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I'm a sole proprietor who has bought some assets for my business, like a chair. My accountant told me that I can't claim the entire price as a business expense in the year I incurred it, and instead have to depreciate it over 10 years.

Depreciation seems equivalent to paying more tax than otherwise, and getting a repayment from the government every year for a decade. I see several disadvantages with this:

  • It ties up my working capital. At the margin, this prevents some investments being made that would otherwise have been made, and bankrupts some businesses.

  • A rupee paid to me a decade later is worth far less than a rupee today, so this is effectively a hidden tax.

  • It makes tax accounting more bureaucratic, since I now have to track all assets and depreciate them over many years at different rates. This takes my time away from running my business. And makes me a hire a CA, wasting more money.

Why do governments subject assets to depreciation for tax deductions? Is there some fundamental reason I've missed?

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    $\begingroup$ It's not a question about politics as much as one about the fundamental economic reason for tax depreciation. $\endgroup$ – Vaddadi Kartick Dec 4 '16 at 7:10
  • $\begingroup$ Regarding your argument about avoiding all taxes on profits, real-world assets (chairs, cars, computers, etc) companies buy are unlike gold chairs — they decline in value every year, and are worth buying only if you plan to generate value from them. Otherwise the money you spent buying the chair has gone waste — better to declare it as a profit and pay tax, so that you can at least keep the rest. Nobody would buy chairs or cars or factories and leave them idle. $\endgroup$ – Vaddadi Kartick Dec 4 '16 at 10:10
  • $\begingroup$ @Jasper Regarding your second comment, are you saying that the tax benefit is given not on the cost of buying the asset, but on the corresponding benefit you get from it? That is, if I bought a chair for ₹10,000 that has an expected life of 10 years, it provides me a notional benefit worth ₹1000 every year, so I get an exemption on ₹1000 each year? That would be... odd. $\endgroup$ – Vaddadi Kartick Dec 4 '16 at 10:14
  • $\begingroup$ Yes, as long as your numbers (including the notional residual value of the item) add up to the original value of the item. Yes, the depreciation schedule is unlikely to exactly match reality for any particular item. Instead, it is a very gross approximation, designed to make the system seem "fair" to both the voters and the taxpayers. $\endgroup$ – Jasper Dec 4 '16 at 13:40
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    $\begingroup$ I'm voting to close this question as off-topic because this is about the politics of taxation structures, not about economics. $\endgroup$ – EnergyNumbers Dec 5 '16 at 7:10
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In theory, income taxes tax "wages", "salaries", and "net income".

The design of a tax system is an important political issue. A good tax system will raise the amount of revenue that the government "needs", and seem fair to both most of the people who vote, and to the people who pay most of the taxes. If the tax system does not seem fair to the voters, the legislature is likely to be thrown out of office. If the tax system does not seem fair to the tax payers, the government will have a difficult time collecting the taxes.

There are countries that tax dividends from businesses, but not the profits of businesses that stay reinvested in the business. There are countries that tax the profits of businesses, but don't "double-tax" the dividends from businesses. And there are countries that tax both the profits of businesses, and dividends from businesses. It sounds like you are in a country that thinks it is fair to tax business profits, but does not think it would be fair to pretend that the assets used up by a business are free.

Anyone designing a tax system needs to think about how someone could "game" the system. If it is possible for business owners to figure out how to not pay any taxes, some of them will. If none of the business owners pay any taxes, the voters will notice.

Suppose you could re-invest all of your profits in physical assets for your business, and those assets retained most of their value for a long time. (For an extreme case, imagine that you bought a chair made of gold, and most of the value of the chair was the gold.) If you could deduct the full cost of the purchase immediately, then you could avoid all taxes on your profits. This would make the tax system seem unfair to most voters (who earn wages and salaries, not business profits.)

Thus, most governments choose a compromise. By letting businesses "depreciate" physical assets over the assets over their estimated useful lives, the governments recognize that the decline in the value of the assets is a cost of doing business. This does not seem completely unfair to most businessmen. This compromise means that most business people wind up paying some taxes, which makes the system seem fair to people who are paying taxes on wages and salaries.

In theory, "depreciation" is supposed to approximately match the decline in value of an asset due to your business' use of it (or due to the time you hold it, because your business might need it). In theory, you only put up with the decline in value of the asset because the asset helps your business make money in other ways. Thus, the "depreciation schedule" is supposed to match up the cost (of the declining asset) with the revenue (at each time in the future) that it should help you earn. In theory, the total amount that is allocated adds up to the total decline in the value of the original asset. If you invest wisely, the incremental revenue you gain (because of the asset) should exceed the cost of the asset. In theory, the incremental revenue you gain per period (because of the asset) might be proportional to the depreciation per period.

In practice, there are lots of fudge factors. Many investments are a waste of money. Other investments are spectacularly good. Sometimes you can figure out which investments were good in hindsight. Some things wear out faster than expected, or need to be replaced for unrelated reasons. Other things are useful (and perhaps even valuable) indefinitely.

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  • $\begingroup$ Please see my comment on mootmoot's answer for why I think most business assets are unlike the hypothetical gold chair. $\endgroup$ – Vaddadi Kartick Dec 7 '16 at 4:14
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I'm going to give the simplest possible answer -- it's a matter of fairness.

Consider yourself, buying a chair for your business, and someone else who is otherwise equally situated but who for some reason didn't or couldn't buy that chair.

They have more money than you do. But you have a chair they don't have. Presumably, you think that chair is better for your business than the money that you paid for it or you wouldn't have bought it. So you are better off than they are.

Your business did better than theirs did, so you should pay more in taxes. It's as simple as that.

Now, over time, that chair will lose value. That is a real loss and it is deductible as depreciation. Over time, your chair will get worn and less valuable, they will not suffer that loss over time. So you are entitled to a deduction later that they are not.

But right now, you made more than they did, since you also have the value of that chair over the money you paid for it.

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  • $\begingroup$ That would be true if the seller offered me a zero-interest loan, payable over 10 years, the same as the depreciation schedule in the tax. As things stand, in year 1, I've incurred a cost, and derived little of the benefit, so I'm worse off than the competitor who didn't buy the chair. Even if the entire price was tax-deductible in the first year, at a tax rate of 36%, since the deduction would account for only 36% of the price of the chair, I'm worse off than my competitor. So, fairness would dictate a full tax deduction in the year of purchase. $\endgroup$ – Vaddadi Kartick Dec 7 '16 at 4:02
  • $\begingroup$ Regarding the statement that "Your business did better than theirs did, so you should pay more in taxes", that's true in the abstract, however, the measure of whether my business did better is profit. Which is already taxed. So, even if the chair was fully tax-deductible in the year of purchase, the tax system would still be fair. We don't need depreciation to make it fair, in the sense you've defined. $\endgroup$ – Vaddadi Kartick Dec 7 '16 at 4:06
  • $\begingroup$ @VaddadiKartick If the chair was fully tax-deductible in the year of purchase, the tax system would not be fair. You would pay less taxes than someone who didn't buy the chair even though you made more profit than they did. (Because, presumably, the chair was worth more to you than you paid for it, so you have the same profit as them plus the value of the chair over its cost.) $\endgroup$ – David Schwartz Dec 7 '16 at 5:02
  • $\begingroup$ Again, you can't total up costs and benefits without regard to when they were incurred. If I pay a tax of ₹200 once, and you pay a tax of ₹100 this year followed by ₹100 next year, it doesn't follow that you and I paid the same amount of tax. You paid less. $\endgroup$ – Vaddadi Kartick Dec 7 '16 at 8:04
  • $\begingroup$ Also, as I said, no matter the tax deduction on the chair, if I make more profit, I pay more tax. So the tax system already is fair. If your theory is right that buying the chair helps me make more profit, that extra profit is already taxed, so it's fair. $\endgroup$ – Vaddadi Kartick Dec 8 '16 at 2:04
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One reason is to prevent hoarding bubbles. If there is such scheme, corporate start buying "asset" to avoid tax, which at the end, any "assets" with resales values will be hoarding items for those company. Even the asset subject to some tax during purchase.

Repeating the cycle, the society will be full of unsold "assets", and company start trading this kind of "tax avoidance asset", and you start building up an "asset bubbles" similar to subprime loan + CDS swap disaster.

In fact, such tax scheme are quite reasonable to convert asset as "cost" as incentive, and also to prevent hoarding behavior.

If you believe in neo-liberalism jungle law economy that deregulate, give me maximum tax benefit and let winners take all mentality, exploits will destroy capitalism long before any other crisis started.


@VaddadiKartick : NEVER underestimated human being abilities to exploit the system, especially those with resources. The financial world already invent something like hedge funds, future trading, CDS, sub-prime loan. It is not difficult to invent "Assets future trading" , "assets hedge funds" if 100% tax writeoff is allowed.
When USA implement tax credit transfer incentive, corporate already exploit the loophole of buying company to get tax credit. Acquisition no longer on the merit basis, but also base on exploitation of loophole.

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    $\begingroup$ That won't work because most assets (whether a chair, computer or car) will lose more value over the years than the tax (36% in my case). Not to mention storage costs, risk of damage or theft, and illiquidity. $\endgroup$ – Vaddadi Kartick Dec 7 '16 at 3:44
  • $\begingroup$ And that assets don't generate an interest like financial investments do. $\endgroup$ – Vaddadi Kartick Dec 7 '16 at 3:47
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Your accountant could make clear the difference between financial accounts and tax accounts.

You can do whatever you like, within the general remit of GAAPs, in your financial accounts and so you can expense the assets in the year of acquisition if you so wish.

... But the tax-man will not allow the depreciation expense in the tax accounts, and instead allows for the deduction of a 'capital allowance', which is calculated according to rules that the tax-man lays down.

The capital allowance (and depreciation expense) has nothing to do with recognising the drop in value of the asset over its life, rather it is to do with allocating the money spent on a longer-than-one-year life of an asset used in a business on a reasonable basis over the estimated useful life of that asset. Granted, it causes minimal book 'profit' or 'loss' on subsequent disposal of such an asset if the magnitude of the capital allowance and depreciation expense does roughly equal the loss in value of the asset, but if there is no intention to dispose of the asset, it does not matter. So, most governments (tax-men) allow either a reducing balance percentage of the original cost of the asset, or a fixed annual percentage of the original cost as the capital allowance. For example if an asset cost 12,000 dollars and the capital allowance is to be calculated as a fixed percentage of 20 percent. of the original cost (implying a useful life of 5 years) then the annual capital allowance in the tax accounts would be 2,400 dollars. If the capital allowance is to be calculated as 25 percent. of the remaining balance of the cost of the asset, then in the first year the capital allowance would be 0.25x12,000 = 3,000 dollars, and in the second year the capital allowance would be 0.25x(12,000 - 3,000) = 2,250 dollars.

For a small business, it is best to keep the depreciation expense the same as the capital allowance that the tax-man determines. This is to avoid any difference in the calculation of the financial accounting profit and the tax accounting profit, which gives rise to horrible accounting entries called deferred tax.

Whatever method you choose in your financial accounts, the amount of tax you pay is dependent on the figures in your tax accounts, which as far as allocating the cost of assets used in the business is concerned, is under the control of the tax-man ... and so your cash flow is no different.

Finally, the tax-man usually allows the pooling of assets that are similar and so the accounting for the capital allowance is not too complicated. Examples would include 'all office furniture', 'all IT equipment', 'all plant & machinery', 'all non-commercial vehicles', etc. ... Ask your accountant !

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