software as capital

[Max B. Sawicky]

Suppose a firm invests $100 in something that throws
off 8% a year in returns.  The following year it has $8.
It uses this to invest, offsetting its total net income by
expensing the full amount.  The following year it earns
8% of $108, or $8.64.  (We could factor in depreciation
by assuming a lower rate of return.)  To zero out this
income with new investment, it has to expand its capital
stock to $116.64.  In other words, to eliminate its tax liability,
it has to expand its capital at a rate equal to the rate of return
from its investment.  Sooner or later this expansion has to
slow down, if not stop,
and the firm has to swallow some actual taxable
net income.  Expensing only puts off the day of
reckoning.  With good rates of return on investment,
the day may be closer in view.  With bad rates of
return, the day is further off, but why invest in such
circumstances.

As well, the owners might like to see some cash come
out of the firm, though this gets into the attractiveness
of stock that does or doesn't pay dividends, on which
I'll take a pass.  Firms do pay some dividends, so they
must be making somebody happy.

Now there may be some tricky financial way of getting
around this.  There are certainly sophisticated tax
avoidance devices.  But the basic arithmetic to me
looks like expensing only postpones the inevitable.

There is no question business firms favor expensing,
though in some cases the tax code could actually be
more favorable as is than expensing would be.  In
other words, taxes can turn negative ROR's to
positive ones.  This was a particular problem coming
out of the '81 tax reform, especially with the investment
tax credit, which took the rest of the decade to clean
up.

mbs

----- Original Message -----
From: Roger Odisio <rodisio at igc.org>
To: <lbo-talk at lists.panix.com>
Sent: Monday, August 30, 1999 8:18 PM
Subject: Re: software as capital

Jordan,

You disagree with Doug that expensing an asset lowers reported
earnings
compared with depreciating it . . .