Calculate tax
A critical aspect of economic neutrality is the tax treatment of investment. Specifically, a neutral tax system provides for identical tax treatment of all types of investments, regardless of the type of asset, the business sector or industry, the source of finance, or the characteristics of the individual of institution providing the funds for the investment. In practice, no tax system achieves the goal of complete investment neutrality.
Much recent research in the economics of taxation has focused on measuring the extent to which tax systems deviate from investment neutrality. The most commonly used approach is the calculation of marginal effective tax rates on capital income. Such tax rates indicate the difference between the gross and net returns on a alternative marginal investments, generally expressed as a percentage of the gross return. They thus provide an indicator of the relative tax burdens facing such investments.
Under a tax system characterized by investment neutrality, marginal effective tax rates would be identical for all types of investments. Accordingly, the differentials in marginal effective tax rates across investments provide an indication of the extent to which the tax system deviates from economic neutrality and thus distorts investment decisions and the allocation of capital.
An example may help clarify the concept of marginal effective tax rates and its usefulness. Suppose that the before-tax real rate of return on a particular marginal investment is 10% and the after-tax return is 6%, clearly the marginal effective tax rate is 40%. If the effective tax rate on another marginal investment with the same before tax real rate of return is only 20%, resources will be allocated away from the former investment and into the latter.
Marginal effective tax rate methodology:
The basic concept underlying a marginal effective tax rate calculation is straightforward. Nevertheless, a wide variety of methods of calculating marginal effective tax rates have appeared in the literature; each has its own advantages and disadvantages. Any calculation of marginal effective tax rates will inevitably be affected by the choice of the method of calculation, as well as a number of assumptions made in the method of calculation chosen. As noted above, this study generally follows the approach of King and Fullerton (1984), which has to some extent become the standard among public finance economists.
The version of the King-Fullerton approach underlying this Report is summarized very briefly below:
In order to calculate the marginal effective tax rate on an investment, the tax wedge imposed on the income from the investment by the business and individual tax systems must be determined. This tax wedge is defined as the difference between the gross returns obtained by the firm that makes the investment and the net return, after all direct business and individual taxes to the saver providing the investment funds to the firm. The marginal effective tax rate is defined as the tax wedge divided by the gross return. Investments are marginal in the sense that the after-tax cost of an asset is assumed to be equal in present value terms to the after-tax returns to the asset. Investments are characterized according to the type of asset, the business sector, the type of finance, and the type of saver providing the investment funds. Since the tax treatment of various types of investment differs, the tax wedge, and thus the marginal effective tax rate, generally varies across types of investments.
A comparison of marginal effective tax rates across types of investments requires that some rate of return in the economy be held fixed. This assumption results in marginal effective tax rates that are easy to interpret. For example, suppose the marginal effective tax rate for a particular investment is calculated as 30%. Since the investment is assumed to generate a total return of 10%, the 30% tax rate simply implies that the government receives 3% points of the return in the form of business or individual income tax revenues, and the remaining 7% points go to the individual or institution providing the funds to finance the investment.
This fixed gross returns approach provides a good description of the relative tax burdens facing alternative marginal investments, relative to equilibrium without any business or individual income taxation. However, it should be noted that the assumption that all marginal investments yield the same gross return cannot be viewed as a realistic description of the actual pattern of gross returns in an economy that is in equilibrium. That is, in the presence of differentials in marginal effective tax rates, investors would be expected to reallocate capital toward relatively low-taxed types of investments and away from relatively high taxed types; this reallocation would result in differentials in gross returns such that net returns were equalized. The tax rates calculated under this assumption should thus be viewed as pre-adjustment rates, that is, marginal effective tax rates that would prevail before adjustment to differentials in tax rates.
Assumptions made in the calculations:
The marginal effective tax rate calculations presented below are based on a large number of assumptions and are subject to a variety of qualifications. These include the following:
The analysis is limited to capital investment made by companies in four assets, equipment, structures, inventories, and land. The marginal effective tax rates on investments in the two non-depreciable assets "inventories and land" are identical in all cases. This occurs because there are no depreciation deductions for either type of asset, because problems of inflation adjustment of business deductions do not arise because firms receive no deductions for land purchases and are assumed to use liFO inventory accounting, and because taxation of income from investments in these assets at the level of the saver is assumed to be identical for both assets. As a result, marginal investments in inventories and land are taxed at the business level at the statutory rate, if they are financed by new share issues or retained earnings, and at a zero (negative) rate if they are debt-financed and the inflation rate is zero (positive), any remaining tax burden on such investments, as measured by the marginal effective tax rate, reflects taxation at the level of the saver which is assumed not to differ across these two assets.
Calculation of the marginal effective tax rate on capital gains is always difficult and to some extent arbitrary. A common procedure is to assume that the advantages of deferral and the exclusion of gains transferred at death imply that the effective tax rate on capital gains is equal to roughly 1/4th the maximum statutory rate on such gains.
Summary:
Calculation of a marginal effective tax rate requires two basic assumptions. First, the marginal effective tax rate methodology does not include a general equilibrium modeling of the effects of tax policy; that is, all of the equilibrium rates of return to investment for a particular tax system are not calculated simultaneously in a model that describes an entire economy. Instead, a partial equilibrium approach is adopted, as some rate of return in the economy is held constant regardless of changes in the tax structure. Second, an assumption regarding the nature of arbitrage in the economy must be chosen. One possibility is firm arbitrage, where the after-tax return to investment at the firm level is independent of the source of finance. Since the returns to debt, retained earnings, and new shares are subject to differing tax treatment at the individual level, this implies that after-tax returns to the individual will vary according to source of finance. These two assumptions are clearly inconsistent.
Other Articles
