Chapter Two

Tax System & Economic

Growth

Prepared by: Prof. Said Ossman

 contents:
1- Introduction.
2- The role of tax system in achieving economic growth.
3- Types of Tax incentives:
* Tax Holiday.
* Carrying losses.
* Investment subsidies.
* Accelerated Depreciation.

Prepared by: Prof. Said Ossman

 Introduction:
 Taxation policy could affect the investment decision and capital
accumulation in society through affecting the component of NPV that
includes:
 The initial investment (I) , which includes all assets are necessary to
implement and establish the proposed project, particularly machinery
and equipment's.
 The total revenue (R) and total operating cost (C) during the project
life.
 The annual net profit or net revenue (NR).
 The taxation policy can affect positively
the component of NPV.
Prepared by: Prof. Said Ossman
 Introduction:
- Investment income tax can affect economic growth through affecting
capital accumulation, especially in the private sector, and affecting also
the investment decision and its determinants.
- Determinants of investment decisions are many, but profit factor and
risk factors are considered the main components of these determinants.
- Overestimating of income taxes and increasing its rates will affect the
achieved profits negatively and so may affect the pattern of investments.
- Imposing unified ad valorem tax on all economic activities may
encourage investment in less risky sectors and not the risky ones which
is effective in achieving economic development.

Prepared by: Prof. Said Ossman

 The role of tax system in
achieving economic growth
- Tax system can achieve the economic growth objective using many tools
with taking in consideration some important factors such as:
1- It should contain some tax incentives to encourage investments towards
favorable economic activities at the location where the government want
to make development.
But note that there are different kinds of tax incentives and has
advantages and disadvantages, so we should choose the suitable one
which is more effective in achieving the target.

Prepared by: Prof. Said Ossman

 The role of tax system in
achieving economic growth
2- It should contain (especially income tax scope) some “Discriminated tax
rates” in favor of the favorable economic activities and against the
activities that are not prior regarding the economic development plan.

3- Discriminated tax rates should be designed to include discriminated

rates between the favorable economic activities itself. This means to
impose different tax rates on each industry.

Why ???
Prepared by: Prof. Said Ossman
 The role of tax system in
achieving economic growth
If the tax rates decrease by the same rate on all favorable economic
activities:

The effectiveness of tax in achieving its target will decrease, as the

investments will be directed towards the investment opportunities in the
sectors or the industries which have higher return before and after tax,
and may be those industries have limited positive effects on economic
development.

Prepared by: Prof. Said Ossman

 The role of tax system in
achieving economic growth
4- We should take into account the relative profit rates of each economic
activity or industry, as neglecting these rates may decrease the
effectiveness of discrimination in achieving its targets.
NOTE: Decreasing tax rates on profits of some favorable activities may not
be effective incentive to increase investments in those favorable activities
if:
Net profit of favorable economic activities after tax is lower than the
net profit of unfavorable activities.

Prepared by: Prof. Said Ossman

 The role of tax system in
achieving economic growth
5- Decreasing tax rates on favorable activities should be accompanied by
increasing tax rates on unfavorable economic activities.
6- The result of the favorable economic activities itself should be positive
(profit), but if the results are negative especially in the first years, so the
discriminated tax rates will be ineffective in encouraging investments, and
here giving tax incentives will be more effective.

Prepared by: Prof. Said Ossman

 The role of tax system in
achieving economic growth

Decision maker should study well other

reasons & determinants that made
certain economic activities not
attractive such as: Huge required
capital, high risk factor, risk of changed
tastes.

What should government

Prepared by: Prof. Said Ossman
do here ???
 The role of tax system in
achieving economic growth
If the government find that there are other determinants and reasons
made certain favorable economic activities not attractive for the investors
such as the previous factors, so here decreasing tax rates will not be
effective, but here government should provide either:

Tax Credit
Incentives Facilities
Prepared by: Prof. Said Ossman
 Tax Incentives &
Economic Growth
- As we know that imposing income tax will affect private investment
decision and capital accumulation in the private sector by affecting many
variables which are:
-

Prepared by: Prof. Said Ossman

Prepared by: Prof. Said Ossman
 Tax Incentives &
Economic Growth
- Effectiveness of tax incentives increases when the economic activities
may result in expected losses, or low private return rates and (high social
return rate).
- Tax incentives are widely used in developing countries which
characterized by “Mis-Allocation of Resources” especially in the
economic sectors which is most preferable by the government.
- Tax incentives can be used to transfer the projects (investment
opportunities) which is accepted from social point of view but not
accepted from private point of view, to be accepted.

Prepared by: Prof. Said Ossman

 Tax Incentives &
Economic Growth

The effectiveness of tax incentives

differ in achieving the targeted
objectives based on the type and
size of the provided tax incentives and
the scope of coordination between
it and the other investment incentives.

Prepared by: Prof. Said Ossman

 Types of Tax Incentives
 Reduction of income tax rate, custom or value added tax rates (may be
all of them).
 Exemption of the annual NR from income tax, totally or partially (tax
holiday).
 Exemption of the new equipments and machinery from custom and
value added taxes (affect positively NPV).
 Specific deductions for some items of costs from tax base or from tax
due.
 Carry backwards or curry forward for annual losses.
 Investment allowance.
 Accelerated depreciation.
 Others.
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 Objectives of Tax Incentives
There are many possible objectives of tax incentives such as:
 Stimulate domestic investment
 Stimulate foreign investment
 New vs. old investors
 Large investors
 Reduce unemployment
 Technology transfer
 Export promotion – but what about WTO requirements?
 Promote specific economic sectors
 Address regional development needs – location incentives
Prepared by: Prof. Said Ossman
 Tax Incentives &
Economic Growth
Tax holiday

Accelerated Tax Carrying

depreciation incentives losses

Prepared by: Prof. Said Ossman Investment subsidies

 1- Tax Holiday

Tax holiday:
- is a tax incentives granted to specific investment projects or specific
activities in specific areas as a tax exemption from income or profit tax
for a number of years , mostly starting from the first year of operating.
- During tax holiday duration the net profit will be exempted from the tax,
it may be totally ( there is no tax during the tax holiday) or partially (only
percentage of the profit exempted) from the profit tax.

Prepared by: Prof. Said Ossman

 1- Tax Holiday
 According to the previous concept:
 Tax holiday can be used in a way to encourage investors ( outside or
inside the country) of the private sector, in different fields of industry
and different areas to increase and improve their investments in the
intended areas and intended activities .
 In Japan tax holiday is granted to many projects work in the exports
sector, petrochemical industries and some targeted industries
concerning on the developing technology and protecting
environment……etc.

Prepared by: Prof. Said Ossman

 1- Tax Holiday Advantages

Tax holiday as a tax incentive could achieve many positive findings on the
amount of invested money from different points of view such as:
1)- Tax holiday is common in using in the most developing countries
because it is a simple incentive in application from both private and tax
authority points of view
2)- Increases the annual net revenues for the exempted activities and
decreases the tax due to zero during the tax holiday duration .
3)- Some of negative NPV projects before tax holiday will become
positive values after tax holiday . In specific meaning a lot of rejected
projects will be accepted projects after using tax holiday .
Prepared by: Prof. Said Ossman
 1- Tax Holiday Advantages

4)- Some of the implemented projects especially the small and medium
projects are facing liquidity problems particularly during the first years
of operating, under these conditions the tax holiday will be more
beneficial for these projects to solve the liquidity problem at least
partially.
5)- Increasing of the investor's liquidity that equals the tax economies
during the tax holiday duration.
6)- A change of the financing structure in favor self financing.

Prepared by: Prof. Said Ossman

 1- Tax Holiday

The number of years of the Tax

holiday and its effectiveness
change from a tax legislation to
another, also from an industry to
another within the same tax
legislation (tax system) .

Prepared by: Prof. Said Ossman

 1- Tax Holiday
- NOTES:
- Some countries grant the tax holiday to certain project which are
considered a pioneer of the national economy. And others require a
certain production capacity or a minimum capital to grant the tax
holiday.
- Therefore the effect of the tax holiday on investment decisions differs
from a tax legislation to another according to the different economic,
political and social conditions...etc.
- Tax holiday duration changes from a country to another, from an
industry to another within the same country, according to the
economical ,political and social conditions ..
Prepared by: Prof. Said Ossman
 1- Tax Holiday

• The tax holiday might be convenient in certain conditions, and

inconvenient in others, so when assessing the tax holiday as an incentive,
we should take into consideration the following :
 1) - From private points of view the more benefits of the tax holiday are
achieved for short term projects especially in projects that make
fast profit at the beginning of its production.
 2)- The benefit from tax holiday is considered a subsidy from
government to the investors ,this subsidy equals the reduction of the tax
due during the period of tax holiday .
 3)- The tax holiday incentive results a discriminatory effect against the
long-term investments, which often do not make a profit at the
Prepared by: Prof. Said Ossman
 1- Tax Holiday
beginning of its production, so that the tax holiday doesn't have an
effective impact on long term projects. But the short term investments
that yield relatively in short period ,will benefit more from tax holiday.
• 4)- The tax holiday can be extended to indirect taxes like VAT and custom
tax. The exemptions from these taxes consider grants or subsidy to some
inputs and the final products for some activities. The most countries
grant exemptions from customs duties to equipments, machinery, tools
and some materials for manufacturing purpose. These exemptions are
used to restrict the inflation rate &reduces the production costs and
encourages final products to compete in the domestic and in the
international markets.
Prepared by: Prof. Said Ossman
 1- Tax Holiday

 5) Tax holiday can be more convenient as a tax incentive specially for

small and medium projects because these projects are relatively labor-
intensive and face liquidity problems .
 6) Tax holiday could be inconvenient and ineffective for projects that
achieve losses at the beginning of its production life and achieve low
profits in the first years .
 7) There is a problem of choosing the start of the tax holiday period. And
the effectiveness of tax holiday as tax incentive differs based on the
starting period.

HOW ???
Prepared by: Prof. Said Ossman
 1- Tax Holiday
- After the previous analysis, there are some points that should be taken in
considerations when designing tax holiday as tax incentives which are:
- Tax systems should include some provisions that distinguish between
long- & short-term investments in determining the tax holiday duration.
- The years of exemption should increase to LT projects, and decrease to
ST projects, Why? Because LT investments are more important for the
economic development in developing countries.
- Some countries set a maximum limit to benefit from the tax holiday like
Lebanon and Senegal.
- In Senegal exemption is canceled if the profits reached to 100% of
capital. So that the exemption stops even if the years of tax holiday not
satisfied.
Prepared by: Prof. Said Ossman
 Tax Holiday in Egypt
 In Egypt ,the tax law number 91 for year 2005 includes a lot of
investment incentives especially tax incentives.
 Some kinds of projects in specific activities and specific areas are
exempted a certain period of time from income tax such as:.
 1- The profits of cultivation projects or land reclamation are exempted
from income tax for ten years starts from the date of activity inception
(or of operating or production).
 2- The profits of poultry farming, livestock, fisheries, fish farming
projects and fishing boats enterprises are exempted from income tax
(tax holiday) for ten years starts from the first year of production.

Prepared by: Prof. Said Ossman

 Tax Holiday in Egypt
 3- The profits of areas planted in desert lands are exempted from income
tax for ten years starts when the lands consider productive.
 4- The profits of the new projects that are financed by the social fund for
development, exempted from tax for five years starts from the first year
of production.
 5- The income received from the securities that are issued by state or
Shareholding companies and registered in the Egyptian stock exchange
market.
 6- Securities income that are registered in the Egyptian stock exchange
market.
 7- The interests received by natural persons from deposits, saving
accounts and deposit certificates in the banks and post office are
registered in Egypt.
Prepared by: Prof. Said Ossman
 Example (1)
 An investor will invest in a project (initial investment $100,000), the
useful life for the project is estimated by 5 years. and the expected
net income (after depreciation) in that period is 30,000 /year). Tax
rate is 50%,and the discount factor is supposed 0.9 , 0.8, 0.7, 0.6 ,0.5
,0.4 respectively in the operating years. According to these data and
information:
 Determine if this projected accepted or rejected and why?.
 Suppose this project could benefit from tax holiday ( three years),
determine NPV for this project.
 Determine the present value of tax economies as result of using tax
holiday.
 Determine the cases or conditions that make the benefit of tax
holiday for some projects less or equal zero.
 Determine the benefits of the tax holiday?
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 2- Carrying Losses
 Any tax system should include allowances for deducting losses from
taxable income in the previous or future years.
 The effectiveness of carrying losses as a tax incentive on the investor
decision depends on the pattern and direction of carrying losses
(Forward – Backward), in addition to the prevailing economic and
non-economic conditions in the society.
 There are two types of carrying losses which are:

Carrying losses Carrying losses

Backward Forward
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 2- Carrying Losses
A- Carrying Losses Backward:

 This means that government will refund in the year of achieving

losses the paid taxes in the previous years (equivalent to losses
amount).
 Example: Suppose that an investor practice his business from 5 years,
and he achieved the following profit (before tax):, 3000, 1000, (2000),
2000, 3000, tax rate is proportional tax 10%.
1st assuming no carrying losses:
 This investor will pay taxes = 300, 100, - , 200,300 = 900$

Prepared by: Prof. Said Ossman

 2- Carrying Losses
 2nd Assuming there is carrying losses backward:
 Profit in the 3rd year will be zero, and profit in the 2nd year isn`t
sufficient to cover those losses, so the remaining losses will be
transferred to the 1st year.
 Here the government is responsible to refund the paid taxes in the 2nd
year which is $100 and part of the paid taxes in the 1st year which is
300$ also
 With applying carrying losses, the tax burden on the tax payer will
decrease, also it decrease risk and increase the investor ability to
reinvest and accumulate capital.
Try to calculate the tax economies from this policy ???
Prepared by: Prof. Said Ossman
 2- Carrying Losses
 From the previous analysis, we can conclude that:
 Carrying losses backward is considered an effective tax incentive for
the operating institutions (which operate since several years) to
expand and increase investments.
 Carrying losses backward is considered a weak tax incentive for the
new institutions that didn`t start its operations yet nor achieving
profit in the first operating years.

Note: The new institutions may benefit from this

tax incentive if it made profits in the first years.
Prepared by: Prof. Said Ossman
 2- Carrying Losses

What about the suitability

and difficulties of applying
this tax incentive in
developing countries
compared to developed
ones ???

Prepared by: Prof. Said Ossman

 2- Carrying Losses
A- Carrying Losses Forward:

 In practice, This tax incentive is considered more suitable to be

applied in the developing countries.
 According to the data in the previous example, if we apply the system
of carrying losses forward, so the taxable profit in the 4th year will be
zero, so the investor will not pay tax in the 4th year anymore.
 This means that the government will not refund any funds as the
investor didn`t pay.
 From investor point of view, The tax burden is the same under
carrying losses forward or backward but carrying forward is more
Prepared by: Prof. Said Ossman
suitable for new institution.
 2- Carrying Losses
Very important notes:

1- The effectiveness of carrying losses depends on the economic

conditions in the society:

Pessimistic Optimistic
conditions conditions

Carrying Carrying
backward
Prepared by: Prof. Said Ossman forward
 2- Carrying Losses
Very important notes:

 In the pessimistic scenario, it will be more effective to use carrying

losses backward, as the investors will need liquidity in the losses`
times to minimize the contractionary effects of losses, and increase
their ability to invest.
 In the optimistic scenario, it will be more effective to use carrying
losses forward to encourage investors to invest more and expand
their productive capacity.

Prepared by: Prof. Said Ossman

 2- Carrying Losses
Very important notes:

2- Carrying losses backward creates discriminatory effect against the

new business which make losses in the first years, and in favor of the
old businesses, so the old ones will be in a better financial position
compared to the new ones, and this may decrease the competition in
the market and enhance the monopolistic power of the old ones.
3- From the investor point of view, he usually prefer carrying losses
backward, WHY ????
4- Present value of tax economies is higher under carrying losses
backward than carrying losses forward.
Prepared by: Prof. Said Ossman
 2- Carrying Losses
Very important notes:

5- The preferences of the taxpayer regarding carrying losses forward or

backward depends on the applied tax rates, as:

Proportional Progressive
rate How, Try to Think ??? rate

Prepared by: Prof. Said Ossman

 2- Carrying Losses
Very important notes:

6- Effectiveness of carrying losses as tax incentive depends on the time

period of carrying losses, as when the time period of carrying losses
increases, the effectiveness of the tax incentive increases also, because
the investor will not be afraid of the long-term risk of huge investment
projects related to long run which is important for economic
development.
7- The time period of carrying losses should eb determined specifically,
as if it isn`t determined, this requires keeping regular accounting books
for infinity number of years, and this is impossible in practice, also this
may make some investors lazy as any achieved losses will be covered,
Prepared by: Prof. Said Ossman
 2- Carrying Losses
Very important notes:

 So they don`t caring of increasing the productive capacity of the

projects and may show fake losses in the accounting books to benefit
from the tax incentive.
8- This tax incentive effectiveness will be eliminated regarding the
projects which usually achieve profit during its operating life.

In Egypt tax law, there is tax incentive of carrying losses

forward for 5 years, but in USA tax law it is permitted to
carry losses forward for 15 years and backward for 3
Prepared by: Prof. Said Ossman years.
 3- Investment Subsidies
 Investment subsidies is considered one of the most important tax
incentives that can be used to encourage private investments in
favorable activities and increase economic growth rate.
 We have two types of investment subsidies which are:

Investment Assets
Allowances reevaluation

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 3- Investment Subsidies
A- Assets Reevaluation:

 Using traditional methods of depreciation may decrease the ability of

maintenance and replacement investment especially in inflation
times, as the value of accumulated depreciation will be less than the
actual Market value of the new equipments and assets. This may cause
negative effect regarding the ability to expand investment.
 Depending on traditional depreciation methods is suitable only under
constant prices conditions (In reality, this isn`t a realistic case). So to
decrease the negative effects of using traditional depreciation
methods we can depend on “Assets Reevaluation method”.
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 3- Investment Subsidies
A- Assets Reevaluation:

 According to this method, the investor is allowed to readjust the

depreciation expenses for taxable purposes to reflect the inflation
conditions, (i.e., increasing depreciation expenses in inflation times
and decreasing depreciation expenses in recession times).
 This tax incentive is very suitable for businesses in developing
countries which suffer from inflationary pressures.
 Using this tax incentive in inflation times is like giving investors
“investment subsidy” equal to tax paid on the difference between
adjusted depreciation and traditional depreciation.
prepared by: Prof. Said Ossman
 3- Investment Subsidies
A- Assets Reevaluation:

 Using this tax incentive will decrease the monetary risks faced by the
investors and increase their ability for maintenance and replacement
investments for keeping the existing productive capacity and
expanding it.
 Example:
Suppose that a company has a capital asset, its cost is 1000 LE, its useful
life is 10 years, and its return yearly is 3000 LE (before depreciation
expenses), tax rate is 10% on net profit. Calculate net profit under
traditional depreciation method and under adjusted method
(reevaluation of asset).
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 3- Investment Subsidies
 ** Traditional depreciation method:
Item 1 2 3 4 5 6 7 8 9 10

Profit 3000 3000 3000 3000 3000 3000 3000 3000 3000 3000

Depreciatio 1000 1000 1000 1000 1000 1000 1000 1000 1000 1000
n

Net profit 2000 2000 2000 2000 2000 2000 2000 2000 2000 2000

Due tax 200 200 200 200 200 200 200 200 200 200
10%

Net return of the asset = 20000 – 2000 = 18000 LE

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 3- Investment Subsidies
 ** Traditional depreciation method:
Item 1 2 3 4 5 6 7 8 9 10

Profit 3000 3000 3000 3000 3000 3000 3000 3000 3000 3000

Depreciatio 1000 1100 1200 1300 1400 1500 1600 1700 1800 1900
n

Net profit 2000 1900 1800 1700 1600 1500 1400 1300 1200 1100

Due tax 200 190 180 170 160 150 140 130 120 110
10%

Net return of the asset = 20000 – 1550 = 18450 LE

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 3- Investment Subsidies
A- Assets Reevaluation:

 Using this tax incentive will result in:

1- Decreasing the tax burden paid by the company, and this is considered
an investment subsidy equal to (due tax on the difference between the
adjusted depreciation and the traditional depreciation).

Yearly Tax economy (Investment subsidy) =

(Adjusted depreciation installment yearly – Traditional depreciation
installment yearly) * tax rate

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 3- Investment Subsidies
A- Assets Reevaluation:

2- Increasing the value of accumulated depreciation at the ending life of

the asset will increase the investor ability to do replacement and
maintenance investments.
3- The benefits of this tax incentive increases as the project is “capital
intensive” and decrease for “labor intensive” projects.
4- Adjusting depreciation expenses will eliminate the negative effect of
inflation if the adjustment is equal to the inflation rate.

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prepared by: Prof. Said Ossman
 3- Investment Subsidies
A- Assets Reevaluation:

 Difficulties of applying assets reevaluation in developing countries:

1- The availability of accurate data about prices and its expected change
rate in all sectors in the economy.
2- The availability of efficient tax administration able to apply this tax
incentive which will differ between sectors and inside the same sector
from time to time.

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 3- Investment Subsidies
B- Investment Allowance:

 This tax incentive is considered such as a subsidy that the investor will
get at the starting life of purchasing new asset.
 According to this tax incentive, the investor will be allowed to deduct
an extra depreciation expense from the tax base beside the ordinary
depreciation at the first year, without affecting the yearly
depreciation expenses all over the asset useful life.
 This tax incentive will allow the investor to depreciate more than
the cost of the asset.
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 3- Investment Subsidies
B- Investment Allowance:

 Example: suppose that an investor purchase new assets, its cost is

10000LE, and its useful life is 5 years, yearly return before
depreciation is 4000LE, and tax rate is 10%.
** According to ordinary depreciation:
 Yearly depreciation expense = 10000 / 5 = 2000 LE
 Yearly net profit = 4000 – 2000 = 2000 LE.
 Yearly tax due = 2000 * 10% = 200 LE
 Total tax due = 200 * 5 = 1000 LE
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 3- Investment Subsidies
B- Investment Allowance:

** According to investment allowance:

Suppose that the government allow the investor to depreciate an extra
20% of the asset at the first year.
So:
Depreciation expense at the first year = 2000 + (20% * 10000) = 4000
Net profit at first year = 4000 – 4000 = zero
This means that the investor will not pay any tax at the first year.

prepared by: Prof. Said Ossman

 3- Investment Subsidies
B- Investment Allowance:

** Advantages of investment allowance:

1- This tax incentive increase liquidity for investor in the first year.
- The increase in liquidity = investment allowance * tax rate
= extra depreciation * tax rate
2- It increase the ability for maintenance and replacement investment.
Some countries provide investment allowance in another
year (not first year), some countries provide this tax
incentive conditioned by that the useful life of the asset
shouldn`t decrease less than certain years.
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 Depreciation Method
 The method used in computing deprecation can affect investment
decisions, and the rate of capital accumulation in the private sector. as it
can be used as a tax incentive to decrease the negative effects of income
tax on the investment decisions especially in the first years of the
productive live of the project.
 Generally depreciation methods that are used to calculate the tax base
could affect in different ways the amount of tax due on the project as
we will explain in the following.

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 Different Types of
Depreciation Method
 There are different methods to distribute the historical cost of the
capital assets over the years of the productive life of the project.
 The most common of there methods are applied:
1- Straight line method.
2- Double declining method.
3- Sum of the years` digits method.

Each method of the previous will affect in different ways the amount of
the annual tax due (tax incentives).
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 1- Straight Line Method
 According to this method, the historical cost of capital assets is allocated
by equal installments on the expected productive life, (i.e., the deducted
installment from the total revenue should be equal along the productive
life.
 This will result in tax savings equal to:
(Depreciation installment * tax rate)
compared to the case of not allowing the deduction of the depreciation
from tax base for tax purpose.
 Tax economies from SLM (Supposing income tax is proportional tax):

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Depreciation installment * tax rate
 1- Straight Line Method
 In inflation times, the same of the depreciation installments according to
straight line method is lower than the real value needed for
replacement.

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 4- Accelerated Depreciation
 Accelerated depreciation as a tax incentive is that all ways to depreciate
the historical cost for capital assets for earlier time before it’s useful life
ended.
 Accelerated depreciation: methods are popular for writing – off
equipment that might be replaced before the end of its useful life since
the equipment might be obsolete. (e.g.: Computer) one example of an
accelerated depreciation method is the modified accelerated cost
recovery system (MACRS).
 In most cases the tax law includes accelerated depreciation to
encourage the firms to replace old machines by new and high
technology ones through allowing to the firms to depreciate these new
equipment’s and machines in the number of years less than their
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productive life with some conditions or restrictions.
 4- Accelerated Depreciation
 Generally any method of depreciation leads to depreciate the historical
value of capital assets within a period less the productive life considers
kind of accelerated depreciation.
 But other methods that depreciate the historical value of assets within
the productive life consider a normal depreciation. According to that
not all methods that recognizing higher amounts of depreciation in the
earlier years and lower amounts in the later years of a fixed asset’s life
consider accelerated depreciation.

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 Types of Accelerated Depreciation
 There are different types of accelerated depreciation that can be used
but some of them are common in the practice such as:

Free depreciation

Depreciation
Methods

Five years Initial depreciation

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 Fifth Year Depreciation Method
 This method is applied and spread in application in USA. It is called
“American method”.
 According to this method any real assets particularly the new
equipment’s and machines are depreciated within fife years regardless
the productive life of the assets.
 The benefits of this incentives will be zero for any asset its productive
life equals or less five years and the benefit will increase with the
increasing of the assets` life.
 This type of accelerated depreciation (the fifth years depreciation) has a
discriminatory effect in favor the long-term projects and investments
and against the short-term investments.
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 Accelerated depreciation &
investment decisions
 It has been cleared that by using the accelerated depreciation, the net
returns will increase at the first years by the tax economies and will
decrease at the last year with the same rate by the diseconomies.
 so:
NR1 + e1 NR2 +e2 NR(n-1)– e1 NRn - e2
PV = ------------- + ------------ + …… + ----------------- + --------------
(1+r) (1+r)² (1+r)n-1 (1+r)n

 Where “e1” = reduction of tax of the first year.

 = tax economies in the first year.
prepared by : Prof. Said Ossman
 Accelerated depreciation &
investment decisions
 The previous equation represents the present value of the net expected
returns after using the accelerated depreciation as a tax incentive.
 And we can notice in this equation that the consequence of using the
accelerated depreciation as a tax incentive is the difference in types of
the net expected returns, as it increased at the first years then it
decreased at the last years.
 Note: The net present value will differ by using the accelerated
deprecation as a tax incentive

prepared by : Prof. Said Ossman

 Accelerated depreciation &
investment decisions
 Example 1: Assume that an investor bought a capital asset its life is 10
years, its cost 10000 LE, and the expected return (revenue) before
imposing taxes is 2000 annually, and the present factor (10%) is 0.909 ,
0.826 , 0.751 & 0.683 and the tax rate is 10% .. Tax legislation allows using
fifth years depreciation method. According to this information we can
calculate the tax economy of using this depreciation method:
solution:
Yearly ordinary depreciation = 10000/10 years = 1000
Tax due before accelerated depreciation = (profit – depreciation ) * t
= 2000 – 1000 = 1000 * 10% = 100
Total tax due on the investor = 100 * 10 = 1000
prepared by : Prof. Said Ossman
 Accelerated depreciation &
investment decisions
 If we use accelerated depreciation:
 The yearly depreciation installment in the first 5 years will equal (10000 /
5 = 2000 ), but in the last 5 years will not be any depreciation.
 This means that the tax base in the first 5 years will equal zero, so no tax
due.
 Yearly tax base = 2000 – 2000 = zero
 This means that the net return in using accelerated depreciation will be
high in the first 5 years.
What about the tax base in the last 5 years ???
prepared by : Prof. Said Ossman
 Accelerated depreciation &
investment decisions
 Tax base in the last 5 years will equal:
 2000 – zero = 2000 LE
 Tax due yearly = 2000 * 10% * 5 = 1000

Conclusion:
 total tax due didn’t differ if using ordinary depreciation or accelerated
depreciation, but what changed is the time of paying the tax.
 This tax incentive allows depreciating the asset according to the
historical value of the asset, not more than it like (investment subsidy).
prepared by : Prof. Said Ossman
 Accelerated depreciation &
investment decisions
 This tax incentive is considered like a loan without interest, the investor
takes it in the first years, and pay it in the last years (when depreciation
installments for tax purposes is lower than the ordinary depreciation
installments).
 As this tax incentive is considered like taking a loan without interest, so
the Tax economy in this case can be represented by the interest that isn`t
paid on the loan.
 So based on the previous example tax economy=
= The yearly decrease in tax * loan`s years
= (tax under ordinary dep. – tax under accelerated dep.) * loans` years
prepared by : Prof. Said Ossman
 Accelerated depreciation &
investment decisions
= (100 – zero) * 5 = 500
 If we assume that the interest rate on loans in banks is 10%
 So tax economy = loan yearly * interest rate * loans years
 = 100 * 10% * 5 = 50 LE
 Note that the loan of the first year will be repaid in the 6th year, and loan
of the second year will be repaid in the 7th year and so on.
 All of the above calculations assuming that the investor will not
purchase any new equipments or machines, otherwise the above results
will differ.
prepared by : Prof. Said Ossman
 Accelerated depreciation &
investment decisions

The degree of benefiting from

accelerated depreciation depends on
the growth rate of total investments
in the institution and the scope of the
added equipments and machines.

prepared by : Prof. Said Ossman