Explain how tax treatment of capital expenditure can affect investment decision.

– The tax treatment of capital purchases can affect an investment decision because where tax relief is available, the tax benefits serve to reduce the effective cost of an investment. For example, suppose that a company estimates the net present value of a two year project to be £10,000, but that this is in the absence of any capital allowances being available on capital purchase. If the government then introduces 100% first year allowances, the company can use the allowances claimed on purchases to offset its corporation tax liability.
– If capital purchases totaled £15,000 and tax was payable at a rate of 33%, the cash impact of the capital allowances would be (£15,000 x 0.33) or £5,000 in reduced tax liabilities. This amounts to a 50% increase in the NPV. The impact on NPV will be less marked where the capital allowances take the form of writing down allowances instead of a large first year allowance, but the general effect is the same.
– Clearly the example given above is an extreme case, but it illustrates the fact that on potential marginal projects, it is possible that tax benefits could serve to convert a negative NPV into one which is positive. For this reason, capital allowances on investments can be viewed as a tool of government economic policy. If the economy is suffering from low levels of industrial investment, then an increase in the level of allowances can be used to encourage such investment.
– Obviously the tax treatment of capital purchases will only affect investment decisions in cases where the investing company is able to take advantage of the reliefs available. For loss making companies or those with tax liabilities below the threshold of the tax relief created by allowances, the situation is more complex, and investment decisions may be made irrespective of the tax position. Similarly, there may be some investments which are being made for strategic reasons, and which would be made regardless of the tax treatment of capital purchases. It is oversimplifying the situation to argue that higher tax allowances will definitely lead to an increase in industrial investment.