Allowing investors to fully deduct the cost of an investment from taxable income is called full expensing of investment. In the absence of other taxes, full expensing reduces the tax paid on the normal return to capital investment to zero, completely removing taxes from the investment decision. This happens for two reasons. First, all assets face the same effective tax rate-zero-so that taxes no longer influence the decision about where or in what to invest. This results in a more efficient allocation of capital. Second, with full expensing there is no difference between the pretax and after-tax rates of return to investment. As a result, taxes do not discourage capital formation.

   It is important to note that full expensing is equivalent to not taxing the ordinary, normal return (or opportunity cost) of new investment. The reason is that full expensing is equivalent to an interest-free loan on the value of foregone tax liability. Under the income tax, the firm pays $35 in tax on the cost of the investment, whereas under full expensing the tax liability on the cost of the investment is zero. Assuming that the pretax return of 10 percent equals the normal opportunity cost of funds, the deferral of tax liability is worth $3.50 to the firm, which is exactly equal to the tax on the investment return. Because the opportunity cost of this loan is equal to the normal return to the investment, full expensing of investment costs is equivalent to excluding the normal return portion of capital income from taxation. However, returns in excess of the opportunity cost (called supra-normal returns) are still subject to taxation. For our example, if the total return of 10 percent is composed as a normal return of 6 percent and a supra-normal return of 4 percent, then the deferral of tax liability is worth $2.10 to the firm. This is equivalent to the firm paying $1.40 in tax, which is a tax of exactly 35 percent on the $4.00 supra-normal return.

   Partial expensing of investment occurs when something less than 100 percent of an asset's purchase price is excluded from taxable income in the year the asset is purchased. Partial expensing reduces, but does not eliminate, the amount of tax paid on the return to capital investment because costs in excess of those expensed are still subject to the tax depreciation schedules, resulting in an inefficient allocation of capital.

   There are several advantages to adopting full expensing as part of the current tax system. First, full expensing reduces the tax wedge between the pretax and the after-tax rates of return on investments, resulting in a more efficient level and allocation of capital throughout the economy. Second, if coupled with the repeal of capital gains and dividends taxes, full expensing completely removes taxes from equity-financed investment decisions. Third, full expensing reduces distortions that affect the financing of new investment by reducing incentives to debt-finance investment. Fourth, expensing is an integral part of many major tax reform proposals, such as a transition to a VAT, a consumed income tax, or the GIT. Overall, full expensing greatly simplifies the tax system and is an important step in the transition to a full consumption tax.