Tax Policy – Answering Four Questions About How Neutral Cost Recovery Works in Practice

Lawmakers can improve the cost recovery treatment of capital investment by allowing full expensing or by approximating full expensing by adjusting depreciation deductions to equal the present value of full expensing. This latter approach of capital cost indexing (sometimes called a neutral cost recovery system or NCRS) lowers the short-term cost of the policy to the federal government while providing nearly equivalent economic benefits. While neutral cost recovery is not a new idea, there are several policy questions lawmakers will want to consider when designing this system.

What is the difference between NCRS and inflation indexing?

A common question about adjusting depreciation allowances is what should we be adjusting for: Should write-offs be adjusted for inflation alone or inflation plus the time value of money?

Without an adjustment, delaying deductions is akin to a business providing an interest-free loan to the government. The goal of neutral cost recovery is to approximate the treatment a business would receive under full expensing. This goal can only be accomplished if, like the interest charged on a loan, the adjustment accounts for both inflation and the time value of money. That is because depreciation deductions are less valuable to companies over time due to both inflation and the time value of money.

If I asked you to loan me $500 today and promised to pay you back in five years with exactly $500, you would understandably balk at that offer. Not only would inflation erode the value of the money over those five years, but if you had that $500 now, you could put it to productive use and earn some rate of return. The same concept applies when a business makes an outlay to buy a capital asset but does not receive the tax deduction for that outlay until years in the future.

Table 1 illustrates why indexing for inflation alone falls short of full expensing treatment, and why neutral cost recovery, which adjusts for both inflation and the time value of money, is necessary to provide the same treatment as full expensing.

Table 1. Adjusting for Inflation and the Time Value of Money is Economically Equivalent to Full Expensing
  Year 1 Year 2 Year 3 Year 4 Year 5 Total

Full Expensing

$500 $0 $0 $0 $0 $500

Present Value

$500 $0 $0 $0 $0



Inflation Indexing

$100 $101 $102 $103 $104 $510

Present Value

$100 $97 $94 $92 $89 $472

Real Rate of Return Indexed

$100 $103 $106 $109 $113 $531

Present Value

$100 $99 $98 $97 $96 $490

Neutral Cost Recovery

$100 $104 $108 $113 $117 $542

Present Value

$100 $100 $100 $100 $100 $500

Note: This example assumes an inflation rate of 1 percent and a real rate of return of 3 percent.

Source: Author calculations. 

Where does the time value of money adjustment come from?

Compared to full expensing, delaying deductions without an adjustment is akin to a business providing an interest-free loan to the government via accelerated tax payments. This overstates real business profits, pulls the tax burden forward, and prevents full cost recovery in real terms.

To maintain the real value of deductions, deductions need to be adjusted for this opportunity cost. Ideally, this adjustment would be based on the historical, real marginal after-tax rate of return that physical capital has earned for decades—approximately 3 percent. This rate recognizes the time value of money that businesses forgo when they are prevented from immediately deducting their outlays on capital investments, and in combination with an inflation adjustment, allows businesses to fully recover their capital investment outlays in real terms. (Other options, such as an after-tax corporate bond rate, are less than ideal and could lead to too high or too low of an adjustment if inflation levels experience significant changes. While interest rates do move with inflation, they do so with a lag.)

Should the inflation adjustment be fixed or variable?

While the time value of money adjustment ought to be set at 3 percent, the measure of inflation ought to be allowed to vary, as it does in other areas of the tax code that are inflation-indexed. Allowing varying annual inflation adjustments each year means all taxpayers get the same adjustments year to year as inflation rises or falls.  

If the inflation rate were locked in place when the investment was made, then dramatic movements up or down in the inflation rate—as occurred from the late ’60s through the early ’90s—would distort the real value of the write-offs and lead to radically different treatment of investments at different times. This is why it is ideal to allow the inflation portion of the adjustment to vary each year—the exact mechanism would be a lagged measure of inflation, such as the deflator for the business sector of GDP—as the Internal Revenue Service (IRS) does as part of the regular indexing process for other aspects of the tax code, so that the adjustment tracks changes in inflation and ensures all taxpayers get the same adjustments year-to-year that reflect actual conditions.

How would the adjustment be implemented for businesses?

Implementation of a NCRS would be easy with any tax software package. After taking a write-off in a year, firms commonly use a software package that calculates an asset’s remaining basis and holds the basis over to become the adjusted basis for the next year. Under a NCRS, this remaining basis would be bumped up by the adjustment factor of inflation plus 3 percent. The year-to-year basis adjustments would be given out by the Internal Revenue Service (IRS) each year, and the taxpayer’s software package would read the adjustment along with all the other tax tables and parameters of the tax system, just as now. There would not be any added work for the taxpayer.

Table 2 illustrates how this would work for a hypothetical five-year investment of $100. The IRS provides the adjustment factor for all assets, and the taxpayer’s software only has to keep track of the basis of the asset over time and the number of years left in the asset’s life—as tax software does for assets currently being depreciated. After taking a write-off in a year, the asset’s remaining basis at the end of the year is bumped up by the next year’s adjustment factor of inflation plus 3 percent. This amount becomes the adjusted basis for the next year from which the business takes its write-off. For example, after taking the $20 year write-off in the first year, the business’s remaining $80 basis is adjusted by the total adjustment factor of 4.03 percent to reach the new adjusted basis of $83.22. The business would then take its normal allowable deduction from this adjusted basis. The same process is repeated over the life of the asset.

Table 2. Illustration of NCRS Adjustments Over Five Years
Year 1 2 3 4 5

Inflation Adjustment

n.a. 1% 1% 1% 1%

Real Return Adjustment

n.a. 3% 3% 3% 3%

Total Adjustment Factor

n.a. 4.03% 4.03% 4.03% 4.03%


Initial and Subsequent Adjusted Basis

$100.00 $83.22 $64.93 $45.03 $23.42


$20.00 $20.81 $21.64 $22.52 $23.42

Remaining Basis

$80.00 $62.42 $43.29 $22.52 $0.00

Source: Author calculations.

Importantly, this would not be a fundamental change from the way the current depreciation system works. The IRS would release the adjustment factor each year, tax software would apply the adjustment factor to each asset’s remaining basis, and the software would calculate the depreciation deduction the business would take.


Designing a neutral cost recovery system to provide the benefits of full expensing requires adjusting for both inflation and the time value of money to prevent the real value of depreciation deductions from eroding over time. These year-to-year adjustments would be provided by the IRS and applied to an asset’s remaining basis by tax software packages, meaning no additional steps would be required on the part of taxpayers to access this improved cost recovery treatment.

Source: Tax Policy – Answering Four Questions About How Neutral Cost Recovery Works in Practice