Journal of Accounting and Economics 10 (1988) 111-125.

North-Holland
ECONOMIC VS. ACCOUNTING DEPRECIATION*
Moshe KIM
Haifa University, Hai@, I srael
University of British Columbia, Vancouver, B.C., Canada V6T 1 W5
Giora MOORE
University of Toronto, Ont., Canada MSS 1 V4
Received November 1986, final version received December 1987
In this paper we present and estimate a model of economic depreciation consistent with
producers optimization. The estimated economic depreciation, which is a function of the rate of
utilization and level of maintenance, is about half of that used according to tax (accounting)
depreciation. The difference between the economic and tax rates of depreciation results in a
subsidy and earlier capital replacement. The implicit maximum net tax subsidy expressed as a
proportion of the acquisition price of the asset is 13.3% for a sample of Canadian trucking firms.
1. Introduction
The divergence between accounting depreciation and economic deprecia-
tion has given rise to a vigorous controversy concerning the appropriate
specification of the neoclassical investment function, tax equity and neutrality,
the demand equation for capital, productivity growth, subsidies, and related
problems.
It is well known that when tax depreciation exceeds economic depreciation,
the effective tax rate on the true income is less than the statutory rate and vice
versa [Samuelson (1964)]. Recently Skinner (1982) and Most (1984) addressed
*We are greatly indebted to Peter L. Swan, the referee, for his most valuable contribution to
this paper. We are also indebted to the editor, Ray Ball, to Bill Schworm and to Jeremy Rudin for
their comments and suggestions. Data were kindly supplied by Statistics Canada. Remaining
errors are our sole responsibility.
We should distinguish between depreciation for tax purposes and depreciation as reported in
the accounting reports. In North America, companies can use different methods for tax purposes
than they use in their own accounts. In this paper we focus on the depreciation method used for
tax purposes, calling it accounting (tax) depreciation. We note here that in our particular case the
depreciation used for tax purposes is identical to book depreciation. Furthermore, we should
distinguish between economic (physical) depreciation and economic (value) depreciation. The first
refers to the loss in productive capacity of a physical asset, while the second refers to the assets
loss in monetary value. In this paper we estimate the economic (physical) depreciation rate.
0165-4101/88/$3.50~1988, Elsevier Science Publishers B.V. (North-Holland)
112 M. Kim and G. Moore, Economic vs. accounting depreciation
the divergence issue more closely. They investigated the question of whether
the useful asset lives on which historical cost depreciation is based are
different than the economic lives of depreciable assets. While Skinners find-
ings for a sample of U.K. firms suggest that the useful lives selected by
accountants are longer than the economic lives, Mosts evidence for U.S. firms
indicates the contrary.
As a result of the potential as well as the actual problems emerging from the
divergence between these two concepts (and measures) of depreciation there
have been considerable efforts to estimate the true rate of economic deprecia-
tion in studies such as those by Griliches (1970), Taubman and Rasche (1969),
Wykoff (1970) Cagan (1973), Hall (1973) Hulten and Wykoff (1980, 1981),
and Epstein and Denny (1980).
There are two basic approaches to the measurement of economic deprecia-
tion generally discussed and estimated in the literature. Broadly categorized
they include: (i) studies which use market (or rental) price data and (ii) studies
that use capital stock data, i.e., use quantities rather than price data. Both
approaches use data generated from the history of the particular asset.
In this study we take a more direct approach in that we introduce a model
of producer behavior where the producer minimizes the users cost-of-capital
services by the choice of the optimal rate of utilization and level of mainte-
nance applied to the stock of capital equipment, thereby directly affecting the
rate of depreciation. The model enables us to estimate the rate of economic
depreciation that is consistent with this producers optimization program.
To ascertain the difference between economic and accounting depreciation
rates, we apply the theoretical model to data taken from trucking firms. It is
demonstrated that, by allowing firms to utilize the accounting depreciation
rate which is effectively higher than the economic rate, there is an implicit
subsidy which the firms can obtain. In order to determine the difference in the
said depreciation rates and the implied subsidy we calculate the present value
of the emerging subsidy and determine the implied capital replacement which
is due to this divergence.
Watts and Zimmerman (1986, p. 231) point out that the use of reported
profits by regulators provide corporate managers with an incentive to adopt
accounting procedures that reduce reported earnings (e.g., accelerated depreci-
ation). Lower reported profits reduce the likelihood of adverse government
actions against, and increase the likelihood of government subsidies to the
firm, if the regulators do not adjust the reported profits to undo managements
earnings-reducing accounting choices. Our empirical findings for the regulated
Canadian trucking industry (using the same rate for tax and book purposes)
show that the accounting depreciation is larger than the economic depreciation
which leads to tax subsidies.
The organization of the paper is as follows: In the following section we
develop the theoretical model of economic depreciation, present its properties,
M. Kim and G. Moore, Economic vs. accounting depreciation 113
and discuss the stochastic specification and estimation procedure. Next, we
examine the consequences of the economic and accounting depreciation rate
differential for the determination of the present value of the implied subsidy
and the optimal replacement of the asset. Finally, we describe the data used,
present the empirical results, and offer concluding remarks.
2. A model of economic depreciation
Owners of capital assets can alter the amount and rate of depreciation of
their assets by varying the rate at which they utilize their assets. The decay of
capital assets increases with increases in utilization. On the other hand, owners
of capital assets can decrease (or hold constant) the decay of their capital
assets by applying maintenance to their capital assets. As a result, the rate of
capital depreciation is a function of both utilization and maintenance.
The rate of capital utilization u is defined as the capital services obtained
from a unit of capital equipment, i.e., u = E/K, where E represents capital
services and K denotes the stock of capital. The quantity of maintenance per
unit of capital is similarly defined as m = M/K, with M being the total
quantity of maintenance applied during the relevant period.2 The rate of
capital decay is specified as a function of both the rate of utilization and the
quantity of maintenance per unit capital as 1 r h( U, m) 2 0 with h, > 0,
h,,, < 0, h,, > 0, and h,, > 0, where subscripts denote partial differentiation.3
The firms technology is described by a concave tranformation function
y =j(x, E), where y denotes output and x is a vector of inputs (x,, . . . , x,)
other than capital applied during the period.
The basic problem faced by the firm is to choose the optimal levels of
maintenance, rate of utilization, and the vector x, given its output constraint
and input prices. Formally, the optimization program takes the form
min {C=w~x+{sm+Q[r+h(u,m)]}K}: ~=f(x,E)},
u,m,x,E
0)
where s is the price of a unit maintenance, Q is the acquisition price of a unit
of capital stock,4 w is a vector of input prices, and r is the one-period
*See Schworm (1977, 1979) for similar specification.
3We assume that the depreciation function h(u, m) is the same across vintages of capital and
therefore utilization rates and levels of maintenance also are equal across vintages. This implies
that the depreciated asset is measured in units of the undepreciated asset. This assumption is
necessary due to lack of data on asset age and its distribution in our cross-section data set.
4Q = q(l - TD), where 4 is the gross (actual) acquisition price of a unit of capital stock, T is
the firms income tax rate, and D is the present value of one dollar of depreciation allowances for
tax purposes.
114 M. Kim and G. Moore, Economic vs. accounting depreciation
after-tax interest rate. The expression in the inner braces is defined as the user
cost of capital services.
The first-order conditions of interest arising from the optimization of (1) are
Qh UK = Xf&,
(2)
SK = - Qh,K,
sm + Q[r+ h(u, m)] =Af,u,
(3)
(4
where h # 0 is the Lagrange multiplier.
Condition (2) equates the marginal cost of increased utilization Qh, (in the
form of faster decay) with the marginal benefit obtained from higher rate of
service flows Af,. Condition (3) equates the marginal benefit from increased
maintenance activity, - Qh m > 0, with the price paid for such maintenance
activity. Condition (4) equates the user cost of capital with the marginal
productivity of capital services.
From (2) and (4) we derive
K/u = Qh,K/{
sm+Q{r+h(u,m)]},
which implies
sm + Q[r+ h(u, m)] = Quh..
(6)
Condition (3) implies
s+ Qh,=O.
(5)
Hence, (6) and (7) can be solved for the optimal rate of utilization and level
of maintenance as functions of the price of maintenance, the acquisition cost
of capital and the interest rate. Thus,
u* = u*(s, Q, r),
(8)
m* = m*(s, Q, r),
(9)
where asterisks denote optimal values.
Using (6), the user cost of capital services is5
P*(s,Q,r)={sm*+Q[r+h(u*,m*)]}/u*.
(10)
In more detail, we obtain P*(s, Q, r) = (sm* + q[(l - TD)/(l - T)][R(l - T) +
h(u*, m*)l)/u*,
where R is the one-period pre-tax interest rate, i.e., r = R(l - T). In the actual
estimation we adjusted all appropriate variables to tax rate and depreciation allowances.
M. Kim and G. Moore, Economic vs. accounting depreciation 115
Identical results can be obtained by minimizing the user cost by the choice
of the optimal level of maintenance and rate of utilization6
(11)
which is analogous to the result obtained in (10).
The user cost P*(s, Q, r) in (10) and (11) is linearly homogeneous in {s, Q}
for a given level of r, it is non-decreasing in { S, Q, r } and is concave in {s, Q }
and in {s, r }. To estimate the economic rate of depreciation consistent with
the producers minimization program with respect to its user cost, we have to
estimate the user cost function P*(e).
The user cost can be written (making use of the homogeneity property) as
~*=S{(**/U*+~[r+h(u*,m*)]/u*},
02)
where Q = Q/s is the normalized (by s) asset price of capital. Note that
minimizing the user cost P* is equivalent to minimizing the normalized user
*
cost P*, i.e., the normalized user cost function is*
P*(&,~)=min{(m*/u*)+Q[r+h(u*,m*)]/~*}. 03)
U. m
This is so because
P*(~,Q,r)=mins{(m*/u*)+Q[r+h(u*,m*)]/u*}
u,m
=.rmin{(m*/u*)+Q[r+h(u*,m*)]/u*)
u, m
=,@*($,r).
6This is due to the assumed separability of utilization and maintenance policies from the factor
demand decisions. Auerbach (1981) uses a similar approach in which the firms behavior is viewed
as a two-stage process, where in the first stage it chooses the rate of depreciation to minimize the
user cost of capital and in the second stage it invests until the marginal product of capital goods
equals this minimized cost.
Note that P(s, Q, r, U, m) is pairwise linear in {s, Q} and in (s, r}. Hence, it follows that
P*(s, Q, r) is pairwise concave in (s, Q) and in {s, r}. Nothing follows about concavity in
{s, Q, r} or (Q, r}. See Kim (1988) for a formal proof.
The reason for using the normalized user cost is due to heteroscedasticity. To see that,
substitute eqs. (17) and (19) multiplied by Q into the left-hand side of (16) and then unnormalize
both sides of (16). The result of this exercise gives rise to disturbance terms multiplicatively
affected by S. In such a case we get non-constant (s dependent) variance and the classical
regression properties are violated. The normalization by s avoids this problem.
116
Thus,
M. Kim and G. Moore, Economic us. accounting depreciation
P*(s,Q,r)=.&*(Q,r).
(14
We hypothesize the following flexible functional form for the normalized
user cost function: 9
n-1 n-1 n-1
P*(i&.., i?$;,, r) = c aiibci + 2 c c cIij( tiiGj)l*
i=l i=l J=i+l
n-l
+ 2 C fxin$*rl/* + an,r,
i=l
(15)
where the (YS are parameters to be estimated. Note that the normalized user
cost function P is a quadratic form in ( iC2,. . . , Gn;,, r).
The normalized user cost is written structurally as
P* = (art + ck2*Q + as3r + 2~xr~&/* + 2a,s( r&)l* + 2a13r12,
(16)
with P* as is defined in (13).
Assuming minimizing behavior, using the
derivatives of the user cost with respect to
capital-use equations which are consistent
function (15):
dP*/ds = hP*/i?s = m*/u*
envelope theorem, and taking
S, Q, r generates the following
with the normalized user cost
= al1 + q3r + q2@/* + a23( rQ) A * + 2a13r1/*,
dP*/dr = aP*/dr = Q/u*
(17)
= a+ + a,,s(&/r) + a13s(1/r)12,
(18)
d P*/dQ = dP*/iiQ = (r + h*)/u*
= a2* + ~r~(l/Q)l* + (Y23( r/&l*.
09)
The system of equations consisting of (16)-(19) constitutes the model to be
estimated. Deviations of the user cost (16) and its associated capital-use
This functional form is said to be flexible, since it can attain arbitrary partial elasticities of
substitutions and is a version of the Generalized Leontief Function [Diewert (1971)].
M. Kim and G. Moore, Economic US. accounting depreciation 117
equations, eqs. (17)-(19) from cost-minimizing levels are assumed to be due
to stochastic errors in optimization, and, therefore, we append additive dis-
turbance terms to eqs. (16)-(19).
The estimation of the above system could be a conventional matter if we
had observed h*, the economic rate of depreciation. However, existing depre-
ciation data are inconsistent with our theoretical specification since they are
exogenous. Consequently the system (16)-(19) is underidentified.
The solution to this problem adopted here is by postulating an exact
relationship between the unobservable variables and other exogenous and
endogenous variables in the system. Specifically, eq. (19) is hypothesized to
be exact, and hence, upon rearranging, we can rewrite it as
h* =~*[~,,+~,,(l/&)+cx,,(r/$)*] --.
(20)
Unfortunately, (20) does not resolve matters completely since we lack a
value for aZ2. Notice that we can obtain initial values for ai2 and a23 from the
initial joint estimation of (17) and (18). In order to arrive at a proxy for a22 we
invoke the following assumption: if the price of maintenance would have been
zero, i.e., s = 0, then no depreciation would have existed since a firm facing a
non-positive price for maintenance would maintain its capital stock up to the
level where no depreciation exists, thereby minimizing with respect to its user
cost. This rationale enables us to calculate (y22 as (Y** = l/nC,ri/ui, i.e., the
initial value for (Y** is calculated at the sample mean noting that when
s = 0 = (l/Q)/* = 0 and ( /@I2 = 0.
In order to obtain parameter estimates we initially calculate $* in (16) by
substituting the observed variables m*/u* and Q[(r + h*)/u*], where h* is
calculated from (20), into the left-hand side of (16). Then we iterate to
convergence over the system of equations consisting of (16) and (18) only,
since (17) is not independent of (16). At each iteration all the (YS are updated
[including those of (19)] and as a result the @* is updated accordingly.
Parameter estimates are obtained by maximizing the concentrated likelihood
function with respect to the parameters of P . * l2 Results of the estimation are
given in section 4. In the ensuing section we present a model of the implicit
subsidy and optimal capital replacement alluded to earlier.
See Epstein and Denny (1980) for a similar practice.
This conceptual treatment views maintenance as analogous to replacement investment. See
Betancourt and Clague (1981) for a similar approach.
t2Note that after the substitution of the variables into the right-hand side of (16) as described,
the estimated equations become non-linear in the parameters and caution should be taken so as
not to confuse local from global maxima of the likelihood function. The reported estimates were
obtained using several different starting values. Convergence was rapid and no local, non-global
maxima were detected.
J.A.E. B
118 M. Kim and G. Moore, Economic us. accounting depreciation
3. Implicit subsidy and optimal replacement
The annual economic depreciation charges and accounting depreciation
charges of an asset are, respectively, h,q and b,q, where q is the purchase
price of the asset, t is the time index, and h and b are the economic and
accounting rates of depreciation, respectively. Since b,q rather than h,q is
allowed to be deducted for tax purposes, the annual implicit tax subsidy
emanating from this difference is Tq( b, - h,). The present value of the tax
subsidy S is
S = Tqln( b, - ht)eerrdt,
0
(21)
where T is the firms income tax rate, r is the appropriate discount rate, and n
is the time of replacement of the asset. When the asset is disposed at year n, a
capital gain tax is incurred due to the difference between the sale price (L,)
and the book value (II,,) of the asset. The book value of the asset is the
purchase price minus the accumulated accounting depreciation, and the sale
price can be assumed to be equal to the purchase price minus the economic
depreciation. I3 Hence, the pre sent value of the capital gain tax G is
G = Z( L, - Bn)efrn
=Zq (b,-h,)dt eprn,
I
where Z is the capital gain tax rate. The net tax subsidy NS due to the
depreciation-differential tax subsidy and the recaptured depreciation is simply
given by the difference between eqs. (21) and (22):
NS=S-G=/(b,-h,)(Tewr-Ze-)dl.
0
(23)
In order to obtain the maximum net tax subsidy possible due to the
divergence between accounting and the economic rates of depreciation, we
assume that the asset (in absence of technological change) performs the same
function from one replacement to another. The proper future period over
which to examine a number of replacement cycles is represented by an infinite
horizon. For the first replacement cycle, where replacement occurs after n
13Note that Samuelson (1964) treats economic depreciation as a negative capital gain
M. Kim and G. Moore, Economic us. accountmg depreciation 119
years, the present value of the net tax subsidy is given by eq. (23); for the
second replacement cycle the present value of the net tax gain is NSe-; and
for the jth replacement cycle it is NSe-(I-jr. It then follows that the cycles
represent an infinite geometric series which reduces to the following expression
for the total present value of the net tax subsidy W:
W= NS/(l - eern)
The implied replacement year is determined by the maximization of (24) with
respect to n. Using Liebnitz theorem, n* can be derived from the following
expression:
F(n) =r/(b,-h,)(Z- Te-)dz
0
+(6,-h,)(l-e-)(T-Z)=O.
(25)
Once n* is determined, the asset is replaced every n* years. For a declining
balance accounting depreciation method and a constant-rate economic depre-
ciation, where b > h, the year of replacing the asset is determined by
+ [b(l - b)-l -II](I - e-)(T- Z) = 0.
(26)
Note that even when T = Z, the replacement year n* depends on T since the
economic depreciation h( .) depends on the tax rate. However, the effects of
the tax rate on economic depreciation are ambiguous.14 Economic deprecia-
tion depends on the rate of capital utilization u and on the quantity of
maintenance per unit of capital m. Schworm (1979) shows that the effects of
tax rates on capital utilization and maintenance are ambiguous,15 and Swan
(1981) shows that tax can increase as well as lower the durability of assets. In
general, little can be said about the qualitative effects of tax rates on optimal
replacement policy.
14Differentiate (26) to get dn*/dT= -F(h)(dh*/dT)/F(n). F(h) = -Z(r+ n - e-) < 0
and F(n) < 0 from the second-order condition. We obtain that sign{dn*/dT} =
sign{dh/dT), but the sign of dh/dTcannot be determined a priori.
-15Notefromeq.() s 8 and (9) that capital utilization and maintenance depend on the tax rate,
because Q = q(1 - TD), cf. note 4.
120 M. Kini and G. Moore, Economic OS. accounting depreciation
The maximum present value of the net tax subsidy is
w*=q{[b/(l-b)]{T[(l-b)-e]/[ln(l-b)-r]
-Z[(l-b)-l]/ln(l-b)}
- hT(e - 1)/r + hZn } /(em - 1).
(27)
Before we turn to the empirical results, we discuss the effects of inflation in
our framework. The user cost P* in a period of inflation at rate p can be
derived as follows:
For an asset with an initial purchase price of $1 the present value of the
depreciation allowances b in historical cost terms (with exponential decay) is
A=
/
oaTbee (h+r)rdt = Tb/b + r,
(28)
where r is the nominal after-tax interest rate. If R is the pre-tax rate,
r = (1 - T)R. The after-tax value of the $1 asset is
l-A=
/
om[P* _ &](l _ T)e-[r+h(u*,m*)-Plfdt
=[P*-sm*](l- T)/[r+h(u*,m*)-p].
(29)
Now
l-A=[b+r-Tb]/(b+r)=[b(l-T)+r]/(b+r),
(30)
so that
[b(l-T)]/(b+r)=[P*-sm*](l-T)/[r+h(u*,m*)-p],
or
P*=[b(l-T)+r][r+h(u*,m*)-p]/(l-T)(b+r)+sm*.
(31)
If we can crudely think of the real after-tax cost of capital, r - p, as being
independent of the inflation rate p (at least as an approximation), then the
influence of p on P* arises via its influence in raising the nominal after-tax
cost r. Thus, aP*/J r > 0; that is, inflation raises the user cost, and we would
expect the rate of economic depreciation to be higher. The average inflation
M. Kim and G. Moore, Economic us. accounting depreciarion 121
rate expressed in terms of the consumer price index was 9.53 percent for 1975.
The (low) after-tax value of the nominal interest rate was 4.75 percent,
suggesting that inflation was not a severe problem during the sample period.16
4. Data and empirical results
In order to estimate the user cost of capital services and its associated rate
of depreciation we used data on Canadian trucking firms. Canadian trucking is
a regulated industry and most of these data were derived from the confidential
tapes compiled by Statistics Canada from the 1975 Motor Carriers Freight
(MCF) Survey and the For-Hire Trucking Origin and Destination (TOD)
Survey. The MCF records mainly financial data collected from trucking firms
and includes 2756 carriers. The TOD survey records information pertaining to
the shipments carried by a subsample of carriers appearing in the MCF
survey.
Trucking firms differ significantly as to the type of commodities they haul,
and as a result use varying types of equipment (e.g., vans, trailers, straight
trucks). Thus, in order to select a relatively homogeneous group of carriers we
selected carriers whose predominant activity is the haulage of general freight.
We arrived at a sample consisting of 99 firms drawn from five Canadian
provinces. The calculation of the specific variables is discussed next.
The one-period interest rate was taken from the Bank of Canada Review
(1977) as the average of the (monthly) prime interest on business loans. This
rate should be viewed as a rough estimate of the true rate of interest since, in
general, interest rates vary according to risk classes. This rate then was
adjusted to account for the various tax rates. The acquisition cost of capital
was arrived at by the use of a Divisia price index accounting for the fact that
firms have different composition of equipment types. Here again, the com-
posite acquisition price of equipment was adjusted to tax rate and depreciation
allowance for tax purposes.
Maintenance expenditures include several categories such as: mechanics and
their supervisors, tires and tubes, lubricants, parts, purchased repairs and
garage. Price indexes for these categories were taken from Statistics Canada,
industry price indexes and the employment earnings and hours were aggre-
gated using the Divisia price index. The quantity of maintenance was the
implicit quantity, that is, maintenance expenditure divided by the Divisia price
index. The rate of utilization was specified as miles driven per vehicle.
The model described in section 2 was estimated for the sample of 99 firms
using a full information maximum likelihood method. Parameter estimates
16See Moore (1987) for the effects of inflation on optimal replacement policy
See Parks (1979) for a similar measure.
JAE. C
122 M. Kim und G. Moore, Economic us. accounting depreciation
Table 1
L
Summary of parameter estimates of the user cost function: P* = aIt + a12Q + assr + 2a,,i)/*
+2a,,(ri))/+ 2a,,r/ + error (all entries were multiplied by 104).
Parameter
a11 a22 a33 a12 a23 a13
Value - 0.0181 0.0065 - 0.4382 0.9660 0.1179 0.0936
Standard error 0.2365 0.0803 0.0324 0.0324 0.0434 0.0028
aLog of likelihood function = 1014.25, sum of squares residuals (SSR) = 0.5138 x lo-, stan-
dard error of regression (SER) = 0.7704 x 10m6.
were obtained by maximizing the concentrated likelihood function with re-
spect to the parameters of @* and are given in table 1.l
Using these estimates we checked for curvature properties. Monotonicity
requires that P,* 2 0, P; 2 0 and P,* 2 0, these conditions were fulfilled.
Concavity was not violated as P,: I 0, P&I 0, P3:P& - P,$Pp*, 2 0 and
P,: 5 0, P,T 2 0, P,fP,'f - P,:P,: 2 0. The F value for (6; 92) is 6.503, and the
1% level of significance is 3.12, thus pointing to the high predictive power of
the model.
The estimated rate of economic depreciation for the sampled firms was
0.148 at the sample mean, with standard deviation of 0.139. One of the
sampled firms had its rate of economic depreciation equal to -0.14 which
should be viewed as a statistical anomaly. 2o Theory dictates that we should
restrict the model to parameters which imply a value for h* between 0 and 1.
If, in fact, the unconstrained parameters which maximize the likelihood
function result in 0 I h* I 1, there is no need to constraint h* to the [0, l]
interval. As it happens, only one out of the 99 observations exhibited the
statistical anomaly of a negative rate of economic depreciation. This single
Since our data consist of a cross-section of firms drawn from five Canadian provinces, we
specified regional dummy variables X,, where i indexes the particular equation and k indexes the
particular province. These regional dummies were statistically insignificant.
The parameters orI and az2 are statistically insignificant. A zero estimated value for a,, is
consistent with the i* eq. (16) being actually an index number. The insignificance of az2 arises
from high correlation of Q and Q The omission of Q from the estimation would have
produced biased results for the included parameters. See Theil (1975).
This high standard deviation is due to the fact that one of the sampled firms had its rate of
economic depreciation negative as reported above. We note that our model admits a zero rate.
However, negative rate is related to the nature of the data. Specifically, we are forced to assume
that all vehicles and equipment are of the same age. In addition, we use a Divisia price aggregate
for Q which is a price index aggregating the various types of equipment actually used by the
sampled firms. This practice may have contributed to the statistical anomaly reported above. Cf.
footnote 3 and the following discussion in the text.
M. Kim and G. Moore, Economic US. accounting depreciation 123
peculiarity hardly justifies the complexities involved in constraining h* to the
[0, l] interval.
Given our method for estimating the rate of economic depreciation and its
results, it is useful to provide an additional perspective on the estimates by
giving an overview of other related studies of depreciation. Transport Canada
(1974, 1976) reports a 12% depreciation rate for trailers and 16% for truck
tractors. Hall (1973) reports a 17% rate for trucks, and Griliches (1970) reports
ll%-12% for tractors. These studies (except Transport Canada) use price-
oriented data. Thus, albeit the differences in methodologies, our results are in
the range of results documented in the literature, with the important caviat
that our depreciation estimates emanate directly from a behavioral model
of producer optimization.
The maximum net tax subsidy and the implied replacement policy depend,
as demonstrated in the previous section, on 4, h, r, b, Z and T. The average
acquisition price of a truck in our sample was $26,844, with an estimated
economic rate of depreciation of 14.8%. The value of the after-tax nominal
interest rate Y was 4.75%, the corporate tax rate T was 50%, and the capital
gain tax rate Z was 50%. The accounting depreciation rate used was 30%,
which is the maximum depreciation rate that Canadian trucking companies
can declare for tax purposes. This is also the depreciation used in the
companies books. Inserting these values into eq. (27) and changing the values
of n to obtain a solution, yielded a maximum net tax subsidy W* = $3,581.
This maximum W* was achieved when the asset was replaced every n* = 4.9
years. Hence, the implicit maximum net tax subsidy expressed as a proportion
of the acquisition price of the asset was 13.3%.
5. Concluding remarks
In this paper we have introduced and estimated a model of a producer who
minimizes the users cost-of-capital services by choosing the optimal rate of
utilization and level of maintenance applied to the stock of capital equipment,
thereby achieving an optimal rate of economic depreciation. This model
enabled us to estimate the rate of economic depreciation which is a decision
variable for the firm, and not a technological or tax datum as generally used in
empirical work. 21 Using data from the Canadian trucking industry we have
shown that estimated economic depreciation is lower than the maximum
allowed accounting rate used for tax purposes. Thus, the divergence between
the actual economic rate and the accounting rate gives rise to implicit subsidy.
We calculated this subsidy and in addition calculated the inferred optimal
replacement time for capital, and we found that the proportion of subsidy
*ISee Hawkins and Leggett (1983).
124 M. Kim and G. Moore, Economic us. accounting depreciation
out of the acquisition price of the asset was 13.3% and that the implied
replacement period was about 4.9 years.22
Our empirical work used data from the Canadian trucking industry which is
regulated. In regulated industries firms want to appear as unprofitable as
possible [Watts and Zimmerman (1986)].23 There are two types of possible
subsidy arising from depreciation methods: (1) subsidy due to tax depreciation
differing from economic depreciation, thus influencing tax payments and then
influencing after-tax cash flows, and (2) subsidy due to book depreciation
differing from economic depreciation, thus influencing the regulatory author-
itys decisions on price and entry to routes and then influencing pre-tax flows.
In this paper we were looking at the incentive to over-depreciate for tax
purposes, although our empirical data is from a regulated industry, and we
calculated the subsidy due to tax depreciation differing from economic depre-
ciation. In order to generalize our conclusions, future research should examine
the issues raised in this paper in the context of unregulated industries and
should examine the incentive to over-depreciate for regulatory purposes.
References
Auerbach, A.J., 1981, Inflation and the tax treatment of firm behavior, American Economic
Review, May, 419-423.
Betancourt, R.R. and C.K. Clague, 1981, Capital utilization: A theoretical and empirical analysis
(Cambridge University Press, Cambridge).
Cagan, P., 1973, Measuring quality changes and the purchasing power of money: An exploratory
studv of automobiles, in: Z. Griliches, ed., Price indexes and quality change (Harvard
U&ersity Press, Cambridge, MA).
Diewert, W.E., 1971, An application of the Shephard duality theorem: A generalized Leontief
production function, Journal of Political Economy, May/June, 481-507.
Epstein, L. and M. Denny, 1980, Endogenous capital utilization in a short-run production model:
Theory and empirical application, Journal of Econometrics, 189-207.
*Tax considerations are not the only considerations leading to the choice of the optimal
disposal date. Typically a truck is highly utilized by its original owners when it is relatively young,
and as it ages it is sold to new owners who put it to a less strenuous form of use, with a lower rate
of utilization and depreciation.
23 Watts and Zimmerman (1986, p. 231) point out that many firms have their prices or rates set
by government regulatory agencies on the basis of formulas that use accounting-determined costs.
For example, most public utility commissions set revenues (and prices) according to the equation:
Revenues = operating expenses + depreciation + taxes + return of capital invested. It follows that
the regulated Canadian trucking firms would like to report the highest depreciation possible. Note
that following the above equation, the subsidy due to regulation is the difference between the
accounting and economic depreciations, e.g., q/{(b, - h,)e-dt. Following our model and
empirical data we obtain that the subsidy due to regulation for an average truck is 26.5% of the
acquisition price. Note that this subsidy is greater than the one which is due to tax effects [eq. (23)]
because taxes do not enter the subsidy calculation for regulatory purposes. See Sloss (1970) for a
discussion on the effects of regulation on the Canadian trucking industry.
M. Kim and G. Moore, Economic vs. accounfing depreciution 125
Griliches, Z., 1970, The demand for a durable input: U.S. farm tractors, 1921-57, in: A.
Harberger, ed., The demand for durable goods (University of Chicago Press, Chicago, IL).
Hall, R., 1973, The measurement of quality change from vintage price data, in: Z. Griliches, ed.,
Price indexes and quality change (Harvard University Press, Cambridge, MA).
Hawkins, C.A. and D.N. Leggett, 1983, The investment tax credit in capital replacement: A
simulation, Journal of Accounting and Public Policy 2, 167-187.
Hulten, C.R. and F.C. Wykoff, 1980, Economic depreciation and the taxation of structures in
United States manufacturing industries: An empirical analysis, in: D. Usher, ed., The
measurement of capital (University of Chicago Press, Chicago, IL).
Hulten, C.R. and F.C. Wykoff, 1981, The estimation of economic depreciation using vintage asset
prices: An application of the Box-Cox power transformation, Journal of Econometrics,
367-396.
Kim, M., 1988, The structure of technology with endogenous capital utilization, International
Economic Review, Feb., 111-130.
Moore, G., 1987, Depreciation, inflation and capital replacement, Contemporary Accounting
Research, Spring, 375-383.
Most, KS., 1984, Depreciation expense and the effect of inflation, Journal of Accounting
Research, Autumn, 782-788.
Parks, R.W., 1979, Durability maintenance and the price of used assets, Economic Enquiry, April,
197-217.
Samuelson, P.A., 1964, Tax deductability of economic depreciation to insure invariant valuations,
Journal of Political Economy, Dec.. 604-606.
Schworm, W.E., 1977, User cost and the demand for capital, Discussion paper, June (University
of British Columbia, Vancouver, BC).
Schworm, W.E., 1979, Tax policy, capital use and investment incentives, Journal of Public
Economics, Oct., 191-204.
Skinner, R.C., 1982, Fixed asset lives and replacement accounting, Journal of Accounting
Research, Spring, 210-226.
Sloss, J., 1970, Regulation of motor freight transportation: A quantitative evaluation of policy,
Bell Journal of Economics 1, 327-366.
Swan, P.L., 1981, Durability and taxes: Market structure and quasi-capital market distortion,
Econometrica, March, 425-435.
Taubman, P. and R. Rasche, 1969, Economic and tax depreciation of office buildings, National
Tax Journal, Sept., 334-346.
Theil, H., 1975, Principles of econometrics (Wiley, New York).
Watts, R.L. and J.L. Zimmerman, 1986, Positive accounting theory (Prentice-Hall, Englewood
Cliffs, NJ).
WykolT, F.C., 1970, Capital depreciation in the postwar period: Automobiles, Review of Eco-
nomics and Statistics, May, 168-176.