue changes associated 

with depreciation provisions in the Tax Reform Act. First, the more rapid 

depreciation method for most equipment combined with the large amount of 

investment in the 5 year class produce a revenue loss for 1987 and 1988 as 

well as for 1986 (when the new schedules were optional for the last five 

Table 7.7 Total Investment by TRA 86 Depreciation Class, 1986-1992 

De~reciation Class 1986 1987 1988 1989 1990 1991 1992 

($ MiUions) 

Class I (3 yeerl <40,3SS 13.663 1!1.3119 17.933 20,0<42 21 ,609 23,368 

Class 2 (5 ~ar) 207.128 1<40.31-4 288,!1« 3!13.903 398,487 <436,010 477,113 

Cla~s 3 (7 year) 2.317 86.299 110.717 141 .709 160.903 177.601 196.606 

Class <4 (10 ~ar) ll ,SIIO !1, 1611 6.!163 11.209 9,023 9,829 10.769 

Class 5 (IS year) .56.3!11 22,!121 29.7110 37.020 «.196 6!1.3-40 70.989 

Cla~s 6 (20 year) 4,924 R60 1,020 1,155 1,273 1.376 1.486 

Class 7 (27 .S year) <45.110 67 .252 15,920 K2 .793 1!9.301 97,<494 106.293 

Class 8 (3U year) 0 98.307 124.744 147,032 1611.5!10 1116.7<46 20<4.306 

Transilion 206,<490 102.<425 62.6-42 2K, I<43 IK.6<4S 0 0 

Tousl !174,254 636.1$09 715.320 KI 7.K9K 910.419 996.004 1.090.932 

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Table 7.8 Total Depreciation Deductions by 

TRA 86 Depreciation Class, 1986-1992 

Deereciation Class 1986 1987 1988 1989 1990 1991 1992 

IS MiUions) 

Class I (3 year) 49,630 34,429 20'.619 14,776 17,369 19.225 20.917 

Class 2 (S year) 234,107 257,076 2\U ,379 293,319 298,512 325,573 370.567 

Oass 3 (7 year) 5,174 21,191 44,778 69,757 94,397 116.204 138,841 

Class 4 (10 year) 9,306 9.577 9.11112 10.479 11,325 12,150 13.082 

Class S (IS year) 39,319 39,682 39.176 39.6911 41,223 43,1167 47,620 

Class 6 (20 year) 2.541 2,529 2,249 2,020 1.1175 1,777 1,731 

Class 7 (27 .5 year) 11 .545 13,672 15.362 17,379 19.663 22.215 25,162 

Class 8 (31. s year) 0 1.560 5,01!3 9,341 14.246 19.717 25,676 

Prior Year & Transition 21.280 41 .679 49,327 50,004 S0,695 31,581 20,733 

Total 372,902 421 ,396 467.854 506.773 549,303 592.308 664,328 

Table 7. 9 Revenue Estimates for Depreciation Schedule Changes in 

TRA 86, 1986-1992* 

1986 1987 1988 1989 1990 1991 1992 

($ MiUions) 

Calendar Year Llabilily 

Individual -84 -335 -362 57.3 1,830 3.463 3.908 

Corporate -312 - 1.356 ·2.126 -77 3.4411 11.672 9.H79 

Total -396 · 1,692 -2.4117 497 5,2711 12, 135 13,787 

Fiscal Year Receipts 

Individual 0 -210 -345 -11 1,045 2.443 3.630 

Corporate 0 - 1.126 -1.1111! -896 2,038 6,51!3 9.396 

Total 0 -1,336 -2.163 -907 3.0113 9.025 13.026 

223 

*These estimates may differ from other pubnshed estimates because they are based on a 

different economic forecast and include only selected capital cost recovery provisions. 

months). These revenue losses total about $4. 6 billion for the three calendar 

year period. These effects dissipate with time as smaller depreciation 

deductions in later years offset faster deductions in earlier years. Second, 

the large investment category of structures that receive smaller annual 

depreciation allowances under the Act increase revenue enough over a few years 

to dominate the revenue reductions on equipment. The revenue loss becomes a 

half billion dollar gain in 1989 which increases to over $5 billion in 1990. 

The total estimated revenue gain from the depreciation provisions exceeds $20 

billion over the seven year period. 
224 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

The combined effect of all depreciation and investment credit changes calculated by the depreciation model is presented in Table 7. 10 The dominant 

effect of the repeal of the investment credit insures a revenue gain in all 

years despite early period losses from increased expensing and depreciation 

allowances for many assets. These estimated revenue increases total about 

$231 billion using the post reform statutory tax rates. The Tax Reform Act 

lowered statutory tax rates which offsets much of this revenue increase. 

B. Adjustments to Depreciation Model Results 

Four adjustments to the results from the depreciation model produce the 

final set of revenue estimates. The first adjustment concerns the 35 percent 

cutback of investment credit carryforwards which are phased in over a two-year 

period. To estimate the effects of the reduction, more recent historical data 

than are contained in the depreciation model were used to determine the amount 

of unused investment credits available for carryforward at the end of 1985. 

Separate more refined estimates, including results from the Treasury corporate 

tax model, were used to determine the pattern of carryover usage, and the 

extent to which the reduction would restrict credit usage. 

Adjustments were also made to the results for the elective 15-year carryback for certain taxpayers, in particular, certain steel companies and qualified fanners. The corporate and individual tax models and an analysis of 

specific tax returns were used to determine the amount of JTC's affected by 

the provision, and the extent to which individuals and corporations would be 

able to utilize the carryback option. 

The third adjustment accounts for the tax treatment of equipment used for 

research and development (R&D) purposes. Under pre-reform law R&D equipment investments were depreciated as three year property. Under tax reform 

these investments are treated as five year property. Because the depreciation 

model does not separately identify investment for R&D purposes. it cannot 

provide estimates that adequately reflect changes in tax depreciation rules 

that apply to this use of investment. A supplemental model was employed to 

obtain an estimate of the change in revenue from the altered treatment of R&D. 

Table 7 .1 0 Summary of the Revenue Changes Associated with 

Capital Cost Recovery Provisions of TRA 86, 1986-1992* 

1986 . 1987 1988 1989 1990 1991 1992 

($ MiUionsl 

Calender Year Tu liability 13.1153 111 .870 27.741 36.1111 45.961 5K.062 59.496 

Fi~cal Year ReceiptS 0 23.997 23.11K6 30.617 41.490 !i:!.!i92 !\1!,615 

•These estimates may differ from other published estimates because they are based on a 

different economic forecast and include only selected capital cost recovery provisions. 

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The Treasury Depreciation Model 225 

which is added to the results of the depreciation model. A forecast of 

investment in R&D property is depreciated according to both pre-refonn and 

reform rules. A marginal tax rate is applied to the difference in annual 

depreciation deductions and the resulting tax change added to the model 

results for depreciation-related revenue changes. These adjustments add 

approximately $4 to $5 billion to revenue through 1992. 

This adjustment is an approximation because information on the distribution 

of tax lives of R&D property is not available. Under pre-refonn law almost 

all R&D equipment would be classified as 5 year ACRS property in the depreciation model. Under post-reform tax ruJes most R&D investment would be classified as 5 year property (computers and high technology instruments) and a 

smaller portion would be classified as 7 year (or longer lived) property. On 

average it is assumed that because of the faster depreciation method under 

reform (200 percent declining balance versus 150 percent) tax depreciation 

would not be substantially slower (or faster) under refonn than before in the 

absence of special treatment of R&D property. Thus. no net revenue increase 

would be shown in the depreciation model from the change in tax treatment of 

R&D property. The supplemental model calculation then approximately adjusts 

revenue for the change in R&D equipment depreciation rules. If all R&D property under the new rules is 5-year property the adjustment understates the 

additional revenue from longer tax lives on R&D equipment. 

The fourth adjustment is for auto and truck leasing. Although the depreciation model makes some provision for the retirement of assets or sales to nonbusiness sectors. it does not adjust depreciation allowances for recapture of 

excess depreciation when an asset is sold on the difference between the sale 

price of assets and the depreciable basis. Recapture increases revenue when 

depreciation schedules overstate depreciation and reduces revenue when depreciation is understated. In effect, recapture adjusts depreciation allowances 

to the correct total amount (neglecting inflation) when the asset is soJd. 

The Tax Reform Act changes the depreciation schedule for autos and light 

trucks from 3 years. which would generally overstate depreciation. to 5 years. 

The depreciation method also is changed from approximately 150 percent declining balance to 200 percent decJining balance (with an op~imal switch to 

straight line). For automobile and truck leasing, where the holding period is 

short in many cases and assets are often systematically resold, an adjustment 

is made to the depreciation model results for recapture. The series for 

investment in autos and trucks are divided into a leased fraction subject to 

depreciation recapture. Proportions of auto and truck investments are assumed 

to be sold each year at a price determined by a depreciation rate, assumed to 

be 33 percent for autos (Hulten and Wycoff (1981)). and an inflation rate. 

assumed to be 3 percent over the forecast period. The value of depreciation 

deductions is calculated twice both assuming no sales and assuming sales distribution patterns for autos and for trucks. The difference between these 

sale and no sale calculations of $4 billion over the period is subtracted from 

revenue estimates. The net change from this adjustment is a reduction in the 
226 Geraldine Gerardi/Hudson Milner/Leslie Whitaker/Roy Wyscarver 

estimated revenue increase in autos and light trucks that would otherwise be 

calculated for the forecast period from a lengthening of tax depreciation 

lives. 

APPENDIX 

Table 7. II compares depreciation systems under prior law and the Tax Reform 

Act of 1986. 

Table 7. l J Comparison of Depreciation Systems 

Asset ~ADR Midpoint Life or DescriEtion~ Pre-Reform Law Tax Reform Act 

2-4 3-yr ACRS 3-yr 008/SL 

R&D equipment (various ADR midpoint Jives) 3-yr ACRS 5-yr 008/SL 

Autos & light trucks (3,4) 3-yr ACRS 5-yr 008/SL 

Race horses over 2 years old 3-yr ACRS 3-yr 008/SL 

I 3-year and older horses 3-yr ACRS 3-yr 008/SL 

4.5-6.5 5-yr ACRS 5-yr 008/SL 

Semi-conductor manufacturing equipment 

(reassigned to 5-year from 6-year ADR 

midpoint life) 5-yr ACRS 5-yr DDB/SL 

Qualified technological equipment 

(various and no ADR lives) 5-yr ACRS 5-yr 008/SL 

Renewable energy property 

(various and no ADR midpoint lives) 5. 15-yr ACRS 5-yr 008/SL 

7-9.5 

Rental clothing (9) 5-yr ACRS 5-yr 008/SL 

Computer based central office-switching 

equipment (reassigned to 9.5 from 

18-year ADR midpoint life) 5-yr ACRS 5-yr 008/SL 

10-12.5 5-yr ACRS 7-yr DDB/SL 

Breeding and work horses (I 0) 5-yr ACRS 7-yr 008/SL 

No ADR life personal property 5-yr ACRS 7-yr 008/SL 

Railroad track (assigned 10-year 

ADR midpoint life) 5-yr ACRS 7-yr 008/SL 

13-15.5 . 5-yr ACRS 7-yr 008/SL 

Railroad tank cars ( 14-15) 10-yr ACRS 7-yr 008/SL 

Single purpose agriculturaJ structures 

(reassigned to IS-year from 34-year 

ADR midpoint life) 5-yr ACRS 7-yr 008/SL 

16-19.5 5-yr ACRS 1 0-yr 008/SL 

20-24.5 5-yr ACRS 15-yr 15008/SL 

Telephone distribution plant 

(reassigned 24-year from 35-year 

ADR midpoint life) 5. 15-yr ACRS 15-yr 15008/SL 

Sewage treatment plant (assigned 

24 year ADR midpoint life) 5-yr ACRS 15-yr 15008/SL 

25-21 5-yr ACRS 20-yr ISODB/SL 

21.5-29.5 5-yr ACRS 20-yr 15008/SL 

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Table 7.11 Comparison (continued) 

Asset (ADR Midpoint Life or Description) 

27.5-29.5 real property 

30-35.5 

30-35 .5 real property 

36 and over ADR midpoint life 

Sewer pipes {assigned 50-year 

ADR midpoint life) 

36 & over ADR midpoint life 

real property 

Less than 27.5 real property 

Residential housing 

Low-income housing 

Manufactured homes 

Public utility property (18 .5-24.5) 

Public utility property (25 + ) 

The Treasury Depreciation Model 227 

Pre-Reform Law 

19-yr ACRS 

5-yr ACRS 

19-yr ACRS 

5-yr ACRS 

15-yr ACRS 

19-yr ACRS 

19-yr ACRS 

19-yr ACRS 

15-yr DDB/SL 

10-yr ACRS 

10-yr ACRS 

15-yr ACRS 

Tax Reform Act 

31.5-yr SL 

20-yr 150DB/SL 

31.5-yr SL 

2Q-yr 150DB/SL 

20-yr 150DB/SL 

31 .5-yr SL 

20-yr 150DB/SL 

27.5-yr SL 

credit provided 

10-yr DDB/SL 

by ADR life 

20-yr 150DB/SL 

REFERENCES 

Fullerton, Don. Robert Gillene. and James Mackie, Investment Incentives Under the Tax Reform 

Act of 1986. Chapter 5 in this volume. 

Gorman. John A .. Musgrave. John C .. Silverstein. Gerald and Comins, Kathy A .. Fixed 

Private Capital in the United States. Survey of Current Business. Washington. D.C. (July). 

pp. 36-47, 1985. 

Hulten , Charles R .. and Wykoff, Frank C .. The Measurement of Economic Depreciation. In 

C.R. Hulten (Ed.). Depreciation. Inflation and The Taxation of Income From Capital, 

Washington, DC: The Urban Institute Press 1981 . 

Nester. Howard W.. A Guide to Interpreting the Dynamic Elements of Revenue Eslimates. 

Chapter I in this volume . 

Winfrey. Robley, Stalistical Analyses of Industrial Property Determinants Bulletin 125. 

Iowa Experiment Station, Iowa State College of Agricultural and MechaoicaJ Arts, 

Symmetrical No. 3, p. 100, 1935.