Tax Reform and the Cost of Capital (Lindahl Lectures on Monetary and Fiscal Policy)

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Tax Reform and the Cost of Capital

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Tax Reform and the Cost of Capital

by Dale W. Jorgenson and Kun-Young Yun

CLARENDON PRESS · OXFORD 1991

Great Clarendon Street, Oxford OX2 6DP Oxford University Press is a department of the University of Oxford It furthers the University's objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Bangkok Buenos Aires Cape Town Chennai Dar es Salaam Delhi Hong Kong Istanbul Karachi Kolkata Kuala Lumpur Madrid Melbourne Mexico City Mumbai Nairobi São Paulo Shanghai Taipei Tokyo Toronto Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Published in the United States by Oxford University Press Inc., New York © 1991 by Dale W. Jorgenson and Kun-Young Yun The moral rights of the authors have been asserted Database right Oxford University Press (maker) All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, or under terms agreed with the appropriate reprographicsrights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this book in any other binding or cover and you must impose this same condition on any acquirer British Library Cataloguing in Publication Data Data available Library of Congress Cataloging in Publication Data Data available ISBN 0-19-828593-0

Foreword The Lindahl Lectures on Monetary and Fiscal Policy have been instituted by Uppsala University with support from Nordbanken as a biannual event to honor the memory of Erik Lindahl (1891–1960). Lindahl was a great economist who held a chair in economics at the University between 1942 and 1958. A concise but thorough account of Lindahl's scientific contributions with a selective bibliography has been published by Otto Steiger.1 A more extensive account, including many valuable biographical details, has been presented by Jan Petersson.2 Lindahl's contributions fall mainly within four areas: 1. 2. 3. 4.

National income accounting. Public finance. Monetary and macroeconomic theory. Stabilization policy.

National accounts are essential for the design of tax policy and stabilization policies. Lindahl developed a consistent intertemporal framework for the basic concept of income by relating it to capital, the pricing of capital goods, and capital gains and losses. He also devoted much time and effort to initiating the empirical measurement of national income movements over time in Sweden. His extremely meticulous work with social accounting concepts has proved to be of such lasting value that it led Sir John Hicks to call him ‘the father of Social Accounting theory.’3 In public finance Lindahl greatly advanced Knut Wicksell's benefit approach to taxation. His theoretical model for distributing the costs of public goods through a political analogue to markets for private goods is a standard reference in tax policy. He also did a substantial amount of empirical work, directed towards measuring the total tax burden and analyzing the effects

1

‘Erik Robert Lindahl,’ in John Eatwell, Murray Milgate, and Peter Newman (eds.), The New Palgrave, Vol. 3, New York, The Stockton Press, 1987, Vol. 3, pp. 194–198.

2

‘Erik Lindahl,’ in Peter Englund (ed.), Research 1990, Annual Report and Program, Uppsala, Department of Economics, Uppsala University, 1990, pp. 6–28.

3

John R. Hicks, ‘Recollections and Documents,’ Economica, Vol. 40, No. 157, February 1973, pp. 2–11.

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FOREWORD

of double taxation of saving through company taxation. He participated in an international comparison of the burden of taxation in different countries. Best remembered and most highly regarded among Lindahl's contributions is his pioneering work in macroeconomics as a leader of the Stockholm School. In fact, the term ‘macroeconomics’ was first introduced into economic parlance by Lindahl. If Wicksell was the first to formulate the idea of ‘disequilibrium dynamics,’ Lindahl was one of the first, and perhaps the first, to develop this into a general area of research. He devised a novel methodology for economic dynamics and introduced many concepts that have become standard in economics, such as temporary equilibrium and the ‘natural rate’ of unemployment. Like all Swedish economists of his time, Lindahl was intensely interested and involved in current economic problems and policies. He directed much of his work at finding solutions to the pressing problems of the inter-war years, namely, the stabilization of prices, output, and employment. To the Swedish public, he became best known for his fight against inflation after World War II, as an adviser to the Riksbank. According to Lindahl, a stable price level should be the declared aim of an independent Central Bank. This target should be reached by using the bank's control of the term structure of interest rates to influence the market's anticipations of future prices. As Lindahl realized, monetary policy by itself is not sufficient to deal with unemployment problems during depressions. He proposed to complement monetary policy by compensatory fiscal policy, letting the budget balance vary inversely with the business cycle. As Ragnar Frisch stated in 1947, ‘Lindahl . . . was one of the first, if not the first, to bring out the view that the essence of problems of public finance resides in the relations that link public finance to monetary policy, and to emphasize the role of the combined monetary and fiscal policy as tools of promoting full employment on a high level of real income and economic welfare.’ This describes perfectly why Uppsala University has thought it fitting to commemorate the work of Erik Lindahl by a series of lectures on monetary and fiscal policy. Bengt-Christer Ysander Uppsala March 1991

Preface The purpose of this book is to present the cost of capital approach to tax policy analysis. This is the first in a series of Lectures on Monetary and Fiscal Policy at Uppsala University to honor the memory of Erik Lindahl. One of the objectives of this series is to provide expositions of important techniques in monetary and fiscal policy analysis, like those exemplified in Lindahl's own contributions. To achieve this goal each technique will be presented in a form suitable for introducing the subject to graduate students and policy analysts. It is worthwhile to emphasize the important points of contact between these inaugural Lindahl Lectures and the work of Erik Lindahl. The contributions of this great Swedish economist range from abstract theory, inspired by the Lausanne School of general equilibrium analysis, to the practical measurement of the national income of Sweden. His best known work in public finance is the often-cited Lindahl pricing scheme, which established the conceptual basis for decentralizing the allocation of public goods. Lindahl prices and the associated Lindahl equilibrium are concepts familiar to every public economist. The first point of contact between the lectures and Lindahl's work is through his theory of capital. This theory employs the crucial simplification of modeling anticipations through the assumption of perfect foresight or ‘rational expectations.’ Lindahl's rationale for this assumption is worth repeating: ‘The import of the assumption is, therefore, that individuals' ideas concerning the future are such that their actions bring about exactly the conditions which they anticipated.’4 This idea is used in modeling anticipations of future prices of investment goods, beginning on page 6 of this book.

4

Erik Lindahl, ‘The Role of Capital in the Theory of Price,’ Studies in the Theory of Money and Capital, New York, A. M. Kelley, 1970, p. 285. (This is an English translation of the Swedish original, dating from 1929.)

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PREFACE

The cost of capital can be derived from abstract principles of intertemporal economic theory, as developed by Lindahl. However, the cost of capital is a much more concrete and specific idea. This idea lends itself directly to the generation of the data required for tax policy analysis. The success of the cost of capital approach is due in large part to its ability to assimilate a virtually unlimited amount of descriptive detail on alternative tax policies and their implementation. The judicious choice of simplifying assumptions greatly facilitates assembling the economically relevant information, as we demonstrate in Chapter 3. The second point of contact with Lindahl's work is the focus on tax policy. Lindahl was a Professor of Law at Uppsala University with responsibility for courses in the economics of taxation. His system of ‘Lindahl prices’ for the allocation of public goods was originally presented in his doctoral dissertation of 1919 at Lund University.5 The associated ‘Lindahl equilibrium’ successfully integrates the revenue and expenditure sides of the government budget. This conceptualization owes a great deal to the so-called benefit approach, employed in Knut Wicksell's influential work on taxation. Wicksell himself served as the official opponent at Lindahl's thesis defense. The cost of capital was introduced almost thirty years ago and quickly became an essential tool for macro-econometric modeling of the impact of tax policy on investment behaviour. Within the past decade the cost of capital has assumed a central role in tax policy analysis through the introduction of the closely related concept of a marginal effective tax rate. This concept, which is the focus of Chapter 4, emerged from the debates over tax reform in the U.S.A., beginning with the Economic Recovery Tax Act of 1981 (ERTA) and culminating in the Tax Reform Act of 1986. The marginal effective tax rate brings out the distorting effects of specific tax provisions on the allocation of capital in a highly succinct and comprehensible way. We illustrate this type of application on pages 128–37 below. The third point of contact with Lindahl's work is his development of a complete system of national accounts for Sweden in his magisterial two volume treatise, The National Income of

5

Key excerpts are published in Erik Lindahl, ‘Just Taxation—A Positive Solution,’ in Richard A. Musgrave and Alan T. Peacock (eds.), Classics in the Theory of Public Finance, New York, Macmillan, 1962, pp. 168–76.

PREFACE

ix

Sweden.6 He considered the concept of income in an intertemporal setting and linked accounts for income with those for wealth. He also made important contributions to the formulation of an economic concept of income for tax purposes. Finally, he developed separate capital and current accounts for the government sector and established the basis for compensatory fiscal policy. The description of the US tax system presented in Chapter 3 has been incorporated into a complete system of national accounts for the United States. The most important innovation in this system of accounts is that production, income and expenditure, and wealth accounts are all presented in both current and constant prices. The cost of capital emerges within the system as the price of capital services, which is an input into production and a source of income for the owners of capital. This accounting system can also be used to generate the data required for econometric modeling of the impact of tax policy.7 We anticipate that an important use of this book will be for self-study or reference. In this Preface we offer some suggestions to readers who plan to utilize the book for these purposes. First, the technical terminology is somewhat specialized but relatively straightforward. To help the reader assimilate this terminology we have italicized all technical terms where they first appear and listed each of these terms in italics in the Subject Index. For example, the cost of capital first occurs as a technical term on page 7 below. It appears as a separate entry in the Subject Index on page 179. Second, we have indented the symbols used in presenting the cost of capital and provided a concise definition for each symbol where it first appears. Our system of notation is intended to be mnemonic with ‘c’ for the cost of capital, ‘t’ for tax rate, ‘I’ for investment, and so on. We refer repeatedly to separate tax provisions for corporate business (subscript or superscript ‘q’), non-corporate business (‘m’), and households (‘h’). All abbreviations used in the text are listed in the Subject Index with

6

This work was published in 1937 in collaboration with Einar Dahlgren and Karin Kock by Norstedt & Soner, Stockholm.

7

We have employed the system for this purpose in our papers, ‘The Efficiency of Capital Allocation’ and ‘Tax Policy and Capital Allocation,’ Scandinavian Journal of Economics, Vol. 88, Nos. 1–2, 1986, pp. 85–107 and 109–31.

x

PREFACE

brief definitions. Page references are given for more detailed definitions. We have tried to ease the reader's task by introducing complexities one step at a time (somewhat in the expository style favoured by Erik Lindahl). We begin with a straightforward model of durable capital and its pricing. We then imbed this into a model of a firm with capital as a factor of production. We next allow the firm to engage in borrowing and lending. Only after this has been accomplished, on page 13, do we introduce a highly simplified model of capital income taxation, which is the central theme of this book. In Chapter 2, beginning on page 17, we provide a representation of a tax system for capital income that is sufficiently detailed for tax policy analysis. In order to make the cost of capital approach as accessible as possible, we have kept the analytical level of this book to an absolute minimum. We have used the most elementary mathematical tools available for developing each concept. To provide detailed guidance to practitioners we have described the full implementation of the approach in Chapters 3 and 4. We have utilized the results in our own research.8 To make the results as useful as possible to others we have employed standard data sources, such as the US national income and product accounts and the flow of funds accounts, wherever possible. We hope that this will facilitate the detailed implementation of our approach for other countries. The cost of capital remains a very active area for investigation, so that we have described opportunities for further research in Chapter 5. We have also presented alternative approaches to our own in Chapters 2, 3, and 4 and provided a comprehensive list of references to the rapidly expanding literature. The alternative approaches presented in Chapter 2 include the ‘new’ and the ‘traditional’ views of corporate income taxation We compare our description of the US tax system in Chapter 3 with an ‘official’ description provided by the US Department of the Treasury. In Chapter 4 we compare marginal effective tax rates with average effective tax rates employed in much of the empirical literature on tax policy.

8

For example, in our article, ‘Tax Reform and US Economic Growth,’ Journal of Political Economy, Vol. 98, No. 5, October 1990, pp. S151–94, which analyzes the economic impact of the Tax Reform Act of 1986.

PREFACE

xi

It is a pleasure to acknowledge the contributions of many colleagues and former students at Berkeley, Chicago, and Harvard to the cost of capital approach. The concept itself was developed in response to persistent questions by Earl Rolph, who shared responsibility with George Break for teaching public finance at Berkeley for many years. The modeling of tax provisions for capital cost recovery presented in this book was a product of collaboration with Robert Hall, who was then an undergraduate student at Berkeley. The system of national accounts we have used in generating the cost of capital was originally developed in collaboration with Laurits Christensen, who was then a graduate student at Berkeley. Erwin Diewert, Sidney Handel, Charles Hulten, Sung-Woo Kim, Calvin Siebert, James Stephenson, and Frank Wykoff are among the many former Berkeley students who have made important contributions to tax policy and the cost of capital. The cost of capital was originally presented in a paper written while the author of this Preface was Ford Foundation Research Professor of Economics at the University of Chicago. Stimulating conversations with Zvi Griliches, Arnold Harberger, and Robert Lucas, who was then a graduate student at Chicago, were especially valuable at this stage. Griliches kindly arranged for the paper to be presented at a meeting of the American Economic Association. The paper was published in May 1963 in the proceedings of that meeting. Lucas incorporated data on the cost of capital into his dissertation research.9 As a consequence of the research and teaching in public finance at Harvard by Martin Feldstein, Richard Musgrave, and Lawrence Summers, Harvard has been a ‘hot bed’ of activity on the cost of capital for the past two decades. The concept of the marginal effective tax rate was developed in collaboration with Alan Auerbach, then Assistant Professor of Economics at Harvard. The research reported in this book is the result of a collaboration that began when KunYoung Yun was a graduate student at Harvard. Christophe Chamley, Robert Fry, Roger Gordon, Fumio Hayashi, Taewon Kwack, John Laitner, Eric Stubbs, Martin Sullivan and Brian Wright are among the many

9

Published in part in his paper, ‘Capital-Labor Substitution in US Manufacturing,’ in Arnold C. Harberger and Martin J. Bailey (eds.), The Taxation of Income from Capital, Washington, Brookings Institution, 1969, pp. 223–74.

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former Harvard students who have made important contributions to tax policy and the cost of capital. Financial support for preparation of the Lindahl Lectures was provided by the Program on Technology and Economic Policy of the Kennedy School of Government at Harvard. Finally, it is also a pleasure to express my gratitude to Professor Bengt-Christer Ysander of Uppsala University. He established the Lindahl Lectures, invited me to initiate the series, and he and his gracious wife, Elisabet, acted as hosts to my wife, Linda, and me during the week devoted to the lectures. Both of us are very grateful to them for their marvelous hospitality. Finally, our thanks go to all the other Uppsala economists who made our visit so enjoyable, especially Professor Ragnar Bentzel, his wife, Bebe, and their daughter, Christina, Dr. Villy Bergstrom, Dr. (now Professor) Jan Sodersten, and Professor Herman Wold. Gertrude Lindahl, Erik Lindahl's widow, kindly traveled from Lund to Uppsala to attend the lectures and participate in the festivities, providing a personal link with Lindahl himself. Dr. Birgitta Swedenborg, who was then Deputy Director of the Industrial Institute for Economic and Social Research in Stockholm, generously contributed two articles to Svenska Dagbladet, describing the implications of the lectures for the Swedish debate on tax policy. Professor Peter Englund of Uppsala University, who is now responsible for the series, has been of great assistance in preparing the final manuscript for publication. This book is dedicated to Bengt-Christer Ysander. Dale W. Jorgenson Cambridge, Massachusetts March 1991

Contents Foreword by Bengt-Christer Ysander Preface by Dale W. Jorgenson List of Tables 1. Introduction 1.1. Cost of Capital 1.2. Capital as a Factor of Production 1.3. Rates of Return 1.4. Capital Income Taxation 2. Taxation of Income from Capital 2.1. Households 2.2. Non-corporate Business 2.3. Corporate Business 2.4. Tax Reform 2.5. Alternative Approaches 3. The US Tax System 3.1. Tax Rates 3.2. Distribution of Assets 3.3. Capital Cost Recovery 3.4. Financial Structure 3.5. Tax Reform 3.6. Alternative Approaches 4. Effective Tax Rates 4.1. Economic Impact of US Tax Law 4.2. Effective Tax Rates 4.3. Differences in Effective Tax Rates 4.4. Tax Reform 4.5. Alternative Approaches 5. Summary and Conclusion 5.1. Opportunities for Further Research 5.2. Tax Policy Analysis References Author Index Subject Index

v vii xv 1 4 8 11 13 17 19 22 26 30 35 39 41 51 73 86 91 106 110 112 115 121 137 147 153 155 160 166 176 178

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Tables 3.1 3.2 3.3 3.4 3.5

Corporate Income Tax Rates Distribution of Adjusted Gross Income (AGI), 1980 Distribution of AGI, Interest, and Dividends, 1980 Average Marginal Tax Rates on Interest and Dividends Ownership Distribution of Corporate Equity (a) Billions of dollars (b) Percentage composition 3.6 Household Ownership Distribution of Corporate Equity 3.7 Ownership Distribution of Corporate Net Debt (a) Billions of dollars (b) Percentage composition 3.8 Household Ownership Distribution of Corporate Net Debt 3.9 Ownership Distribution of Non-corporate Net Debt (a) Billions of dollars (b) Percentage composition 3.10 Household Ownership Distribution of Non-corporate Net Debt 3.11 Ownership Distribution of Household Net Debt (a) Billions of dollars (b) Percentage composition 3.12 Household Ownership Distribution of Household Net Debt 3.13 Average Marginal Tax Rates on Household Income 3.14 Average Marginal Tax Rates on Equity Income 3.15 Average Marginal Tax Rates on Capital Gains 3.16 Average Marginal Tax Rates on Interest Income 3.17 Property Tax Rates 3.18 Economic Depreciation Rates: Business Assets I 3.19 Economic Depreciation Rates: Business Assets II 3.20 Economic Depreciation Rates: Consumer Durables 3.21 Present Value of Capital Consumption Allowances (z) 3.22 Investment Tax Credit Rates (k) 3.23 After-tax Corporate Profits and Dividend Payments 3.24 Debt-asset Ratios 3.25 Tax Rates 94, 3.26 Indexing and Deductions from Capital Income 3.27 Rate of Economic Depreciation (δ), Investment Tax Credit (k), and Tax Lifetimes

42 45 46 48 52 53 55 56 57 59 60 61 62 64 65 66 68 69 70 71 72 77 79 80 84 85 89 90 95 97 98

xvi 3.28 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14

PREFACE

Rate of Investment Tax Credit (k) and Present Value of Capital Consumption Allowances (z) Rates of Inflation and Interest, Discount Rates, and Private Rates of Return Effective Tax Rates on Business Assets Effective Tax Rates on Corporate Assets Effective Tax Rates on Non-corporate Assets Effective Tax Rates on Household Assets Effective Tax Rate on Private Assets Inter-asset Tax Wedges Intersectoral Tax Wedges: Corporate–Non-corporate Intersectoral Tax Wedges: Corporate–Household Intersectoral Tax Wedges: Non-corporate–Household Effective Tax Rates and Tax Wedges: 1985 Tax Law Effective Tax Rates and Tax Wedges: Treasury Proposal Effective Tax Rates and Tax Wedges: President's Proposal Effective Tax Rates and Tax Wedges: Tax Reform Act 1986

102 114 117 122 125 129 130 131 133 134 135 139 142 145 148

1 Introduction When the administration of President Ronald Reagan took office in January 1981, there was widespread concern about the slowdown of US economic growth. Tax reform proposals by the administration received overwhelming support from Congress with the enactment of the Economic Recovery Tax Act (ERTA) of 1981. The 1981 Tax Act combined substantial reductions in statutory tax rates for individuals and corporations with sizeable enhancements in investment incentives.10 Beginning with the introduction of accelerated depreciation in 1954 and the investment tax credit in 1962, US tax policy had incorporated a series of progressively more elaborate tax preferences for specific forms of capital income. The Tax Act of 1981 brought this approach to its ultimate realization with adoption of the Accelerated Cost Recovery System (ACRS) and the introduction of a 10 per cent investment tax credit. With these provisions the 1981 Tax Act totally severed the connection between capital cost recovery for tax purposes and the economic concept of income. The tax reforms of the early 1980s substantially reduced the burden of taxation on capital income. However, these policy changes also heightened the discrepancies among tax burdens born by different types of capital. These discrepancies gave rise to concerns in Congress about the impact of tax-induced distortions on the efficiency of capital allocation. In the State of the Union address in January 1984, President Reagan announced that he had requested a plan for further reform from the Department of the Treasury, setting off a lengthy debate that eventuated in the Tax Reform Act of 1986.11

10

An analysis of the impact of the 1981 Tax Act on US economic growth is given in Jorgenson and Yun (1986b), esp. pp. 365–70.

11

An illuminating account for the tax reform debate is presented by Birnbaum and Murray (1987). We have analysed the impact of the 1986 Tax Act on US economic growth in Jorgenson and Yun (1990).

2

INTRODUCTION

The 1986 Tax Act represented a striking reversal in the direction of US tax policy for income from capital. Statutory tax rates were lowered as in 1981, but the tax base was broadened by wholesale elimination of tax preferences for both individuals and corporations. This included sharp cutbacks in special tax incentives for investment. The 1986 Tax Act repealed the 10 per cent investment tax credit for property placed in service after 31 December, 1985. In addition, accelerated depreciation based on ACRS was substantially scaled back. The provisions for capital recovery in the Tax Reform Act of 1986 reflected a new conceptual framework for the analysis of capital income taxation. This framework had its origins in two concepts introduced in the 1960s—the effective tax rate, pioneered by Harberger (1962, 1966), and the cost of capital, originated by Jorgenson (1963, 1965). The cost of capital and the effective tax rate were combined in the marginal effective tax rate introduced by Auerbach and Jorgenson (1980).12 Auerbach and Jorgenson used marginal effective tax rates to expose differences in the tax treatment of income from different types of capital in the 1981 Tax Act. Marginal effective tax rates under the 1981 Tax Act were presented for all types of assets and all industries by Jorgenson and Sullivan (1981). Subsequently, these effective tax rates helped to frame the debate over alternative proposals that led to the Tax Reform Act of 1986. An important objective of tax reform was to ‘level the playing field’ by equalizing marginal effective tax rates on different forms of capital income.13 The purpose of this book is to present the cost of capital approach to the analysis of tax policy for capital income. Widespread application of the cost of capital is due to the fact that this concept makes it possible to represent the economically relevant features of highly complex tax statutes in a very succinct form. The cost of capital summarizes the information about the

12

A discussion of alternative notions of the effective tax rate is presented by Fullerton (1984). A summary of the literature on implementation of the cost of capital is given by Harper, Berndt, and Wood (1989).

13

The objectives of the 1986 tax reform are discussed by McLure and Zodrow (1987). Tax reforms along similar lines have been enacted or are under consideration by many other countries. A volume edited by Pechman (1988) provides a comparison of current efforts at tax reform in Australia, Canada, Japan, the USA, and seven European countries.

INTRODUCTION

3

future consequences of investment decisions required for current decisions about capital allocation. The marginal effective tax rate characterizes the tax consequences of investment decisions in a way that is useful for comparisons among alternative tax policies. In this chapter we begin by showing how the cost of capital arises in the management of capital as a factor of production. We introduce the concept of an effective tax rate within a highly simplified system for taxation of income from capital. We define a tax wedge as the difference between the remuneration of capital before taxes, which corresponds to the marginal product of capital, and the compensation after taxes available to holders of financial claims on the firm. The effective tax rate is the ratio of this tax wedge to the marginal product. In Chapter 2 we employ features of the US tax system to illustrate the complexities that arise in practical discussions of tax policy. Corporate capital income is taxed at both corporate and individual levels, non-corporate capital income is taxed only at the individual level, and household capital income is not taxed at either level. We begin with the taxation of household capital income, since the tax treatment of this form of income is the simplest. We then consider the taxation of income from corporate and non-corporate capital. In Chapter 3 we present a quantitative description of the US tax system. We first document the progressive elaboration of tax preferences for specific forms of income from capital over the period 1947–86. The adoption of these tax preferences dramatically altered incentives to invest in different types of assets and radically changed the distribution of the tax burden among households, non-corporate businesses, and corporations. We then analyse the impact of the Tax Reform Act of 1986 on the tax structure for income from capital. In Chapter 4 we compare alternative provisions for capital income taxation in terms of marginal effective tax rates. By measuring effective tax rates for different assets, we can quantify the sources of distortions in decisions involving the allocation of capital among different uses. The effective tax rate for capital as a whole makes it possible to quantify the sources of distortions in decisions involving the intertemporal allocation of wealth. We first present marginal effective tax rates for capital income

4

INTRODUCTION

over the period 1947–86. We then consider effective tax rates under the 1986 Tax Act. Chapter 5 provides an evaluation of the cost of capital approach to tax policy analysis. This approach has amply proved its usefulness as a guide to tax reform. While the tax policy changes of the early 1980s introduced additional barriers to efficient allocation of capital, the Tax Reform Act of 1986 reduced these barriers substantially. However, important discrepancies remain between effective tax rates on income from household and business assets. Further reduction in these discrepancies presents an important opportunity for increasing the efficiency of capital allocation.14 A significant limitation of the 1986 Tax Act is that the definition of capital income for tax purposes was not insulated from the effects of inflation. Both the level and the distribution of the tax burden on income from capital remain highly sensitive to changes in the inflation rate. Redesigning the tax structure for capital income to eliminate the impact of inflation should receive high priority in future deliberations about tax reform. Proposals that preceded the adoption of the 1986 Tax Act can provide practical guidance in realizing this objective.

1.1 Cost of Capital The simplest form of the cost of capital arises in a model of production with durable capital goods.15 In this model a producer acquires capital goods through investment and rents or leases them to generate income. The cost of capital plays a natural role in the management of capital, since it transforms the price of acquisition of a capital good into a rental price that generates income. The cost of capital can be avoided by postponing acquisition of a capital good. However, a delay in acquisition results in forgoing the rental value. The rental price of capital services is the unit cost of using a capital good for a specified period of time. For example, a building

14

In Jorgenson and Yun (1990) we provide quantitative estimates of the potential gains in efficiency.

15

The durable goods model of production was originated by Walras (1954). Capital as a factor of production has been discussed by Jorgenson (1967), Diewert (1980), and Hulten (1990).

INTRODUCTION

5

can be leased for a number of months or years, an automobile can be rented for a number of days or weeks, and computer time can be purchased by the second or the minute. The cost of capital transforms the acquisition price of an asset into an appropriate rental price. This cost depends on the rate of return and depreciation. The rate of return is the opportunity cost of holding a capital good rather than a financial asset. Depreciation arises from the decline in the price of a capital good with age. In the simplest model of a firm the production process is financed by issuing equity. The income generated from production is distributed to the shareholders through dividends. The firm's objective is to choose a production plan that maximizes the value of the firm's outstanding shares. This coincides with the interests of the shareholders in maximizing their wealth. The rental price of capital services makes it possible to decompose the maximization of the value of the firm into a sequence of one-period problems, each involving the maximization of profit. The distinguishing feature of capital as a factor of production is that durable goods contribute services to production at different points of time. We describe the technology of this model in terms of relative efficiencies of capital goods of different ages. The relative efficiency of a capital good depends on the age of the good and not on the time it is acquired. When a capital good is retired, its relative efficiency drops to zero. For simplicity, we assume that the relative efficiencies of durable goods of different ages decline geometrically.16 The rate of decline in efficiency δ is constant, so that the relative efficiencies take the form

(1.1) where we normalize the relative efficiency of a new durable good at unity. In order to characterize the durable goods model of production in greater detail, we require the following notation: It — quantity of capital goods acquired at time t Kt — capital stock at time t qt — acquisition price of investment goods at time t ct — rental price of capital input at time t

16

While the assumption of geometric decline in relative efficiency of capital goods is a convenient simplification, this assumption is inessential to modelling capital as a factor of production. For a more general treatment, see Jorgenson (1973, 1989) and Biorn (1989).

6

INTRODUCTION

We assume that capital input is characterized by perfect substitutability among the services of capital goods of different ages. Under the additional assumption that the services provided by a durable good are proportional to the initial investment in this good, we can express capital stock as a weighted sum of past investments:

(1.2) The weights are given by the relative efficiencies {(1 − δ)τ}. The quantity of capital input is proportional to capital stock at the beginning of the period Kt − 1. Capital goods decline in efficiency at each point of time, giving rise to needs for replacement to maintain productive capacity. The proportion of an investment to be replaced during the τth period after its acquisition is equal to the decline in efficiency during that period. Taking the first difference of the expression for capital stock in terms of past investments, we obtain

(1.3) where replacement requirements δKt − 1 are proportional to capital stock at the beginning of the period with a constant rate of replacement δ. In the durable goods model of production the price counterpart of capital stock is the acquisition price of investment goods. The rental prices of capital goods of different ages are proportional to the rental price of a new capital good. The constants of proportionality are the relative efficiencies {(1 − δ)τ}. The acquisition price of investment goodsqt is the sum of future rental prices of capital service {ct}, weighted by the relative efficiencies of capital goods in each future period:

(1.2) where rs + t is the rate of return in period s + t. The future rental prices are discounted in order to express prices for different time periods in terms of present values at time t. This expression can

7

INTRODUCTION

be compared with the corresponding expression (1.2) giving capital stock as a weighted sum of past investments. The acquisition price of a durable good declines with age. Depreciation reflects both the current decline in efficiency and the present value of future declines in efficiency. Taking the first difference of the expression for the acquisition price of investment goods in terms of future rentals, we obtain

(1.3) so that the rental price of capital services is given by

(1.4) The cost of capital is an annualization factor that transforms the acquisition price of investment goods into the price of capital input:

(1.5) where πt is the rate of inflation in the price of investment goods:

(1.8) The cost of capital is the sum of two terms. The first term (rt − πt) is the rate of return, net of inflation. The second term (1 + πt)δ is the rate of depreciation δ, corrected for inflation. The durable goods model of production is characterized by price–quantity duality. In this duality capital stock Kt corresponds to the acquisition price of investment goods qt and investment It corresponds to the rental price of capital services ct. Capital stock is a weighted sum of past investments, while the acquisition price of investment goods is a weighted sum of future rentals. Capital input is the service flow from the capital stock available at the beginning of the period. The price of capital input is the rental price of capital services.17 In the definition of capital stock, the weights on past investments correspond to relative efficiencies of capital goods of different ages. These weights are also applied to future rental

17

The dual to the durable goods model of production was originated by Hotelling (1925) and Haavelmo (1960). The dual to this model was further developed by Arrow (1964) and Hall (1968).

8

INTRODUCTION

prices in defining the acquisition price of investment goods. Replacement requirements are generated by the decline in efficiency of a capital good with age. Depreciation results from the decline in the price of acquisition of a capital good with age. A special feature of geometrically declining relative efficiencies is that the rate of replacement and the rate of depreciation are equal to the rate of decline in efficiency δ.

1.2 Capital as a Factor of Production The second level of complexity in analysing the cost of capital arises in a model of the firm with capital as a factor of production. The durable goods model of production can be imbedded in an elementary model of the firm with the flow of capital services as capital input. Taking the price of capital input as the rental price of capital services, capital is analogous to any other factor of production. In the simplest version of this model production is financed by issuing equity. All revenue generated from production is distributed to the shareholders. We can regard a firm with capital as a factor of production as composed of two departments. The first department manages capital input, purchasing investment goods and supplying capital services. The second manages production, transforming capital and labour inputs into final output. In this model the cost of capital arises in a natural way. The rental price of capital is an internal transfer price at which capital services are made available to the production process. To represent the technology of a firm with capital as a factor of production, we require the following additional notation: Lt — labour input at time t Qt — output at time t wt — price of labour input at time t pt — price of output at time t We represent the technology of the firm by means of a production function, say F, where

(1.9) In this technology output is a function of capital and labour inputs. For simplicity we assume that production is characterized

INTRODUCTION

9

by constant returns to scale. The specification of technology also includes the relationship between capital stock and past investments (1.2). The management of capital input involves purchasing investment goods and supplying capital services to production. To complete the specification of our model of the firm, we must consider the objectives of the shareholders. For this purpose we require the following notation: Dt — dividends distributed to equity-holders at time t St — new share issues at time t Vt — value of the firm's outstanding shares at time t Pt — profit of the firm at time t Production is financed through the issue of equity, which we represent in the form of new share issues. The income generated from production is distributed to shareholders in the form of dividends. The portfolio equilibrium of the holders of equity requires

(1.10) DividendsDt and the change in the value of outstanding sharesVt − Vt − 1, less new share issuesSt, are equal to the rate of return on equity rt, multiplied by the value of outstanding shares at the beginning of the period Vt − 1. We can treat the condition for portfolio equilibrium of the shareholders as a difference equation in the value of outstanding shares. Using this equation, we can express the share value in the current period Vt as a discounted sum of future dividends less issues of new shares:

(1.11) The objective of the firm is to maximize the value of the outstanding shares Vt. This objective coincides with the interests of the shareholders in maximizing their wealth.18 In each period the firm operates under a constraint on cash flow:

(1.12) The value of dividends distributed

18

The relationship between the objective of the firm and the interests of the shareholders was introduced by Fisher (1961). This relationship was discussed in detail by Hirshleifer (1970).

10

INTRODUCTION

Dt, less the value of new share issues St, must be equal to the cash flow generated from production, ptQt − wtLt, less investment expenditures qtIt. Substituting the cash flow generated from production, less investment, into the expression for the share value, we obtain

(1.13) Finally, expressing investment in terms of the change in capital stock and replacement requirements,

(1.14) where ct is the rental price of capital services:

(1.15) We can define the profit of the firmPt as the difference between the value of output and the value of labour and capital inputs:

(1.16) using the rental price of capital services ct. The value of outstanding shares Vt is equal to the value of the firm's capital stock qtKt, plus the discounted sum of future profits:

(1.17)

INTRODUCTION

11

In order to achieve the objectives of the firm's shareholders, the production plan must maximize the firm's share value. For this purpose it is sufficient to maximize profits in every period. Under constant returns to scale this maximum is zero, so that the share value is equal to the value of the firm's capital stock:

(1.18) We can treat the rental price of capital services as a difference equation in the price of investment goods. The price of investment goods in the current period is a weighted sum of future prices of capital services, as in (1.4) above. Rental prices are discounted at the rate of return on equity to express prices in different time periods in terms of present values. The durable goods model can be regarded as a description of one of the two departments of the firm. This department invests in capital goods and generates income from the rental of capital services. A second department transforms labour and capital services into final output. The rental price of capital services is an internal transfer price that links these decisions.

1.3 Rates of Return We can extend the model of a firm with capital as a factor of production by permitting borrowing and lending. We assume that the firm can borrow or lend at a fixed rate of interest by issuing or purchasing debt in the form of bonds, notes, or mortgages. We assume further that the rate of interest is less than or equal to the rate of return to equity. Finally, we assume that the firm has a maximum debt capacity that is proportional to the value of the firm's capital stock. As before, the objective of the firm is to maximize the share value. We can think of a firm with borrowing and lending as consisting of departments for managing capital, production, and the liabilities of the firm. The first two departments are present in the simplest model of a firm with capital as a factor of production. The third is a finance department that issues and redeems debt and equity in order to satisfy the cash flow requirements of the firm. The objective of this department is to minimize the cost of financing the firm's investments. With a fixed rate of interest, the cost of capital plays the same role with debt and equity financing as with equity financing alone. However, the rate of return is now a weighted average of rates of return on debt and equity. These rates of return represent the opportunity costs of holding durable goods rather than financial claims. The weights correspond to the relative proportions of debt and equity in the value of the firm's capital. The weighted average rate of return is an internal transfer price

12

INTRODUCTION

at which financial capital is made available to the department that manages capital goods. The optimal financial strategy for the firm is to finance investment through new share issues and new borrowing in fixed proportions. The proportions of debt and equity reflect the firm's debt capacity. To represent the financial structure of the firm with borrowing and lending, we require the following additional notation: it — rate of interest at time t ρt — rate of return on equity at time t β — ratio of debt capacity to the value of the firm's capital stock Given the portfolio equilibrium condition for shareholders, the value of the firm's equity is equal to the sum of future dividends less issues of new shares, discounted at the rate of return on equity ρt:

(1.19) However, the cash flow constraint must be modified to permit borrowing or lending. If β is the ratio of the firm's debt capacity to its capital stock, the cash flow constraint takes the form

(1.20) The cash flow generated by production, less the value of investment, is reduced by interest payments on outstanding debt βitqt − 1Kt − 1 and augmented by new issues of debt. These new issues are required to finance the increase in the value of capital stock arising from inflation in the price of capital goods πtqt − 1Kt − 1 and the value of investment net of replacement, qt(Kt − Kt − 1). With a fixed ratio of debt to capital stock β, the value of the firm's equity can be written in the form

(1.21) where Pt is profit, as in (1.16). The rental price of capital services ct takes the same form as in (1.15). Finally, the rate of return rt is

INTRODUCTION

13

a weighted average of the rate of interest it and the rate of return on equity ρt:

(1.22) We can treat the rental price of capital services as a difference equation in the price of investment goods, as in (1.4) above. This price is a weighted sum of future prices of capital services, discounted at the weighted average rate of return to debt and equity (1.22). We conclude that the availability of debt financing does not alter the role of the price of capital services or the cost of capital. However, the rate of return on equity in a firm without debt financing must be replaced by the weighted average rate of return appropriate to a firm with debt financing. We can consider a separate department of the firm, the finance department, with responsibility for managing the firm's cash flow by issuing and redeeming debt and equity. The objective of this department is to minimize the cost of financing the firm's investments. The weighted average rate of return is an internal price at which finance is made available to the department that manages capital. As before, the rental price of capital services is an internal price at which capital services are supplied to the production process. To meet the objectives of the firm's shareholders it is sufficient to maximize profit in every period. Under constant returns to scale this maximum is zero, so that the share value is a constant fraction of capital stock:

(1.23) The remainder of the value of capital is, of course, the outstanding debt.

1.4 Capital Income Taxation In order to complete the presentation of our elementary model of the firm, we introduce a simplified tax on income from capital. To represent this tax we require the following additional notation: Tt — tax revenue at time t et — effective tax rate at time t σt — social rate of return at time t

14

INTRODUCTION

In every period the income from capital is the rental value of capital services. However, this rental value is gross of depreciation on capital goods. We define the tax base for the capital income tax by reducing the rental value of capital services by the value of depreciation. The tax revenue generated by taxation of income from capital is equal to the effective tax rate, multiplied by the tax base:

(1.24) To characterize the effective tax rate, we find it useful to define the social rate of return as the cost of capital before taxes, plus the rate of inflation in the price of capital goods, less depreciation, so that

(1.25) This before-tax rate of return, adjusted for inflation, is the cost of capital less the rate of depreciation. The social rate of return corresponds to the marginal product of capital as a factor of production. Second, we can define the private rate of return as the cost of capital after taxes, plus the rate of inflation and less depreciation, so that

(1.26) This after-tax rate of return, adjusted for inflation, represents the rate of compensation of holders of the firm's debt and equity after all taxes have been paid. Finally, we define the tax wedge as the difference between social and private rates of return. The effective tax rate is equal to the tax wedge divided by the social rate of return, net of inflation:

(1.27) The effective tax rate is the proportional difference between the remuneration of capital in production and the compensation available to the holders of financial claims on the firm. In this chapter we have described the taxation of income from capital by means of an elementary model of the firm and a simplified tax system. The firm employs capital as a factor of

INTRODUCTION

15

production and transforms capital and labour inputs into output. We measure the income from capital generated in production by means of the cost of capital. The cost of capital is an annualization factor that translates the price of acquisition of investment goods into the rental price of capital services. In the absence of taxation, the cost of capital is the sum of the return on capital, adjusted for inflation, and depreciation on investment goods. We have described the taxation of income from capital in terms of the effective tax rate. The effective tax rate corresponds to the tax wedge between the remuneration of capital before taxes and compensation received by the holders of financial claims on the firm after taxes. These claims take the form of both debt and equity. The effective tax rate is defined in terms of the cost of capital. The social rate of return is the cost of capital before taxes, adjusted for inflation and depreciation. The private rate of return is the cost of capital after taxes. The effective tax rate is equal to the difference between social and private rates of return, divided by the social rate of return, net of inflation. Actual tax systems for income from capital differ from the simplified tax system we have considered in many respects. First, income from capital may be taxed at the level of the corporate firm and the level of the individual, so that the distribution of the income to holders of the firm's equity in the form of dividends or capital gains may affect tax liabilities. Second, distributions of income to shareholders may be treated differently from interest payments. Third, the definition of income from capital for tax purposes may differ from the compensation of capital in production. Fourth, income from newly acquired assets may be taxed differently from existing assets, giving rise to differences between marginal tax rates on new assets and average tax rates on all assets. In the following chapter we employ features of the US tax system to illustrate the characteristics of tax systems encountered in practical discussions of tax policy. We consider the tax treatment of income from assets held by households, non-corporate businesses, and corporations under US tax law. For assets held in each sector we define an appropriate cost of capital and rate of return. We begin with the household sector, where the taxation of income from capital takes its simplest form. We then consider the taxation of income from non-corporate business under the

16

INTRODUCTION

individual income tax. Finally, we analyse the taxation of corporate income, which requires the integration of provisions of individual and corporate income tax laws.

2 Taxation of Income from Capital The purpose of this chapter is to introduce the characteristic features of US tax law into the cost of capital.19 We distinguish among assets employed in three different legal forms of organization—households and non-profit institutions, non-corporate businesses, and corporate businesses. Income from capital employed in corporate business is subject to corporate income tax, while distributions of this income to households are subject to individual income tax. Income from unincorporated businesses—partnerships and sole proprietorships—is taxed only at the individual level. Income from equity in household assets is not subject to income tax. Capital utilized in all three forms of organization is subject to property taxation. Although income from equity in the household sector is not subject to tax, property taxes and interest payments on household debt are deductible from income for tax purposes under the individual income tax. The value of these tax deductions is equivalent to a subsidy to capital employed in the household sector. Interest payments to holders of household debt are taxable to the recipients. Capital gains on household assets are effectively excluded from taxable income at the individual level by generous ‘roll-over’ provisions for owner-occupied residential housing. Capital gains on owner-occupied housing are not included in income so long as they are ‘rolled over’ into the same form of investment. We consider the treatment of income from assets employed in the household sector in Section 2.1 below. Income from capital employed in non-corporate businesses is taxed at the level of the individual. Income from noncorporate

19

The standard reference on US tax policy is Pechman (1987b). A less detailed description of tax systems in Canada, Japan, and six European countries is given in a volume edited by Pechman (1987a). The taxation of capital income in Germany, Sweden, the UK, and the USA is compared in a volume edited by King and Fullerton (1984).

18

TAXATION OF INCOME FROM CAPITAL

equity is treated as fully distributed to equity-holders, whether or not the income is actually paid out. Interest payments to holders of debts on non-corporate businesses are subject to taxation. Property taxes and interest payments are treated as deductions from revenue in defining income from non-corporate businesses for tax purposes. Revenue is also reduced by deductions for capital consumption allowances. Tax liability has been reduced by an investment tax credit that is proportional to investment expenditures. Capital gains on non-corporate assets are subject to favourable treatment as outlined below. We describe the taxation of non-corporate income in Section 2.2. Property taxes and interest payments are treated as deductions from revenue in defining corporate income for tax purposes. Revenue is also reduced by allowances for capital consumption and an investment tax credit has been directly offset against tax liability. At the individual level distributions of corporate income in the form of interest and dividends are subject to taxation as ordinary income. Capital gains realized from the sale of corporate equities are subject to special treatment outlined below. Interest payments to holders of corporate bonds are also taxable. We discuss the taxation of corporate income in Section 2.3. The special treatment of capital gains arises from three separate features of US tax law. First, capital gains are taxed only when they are realized and not when they are accrued. This feature makes it possible to defer tax liability on capital gains until assets are sold. Second, capital gains have often been given favourable treatment by including only a fraction of these gains in income defined for tax purposes. Finally, capital gains taxes on assets received as part of a bequest are based on their value at the time of the bequest. Capital gains accrued prior to the bequest are not subject to tax. In Section 2.4 we extend the cost of capital framework to include features of tax reform proposals that were considered in the debate over the Tax Reform Act of 1986. These proposals centred on indexing interest income and expenses, capital gains, and capital consumption allowances for inflation. In addition, limitations on deductions for state and local taxes in defining taxable income at the federal level were considered. Finally, proposals were discussed for integration of corporate and individual


19

income tax systems by permitting deductions for dividends paid at the corporate level. We consider alternative approaches to corporate income taxation in Section 2.5. The approach presented in this chapter is based on the ‘traditional’ view that dividends are a fixed proportion of corporate income. In this view the marginal source of funds for the equity portion of corporate investments is new issues of equity. An alternative to this approach is provided by the ‘new’ view that the marginal source of funds is retained earnings. In this view new issues of equity are fixed exogenously and dividend payments are determined as a residual.

2.1 Households Distributions of income from household assets take the form of capital services provided directly to consumption. The value of these services is not included in income for tax purposes. Household assets are subject to taxation as property, but property tax payments and interest on household debt are deductible from income for tax purposes under the individual income tax. We analyse the management of household assets by means of the elementary model of the firm presented in the preceding chapter. We treat the household as encompassing a ‘firm’ that invests in residential real estate and consumer durables and ‘rents’ the services of these capital goods to the household itself. The financial structure of the household includes both debt and equity. We assume that the household can borrow and lend at a fixed rate of interest that is less than or equal to the rate of return to household equity. We also assume that the household has a maximum debt capacity that is proportional to the value of household capital. The optimal financial strategy for the household is to finance investment through new equity and new debt in fixed proportions. Of course, all new equity is ‘issued’ to the household itself. To represent the portfolio equilibrium of the household sector, we require the following notation: βh — ratio of debt capacity to the value of the household's capital stock

20


— marginal tax rate on income from which interest payments and property taxes on household assets are deductible — property tax rate on household assets The portfolio equilibrium of holders of equity in household assets requires

(2.1) where tax liabilities for ordinary income from capital in the household sector Tt are negative and represent an implicit subsidy to the consumption of household capital services:

(2.2) The value of capital services provided to the household for consumption Dt, plus the value of tax deductions for property taxes , interest payments on household debt , and the change in the value of household equity Vt−Vt−1, less new equity St, is equal to the rate of return on equity ρt, multiplied by the value of equity at the beginning of the period Vt−1. The value of tax deductions is equal to the reduction in tax liabilities on income taxed at the marginal rate . Treating the condition for portfolio equilibrium as a difference equation in the value of equity in household assets in the current period, we obtain

(2.3) Under the assumption that debt is a fixed proportion of the value of household capital stock, the cash flow constraint for the household sector takes the form

(2.4) Capital services provided to the household Dt, less new equity St, are equal to the value of household capital services ptQt, less the value of investment qtIt, and less property taxes and interest payments on debt βhitqt−1Kt−1. This flow is augmented by new issues of debt to finance the increase in the value of household capital arising from inflation πtqt−1Kt−1 and investment net of replacement qt(Kt−Kt−1). Substituting household capital services Dt less the equity share


21

of net investment St into the value of equity in household assets, we obtain

(2.5) where Pt is the ‘profit’ of the household:

(2.6) ct is the rental price of household capital services:

(2.7) and rt is a weighted average rate of return:

(2.8) Since the output of the household sector consists entirely of capital services provided to the household itself for consumption, ‘profit’ is zero. The key provisions of US tax law for income from household assets are represented in the rental price of household capital services and the household rate of return. Property taxes are net of the value of tax deductions under the individual income tax . Similarly, the rate of return on debt financing is net of the value of tax deductions . Capital gains on household assets are not included in taxable income, since households are permitted to ‘roll-over’ investments in owner-occupied residential real estate into new assets of the same type without incurring tax liabilities for realized capital gains. To characterize the effective tax rate on household assets, we require the following notation: — effective tax rate on income from household assets at time t — social rate of return on household assets at time t — private rate of return on household assets at time t — marginal tax rate on income from interest payments on household debt We define the social rate of return on household assets depreciation, so that

as the cost of capital before taxes, plus the rate of inflation and less

(2.9) This before-tax rate of return represents the rate of remuneration

22


of capital in the production of household capital services. Similarly, we define the private rate of return on household assets as the compensation of the holders of the household's debt and equity after all taxes have been paid:

(2.10) Finally, we define the tax wedge on household assets as the difference between social and private rates of return. The effective tax rate on household assets is equal to the tax wedge divided by the social rate of return, net of inflation:

(2.11) We can also define tax wedges and effective tax rates separately for equity and debt financing by substituting the rate of return on equity ρt or the after-tax rate of interest on debt for the private rate of return in the definitions of the tax wedge and the effective tax rate.

2.2 Non-corporate Business We next consider the tax treatment of income from capital employed in non-corporate businesses under US tax law. Income from non-corporate capital is treated as fully distributed to the owners of a non-corporate business. In defining non-corporate income for tax purposes, interest payments and capital consumption allowances are treated as deductions from income. The investment tax credit results in a direct reduction in tax liabilities that is proportional to the level of investment expenditures. Capital gains on non-corporate assets are subject to tax, but the tax rate differs from the rate on ordinary income. To represent the portfolio equilibrium of the non-corporate sector, we require the following notation: βm — ratio of debt capacity to the value of non-corporate capital stock — marginal tax rate on income from non-corporate capital — marginal tax rate on capital gains on non-corporate capital — property tax rate on non-corporate assets The portfolio equilibrium of holders of equity in non-corporate business implies


23

(2.12) The required rate of return on equity ρt, multiplied by the value of equity at the beginning of the period Vt−1, is equal to the value of distributions Dt, less tax liabilities for ordinary income from capital Tt, plus the change in the value of equity, Vt−Vt−1, and less the equity portion of investment net of replacement St, net of capital gains taxes. Treating the condition for portfolio equilibrium as a difference equation in the value of equity in non-corporate assets in the current period, we obtain

(2.13) Capital gains taxes are assessed on the change in the value of equity in non-corporate assets, less the equity share of investment net of replacement. The tax rate on non-corporate capital gains reflects the deferral of taxes owing to taxation of capital gains after they are realized, rather than when they are accrued. This tax rate also reflects the facts that only a fraction of capital gains are taxed and that gains on assets received in the form of a bequest are assessed only on gains in the value of the assets after the bequest is made. We model provisions for capital consumption allowances and the investment tax credit under US tax law as equivalent reductions in the acquisition price of investment goods.20 This price is reduced by the investment tax credit and the present value of tax deductions for capital consumption. We assume that the present value of deductions for capital consumption on a new asset is precisely offset by an equal amount of debt. This debt is amortized over the lifetime of the asset as the tax deductions are actually realized. We employ the following notation in representing provisions for capital consumption allowances under US tax law and the investment tax credit:

20

This approach to modelling investment incentives was introduced by Hall and Jorgenson (1967, 1969, 1971).

24


Aτ — capital consumption allowances on an asset of age τ km — rate of the investment tax credit on non-corporate assets zm — present value of capital consumption allowances on a new asset The present value of capital consumption allowances is

(2.14) In this expression the discount rate is the interest rate it after taxes on non-corporate income at the rate

.21

Under the assumption that the firm finances investment net of replacement through new equity and new debt in fixed proportions, new equity is

(2.15) The acquisition price of investment goods is reduced by the investment tax credit km and the present value of tax deductions for capital consumption . Tax liabilities for ordinary income from capital in the non-corporate sector are given by

(2.16) Property taxes on non-corporate assets and interest payments on the proportion of these assets financed by debt are deductible from income for tax purposes. Under the assumption that debt is a fixed proportion of the value of non-corporate capital stock, the cash flow constraint for the non-corporate sector takes the form

(2.17) Distributions Dt less new equity St are equal to the cash flow generated by production, ptQt−wtLt, less investment , and less deductions for property taxes on non-corporate assets and interest payments on non-corporate debt . In addition, a fixed proportion of debt to the value of non-corporate assets βm is maintained by issuing new debt to finance the increase in the

21

Discounting capital consumption allowances at the after-tax rate of interest is suggested by Summers (1987).


25

value of non-corporate assets. This increase is due to inflation πtqt−1Kt−1 and investment net of replacement qt(Kt−Kt−1). Substituting the equity share of investment net of replacement (2.15) and tax liabilities on ordinary income (2.16) into the expression (2.13) for the value of non-corporate equity, we can rewrite this expression in the form

(2.18) where Pt is the profit of the firm

(2.19) ct is the rental price of capital services:


(2.21) Under constant returns to scale the maximum value of profit is equal to zero. The key features of US tax law for income from non-corporate assets are represented in the rental price of noncorporate capital services and the non-corporate rate of return. The denominator of the first term in the rental price of capital services represents the after-tax proportion of non-corporate income from capital at the tax rate . Second, the price of investment goods is reduced by the investment tax credit km and the present value of tax deductions for capital consumption . Third, the rental price includes the property tax rate , net of the value of tax deductions at the tax rate . Fourth, the rate of return includes the rate of interest, also net of tax deductions . Fifth, the tax rate on capital gains enters the cost of capital through the rate of inflation in the acquisition price of investment goods πt. To characterize the effective tax rate on non-corporate assets, we require the following notation: —effective tax rate on income from non-corporate assets at time t —social rate of return on non-corporate assets at time t

26


—private rate of return on non-corporate assets at time t —marginal tax rate on interest payments on non-corporate debt We define the social rate of return on non-corporate assets as the cost of capital before taxes, plus the rate of inflation and less depreciation, as in (2.9) above. This before-tax rate of return represents the rate of remuneration of capital in noncorporate business. Similarly, we define the private rate of return on non-corporate assets as

(2.22) This after-tax rate of return represents the compensation of the holders of the non-corporate firm's debt and equity after all taxes have been paid. Finally, we define the tax wedge on non-corporate assets as the difference between social and private tax rates of return. The effective tax rate on non-corporate assets is the tax wedge divided by the social rate of return, net of inflation, as in (2.11) above. As before, we can define tax wedges and effective tax rates for equity- or debt-financed investments in the noncorporate sector separately by replacing the private rate of return by the rate of return on equity ρt or the after-tax rate of interest in the definitions of the tax wedge and the effective tax rate.

2.3 Corporate Business Finally, we consider the taxation of income from capital employed in corporate businesses. Corporate income, as defined for tax purposes, is taxable at the corporate level. Interest payments and capital consumption allowances are treated as deductions from corporate income. The investment tax credit results in a reduction in corporate tax liabilities that is proportional to investment expenditures. Distributions of corporate income in the form of dividends and capital gains are taxable at the individual level, where the tax rate on dividends differs from the rate on capital gains. We can introduce personal income taxes on distributions of corporate income through the portfolio equilibrium of holders of equity in corporate business. To represent this equilibrium we require the following notation:


27

βq—ratio of debt capacity to the value of corporate capital stock tq—corporate income tax rate —marginal tax rate on dividends —marginal tax rate on capital gains on corporate equities —property tax rate on corporate assets The condition for portfolio equilibrium of holders of corporate equity is precisely analogous to the corresponding condition for non-corporate business:

(2.23) where Dt is corporate dividends, taxes Tt are proportional to dividends,

(2.24) and is the tax rate on capital gains accrued on corporate equity at the personal level. This rate reflects the favourable treatment of capital gains relative to ordinary income. The value of corporate equity in the current period is

(2.25) As before, we model provisions for capital consumption allowances and the investment tax credit under the US corporate income tax as equivalent reductions in the acquisition price of investment goods. To represent these provisions of US tax law we require the following notation: kq—rate of the investment tax credit on corporate assets zq—present value of capital consumption allowances on a new asset The discount rate for capital consumption allowances is the interest rate it after deductions from corporate income for tax purposes at the corporate tax rate tq. We assume that the corporation maintains a fixed proportion of debt to the value of corporate assets. However, the corporate firm can finance investment through equity by retaining earnings or issuing new shares. We assume that dividends are a fixed proportion α of income after corporate taxes Ct:

28


(2.26) Corporate taxes Ct are proportional to the cash flow generated by production, less deductions for interest payments and property taxes:

(2.27) Under the assumption that debt is a fixed proportion of the value of corporate capital stock, the cash flow constraint for the corporation takes the form

(2.28) Dividends Dt less new share issues St are equal to the cash flow generated by production ptQt−wtLt, less investment (1−kq−tqzq)qtIt, less deductions for property taxes on corporate assets , and interest payments on corporate debt βq(1−kq−tqzq)itqt−1Kt−1, and less corporate taxes Ct. In addition, a fixed proportion of debt to the value of corporate assets βq is maintained by issuing new debt to finance the increase in the value of corporate assets. This increase is due to inflation πtqt−1Kt−1 and investment net of replacement qt(Kt−Kt−1). Substituting dividends and corporate tax liabilities into the expression given above for the value of corporate equity, we can rewrite this expression in the form

(2.29) where Pt is corporate profit, defined in the same way as in (2.18) above, ct is the rental price of corporate capital services:



29

(2.31) Under constant returns to scale, the maximum value of corporate profits is zero. The key features of the US corporate income tax and the taxation of distributions of corporate income through the individual income tax are represented in the rental price of corporate capital services and the corporate rate of return. The denominator of the first term in the rental price of capital services represents the after-tax proportion of income from corporate capital at the corporate tax rate tq. Second, the price of investment goods is reduced by the investment tax credit kq and the present value of tax deductions from corporate income for capital consumption tqzq. Third, the rental price includes the property tax rate , net of the value of tax deductions at the corporate level at the tax rate tq. Fourth, the rate of return includes the rate of interest, also net of tax deductions at the corporate level tqit. Tax rates at the individual level on capital gains on corporate equities and corporate dividends enter the cost of capital through the rate of return on corporate equity ρt and the rate of inflation πt. To characterize the effective tax rate on corporate assets, we require the following notation: —effective tax rate on income from corporate assets at time t —social rate of return on corporate assets at time t —private rate of return on corporate assets at time t —marginal tax rate on income from interest payments on corporate debt We define the social rate of return on corporate assets as the cost of capital before taxes, plus the rate of inflation and less depreciation, as in (2.9) above. This before-tax rate of return represents the rate of remuneration of capital in corporate business. Similarly, we define the private rate of return on corporate assets as

(2.32) This after-tax rate of return represents the compensation of the

30


holders of the corporate firm's debt and equity after all taxes have been paid. Finally, we define the tax wedge on corporate assets as the difference between social and private rates of return. The effective tax rate on corporate assets is the tax wedge divided by the social rate of return, net of inflation, as in (2.11), above. As before, we can also define effective tax rates for equity- or debt-financed investments in the corporate sector separately by replacing the private rate of return by the rate of return to equity ρt or the after-tax rate of return to debt in the definitions of the tax wedge and the effective tax rate. The tax wedge and the effective tax rate on corporate assets can be divided into two components—a component that can be attributed to taxation at the corporate level, and an additional component attributable to taxation at the individual level. This separation is useful in comparing effective tax rates with statutory rates. We first define the total tax wedge on corporate assets as the difference between private and social rates of return, as before. We then define the corporate tax wedge as the difference between the social rate of return and the corporate rate of return (2.31). Similarly, we can define the individual tax wedge as the difference between the corporate rate of return and the private rate of return. Given corporate and individual tax wedges, we can define the effective corporate tax rate as the corporate tax wedge divided by the social rate of return, net of inflation. Similarly, we can define the effective individual tax rate as the individual tax wedge divided by the social rate of return, net of inflation. The effective tax rate on corporate assets is the sum of the effective corporate and individual tax rates.

2.4 Tax Reform We have summarized the provisions of US tax law for income from capital employed in the household, non-corporate, and corporate sectors. Turning to features of tax reform proposals considered in the debate over the Tax Reform Act of 1986, we find that indexing capital consumption allowances for inflation requires a simple modification of our expressions for the cost of capital for non-corporate and corporate businesses. This modification


31

involves adjusting the present value of capital consumption allowances (2.14) for non-corporate assets and the corresponding value for corporate assets to permit these allowances to depend on inflation. Typically, these allowances are adjusted to reflect the change in the price of an asset between the time of acquisition and the time that capital consumption is deducted from income for tax purposes. Indexing interest payments and interest income and indexing capital gains require modifications of our expressions for the cost of capital and the rate of return in corporate and non-corporate businesses and households. Similarly, the limitation of deductions for state and local taxes in defining taxable income at the federal level changes the expressions we have derived. Finally, the introduction of a deduction for dividends paid by corporations into the definition of taxable income at the corporate level would alter our expressions for the cost of capital and the rate of return for the corporate sector. We begin by introducing indexing of capital gains and interest expenses, limitations on the deductibility of state and local property taxes, and a deduction for dividends paid from corporate income for tax purposes. We require the following notation: —proportion of dividends deducted from revenue in determining corporate income for tax purposes —proportion of capital gains on corporate equities excluded for individual income for tax purposes —proportion of interest payments deducted from revenue in determining corporate income for tax purposes —proportion of property taxes deducted from revenue in determining corporate income for tax purposes With indexing of capital gains, the condition for portfolio equilibrium of holders of corporate equity (2.23) becomes

(2.33) so that

replaces ρt in expression (2.25) for the value of corporate equity.

We assume, as before, that dividends are a fixed proportion of income after corporate taxes, as in (2.26). Corporate taxes are proportional to the cash flow generated by production, less partial deductions for dividends paid out, interest payments, and property taxes:

32


(2.34) The cash flow constraint for the corporation (2.28) takes the same form as before. Substituting corporate dividends Dt and new issues of equity St into the value of corporate equity (2.25), we obtain

(2.35) where Pt is corporate profit, as before. The rental price of capital services ct is

(2.36) and the rate of return rt takes the form

(2.37) This formulation of the corporate cost of capital generalizes the one we have presented in Section 2.3 above. To show this we consider the special case in which dividend payments are not deductible , interest payments and property taxes are fully deductible , and capital gains on corporate equity are not indexed for inflation . Under these conditions the formulas for the price of capital services (2.36) and the rate of return (2.37) reduce to those given in the previous section—formulas (2.30) and (2.31), respectively. As a second application of the new formulation of the cost of capital we consider indexing interest deductions for inflation. Fisher's Law states that an increase in the rate of inflation πt raises the nominal interest rate it point-for-point. Under this


33

assumption interest payments are completely indexed for inflation if the proportion of these payments that is tax deductible takes the form

(2.38) If a greater proportion of interest payments is deductible, the tax deduction exceeds real interest costs. Similarly, a smaller deduction results in taxation of a portion of the inflation premium included in the nominal rate of interest.22 Finally, we can derive appropriate formulas for the rental price of capital services and the rate of return for noncorporate and household sectors by specializing the formulas we have given for the corporate sector. We first introduce the following notation: —proportion of inflationary capital gains on non-corporate assets excluded from taxable income For the non-corporate sector we substitute the marginal tax rate on capital gains on non-corporate capital and the proportion of inflation gains excluded from taxable income for the corresponding corporate rates in the condition for portfolio equilibrium (2.33). This has the effect of replacing ρt by in (2.12) for the value of equity in noncorporate assets in the current period. In modelling the taxation of income from non-corporate assets we drop corporate taxes Ct from the cash flow constraint (2.28). We represent tax liabilities at the individual level Tt in a form that is analogous to corporate taxes (2.34). For this purpose we require the following notation: —proportion of interest payments on non-corporate assets that is tax deductible —proportion of property taxes on non-corporate assets that is tax deductible To define non-corporate tax liabilities Tt we first substitute the present value of capital consumption allowances zm and the rate

22

Our assumption that the nominal rate of interest before taxes increases point for point with inflation is consistent with the results of Summers (1983). King and Fullerton (1984) employ the alternative assumption that the nominal interest rate after taxes increases point-for-point with inflation.

34


of the investment tax credit km on non-corporate assets for the corresponding corporate tax parameters in expression (2.34) for corporate taxes. Similarly, we substitute the marginal tax rate on income from non-corporate capital for the corporate tax rate tq, and the ratio of debt capacity to the value of non-corporate capital stock βm for the corresponding corporate ratio βq. Non-corporate tax liabilities are given by

(2.39) The cash flow constraint for the non-corporate sector (2.17) is unchanged; non-corporate income is treated as fully distributed under the individual income tax, so that the payment ratio α is equal to one. There is no second level of taxation, so that we set the tax parameter in this constraint equal to zero. Substituting distributions Dt, new issues of equity St, and tax liabilities Tt into the value of equity in non-corporate assets (2.13), we obtain

(2.40) where Pt is non-corporate profit (2.19), the rental price of capital services is

(2.41) and the rate of return rt takes the form

(2.42) These expressions reduce to those given in Section 2.2 above by making interest payments and property taxes fully deductible and eliminating indexation for capital gains on non-corporate assets . For the household sector there is no taxation of income from assets at either the corporate or the individual level; however, there are implicit subsidies for consumption of household capital services in the form of tax deductions for property taxes and


35

interest payments under the individual income tax. To model the taxation of income from household assets, we require the following notation: —proportion of interest payments on household assets that is tax deductible —proportion of property taxes on household assets that is tax deductible The reduction in tax liabilities for income from capital in the household sector is given by

(2.43) as in (2.2). The cash flow constraint for the household sector (2.4) is altered by the substitution of the implicit subsidy (2.43) for the corresponding term . The value of equity in household assets (2.3) takes the same form as before, where the rental value of capital services ct is

(2.44) and the rate of return rt is

(2.45) These expressions reduce to those given in Section 2.1 by making interest payments and property taxes fully deductible .

2.5 Alternative Approaches In this chapter we have described the characteristic features of US tax law in terms of the cost of capital and the rate of return. We have modelled provisions of US tax law on corporate income taxes, individual income taxes, and property taxes. We have also incorporated the effects of the financial structure of the firm on the taxation of capital income. The financial structure determines the form of distributions of capital income to owners of financial claims. We have distinguished between equity, associated with distributions in the form of dividends and capital gains, and debt, associated with distributions in the form of interest payments. Under US tax law income from corporate businesses is taxed at the level of the corporation. Distributions of this income in the

36


form of dividends and capital gains are taxed at the level of the individual. Income from equity in non-corporate businesses is treated as if it were fully distributed to equity-holders, but this income is taxed only at the individual level. Income from equity in household capital is not subject to income taxation at either corporate or individual levels. However, interest payments to holders of household debt, like interest payments to holders of corporate and noncorporate debt, are taxable to the recipients. Property taxes and interest payments are treated as deductions from revenue in defining corporate and non-corporate income for tax purposes. While income from equity in household assets is not subject to tax, property taxes and interest payments on household debt are deductible from income for tax purposes at the individual level. This is equivalent to a subsidy to capital employed in the household sector. Revenue is reduced by allowances for capital consumption in defining income from corporate and non-corporate assets for tax purposes. Tax liabilities are reduced directly by a tax credit for investment expenditures. The introduction of the marginal effective tax rate by Auerbach and Jorgenson (1980) was limited to the effective corporate tax rate presented in Section 2.3. This concept was employed in detailed studies of effective tax rates by type of asset and industry by Jorgenson and Sullivan (1981). The integration of corporate and individual income tax provisions into the marginal effective tax rate for the corporate sector was initiated by Hall (1981). Alternative marginal effective tax rate concepts are compared and analysed by Bradford and Fullerton (1981). The marginal effective tax rate for the corporate sector, including both corporate and individual taxes, provided the basis for the detailed studies of taxation of the corporate sector in Canada by Boadway, Bruce, and Mintz (1984) and in Germany, Sweden, the UK, and the USA by King and Fullerton (1984). The effect of the individual income tax on the corporate cost of capital depends on the determinants of corporate financial policy. A number of alternative approaches to corporate taxation have been discussed in the literature.23

23

Summaries of the alternative views of corporate income taxation are given by Atkinson and Stiglitz (1980, esp. pp. 128–59) and Auerbach (1983b).


37

We have presented a model of the cost of capital in the corporate sector based on a fixed ratio of dividends to corporate income in Jorgenson and Yun (1986b). This is the ‘traditional’ view of corporate taxation employed, for example, by McLure (1979), Summers (1981), and Poterba and Summers (1983). In this view the marginal source of funds for the equity portion of the firm's investments is new issues of equity, since dividends are fixed. An important implication of the traditional view is that an additional dollar of new issues adds precisely one dollar to the value of the firm's assets. The value of outstanding financial liabilities of the firm is equal to the value of the firm's assets. It is important to emphasize the critical role of the assumption that dividends are a fixed proportion of corporate income in the traditional view of corporate taxation. This view does not provide an explanation of the corporate firm's dividend policy. If the firm were to reduce dividend payments by one dollar and retain the earnings in order to finance investment, stockholders would avoid taxes on dividend payments at the rate on corporate equity . The addition to retained earnings would result in a capital gain taxed at the rate . Since the effective tax rate for capital gains is lower than the rate for dividends under US tax law, shareholders would experience an increase in wealth. Following this line of reasoning, it would always be in the interest of the shareholders for the firm to finance investment from retained earnings rather than new issues of equity. An alternative approach to corporate taxation proposed by King (1977), Auerbach (1979), and Bradford (1981) is that new issues of equity rather than dividends are fixed. This view is employed in modelling the cost of capital by Boadway, Bruce, and Mintz (1984) and King and Fullerton (1984). The corporate firm retains earnings sufficient to finance the equity portion of investment. Dividends paid by the firm are determined by the cash flow constraint (2.26). In this ‘new’ view of corporate taxation the marginal source of equity funds is retained earnings, so that the corporate rate of return (2.31) is replaced by a rate of return with pay-out ratio α equal to zero. In this view the corporate rate of return is independent of the tax rate on dividends at the individual level , so that taxation of dividends does not affect the rental price of capital services or the effective tax rate on income from corporate assets.

38


Under the new view of corporate taxation, each dollar of investment financed by decreasing dividend payments and increasing retained earnings raises the value of the firm's outstanding shares by dollars. Unless the possibility of repurchasing the firm's outstanding shares is ruled out by assumption, the most attractive investment opportunity available to the firm is to liquidate its assets and repurchase its outstanding shares. Each dollar of assets liquidated reduces the value of the firm's outstanding shares by dollars. Accordingly, this view of corporate taxation has been characterized as the ‘trapped equity’ approach. If repurchase of the firm's outstanding shares is ruled out, equity is ‘trapped’ in the firm and it makes sense for the firm to continue holding assets. Both the ‘traditional’ and the ‘new’ views of corporate taxation depend critically on assumptions about financial policy of the firm. The traditional view depends on the assumption that dividends are a fixed proportion of corporate income, so that the marginal source of funds for financing investment is new issues of equity. The new view depends on the assumption that new issues of equity (or repurchases) are fixed, so that the marginal source of funds is retained earnings. Neither of these views is completely satisfactory.24 Empirical support for the traditional view has been presented by Poterba and Summers (1983, 1985), while support for the new view is given by Auerbach (1984). In Chapter 3 we provide a quantitative description of US tax law. We first provide estimates of the rates of income taxation at both corporate and individual levels for the period 1947–86. We also present property tax rates for household, non-corporate, and corporate sectors. We then discuss provisions for capital cost recovery, including capital consumption allowances and the investment tax credit. We go on to describe features of the financial structure of corporate and non-corporate businesses and households that affect the taxation of income from capital. Finally, we consider the impact of the Tax Reform Act of 1986 on the US tax system, again in quantitative terms. Our data can be used to implement either the traditional or the new view of the corporate cost of capital.

24

A third view of corporation taxation is presented by Stiglitz (1973). This view drops the assumption we have made that the debt-equity ratio is fixed, so that the cheapest source of finance is debt, which is tax deductible at the corporate level.

3 The US Tax System The purpose of this chapter is to provide a quantitative description of the US tax system. We first estimate income and property tax rates at both corporate and individual levels. Our estimates of corporate income tax rates are based on statutory rates at federal and at state and local levels. We take into account the fact that state and local tax payments are treated as deductions from revenue in defining corporate income at the federal level. We represent the corporate income tax as a flat rate tax, so that corporate tax liabilities are simply proportional to corporate income. By contrast with the corporate income tax, liabilities under the individual income tax are a steadily rising proportion of the income of each taxpayer. Accordingly, we can say that the individual income tax is progressive at both federal and state and local levels. State and local personal income tax payments are deducted from revenue in defining individual income for tax purposes at the federal level. We employ the concept of the average marginal tax rate to summarize the progressive rate schedules for the individual income tax. We estimate average marginal tax rates under the individual income tax by assuming that the amounts of income subject to tax at various marginal rates will increase or decrease in the same proportion. In order to estimate average marginal tax rates on individual income from debt and equity, we distinguish among alternative forms of legal ownership by individuals. This makes it possible to incorporate differences in the tax treatment of different types of income such as dividends and interest. We first estimate the average marginal tax rate by type of income and form of ownership. Then in Section 3.2 we determine the distribution of financial claims on assets among ownership categories from the US Flow of Funds Accounts. In the following chapter we compute average marginal tax rates as a weighted average of the corresponding tax rates for all ownership categories, using the distribution of financial claims as weights.

40

THE US TAX SYSTEM

Capital consumption allowances are permitted as a deduction from revenue in defining taxable income for both corporate and non-corporate businesses. These allowances permit taxpayers to recover capital outlays over the lifetime of an investment good. The investment tax credit can also be viewed as a form of capital cost recovery. The economic definition of income requires that tax deductions for capital cost recovery must equal economic depreciation, as defined in Chapter 1. Economic depreciation corresponds to the decline in the acquisition price of an investment good with age. In Section 3.3 we describe the measurement of economic rates of depreciation, present values of capital consumption allowances, and investment tax credit rates. Property taxes are levied on assets in household, non-corporate, and corporate sectors, primarily by local governments. Property taxes on household and non-corporate assets are deductible from revenue under the individual income tax; similarly, property taxes on corporate assets are deductible from revenue under the corporate income tax. We use the average rate of property taxes in each sector for all assets in that sector. The average property tax rate is computed as the ratio of total property tax liability to the value of capital stock. We describe the estimation of the value of capital stock for each legal form of organization in Section 3.4. There are important interactions between the taxation of income from capital and financial policies of business firms and households. For our purposes the most important characteristics of the financial structure of a firm are the allocation of the value of capital between debt and equity and the dividend policy of a corporate firm. Similarly, the allocation of household wealth between debt and equity is important in determining the impact of tax policies. The features of tax policy that are most affected by the financial structure are tax deductions for interest expenses, deductions for dividends paid and received, and the differential tax treatment of dividends and retained earnings of corporations at the level of the individual income tax. In Section 3.4 we estimate the dividend pay-out ratio of the corporate sector and ratios of debt to the value of capital stock for households and non-corporate and corporate businesses. Of course, the dividend pay-out ratio does not affect the corporate rate of return in the

THE US TAX SYSTEM

41

‘new’ view of the corporate income tax, discussed in Section 2.5 above. We consider the effects of the Tax Reform Act of 1986 on the taxation of income from capital. We also analyse the potential impact of proposals for tax reform that figured prominently in the debate leading up to the 1986 tax reform. We consider proposals advanced by the Department of the Treasury and President Ronald Reagan in detail, since these proposals were instrumental in shaping the final legislation. In Section 3.5 we analyse the tax burdens on capital income under four alternative tax policy regimes — the tax law in effect before the 1986 tax reform, the Treasury proposal, the President's proposal, and the Tax Reform Act of 1986. Finally, in Section 3.6 we consider alternative approaches for describing the US tax system. We employ estimates of economic depreciation based on the decline in the acquisition price of an asset with age. Estimates based on rental prices of capital input and investment for replacement purposes have also been proposed in the literature. In this chapter we document changes over time in provisions for capital recovery under US tax law. These provisions have allowed taxpayers the possibility of selecting among alternative methods for calculating capital consumption allowances. Our estimates are based on the choices actually made by taxpayers. An alternative approach is to assume that taxpayers minimize their tax liabilities.

3.1 Tax Rates We begin with estimation of the corporate income tax rate. The first column in Table 3.1 presents the statutory rate of the corporate income tax at the federal level for the period 1947–86. This tax rate rose until 1952 and then declined steadily thereafter. The only exception to this trend is the period 1968–70, when the Nixon administration imposed the Vietnam War tax surcharge. This amounted to 10 per cent in 1968 and 1969 and 2.5 per cent in 1970. The surcharge was eliminated in 1971. Corporate profits are subject to state and local taxes as well as the federal corporate income tax. Corporate income tax rates differ among states and localities. We assume that all corporate firms are subject to the maximum statutory tax rate at the federal

42

THE US TAX SYSTEM

Table 3.1 Corporate Income Tax Rates Year

Federal, state, and local tq

Federal

State and local

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.3934 0.3929 0.3937 0.3944 0.4311 0.5201 0.5305 0.5300 0.5315 0.5315 0.5317 0.5319 0.5335 0.5330 0.5336 0.5346 0.5355 0.5360 0.5159 0.4958 0.4959 0.4995 0.5484 0.5505 0.5198 0.5089 0.5114 0.5100 0.5118 0.5140 0.5151 0.5164 0.5135 0.4955 0.4991 0.5017 0.5078 0.5066 0.5051 0.5072 0.5084

0.3800 0.3800 0.3800 0.3800 0.4200 0.5100 0.5200 0.5200 0.5200 0.5200 0.5200 0.5200 0.5200 0.5200 0.5200 0.5200 0.5200 0.5200 0.5000 0.4800 0.4800 0.4800 0.5280 0.5280 0.4920 0.4800 0.4800 0.4800 0.4800 0.4800 0.4800 0.4800 0.4800 0.4600 0.4600 0.4600 0.4600 0.4600 0.4600 0.4600 0.4600

0.0216 0.0209 0.0220 0.0232 0.0192 0.0207 0.0219 0.0209 0.0240 0.0241 0.0243 0.0249 0.0281 0.0270 0.0283 0.0305 0.0324 0.0333 0.0318 0.0304 0.0306 0.0374 0.0433 0.0476 0.0546 0.0555 0.0604 0.0576 0.0612 0.0654 0.0675 0.0701 0.0645 0.0657 0.0724 0.0773 0.0885 0.0863 0.0834 0.0874 0.0896

Note For a derivation of tq and Source: Federal tax rates

, see the accompanying text. are from Pechman (1987)

43

THE US TAX SYSTEM

level, say , since almost all corporate income is taxed at this rate. In most states and localities the base for the corporate income tax is the same as the federal tax. However, state and local taxes are deductible from corporate income, as defined for federal income tax purposes. If the average tax rate for state and local taxation of corporate income is , then the corporate income tax rate tq, including both federal and state and local taxes, is

3.1 The Table presents our estimates of federal tax rate

and the state and local tax rate

.

By contrast with the federal corporate income tax rate, the state and local rate follows a steadily rising trend, partially offsetting the decline in the federal rate. The corporate tax rate tq rose until 1952, in parallel with the trend of the federal rate, and then increased very gradually until 1964, when both federal and state and local tax rates declined. Except for the period of the Vietnam War tax surcharge, the corporate tax rate exhibited virtually no change from 1964 to 1986. Decreases in the federal rate were offset by increases in the state and local rates. Capital gains received by corporate taxpayers are subject to an alternative tax rate whenever this rate is lower than the regular corporate tax rate. This alternative tax rate was 30 per cent until 1978 and 28 per cent thereafter. Since almost all corporate income is subject to the maximum corporate tax rate, we assume that capital gains on assets held by corporations are taxed at the alternative rate. Taxation of corporate capital gains is based on realization rather than accrual, so that we must adjust the effective tax on accrued capital gains for the effects of tax deferral. We assume that deferral reduces this rate by 50 per cent. Thus the effective marginal tax rate on accrued capital gains is 15 per cent for 1947–78 and 14 per cent thereafter. We next consider the estimation of the average marginal tax rates on income to holders of debt and equity under the individual income tax. We distinguish between three alternative forms of ownership by individuals in estimating average marginal tax rates for different types of income from capital.25 These are

25

These forms of ownership are distinguished, for example, by King and Fullerton (1984).

44

THE US TAX SYSTEM

households, tax-exempt institutions, and insurance companies. The financial institutions in these ownership categories provide legal channels through which individuals own claims on the assets employed in the private sector of the US economy. The household ownership category includes individuals and financial institutions that are taxed in the same way as individuals. These institutions include commercial banks, savings institutions—such as savings and loan associations, mutual savings banks, and credit unions—mutual funds, mortgage pools, finance companies, and real estate investment trusts. Demand deposits in commercial banks and savings institutions generate non-taxable returns in the form of financial services. The tax-exempt ownership category includes private pension funds, the pension business of life insurance companies, non-profit institutions, and state and local government retirement funds. The final ownership category is insurance companies, which are subject to special provisions for income taxation described in more detail below. In order to estimate average marginal tax rates for returns to debt and equity, we utilize the distribution of adjusted gross income (AGI) across brackets associated with different marginal tax rates at the federal level. We also consider the distribution of dividends and interest received across these income brackets. We assign weights to different marginal tax rates in proportion to dividends or interest received by individuals in the corresponding income brackets. We then take a weighted average of marginal tax rates to obtain the average marginal tax rate at the federal level.26 As an illustration, we consider the calculation of the average marginal tax rate for 1980. In Table 3.2 we present the distribution of AGI across income brackets corresponding to different marginal tax rates at the federal level.27 Table 3.3 gives the distribution of this income and the associated distributions of interest and dividends received. The total in Table 3.2 is greater than that in Table 3.3 since the former excludes tax returns with

26

This method of estimation of average marginal tax rates was introduced by Barro and Sahasakul (1983, 1986).

27

Data are from Statistics of Income and Statistics of Income Bulletin, various issues.

45

THE US TAX SYSTEM

Table 3.2 Distribution of Adjusted Gross Income (AGI), 1980 (Millions of Dollars) Marginal tax rate 0 14 16 18 19 21 22 24 26 28 30 31 32 34 36 Total

AGI 40,284 41,692 50,159 122,621 32,926 154,192 14,657 194,247 39,794 160,798 40,073 8,912 164,372 43,731 4,445

Marginal tax rate 37 39 42 43 44 46 49 50 54 55 59 63 64 69 70

AGI 119,560 21,179 1,901 119,143 10,679 1,900 72,360 9,542 45,294 6,058 20,805 5,052 21,770 13,057 34,875 1,616,177

Source: Statistics of Income Bulletin, Winter, 1982/3

income below the amount exempt from tax, including those with a deficit. To eliminate this discrepancy we first compute the total of positive AGI in all returns by adding the deficits to total income. Then we calculate the total of positive AGI in non-taxable returns by subtracting total income in Table 3.2 from the total of positive income in all returns. We assign the total of positive AGI in the non-taxable returns to the zero marginal tax rate bracket in Table 3.3. This involves allocating the income in the first two size categories given in the table to the zero tax bracket. At this point, the total of the remaining positive income in the table is equal to the total income in Table 3.2. The next step is to fill the tax brackets corresponding to positive marginal tax rates with the remaining positive income in Table 3.3. We assume that the distributions of income from taxable returns and from all returns are monotone in the marginal tax rates. Next we allocate the interest and dividends received in Table 3.3 to each of the tax brackets in proportion to AGI. Interest and dividends received from returns with a deficit are allocated to the tax bracket with a zero marginal tax rate.

46

THE US TAX SYSTEM

Table 3.3 Distribution of AGI, Interest, and Dividends, 1980 (Millions of Dollars) Size of AGI All Returns no AGI 1–1,000 1,001–2,000 2,001–3,000 3,001–4,000 4,001–5,000 5,001–6,000 6,001–7,000 7,001–8,000 8,001–9,000 9,001–10,000 10,001–11,000 11,001–12,000 12,001–13,000 13,001–14,000 14,001–15,000 15,001–16,000 16,001–17,000 17,001–18,000 18,001–19,000 19,001–20,000 20,001–25,000 25,001–30,000 30,001–40,000 40,001–50,000 50,001–75,000 75,001–100,000 100,001–200,000 200,001–500,000 500,001–1,000,000 over 1,000,000

AGI less deficit 1,613,731 − 12,823 1,759 6,385 10,929 13,746 16,907 21,116 24,622 28,373 30,235 32,291 33,616 33,690 36,222 36,954 36,636 37,322 37,065 38,453 39,814 40,776 205,479 185,761 273,095 134,908 121,000 45,918 58,591 28,344 8,323 9,210

Source: Statistics of Income: Individual Income Tax Returns, 1980

Interest 102,009 988 167 490 681 1,188 1,687 1,996 2,270 2,497 2,496 2,502 2,508 2,518 2,299 2,648 2,430 2,215 2,057 2,209 1,905 2,175 10,098 8,470 12,569 7,577 9,866 4,025 5,249 2,621 777 830

Dividends 40,376 510 33 88 136 164 212 249 363 374 376 475 506 441 405 442 361 409 367 390 385 393 2,255 1,906 4,349 2,649 5,486 3,034 5,466 4,245 1,752 2,255

THE US TAX SYSTEM

47

Finally, state and local individual income taxes are deductible from revenue in defining income for federal tax purposes. We adjust the federal tax rates for state and local individual income taxes to obtain the average marginal tax rate at both levels. For this purpose we multiply the federal tax rates by the ratio of the sum of federal and state and local individual income tax revenues to federal income tax revenue. Because of data limitations, this approach requires minor modifications for the years 1947–60. The resulting average marginal tax rates are given in Table 3.4. Capital gains on corporate equities held by households are subject to taxation only when the gains are realized and not when they are accrued. Until 1978, 50 per cent of net capital gains, defined as long-term gains less short-term losses, were excluded from income for tax purposes; after 1978, 60 per cent of net capital gains were excluded from income. We assume that deferral of tax liabilities owing to taxation of realized capital gains reduces the effective tax rate on accrued capital gains by 50 per cent.28 We also assume that elimination of tax liabilities for capital gains prior to the death of the owner of assets included in a bequest reduces the effective tax rate by an additional 50 per cent. Under these assumptions the effective tax rate on capital gains is

(3.2) where E is the proportion of net capital gains excluded for individual income tax purposes, and marginal tax rate on household income in the form of corporate dividends.

is the average

We have now completed the discussion of corporate and individual income tax rates. Tax-exempt owners include private pension funds, the pension business of life insurance companies, state and local government retirement funds, and non-profit institutions. Although income received by pension funds is not tax-exempt, the returns to assets held in the pension funds are not taxable until they are distributed to the beneficiary. Deferral of taxes and the possibility of low tax rates after retirement reduce the effective rate of taxation on these returns to negligible

28

This assumption is employed, for example, by Bailey (1969) and King and Fullerton (1984).

48

THE US TAX SYSTEM

Table 3.4 Average Marginal Tax Rates on Interest and Dividends Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Interest Federal 0.3309 0.3309 0.2549 0.2399 0.2707 0.2947 0.3180 0.3027 0.2655 0.2657 0.2766 0.2728 0.2684 0.2698 0.2598 0.2589 0.2541 0.2744 0.2428 0.2186 0.2221 0.2301 0.2539 0.2642 0.2585 0.2460 0.2508 0.2596 0.2714 0.2691 0.2756 0.2803 0.2796 0.2959 0.3144 0.3240 0.2886 0.2607 0.2595 0.2582 0.2582

Federal, state, and local 0.3363 0.3368 0.2611 0.2481 0.2796 0.3020 0.3251 0.3094 0.2731 0.2740 0.2860 0.2820 0.2782 0.2809 0.2712 0.2713 0.2669 0.2878 0.2584 0.2329 0.2376 0.2464 0.2725 0.2844 0.2813 0.2719 0.2808 0.2911 0.3018 0.3035 0.3104 0.3156 0.3144 0.3291 0.3488 0.3577 0.3224 0.2974 0.2995 0.2963 0.2970

Source: Statistics of Income Bulletin, Statistics of Income, various issues

Dividends Federal 0.4877 0.4877 0.4120 0.3929 0.4380 0.4640 0.4781 0.4428 0.4316 0.4433 0.4566 0.4384 0.4351 0.4432 0.4293 0.4321 0.4220 0.4444 0.4029 0.3684 0.3723 0.3792 0.4084 0.4217 0.3874 0.3779 0.3815 0.3942 0.4044 0.4094 0.4196 0.4213 0.4190 0.4383 0.4496 0.4370 0.3711 0.3517 0.3458 0.3426 0.3426

Federal, state, and local 0.4937 0.4942 0.4199 0.4036 0.4490 0.4727 0.4862 0.4506 0.4411 0.4537 0.4681 0.4498 0.4473 0.4570 0.4436 0.4478 0.4383 0.4609 0.4230 0.3877 0.3929 0.4006 0.4318 0.4466 0.4151 0.4100 0.4184 0.4325 0.4406 0.4507 0.4610 0.4630 0.4602 0.4766 0.4881 0.4742 0.4091 0.3944 0.3921 0.3866 0.3874

THE US TAX SYSTEM

49

levels, so that we assume that returns to assets held by pension funds are tax-free. A similar argument applies to the assets held by the state and local government retirement funds.29 The final ownership category for assets owned by individuals consists of insurance companies. These are subject to special tax provisions which we shall now describe in detail. Until 1947 life insurance companies paid virtually no taxes. Under the tax law enacted in 1951 they were subject to a tax of 6.5 per cent on investment income, net of investment expenses. If we assume that seven-eighths of the net investment income is needed to meet future insurance obligations, this amounts to a tax of 52 per cent on the company's share of investment income.30 The Life Insurance Income Tax Act of 1959 introduced new rules for the taxation of life insurance companies. These rules were put into effect retroactively for 1958 incomes. Under the 1959 Act the income of life insurance companies was taxed in two phases. First, taxable income was defined as the lesser of the gain from operations and investment income. Second, if the gain from operations exceeded investment income, one-half of the excess was taxable. Since gains from operations are approximately equal to the total of investment income and income from underwriting, a company subject to excess taxation was taxed on the sum of its investment income and one-half of its underwriting income. The remaining half of the excess became part of the policy-holders' surplus account. This was taxed only when distributed to stockholders or upon dissolution of the company. The Deficit Reduction Act of 1984 (DEFRA) repealed the provisions of the 1959 Act. Under DEFRA taxation of life insurance companies was consolidated into a single phase. Compared with earlier law, as amended by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), this change increased the taxable income of insurance companies substantially. In order to shield insurance companies from a sudden and substantial increase in taxes, DEFRA allowed a special life insurance company deduction for 20 per cent of taxable income. This special deduction was repealed in the Tax Reform Act of 1986.

29

See Feldstein and Summers (1979) and King and Fullerton (1984).

30

See Pechman (1977), p. 155.

50

THE US TAX SYSTEM

We assume that dividends and interest received by life insurance companies were taxed under the 1959 Act on gross investment income. Taxable income is the sum of interest, dividends, rents, and short-term capital gains, less investment expenses, income on reserves necessary to meet future insurance obligations, the company's share of taxexempt interest, and 85 per cent of intercorporate dividends. Deductions of income on reserves was determined by the ‘10-for-1’ Menge formula, iR*[1 − 10(i − i*)], where i is the company's adjusted reserve rate in decimal fraction, R* is the reserve required to meet future insurance obligations, and i* is the rate of return in decimal fraction assumed in determining the required reserve, R*.31 Thus the tax liability is tq{iR − iR*[1 − 10(i − i*)]}, where R is the total assets of the company. We assume that total assets of an insurance company are equal to the reserves required to meet future insurance obligations. Under this assumption the marginal tax rate on one dollar's worth of additional assets is 10tq(i − i*). Since the assumed rate of return has been 3 per cent, we estimate the marginal tax rate on interest received by life insurance companies to be 10tq(i − 0.03), where i is set equal to the interest rate on Baa class corporate bonds. We assume further that the company's share of intercorporate dividends is the same as the corresponding share of interest. We estimate that the marginal tax rate on dividends received by the life insurance companies is 10tq(i − 0.03)(1 − 0.85).32 In summary, we estimate that the marginal tax rate on both interest and dividends received by insurance companies was 6.5 per cent for 1950–7. The marginal tax rate for interest income was 10tq(i − 0.03) for 1958–81. We calculate the marginal tax rates using the geometric version of the Menge formula for 1982–6. The marginal tax rate on interest is calculated

31

In 1982 TEFRA changed the formula to a geometric 10-for-1 formula to provide a better approximation to the deduction when the rate of inflation is high. The geometric version of the formula is iR *(0.9100(i − i*) ).

32

King and Fullerton (1984), p. 227, and Table 6.13, p. 234, estimate that the marginal tax rate on dividends is 0.15tq , which is equivalent to assuming that all intercorporate dividends are allocated to the company. However, the dividends received by the company are included in gross investment income and are divided between the company and the policy-holders in accord with the Menge formula.

THE US TAX SYSTEM

51

according to the formula for 1982–3 and for 1984–6. The marginal tax rate on dividends is adjusted for the intercorporate dividend deduction on the company's share. We set the marginal tax rate on dividends equal to 15 per cent of the marginal tax rate on interest income for the period of 1958–86. Non-life insurance companies are taxed like other corporations. The marginal tax rate on interest received by non-life insurance companies is tq. The marginal tax rate for dividend income is estimated to be (1 − 0.85)tq, owing to the deduction for intercorporate dividends. The marginal tax rate on capital gains is the same as for insurance companies as for other corporations. We have ignored the tax liabilities that might arise at the individual level when benefits are distributed to the insured. This reflects the effects of tax deferral, lower personal tax rates after retirement, and the possibility of death of the insured in the case of life insurance companies. We have now completed the derivation of marginal tax rates at the corporate and individual levels for all three categories of ownership.

3.2. Distribution of Assets Our next objective is to determine the distribution of corporate equity and debt for households and non-corporate and corporate businesses among the three categories of institutions through which individuals own claims on assets. For this purpose we utilize data from the US Flow of Funds Accounts. The Flow of Funds Accounts provide the distribution of corporate equity among the various ownership categories. However, the ‘Households’ sector of the Flow of Funds Accounts includes both individuals and non-profit institutions. We allocate 7 per cent of the corporate equity held by households to non-profit institutions.33 Corporate equity held by life insurance companies must be divided between insurance business and pension business. We allocate the corporate equity held by life insurance companies in proportion to pension and life insurance reserves. Table 3.5 shows the ownership

33

This allocation is employed, for example, by Feldstein and Summers (1979).

52

THE US TAX SYSTEM

Table 3.5 Ownership Distribution of Corporate Equity (a) Billions of Dollars Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Total 107.917 106.060 105.232 116.321 142.566 166.000 181.683 174.753 252.016 309.552 330.347 292.141 409.184 428.300 424.100 539.200 473.800 558.900 618.200 698.000 633.800 796.800 950.400 837.800 830.300 970.900 1096.600 865.200 615.400 810.900 958.700 906.200 936.800 1129.000 1504.900 1435.000 1641.400 1916.800 1915.500 2448.300 2770.900

Households 97.432 95.462 94.511 104.652 127.386 148.528 162.163 155.000 224.505 274.186 292.624 257.085 360.261 374.466 368.012 466.347 406.866 478.391 525.801 591.665 533.937 670.759 799.017 693.663 677.511 775.740 857.960 659.848 457.907 594.998 702.758 656.559 658.491 803.730 1089.230 1034.963 1145.550 1310.585 1312.858 1687.910 1883.964

Tax-exempt institutions 7.610 7.576 7.609 8.378 10.706 12.590 14.132 14.179 20.169 26.876 29.174 27.079 38.822 42.903 44.555 58.502 53.301 64.870 74.850 87.282 82.088 104.776 126.835 120.825 128.632 163.808 197.668 167.391 129.493 182.817 217.028 212.163 237.626 277.930 358.060 343.621 432.012 530.338 532.864 675.976 789.118

Insurance companies 2.875 3.022 3.112 3.291 4.475 4.881 5.388 5.574 7.343 8.491 8.549 7.977 10.101 10.931 11.533 14.351 13.633 15.639 17.549 19.053 17.775 21.265 24.548 23.312 24.157 31.352 40.972 37.961 28.000 33.085 38.914 37.478 40.683 47.340 57.610 56.416 63.838 75.877 69.778 84.414 97.818

Source: Board of Governors of the Federal Reserve System, Flow of Funds Accounts 1949–78, Annual Total Flows & Year-end Assets and Liabilities, and Flow of Funds Accounts, Assets and Liabilities Outstanding 1962–85

(b) Percentages

53

THE US TAX SYSTEM

Year

Households

Tax-exempt institutions

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.9028 0.9001 0.8981 0.8997 0.8935 0.8947 0.8926 0.8870 0.8908 0.8857 0.8858 0.8800 0.8804 0.8743 0.8677 0.8649 0.8587 0.8560 0.8505 0.8477 0.8424 0.8418 0.8407 0.8280 0.8160 0.7990 0.7824 0.7627 0.7441 0.7338 0.7330 0.7245 0.7029 0.7119 0.7238 0.7212 0.6979 0.6837 0.6854 0.6894 0.6799

0.0705 0.0714 0.0723 0.0720 0.0751 0.0758 0.0778 0.0811 0.0800 0.0868 0.0883 0.0927 0.0949 0.1002 0.1051 0.1085 0.1125 0.1161 0.1211 0.1250 0.1295 0.1315 0.1335 0.1442 0.1549 0.1687 0.1803 0.1935 0.2104 0.2254 0.2264 0.2341 0.2537 0.2462 0.2379 0.2395 0.2632 0.2767 0.2782 0.2761 0.2848

Source: see Table 3.5(a)

Insurance companies Total 0.0266 0.0285 0.0296 0.0283 0.0314 0.0294 0.0297 0.0319 0.0291 0.0274 0.0259 0.0273 0.0247 0.0255 0.0272 0.0266 0.0288 0.0280 0.0284 0.0273 0.0280 0.0267 0.0258 0.0278 0.0291 0.0323 0.0374 0.0439 0.0455 0.0408 0.0406 0.0414 0.0434 0.0419 0.0383 0.0393 0.0389 0.0396 0.0364 0.0345 0.0353

Life 0.0107 0.0121 0.0124 0.0092 0.0132 0.0119 0.0118 0.0128 0.0111 0.0100 0.0089 0.0096 0.0083 0.0087 0.0095 0.0094 0.0106 0.0101 0.0099 0.0101 0.0107 0.0104 0.0105 0.0120 0.0132 0.0152 0.0175 0.0211 0.0247 0.0233 0.0230 0.0225 0.0227 0.0200 0.0168 0.0167 0.0154 0.0145 0.0131 0.0112 0.0107

Other 0.0159 0.0164 0.0172 0.0191 0.0181 0.0175 0.0179 0.0191 0.0180 0.0175 0.0169 0.0177 0.0164 0.0168 0.0177 0.0172 0.0182 0.0179 0.0184 0.0172 0.0174 0.0163 0.0154 0.0159 0.0159 0.0171 0.0199 0.0228 0.0208 0.0175 0.0176 0.0189 0.0207 0.0220 0.0215 0.0226 0.0235 0.0251 0.0233 0.0233 0.0246

54

THE US TAX SYSTEM

distribution of corporate equity and Table 3.6 breaks down the equity held by the households into that held by individuals, commercial banks, savings institutions, and mutual funds. Data from the Flow of Funds Accounts include the assets and liabilities of corporate and non-corporate sectors of non-farm non-financial businesses and farm businesses. These Accounts do not provide a breakdown of farm businesses between corporate and non-corporate sectors, so that we allocate the assets and liabilities of farm businesses between corporate and non-corporate sectors in proportion to depreciable capital stocks in the two farm sectors. We estimate the stocks of depreciable capital for corporate and non-corporate farm businesses, using investment data from the Bureau of Economic Analysis described in more detail in Section 3.4 below. Corporate financial assets include demand deposits and currency, time deposits, security repurchase agreements, US government securities, state and local government obligations, commercial paper, consumer credit, trade credit, and miscellaneous assets. Liabilities include corporate bonds (including tax-exempt bonds), mortgages—home, multifamily, commercial, and farm—bank loans, commercial paper, banker's acceptances, finance company loans, US government loans, trade debt, and miscellaneous liabilities. In computing the distribution of corporate net debt, we exclude government securities and loans, net trade credit, and miscellaneous assets and liabilities. We then determine the distribution of each category of assets and liabilities among the ownership categories. On the asset side we allocate demand deposits and currency between the liabilities of commercial banks and savings institutions in proportion to the relative shares of total demand deposits and currency held in commercial banks and savings institutions. We allocate time deposits between these two ownership categories in the same way. We allocate commercial paper to finance companies and consumer credit to individuals. On the liabilities side we allocate corporate bonds, including a small amount of tax-exempt bonds, in proportion to the distribution of corporate and foreign bonds among households, savings institutions, life insurance companies, pension funds, state and local government retirement funds, other insurance companies,

55

THE US TAX SYSTEM

Table 3.6 Household Ownership Distribution of Corporate Equity (Billions of Dollars) Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 Source: see Table 3.5(a)

Households total 97.432 95.462 94.511 104.652 127.386 148.528 162.163 155.000 224.505 274.186 292.624 257.085 360.261 374.466 368.012 466.347 406.866 478.391 525.801 591.665 533.937 670.759 799.017 693.663 677.511 775.740 857.960 659.848 457.907 594.998 702.758 656.559 658.491 803.730 1089.230 1034.963 1145.550 1310.585 1312.858 1687.910 1883.964

Individuals 96.148 94.159 93.124 101.784 124.307 145.352 158.499 151.045 218.568 266.253 283.731 248.665 347.179 359.166 351.912 444.447 387.066 454.491 498.201 558.465 503.037 628.959 750.417 650.163 634.911 723.540 801.660 617.148 427.707 556.698 660.858 619.659 621.891 763.530 1042.530 994.263 1092.750 1231.785 1228.158 1568.910 1715.664

Commercial banks 0.003 0.004 0.004 0.001 0.001 0.001 0.002 0.003 0.005 0.006 0.006 0.009 0.010 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.100 0.100 0.100 0.100 0.100 0.100 0.200 0.200 0.200 0.200 0.200 0.100 0.100 0.100 0.100 0.100 0.100 0.000 0.100 0.100

Savings institutions 0.187 0.146 0.157 0.157 0.181 0.227 0.336 0.431 0.571 1.000 1.000 1.000 1.400 1.400 1.300 1.600 1.500 1.800 2.000 2.300 2.000 2.500 2.400 2.500 2.800 3.500 4.500 4.200 3.700 4.400 4.400 4.800 4.800 4.700 4.200 3.200 3.300 4.300 4.100 5.200 7.000

Mutual funds 1.094 1.153 1.226 2.710 2.897 2.948 3.326 3.521 5.361 6.927 7.887 7.411 11.672 13.900 14.800 20.300 18.300 22.100 25.600 30.900 28.900 39.200 46.100 40.900 39.700 48.600 51.700 38.300 26.300 33.700 37.300 31.900 31.700 35.400 42.400 37.400 49.400 74.400 80.600 113.700 161.200

56

THE US TAX SYSTEM

Table 3.7 Ownership Distribution of Corporate Net Debt (a) Billions of Dollars Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Total 30.371 33.649 38.895 41.691 43.712 48.549 54.342 58.083 62.640 68.050 78.614 88.257 94.973 105.194 115.531 121.270 128.127 140.601 150.771 165.367 186.463 206.658 230.857 256.149 282.661 300.470 323.814 356.990 419.561 426.481 454.849 515.116 589.416 668.767 728.034 794.981 829.129 841.851 994.998 1132.053 1274.179

Households 14.366 14.164 14.637 14.100 13.371 14.589 15.626 15.724 15.803 17.840 24.794 29.153 31.017 37.728 44.287 44.197 44.909 51.324 56.158 64.754 75.397 85.995 102.027 120.314 138.487 150.350 167.153 190.017 239.007 226.764 239.014 271.447 313.056 364.324 379.039 409.392 412.523 400.912 501.980 564.709 665.881



(b) Percentage Composition Year

Households


Insurance companies


57

THE US TAX SYSTEM

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985

1986


0.4730 0.4209 0.3763 0.3382 0.3059 0.3005 0.2876 0.2707 0.2523 0.2622 0.3154 0.3303 0.3266 0.3587 0.3833 0.3645 0.3505 0.3650 0.3725 0.3916 0.4044 0.4161 0.4419 0.4697 0.4899 0.5004 0.5162 0.5323 0.5697 0.5317 0.5255 0.5270 0.5311 0.5448 0.5206 0.5150 0.4975 0.4762 0.5045 0.4988

0.5226

0.0683 0.0808 0.0922 0.1066 0.1334 0.1467 0.1682 0.1912 0.2164 0.2289 0.2273 0.2404 0.2559 0.2561 0.2569 0.2739 0.2866 0.2883 0.2932 0.2900 0.2936 0.2933 0.2824 0.2750 0.2711 0.2684 0.2673 0.2632 0.2462 0.2789 0.2805 0.2814 0.2878 0.2878 0.3191 0.3314 0.3542 0.3811 0.3673 0.3748

0.3571

Total 0.4586 0.4983 0.5315 0.5552 0.5607 0.5528 0.5443 0.5381 0.5313 0.5089 0.4573 0.4293 0.4175 0.3853 0.3598 0.3617 0.3629 0.3467 0.3343 0.3185 0.3020 0.2906 0.2757 0.2553 0.2389 0.2312 0.2165 0.2045 0.1841 0.1894 0.1940 0.1916 0.1811 0.1675 0.1603 0.1536 0.1483 0.1427 0.1282 0.1264

0.1203

Life 0.4421 0.4814 0.5133 0.5386 0.5441 0.5359 0.5266 0.5198 0.5134 0.4919 0.4424 0.4142 0.4023 0.3716 0.3468 0.3487 0.3485 0.3343 0.3208 0.3034 0.2858 0.2727 0.2552 0.2341 0.2129 0.2062 0.1958 0.1860 0.1644 0.1660 0.1655 0.1605 0.1511 0.1380 0.1318 0.1233 0.1192 0.1183 0.1033 0.0970

0.0877

Other 0.0166 0.0168 0.0182 0.0166 0.0165 0.0169 0.0177 0.0183 0.0180 0.0171 0.0149 0.0150 0.0152 0.0137 0.0130 0.0130 0.0144 0.0124 0.0135 0.0151 0.0163 0.0179 0.0205 0.0212 0.0260 0.0251 0.0207 0.0185 0.0197 0.0234 0.0285 0.0312 0.0300 0.0295 0.0285 0.0303 0.0291 0.0244 0.0249 0.02 94

0.0326

58

THE US TAX SYSTEM

and mutual funds. Similarly, we allocate the four types of mortgages among households, mortgage pools, commercial banks, savings institutions, life insurance companies, private pension funds, state and local government retirement funds, finance companies, and real estate investment trusts. Since non-profit institutions hold a very small fraction of corporate debt, we allocate the entire corporate debt held by the ‘Households’ sector of the Flow of Funds Accounts to individuals. The debt allocated to insurance companies is further divided between life insurance and pensions in proportion to the reserves attributable to the two sectors. Finally, we allocate bank loans and banker's acceptances to commercial banks and we allocate commercial paper and finance company loans to finance companies. Whenever the net liability of an ownership category is negative we replace the value of net debt with zero and assign zero weight to it. The results are shown in Table 3.7. Table 3.8 gives the corporate net debt held by commercial banks and savings institutions. Assets of the non-corporate sector include demand deposits and currency, consumer credit, trade credit, and miscellaneous assets. Liabilities include mortgages—home, multi-family, commercial, and farm—bank loans, US government loans, trade debt, and miscellaneous liabilities. We exclude government liabilities, net trade debt, and miscellaneous assets and liabilities. We follow the same procedures for allocating non-corporate net debt among ownership categories as for corporate net debt. When an ownership category shows a net asset position or negative net debt, we set net debt equal to zero and assign zero weight to it. The results are shown in Tables 3.9 and 3.10. Household assets include demand deposits and currency, time and savings deposits, money market fund shares, US government securities, corporate bonds, mortgages, corporate equities, life insurance and pension reserves, and miscellaneous assets. Household liabilities include home mortgages, consumer installment credit, bank loans, trade debt, and miscellaneous liabilities. Of these assets and liabilities, we consider consumer installment credit and mortgages as most relevant to the financing of household assets. We include the credit obtained from commercial banks, savings and loan associations, mutual savings banks, credit unions, and finance companies in consumer installment

59

THE US TAX SYSTEM

Table 3.8 Household Ownership Distribution of Corporate Net Debt (Billions of Dollars) Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 Source: see Table 3.5(a)



Savings institutions 2.423 2.963 3.673 4.052 4.455 4.997 5.643 6.099 6.546 6.634 6.820 7.367 8.071 8.730 8.580 9.032 10.461 11.834 12.618 12.256 13.204 15.483 17.964 20.936 21.726 25.781 27.921 25.538 25.409 28.431 31.202 31.901 32.544 28.959 27.178 17.139 8.230 2.915 −4.756 −12.986 −23.556

60

THE US TAX SYSTEM

Table 3.9 Ownership Distribution of Non-corporate Net Debt (a) Billions of Dollars Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Total 4.179 4.052 4.196 4.566 4.966 5.590 5.949 6.488 7.302 8.096 8.591 9.046 10.456 11.234 13.243 15.815 18.198 20.943 26.144 34.020 41.789 50.659 60.220 73.946 87.085 109.708 140.215 171.968 195.722 213.679 232.782 270.019 306.335 350.760 384.022 415.943 455.263 521.746 605.841 676.386 768.021

Households 1.950 1.619 1.445 1.371 1.261 1.388 1.297 1.520 1.965 2.300 2.409 2.769 3.846 4.227 5.713 7.437 9.064 10.687 13.351 18.467 23.571 29.398 36.195 46.255 55.764 74.342 99.906 124.464 140.666 152.643 167.152 196.416 222.174 253.543 273.475 294.592 325.359 378.223 450.991 504.058 573.441




Households


Insurance companies


61

THE US TAX SYSTEM

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.4665 0.3994 0.3444 0.3002 0.2539 0.2483 0.2181 0.2343 0.2691 0.2840 0.2805 0.3060 0.3679 0.3763 0.4314 0.4703 0.4981 0.5103 0.5106 0.5428 0.5640 0.5803 0.6011 0.6255 0.6403 0.6776 0.7125 0.7238 0.7187 0.7144 0.7181 0.7274 0.7253 0.7228 0.7121 0.7083 0.7147 0.7249 0.7444 0.7452 0.7466


0.0422 0.0521 0.0623 0.0718 0.0835 0.0929 0.1065 0.1131 0.1162 0.1225 0.1305 0.1369 0.1349 0.1435 0.1414 0.1415 0.1387 0.1387 0.1430 0.1370 0.1340 0.1319 0.1273 0.1217 0.1179 0.1081 0.0976 0.0941 0.0966 0.1046 0.1116 0.1127 0.1195 0.1271 0.1406 0.1503 0.1591 0.1612 0.1568 0.1636 0.1675

Total 0.4912 0.5485 0.5933 0.6280 0.6626 0.6587 0.6754 0.6526 0.6148 0.5934 0.5891 0.5570 0.4973 0.4802 0.4272 0.3882 0.3632 0.3510 0.3464 0.3202 0.3019 0.2878 0.2717 0.2527 0.2417 0.2143 0.1898 0.1822 0.1847 0.1810 0.1704 0.1599 0.1552 0.1500 0.1472 0.1415 0.1263 0.1139 0.0988 0.0912 0.0858

Life 0.4899 0.5469 0.5917 0.6263 0.6608 0.6570 0.6738 0.6510 0.6133 0.5920 0.5876 0.5557 0.4961 0.4795 0.4267 0.3873 0.3628 0.3506 0.3460 0.3199 0.3016 0.2871 0.2709 0.2519 0.2409 0.2136 0.1891 0.1815 0.1841 0.1804 0.1695 0.1588 0.1543 0.1485 0.1453 0.1390 0.1235 0.1102 0.0950 0.0870 0.0807

Other 0.0014 0.0016 0.0016 0.0018 0.0018 0.0017 0.0016 0.0017 0.0015 0.0014 0.0014 0.0013 0.0011 0.0007 0.0006 0.0009 0.0004 0.0004 0.0004 0.0004 0.0003 0.0007 0.0007 0.0008 0.0008 0.0007 0.0007 0.0006 0.0006 0.0006 0.0008 0.0010 0.0009 0.0015 0.0020 0.0024 0.0028 0.0036 0.0038 0.0042 0.0052

62

THE US TAX SYSTEM

Table 3.10 Household Ownership Distribution of Non-corporate Net Debt (Billions of Dollars) Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986





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63

credit and exclude the credit obtained from the non-financial corporate and non-farm non-corporate business. Mortgages, which include home mortgages and small amounts of other mortgages, are allocated among individuals, mortgage pools, commercial banks, savings institutions, life insurance companies, mutual funds, state and local government retirement funds, finance companies, and real estate investment trusts in proportion to the distribution of home mortgages. Mortgages allocated to life insurance companies are further divided between the life insurance reserves and pension funds reserves. The results are presented in Tables 3.11 and 3.12. Our next objective is to calculate averages of the marginal tax rates for households, tax-exempt institutions, and insurance companies. First, we adjust the marginal tax rate on the assets held by households for the fact that demand deposits and currency held in the commercial banks and savings institutions yield returns in the form of services that are not taxable. Commercial banks and savings institutions hold only a minuscule amount of corporate equity, but they hold substantial amounts of corporate, non-corporate, and household debt. We adjust the marginal tax rates for corporate equity and debt of corporate, non-corporate, and household sectors held by households through these two financial institutions. We first calculate the ratio of currency and demand deposits held in commercial banks to the total liabilities of the commercial banks. We assume that this ratio represents the proportion of debt held in commercial banks and balanced by liabilities of commercial banks in the form of demand deposits. We adjust the marginal tax rate on interest received by individuals for demand deposits and currency held in commercial banks to obtain the marginal tax rate of the entire household ownership category. We make a similar adjustment for demand deposits held in savings institutions. As an illustration, consider the marginal tax rate on returns to corporate debt held by households. In 1980 the total liabilities of commercial banks and savings institutions were $1469.0 and $817.8 billion, respectively. In that year currency and demand deposits were $307.1 and $7.3 billion. Of the $396.5 billion of corporate net debt held in the household ownership categories in the same year, $229.1 billion was held by commercial banks and

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THE US TAX SYSTEM

Table 3.11 Ownership Distribution of Household Net Debt (a) Billions of Dollars Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Total 25.484 32.352 39.112 46.698 56.581 64.162 74.435 86.112 95.951 113.690 128.265 140.235 150.060 168.687 185.192 199.268 218.781 241.979 267.137 292.663 313.281 330.512 357.213 386.381 405.289 441.712 496.474 562.451 607.569 650.941 730.861 854.215 1004.431 1160.239 1258.847 1355.428 1415.784 1573.517 1776.368 2004.000 2255.700

Households 22.933 28.883 34.201 40.457 47.927 53.071 62.080 72.100 79.974 95.028 106.639 116.653 125.363 141.833 156.210 168.992 187.458 209.699 233.101 256.797 275.647 292.812 319.995 350.101 369.423 408.743 466.840 535.056 581.397 626.688 708.955 834.092 984.470 1137.637 1233.091 1329.632 1389.120 1548.577 1753.361 1983.080 2235.174




Households


Insurance companies


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THE US TAX SYSTEM

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.8999 0.8928 0.8744 0.8664 0.8470 0.8271 0.8340 0.8373 0.8335 0.8359 0.8314 0.8318 0.8354 0.8408 0.8435 0.8481 0.8568 0.8666 0.8726 0.8775 0.8799 0.8859 0.8958 0.9061 0.9115 0.9254 0.9403 0.9513 0.9569 0.9627 0.9700 0.9764 0.9801 0.9805 0.9795 0.9810 0.9812 0.9842 0.9870 0.9896 0.9909


0.0081 0.0094 0.0119 0.0137 0.0169 0.0210 0.0222 0.0236 0.0259 0.0273 0.0295 0.0320 0.0336 0.0353 0.0370 0.0377 0.0372 0.0360 0.0363 0.0367 0.0375 0.0373 0.0352 0.0328 0.0320 0.0281 0.0232 0.0194 0.0177 0.0160 0.0138 0.0116 0.0102 0.0105 0.0116 0.0115 0.0122 0.0108 0.0091 0.0077 0.0068

Total 0.0921 0.0979 0.1136 0.1199 0.1360 0.1519 0.1438 0.1391 0.1406 0.1368 0.1391 0.1361 0.1310 0.1239 0.1195 0.1143 0.1059 0.0974 0.0912 0.0859 0.0826 0.0768 0.0690 0.0610 0.0565 0.0465 0.0365 0.0293 0.0254 0.0212 0.0162 0.0120 0.0096 0.0090 0.0088 0.0076 0.0066 0.0050 0.0038 0.0027 0.0023

Life 0.0921 0.0979 0.1136 0.1199 0.1360 0.1519 0.1438 0.1391 0.1406 0.1368 0.1391 0.1361 0.1310 0.1239 0.1195 0.1143 0.1059 0.0974 0.0912 0.0859 0.0826 0.0768 0.0690 0.0610 0.0565 0.0465 0.0365 0.0293 0.0254 0.0212 0.0162 0.0120 0.0096 0.0090 0.0088 0.0076 0.0066 0.0050 0.0038 0.0027 0.0023

Other 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

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THE US TAX SYSTEM

Table 3.12 Household Ownership Distribution of Household Net Debt (billions of Dollars) Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986





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67

$28.5 billion by savings banks. Since the marginal tax rate on interest received by individuals was 34.88, the marginal tax rate on interest received by households is 30.67 per cent:

Table 3.13 shows the average marginal tax rates on interest income received by households. We next calculate average marginal tax rates for returns to corporate equity and the debt of household, non-corporate, and corporate sectors. We combine the distribution of the financial assets across the various ownership categories and the marginal tax rates for each ownership category on dividends, interest, and capital gains on corporate equity. The average marginal tax rate on dividends is a weighted average of the marginal tax rates on dividends for households, life insurance companies, other insurance companies, and tax-exempt owners, where the marginal tax rate of the tax-exempt institutions is zero by definition. We calculate average marginal tax rates on corporate capital gains and interest income from corporate, non-corporate, and household debt in the same way. We do not have separate estimates of average marginal tax rates on returns to non-corporate equity. We assume that the average marginal tax rate on income from non-corporate equity is the same as the rate on interest income accruing to individuals given in Table 3.4. While income from household equity is not subject to tax, household interest and property tax payments are

deductible from revenue under the individual income tax. We take the average marginal tax rate for these deductions to be the same as the rate on interest income.

The accrual-based average marginal tax rate on capital gains on non-corporate equity is set at one-quarter of the tax rate on other income on non-corporate equity:

(3.3) where E is the proportion of net capital gains excluded for individual income tax purposes. We set the marginal tax rate of capital gains on household equity at zero. The generous ‘roll-over’ provisions for capital gains on owner-occupied residential real estate and the effects of tax deferral combine to lower the

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THE US TAX SYSTEM

Table 3.13 Average Marginal Tax Rates on Household Income Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Dividends 0.4937 0.4942 0.4199 0.4036 0.4490 0.4727 0.4862 0.4506 0.4411 0.4537 0.4681 0.4498 0.4473 0.4570 0.4436 0.4478 0.4383 0.4609 0.4230 0.3877 0.3929 0.4006 0.4318 0.4465 0.4151 0.4100 0.4184 0.4324 0.4406 0.4506 0.4609 0.4629 0.4602 0.4766 0.4881 0.4742 0.4091 0.3943 0.3921 0.3866 0.3873

Corporate interest 0.3362 0.3367 0.2611 0.2480 0.2795 0.2941 0.3155 0.3054 0.2730 0.2624 0.2396 0.2353 0.2415 0.2277 0.2184 0.2276 0.2257 0.2370 0.2054 0.1782 0.1788 0.1881 0.2112 0.2250 0.2289 0.2255 0.2349 0.2442 0.2547 0.2608 0.2708 0.2770 0.2763 0.2883 0.3067 0.3144 0.2809 0.2589 0.2628 0.2618 0.2602

Non-corporate interest 0.3360 0.3364 0.2608 0.2477 0.2791 0.3014 0.3244 0.3087 0.2726 0.2736 0.2856 0.2817 0.2779 0.2806 0.2710 0.2710 0.2666 0.2874 0.2581 0.2164 0.2114 0.2160 0.2363 0.2435 0.2448 0.2404 0.2492 0.2591 0.2709 0.2733 0.2802 0.2853 0.2853 0.2989 0.3173 0.3231 0.2890 0.2666 0.2686 0.2646 0.2603

Household interest 0.2765 0.2671 0.2066 0.1952 0.2173 0.2365 0.2563 0.2465 0.2213 0.2236 0.2354 0.2356 0.2350 0.2375 0.2325 0.2358 0.2341 0.2537 0.2289 0.2071 0.2121 0.2204 0.2437 0.2554 0.2549 0.2473 0.2561 0.2669 0.2788 0.2817 0.2890 0.2940 0.2933 0.3075 0.3278 0.3361 0.3026 0.2793 0.2815 0.2780 0.2774

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THE US TAX SYSTEM

Table 3.14 Average Marginal Tax Rates on Equity Income Year

Corporate

Non-corporate

Household

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.4474 0.4466 0.3789 0.3648 0.4032 0.4251 0.4362 0.4020 0.3951 0.4039 0.4165 0.3979 0.3952 0.4010 0.3865 0.3888 0.3780 0.3961 0.3614 0.3301 0.3325 0.3387 0.3646 0.3715 0.3406 0.3295 0.3295 0.3324 0.3307 0.3334 0.3404 0.3379 0.3262 0.3421 0.3562 0.3453 0.2882 0.2723 0.2711 0.2687 0.2656

0.3363 0.3368 0.2611 0.2481 0.2796 0.3020 0.3251 0.3094 0.2731 0.2740 0.2860 0.2820 0.2782 0.2809 0.2712 0.2713 0.2669 0.2878 0.2584 0.2329 0.2376 0.2464 0.2725 0.2844 0.2813 0.2719 0.2808 0.2911 0.3018 0.3035 0.3104 0.3156 0.3144 0.3291 0.3488 0.3577 0.3224 0.2974 0.2995 0.2963 0.2970

0.3363 0.3368 0.2611 0.2481 0.2796 0.3020 0.3251 0.3094 0.2731 0.2740 0.2860 0.2820 0.2782 0.2809 0.2712 0.2713 0.2669 0.2878 0.2584 0.2329 0.2376 0.2464 0.2725 0.2844 0.2813 0.2719 0.2808 0.2911 0.3018 0.3035 0.3104 0.3156 0.3144 0.3291 0.3488 0.3577 0.3224 0.2974 0.2995 0.2963 0.2970

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THE US TAX SYSTEM

Table 3.15 Average Marginal Tax Rates on Capital Gains Year

Corporate

Non-corporate

Household

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.0597 0.0599 0.0516 0.0496 0.0549 0.0573 0.0587 0.0547 0.0535 0.0543 0.0557 0.0536 0.0529 0.0538 0.0522 0.0524 0.0514 0.0535 0.0492 0.0452 0.0456 0.0462 0.0493 0.0504 0.0467 0.0458 0.0465 0.0478 0.0478 0.0475 0.0483 0.0481 0.0469 0.0398 0.0407 0.0397 0.0340 0.0325 0.0320 0.0315 0.0313

0.0420 0.0421 0.0326 0.0310 0.0350 0.0377 0.0406 0.0387 0.0341 0.0342 0.0357 0.0353 0.0348 0.0351 0.0339 0.0339 0.0334 0.0360 0.0323 0.0291 0.0297 0.0308 0.0341 0.0355 0.0352 0.0340 0.0351 0.0364 0.0377 0.0379 0.0388 0.0395 0.0393 0.0329 0.0349 0.0358 0.0322 0.0297 0.0299 0.0296 0.0297

0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

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THE US TAX SYSTEM

Table 3.16 Average Marginal Tax Rates on Interest Income Year

Corporate

Non-corporate

Households

Government

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.1943 0.1796 0.1388 0.1254 0.1280 0.1320 0.1343 0.1262 0.1118 0.1098 0.1123 0.1127 0.1241 0.1296 0.1312 0.1287 0.1245 0.1265 0.1138 0.1054 0.1182 0.1312 0.1597 0.1793 0.1933 0.1839 0.1835 0.1891 0.2099 0.2157 0.2145 0.2116 0.2125 0.2242 0.2441 0.2578 0.1999 0.1759 0.1741 0.1708 0.1718

0.1891 0.1705 0.1289 0.1158 0.1146 0.1184 0.1154 0.1155 0.1140 0.1169 0.1190 0.1230 0.1486 0.1583 0.1671 0.1710 0.1723 0.1818 0.1646 0.1473 0.1593 0.1720 0.2010 0.2195 0.2337 0.2237 0.2278 0.2364 0.2562 0.2661 0.2605 0.2570 0.2588 0.2734 0.3043 0.3210 0.2549 0.2326 0.2284 0.2220 0.2147

0.2548 0.2448 0.1881 0.1769 0.1929 0.2055 0.2231 0.2154 0.1936 0.1958 0.2047 0.2049 0.2085 0.2132 0.2101 0.2127 0.2120 0.2296 0.2083 0.1896 0.1975 0.2076 0.2333 0.2475 0.2503 0.2420 0.2505 0.2617 0.2752 0.2795 0.2859 0.2908 0.2907 0.3049 0.3258 0.3347 0.2994 0.2766 0.2789 0.2758 0.2754

0.1983 0.2017 0.1659 0.1583 0.1803 0.1965 0.2119 0.2030 0.1793 0.1844 0.1953 0.1960 0.1910 0.2003 0.1948 0.1947 0.1952 0.2121 0.1940 0.1795 0.1880 0.1941 0.2157 0.2317 0.2290 0.2223 0.2272 0.2370 0.2462 0.2453 0.2489 0.2503 0.2496 0.2593 0.2717 0.2764 0.2465 0.2269 0.2271 0.2267 0.2275

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THE US TAX SYSTEM

Table 3.17 Property Tax Rates Year

Corporate

Non-corporate

Household

1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

0.0124 0.0118 0.0120 0.0122 0.0132 0.0130 0.0126 0.0132 0.0132 0.0136 0.0141 0.0136 0.0123 0.0125 0.0132 0.0137 0.0142 0.0143 0.0146 0.0147 0.0145 0.0145 0.0145 0.0145 0.0145 0.0151 0.0149 0.0146 0.0137 0.0126 0.0121 0.0118 0.0109 0.0098 0.0095 0.0095 0.0091 0.0091 0.0098 0.0099 0.0100

0.0128 0.0124 0.0108 0.0110 0.0109 0.0117 0.0113 0.0114 0.0118 0.0122 0.0126 0.0126 0.0112 0.0118 0.0122 0.0127 0.0132 0.0133 0.0139 0.0141 0.0141 0.0145 0.0150 0.0153 0.0154 0.0160 0.0162 0.0158 0.0147 0.0136 0.0131 0.0128 0.0114 0.0103 0.0094 0.0093 0.0088 0.0089 0.0093 0.0094 0.0096

0.0102 0.0098 0.0082 0.0077 0.0081 0.0077 0.0078 0.0079 0.0078 0.0085 0.0090 0.0092 0.0096 0.0101 0.0108 0.0110 0.0113 0.0121 0.0124 0.0127 0.0130 0.0131 0.0138 0.0142 0.0143 0.0146 0.0143 0.0141 0.0133 0.0128 0.0127 0.0125 0.0112 0.0099 0.0094 0.0093 0.0093 0.0098 0.0098 0.0099 0.0100

THE US TAX SYSTEM

73

effective tax rate on these capital gains virtually to zero. Average marginal tax rates for all forms of income from capital are summarized in Tables 3.14–3.16. In the household sector, property taxes include taxes on owner-occupied farm and non-farm dwellings, automobile use taxes, state and local personal motor vehicle licences, state and local personal property taxes, and other state and local personal taxes. Non-corporate property taxes include state and local non-corporate business property taxes, the non-corporate part of the state and local business motor vehicle licences, and the non-corporate part of other state and local business taxes. Finally, corporate property taxes include the corporate part of state and local business property taxes, state and local business motor vehicle licences, and the other state and local taxes. Average property tax rates for all three sectors are shown in Table 3.17.

3.3. Capital Cost Recovery The economic definition of taxable income requires that capital cost recovery must equal economic depreciation.34 Capital cost recovery for tax purposes has increasingly diverged from economic depreciation as capital consumption allowances and the investment tax credit have been utilized in providing tax incentives for private investment. Furthermore, capital consumption allowances are based on the original acquisition price of an asset rather than on current acquisition cost; as average inflation rates have increased, the original acquisition price and the current acquisition cost have come to differ substantially. With perfect substitutability among durable goods of different ages, market equilibrium implies the existence of a vintage price function for each durable good. This function gives the price of acquisition as a function of age and the price of a new durable good of the same type, expressed as a function of time. Vintage price functions for each category of assets can be estimated from annual observations on used asset prices. Under the assumption that the pattern of decline in efficiency of a durable good is geometric, the prices for acquisition of

34

The economic definition of income can be attributed to Haig (1921) and Simons (1938). The implications of this definition for capital cost recovery are discussed by Samuelson (1964).

74

THE US TAX SYSTEM

capital goods of age ν{qt,ν} are proportional to the price for new capital goods. The constants of proportionality decline geometrically at the rate of decline in efficiency δ. The rate of decline can be estimated from a sample of prices for acquisition of capital goods of different vintages as an unknown parameter in an econometric model. To formulate an econometric model of the technology that characterizes the durable goods model of production, we add a stochastic component to the equation for the prices of acquisition of capital goods of different ages. We associate this component with unobservable characteristics of the durable goods. We assume that the equation for the prices for acquisition has two additive components. The first is a non-random function of the age ν of the capital good and the price for acquisition of new capital goods qt. The second is an unobservable random disturbance. We obtain an econometric model for vintage price functions by taking logarithms of the prices for acquisition {qt,ν} and adding a random disturbance term:

(3.4) where εt,ν is an unobservable random disturbance for the price for acquisition of a capital good of age ν at time t. We assume that the disturbance has expected value equal to zero for all observations, that the variance, say σ2, is constant, and that disturbances corresponding to distinct observations are uncorrelated:

(3.5) Under these assumptions, the rate of decline in efficiency of a durable good δ and the rate of inflation in the prices for acquisition of new durable goods γ can be estimated by linear regression methods. The econometric model for vintage price functions can be generalized in several ways. First, the age of the durable good ν and the time period t can enter nonlinearly into the vintage price function. Hall (1971) has proposed an analysis of variance model

THE US TAX SYSTEM

75

for vintage price function. In this model each age can be represented by a dummy variable that is equal to one for the price for acquisition of a durable good of that age and zero otherwise. Similarly, each time period can be represented by a dummy variable equal to one for that time period and zero otherwise. The analysis of variance model for vintage price functions can be written

(3.6) where Dν is a vector of dummy variables for age ν and Dt is a vector of dummy variables for time t; βν and βt are the corresponding vectors of parameters. In the estimation of this model, dummy variables for one vintage and one time period can be dropped in order to obtain a matrix of observations on the independent variables of full rank. An alternative approach to nonlinearity in an econometric model for vintage price functions has been proposed by Hulten and Wykoff (1981b). They transform the prices of acquisition {qt,ν}, age ν, and time t by means of the Box–Cox transformation, obtaining

(3.7) where the parameters θq,θν, and θt can be estimated by nonlinear regression methods from the nonlinear model for vintage price functions:

(3.8) The econometric model of vintage price functions (3.4), giving the logarithm of prices for acquisition as a linear function of age ν and time period t, is a limiting case of the model (3.8) with parameter values

(3.9) Hulten and Wykoff (1981b) implement the model (3.8) for eight categories of assets in the USA: tractors, construction machinery, metalworking machinery, general industrial equipment, trucks, autos, industrial buildings, and commercial buildings. In 1977 these categories included 55 per cent of investment expenditures on producers' durable equipment and 42 per cent of expenditures on non-residential structures.

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THE US TAX SYSTEM

In the estimation of econometric models based on vintage price functions, the sample of used asset prices is ‘censored’ by the retirement of assets from service. The price of acquisition for assets that have been retired from service is equal to zero. If only surviving assets are included in a sample of used asset prices, the sample is censored by excluding assets that have been retired. In order to correct the resulting bias in estimates of vintage price functions, Hulten and Wykoff (1981b) multiply the prices of surviving assets of each vintage by the probability of survival, expressed as a function of age. Finally, the rate of economic depreciation for each class of assets is tabulated as a function of the age of the asset. The natural logarithm of the price is regressed on age and time to obtain an average rate of depreciation, which Hulten and Wykoff refer to as the best geometric average rate (BGA). Hulten and Wykoff (1981b, p. 387) conclude that ‘ . . . a constant rate of depreciation can serve as a reasonable statistical approximation to the underlying Box–Cox rates even though the latter are not geometric. This result, in turn, supports those who use the single parameter depreciation approach in calculating capital stocks using the perpetual inventory method’ (italics in original). In Table 3.18 we present rates of economic depreciation derived from the best geometric approximation approach of Hulten and Wykoff (1981c) for 34 categories of depreciable non-residential business assets and one category of residential assets. These rates were extended by Jorgenson and Sullivan (1981) to include public utility and residential property. Hulten and Wykoff (1981c) have compared the best geometric depreciation rates presented in Table 3.18 with depreciation rates employed by the Bureau of Economic Analysis (BEA) in perpetual inventory estimates of capital stock. The Hulten–Wykoff rate for equipment averages 0.133, while the BEA rate averages 0.141, so that the two rates are similar. The Hulten–Wykoff rate for structures is 0.037, while the BEA rate is 0.060; these rates are substantially different. Making use of a more recent asset classification scheme of the Bureau of Economic Analysis of the US Department of Commerce, we have mapped the economic depreciation rates for the 35 asset categories into the new BEA asset classification scheme, which includes 51 categories of assets. We have adjusted the

THE US TAX SYSTEM

Table 3.18 Economic Depreciation Rates: Business Assets I Asset Producer durable equipment 1. Furniture and fixtures 2. Fabricated metal products 3. Engines and turbines 4. Tractors 5. Agricultural machinery 6. Construction machinery 7. Mining and oilfield machinery 8. Metalworking machinery 9. Special industry machinery 10. General industrial equipment 11. Office, computing, and accounting machinery 12. Service industry machinery 13. Electrical machinery 14. Trucks, buses, and truck trailers 15. Autos 16. Aircraft 17. Ships and boats 18. Railroad equipment 19. Instruments 20. Other equipment Non-residential structures 21. Industrial buildings 22. Commercial buildings 23. Religious buildings 24. Educational buildings 25. Hospital and institutional buildings 26. Other non-farm buildings 27. Railroad structures 28. Telephone and telegraph structures 29. Electric light and power structures 30. Gas structures 31. Other public utility structures 32. Farm structures 33. Mining exploration, shaft, and wells 34. Other non-building structures Residential structures 35. Residential structures Source: Jorgenson and Sullivan (1981), Table 2, p. 181

Depreciation Rate 0.1100 0.0917 0.0786 0.1633 0.0971 0.1722 0.1650 0.1225 0.1031 0.1225 0.2729 0.1650 0.1179 0.2537 0.3333 0.1833 0.0750 0.0660 0.1500 0.1500 0.0361 0.0247 0.0188 0.0188 0.0233 0.0454 0.0176 0.0333 0.0300 0.0300 0.0450 0.0237 0.0563 0.0290 0.0130

77

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THE US TAX SYSTEM

depreciation rates to incorporate the most recent revision of asset lives by the BEA.35 We begin by classifying the 50 non-residential asset classes in the BEA scheme into three groups. The first includes the asset classes for which Hulten and Wykoff estimated economic depreciation rates directly from data on the acquisition prices of used capital goods. This group includes asset classes 6–7, 9, 11, 13, 20, 21, 28, and 29–32 in Table 3.18. The second group includes asset classes for which Hulten and Wykoff did not have sufficient price data to estimate depreciation rates but had information useful in choosing appropriate rates of depreciation. Asset classes 14, 22, 25–6, 27, 35, 36, 37–8, 43, and 44 belong to the second group. The third group includes asset classes for which little or no reliable information was available. Hulten and Wykoff assumed rates of depreciation equal to 1.65 times declining balance rates based on BEA asset lifetimes for equipment and 0.90 times these rates for structures. These ratios are based on averages for assets in the first two groups. Asset classes 1–5, 8, 10, 12, 15–19, 23–4, 33, 34, 39–42, and 45–9 belong to the third group. We did not adjust rates of economic depreciation for assets in the first and second groups for the recent revision of asset lifetimes by BEA, except where an asset class under the old classification scheme is broken into two or more classes under the new classification scheme and the new asset lifetimes are different from the old lifetimes. For these classes of assets we first compute the declining balance rates based on the unrevised BEA asset lifetimes. The lifetimes are usually taken to be 85 per cent of the Bulletin F lifetimes. We then multiply these rates by ratios of unrevised to revised lifetimes to obtain adjusted rates of economic depreciation. We have made adjustments for asset classes 6 and 7, 29–32, 37–8, 39, and 49 in Table 3.19. For assets in the third group, we maintain the assumptions made by Hulten and Wykoff that the economic depreciation rate is 1.65 times the corresponding BEA declining balance rate for equipment and 0.90 times this rate for structures. We have adjusted the depreciation rates to incorporate the revised asset lifetimes. Finally, we assign the depreciation rate of 0.0247 to

35

For the revision of the asset lives, see Gorman et al. (1985) and Musgrave (1986).

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THE US TAX SYSTEM

Table 3.19 Economic Depreciation Rates: Business Assets II Assets

Old lifetime

1. Household furniture and fixtures 2. Other furniture 3. Fabricated metal products 4. Steam engines and turbines 5. Internal combustion engines 6. Farm tractors 7. Construction tractors 8. Agricultural machinery 9. Construction machinery 10. Mining and oilfield machinery 11. Metalworking machinery 12. Special industry machinery 13. General industrial 14. Office, computing 15. Service industry machinery 16. Communication equipment 17. Electrical transmission 18. Household appliances 19. Other electrical equipment 20. Trucks, buses, and truck trailers 21. Autos 22. Aircraft 23. Ships and boats 24. Railroad equipment 25. Scientific and engineering instruments 26. Photocopy and related equipment 27. Other non-residential equipment 28. Industrial buildings 29. Mobile offices 30. Office buildings 31. Commercial warehouses 32. Other commercial buildings 33. Religious buildings 34. Educational buildings 35. Hospital and institutional buildings 36. Hotels and motels 37. Amusement and recreational 38. Other non-farm buildings 39. Railroad structures 40. Telephone and telegraph structures 41. Electric light and power structures 42. Gas structures 43. Local transit 44. Petroleum pipelines 45. Farm structures 46. Petroleum and natural gas 47. Other mining exploration 48. Other non-residential structures 49. Railroad replacement track 50. Nuclear fuel 51. Residential structures

15 15 18 21 21 8 8 17 9 10 16 16 14 8 10 14 14 14 14 9 10 16 22 25 11 11 11 27 36 36 36 36 48 48 48 40 31 31 51 27 30 30 26 26 38 16 16 31 51 — —

Old depreciation rate 0.1100 0.1100 0.0917 0.0786 0.0786 0.1633 0.1633 0.0971 0.1722 0.1650 0.1225 0.1031 0.1225 0.2729 0.1650 0.1179 0.1179 0.1179 0.1179 0.2537 0.3333 0.1833 0.0750 0.0660 0.1473 0.1473 0.1473 0.0361 0.0247 0.0247 0.0247 0.0247 0.0188 0.0188 0.0233 0.0247 0.0454 0.0454 0.0176 0.0333 0.0300 0.0300 0.0450 0.0450 0.0237 0.0563 0.0563 0.0290 0.0176 — 0.0130

New lifetime 12 14 18 32 8 9 8 14 10 11 16 16 16 8 10 15 33 10 9 9 10 16 27 30 12 9 11 31 16 36 40 34 48 48 48 32 30 38 54 40 40 40 38 40 38 16 16 40 38 6 —

New depreciation rate 0.1375 0.1179 0.0917 0.0516 0.2063 0.1452 0.1633 0.1179 0.1722 0.1500 0.1225 0.1031 0.1225 0.2729 0.1650 0.1100 0.0500 0.1651 0.1834 0.2537 0.3333 0.1833 0.0611 0.0550 0.1350 0.1800 0.1473 0.0361 0.0556 0.0247 0.0222 0.0262 0.0188 0.0188 0.0233 0.0247 0.0469 0.0370 0.0166 0.0225 0.0225 0.0225 0.0450 0.0450 0.0237 0.0563 0.0563 0.0225 0.0236 0.2500 0.0130

Source: Hulten and Wykoff (1981c) and Jorgenson and Sullivan (1981), adjusted for the reclassification of assets and the revision of the asset lives

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Table 3.20 Economic Depreciation Rates: Consumer Durables Asset 1. Furniture, including mattresses and bedsprings 2. Kitchen and other household appliances 3. China, glassware, tableware and utensils 4. Other durable house furnishings 5. Radio and television receivers, records, and musical instruments 6. Jewelry and watches 7. Ophthalmic products and orthopaedic appliances 8. Books and maps 9. Wheel goods, durable toys, sports equipment, boats and pleasure aircraft 10. Other motor vehicles 11. Autos Source: Jorgenson and Stubbs (1986)

Depreciation rate 0.1268 0.1570 0.1943 0.1786 0.1749 0.1540 0.3027 0.1855 0.1649 0.1996 0.2550

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asset class 36, hotels and motels, which is the same as the depreciation rate of the asset class 30, office buildings. We assign the depreciation rate of 0.25 to asset class 50, nuclear fuel. The results are summarized in Table 3.19 along with pre- and post-revision lifetimes and depreciation rates. Economic depreciation rates for consumer durables estimated by Jorgenson and Stubbs (1986) are presented in Table 3.20. We have now completed the presentation of economic depreciation rates. We next consider capital consumption allowances for tax purposes under US tax law. Since the Internal Revenue Service introduced Bulletin F lifetimes in 1942, tax policy on capital cost recovery has undergone a number of substantial changes. The first significant change was the adoption of double declining balance and the sum-of-the-years digits methods for cost recovery in 1954 as alternatives to the traditional straight-line method for new investments. In 1962 the Internal Revenue Service introduced Guideline lifetimes for machinery and equipment, which were 30–40 per cent shorter than the Bulletin F lifetimes. The Revenue Act of 1971 introduced the Asset Depreciation Range (ADR) system, which permitted taxpayers to use lifetimes 20 per cent above or below the Guideline lifetimes. The Economic Recovery Tax Act (ERTA) of 1981 introduced the Accelerated Cost Recovery System (ACRS), further liberalizing tax deductions for capital cost recovery. ACRS distinguished real property and four classes of personal property. This system provided three cost recovery schedules for each of the personal property classes. The slowest cost recovery schedule, applied to investment in personal property made in 1981–4, consisted of capital consumption allowances approximating the 150 per cent declining balance method for the early recovery years and the straight-line method for later years. Under ACRS, the cost of investment made in 1985 was to be recovered according to a schedule that approximated the 175 per cent declining balance method for the early years and the sum-of-the-years digits method for later years. The most accelerated cost recovery schedule was to be applied to investment made after 1985. This schedule approximated 200 per cent of the declining balance method for the early years and the sum-of-the-years digits method for the later years. For real property

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THE US TAX SYSTEM

ACRS provided a schedule that approximated the 175 per cent declining balance method for the early years and the straight-line method for the later years. The prospect of an unacceptably large federal budget deficit resulted in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). This Act repealed the provisions of ERTA for phasing in a more accelerated cost recovery system for personal property placed in service in 1985 and after. The tax life of real property was increased from 15 to 18 years in 1984 and then to 19 years in 1985. The Tax Reform Act of 1986 modified ACRS by further lengthening the capital cost recovery periods. Under the 1986 Act the double declining balance method is allowed for most equipment, other than public utility property, and real property is recovered by the straight-line method over a period of 27.5 or 31.5 years. Jorgenson and Sullivan (1981) conducted a detailed simulation study of the tax provisions for capital cost recovery to 1980. This study reproduced the capital consumption allowances actually claimed by corporate taxpayers over the period 1946–80 on the basis of assumptions about formulas actually used for capital cost recovery, tax lifetimes, and salvage values for the 35 types of assets listed in Table 3.18. The study also estimated effective rates of the investment tax credit for these same types of assets for the period 1962–80. For the period 1947–80, we begin with estimates of capital cost recovery schedules and salvage values by Jorgenson and Sullivan. We have mapped these into our 51 asset classification system in the same way as estimates of economic depreciation rates by Hulten and Wykoff. We assign the schedule for capital consumption allowances for office buildings to hotels and motels. Similarly, we assume that schedules for assets in the classes of railroad replacement track (class 49) and nuclear fuel (class 50) are the same as those for railroad structures (class 39) and aircraft (class 22), respectively. For 1981–6 we use the capital cost recovery rules provided by the ERTA of 1981, the TEFRA of 1982, and the 1984 and 1985 Tax Acts. We summarize tax provisions for capital cost recovery in terms of the present value of tax deductions for capital consumption allowances and investment tax credit. In computing the present value of capital consumption allowances, we use the interest rate on corporate bonds of the Baa class after corporate

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taxes. Table 3.21 presents the present value of capital consumption allowances for selected years. This completes our discussion of capital consumption allowances for tax purposes under US tax law. We now turn our attention to investment tax credit, which can also be regarded as a form of capital cost recovery. Investment tax credit was first introduced in 1962. This credit was allowed for equipment and special-purpose structures such as research facilities and certain storage facilities. Under the Long amendment of 1962, which was repealed in 1964, the value of investment expenditures for calculating capital consumption allowances was reduced by the amount of the investment tax credit. The investment tax credit was suspended briefly for a period of five months from October 1966 to March 1967. It was eliminated in April 1969 and reinstated by the Revenue Act of 1971. The Tax Revenue Act of 1975 temporarily increased the regular credit from 7 to 10 per cent and the credit for eligible public utility property from 4 to 10 per cent. The temporary credit was to expire at the end of 1980, but the Revenue Act of 1978 made the 10 per cent credit permanent. The Economic Recovery Tax Act of 1981 increased the rates of the investment tax credit. Previously, the 10 per cent regular credit was allowed for assets with a useful lifetime of seven years or more, two-thirds for assets with a useful lifetime of five or six years, and one-third for assets with a useful lifetime of three or four years. ERTA made the 10 per cent credit available for personal property with five-year, ten-year, and fifteen-year tax lifetimes and other tangible assets such as elevators. It also increased the credit for property with a three-year tax lifetime to 60 per cent of the regular credit. The Tax Reform Act of 1986 repealed the investment tax credit for assets acquired after 31 December 1985. Fullerton, Gillette, and Mackie (1987) have estimated effective rates of the investment tax credit for the 51 classes of depreciable assets prior to the 1986 Tax Act. For 1962–80 we match the asset classes under the 35-asset classification scheme with those under the 51-asset classification scheme along the lines outlined above. We then assign appropriate rates of the investment tax credit to each class. We also make some specific adjustments to reflect changes in the composition in certain classes of assets in the more detailed classification scheme used by Fullerton et al.

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Table 3.21 Present Value of Capital Consumption Allowances (z) Asset 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51

1950 0.8157 0.8157 0.7952 0.7754 0.7754 0.8666 0.8666 0.8021 0.8592 0.8516 0.8089 0.8089 0.8229 0.8666 0.8516 0.8229 0.8229 0.8229 0.8229 0.8592 0.8516 0.8592 0.7691 0.7499 0.8444 0.8444 0.8444 0.7850 0.7295 0.7295 0.7295 0.7295 0.6639 0.6639 0.6639 0.7295 0.7595 0.7595 0.6489 0.7850 0.7656 0.7656 0.7913 0.7913 0.7179 0.8607 0.8607 0.7595 0.6489 0.9144 0.7414

1960 0.8201 0.8201 0.7994 0.7779 0.7779 0.8747 0.8747 0.8057 0.8676 0.8589 0.8136 0.8136 0.8283 0.8747 0.8589 0.8283 0.8283 0.8283 0.8283 0.8676 0.8589 0.8676 0.7705 0.7516 0.8503 0.8503 0.8503 0.7718 0.7138 0.7138 0.7138 0.7138 0.6459 0.6459 0.6459 0.7138 0.7439 0.7439 0.6302 0.7718 0.7511 0.7511 0.7776 0.7776 0.7020 0.8526 0.8526 0.7439 0.6302 0.9111 0.7259

1970 0.8074 0.8074 0.7754 0.7408 0.7408 0.9104 0.9104 0.8040 0.8164 0.8221 0.7754 0.7787 0.7894 0.8221 0.8164 0.7832 0.7832 0.7832 0.7832 0.8758 0.9090 0.8705 0.7109 0.7357 0.8074 0.8074 0.8164 0.6152 0.4808 0.4808 0.4808 0.4808 0.4656 0.4656 0.4656 0.4808 0.5921 0.5921 0.5725 0.6272 0.6237 0.6488 0.6734 0.6734 0.6272 0.8543 0.8543 0.5841 0.5725 0.8753 0.5937

1980 0.7915 0.7915 0.7507 0.7049 0.7049 0.8814 0.8814 0.7915 0.7931 0.8012 0.7461 0.7461 0.7537 0.7915 0.7866 0.7522 0.7522 0.7522 0.7522 0.8794 0.9278 0.8573 0.6685 0.7131 0.7818 0.7818 0.7882 0.5155 0.3731 0.3731 0.3731 0.3731 0.3688 0.3688 0.3688 0.3731 0.4931 0.4931 0.5051 0.5355 0.5355 0.5689 0.5937 0.5937 0.5579 0.8389 0.8389 0.5203 0.5051 0.8389 0.5033

1986 0.9023 0.9023 0.9023 0.8160 0.8160 0.9023 0.9023 0.9023 0.9023 0.9023 0.9023 0.9023 0.9023 0.9023 0.9023 0.9464 0.9464 0.9023 0.9023 0.9023 0.9464 0.9023 0.9023 0.9023 0.9464 0.9023 0.9023 0.6998 0.6998 0.6998 0.6998 0.8160 0.6998 0.6998 0.6998 0.6998 0.8160 0.6998 0.9023 0.8160 0.7383 0.8160 0.9023 0.9023 0.6998 0.9023 0.9023 0.6998 0.9023 0.9023 0.6998

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Table 3.22 Investment Tax Credit Rates (k) Asset 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51

1962 0.063 0.063 0.057 0.044 0.044 0.021 0.021 0.064 0.064 0.064 0.064 0.064 0.062 0.063 0.063 0.058 0.058 0.058 0.058 0.032 0.021 0.042 0.064 0.064 0.063 0.063 0.064 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

1969 0.018 0.018 0.016 0.010 0.010 0.006 0.006 0.019 0.018 0.019 0.019 0.019 0.017 0.018 0.017 0.015 0.015 0.015 0.015 0.008 0.006 0.012 0.019 0.019 0.017 0.017 0.019 0.003 0.000 0.000 0.000 0.008 0.000 0.000 0.000 0.000 0.012 0.000 0.005 0.004 0.005 0.003 0.005 0.005 0.000 0.008 0.008 0.000 0.012 0.012 0.000

1975 0.083 0.083 0.083 0.083 0.083 0.055 0.055 0.083 0.083 0.083 0.083 0.083 0.083 0.083 0.083 0.083 0.083 0.083 0.083 0.041 0.028 0.075 0.083 0.083 0.083 0.083 0.083 0.021 0.000 0.000 0.000 0.055 0.000 0.000 0.000 0.000 0.083 0.000 0.083 0.063 0.083 0.047 0.083 0.083 0.000 0.055 0.055 0.000 0.083 0.083 0.000

1980 0.092 0.092 0.092 0.092 0.092 0.061 0.061 0.092 0.092 0.092 0.092 0.092 0.092 0.092 0.092 0.092 0.092 0.092 0.092 0.046 0.031 0.083 0.092 0.092 0.092 0.092 0.092 0.023 0.000 0.000 0.000 0.062 0.000 0.000 0.000 0.000 0.092 0.000 0.092 0.070 0.092 0.052 0.092 0.092 0.000 0.061 0.061 0.000 0.092 0.092 0.000

1985 0.100 0.100 0.100 0.100 0.100 0.100 0.100 0.100 0.100 0.100 0.091 0.098 0.098 0.100 0.100 0.100 0.099 0.100 0.100 0.071 0.060 0.100 0.100 0.100 0.100 0.100 0.100 0.025 0.000 0.000 0.000 0.067 0.000 0.000 0.000 0.000 0.100 0.000 0.100 0.076 0.100 0.057 0.100 0.100 0.000 0.100 0.100 0.000 0.100 0.100 0.001

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We assign 25, 67, and 100 per cent of the investment tax credit given to the class of ‘other non-building structures’ to the assets in classes 28, 32, and 37. Similarly, we assign 76 and 57 per cent, respectively, of the credit given to the class of railroad structures to the assets in the classes 40 and 42. Assets in the classes 35 (farm structures) and 48 (other non-residential structures) are not eligible for the investment tax credit. For the years 1981–5 we assume that taxpayers claim the full amount of investment tax credit on all eligible investments. We use rates estimated by Fullerton et al. The investment tax credit rates in 1986 are set equal to zero to reflect the repeal of the regular credit by the Tax Reform Act of 1986. Table 3.22 gives the rates of the investment tax credit for the 51 depreciable assets for selected years.

3.4. Financial Structure We next consider the impact of the financial policy of firms and households on the cost of capital. The most important features of the financial structure are the ratios of debt to the value of capital stock for firms and households and the dividend pay-out ratio for corporations. We begin by describing the estimation of capital stock in households and noncorporate and corporate

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businesses. We describe the construction of estimates for depreciable and non-depreciable assets separately. For depreciable assets we employ investment data from the Bureau of Economic Analysis, which include investment expenditures in current and constant prices for 50 categories of non-residential business assets and 22 categories of residential assets in the corporate, non-corporate, and household sectors. These data also include investment expenditures for 11 categories of consumer durables in the household sector. We first aggregate the 22 categories of residential assets into a single category. At this level of aggregation we construct price indexes for investment expenditures for 62 categories of assets by dividing the current dollar values of investment by the corresponding constant dollar values. The 62 categories of assets include 50 categories of non-residential business assets, 1 category of residential assets, and 11 categories of consumer durables. We assume that existing capital goods and new capital goods are perfect substitutes in production, as in the model of capital as a factor of production presented in Chapter 1. The rates of substitution can be determined from the relative efficiencies of capital goods of different ages. In measuring capital stock for each category of assets, we utilize the rates of economic depreciation in Tables 3.19 and 3.20 as rates of replacement. Rates of depreciation and replacement are identical under the assumption that relative efficiencies of capital goods decline geometrically with age of the asset. The current value of capital stock is the product of capital stock and the corresponding acquisition price of investment goods. Non-depreciable assets include farm inventories, non-farm inventories, and land. Our data on inventories are taken from the Bureau of Economic Analysis. Inventories are divided among three categories—farm, non-farm corporate, and non-farm non-corporate inventories. We allocate farm inventories to the non-corporate sector. We construct price and quantity indexes for land in the corporate, non-corporate, and household sectors by combining the current values of land in these sectors with sales and purchase values of land by federal and state and local governments.36

36

Data for current values of land are from Board of Governors of the Federal Reserve System (1987). Data for sales and purchases of land are from Survey of Current Business, July 1987, Table 3.17B and Table 3.18, and various monthly issues of the Survey of Current Business.

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We define the dividend pay-out ratio of the corporate sector as the ratio of dividend payments to income from corporate equity.37 Income from corporate equity is defined as total remuneration of corporate capital inputs, less economic depreciation, less real interest expenses, less federal and state and local income taxes, and less property taxes. Table 3.23 shows dividends paid, income from corporate equity, and the dividend pay-out ratio. We describe the capital structures of the household, non-corporate, and corporate sectors in terms of ratios of the value of outstanding debt to the value of capital stock. To estimate debt–capital ratios for the non-corporate and corporate sectors, we first convert the book values of financial assets and liabilities to market values by applying market-to-par indexes for longterm debt instruments estimated by Strong (1989). We then allocate net liabilities—total liabilities less total financial assets—of farm businesses between corporate and non-corporate sectors in proportion to the stocks of depreciable assets in these sectors. Assuming that debt claims on assets are equal to net financial liabilities, we calculate debt–capital ratios for the corporate and non-corporate sectors by dividing the market value of the net financial liabilities by the value of tangible assets. The value of depreciable assets for these sectors is net of the investment tax credit and the present value of tax deductions for capital consumption. Although income from equity in household assets is not taxed, interest payments corresponding to financial liabilities of the household sector are deductible from revenue in defining taxable income at the individual level. However, not all of the outstanding household liabilities are associated with the financing of household assets. We consider mortgages, and installment credit from commercial banks, savings and loan associations, mutual savings banks, credit unions, and finance companies as household liabilities associated with the acquisition of household assets. We define the capital structure of the household sector as the ratio of these liabilities to the value of household assets. Estimates

37

Dividend data are from Bureau of Economic Analysis (1986) and various monthly issues of the Survey of Current Business.

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THE US TAX SYSTEM

Table 3.23 After-tax Corporate Profits and Dividend Payments Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984

Dividends 5.560 6.302 7.015 7.210 8.803 8.520 8.493 8.795 9.149 10.311 11.085 11.514 11.304 12.171 12.890 13.347 14.410 15.504 17.325 19.120 19.439 20.157 22.029 22.529 22.450 22.907 24.436 27.042 29.748 29.600 34.640 39.482 44.743 50.099 54.747 63.573 66.879 71.525 79.018

After-tax profits 10.353 13.952 18.585 17.033 16.890 17.861 17.238 17.090 18.312 25.079 25.037 24.003 19.939 26.684 27.016 26.814 34.579 36.084 42.594 51.454 56.119 55.071 53.564 52.791 46.515 56.245 67.633 70.437 70.254 87.471 93.239 119.604 137.078 135.504 124.097 153.110 126.284 164.465 203.964

Payout-ratio (α) 0.5370 0.4517 0.3775 0.4233 0.5212 0.4770 0.4927 0.5146 0.4996 0.4111 0.4427 0.4797 0.5669 0.4561 0.4771 0.4978 0.4167 0.4297 0.4067 0.3716 0.3464 0.3660 0.4113 0.4268 0.4826 0.4073 0.3613 0.3839 0.4234 0.3384 0.3715 0.3301 0.3264 0.3697 0.4412 0.4152 0.5296 0.4349 0.3874

1985 1986

81.346 86.802

205.692 206.224

0.3955 0.4209

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Table 3.24 Debt-asset Ratios Year 1946 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Corporate βq 0.0735 0.0742 0.0807 0.0643 0.0916 0.1005 0.1017 0.1005 0.1006 0.1049 0.0975 0.0949 0.0926 0.0848 0.0994 0.1070 0.1192 0.1297 0.1337 0.1437 0.1473 0.1526 0.1630 0.1447 0.1535 0.1683 0.1658 0.1589 0.1264 0.1128 0.1348 0.1394 0.1380 0.1202 0.1019 0.1120 0.1438 0.1419 0.1753 0.2180 0.2307

Non-corporate βm 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0058 0.0149 0.0143 0.0150 0.0193 0.0278 0.0347 0.0413 0.0502 0.0606 0.0686 0.0812 0.0853 0.0988 0.0981 0.1077 0.1114 0.1332 0.1514 0.1587 0.1503 0.1481 0.1636 0.1712 0.1726 0.1680 0.1499 0.1323 0.1366 0.1655 0.1725 0.1983 0.2144

Household βh 0.1436 0.1435 0.1449 0.1578 0.1725 0.1665 0.1793 0.1947 0.2055 0.2202 0.2205 0.2170 0.2317 0.2384 0.2458 0.2626 0.2803 0.2980 0.3072 0.3210 0.3093 0.3129 0.2885 0.2775 0.2626 0.2722 0.2770 0.2728 0.2494 0.2383 0.2561 0.2709 0.2727 0.2750 0.2553 0.2194 0.2293 0.2545 0.2640 0.3013 0.3109

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of the debt–capital ratios for household, non-corporate, and corporate sectors are given in Table 3.24.

3.5 Tax Reform In describing the key features of the 1986 tax reform, we find it useful to begin with a description of the pre-existing tax law in order to provide a basis for comparison. The main provisions of the 1986 Tax Act went into effect on 1 January 1987. However, the investment tax credit was repealed for assets acquired after 31 December 1985. We refer to the pre-existing tax law as the Tax Law of 1985, since it remained in force until the end of calendar 1985. To provide additional perspective on the objectives of the 1986 tax reform, we also characterize two alternative tax reform proposals presented by the Department of the Treasury and the President. The Treasury Department presented a tax reform plan in November 1984 that became known as the Treasury proposal. A principal objective of the Treasury plan was to reduce statutory tax rates at both individual and corporate levels. However, the Treasury plan was intended to be ‘revenue-neutral’, that is, to produce the same revenue as the existing tax system.38 Lower statutory tax rates were to be offset by eliminating a wide range of tax preferences, greatly broadening the tax base. In addition, the plan had the objective of introducing greater neutrality in the tax treatment of different types of assets. The Treasury proposed to offset the decreased progressivity of the rate structure by curtailing tax preferences heavily used by high income taxpayers. The tax burden for low income earners was to be reduced through increased personal exemptions and zero bracket amounts for household heads. The Treasury tax reform plan resulted in a great public outcry, especially among taxpayers whose tax liabilities would have been adversely affected by the elimination of tax preferences. However, the rate reductions in the proposal attracted widespread approval and considerable public support. The Reagan administration did not endorse the Treasury plan, but set the

38

See US Department of the Treasury (1984). The Treasury plan and its relationship to the Tax Reform Act of 1986 are discussed in detail by McLure and Zodrow (1987).

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Treasury staff to work on a revised proposal, duly delivered in May 1985.39 The second Treasury tax reform plan was endorsed by the administration and became known as the President's proposal. The lengthy debate over tax reform was brought to a conclusion on 22 October 1986 by enactment of the Tax Reform Act of 1986.40 The main provisions of the new tax law took effect on 1 January 1987. The 1986 Tax Act preserved many features of the Treasury and President's proposals. The final legislation resulted in sharply lower tax rates for both individuals and corporations. The highest statutory tax rate for individuals was lowered from 50 to 28 per cent.41 The corresponding rate for corporations was lowered from 46 to 34 per cent. The substantial reductions in tax rates were offset by sharp cutbacks in tax preferences for both individuals and corporations.

3.5.1. 1985 Tax Law We summarize the statutory tax rates under the 1985 Tax Law, the Treasury and President's proposals, and the 1986 Tax Act in Table 3.25. The first column in the table gives average marginal tax rates for different types of income under the 1985 Tax Law for 0, 6, and 10 per cent annual inflation rates. The tax rate on each type of income is a weighted average of marginal tax rates paid by taxpayers in all income tax brackets. Average tax rates on different types of income reflect differences in the distribution of each type of income over the tax brackets. This table presents average marginal tax rates for income in the form of dividends and other distributions on corporate and non-corporate equity, capital gains accruing on corporate and non-corporate equity, and interest on corporate, non-corporate,

39

See US Department of the Treasury (1985). The provisions of the Treasury proposal, the President's proposal, and the 1985 Tax Law are compared in Chart 18, pp. 26–30.

40

The Tax Reform Act of 1986 is described by the Joint Committee on Taxation (1986). The economic impact of the 1986 tax reform is discussed in detail by Musgrave (1987) and Pechman (1987c) in the symposium edited by Aaron (1987).

41

Owing to the phase-out of the 15 per cent tax bracket and the personal and dependents' exemptions for high income taxpayers, the top marginal rate is as high as 33 per cent for certain ranges of taxable income. Statutory tax rates under the 1986 Tax Act were higher for the transitional year 1987.

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household, and government debt.42 We also give the average marginal tax rate on labour income, the average marginal tax rate on income under the corporate income tax, and the average tax rate under the individual income tax. All tax rates include taxes levied at both federal and state and local levels and take into account the deductibility of state and local taxes at the federal level. We summarize the definition of income for tax purposes under the 1985 Tax Law in Table 3.26. The first section describes the provisions for indexing the tax base for inflation. The 1985 Tax Law included no provisions of this type. The second section of the table describes provisions for deductibility of capital income. Dividends paid were not deductible from corporate income for tax purposes under the 1985 Tax Law. However, 85 per cent of corporate dividends received were excluded from corporate income. The inside build-up of life insurance companies was not taxed under the 1985 Tax Law. Household interest expenses were fully deductible from income at the personal level. Only 40 per cent of capital gains were included in income for tax purposes. Finally, all state and local taxes were deductible from income for tax purposes, as indicated in the third section of the table. In Table 3.27 we present economic depreciation rates for each of 51 classes of assets distinguished in the US national income and product accounts. We also give statutory rates of the investment tax credit and tax lifetimes under 1985 Tax Law, and tax lifetimes under the Treasury and President's proposals, and the Tax Reform Act of 1986.43 In Part (a) of Table 3.28 we present average rates of the investment tax credit and present values of capital consumption allowances for short-lived and long-lived business assets under the 1985 Tax Law. Short-lived assets include all types of producers' durable equipment employed in the business sector. Long-lived assets include residential and nonresidential structures, land, and inventories.

42

These tax rates are based on detailed simulations of the Office of Tax Analysis Individual Income Tax Model presented by Cilke and Wyscarver (1987).

43

The statutory rates of the investment tax credit and the tax lifetimes are based on the estimates of Fullerton, Gillette, and Mackie (1987).

94

THE US TAX SYSTEM

Table 3.25 Tax Rates (a) Average Marginal Tax Rates on Household Income 1985 Tax Law

Treasury proposal

President's proposal

1986 Tax Act

0.2555

0.2261

0.2240

0.2029

0.2934

0.2427

0.2572

0.2494

0.0303

0.0596

0.0325

0.0562

0.0293

0.0607

0.0322

0.0624

0.1533

0.1452

0.1532

0.1285

0.1971

0.1805

0.1912

0.1670

0.2717

0.2252

0.2387

0.2310

0.2205

0.1868

0.1970

0.1852

0.2559

0.2261

0.2240

0.2033

0.2934

0.2427

0.2572

0.2494

0.0303

0.0596

0.0600

0.0562

0.0293

0.0607

0.0643

0.0624

0.1730

0.1452

0.1532

0.1434

0.2151

0.1805

0.1912

0.1807

0.2722

0.2252

0.2387

0.2314

0.2260

0.1868

0.1970

0.1894

0.2560

0.2261

0.2240

0.2034

0.2934

0.2427

0.2572

0.2494

0.0303

0.0596

0.0600

0.0562

0.0293

0.0607

0.0643

0.0624

0.1806

0.1452

0.1532

0.1492

0.2222

0.1805

0.1912

0.1861

0.2724

0.2252

0.2387

0.2315

0.2282

0.1868

0.1970

0.1910

Zero inflation

6% annual inflation

10% annual inflation

95

THE US TAX SYSTEM

Notes : average marginal tax rates on individual income accruing to corporate, non-corporate, and household equities, respectively : average marginal tax rates on capital gains accruing to corporate, non-corporate, and household equities, respectively : average marginal tax rates on interest income accruing on corporate, non-corporate, household, and government debt, respectively and

(b) Average Marginal Tax Rates on Labour Income, Corporate Income, and Average Individual Tax Rates 1985 Tax Law

Treasury proposal

President's proposal

1986 Tax Act

0.2967

0.2512

0.2536

0.2517

tq

0.5084

0.4006

0.4006

0.3847

ta

0.1315

0.1203

0.1223

0.1233

Notes : average marginal tax rate of labour income tq: corporate income tax rate (federal, state, and local) ta: average tax rate on individual income. The Treasury proposal, the President's proposal, and the Tax Reform Act of 1986 reduce ta by 8.5, 7.0, and 6.2%, respectively

(c) Tax Rates Held Constant Across the Alternative Tax Policies tC=0.0579 tt=0.0229 tw=0.0006

tl=0.0579

Notes : property tax rates of corporate, non-corporate, and household assets, respectively tC, tI: sales tax rates of consumption and investment goods tt: rate of personal non-taxes tw: effective rate of wealth taxation

96

THE US TAX SYSTEM

3.5.2 Treasury Proposal Under the 1985 Tax Law the rate structure for the individual income tax consisted of 14 separate tax brackets with statutory tax rates ranging from 11 to 50 per cent of taxable income. Corporate income was taxed under a graduated rate structure with a top rate of 46 per cent. The Treasury plan proposed to replace the 14 individual income tax brackets with three broader brackets. Individual income was to be taxed at statutory rates of 15, 25, and 35 per cent. The reduction of statutory income tax rates was expected to lower the average marginal tax rate of individuals by 20 per cent and the average individual tax rate by 8.5 per cent. Table 3.25 shows the effects of the Treasury plan on average marginal tax rates. Under the central assumption of 6 per cent inflation, the average marginal tax rate on income from equity would have been reduced by 11.6 per cent—from 25.59 to 22.61 per cent—and the corresponding average marginal tax rate on interest from corporate bonds would have been reduced by 16.1 per cent—from 17.30 to 14.52 per cent. Finally, the average marginal tax rate on labour income would have been reduced by 15.3 per cent—from 29.67 to 25.12 per cent. These reductions in average marginal tax rates would have been offset by broadening the definition of taxable income at both individual and corporate levels in order to achieve revenue neutrality. Under the Treasury proposal the tax base would have been broadened by wholesale elimination of tax preferences for individuals and corporations. For example, the deduction for state and local income taxes would have been repealed and other state and local taxes would have been deductible only to the extent that they were incurred in incomegenerating activity, as indicated in Table 3.26. Property taxes on owner-occupied residential real estate would not have been deductible. Other proposed changes included the taxation of unemployment compensation, curtailment of the tax deductions for mortgage and other personal interest expenses, elimination of accelerated capital cost recovery, abolition of the investment tax credit, taxation of interest on private purpose municipal bonds, accrual basis taxation of earnings on life insurance policies, recovery of intangible drilling costs in the production of petroleum and natural gas

97

THE US TAX SYSTEM

Table 3.26 Indexing and Deductions from Capital Income 1985 Tax Law Indexing DC 0.0 DI 0.0 HDI 0.0 Deductions from capital income DD 0.0 ICDD 0.85 IRCR 0.0 DHI 1.0 Inclus 0.4 Deduction of state and local taxes DSLI 1.0 DSLQ 1.0 DSLM 1.0 DSLH 1.0

Treasury proposal

President's proposal 1986 Tax Act

1.0 π/(0.06+π) 0.0

0.0(1.0) 0.0 0.0

0.0 0.0 0.0

0.5 0.50 1.0 1.0 1.0

0.1 0.90 1.0 1.0 0.5(1.0)

0.0 0.80 0.0 1.0 1.0

0.0 1.0 1.0 0.0

0.0 1.0 1.0 0.0

1.0 1.0 1.0 1.0

Notes

DC: indexing of long-term capital gains; DC=1.0 for complete indexing DI: indexing of interest income and interest expenses of the corporate and non-corporate sectors; DI=1.0 for complete indexing HDI: indexing of household interest payments DD: deduction of dividends paid for corporate tax purposes ICDD: deduction of intercorporate dividends received IRCR: fraction of accrual-based taxation of life insurance company's inside build-up DHI: deduction of household interest expenses Inclus: fraction of long-term capital gains taxed as ordinary income DSLI: deduction of state and local income taxes DSLQ: deduction of state and local other taxes, corporate DSLM: deduction of state and local other taxes, non-corporate DSLH: deduction of state and local other taxes, households π: annual rate of inflation Inclus: Beginning in 1991, instead of excluding 50% of long-term capital gains taxpayers have the option of 100% inclusion and complete indexing. We assume that if inflation is higher than 6% taxpayers choose indexing.

98

THE US TAX SYSTEM

Table 3.27 Rate of Economic Depreciation (δ), Investment Tax Credit (k), and Tax Lifetimes Asset

δ

k

BEA

1985 Tax Law

Treasury proposal

President's proposal 7.0

1986 Tax Act

1. Household furniture and fixtures 2. Other furniture 3. Fabricated metal products 4. Steam engines and turbines 5. Internal combustion engines 6. Farm tractors 7. Construction tractors 8. Agricultural machinery 9. Construction machinery 10. Mining and oilfield machinery 11. Metalwork machinery 12. Special industry machinery 13. General industrial machinery 14. Office and computing machinery 15. Service industry machinery 16. Communication equipment 17. Electrical transmission 18. Household appliances 19. Other electrical equipment 20. Trucks, buses and truck trailers 21. Autos 22. Aircraft 23. Ships and boats 24. Railroad equipment 25. Instruments 26. Photocopy and related equipment 27. Other non-residential equipment 28. Industrial buildings 29. Mobile offices 30. Office buildings 31. Commercial warehouses 32. Other commercial buildings

0.138

0.10

12.0

5.0

17.0

0.118 0.092

0.10 0.10

14.0 18.0

5.0 5.0

17.0 17.0

7.0 7.0

7.0 7.0

0.052

0.10

32.0

10.0

25.0

10.0

15.0

0.206

0.10

8.0

10.0

25.0

10.0

10.0

0.145 0.163

0.10 0.10

9.0 8.0

5.0 5.0

12.0 12.0

6.0 6.0

7.0 5.0

0.118

0.10

14.0

5.0

17.0

7.0

7.0

0.172

0.10

10.0

5.0

12.0

6.0

5.0

0.150

0.10

11.0

5.0

12.0

6.0

7.0

0.123

0.09

16.0

5.0

17.0

7.0

5.0

0.103

0.10

16.0

5.0

17.0

7.0

7.0

0.123

0.10

16.0

5.0

17.0

7.0

7.0

0.273

0.10

8.0

5.0

8.0

5.0

5.0

0.165

0.10

10.0

5.0

12.0

6.0

5.0

0.110

0.10

15.0

7.0

17.0

7.0

10.0

0.050

0.10

33.0

7.0

17.0

7.0

10.0

0.165

0.10

10.0

5.0

17.0

7.0

5.0

0.183

0.10

9.0

5.0

17.0

7.0

5.0

0.254

0.07

9.0

5.0

8.0

5.0

5.0

0.333 0.183 0.061 0.055

0.06 0.10 0.10 0.10

10.0 16.0 27.0 30.0

3.0 5.0 5.0 5.0

5.0 12.0 25.0 25.0

4.0 6.0 10.0 7.0

5.0 7.0 10.0 7.0

0.135 0.180

0.10 0.10

12.0 9.0

7.0 5.0

12.0 12.0

6.0 6.0

7.0 5.0

0.147

0.10

11.0

5.0

12.0

6.0

5.0

0.036

0.03

31.0

19.0

63.0

28.0

31.5

0.056 0.025

0.00 0.00

16.0 36.0

19.0 19.0

63.0 63.0

28.0 28.0

31.5 31.5

0.022

0.00

40.0

19.0

63.0

28.0

31.5

0.026

0.07

34.0

10.0

17.0

7.0

15.0

5.0

99

THE US TAX SYSTEM 33. Religious buildings 34. Educational buildings 35. Hospital and institutional buildings 36. Hotels and motels 37. Amusement and recreational buildings 38. Other nonfarm buildings 39. Railroad structures 40. Telephone and telegraph structures 41. Electric light and power structures 42. Gas structures 43. Local transit 44. Petroleum pipelines 45. Farm structures 46. Petroleum and natural gas 47. Other mining exploration 48. Other non-residential structures 49. Railroad replacement track 50. Nuclear fuel 51. Residential structures

0.019

0.00

48.0

19.0

63.0

28.0

31.5

0.019

0.00

48.0

19.0

63.0

28.0

31.5

0.023

0.00

48.0

19.0

63.0

28.0

31.5

0.025

0.00

32.0

19.0

63.0

28.0

31.5

0.047

0.10

30.0

10.0

17.0

7.0

15.0

0.037

0.00

38.0

19.0

63.0

28.0

31.5

0.017

0.10

54.0

5.0

38.0

10.0

7.0

0.023

0.08

40.0

10.0

38.0

10.0

15.0

0.023

0.10

40.0

15.0

38.0

10.0

20.0

0.023 0.045 0.045

0.06 0.10 0.10

40.0 38.0 40.0

10.0 5.0 5.0

38.0 38.0 38.0

10.0 10.0 10.0

20.0 5.0 15.0

0.024

0.00

38.0

19.0

63.0

28.0

20.0

0.056

0.10

16.0

5.0

38.0

7.0

7.0

0.056

0.10

16.0

5.0

38.0

7.0

7.0

0.023

0.00

40.0

19.0

63.0

28.0

31.5

0.024

0.10

38.0

5.0

38.0

10.0

7.0

0.250 0.013

0.10 0.00

6.0

5.0 19.0

12.0 63.0

6.0 28.0

7.0 27.5

Notes

δ: depreciation rate k: investment tax credit rate in 1985 BEA: economic lifetime from Bureau of Economic Analysis

100

THE US TAX SYSTEM

through amortization rather than immediate expensing, and many others. The Treasury proposal included extensive provisions for indexing income and deductions from income for tax purposes for inflation. This proposal would have retained the indexing of tax brackets, personal exemptions, and zero bracket amounts from the 1981 Tax Act to prevent the upward creep of tax brackets as a consequence of inflation. In addition, the proposal would have indexed capital gains, interest expenses, interest income, FIFO inventory accounting, and capital cost recovery.44 Prior to the tax reform of 1986, 60 per cent of net capital gains were excluded from income. With the indexing of capital gains, this exclusion could no longer be justified as an adjustment for inflation and would have been eliminated. In order to provide relief from multiple taxation of dividend income, the Treasury proposal would have allowed 50 per cent of dividends to be deducted from corporate income, as defined for tax purposes. The proposal would have eliminated multiple taxation for intercorporate dividends by excluding 50 per cent of dividends received by corporations from taxable income. About 40–50 per cent of corporate profits after taxes is distributed to the shareholders in the form of dividends, so that these provisions would have significantly reduced the tax burden on corporate equity. Table 3.26 includes a summary of the key features of the Treasury proposal. Utilization of the economic concept of income as the base for income taxation requires that capital cost recovery must coincide with economic depreciation. To achieve this objective the Treasury proposal would have classified producers' durable equipment into 5-, 8-, 12-, 17-, and 25-year property and structures into two categories with tax lives of 38 and 63 years. The corresponding annual rates of depreciation were 0.32, 0.24, 0.18, 0.12, and 0.08 for producers' durables and 0.05 and 0.03 for structures, respectively. In addition, the Treasury proposal

44

Deduction of mortgage and other personal interest would not have been indexed under the Treasury proposal. Indexing of interest income and interest expenses would have been based on the assumptions that the real interest rate is constant at 6 per cent per year and that inflation raises the rate of inflation point for point. To the extent that the real interest rate deviates from 6 per cent, the indexing would have been incomplete.

THE US TAX SYSTEM

101

would have indexed capital cost recovery for inflation. Parts (a) and (b) of Table 3.28 show that capital cost recovery under the Treasury proposal would have been more favourable than under the 1986 Tax Law for both short-lived and long-lived assets at a high rate of inflation; the reverse is true at a low rate of inflation.45

3.5.3. President's Proposal The President's proposal would have followed the Treasury proposal by taxing individual income in only three tax brackets with statutory rates of 15, 25, and 35 per cent. The President's proposal would also have raised personal exemptions and zero bracket amounts in order to compensate low income taxpayers for the loss in progressivity of the tax structure. The President's proposal would have maintained the favourable treatment of long-term capital gains under the 1985 Tax Law, but would have reduced the proportion of capital gains excluded from income from 60 to 50 per cent. In addition, beginning in 1991 taxpayers would have had the option of electing to exclude 50 per cent of capital gains from income for tax purposes or to include 100 per cent of capital gains with complete indexing. Under the President's proposal the corporate tax rate would have been graduated up to a top rate of 33 per cent and corporate capital gains would have been taxed at a lower rate of 28 per cent, as under the 1985 Tax Law. Table 3.25 shows the impact of the proposal on average marginal tax rates. These changes would have lowered the average marginal tax rates at the individual level by 19 per cent and the average individual tax rate by 7 per cent. We find that average marginal tax rates under the Treasury and President's proposals are similar, except that the tax rates on interest and labour income would have been slightly higher under the President's proposal.46

45

In this calculation, we have assumed that inflation rate increases the nominal interest rate point-for-point. Thus, the after-tax real interest rate would have declined with inflation and the present value of capital consumption allowances would have increased with inflation under the Treasury proposal.

46

In Table 3.25 we assume that the taxpayers would elect to be taxed on real capital gains when inflation is zero and 50 per cent of nominal capital gains when inflation is 6 or 10 per cent.

102

THE US TAX SYSTEM

Table 3.28 Rate of Investment Tax Credit (k) and Present Value of Capital Consumption Allowances (z) π (a) 1985 Tax Law Investment tax credit 0.00 0.06 0.10 Present value of capital consumption allowances 0.00 0.06 0.10 (b) Treasury proposal Investment tax credit 0.00 0.06 0.10 Present value of capital consumption allowances 0.00 0.06 0.10 (c) President's proposal Investment tax credit 0.00 0.06 0.10 Present value of capital consumption allowances 0.00 0.06 0.10 (d) 1986 Tax Act Investment tax credit 0.00 0.06 0.10 Present value of capital consumption allowances 0.00 0.06 0.10

Corporate Short

Long

Non-corporate Short

Long

0.0945 0.0944 0.0944

0.0423 0.0426 0.0427

0.0954 0.0953 0.0953

0.0056 0.0057 0.0057

0.9223 0.8755 0.8469

0.6347 0.5569 0.5156

0.9204 0.8714 0.8416

0.5529 0.4609 0.4143

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.8926 0.9194 0.9275

0.4997 0.5479 0.5647

0.8981 0.9237 0.9313

0.3960 0.4441 0.4610

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.9471 1.0059 1.0452

0.6142 0.7320 0.8283

0.9490 1.0058 1.0437

0.4843 0.6487 0.7925

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.0000 0.0000 0.0000

0.9472 0.8714 0.8281

0.5929 0.4626 0.4058

0.9515 0.8807 0.8397

0.4861 0.3407 0.2807

Note

π: annual rate of inflation

THE US TAX SYSTEM

103

Like the Treasury proposal, the President's proposal was intended to produce the same tax revenue as the 1985 Tax Law. In order to offset the sharply lower statutory tax rates, the tax base would have been broadened by curtailing or eliminating tax preferences at both individual and corporate levels. In addition, many preferences favouring high income taxpayers would have been limited or abolished on grounds of fairness. Important changes in the list of tax preferences would have included the repeal of the investment tax credit, repeal of the deductibility of state and local income taxes, and accrual based taxation of earnings on life insurance policies, as indicated in Table 3.26. Unlike the Treasury proposal, however, the President's proposal would not have indexed interest income and expenses. When combined with the option of indexing capital gains, this feature of the proposal would have reduced the cost of capital for projects with debt financing. Another implication of the deduction of nominal interest expenses is apparent in part (c) of Table 3.28. The present value of capital consumption allowances for short-lived assets is slightly greater than unity when inflation is 6 or 10 per cent per year, since the after-tax real interest rate becomes negative above a certain inflation rate;47 the present value for

47

Under our assumption that an increase in the rate of inflation would result in a point-for-point increase in the nominal rate of interest, the after-tax real interest rate is (1 − tq )(i − π) − π, where i is the nominal interest rate, π is the rate of inflation, and tq is the corporate tax rate. The after-tax real interest rate is negative for an inflation rate above (1 − tq )i /tq .

104

THE US TAX SYSTEM

long-lived assets is smaller than unity only because this category includes land and inventories as well as depreciable assets. In order to alleviate multiple taxation of income from corporate equity, the President's proposal would have allowed a deduction of 10 per cent of dividends paid from corporate income. Double taxation of intercorporate dividends would have been eliminated by excluding 90 per cent of dividends received by corporations from taxable income. The President's proposal would have had the same effect as the Treasury proposal on the double taxation of intercorporate dividends, but would have had less impact on double taxation at corporate and individual levels. Table 3.26 includes a summary of the specific provisions of the President's proposal pertaining to taxation of income from capital. The President's proposal would have replaced the Accelerated Cost Recovery System (ACRS) of the 1981 Tax Law with a new Capital Cost Recovery System (CCRS). An important difference from the Treasury proposal is that CCRS would have permitted accelerated capital cost recovery in order to provide systematic incentives for investment that are neutral across asset classes. Producers' durable equipment would have been classified into four-, five-, six-, seven-, and ten-year capital cost recovery classes. Structures would have been assigned to a 28-year class. Furthermore, capital cost recovery under CCRS would have been indexed against inflation. This is one of the most important ideas carried over from the Treasury proposal.

3.5.4. Tax Reform Act of 1986 Table 3.25 shows that the tax reform reduced average marginal tax rates on various types of income in approximately the same proportion as the Treasury and President's proposals. For example, at an annual rate of inflation of 6 per cent, the average marginal tax rate on individual income from equity was reduced by 20.6 per cent—from 25.59 to 20.33 per cent—and the average marginal tax rate on interest income from corporate debt was reduced by 17.1 per cent—from 17.30 to 14.34 per cent. The reduction in the corporate income tax rate by 24.3 per cent—from 50.84 to 38.47 per cent—is even more dramatic. By contrast, the average marginal tax rate on labour income

THE US TAX SYSTEM

105

was reduced by only 15.2 per cent—from 29.67 to 25.17 per cent. The magnitude of the 1986 reductions in statutory tax rates for individuals and corporations is very large. It is not surprising that the base for income taxation at both individual and corporate levels had to be broadened very substantially in order to achieve revenue neutrality. Under the 1985 Tax Law individuals, estates, and trusts were eligible for a 60 per cent exclusion of realized net capital gains from taxable income. Corporations were taxed on capital gains at a rate of 28 per cent, which was lower than the statutory corporate tax rate. Under the Tax Reform Act of 1986, the 60 per cent exclusion of capital gains from taxable income at the individual level was repealed. All corporate capital gains, whether long-term or short-term, are taxed at the statutory corporate tax rate. In spite of the reduction in the individual income tax rates, the accrual-based average marginal tax rate on capital gains increased from 3.03 per cent under the 1985 Tax Law to 5.62 per cent under the Tax Reform Act of 1986. The 1986 tax reform did not include a provision for excluding dividend payments from corporate income. In addition, the deductibility of dividends received by corporations was reduced from 85 to 80 per cent. This change mainly affects the tax burden on corporate equity owned through life insurance and other insurance companies and has little impact on the overall tax burden on corporate equity. The Tax Reform Act of 1986 also repealed the 10 per cent investment tax credit for property placed in service after 31 December 1985. Since the credit was applicable mainly to investments in short-lived business assets, it had been a major source of non-neutralities in the taxation of income from different types of assets. Table 3.28 shows the differential impact of the investment tax credit on the cost of capital for short-lived and long-lived assets in the corporate and non-corporate sectors. Under the 1985 Tax Law the average rate of the investment tax credit in the corporate sector was 9.44 per cent for short-lived assets and 4.26 per cent for long-lived assets.48 The repeal of the investment

48

If capital cost recovery coincides with economic depreciation, equality of effective tax rates requires that the investment tax credit must be larger for long-lived assets than short-lived assets, since short-lived assets can take the credit more frequently.

106

THE US TAX SYSTEM

tax credit has substantially reduced differences in the tax treatment of different types of assets. Compared with the 1986 Tax Law, the Tax Reform Act of 1986 spreads capital cost recovery over longer periods of time. The 1986 Act retains the three-year class, but automobiles, light-duty trucks, and property used in connection with research and experimentation were moved to the five-year class. In addition, the 1986 Act provides for 7-, 10-, 15-, and 20-year capital cost recovery classes for equipment. Structures are classified into residential rental property and non-residential property with tax lives of 27.5 and 31.5 years, respectively. Table 3.28 shows that the Tax Reform Act of 1986 increased the present value of capital consumption allowances for short-lived corporate assets at low or moderate rates of inflation and reduced the present value for high rates of inflation. This reflects the repeal of investment tax credit, since the basis of capital cost recovery was reduced by 50 per cent of the investment tax credit under the 1985 Tax Law.49 Capital cost recovery was made less rapid for producers' durable equipment, primarily through longer tax lifetimes. For structures the adoption of longer tax lives works in the same direction, reducing the present value of capital cost recovery.

3.6. Alternative Approaches In this chapter we have presented a quantitative description of the US tax system. For this purpose we have developed estimates of income and property tax rates for assets utilized by households and non-corporate and corporate businesses. We have represented the corporate income tax as a flat rate tax on

49

If we adjust the present value of capital consumption allowances by increasing the basis for capital cost recovery to 100 per cent, we find that the tax reform reduced the present value of capital cost recovery for short-lived assets. To adjust capital consumption allowances under the 1985 Tax Law for the effect of the provisions reducing the basis of capital cost recovery by 50 per cent of the investment tax credit, we can multiply the present value of capital cost recovery in Table 3.28 under 1985 law by 1/(1 − 0.5k ), where k is the rate of the investment tax credit in the same table. For example, when the annual rate of inflation is zero, the adjusted present value of capital cost recovery for a short-lived corporate asset is 0.9223/(1 − 0.5 * 0.0944)=0.9680, which is larger than the corresponding value, 0.9472, under the Tax Reform Act of 1986.

THE US TAX SYSTEM

107

income from corporate assets. By contrast, the personal income tax is progressive. Tax liabilities increase as a proportion of the income of each taxpayer. We have characterized the personal income tax schedule by means of average marginal tax rates for each category of income. Finally, we have represented the property tax as a flat tax on the value of assets held by each legal form of organization. Corporate income is the base for the corporate income tax and personal income is the base for the individual income tax. However, income defined for tax purposes differs substantially from the economic concept of income. Tax provisions for capital cost recovery are an important source of these differences. We have analysed capital cost recovery by first estimating rates of economic depreciation for 62 categories of assets. We have presented data on capital consumption allowances and the investment tax credit for all categories of depreciable assets utilized in noncorporate and corporate businesses. Our estimates of economic depreciation are based on those of Hulten and Wykoff (1981b), using the vintage price approach outlined in Section 3.3 above. Hulten and Wykoff have summarized extensive studies of economic depreciation completed before their own study. The most common methodology for such studies is based on vintage price functions, first employed by Terborgh (1954). Unfortunately, none of the studies completed before that of Hulten and Wykoff corrects for censored sample bias. Hulten and Wykoff (1981a) have shown that this correction is extremely important. An alternative to the vintage price approach is to employ rental prices of capital input rather than prices of acquisition of capital assets to estimate the pattern of decline in efficiency with age. This approach has been employed by Malpezzi, Ozanne, and Thibodeau (1987) to analyse rental price data on residential structures, and by Taubman and Rasche (1969) to study rental price data on commercial structures. A second alternative to the vintage price approach is to analyse investment for replacement purposes. This approach was originated by Meyer and Kuh (1957) and has been employed by Eisner (1972), Feldstein and Foot (1974), and Coen (1975, 1980). Coen (1980) compares the explanatory power of alternative patterns of decline in efficiency in a model of investment behaviour that also includes the

108

THE US TAX SYSTEM

price of capital input. Hulten and Wykoff (1981c) have summarized his results as follows: ‘ . . . the weight of Coen's study is evidently on the side of the geometric and near-geometric forms of depreciation’. The model of capital as a factor of production presented in Chapter 1 is simplified by assuming that the decline in efficiency of durable goods is geometric. However, this assumption is inessential to the model. Biorn (1989) has developed appropriate concepts of the cost of capital, the rate of return, and effective tax rates for a model of capital as a factor of production that does not require geometric decline in efficiency. He has also developed similar concepts for putty–clay technologies where substitution among inputs is limited to the ex ante representation of technology before an investment has been made. After capital goods have been put in place, the ex post representation of this technology is characterized by fixed input proportions. Christensen and Jorgenson (1969, 1973) have estimated present values of capital consumption allowances for new assets and effective rates of the investment tax credit for inclusion in their estimates of the cost of capital for the corporate sector. Corporations are assumed to use formulas for calculating capital consumption for tax purposes that minimize their tax liabilities. Christensen and Jorgenson have estimated the cost of capital for household, noncorporate, and corporate sectors for the period 1929–69 on an annual basis. Jorgenson and Sullivan (1981) have estimated present values of capital consumption allowances for new assets and effective rates of the investment tax credit for the corporate sector for period 1946–80, using the classification of assets from the Bureau of Economic Analysis presented in Table 3.18. These estimates incorporate information on the formulas actually used by corporations for calculating capital consumption allowances, together with estimates of tax lifetimes and salvage values for all types of assets. This information is derived from simulations of capital consumption allowances claimed by corporate taxpayers. We have estimated present values of capital consumption allowances and effective rates of the investment tax credit for both corporate and non-corporate sectors in Jorgenson and Yun (1986b). These estimates are given for the provisions of the 1981 Tax Act and the pre-existing tax law in 1980. Fullerton (1987)

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and Fullerton, Gillette, and Mackie (1987) have presented alternatives to the descriptions of provisions for capital cost recovery the 1985 Tax Law, the Treasury proposal, the President's proposal, and the Tax Reform Act of 1986 given in Section 3.5. Our description is closest to that of Fullerton, Gillette, and Mackie. Both studies use the latest BEA classification of assets given in Table 3.19 in describing economic depreciation and provisions for capital cost recovery for the business sector. Fullerton (1987) employs the earlier BEA classification of assets presented in Table 3.18. This classification was also used by Hulten and Wykoff (1981c) and Jorgenson and Sullivan (1981).50 The final step in describing the US tax structure is to estimate the proportions of debt and equity in the value of capital for households and non-corporate and corporate businesses. For this purpose we have presented data on the value of capital by legal form of organization. These data are based on the model of capital as a factor of production given in Chapter 1 and utilize rates of economic depreciation based on those of Hulten and Wykoff (1981c). We have estimated the value of debt for each form of organization. We have also estimated the dividend payout ratio for the corporate sector from dividend payments and the income from corporate assets. In Chapter 4 we analyse the impact of tax policy on the cost of capital and the rate of return by means of the concept of the marginal effective tax rate presented in Chapter 2. For this purpose we utilize the information on tax rates, provisions for capital cost recovery, and the financial structure of corporate and non-corporate businesses and households presented in this chapter to estimate private and social returns for all assets in the private sector of the US economy. We estimate effective tax rates for these assets and employ these tax rates to assess the impact of the US tax structure on the efficiency of capital allocation. Our effective tax rates for the corporate sector are based on the ‘traditional’ view of corporate income taxation presented in Chapter 2.

50

Fullerton (1987, pp. 30–5) presents a detailed description of the data employed in his study. A similar description is given by Fullerton, Gillette, and Mackie (1987, pp. 135–42) for the data used in their study.

4 Effective Tax Rates In this chapter we summarize the tax burden on capital income by means of the marginal effective tax rate introduced by Auerbach and Jorgenson (1980). An effective tax rate represents the complex provisions of tax law in terms of a single ad valorem rate. This tax rate is based on the social rate of return, defined as income per dollar of capital, adjusted for inflation and depreciation but not for taxes. This social rate of return can be compared with the corresponding private rate of return, which excludes all tax liabilities at both corporate and individual levels. The effective tax rate is defined as the difference between the social and private rates of return, divided by the social rate of return, net of inflation. We calculate private and social rates of return for assets in the corporate, non-corporate, and household sectors. Private rates of return on capital differ among sectors, since they depend on the debt–capital ratio of each sector. However, these rates of return are the same for all types of assets within a given sector. The social rates of return depend on asset-specific provisions of US tax law, such as the rate of the investment tax credit and the present value of tax deductions for capital consumption allowances, and may differ among assets within a sector. We also present tax wedges, defined as differences between social and private rates of return, and marginal effective tax rates, defined as ratios of the tax wedges to the social rates of return, net of inflation, for all types of assets. In Section 4.1 we estimate social rates of return for 65 types of assets—the 51 types of depreciable business assets listed in Table 3.19, the 11 types of consumer durables listed in Table 3.20 and 3 types of non-depreciable assets (farm inventories, non-farm inventories, and land) in the household, non-corporate, and corporate sectors. We assume that interest rates on net debt in the household, non-corporate, and corporate sectors are equal to the interest rate on corporate bonds of the Baa class. We also

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assume that nominal private rates of return on equity are the same in all three sectors. In order to establish a basis for comparison among sectors and time periods, we calculate the social rate of return and the effective tax rate for a rate of return on corporate capital after corporate taxes of 6.516 per cent per year and a dividend pay-out ratio of 42.709 per cent. These are the sample averages for the period 1947–86. We can solve for the nominal private rate of return on equity ρ from the definition of the weighted average rate of return to corporate capital, adjusted for inflation, presented in Chapter 2. We assume that this rate of return is the same for corporate, non-corporate, and household sectors. For each class of assets in the corporate and non-corporate sectors, we calculate weighted averages of social rates of return, where the values of the assets are used as weights. Owing to sectoral differences in the capital structure, the ownership distribution of financial claims, and the tax treatment of different owners, the private and social rates of return for an asset may depend on the sector in which it is employed. We present tax wedges, defined as differences between social and the private rates of return, and effective tax rates, defined as ratios of the tax wedges to the social rates of return, net of inflation, for assets employed in the corporate, non-corporate, and household sectors in Section 4.2. In Section 4.3 we discuss discrepancies in tax burdens among different assets within a given sector and the same asset in different sectors. Differences among social rates of return provide a means of quantifying the impact of distortions in the allocation of capital. For example, suppose that the social rates of return on two assets differ by, say, 5 per cent and that the private rate of return is 5 per cent. If tax policy can be changed so that one dollar's worth of capital is transferred from the lightly taxed asset to the heavily taxed asset, the yield at the margin is five cents. At a private rate of return of 5 per cent, this addition to the stream of income is worth one dollar. Wealth is one dollar before the transfer and two dollars after the transfer, so that the national wealth can be doubled at the margin by changing tax policy. In Section 4.4 our objective is to describe the Tax Reform Act of 1986, the pre-existing 1985 Tax Law, and the alternative

112

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reform proposals presented by the Treasury and the President in terms of effective tax rates. We present effective tax rates for assets held by three different legal forms of organization—corporate, non-corporate, and household—and for short-lived and long-lived assets. We also present differences in social rates of return among different types of assets. We give tax differences for transfers between asset categories within a sector, between sectors, and between the present and the future. Finally, the effective tax rates for the corporate sector presented in this chapter are based on the ‘traditional’ view of corporate income taxation discussed in Chapter 2. Effective tax rates for the corporate sector have also been calculated on the basis of the ‘new’ view outlined in Section 2.5. In Section 4.5 we compare results based on these alternative approaches. We also distinguish marginal effective tax rates based on the cost of capital from average effective tax rates. Average effective tax rates are based on comparisons of corporate tax liabilities with corporate income from both new and existing assets. It is marginal rather than average tax rates that are relevant to comparisons among alternative tax policies.

4.1 Economic Impact of US Tax Law The effective tax rate on an asset depends on provisions of US tax law as well as on factors not determined by the tax law that affect the economic impact of the tax system. The tax provisions include the definitions of taxable income, rate schedules for the various types of income, and rules for capital cost recovery, such as the rate of the investment tax credit and formulas for calculating capital consumption allowances. Other determinants of effective tax rates include the rate of inflation, the interest rate, the rate of return to equity, the dividend pay-out rate in the corporate sector, and the distributions of financial assets among owners with different tax statuses. The analytical framework presented in Chapter 2 makes it possible to show how the rate of interest and the rate of inflation interact in determining effective tax rates. For example, if the marginal tax rate of a firm is greater than that of the individual who holds the debt of the firm, inflation can reduce the tax burden on income from capital by increasing nominal interest rates.

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An increase in nominal interest rates raises deductions for interest expenses at the level of the firm and increases tax liabilities for interest income at the level of the individual by the same amount. The reduction in taxes resulting from the deductibility of nominal interest expenses outweighs the increased tax liability for interest income.51 Since capital consumption allowances are based on the original acquisition cost of investment goods, nominal interest rates affect the present value of capital consumption allowances. To the extent that inflation increases the nominal interest rate, it can raise the tax burden on assets by reducing the present value of capital consumption allowances, inflating nominal capital gains and pushing taxpayers into higher marginal tax brackets. The first column of Table 4.1 shows the rate of inflation in the acquisition price of tangible assets in the USA for the period 1947–86. The nominal interest rate has increased substantially over the postwar period, reaching a peak of 16.11 per cent in 1982. This trend on the nominal interest rate affects costs of capital, social rates of return, and effective tax rates. Changes in the distribution of financial assets affect the tax burden on income from capital through changes in average tax rates. In the case of corporate equity, the share of households declined steadily, from 90.28 per cent in 1946 to 67.99 per cent in 1986. In the same period the share of tax-exempt owners increased from 7.05 to 28.48 per cent and that of insurance companies fluctuated between 2.66 and 4.55 per cent with a slight upward trend. These changes in the distribution of corporate equity among owners with different tax statuses, especially the increase in the share of the tax-exempt institutions, underly the downward trend in average marginal tax rates on dividends and capital gains. We can conduct a parallel analysis for the debt of the corporate, non-corporate, and household sectors. Changes in the distribution of debt had major impacts on the marginal tax rates on interest income. Average marginal tax rates on corporate and non-corporate interest payments have risen significantly because of the dramatic decline in the ownership share of insurance

51

A more detailed discussion of the effect of inflation on the taxation of income from capital is given by Feldstein (1983).

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Table 4.1 Rates of Inflation and Interest, Discount Rates, and Private Rates of Return Year 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

π 0.1611 0.0845 0.0163 0.0323 0.0865 0.0381 0.0232 0.0027 0.0265 0.0549 0.0398 0.0211 0.0048 0.0215 0.0061 0.0205 0.0015 0.0166 0.0219 0.0380 0.0361 0.0423 0.0642 0.0403 0.0526 0.0614 0.0790 0.1243 0.1023 0.0807 0.1042 0.1144 0.1233 0.1150 0.1022 0.0328 0.0348 0.0347 0.0176 0.0305

i 0.0324 0.0347 0.0342 0.0324 0.0341 0.0352 0.0374 0.0351 0.0353 0.0388 0.0471 0.0473 0.0505 0.0519 0.0508 0.0502 0.0486 0.0483 0.0487 0.0567 0.0623 0.0694 0.0781 0.0911 0.0856 0.0816 0.0824 0.0950 0.1061 0.0975 0.0897 0.0949 0.1069 0.1367 0.1604 0.1611 0.1355 0.1419 0.1272 0.1039

rq 0.0642 0.0641 0.0641 0.0643 0.0635 0.0633 0.0631 0.0633 0.0633 0.0630 0.0627 0.0628 0.0627 0.0628 0.0625 0.0623 0.0621 0.0619 0.0619 0.0611 0.0606 0.0594 0.0582 0.0583 0.0585 0.0581 0.0582 0.0574 0.0583 0.0595 0.0589 0.0584 0.0579 0.0570 0.0570 0.0560 0.0553 0.0550 0.0539 0.0536

rm 0.0596 0.0585 0.0562 0.0548 0.0588 0.0561 0.0562 0.0550 0.0560 0.0567 0.0555 0.0544 0.0531 0.0536 0.0533 0.0542 0.0530 0.0548 0.0559 0.0556 0.0549 0.0532 0.0534 0.0522 0.0531 0.0526 0.0507 0.0478 0.0471 0.0476 0.0460 0.0453 0.0442 0.0439 0.0463 0.0526 0.0524 0.0527 0.0524 0.0522

rh 0.0251 0.0393 0.0490 0.0438 0.0352 0.0431 0.0458 0.0487 0.0439 0.0376 0.0415 0.0454 0.0483 0.0450 0.0482 0.0449 0.0482 0.0454 0.0451 0.0417 0.0434 0.0415 0.0387 0.0460 0.0444 0.0422 0.0381 0.0300 0.0354 0.0387 0.0331 0.0307 0.0296 0.0320 0.0379 0.0542 0.0524 0.0532 0.0541 0.0503

rb 0.0462 0.0518 0.0540 0.0518 0.0503 0.0513 0.0529 0.0536 0.0527 0.0511 0.0518 0.0523 0.0525 0.0521 0.0527 0.0526 0.0528 0.0535 0.0543 0.0534 0.0530 0.0513 0.0498 0.0512 0.0512 0.0505 0.0487 0.0449 0.0460 0.0472 0.0453 0.0448 0.0443 0.0441 0.0458 0.0532 0.0534 0.0538 0.0542 0.0537

rq 0.0390 0.0476 0.0523 0.0500 0.0452 0.0483 0.0506 0.0523 0.0504 0.0479 0.0498 0.0511 0.0520 0.0514 0.0523 0.0517 0.0525 0.0526 0.0533 0.0522 0.0520 0.0505 0.0484 0.0510 0.0507 0.0499 0.0485 0.0452 0.0471 0.0484 0.0467 0.0464 0.0462 0.0461 0.0472 0.0533 0.0539 0.0540 0.0548 0.0541

rm 0.0528 0.0558 0.0557 0.0537 0.0556 0.0545 0.0553 0.0550 0.0552 0.0548 0.0542 0.0538 0.0530 0.0530 0.0533 0.0537 0.0532 0.0545 0.0556 0.0550 0.0543 0.0524 0.0518 0.0514 0.0520 0.0513 0.0489 0.0445 0.0444 0.0456 0.0434 0.0425 0.0419 0.0415 0.0441 0.0531 0.0527 0.0535 0.0536 0.0531

rh 0.0256 0.0397 0.0494 0.0442 0.0357 0.0437 0.0464 0.0492 0.0445 0.0383 0.0423 0.0461 0.0491 0.0457 0.0490 0.0456 0.0489 0.0461 0.0457 0.0424 0.0441 0.0424 0.0396 0.0468 0.0451 0.0429 0.0387 0.0307 0.0361 0.0393 0.0337 0.0313 0.0304 0.0328 0.0389 0.0550 0.0531 0.0540 0.0548 0.0510

Notes The rate of return on corporate capital after corporate taxes is set at 6.516% and the dividend payment ratio (α) is set at 42.709%.

π: rate of inflation in the price of assets i: rate of interest on Baa class corporate bonds rq: rate of discount for corporate capital rm: rate of discount for non-corporate capital rh: rate of discount for household capital rb: rate of private return on business capital rq: rate of private return on corporate capital rm: rate of private return on non-corporate capital rh: rate of private return on household capital

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companies. In the case of non-corporate debt the increase in the share of the household owners also contributed to the rise in the marginal tax rate. The combined effects more than offset the impact of the increasing share of the taxexempt owners. Since the introduction of accelerated depreciation in 1954, most of the significant changes in the treatment of income from capital US tax law have been directed towards providing tax incentives for private investment. In the years of tax reductions — 1954, 1962, 1966, 1969, 1971, 1975, 1981 — unemployment peaked. During 1966–9, when taxes were increased, unemployment was in the exceptionally low range of 3.5–3.8 per cent. We conclude that past changes in tax law have been motivated in part by the objective of counteracting the fluctuations of the US economy. The effects of changes in tax policy are most visible in the case of short-lived assets. This is not surprising since most of the tax changes were targeted at short-lived assets, particularly through the liberalization of the investment tax credit and capital consumption allowances.

4.2. Effective Tax Rates In order to condense the presentation of effective tax rates, we aggregate the assets within each sector into larger groups. We aggregate the corporate and non-corporate assets into producer's durable equipment (PDE), nonresidential structures (NRS), residential structures (RS), and non-depreciable assets (ND). We also aggregate the assets into the short-lived depreciable assets (SD), long-lived depreciable assets (LD), short-lived assets (S), long-lived assets (L), depreciable assets (D), non-depreciable assets (ND), and all assets (A). PDE includes the first 27 types of assets in Table 3.19, NRS includes the next 23 types of assets, and RS is the remaining asset type included in the table. We use names of the asset groups to indicate the criterion for asset classification. Long-lived depreciable assets (LD) include NRS and RS, and also non-depreciable assets (ND), which in turn include inventories and land. Depreciable assets (D) include SD and LD, and all assets (A) include S and L or equivalently D and ND. For household assets there are no asset-specific tax provisions; therefore, we group all the household assets into a single category.

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In 1952 the maximum corporate tax rate was 53.05 per cent and the use of accelerated depreciation was negligible. In 1954 accelerated depreciation was made available for all new investment goods and the proportion of new investment using accelerated depreciation methods began to increase rapidly. Jorgenson and Sullivan (1981) estimate that the proportion of new investment using accelerated depreciation was only 9 per cent in 1953. This proportion jumped to 52 per cent in 1955 and to 85 per cent by 1978. However, the effects of this tax reduction were not sufficient to offset the effects of rising interest rates. As a consequence, the effective tax rates on depreciable assets given in Table 4.2 did not show significant changes until 1962. The Kennedy–Johnson tax cuts of 1962–4 brought about sizeable changes in effective tax rates. The investment tax credit was introduced in 1962 and capital consumption allowances were liberalized by the introduction of Guideline lifetimes in that year. The Revenue Act of 1964 lowered the maximum federal corporate tax rate from 52 per cent in 1964 to 48 per cent in 1965. At the same time this Act repealed the Long amendment in 1964, stepping up the basis for calculating capital consumption allowances to the full acquisition cost of investment goods. The effective tax rate on depreciable assets in the business sector given in columns (9) and (10) of Table 4.2 dropped from 44.38 per cent in 1962 to 39.64 per cent in 1963 and to 35.63 per cent in 1965. The impact was most substantial for effective tax rates on short-lived depreciable assets given in columns (5) and (6) of the table. The effective tax rate on these assets dropped from 49.61 per cent in 1962 to 29.11 per cent in 1965. By contrast, the effective tax rate decreased by only 4.36 per cent for long-lived depreciable assets given in columns (5) and (6) and by 3.54 per cent for non-depreciable assets given in columns (1)–(4) during the same period. By 1966 tax rates and the rate of inflation began to rise and the investment tax credit was temporarily suspended. The result was a sharp increase in effective tax rates. Since the investment tax credit applied mainly to short-lived assets, the impact was the greatest for short-lived assets. Between 1965 and 1967 the effective tax rate on short-lived assets given in columns (5) and (6) rose from 29.11 to 35.89 per cent, while effective tax rates rose from 37.81 to 40.12 per cent for long-lived depreciable assets and

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Table 4.2 Effective Tax Rates on Business Assets Year

1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

(1) PDE σb 0.0972 0.0950 0.0942 0.0979 0.1063 0.1034 0.1034 0.1034 0.1005 0.1006 0.1010 0.1023 0.1017 0.1033 0.1039 0.1044 0.0815 0.0784 0.0766 0.0759 0.0827 0.0858 0.0838 0.0979 0.1062 0.0864 0.0790 0.0772 0.0794 0.0748 0.0684 0.0643 0.0630 0.0655 0.0717 0.0533 0.0523 0.0568 0.0569 0.0548

GAP 0.0510 0.0433 0.0401 0.0461 0.0560 0.0521 0.0506 0.0498 0.0479 0.0495 0.0492 0.0499 0.0492 0.0512 0.0511 0.0518 0.0287 0.0249 0.0223 0.0225 0.0297 0.0345 0.0340 0.0467 0.0549 0.0359 0.0303 0.0323 0.0334 0.0275 0.0231 0.0195 0.0187 0.0215 0.0259 0.0001 −0.0011 0.0030 0.0026 0.0011

eb 0.5246 0.4554 0.4263 0.4706 0.5266 0.5037 0.4889 0.4817 0.4762 0.4918 0.4870 0.4884 0.4842 0.4955 0.4923 0.4961 0.3524 0.3179 0.2911 0.2963 0.3589 0.4018 0.4055 0.4770 0.5176 0.4153 0.3837 0.4182 0.4212 0.3681 0.3373 0.3036 0.2964 0.3276 0.3613 0.0013 −0.0209 0.0523 0.0466 0.0205

(2) NRS σb 0.0910 0.0901 0.0902 0.0933 0.0989 0.0961 0.0963 0.0971 0.0954 0.0951 0.0954 0.0969 0.0963 0.0983 0.0987 0.0988 0.0973 0.0945 0.0929 0.0929 0.0943 0.0972 0.0982 0.0988 0.1039 0.1004 0.0978 0.0959 0.0972 0.0957 0.0920 0.0881 0.0858 0.0878 0.0933 0.0760 0.0746 0.0750 0.0761 0.0751

GAP 0.0448 0.0384 0.0361 0.0414 0.0486 0.0448 0.0435 0.0435 0.0428 0.0439 0.0436 0.0446 0.0438 0.0462 0.0460 0.0462 0.0445 0.0410 0.0386 0.0395 0.0412 0.0459 0.0484 0.0476 0.0527 0.0498 0.0491 0.0509 0.0512 0.0485 0.0466 0.0433 0.0415 0.0437 0.0475 0.0228 0.0213 0.0212 0.0219 0.0215

eb 0.4921 0.4258 0.4009 0.4443 0.4913 0.4658 0.4512 0.4483 0.4483 0.4621 0.4571 0.4600 0.4553 0.4699 0.4659 0.4675 0.4573 0.4340 0.4151 0.4250 0.4374 0.4721 0.4926 0.4816 0.5073 0.4966 0.5021 0.5313 0.5272 0.5064 0.5071 0.4918 0.4834 0.4980 0.5088 0.2994 0.2849 0.2829 0.2877 0.2859

(3) RS σb 0.0821 0.0769 0.0746 0.0742 0.0796 0.0762 0.0759 0.0743 0.0750 0.0761 0.0752 0.0736 0.0727 0.0737 0.0741 0.0753 0.0745 0.0757 0.0765 0.0766 0.0772 0.0774 0.0789 0.0780 0.0807 0.0803 0.0777 0.0740 0.0730 0.0742 0.0717 0.0688 0.0675 0.0684 0.0739 0.0731 0.0717 0.0714 0.0723 0.0720

GAP 0.0359 0.0252 0.0205 0.0224 0.0292 0.0249 0.0230 0.0208 0.0224 0.0250 0.0234 0.0213 0.0203 0.0216 0.0214 0.0227 0.0217 0.0223 0.0222 0.0232 0.0242 0.0261 0.0290 0.0268 0.0295 0.0298 0.0290 0.0290 0.0270 0.0270 0.0264 0.0240 0.0231 0.0243 0.0281 0.0199 0.0183 0.0176 0.0180 0.0183

eb 0.4371 0.3271 0.2754 0.3013 0.3674 0.3266 0.3036 0.2792 0.2981 0.3282 0.3116 0.2895 0.2786 0.2935 0.2883 0.3018 0.2913 0.2942 0.2899 0.3024 0.3132 0.3374 0.3681 0.3437 0.3657 0.3707 0.3733 0.3926 0.3702 0.3637 0.3677 0.3491 0.3425 0.3558 0.3801 0.2718 0.2553 0.2464 0.2495 0.2544

(4) ND σb 0.1076 0.1007 0.0986 0.1022 0.1163 0.1162 0.1151 0.1129 0.1146 0.1169 0.1160 0.1139 0.1129 0.1136 0.1135 0.1148 0.1149 0.1126 0.1101 0.1093 0.1096 0.1150 0.1150 0.1107 0.1104 0.1106 0.1088 0.1055 0.1059 0.1065 0.1047 0.1013 0.0977 0.0970 0.0994 0.1018 0.0994 0.0998 0.0991 0.0995

GAP 0.0614 0.0489 0.0446 0.0503 0.0660 0.0649 0.0623 0.0593 0.0619 0.0658 0.0643 0.0616 0.0605 0.0615 0.0608 0.0622 0.0622 0.0591 0.0557 0.0559 0.0566 0.0637 0.0652 0.0595 0.0592 0.0601 0.0602 0.0606 0.0599 0.0593 0.0593 0.0565 0.0534 0.0529 0.0536 0.0486 0.0460 0.0461 0.0449 0.0458

eb 0.5704 0.4858 0.4520 0.4927 0.5672 0.5584 0.5408 0.5254 0.5403 0.5626 0.5538 0.5407 0.5354 0.5413 0.5355 0.5418 0.5407 0.5251 0.5064 0.5112 0.5162 0.5540 0.5667 0.5373 0.5363 0.5432 0.5527 0.5741 0.5659 0.5566 0.5669 0.5581 0.5462 0.5455 0.5393 0.4771 0.4628 0.4613 0.4527 0.4607

Notes Property taxes are included in the calculation and the after-corporate-tax real rate of return and the corporate dividend pay-out ratio (α) are set at their sample averages, 6.516 and 42.709%, respectively.

PDE: producer durable equipment NRS: non-residential structures RS: residential structures ND: non-depreciable assets σb: real social rate of return rb: real private rate of return GAP: tax wedge, σb − rb eb: effective tax rate

118 Year

1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

EFFECTIVE TAX RATES (5) SD σb 0.0972 0.0950 0.0942 0.0979 0.1063 0.1034 0.1034 0.1034 0.1005 0.1006 0.1010 0.1023 0.1017 0.1033 0.1039 0.1044 0.0815 0.0784 0.0766 0.0759 0.0827 0.0858 0.0838 0.0979 0.1062 0.0864 0.0790 0.0772 0.0794 0.0748 0.0684 0.0643 0.0630 0.0655 0.0717 0.0533 0.0523 0.0568 0.0569 0.0548

GAP 0.0510 0.0433 0.0401 0.0461 0.0560 0.0521 0.0506 0.0498 0.0479 0.0495 0.0492 0.0499 0.0492 0.0512 0.0511 0.0518 0.0287 0.0249 0.0223 0.0225 0.0297 0.0345 0.0340 0.0467 0.0549 0.0359 0.0303 0.0323 0.0334 0.0275 0.0231 0.0195 0.0187 0.0215 0.0259 0.0001 −0.0011 0.0030 0.0026 0.0011

eb 0.5246 0.4554 0.4263 0.4706 0.5266 0.5037 0.4889 0.4817 0.4762 0.4918 0.4870 0.4884 0.4842 0.4955 0.4923 0.4961 0.3524 0.3179 0.2911 0.2963 0.3589 0.4018 0.4055 0.4770 0.5176 0.4153 0.3837 0.4182 0.4212 0.3681 0.3373 0.3036 0.2964 0.3276 0.3613 0.0013 −0.0209 0.0523 0.0466 0.0205

(6) LD σb 0.0875 0.0851 0.0843 0.0860 0.0915 0.0887 0.0888 0.0888 0.0880 0.0882 0.0884 0.0891 0.0884 0.0901 0.0906 0.0910 0.0897 0.0882 0.0874 0.0874 0.0886 0.0906 0.0918 0.0917 0.0962 0.0937 0.0911 0.0885 0.0892 0.0888 0.0854 0.0817 0.0797 0.0810 0.0864 0.0750 0.0736 0.0737 0.0747 0.0740

GAP 0.0413 0.0333 0.0303 0.0342 0.0412 0.0374 0.0359 0.0353 0.0354 0.0371 0.0366 0.0368 0.0360 0.0380 0.0378 0.0384 0.0369 0.0347 0.0330 0.0340 0.0355 0.0393 0.0419 0.0405 0.0450 0.0432 0.0424 0.0436 0.0432 0.0416 0.0401 0.0369 0.0353 0.0369 0.0406 0.0217 0.0202 0.0199 0.0205 0.0203

eb 0.4719 0.3915 0.3592 0.3973 0.4499 0.4213 0.4046 0.3969 0.4017 0.4203 0.4142 0.4131 0.4069 0.4218 0.4176 0.4217 0.4112 0.3937 0.3781 0.3889 0.4012 0.4339 0.4569 0.4416 0.4675 0.4607 0.4657 0.4922 0.4848 0.4680 0.4694 0.4521 0.4433 0.4560 0.4697 0.2899 0.2748 0.2705 0.2743 0.2748

Notes

SD: short-lived depreciable assets (PDE) LD: long-lived depreciable assets (NRS + RS) S: short-lived assets (PDE) L: long-lived assets (NRS + RS + inventories + land)

(7) S σb 0.0972 0.0950 0.0942 0.0979 0.1063 0.1034 0.1034 0.1034 0.1005 0.1006 0.1010 0.1023 0.1017 0.1033 0.1039 0.1044 0.0815 0.0784 0.0766 0.0759 0.0827 0.0858 0.0838 0.0979 0.1062 0.0864 0.0790 0.0772 0.0794 0.0748 0.0684 0.0643 0.0630 0.0655 0.0717 0.0533 0.0523 0.0568 0.0569 0.0548

GAP 0.0510 0.0433 0.0401 0.0461 0.0560 0.0521 0.0506 0.0498 0.0479 0.0495 0.0492 0.0499 0.0492 0.0512 0.0511 0.0518 0.0287 0.0249 0.0223 0.0225 0.0297 0.0345 0.0340 0.0467 0.0549 0.0359 0.0303 0.0323 0.0334 0.0275 0.0231 0.0195 0.0187 0.0215 0.0259 0.0001 −0.0011 0.0030 0.0026 0.0011

eb 0.5246 0.4554 0.4263 0.4706 0.5266 0.5037 0.4889 0.4817 0.4762 0.4918 0.4870 0.4884 0.4842 0.4955 0.4923 0.4961 0.3524 0.3179 0.2911 0.2963 0.3589 0.4018 0.4055 0.4770 0.5176 0.4153 0.3837 0.4182 0.4212 0.3681 0.3373 0.3036 0.2964 0.3276 0.3613 0.0013 −0.0209 0.0523 0.0466 0.0205

(8) L σb 0.0965 0.0915 0.0901 0.0924 0.1017 0.1002 0.0998 0.0989 0.0991 0.1004 0.1001 0.0997 0.0991 0.1006 0.1009 0.1018 0.1012 0.0994 0.0978 0.0975 0.0983 0.1018 0.1023 0.1000 0.1022 0.1006 0.0984 0.0957 0.0964 0.0962 0.0936 0.0902 0.0876 0.0881 0.0922 0.0869 0.0846 0.0850 0.0852 0.0846

GAP 0.0503 0.0398 0.0360 0.0406 0.0514 0.0489 0.0469 0.0453 0.0465 0.0492 0.0483 0.0474 0.0466 0.0485 0.0482 0.0492 0.0484 0.0459 0.0435 0.0441 0.0453 0.0505 0.0524 0.0488 0.0510 0.0501 0.0497 0.0508 0.0504 0.0489 0.0482 0.0454 0.0432 0.0440 0.0464 0.0336 0.0312 0.0312 0.0310 0.0310

eb 0.5211 0.4345 0.4001 0.4392 0.5051 0.4877 0.4702 0.4582 0.4688 0.4905 0.4827 0.4753 0.4706 0.4819 0.4776 0.4833 0.4783 0.4620 0.4445 0.4522 0.4606 0.4962 0.5126 0.4880 0.4991 0.4981 0.5052 0.5304 0.5232 0.5089 0.5155 0.5036 0.4936 0.4997 0.5032 0.3872 0.3689 0.3669 0.3636 0.3659

119

EFFECTIVE TAX RATES Year

1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

(9) D σb 0.0893 0.0869 0.0862 0.0885 0.0947 0.0920 0.0921 0.0922 0.0910 0.0912 0.0915 0.0925 0.0920 0.0936 0.0942 0.0946 0.0875 0.0855 0.0844 0.0842 0.0869 0.0892 0.0894 0.0935 0.0991 0.0916 0.0876 0.0853 0.0864 0.0846 0.0803 0.0764 0.0746 0.0763 0.0819 0.0684 0.0671 0.0685 0.0693 0.0682

GAP 0.0430 0.0351 0.0322 0.0366 0.0444 0.0406 0.0392 0.0386 0.0383 0.0401 0.0397 0.0402 0.0395 0.0415 0.0414 0.0420 0.0347 0.0320 0.0301 0.0308 0.0339 0.0379 0.0396 0.0423 0.0479 0.0410 0.0390 0.0404 0.0404 0.0374 0.0349 0.0316 0.0302 0.0322 0.0361 0.0151 0.0138 0.0147 0.0151 0.0145

eb 0.4821 0.4043 0.3735 0.4141 0.4685 0.4419 0.4259 0.4188 0.4211 0.4393 0.4339 0.4344 0.4296 0.4434 0.4399 0.4438 0.3964 0.3748 0.3563 0.3654 0.3897 0.4249 0.4425 0.4525 0.4833 0.4483 0.4445 0.4731 0.4681 0.4416 0.4353 0.4140 0.4053 0.4223 0.4409 0.2214 0.2049 0.2152 0.2174 0.2130

(10) ND σb 0.1076 0.1007 0.0986 0.1022 0.1163 0.1162 0.1151 0.1129 0.1146 0.1169 0.1160 0.1139 0.1129 0.1136 0.1135 0.1148 0.1149 0.1126 0.1101 0.1093 0.1096 0.1150 0.1150 0.1107 0.1104 0.1106 0.1088 0.1055 0.1059 0.1065 0.1047 0.1013 0.0977 0.0970 0.0994 0.1018 0.0994 0.0998 0.0991 0.0995

Notes

D: depreciable assets (PDE + NRS + RS) ND: non-depreciable assets (inventories + land) A: all assets (PDE + NRS + RS + inventories + land)

GAP 0.0614 0.0489 0.0446 0.0503 0.0660 0.0649 0.0623 0.0593 0.0619 0.0658 0.0643 0.0616 0.0605 0.0615 0.0608 0.0622 0.0622 0.0591 0.0557 0.0559 0.0566 0.0637 0.0652 0.0595 0.0592 0.0601 0.0602 0.0606 0.0599 0.0593 0.0593 0.0565 0.0534 0.0529 0.0536 0.0486 0.0460 0.0461 0.0449 0.0458

eb 0.5704 0.4858 0.4520 0.4927 0.5672 0.5584 0.5408 0.5254 0.5403 0.5626 0.5538 0.5407 0.5354 0.5413 0.5355 0.5418 0.5407 0.5251 0.5064 0.5112 0.5162 0.5540 0.5667 0.5373 0.5363 0.5432 0.5527 0.5741 0.5659 0.5566 0.5669 0.5581 0.5462 0.5455 0.5393 0.4771 0.4628 0.4613 0.4527 0.4607

(11) A σb 0.0966 0.0919 0.0906 0.0932 0.1023 0.1007 0.1003 0.0995 0.0993 0.1004 0.1002 0.1001 0.0995 0.1010 0.1014 0.1022 0.0979 0.0958 0.0942 0.0938 0.0955 0.0989 0.0988 0.0996 0.1030 0.0979 0.0947 0.0922 0.0932 0.0919 0.0885 0.0850 0.0827 0.0836 0.0882 0.0803 0.0781 0.0793 0.0796 0.0786

GAP 0.0504 0.0402 0.0366 0.0413 0.0520 0.0493 0.0474 0.0460 0.0467 0.0493 0.0485 0.0478 0.0471 0.0489 0.0487 0.0496 0.0451 0.0424 0.0399 0.0403 0.0425 0.0476 0.0489 0.0484 0.0518 0.0474 0.0460 0.0473 0.0473 0.0447 0.0432 0.0402 0.0383 0.0396 0.0424 0.0271 0.0247 0.0255 0.0253 0.0249

eb 0.5214 0.4370 0.4036 0.4437 0.5082 0.4900 0.4730 0.4618 0.4699 0.4907 0.4834 0.4775 0.4730 0.4842 0.4801 0.4855 0.4608 0.4422 0.4232 0.4303 0.4450 0.4811 0.4954 0.4860 0.5028 0.4839 0.4858 0.5129 0.5071 0.4861 0.4878 0.4734 0.4637 0.4732 0.4808 0.3371 0.3167 0.3216 0.3183 0.3173

120

EFFECTIVE TAX RATES

from 50.64 to only 51.62 per cent for non-depreciable assets given in columns (1)–(4). In 1968 the 10 per cent Vietnam War tax surcharge was imposed. The investment tax credit was abolished in April 1969. Capital consumption allowances for structures signed into contract after 24 July 1969 were restricted to the 150 per cent declining balance method. These changes in the tax law, coupled with rising nominal interest rates and increasing tax rates at individual and corporate levels, raised the effective tax rate on depreciable business assets. By 1971 the effective tax rate on the short-lived assets had risen to 51.76 per cent and that on long-lived depreciable assets had risen to 46.75 per cent. In 1970 the Vietnam War tax surcharge was reduced to 2.5 per cent. The surcharge was phased out in 1971. The Revenue Act of 1971 reinstated the investment tax credit and reduced the lifetimes used in calculating capital consumption allowances for tax purposes. This Revenue Act also introduced the Asset Depreciation Range system. The effects of this series of changes in tax policy on effective tax rates are clearly visible in the case of short-lived assets. The effective tax rate on short-lived assets fell from 51.76 per cent in 1971 to 38.37 per cent in 1973. For other categories of assets, the rise in inflation rates and the increase in nominal interest rates more than offset the effects of the tax cut. The Revenue Reduction Act of 1975 liberalized the investment tax credit. This resulted in a drop in the effective tax rate on depreciable assets. The effective tax rate on short-lived assets dropped from 42.12 per cent in 1975 to 36.81 per cent in 1976 and that on long-lived depreciable assets dropped from 48.48 to 46.80 per cent in the same period. Part of the decline in effective tax rates is attributable to changes in other factors, especially the rate of inflation and the nominal interest rate. Effective tax rates on residential structures and non-depreciable assets decreased in the same period. In 1979 the maximum federal corporate tax rate was reduced from 48 to 46 per cent. The last major change in the US tax policy to be considered in this section is the Economic Recovery Tax Act (ERTA) of 1981. This Act resulted in one of the largest tax reductions in US history. There are three areas in which it introduced important changes. First, it reduced the maximum marginal tax rate for

EFFECTIVE TAX RATES

121

individuals from 70 to 50 per cent. Second, it introduced the Accelerated Cost Recovery System (ACRS), which drastically cut asset lifetimes for capital cost recovery. It also introduced new schedules for capital consumption allowances on personal and real property. Finally, ERTA liberalized the investment tax credit by reducing the tax lifetime of assets eligible for the 10 per cent regular credit. The result was a dramatic reduction in effective tax rates, as shown in Table 4.2. The effective tax rate on short-lived assets dropped from 36.13 per cent in 1981 to a negligible 2.09 per cent in 1983. In the same period the effective tax rate on long-lived depreciable assets declined from 46.97 to 27.48 per cent, and that on non-depreciable assets dropped from 53.93 to 46.28 per cent.

4.3. Differences in Effective Tax Rates We next discuss inequalities in tax burdens born by different assets within a given sector and by the same asset in different sectors. For household assets there are no asset-specific tax provisions, so that all household assets bear the same tax burden. Table 4.3 shows social rates of return and effective tax rates for various categories of assets in the corporate sector, while Table 4.4 gives the corresponding information for the non-corporate sector. Tables 4.5 and 4.6 give social rates of return and effective tax rates for the household sector and the entire private sector of the US economy, respectively. Table 4.7 shows differences between social rates of return on different assets in the corporate and non-corporate sectors as well as differences for the entire business sector. Until 1962, short-lived depreciable assets bore a heavier tax burden than long-lived depreciable assets in both corporate and non-corporate sectors. However, the pattern was reversed in 1963 with the introduction of the investment tax credit and the adoption of Guideline lifetimes for calculating capital consumption allowances. The new pattern of relative tax burdens was maintained and strengthened by successive liberalizations of tax rules for capital cost recovery. A slightly different pattern emerges when we combine long-lived depreciable assets and non-depreciable assets and compare the social rates of return on short-lived assets and long-lived assets. Throughout the period

122

EFFECTIVE TAX RATES

Table 4.3 Effective Tax Rates on Corporate Assets Year

1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 Year

1947 1948 1949 1950 1951

(1) PDE σq 0.0991 0.0994 0.0997 0.1048 0.1143 0.1114 0.1117 0.1124 0.1083 0.1077 0.1081 0.1098 0.1093 0.1111 0.1115 0.1116 0.0868 0.0826 0.0803 0.0794 0.0868 0.0906 0.0883 0.1031 0.1117 0.0905 0.0829 0.0816 0.0844 0.0794 0.0727 0.0684 0.0671 0.0698 0.0760 0.0547 0.0536 0.0584 0.0585 0.0561 (5) SD σq 0.0991 0.0994 0.0997 0.1048 0.1143

GAP 0.0601 0.0519 0.0474 0.0549 0.0690 0.0631 0.0611 0.0602 0.0579 0.0598 0.0583 0.0587 0.0573 0.0597 0.0592 0.0599 0.0343 0.0300 0.0270 0.0272 0.0348 0.0401 0.0399 0.0520 0.0611 0.0405 0.0345 0.0364 0.0373 0.0310 0.0260 0.0219 0.0209 0.0238 0.0288 0.0014 −0.0003 0.0044 0.0037 0.0020

GAP 0.0601 0.0519 0.0474 0.0549 0.0690

eq 0.6065 0.5214 0.4753 0.5234 0.6041 0.5666 0.5468 0.5349 0.5346 0.5551 0.5392 0.5347 0.5243 0.5378 0.5307 0.5367 0.3956 0.3636 0.3360 0.3426 0.4004 0.4427 0.4520 0.5049 0.5466 0.4482 0.4154 0.4458 0.4421 0.3906 0.3574 0.3207 0.3108 0.3405 0.3790 0.0259 −0.0058 0.0751 0.0628 0.0365

(2) NRS σq 0.0925 0.0931 0.0938 0.0976 0.1032 0.1006 0.1010 0.1022 0.0999 0.0992 0.0998 0.1020 0.1014 0.1035 0.1040 0.1039 0.1023 0.0987 0.0967 0.0967 0.0982 0.1018 0.1027 0.1034 0.1091 0.1049 0.1024 0.1010 0.1029 0.1008 0.0966 0.0927 0.0902 0.0924 0.0978 0.0776 0.0764 0.0767 0.0779 0.0767

eq 0.6065 0.5214 0.4753 0.5234 0.6041

(6) LD σq 0.0924 0.0930 0.0937 0.0975 0.1030

GAP 0.0535 0.0455 0.0414 0.0476 0.0579 0.0523 0.0504 0.0499 0.0496 0.0513 0.0500 0.0508 0.0494 0.0522 0.0517 0.0521 0.0498 0.0461 0.0434 0.0445 0.0462 0.0514 0.0543 0.0524 0.0584 0.0550 0.0539 0.0558 0.0559 0.0524 0.0499 0.0462 0.0440 0.0463 0.0506 0.0243 0.0224 0.0227 0.0231 0.0227

GAP 0.0534 0.0454 0.0413 0.0475 0.0578

eq 0.5786 0.4888 0.4419 0.4880 0.5615 0.5200 0.4988 0.4885 0.4959 0.5169 0.5013 0.4987 0.4870 0.5040 0.4971 0.5020 0.4871 0.4671 0.4485 0.4601 0.4702 0.5044 0.5289 0.5065 0.5354 0.5242 0.5266 0.5523 0.5427 0.5198 0.5165 0.4988 0.4874 0.5014 0.5173 0.3129 0.2939 0.2961 0.2969 0.2955

(3) RS σq 0.0893 0.0900 0.0907 0.0941 0.0983 0.0963 0.0967 0.0980 0.0961 0.0955 0.0960 0.0978 0.0974 0.0994 0.0999 0.0998 0.0987 0.0964 0.0954 0.0947 0.0965 0.1008 0.1013 0.0998 0.1039 0.1021 0.1004 0.0990 0.1010 0.1045 0.1018 0.0981 0.0955 0.0972 0.1021 0.0897 0.0885 0.0860 0.0880 0.0873

eq 0.5781 0.4882 0.4413 0.4874 0.5608

(7) S σq 0.0991 0.0994 0.0997 0.1048 0.1143

GAP 0.0503 0.0424 0.0384 0.0441 0.0531 0.0480 0.0461 0.0457 0.0457 0.0475 0.0463 0.0467 0.0454 0.0480 0.0476 0.0481 0.0462 0.0438 0.0420 0.0425 0.0445 0.0503 0.0529 0.0488 0.0533 0.0522 0.0519 0.0538 0.0539 0.0561 0.0551 0.0517 0.0493 0.0511 0.0549 0.0364 0.0346 0.0320 0.0332 0.0332

GAP 0.0601 0.0519 0.0474 0.0549 0.0690

eq 0.5634 0.4710 0.4230 0.4688 0.5398 0.4984 0.4769 0.4663 0.4755 0.4979 0.4816 0.4774 0.4660 0.4834 0.4765 0.4820 0.4684 0.4544 0.4406 0.4489 0.4608 0.4991 0.5223 0.4887 0.5125 0.5112 0.5170 0.5431 0.5340 0.5367 0.5412 0.5266 0.5159 0.5260 0.5374 0.4058 0.3908 0.3719 0.3776 0.3806

(4) ND σq 0.1176 0.1178 0.1180 0.1261 0.1454 0.1474 0.1475 0.1482 0.1486 0.1486 0.1476 0.1469 0.1467 0.1479 0.1479 0.1483 0.1481 0.1425 0.1375 0.1357 0.1355 0.1459 0.1439 0.1359 0.1341 0.1339 0.1333 0.1314 0.1325 0.1348 0.1337 0.1309 0.1245 0.1232 0.1238 0.1229 0.1212 0.1209 0.1192 0.1191

GAP 0.0786 0.0702 0.0657 0.0761 0.1002 0.0991 0.0969 0.0959 0.0982 0.1007 0.0978 0.0958 0.0947 0.0965 0.0956 0.0965 0.0956 0.0899 0.0842 0.0835 0.0835 0.0955 0.0955 0.0849 0.0835 0.0840 0.0849 0.0862 0.0854 0.0864 0.0870 0.0844 0.0783 0.0771 0.0766 0.0695 0.0672 0.0669 0.0644 0.0650

eq 0.6683 0.5960 0.5565 0.6038 0.6888 0.6724 0.6570 0.6472 0.6610 0.6774 0.6627 0.6520 0.6456 0.6527 0.6463 0.6511 0.6457 0.6309 0.6121 0.6154 0.6160 0.6541 0.6638 0.6244 0.6223 0.6271 0.6364 0.6558 0.6448 0.6411 0.6505 0.6451 0.6286 0.6261 0.6185 0.5660 0.5549 0.5532 0.5404 0.5460

eq 0.6065 0.5214 0.4753 0.5234 0.6041

(8) L σq 0.1014 0.1016 0.1019 0.1069 0.1182

GAP 0.0624 0.0540 0.0496 0.0570 0.0729

eq 0.6154 0.5315 0.4866 0.5327 0.6170

123

EFFECTIVE TAX RATES 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Year

1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960

0.1114 0.1117 0.1124 0.1083 0.1077 0.1081 0.1098 0.1093 0.1111 0.1115 0.1116 0.0868 0.0826 0.0803 0.0794 0.0868 0.0906 0.0883 0.1031 0.1117 0.0905 0.0829 0.0816 0.0844 0.0794 0.0727 0.0684 0.0671 0.0698 0.0760 0.0547 0.0536 0.0584 0.0585 0.0561

(9) D σq 0.0940 0.0946 0.0952 0.0994 0.1061 0.1035 0.1039 0.1051 0.1023 0.1017 0.1023 0.1044 0.1039 0.1059

0.0631 0.0611 0.0602 0.0579 0.0598 0.0583 0.0587 0.0573 0.0597 0.0592 0.0599 0.0343 0.0300 0.0270 0.0272 0.0348 0.0401 0.0399 0.0520 0.0611 0.0405 0.0345 0.0364 0.0373 0.0310 0.0260 0.0219 0.0209 0.0238 0.0288 0.0014 −0.0003 0.0044 0.0037 0.0020

0.5666 0.5468 0.5349 0.5346 0.5551 0.5392 0.5347 0.5243 0.5378 0.5307 0.5367 0.3956 0.3636 0.3360 0.3426 0.4004 0.4427 0.4520 0.5049 0.5466 0.4482 0.4154 0.4458 0.4421 0.3906 0.3574 0.3207 0.3108 0.3405 0.3790 0.0259 −0.0058 0.0751 0.0628 0.0365

GAP 0.0550 0.0470 0.0429 0.0494 0.0609 0.0552 0.0533 0.0528 0.0519 0.0538 0.0525 0.0533 0.0519 0.0546

0.1004 0.1008 0.1021 0.0998 0.0991 0.0997 0.1018 0.1013 0.1034 0.1039 0.1037 0.1022 0.0986 0.0967 0.0966 0.0982 0.1018 0.1026 0.1033 0.1089 0.1048 0.1023 0.1009 0.1028 0.1009 0.0968 0.0928 0.0904 0.0925 0.0980 0.0780 0.0768 0.0770 0.0783 0.0771

eq 0.5852 0.4967 0.4502 0.4974 0.5735 0.5336 0.5129 0.5024 0.5075 0.5287 0.5132 0.5103 0.4995 0.5152

0.0522 0.0502 0.0498 0.0494 0.0512 0.0499 0.0507 0.0493 0.0521 0.0516 0.0520 0.0497 0.0460 0.0433 0.0444 0.0461 0.0513 0.0543 0.0523 0.0582 0.0549 0.0539 0.0557 0.0558 0.0525 0.0501 0.0464 0.0441 0.0465 0.0508 0.0247 0.0228 0.0230 0.0235 0.0230

(10) ND σq 0.1176 0.1178 0.1180 0.1261 0.1454 0.1474 0.1475 0.1482 0.1486 0.1486 0.1476 0.1469 0.1467 0.1479

0.5193 0.4981 0.4879 0.4953 0.5163 0.5008 0.4981 0.4864 0.5034 0.4965 0.5014 0.4865 0.4667 0.4483 0.4597 0.4699 0.5042 0.5287 0.5059 0.5346 0.5237 0.5263 0.5520 0.5424 0.5204 0.5173 0.4997 0.4884 0.5023 0.5181 0.3165 0.2976 0.2988 0.3000 0.2987

0.1114 0.1117 0.1124 0.1083 0.1077 0.1081 0.1098 0.1093 0.1111 0.1115 0.1116 0.0868 0.0826 0.0803 0.0794 0.0868 0.0906 0.0883 0.1031 0.1117 0.0905 0.0829 0.0816 0.0844 0.0794 0.0727 0.0684 0.0671 0.0698 0.0760 0.0547 0.0536 0.0584 0.0585 0.0561

GAP 0.0786 0.0702 0.0657 0.0761 0.1002 0.0991 0.0969 0.0959 0.0982 0.1007 0.0978 0.0958 0.0947 0.0965

0.0631 0.0611 0.0602 0.0579 0.0598 0.0583 0.0587 0.0573 0.0597 0.0592 0.0599 0.0343 0.0300 0.0270 0.0272 0.0348 0.0401 0.0399 0.0520 0.0611 0.0405 0.0345 0.0364 0.0373 0.0310 0.0260 0.0219 0.0209 0.0238 0.0288 0.0014 −0.0003 0.0044 0.0037 0.0020

eq 0.6683 0.5960 0.5565 0.6038 0.6888 0.6724 0.6570 0.6472 0.6610 0.6774 0.6627 0.6520 0.6456 0.6527

0.5666 0.5468 0.5349 0.5346 0.5551 0.5392 0.5347 0.5243 0.5378 0.5307 0.5367 0.3956 0.3636 0.3360 0.3426 0.4004 0.4427 0.4520 0.5049 0.5466 0.4482 0.4154 0.4458 0.4421 0.3906 0.3574 0.3207 0.3108 0.3405 0.3790 0.0259 −0.0058 0.0751 0.0628 0.0365

(11) A σq 0.1010 0.1012 0.1015 0.1065 0.1174 0.1162 0.1163 0.1174 0.1156 0.1156 0.1157 0.1167 0.1164 0.1185

0.1173 0.1175 0.1187 0.1175 0.1177 0.1178 0.1187 0.1185 0.1207 0.1213 0.1216 0.1207 0.1165 0.1135 0.1127 0.1137 0.1200 0.1194 0.1163 0.1186 0.1157 0.1138 0.1126 0.1146 0.1134 0.1105 0.1072 0.1035 0.1045 0.1081 0.0953 0.0931 0.0934 0.0940 0.0930

0.0691 0.0669 0.0664 0.0672 0.0697 0.0680 0.0676 0.0665 0.0694 0.0689 0.0699 0.0682 0.0639 0.0601 0.0605 0.0617 0.0695 0.0710 0.0653 0.0680 0.0658 0.0653 0.0673 0.0675 0.0650 0.0638 0.0607 0.0573 0.0584 0.0608 0.0420 0.0392 0.0394 0.0392 0.0389

GAP 0.620 0.0536 0.0492 0.0565 0.0722 0.0679 0.0657 0.0651 0.0652 0.0676 0.0659 0.0656 0.0644 0.0672

0.5886 0.5693 0.5593 0.5713 0.5926 0.5773 0.5695 0.5611 0.5746 0.5686 0.5746 0.5652 0.5485 0.5299 0.5369 0.5423 0.5793 0.5947 0.5613 0.5729 0.5685 0.5740 0.5983 0.5892 0.5733 0.5771 0.5666 0.5533 0.5592 0.5630 0.4405 0.4209 0.4216 0.4170 0.4187

eq 0.6139 0.5298 0.4846 0.5309 0.6146 0.5844 0.5649 0.5545 0.5641 0.5852 0.5697 0.5621 0.5531 0.5667

124 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

EFFECTIVE TAX RATES

0.1065 0.1064 0.0970 0.0931 0.0910 0.0905 0.0941 0.0976 0.0972 0.1032 0.1100 0.0995 0.0952 0.0938 0.0960 0.0927 0.0875 0.0833 0.0812 0.0835 0.0892 0.0686 0.0674 0.0694 0.0701 0.0684

0.0541 0.0547 0.0445 0.0405 0.0376 0.0383 0.0420 0.0472 0.0488 0.0522 0.0593 0.0495 0.0467 0.0486 0.0490 0.0443 0.0408 0.0368 0.0350 0.0374 0.0420 0.0153 0.0135 0.0154 0.0153 0.0144

0.5085 0.5139 0.4590 0.4353 0.4136 0.4231 0.4466 0.4830 0.5023 0.5055 0.5392 0.4981 0.4906 0.5178 0.5099 0.4780 0.4661 0.4423 0.4305 0.4482 0.4705 0.2229 0.2001 0.2219 0.2183 0.2098

0.1479 0.1483 0.1481 0.1425 0.1375 0.1357 0.1355 0.1459 0.1439 0.1359 0.1341 0.1339 0.1333 0.1314 0.1325 0.1348 0.1337 0.1309 0.1245 0.1232 0.1238 0.1229 0.1212 0.1209 0.1192 0.1191

0.0956 0.0965 0.0956 0.0899 0.0842 0.0835 0.0835 0.0955 0.0955 0.0849 0.0835 0.0840 0.0849 0.0862 0.0854 0.0864 0.0870 0.0844 0.0783 0.0771 0.0766 0.0695 0.0672 0.0669 0.0644 0.0650

0.6463 0.6511 0.6457 0.6309 0.6121 0.6154 0.6160 0.6541 0.6638 0.6244 0.6223 0.6271 0.6364 0.6558 0.6448 0.6411 0.6505 0.6451 0.6286 0.6261 0.6185 0.5660 0.5549 0.5532 0.5404 0.5460

0.1190 0.1193 0.1127 0.1085 0.1055 0.1046 0.1070 0.1124 0.1111 0.1128 0.1168 0.1089 0.1055 0.1043 0.1067 0.1039 0.0998 0.0961 0.0931 0.0945 0.0988 0.0834 0.0813 0.0828 0.0832 0.0818

0.0666 0.0676 0.0603 0.0559 0.0522 0.0524 0.0549 0.0619 0.0627 0.0618 0.0661 0.0589 0.0570 0.0591 0.0596 0.0555 0.0531 0.0496 0.0468 0.0484 0.0515 0.0301 0.0274 0.0288 0.0284 0.0277

0.5602 0.5664 0.5347 0.5152 0.4945 0.5007 0.5135 0.5509 0.5645 0.5475 0.5661 0.5414 0.5404 0.5666 0.5589 0.5342 0.5319 0.5167 0.5032 0.5125 0.5219 0.3605 0.3365 0.3476 0.3417 0.3389

125

EFFECTIVE TAX RATES

Table 4.4 Effective Tax Rates on Non-Corporate Assets Year

1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Year

1947

(1) PDE σm 0.0918 0.0832 0.0799 0.0806 0.0869 0.0837 0.0827 0.0795 0.0794 0.0809 0.0798 0.0781 0.0772 0.0778 0.0780 0.0792 0.0629 0.0630 0.0632 0.0628 0.0671 0.0666 0.0655 0.0761 0.0824 0.0687 0.0621 0.0585 0.0580 0.0540 0.0488 0.0456 0.0445 0.0458 0.0515 0.0463 0.0456 0.0483 0.0485 0.0474

GAP 0.0390 0.0274 0.0241 0.0269 0.0314 0.0292 0.0274 0.0246 0.0242 0.0261 0.0256 0.0243 0.0242 0.0247 0.0248 0.0255 0.0097 0.0085 0.0076 0.0079 0.0127 0.0142 0.0137 0.0247 0.0305 0.0174 0.0131 0.0139 0.0135 0.0083 0.0054 0.0031 0.0026 0.0042 0.0075 −0.0068 −0.0071 −0.0052 −0.0050 −0.0057

em 0.4250 0.3292 0.3023 0.3339 0.3609 0.3486 0.3315 0.3090 0.3053 0.3224 0.3209 0.3108 0.3131 0.3182 0.3173 0.3217 0.1537 0.1343 0.1201 0.1250 0.1901 0.2136 0.2091 0.3242 0.3698 0.2529 0.2117 0.2380 0.2331 0.1546 0.1109 0.0685 0.0587 0.0927 0.1447 −0.1469 −0.1558 −0.1071 −0.1032 −0.1205

(5) SD σm GAP em 0.0918 0.0390 0.4250

(2) NRS σm 0.0841 0.0779 0.0753 0.0749 0.0805 0.0771 0.0766 0.0746 0.0753 0.0765 0.0756 0.0740 0.0730 0.0740 0.0743 0.0755 0.0749 0.0759 0.0763 0.0767 0.0773 0.0773 0.0791 0.0792 0.0824 0.0815 0.0788 0.0752 0.0740 0.0745 0.0716 0.0685 0.0674 0.0688 0.0747 0.0695 0.0678 0.0683 0.0693 0.0691

GAP 0.0313 0.0221 0.0195 0.0213 0.0250 0.0225 0.0213 0.0197 0.0202 0.0217 0.0214 0.0202 0.0200 0.0209 0.0210 0.0218 0.0217 0.0213 0.0208 0.0218 0.0230 0.0249 0.0273 0.0277 0.0305 0.0302 0.0298 0.0306 0.0296 0.0289 0.0283 0.0260 0.0256 0.0273 0.0306 0.0164 0.0151 0.0148 0.0158 0.0160

em 0.03723 0.2838 0.2596 0.2837 0.3101 0.2925 0.2785 0.2634 0.2676 0.2839 0.2834 0.2727 0.2737 0.2830 0.2831 0.2888 0.2896 0.2811 0.2720 0.2836 0.2978 0.3220 0.3450 0.3504 0.3697 0.3701 0.3788 0.4076 0.3996 0.3875 0.3944 0.3795 0.3795 0.3966 0.4098 0.2359 0.2229 0.2169 0.2276 0.2311

(6) LD σm GAP em 0.0823 0.0295 0.3589

(3) RS σm 0.0818 0.0763 0.0738 0.0732 0.0787 0.0753 0.0749 0.0732 0.0740 0.0752 0.0742 0.0724 0.0715 0.0724 0.0727 0.0740 0.0731 0.0745 0.0753 0.0754 0.0759 0.0758 0.0773 0.0765 0.0792 0.0788 0.0762 0.0724 0.0712 0.0724 0.0698 0.0670 0.0658 0.0668 0.0723 0.0722 0.0708 0.0706 0.0715 0.0712

GAP 0.0290 0.0205 0.0181 0.0196 0.0231 0.0207 0.0197 0.0182 0.0188 0.0204 0.0200 0.0186 0.0185 0.0194 0.0195 0.0203 0.0199 0.0200 0.0198 0.0204 0.0216 0.0235 0.0255 0.0251 0.0272 0.0275 0.0273 0.0278 0.0268 0.0267 0.0265 0.0245 0.0239 0.0252 0.0283 0.0191 0.0181 0.0171 0.0179 0.0181

em 0.3548 0.2690 0.2449 0.2670 0.2939 0.2755 0.2624 0.2491 0.2544 0.2710 0.2698 0.2572 0.2583 0.2678 0.2679 0.2744 0.2722 0.2681 0.2622 0.2711 0.2848 0.3093 0.3298 0.3280 0.3438 0.3488 0.3578 0.3846 0.3759 0.3694 0.3789 0.3655 0.3639 0.3777 0.3907 0.2642 0.2557 0.2421 0.2506 0.2536

(7) S σm GAP em 0.0918 0.0390 0.4250

(4) ND σm 0.1022 0.0900 0.0858 0.0870 0.0960 0.0944 0.0927 0.0875 0.0894 0.0919 0.0898 0.0866 0.0856 0.0857 0.0858 0.0871 0.0877 0.0877 0.0870 0.0871 0.0874 0.0882 0.0899 0.0880 0.0889 0.0894 0.0873 0.0831 0.0812 0.0821 0.0800 0.0775 0.0762 0.0767 0.0813 0.0865 0.0835 0.0846 0.0839 0.0838

GAP 0.0494 0.0342 0.0301 0.0333 0.0404 0.0399 0.0374 0.0325 0.0342 0.0371 0.0357 0.0328 0.0326 0.0326 0.0325 0.0334 0.0345 0.0332 0.0314 0.0322 0.0331 0.0358 0.0380 0.0366 0.0369 0.0380 0.0383 0.0386 0.0386 0.0365 0.0366 0.0350 0.0343 0.0352 0.0373 0.0333 0.0308 0.0311 0.0303 0.0307

em 0.4836 0.3803 0.3504 0.3831 0.4211 0.4224 0.4039 0.3719 0.3825 0.4038 0.3969 0.3787 0.3805 0.3810 0.3793 0.3836 0.3931 0.3782 0.3610 0.3692 0.3786 0.4058 0.4233 0.4157 0.4153 0.4256 0.4392 0.4640 0.4530 0.443 0.4577 0.4515 0.4507 0.4587 0.4582 0.3855 0.3688 0.3674 0.3613 0.3660

(8) L σm GAP em 0.0927 0.0399 0.4305

126 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

EFFECTIVE TAX RATES

0.0832 0.0274 0.0799 0.0241 0.0806 0.0269 0.0869 0.0314 0.0837 0.0292 0.0827 0.0274 0.0795 0.0246 0.0794 0.0242 0.0809 0.0261 0.0798 0.0256 0.0781 0.0243 0.0772 0.0242 0.0778 0.0247 0.0780 0.0248 0.0792 0.0255 0.0629 0.0097 0.0630 0.0085 0.0632 0.0076 0.0628 0.0079 0.0671 0.0127 0.0666 0.0142 0.0655 0.0137 0.0761 0.0247 0.0824 0.0305 0.0687 0.0174 0.0621 0.0131 0.0585 0.0139 0.0580 0.0135 0.0540 0.0083 0.0488 0.0054 0.0456 0.0031 0.0445 0.0026 0.0458 0.0042 0.0515 0.0075 0.0463 −0.0068 0.0456 −0.0071 0.0483 −0.0052 0.0485 −0.0050 0.0474 −0.0057

0.3292 0.3023 0.3339 0.3609 0.3486 0.3315 0.3090 0.3053 0.3224 0.3209 0.3108 0.3131 0.3182 0.3173 0.3217 0.1537 0.1343 0.1201 0.1250 0.1901 0.2136 0.2091 0.3242 0.3698 0.2529 0.2117 0.2380 0.2331 0.1546 0.1109 0.0685 0.0587 0.0927 0.1447 −0.1469 −0.1558 −0.1071 −0.1032 −0.1205

0.0767 0.0742 0.0737 0.0791 0.0757 0.0753 0.0735 0.0743 0.0755 0.0746 0.0729 0.0719 0.0728 0.0732 0.0744 0.0736 0.0749 0.0756 0.0758 0.0763 0.0763 0.0778 0.0773 0.0801 0.0796 0.0770 0.0732 0.0721 0.0730 0.0704 0.0674 0.0663 0.0673 0.0730 0.0715

0.0209 0.0184 0.0200 0.0236 0.0212 0.0201 0.0186 0.0192 0.0207 0.0204 0.0191 0.0189 0.0198 0.0199 0.0207 0.0204 0.0204 0.0200 0.0208 0.0220 0.0239 0.0260 0.0259 0.0282 0.0283 0.0280 0.0287 0.0276 0.0274 0.0270 0.0249 0.0244 0.0258 0.0289 0.0183

0.2727 0.2487 0.2712 0.2978 0.2799 0.2666 0.2528 0.2578 0.2743 0.2735 0.2616 0.2626 0.2720 0.2721 0.2784 0.2771 0.2718 0.2650 0.2747 0.2886 0.3130 0.3342 0.3345 0.3515 0.3553 0.3642 0.3916 0.3832 0.3750 0.3836 0.3696 0.3684 0.3830 0.3960 0.2565

0.0699 0.0173 0.2467 0.0700 0.0164 0.2351 0.0709 0.0173 0.2443 0.0706 0.0175 0.2475

0.0832 0.0274 0.0799 0.0241 0.0806 0.0269 0.0869 0.0314 0.0837 0.0292 0.0827 0.0274 0.0795 0.0246 0.0794 0.0242 0.0809 0.0261 0.0798 0.0256 0.0781 0.0243 0.0772 0.0242 0.0778 0.0247 0.0780 0.0248 0.0792 0.0255 0.0629 0.0097 0.0630 0.0085 0.0632 0.0076 0.0628 0.0079 0.0671 0.0127 0.0666 0.0142 0.0655 0.0137 0.0761 0.0247 0.0824 0.0305 0.0687 0.0174 0.0621 0.0131 0.0585 0.0139 0.0580 0.0135 0.0540 0.0083 0.0488 0.0054 0.0456 0.0031 0.0445 0.0026 0.0458 0.0042 0.0515 0.0075 0.0463 −0.0068 0.0456 −0.0071 0.0483 −0.0052 0.0485 −0.0050 0.0474 −0.0057

0.3292 0.3023 0.3339 0.3609 0.3486 0.3315 0.3090 0.3053 0.3224 0.3209 0.3108 0.3131 0.3182 0.3173 0.3217 0.1537 0.1343 0.1201 0.1250 0.1901 0.2136 0.2091 0.3242 0.3698 0.2529 0.2117 0.2380 0.2331 0.1546 0.1109 0.0685 0.0587 0.0927 0.1447 −0.1469 −0.1558 −0.1071 −0.1032 −0.1205

0.0830 0.0795 0.0797 0.0869 0.0845 0.0835 0.0801 0.0814 0.0833 0.0818 0.0795 0.0787 0.0793 0.0796 0.0809 0.0808 0.0815 0.0814 0.0816 0.0820 0.0823 0.0839 0.0824 0.0842 0.0840 0.0817 0.0778 0.0764 0.0773 0.0750 0.0724 0.0712 0.0720 0.0772 0.0789

0.0272 0.0238 0.0261 0.0313 0.0300 0.0283 0.0252 0.0262 0.0284 0.0276 0.0257 0.0256 0.0263 0.0264 0.0272 0.0276 0.0269 0.0259 0.0266 0.0277 0.0299 0.0320 0.0310 0.0322 0.0327 0.0327 0.0333 0.0319 0.0317 0.0316 0.0299 0.0293 0.0305 0.0331 0.0258

0.3280 0.2991 0.3268 0.3605 0.3547 0.3386 0.3143 0.3223 0.3416 0.3373 0.3230 0.3259 0.3314 0.3313 0.3363 0.3417 0.3305 0.3175 0.3265 0.3379 0.3636 0.3820 0.3762 0.3830 0.3891 0.4007 0.4277 0.4181 0.4096 0.4215 0.4126 0.4118 0.4230 0.4288 0.3269

0.0764 0.0238 0.3108 0.0770 0.0235 0.3054 0.0770 0.0235 0.3046 0.0766 0.0235 0.3063

127

EFFECTIVE TAX RATES

Year

1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

(9) D σm 0.0833 0.0774 0.0749 0.0746 0.0802 0.0769 0.0764 0.0744 0.0751 0.0764 0.0754 0.0737 0.0728 0.0736 0.0740 0.0752 0.0720 0.0730 0.0737 0.0737 0.0749 0.0747 0.0759 0.0771 0.0805 0.0780 0.0748 0.0711 0.0700 0.0701 0.0670 0.0641 0.0630 0.0642 0.0699 0.0680 0.0666 0.0671 0.0680 0.0678

GAP 0.0305 0.0216 0.0191 0.0209 0.0247 0.0224 0.0212 0.0195 0.0199 0.0215 0.0212 0.0199 0.0197 0.0206 0.0207 0.0215 0.0187 0.0185 0.0181 0.0188 0.0205 0.0223 0.0241 0.0257 0.0285 0.0267 0.0259 0.0266 0.0256 0.0245 0.0237 0.0216 0.0211 0.0226 0.0259 0.0148 0.0140 0.0136 0.0145 0.0147

em 0.3663 0.2794 0.2557 0.2803 0.3075 0.2910 0.2770 0.2618 0.2654 0.2821 0.2812 0.2698 0.2714 0.2799 0.2798 0.2856 0.2603 0.2533 0.2456 0.2546 0.2745 0.2987 0.3170 0.3330 0.3544 0.3419 0.3456 0.3734 0.3652 0.3491 0.3529 0.3369 0.3354 0.3527 0.3697 0.2184 0.2095 0.2022 0.2127 0.2162

(10) ND σm 0.1022 0.0900 0.0858 0.0870 0.0960 0.0944 0.0927 0.0875 0.0894 0.0919 0.0898 0.0866 0.0856 0.0857 0.0858 0.0871 0.0877 0.0877 0.0870 0.0871 0.0874 0.0882 0.0899 0.0880 0.0889 0.0894 0.0873 0.0831 0.0812 0.0821 0.0800 0.0775 0.0762 0.0767 0.0813 0.0865 0.0835 0.0846 0.0839 0.0838

GAP 0.0494 0.0342 0.0301 0.0333 0.0404 0.0399 0.0374 0.0325 0.0342 0.0371 0.0357 0.0328 0.0326 0.0326 0.0325 0.0334 0.0345 0.0332 0.0314 0.0322 0.0331 0.0358 0.0380 0.0366 0.0369 0.0380 0.0383 0.0386 0.0368 0.0365 0.0366 0.0350 0.0343 0.0352 0.0373 0.0333 0.0308 0.0311 0.0303 0.0307

em 0.4836 0.3803 0.3504 0.3831 0.4211 0.4224 0.4039 0.3719 0.3825 0.4038 0.3969 0.3787 0.3805 0.3810 0.3793 0.3836 0.3931 0.3782 0.3610 0.3692 0.3786 0.4058 0.4233 0.4157 0.4153 0.4256 0.4392 0.4640 0.4530 0.4443 0.4577 0.4515 0.4507 0.4587 0.4582 0.3855 0.3688 0.3674 0.3613 0.3660

(11) A σm 0.0926 0.0830 0.0795 0.0798 0.0869 0.0844 0.0835 0.0801 0.0812 0.0831 0.0816 0.0794 0.0785 0.0792 0.0795 0.0808 0.0794 0.0799 0.0799 0.0800 0.0808 0.0810 0.0823 0.0819 0.0840 0.0827 0.0800 0.0762 0.0749 0.0753 0.0727 0.0701 0.0689 0.0699 0.0752 0.0765 0.0741 0.0749 0.0750 0.0746

GAP 0.0398 0.0272 0.0238 0.0261 0.0313 0.0299 0.0282 0.0251 0.0261 0.0282 0.0274 0.0256 0.0255 0.0261 0.0262 0.0271 0.0261 0.0254 0.0243 0.0251 0.0264 0.0286 0.0304 0.0305 0.0321 0.0314 0.0310 0.0317 0.0304 0.0296 0.0293 0.0276 0.0271 0.0284 0.0311 0.0234 0.0214 0.0214 0.0214 0.0214

em 0.4302 0.3280 0.2993 0.3274 0.3606 0.3542 0.3380 0.3138 0.3209 0.3400 0.3359 0.3220 0.3248 0.3302 0.3301 0.3351 0.3293 0.3177 0.3045 0.3133 0.3275 0.3530 0.3701 0.3720 0.3818 0.3793 0.3881 0.4158 0.4063 0.3937 0.4034 0.3937 0.3929 0.4058 0.4138 0.3055 0.2893 0.2858 0.2858 0.2871

128

EFFECTIVE TAX RATES

1947–86, short-lived assets bore a lighter tax burden than long-lived assets in the corporate sector. The same pattern obtains, except for the years 1948–51, in the non-corporate sector. Differences between rates of return for short-lived and long-lived depreciable assets increased substantially after the 1962–4 tax cut. In 1962 this difference was 3.53 per cent in the corporate sector and 4.33 per cent in the noncorporate sector. The difference jumped to 9.09 per cent in the corporate sector and 12.34 per cent in the noncorporate sector in 1963. The differences stayed far above the pre-1963 levels in both sectors, except for 1970–1, when the tax burden on business assets was sharply increased by the abolition of investment tax credit and the elimination of Guideline lifetimes for capital consumption allowances. The results presented in Tables 4.3 and 4.4, columns (1)–(4), show that non-depreciable assets have been taxed more heavily than any other category of assets. The difference between social rates of return on depreciable and non-depreciable assets has been substantial throughout the period 1947–86. By contrast, the differences between short-lived and long-lived depreciable assets and between short-lived and long-lived assets in the corporate and non-corporate sectors were very modest until 1962. Since 1963 these differences have been much larger. The tax policy changes after 1962 reduced the average tax burden on business assets. However, they created important distortions in resource allocation within the corporate and noncorporate sectors by increasing the differences between effective tax rates on short-lived and long-lived depreciable assets. To quantify the potential distortions in the allocation of capital arising from tax policy, we consider social rates of return for assets utilized in the corporate sector presented in Tables 4.3 and 4.7. In 1986 the social rates of return were 5.61 per cent for short-lived depreciable assets, 7.71 per cent for long-lived depreciable assets, 9.30 per cent for longlived assets, 6.84 per cent for all depreciable assets, and 11.91 per cent for non-depreciable assets. The corresponding differences in social rates of return were 2.10 per cent between short-lived and long-lived depreciable assets, 3.69 per cent between short-lived and long-lived assets, and 5.07 per cent between depreciable and non-depreciable assets. The greatest difference was 6.30 per cent

129

EFFECTIVE TAX RATES

Table 4.5 Effective Tax Rates on Household Assets Year 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

σh 0.0317 0.0454 0.0548 0.0496 0.0406 0.0483 0.0513 0.0544 0.0501 0.0441 0.0481 0.0523 0.0556 0.0529 0.0562 0.0532 0.0568 0.0546 0.0548 0.0516 0.0532 0.0515 0.0489 0.0563 0.0550 0.0525 0.0480 0.0393 0.0443 0.0475 0.0416 0.0384 0.0363 0.0381 0.0439 0.0605 0.0594 0.0601 0.0611 0.0574

Note There are no inter-asset tax wedges in the household sector.

GAP 0.0061 0.0057 0.0055 0.0054 0.0048 0.0047 0.0048 0.0051 0.0056 0.0058 0.0058 0.0062 0.0065 0.0071 0.0073 0.0076 0.0079 0.0085 0.0091 0.0092 0.0091 0.0092 0.0093 0.0095 0.0100 0.0096 0.0093 0.0086 0.0083 0.0082 0.0080 0.0071 0.0060 0.0053 0.0050 0.0055 0.0063 0.0061 0.0063 0.0064

eh 0.1924 0.1252 0.0995 0.1082 0.1191 0.0964 0.0939 0.0942 0.1123 0.1305 0.1203 0.1188 0.1170 0.1352 0.1293 0.1424 0.1383 0.1550 0.1660 0.1780 0.1711 0.1779 0.1908 0.1685 0.1813 0.1832 0.1935 0.2183 0.1865 0.1727 0.1913 0.1847 0.1639 0.1380 0.1149 0.0908 0.1056 0.1022 0.1028 0.1112

130

EFFECTIVE TAX RATES

Table 4.6 Effective Tax Rate on Private Assets Year 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

σ 0.0772 0.0773 0.0790 0.0784 0.0807 0.0822 0.0826 0.0829 0.0809 0.0790 0.0805 0.0820 0.0828 0.0825 0.0839 0.0830 0.0817 0.0795 0.0785 0.0770 0.0787 0.0799 0.0785 0.0818 0.0833 0.0791 0.0753 0.0703 0.0733 0.0739 0.0694 0.0657 0.0633 0.0647 0.0702 0.0723 0.0708 0.0715 0.0721 0.0699

GAP 0.0372 0.0294 0.0265 0.0292 0.0355 0.0335 0.0321 0.0309 0.0313 0.0327 0.0323 0.0320 0.0316 0.0328 0.0326 0.0332 0.0305 0.0289 0.0276 0.0280 0.0292 0.0322 0.0329 0.0324 0.0346 0.0317 0.0308 0.0313 0.0314 0.0299 0.0288 0.0265 0.0248 0.0253 0.0272 0.0184 0.0175 0.0177 0.0176 0.0173

ea 0.4812 0.3797 0.3352 0.3719 0.4396 0.4082 0.3881 0.3730 0.3872 0.4144 0.4010 0.3907 0.3819 0.3981 0.3887 0.3994 0.3726 0.3640 0.3517 0.3630 0.3710 0.4026 0.4184 0.3963 0.4157 0.4013 0.4086 0.4446 0.4282 0.4046 0.4152 0.4036 0.3917 0.3914 0.3875 0.2545 0.2474 0.2472 0.2442 0.2480

131

EFFECTIVE TAX RATES

Table 4.7 Inter-Asset Tax Wedges Year 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

Business SD–LD 0.0097 0.0100 0.0099 0.0119 0.0148 0.0147 0.0146 0.0145 0.0125 0.0124 0.0125 0.0131 0.0133 0.0132 0.0133 0.0134 −0.0081 −0.0098 −0.0107 −0.0115 −0.0059 −0.0049 −0.0079 0.0062 0.0100 −0.0073 −0.0121 −0.0113 −0.0098 −0.0140 −0.0170 −0.0174 −0.0166 −0.0155 −0.0147 −0.0217 −0.0213 −0.0170 −0.0179 −0.0192

S–L 0.0007 0.0035 0.0041 0.0055 0.0046 0.0032 0.0037 0.0045 0.0014 0.0003 0.0008 0.0026 0.0026 0.0027 0.0029 0.0026 −0.0197 −0.0210 −0.0212 −0.0216 −0.0156 −0.0161 −0.0184 −0.0021 0.0039 −0.0142 −0.0194 −0.0185 −0.0170 −0.0214 −0.0252 −0.0259 −0.0245 −0.0225 −0.0205 −0.0336 −0.0323 −0.0282 −0.0283 −0.0298

D–ND −0.0184 −0.0138 −0.0123 −0.0137 −0.0216 −0.0243 −0.0230 −0.0207 −0.0236 −0.0257 −0.0246 −0.0214 −0.0209 −0.0200 −0.0194 −0.0202 −0.0275 −0.0271 −0.0257 −0.0251 −0.0227 −0.0258 −0.0256 −0.0171 −0.0113 −0.0190 −0.0212 −0.0202 −0.0195 −0.0219 −0.0244 −0.0249 −0.0232 −0.0207 −0.0175 −0.0334 −0.0322 −0.0313 −0.0298 −0.0313

Corporate SD–LD 0.0067 0.0065 0.0061 0.0074 0.0113 0.0110 0.0108 0.0103 0.0084 0.0086 0.0083 0.0080 0.0081 0.0077 0.0076 0.0079 −0.0154 −0.0160 −0.0163 −0.0172 −0.0114 −0.0112 −0.0144 −0.0002 0.0029 −0.0143 −0.0194 −0.0193 −0.0185 −0.0215 −0.0241 −0.0245 −0.0233 −0.0227 −0.0219 −0.0233 −0.0232 −0.0186 −0.0198 −0.0210

S–L −0.0023 −0.0021 −0.0022 −0.0021 −0.0039 −0.0059 −0.0058 −0.0062 −0.0093 −0.0099 −0.0097 −0.0089 −0.0092 −0.0096 −0.0098 −0.0099 −0.0338 −0.0339 −0.0331 −0.0333 −0.0269 −0.0294 −0.0311 −0.0133 −0.0069 −0.0252 −0.0309 −0.0310 −0.0302 −0.0340 −0.0378 −0.0388 −0.0364 −0.0346 −0.0320 −0.0406 −0.0395 −0.0350 −0.0355 −0.0369

D–ND −0.0236 −0.0233 −0.0228 −0.0267 −0.0393 0.0438 −0.0436 −0.0431 −0.0463 −0.0469 −0.0454 −0.0425 −0.0428 −0.0419 −0.0415 −0.0419 −0.0511 −0.0494 −0.0466 −0.0452 −0.0415 −0.0483 −0.0467 −0.0327 −0.0242 −0.0344 −0.0382 −0.0376 −0.0365 −0.0421 −0.0462 −0.0476 −0.0433 −0.0397 −0.0346 −0.0543 −0.0537 −0.0515 −0.0491 −0.0507

Non-corporate SD–LD S–L 0.0095 −0.0009 0.0065 0.0001 0.0057 0.0004 0.0069 0.0008 0.0078 0.0000 0.0080 −0.0008 0.0073 −0.0009 0.0060 −0.0006 0.0051 −0.0020 0.0054 −0.0024 0.0052 −0.0020 0.0052 −0.0014 0.0053 −0.0015 0.0049 −0.0015 0.0048 −0.0016 0.0048 −0.0017 −0.0107 −0.0180 −0.0119 −0.0185 −0.0125 −0.0183 −0.0130 −0.0188 −0.0093 −0.0150 −0.0096 −0.0157 −0.0123 −0.0183 −0.0012 −0.0063 0.0023 −0.0018 −0.0109 −0.0153 −0.0149 −0.0196 −0.0148 −0.0194 −0.0141 −0.0184 −0.0190 −0.0233 −0.0216 −0.0262 −0.0218 −0.0267 −0.0218 −0.0267 −0.0215 −0.0262 −0.0214 −0.0256 −0.0251 −0.0326 −0.0244 −0.0309 −0.0216 −0.0287 −0.0223 −0.0285 −0.0232 −0.0292

D–ND −0.0189 −0.0126 −0.0109 −0.0124 −0.0157 −0.0175 −0.0163 −0.0131 −0.0143 −0.0156 −0.0145 −0.0129 −0.0128 −0.0120 −0.0119 −0.0120 −0.0157 −0.0147 −0.0133 −0.0134 −0.0125 −0.0135 −0.0140 −0.0109 −0.0084 −0.0114 −0.0125 0.0120 −0.0112 −0.0120 −0.0130 −0.0134 −0.0132 −0.0126 −0.0114 −0.0185 −0.0168 −0.0175 −0.0158 −0.0160

132

EFFECTIVE TAX RATES

between social rates of return for short-lived and non-depreciable assets. If we were to transfer one dollar from short-lived assets to long-lived depreciable assets, national income would increase by 2.10 cents per year in perpetuity. If we were to transfer one dollar worth of capital from depreciable to nondepreciable assets, national income would increase by 5.07 cents per year, again in perpetuity. Finally, if we were to transfer one dollar from short-lived assets to non-depreciable assets, the gain in national income would be as much as 6.30 cents per year. Considering the fact that the private rate of return was in the range of 5.1–5.4 per cent with an average of 5.26 per cent in 1986, these gains correspond to very substantial increases in the national wealth. For example, at a private rate of return of 5.26 per cent, the transfer of each dollar with a perpetual return of 6.30 per cent results in an increase in national wealth of $1.20. We conclude that national wealth can be more than doubled at the margin by transferring capital from the least heavily taxed asset into the most heavily taxed asset. Differences between social rates of return for short-lived and long-lived depreciable assets, all short-lived and longlived assets, depreciable and non-depreciable assets, and differences among social rates of return for all assets held in the household, non-corporate, and corporate sectors are given in Tables 4.8–4.10. Since assets in the corporate sector are usually the most heavily taxed and those in the household sector are the most lightly taxed, the largest intersector differences are usually between the corporate and household sectors. The differences between assets in the corporate and non-corporate sectors and between assets in the non-corporate and household sectors were also large and economically significant. Second, our results show that discrepancies in tax burdens are greatest between non-depreciable assets in the corporate and household sectors. This is due to the fact that non-depreciable assets are not eligible for the investment tax credit and accelerated capital consumption allowances. These provisions for capital cost recovery have tended to reduce the tax burden. For example, in 1986 the difference between social rates of return on non-depreciable assets in the corporate and household sectors was 6.17 per cent, which is greater than the private rates of

133

EFFECTIVE TAX RATES

Table 4.8 Intersectoral Tax Wedges: Corporate–Non-Corporate Year 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

SD 0.0073 0.0163 0.0199 0.0242 0.0274 0.0277 0.0290 0.0329 0.0288 0.0268 0.0283 0.0318 0.0321 0.0333 0.0335 0.0325 0.0239 0.0196 0.0172 0.0166 0.0198 0.0240 0.0228 0.0270 0.0293 0.0218 0.0208 0.0231 0.0264 0.0254 0.0239 0.0227 0.0226 0.0240 0.0245 0.0084 0.0080 0.0101 0.0099 0.0087

LD 0.0101 0.0163 0.0195 0.0238 0.0239 0.0247 0.0255 0.0286 0.0255 0.0236 0.0251 0.0290 0.0294 0.0306 0.0307 0.0293 0.0285 0.0237 0.0211 0.0208 0.0219 0.0256 0.0248 0.0260 0.0288 0.0252 0.0254 0.0277 0.0308 0.0279 0.0264 0.0254 0.0241 0.0252 0.0250 0.0066 0.0068 0.0071 0.0074 0.0065

S 0.0073 0.0163 0.0199 0.0242 0.0274 0.0277 0.0290 0.0329 0.0288 0.0268 0.0283 0.0318 0.0321 0.0333 0.0335 0.0325 0.0239 0.0196 0.0172 0.0166 0.0198 0.0240 0.0228 0.0270 0.0293 0.0218 0.0208 0.0231 0.0264 0.0254 0.0239 0.0227 0.0226 0.0240 0.0245 0.0084 0.0080 0.0101 0.0099 0.0087

L 0.0087 0.0186 0.0224 0.0272 0.0313 0.0328 0.0339 0.0385 0.0361 0.0344 0.0360 0.0393 0.0399 0.0414 0.0416 0.0407 0.0398 0.0350 0.0320 0.0311 0.0317 0.0377 0.0355 0.0339 0.0344 0.0317 0.0321 0.0347 0.0382 0.0361 0.0355 0.0348 0.0323 0.0325 0.0309 0.0164 0.0167 0.0163 0.0170 0.0164

D 0.0108 0.0171 0.0203 0.0248 0.0259 0.0266 0.0275 0.0306 0.0272 0.0254 0.0269 0.0307 0.0311 0.0323 0.0325 0.0312 0.0250 0.0201 0.0173 0.0168 0.0192 0.0229 0.0213 0.0261 0.0295 0.0215 0.0204 0.0227 0.0260 0.0226 0.0205 0.0192 0.0182 0.0193 0.0193 0.0006 0.0008 0.0023 0.0021 0.0006

ND 0.0154 0.0278 0.0322 0.0391 0.0495 0.0530 0.0548 0.0607 0.0593 0.0567 0.0578 0.0603 0.0612 0.0622 0.0621 0.0611 0.0604 0.0548 0.0505 0.0486 0.0481 0.0578 0.0540 0.0479 0.0453 0.0445 0.0461 0.0483 0.0512 0.0527 0.0537 0.0534 0.0483 0.0464 0.0424 0.0364 0.0377 0.0363 0.0354 0.0353

A 0.0084 0.0182 0.0220 0.0267 0.0305 0.0317 0.0328 0.0373 0.0343 0.0325 0.0341 0.0374 0.0378 0.0393 0.0395 0.0385 0.0334 0.0286 0.0256 0.0245 0.0262 0.0314 0.0288 0.0309 0.0327 0.0262 0.0255 0.0281 0.0318 0.0286 0.0271 0.0260 0.0241 0.0246 0.0236 0.0069 0.0072 0.0079 0.0082 0.0072

134

EFFECTIVE TAX RATES

Table 4.9 Intersectoral Tax Wedges: Corporate–Household Year 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

SD 0.0675 0.0541 0.0449 0.0552 0.0737 0.0631 0.0604 0.0581 0.0582 0.0637 0.0599 0.0575 0.0538 0.0582 0.0552 0.0584 0.0300 0.0280 0.0255 0.0278 0.0336 0.0391 0.0394 0.0468 0.0567 0.0380 0.0349 0.0423 0.0400 0.0319 0.0311 0.0300 0.0308 0.0317 0.0321 −0.0057 −0.0057 −0.0017 −0.0026 −0.0012

LD 0.0608 0.0476 0.0388 0.0479 0.0625 0.0521 0.0496 0.0477 0.0497 0.0550 0.0516 0.0495 0.0457 0.0505 0.0477 0.0505 0.0454 0.0440 0.0418 0.0450 0.0450 0.0503 0.0537 0.0470 0.0538 0.0524 0.0543 0.0616 0.0585 0.0534 0.0552 0.0545 0.0541 0.0544 0.0540 0.0175 0.0174 0.0169 0.0172 0.0197

S 0.0675 0.0541 0.0449 0.0552 0.0737 0.0631 0.0604 0.0581 0.0582 0.0637 0.0599 0.0575 0.0538 0.0582 0.0552 0.0584 0.0300 0.0280 0.0255 0.0278 0.0336 0.0391 0.0394 0.0468 0.0567 0.0380 0.0349 0.0423 0.0400 0.0319 0.0311 0.0300 0.0308 0.0317 0.0321 −0.0057 −0.0057 −0.0017 −0.0026 −0.0012

L 0.0697 0.0562 0.0471 0.0573 0.0776 0.0690 0.0662 0.0643 0.0675 0.0736 0.0697 0.0664 0.0629 0.0679 0.0650 0.0684 0.0638 0.0619 0.0586 0.0611 0.0605 0.0685 0.0704 0.0600 0.0636 0.0632 0.0658 0.0733 0.0703 0.0659 0.0689 0.0688 0.0672 0.0664 0.0641 0.0348 0.0338 0.0333 0.0329 0.0357

D 0.0624 0.0492 0.0404 0.0498 0.0656 0.0552 0.0526 0.0507 0.0522 0.0576 0.0542 0.0521 0.0483 0.0531 0.0502 0.0532 0.0402 0.0385 0.0361 0.0389 0.0408 0.0461 0.0483 0.0469 0.0549 0.0470 0.0471 0.0545 0.0517 0.0452 0.0459 0.0449 0.0449 0.0454 0.0452 0.0081 0.0081 0.0093 0.0090 0.0111

ND 0.0859 0.0724 0.0632 0.0765 0.1049 0.0990 0.0962 0.0939 0.0985 0.1045 0.0995 0.0946 0.0912 0.0950 0.0917 0.0950 0.0913 0.0879 0.0827 0.0841 0.0823 0.0944 0.0950 0.0796 0.0791 0.0814 0.0853 0.0921 0.0882 0.0873 0.0921 0.0925 0.0882 0.0851 0.0798 0.0624 0.0618 0.0608 0.0581 0.0617

A 0.0694 0.0558 0.0467 0.0569 0.0769 0.0678 0.0650 0.0630 0.0655 0.0715 0.0676 0.0644 0.0608 0.0657 0.0627 0.0661 0.0559 0.0539 0.0507 0.0529 0.0538 0.0609 0.0622 0.0565 0.0617 0.0564 0.0574 0.0650 0.0624 0.0564 0.0582 0.0577 0.0568 0.0564 0.0548 0.0229 0.0219 0.0227 0.0221 0.0244

135

EFFECTIVE TAX RATES

Table 4.10 Intersectoral Tax Wedges: Non-Corporate–Household Year 1947 1948 1949 1950 1951 1952 1953 1954 1955 1956 1957 1958 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986

SD 0.0601 0.0378 0.0251 0.0310 0.0464 0.0354 0.0314 0.0252 0.0293 0.0368 0.0317 0.0258 0.0216 0.0249 0.0218 0.0260 0.0061 0.0084 0.0083 0.0112 0.0138 0.0151 0.0166 0.0198 0.0274 0.0162 0.0141 0.0191 0.0136 0.0065 0.0072 0.0073 0.0082 0.0077 0.0076 −0.0141 −0.0138 −0.0118 −0.0126 −0.0099

LD 0.0507 0.0313 0.0194 0.0240 0.0386 0.0274 0.0241 0.0192 0.0243 0.0314 0.0265 0.0206 0.0163 0.0200 0.0169 0.0212 0.0168 0.0203 0.0208 0.0241 0.0231 0.0247 0.0289 0.0210 0.0251 0.0271 0.0289 0.0339 0.0277 0.0255 0.0288 0.0291 0.0300 0.0292 0.0290 0.0110 0.0106 0.0099 0.0098 0.0133

S 0.0601 0.0378 0.0251 0.0310 0.0464 0.0354 0.0314 0.0252 0.0293 0.0368 0.0317 0.0258 0.0216 0.0249 0.0218 0.0260 0.0061 0.0084 0.0083 0.0112 0.0138 0.0151 0.0166 0.0198 0.0274 0.0162 0.0141 0.0191 0.0136 0.0065 0.0072 0.0073 0.0082 0.0077 0.0076 −0.0141 −0.0138 −0.0118 −0.0126 −0.0099

L 0.0610 0.0376 0.0247 0.0301 0.0463 0.0362 0.0323 0.0258 0.0313 0.0392 0.0337 0.0272 0.0231 0.0265 0.0234 0.0277 0.0240 0.0269 0.0266 0.0300 0.0288 0.0308 0.0350 0.0261 0.0292 0.0316 0.0336 0.0385 0.0321 0.0298 0.0334 0.0340 0.0348 0.0339 0.0332 0.0185 0.0171 0.0169 0.0159 0.0192

D 0.0516 0.0320 0.0201 0.0250 0.0397 0.0286 0.0252 0.0201 0.0250 0.0323 0.0273 0.0214 0.0172 0.0208 0.0177 0.0220 0.0151 0.0185 0.0188 0.0221 0.0216 0.0232 0.0270 0.0208 0.0254 0.0255 0.0268 0.0318 0.0257 0.0226 0.0254 0.0258 0.0267 0.0261 0.0260 0.0075 0.0073 0.0070 0.0069 0.0104

ND 0.0705 0.0446 0.0310 0.0374 0.0554 0.0461 0.0414 0.0331 0.0393 0.0479 0.0417 0.0343 0.0300 0.0328 0.0296 0.0339 0.0309 0.0331 0.0321 0.0355 0.0342 0.0366 0.0410 0.0317 0.0338 0.0369 0.0392 0.0438 0.0369 0.0346 0.0384 0.0392 0.0399 0.0387 0.0374 0.0260 0.0241 0.0245 0.0228 0.0265

A 0.0610 0.0376 0.0247 0.0302 0.0463 0.0361 0.0322 0.0257 0.0312 0.0390 0.0335 0.0271 0.0230 0.0263 0.0233 0.0276 0.0226 0.0253 0.0251 0.0284 0.0275 0.0294 0.0334 0.0256 0.0290 0.0302 0.0320 0.0369 0.0305 0.0278 0.0311 0.0318 0.0326 0.0318 0.0313 0.0160 0.0148 0.0148 0.0139 0.0172

136

EFFECTIVE TAX RATES

return on assets in the corporate and household sectors in the same year. Even when we compare the corporate and non-corporate sectors, the differences in social rates of return were as large as 3.53 per cent. Third, across-the-board tax cuts since 1962 have significantly reduced differences in social rates of return between sectors. However, the reductions have been concentrated on depreciable assets, since the tax cuts were achieved mainly through liberalization of the investment tax credit and capital consumption allowances. These tax cuts have tended to favour short-lived assets over long-lived assets. This can be contrasted with our previous finding that past tax cuts have tended to widen the differences between assets in the same sector. We conclude that inter-asset and intersectoral differences in social rates of return have been very substantial, relative to the private rate of return to capital. The potential loss of economic welfare arising from the misallocation of capital is very great. It is important to consider the distortions caused by the inter-asset differences as well as intersectoral differences in analysing the distortion of capital allocation arising from the taxation of income from capital. For example, in 1980 the difference in social rates of return between the corporate and non-corporate sectors was 2.46 per cent; in the same year the differences for short-lived and long-lived assets were 3.46 per cent in the corporate sector and 2.62 per cent in the non-corporate sector. Ignoring either inter-asset or intersectoral tax differences would result in omitting an important source of resource misallocation arising from tax policy. This must be kept in mind in formulating and analysing tax reform proposals. We have noted that the reduction in tax burdens on business assets and the resulting reduction in the intersectoral tax differences were achieved through tax cuts that widened the inter-asset tax differences. This is the consequence of excessive emphasis on reducing the average tax burden, while ignoring the consequences of distortions of resource allocation arising from tax policy. The tax wedge between social and private rates of return on all forms of capital results in distortions of resource allocation over time. The average intertemporal tax wedges on assets in the business, corporate, non-corporate, and household sectors are shown in column (11) of Tables 4.2, 4.3, and 4.4 and in Table 4.5.

EFFECTIVE TAX RATES

137

In the corporate sector this tax wedge was in the range of 2.74–7.22 per cent during the period 1947–86. In the same period the corresponding ranges were 2.14–3.17 per cent and 0.47–1.00 per cent in the non-corporate and household sectors, respectively. In the period 1947–86 private rates of return ranged from 3.90 to 5.48 per cent, 4.15 to 5.58 per cent, and 2.56 to 5.50 per cent in the corporate, non-corporate, and household sectors, respectively. The welfare costs of tax distortion in the intertemporal allocation of resources is potentially very important. However, we must bear in mind that tax distortions are inevitable. If the tax on income from capital were to be cut, the reduction in tax revenue would have to be made up by other taxes. Hence, the issue is how to minimize the total welfare loss from taxation, not how to eliminate intertemporal tax distortions.

4.4 Tax Reform To describe the Tax Reform Act of 1986, the pre-existing 1985 Tax Law, and the alternative reform proposals presented by the Treasury and the President, we utilize marginal effective tax rates for capital income from three different legal forms of organization—corporate, non-corporate, and household—and from short-lived and long-lived assets. We also present tax wedges among different types of assets, defined as differences between social rates of return on these assets. We give tax wedges for transfers between asset categories within a sector, between sectors, and between the present and the future. We refer to these as inter-asset, intersectoral, and intertemporal tax wedges. The inter-asset and intersectoral wedges correspond to differences between marginal products of different types of assets. In generating marginal effective tax rates and tax wedges, we have employed parameters describing alternative tax laws and tax reform proposals from Tables 3.25, 3.26, and 3.27. In addition, we have set the values of parameters describing the financial structure of each sector, the after-corporate-tax rate of return to corporate equity, and the rate of interest at corresponding averages for the 1967–86 period. We assume that nominal after-tax rates of return to equity are the same for all sectors and

138

EFFECTIVE TAX RATES

debt–equity ratios are the same for all assets within each sector. Property tax rates are set at 1986 levels. Finally, we have assumed that an increase in the rate of inflation raises the nominal rate of interest point-for-point.52

4.4.1. 1985 Tax Law We present effective tax rates under the 1985 Tax Law in Table 4.11. With a 6 per cent rate of inflation, these rates were 2.4 per cent for short-lived assets and 44.4 per cent for long-lived assets in the corporate sector. The difference in social rates of return between the two asset classes was 4.0 per cent. Transferring one dollar's worth of capital from short-lived to long-lived assets would have increased the national income in perpetuity by four cents per year with no additional investment. This is a very substantial tax wedge, comparable in magnitude to the private rate of return, suggesting that the potential gains from tax reform were very large. These gains approached one dollar for each dollar transferred as a consequence of a change in tax policy. The provisions of tax law interact with the rate of inflation in determining the tax burden on capital income. First, a higher rate of inflation reduced the present value of capital cost recovery under the 1985 Tax Law, since cost recovery was not indexed against the impact of inflation. Second, taxation of nominal interest income, coupled with tax deductibility of nominal interest expenses, reduced the tax burden as the rate of inflation increased. For corporate and non-corporate assets the firm's marginal tax rate for the deduction of interest expenses was higher than the individual's marginal tax rate on interest income. On balance the tax burden on corporate and non-corporate assets increased with the rate of inflation.53 As the rate of inflation rose, the tax burden on short-lived assets increased faster than that on long-lived assets. As a consequence the inter-asset tax wedge declined with the rate of inflation.

52

The validity of our assumption that the debt–equity ratio is the same for all assets within each sector is debated by Gordon, Hines, and Summers (1987) and Gravelle (1987).

53

Another mechanism, which we do not model, is that firms using the first-in-first-out (FIFO) inventory accounting method overstate their profits and hence their taxable income when inflation is positive.

139

EFFECTIVE TAX RATES

Table 4.11 Effective Tax Rates and Tax Wedges: 1985 Tax Law Sector σ

Zero inflation Corp. Non-corp. Househ. 0% inflation Corp. Non-corp. Househ. 10% inflation Corp. Non-corp. Househ.

Short-lived assets Long-lived assets All assets GAP e

0.049 0.044

−0.007 −0.011

σ

−0.133 −0.257

GAP e

0.094 0.076

0.039 0.021

σ

0.410 0.272

GAP e

0.080 0.074

0.025 0.018

Inter-asset tax

Wedge (S–L) Cor- Nop. n-corp. −0.045

C–NC

Intersector tax wedge (S and L) C–HH NC–HH

Sho- Long Sho- Long Sho- Long rt rt rt −0.- 0.00- 0.01- −0.- 0.03- −0.- 0.01032 5 8 008 6 014 8

0.308 0.251

0.05- 0.00- 0.11- 0.05- 0.00- 0.11- 0.05- 0.00- 0.118 7 9 8 7 9 8 7 9 −0.- −0.- 0.00- 0.01- 0.00- 0.04- −0.- 0.02040 030 9 9 2 2 007 3 0.053 0.045

0.001 −0.007

0.024 −0.152

0.094 0.075

0.042 0.023

0.444 0.312

0.081 0.073

0.029 0.021

0.359 0.293

0.05- 0.00- 0.12- 0.05- 0.00- 0.12- 0.05- 0.00- 0.122 7 7 2 7 7 2 7 7 −0.- −0.- 0.01- 0.01- 0.00- 0.04- −0.- 0.02037 029 1 9 9 5 002 6 0.056 0.045

0.006 −0.004

0.110 −0.085

0.093 0.074

0.043 0.025

0.461 0.337

0.082 0.072

0.032 0.023

0.387 0.319

0.04- 0.00- 0.13- 0.04- 0.00- 0.13- 0.04- 0.00- 0.138 6 3 8 6 3 8 6 3

Notes

σ:social rate of return e:effective tax rate

140

EFFECTIVE TAX RATES

Under the 1985 Tax Law assets in the non-corporate sector had lower tax burdens than corresponding assets in the corporate sector. Table 4.11 shows that the effective marginal tax rates for short-lived and long-lived assets were −15.2 and 31.2 per cent, respectively. These rates were substantially lower than the corresponding rates in the corporate sector. The inter-asset tax wedge between short-lived and the long-lived assets was 3.0 percentage points. Although this tax wedge was smaller than that in the corporate sector, the inter-asset tax wedge in the non-corporate sector suggests substantial opportunities for potential gains from tax reform. A striking feature of effective tax rates in the non-corporate sector under the 1985 Tax Law is that the effective tax rate on short-lived assets was negative. The provisions for capital cost recovery and the investment tax credit were so favourable that the tax system, in effect, provided subsidies to non-corporate investment in short-lived assets. These subsidies took the form of ‘tax shelter’ that could be used to reduce tax liabilities on other types of income. The effects of inflation on the tax burdens and the inter-asset tax wedge in the non-corporate sector was similar to that in the corporate sector. Inflation increased the tax burden on capital income and reduced the inter-asset tax wedge. The value of capital services of household assets, such as the rental equivalent of owner-occupied housing or the services of consumer durables, was not included in taxable income under the 1985 Tax Law. However, effective tax rates on household assets were affected by provisions of the individual income tax, since payments for personal and mortgage interest were deductible and interest income from the debt claims on household assets was taxable. Like the assets in the corporate and non-corporate sectors, household assets were also subject to property taxes. Table 4.11 shows that the effective tax rate on household assets was 12.7 per cent with 6 per cent inflation. This rate increased slightly with inflation. Since the income from household assets was not taxable, there was no inter-asset tax wedge in the household sector. Table 4.11 shows intersectoral tax wedges under the 1985 Tax Law for short-lived and long-lived assets. When the rate of inflation was 6 per cent per year, the intersectoral tax wedge between the corporate and non-corporate sectors was 0.9 per

EFFECTIVE TAX RATES

141

cent for the short-lived assets and 1.9 per cent for long-lived assets. The wedges between the non-corporate and household sectors were −0.7 per cent for short-lived assets and 2.3 per cent for long-lived assets. The wedges between the corporate and household sectors were 0.2 per cent for short-lived assets and 4.2 per cent for long-lived assets. Unlike the inter-asset tax wedges, the intersectoral tax wedges tended to increase with the rate of inflation, since the tax burden of corporate assets increased faster than that of non-corporate assets, which in turn increased faster than that of household assets.

4.4.2. Treasury Proposal Effective marginal tax rates on business assets under the Treasury proposal are given in Table 4.12. These rates are similar to those under the 1985 Tax Law. A comparison of Tables 4.11 and 4.12 reveals that at 6 per cent inflation the Treasury proposal would have slightly reduced the effective marginal tax rate, from 35.9 to 35.1 per cent for corporate assets and from 29.3 to 27.1 per cent for non-corporate assets. Since the 1985 Tax Law did not index taxable income and tax deductions, the Treasury proposal would have increased the tax burden at a lower rate of inflation, but would have decreased it at a higher inflation rate. The effective marginal tax rates under the Treasury proposal reflect the combined effects of the repeal of investment tax credit, the introduction of economic depreciation, a lowering of statutory tax rates, and the indexing of interest income, interest expenses, and capital gains. Of the many tax policy changes in the Treasury proposal, the repeal of investment tax credit would have had the greatest impact on effective tax rates on income from capital. Since shortlived business assets received the most important benefits from the investment tax credit under the 1985 Tax Law, the increase in the tax burden on short-lived assets under the Treasury proposal would have been most marked. The objectives of the Treasury proposal were to reduce tax wedges among different forms of investment and insulate the tax structure from the impact of inflation. We find that the Treasury proposal would have reduced inter-asset tax wedges substantially. Under the 1985 Tax Law, with 6 per cent inflation, the tax wedges between short-lived and longlived assets were 4.0 per

142

EFFECTIVE TAX RATES

Table 4.12 Effective Tax Rates and Tax Wedges: Treasury Proposal Sector σ



0.080 0.071

0.025 0.016

σ

0.310 0.224

GAP e

0.091 0.077

0.036 0.022

σ

0.397 0.284

GAP e

0.088 0.076

0.033 0.021

Inter-asset tax


C–NC

Intersector tax wedge (S and L) C–HH NC–HH

Sho- Long Sho- Long Sho- Long rt rt rt −0.- 0.00- 0.01- 0.02- 0.03- 0.01- 0.01006 9 5 0 1 0 6

0.373 0.280

0.06- 0.00- 0.15- 0.06- 0.00- 0.15- 0.06- 0.00- 0.150 9 6 0 9 6 0 9 6 −0.- −0.- 0.00- 0.01- 0.01- 0.02- 0.00- 0.01012 006 7 3 7 9 9 6 0.076 0.069

0.021 0.014

0.280 0.207

0.088 0.075

0.033 0.021

0.379 0.275

0.085 0.075

0.030 0.020

0.351 0.271

0.06- 0.00- 0.15- 0.06- 0.00- 0.15- 0.06- 0.00- 0.150 9 7 0 9 7 0 9 7 −0.- −0.- 0.00- 0.01- 0.01- 0.02- 0.00- 0.01012 007 7 3 6 8 9 6 0.075 0.068

0.020 0.014

0.271 0.203

0.087 0.075

0.033 0.020

0.373 0.272

0.084 0.074

0.029 0.020

0.345 0.268

0.05- 0.00- 0.15- 0.05- 0.00- 0.15- 0.05- 0.00- 0.159 9 8 9 9 8 9 9 8

Notes


EFFECTIVE TAX RATES

143

cent in the corporate sector and 3.0 per cent in the non-corporate sector. They would have been reduced to only 1.2 and 0.6 per cent, respectively, under the Treasury proposal. To the extent that the welfare cost of a tax distortion increases with the tax wedge, reductions in the inter-asset tax wedges of this magnitude would have improved the efficiency of capital allocation within each sector significantly. Second, the Treasury proposal would have substantially reduced the intersectoral tax wedges for long-lived assets, owing in part to the elimination of property tax deductions, but it would have had mixed effects for short-lived assets. The impact of the proposal on intersectoral tax wedges for short-lived assets would have depended on the rate of inflation. The Treasury proposal would have been relatively ineffective in eliminating the substantial intersectoral tax wedges for long-lived assets under the 1985 Tax Law, since long-lived assets would have born a heavier tax burden than the short-lived assets under the proposal. In addition, corporate assets would have been more heavily taxed than non-corporate assets, which, in turn, would have been more heavily taxed than household assets. Third, the repeal of investment tax credit would have increased the tax burden roughly as much as the reduction of the statutory tax rates would have decreased it at a 6 per cent rate of inflation. The average effective tax rate for the entire corporate sector would have changed only from 35.9 to 35.1 per cent, and the intertemporal tax wedge would have increased slightly from 2.9 to 3.0 per cent. The effect of the repeal of investment tax credit is seen most clearly in the case of the short-lived business assets. At a six per cent rate of inflation, the effective tax rate on short-lived corporate assets would have increased from 2.4 per cent under the 1985 law to 28.0 per cent under the Treasury proposal and the intertemporal tax wedge would have increased from 0.1 to 2.1 per cent. The pattern is reversed for long-lived assets, since the intertemporal tax wedges would have been smaller under the Treasury proposal. Finally, the Treasury proposal would have reduced the impact of inflation on the tax burden on capital income by defining taxable income to approximate economic income more closely. In fact, the tax burden would have declined with inflation, owing to

144

EFFECTIVE TAX RATES

incomplete indexing of interest payments.54 To the extent that interest is not completely indexed, inflation tends to lower the after-tax real interest rate and increase the present value of capital consumption allowances, even if tax depreciation is completely indexed against inflation. At the same time, incomplete indexing reduces the cost of debt financing. Table 4.12 indicates that the result of these two effects would have been to reduce the marginal tax burden of capital with higher rates of inflation.

4.4.3. President's Proposal We summarize effective tax rates under the President's proposal in Table 4.13. Overall, the effects of the President's proposal would have been similar to those of the Treasury proposal. The tax burden on income from capital would have increased at a low rate of inflation and decreased at a high rate. The inter-asset tax wedges in the corporate and non-corporate sectors would have been reduced; the intersectoral tax wedges of long-lived assets would also have been reduced; but effects on the tax wedges for the short-lived assets would have been mixed. However, a careful comparison of Tables 4.12 and 4.13 reveals a number of subtle differences between the Treasury and President's proposals, many of which are attributable to differences in the impact of inflation on the tax system. With no inflation, the President's proposal would have been more favourable to investment, since it would have retained accelerated schedules for capital cost recovery. At 6 or 10 per cent inflation rates, the President's proposal would have been even more favourable to investment, since the indexing of capital consumption allowances would have been coupled with the deduction of nominal interest expenses. This would have increased the present value of capital consumption allowances at higher rates of inflation. In addition, inflation would have lowered the tax burden on capital as a consequence of the tax deductibility of nominal interest expenses. The value of the resulting deductions would have been greater than the additional

54

We assume that the real interest rate is 3.57 per cent, as opposed to the 6 per cent used in the proposal. Under our assumptions, interest income and expenses would have been incompletely indexed and inflation would have had an impact on effective tax rates.

145

EFFECTIVE TAX RATES

Table 4.13 Effective Tax Rates and Tax Wedges: President's Proposal Sector σ



0.077 0.069

0.021 0.013

σ

0.271 0.187

GAP e

0.091 0.077

0.034 0.021

σ

0.381 0.273

GAP e

0.086 0.076

0.030 0.020


Inter-asset tax C–NC

C–HH

Intersector tax wedge (S and L) NC–HH


0.351 0.268

0.06- 0.00- 0.15- 0.06- 0.00- 0.15- 0.06- 0.00- 0.151 9 4 1 9 4 1 9 4 −0.- −0.- 0.00- 0.01- 0.01- 0.02- 0.00- 0.01014 008 4 1 0 4 5 3 0.066 0.061

0.012 0.008

0.182 0.134

0.080 0.070

0.026 0.016

0.330 0.235

0.076 0.069

0.022 0.016

0.290 0.229

0.05- 0.00- 0.16- 0.05- 0.00- 0.16- 0.05- 0.00- 0.166 9 2 6 9 2 6 9 2 −0.- −0.- 0.00- 0.00- 0.00- 0.01- 0.00- 0.01014 008 1 8 5 9 4 1 0.058 0.057

0.005 0.005

0.091 0.089

0.073 0.065

0.020 0.013

0.271 0.196

0.068 0.064

0.015 0.012

0.224 0.190

0.05- 0.00- 0.16- 0.05- 0.00- 0.16- 0.05- 0.00- 0.163 9 7 3 9 7 3 9 7

Notes


146

EFFECTIVE TAX RATES

tax liabilities resulting from the taxation of nominal interest income at the individual level. Similar reasoning can be applied to explain the decline of the intersectoral tax wedges with inflation. Under the 1985 Tax Law and the Tax Reform Act of 1986, capital cost recovery is not indexed for inflation, so that an increase in the inflation rate adds to the tax burden on income from capital. Under the Treasury proposal, the recovery of capital cost would have been indexed and interest would have been indexed incompletely. There would have been a slight tendency for the tax burden on capital income to decline with inflation. This tendency would have been strengthened under the President's proposal, since capital cost recovery would have been indexed, while interest deductions would not. Tables 4.12 and 4.13 show that the President's proposal would have narrowed the intersectoral tax wedges relative to the Treasury proposal. By contrast, the Treasury proposal would have had uniformly smaller inter-asset tax wedges.

4.4.4. Tax Reform Act of 1986 Since the Tax Reform Act of 1986 embraced many of the ideas contained in the Treasury and President's proposals, the impact of the tax reform on effective tax rates and tax wedges is similar to that of the two proposals. Table 4.14 shows that the repeal of the investment tax credit more than offset the reduction in the statutory tax rates, so that the overall tax burden on income from capital is increased. Despite the acceleration of capital cost recovery and lower marginal tax rates, the impact of repeal of the investment tax credit is most evident in the increase of the tax burden on short-lived business assets. At 6 per cent inflation, the Tax Reform Act of 1986 imposes an effective tax rate on shortlived assets of 38.2 per cent in the corporate sector and 28.2 per cent in the non-corporate sector, while the corresponding tax rates were 2.4 and −15.2 per cent under the 1985 Tax Law. For long-lived assets, effective tax rates were not much affected by tax reform. The effects of lower tax rates were approximately offset by the combined effects of the longer cost recovery period and the repeal of the investment tax credit. At 6 per cent inflation, the inter-asset tax wedges in the corporate and

EFFECTIVE TAX RATES

147

non-corporate sectors are only 1.0 and 0.6 per cent, while the corresponding figures were 4.0 and 3.0 per cent, respectively, under the 1985 Tax Law. Table 4.14 shows that the effective tax rates on household assets were essentially unaffected by the reform, since the difference between the average marginal tax rates on equity and debt claims was almost unchanged and property taxes remained the same. Overall, the tax burden on the income from capital was increased by the 1986 tax reform. As a consequence, the intertemporal tax wedges are larger and the efficiency of intertemporal resource allocation was adversely affected. On the other hand, the inter-asset tax wedges were considerably reduced and the efficiency of inter-asset capital allocation was enhanced. At 6 per cent inflation, intersectoral wedges were increased for short-lived assets and decreased for long-lived assets.

4.5. Alternative Approaches In this chapter we have implemented the cost of capital approach for the analysis of taxation of income from capital in the USA. We have found that changes in tax policies have had significant effects on the tax burden of income from capital. In addition to provisions of the tax law, there are other factors that play an important role in determining the tax burden of assets. These include the rate of inflation, the interest rate, financial policy of corporate and noncorporate businesses and households, and the distribution of debt and equity claims among owners differing in tax status. Our most significant findings are, first, that there have been very substantial differences in the tax treatment of assets within the corporate and non-corporate sectors. These differences have resulted in severe distortions in the allocation of capital within these sectors. Second, there are important differences in the tax treatment of the same type of assets in different sectors. These differences are attributable to the distribution of financial claims subject to different tax treatment among taxpayers, the financial policies of the taxpayers, and the fact that the tax treatment of an asset depends on the legal form of organization in which the asset is employed.

148

EFFECTIVE TAX RATES

Table 4.14 Effective Tax Rates and Tax Wedges: Tax Reform Act of 1986 Sector σ



0.078 0.068

0.022 0.012

σ

0.279 0.182

GAP e

0.092 0.076

0.036 0.020

σ

0.390 0.268

GAP e

0.087 0.075

0.031 0.020


Inter-asset tax C–NC

C–HH

Intersector tax wedge (S and L) NC–HH


0.360 0.262

0.05- 0.00- 0.12- 0.05- 0.00- 0.12- 0.05- 0.00- 0.129 7 5 9 7 5 9 7 5 −0.- −0.- 0.01- 0.01- 0.03- 0.04- 0.01- 0.02010 006 2 7 1 1 9 5 0.084 0.071

0.032 0.020

0.382 0.282

0.094 0.077

0.042 0.026

0.449 0.335

0.091 0.076

0.039 0.025

0.430 0.332

0.05- 0.00- 0.13- 0.05- 0.00- 0.13- 0.05- 0.00- 0.132 7 5 2 7 5 2 7 5 −0.- −0.- 0.01- 0.01- 0.03- 0.04- 0.02- 0.02006 004 4 7 9 5 5 9 0.087 0.073

0.038 0.025

0.439 0.342

0.093 0.077

0.045 0.029

0.478 0.373

0.091 0.076

0.043 0.028

0.467 0.371

0.04- 0.00- 0.14- 0.04- 0.00- 0.14- 0.04- 0.00- 0.148 7 3 8 7 3 8 7 3

Notes


EFFECTIVE TAX RATES

149

The impacts of inflation on effective tax rates and tax wedges under the Tax Reform Act of 1986 are similar to those under the 1985 Tax Law. The tax burden on income from capital increases with inflation. Since the tax burden on short-lived assets rises faster than that on long-lived assets, inter-asset tax wedges decline with the rate of inflation. The tax burden on corporate assets increases faster than that on non-corporate assets, which in turn increases faster than that on household assets, so that intersectoral tax wedges increase with the rate of inflation. Our estimates of tax wedges and effective tax rates are based on the concept of the marginal effective tax rate, introduced by Auerbach and Jorgenson (1980). The marginal effective tax rate is based on provisions of tax law that are applicable to new assets. Auerbach and Jorgenson have presented marginal effective corporate tax rates for different types of assets within the corporate sector. Jorgenson and Sullivan (1981) have given marginal effective corporate tax rates for the 35 categories of assets listed in Table 3.18. They have also given these tax rates for 44 industrial groups, covering the whole of the US economy. Both sets of effective tax rates cover the period 1946–80.55 These effective tax rates are also given for the 1981 Tax Act and the pre-existing tax law in 1980. Tax wedges and marginal effective tax rates incorporating provisions of both corporate and individual income taxes were introduced by Hall (1981). Detailed estimates were given for Canada by Boadway, Bruce, and Mintz (1984) and for Germany, Sweden, the UK and the USA by King and Fullerton (1984). Under our assumption that the private rate of return is the same for all assets in the corporate sector, differences in effective tax rates among assets are due entirely to differences in the marginal effective corporate tax rates introduced by Auerbach and Jorgenson. However, comparisons of marginal effective tax rates among corporate, non-corporate, and household sectors obviously require both corporate and individual tax wedges for the corporate sector. We have presented marginal effective tax rates

55

Marginal effective corporate tax rates are also presented by Bradford and Fullerton (1981), Hall (1981), and Hulten and Wykoff (1981a), and subsequently, by Auerbach (1983, 1987), Gravelle (1982, 1985), Hulten and O'Neill (1982), Hulten and Robertson (1984), and many others. The first official estimates for the United States are given by the Council of Economic Advisers (1982).

150

EFFECTIVE TAX RATES

for all three sectors in Jorgenson and Yun (1986b). Our effective tax rates for the corporate sector are based on the ‘traditional’ view of corporate income taxation presented in Chapter 2. The marginal effective tax rates presented by Boadway, Bruce, and Mintz and by King and Fullerton are limited to the corporate sector. However, the King–Fullerton methodology has been extended to the non-corporate sector and owner-occupied housing by Fullerton (1987) and Fullerton, Gillette, and Mackie (1987). This methodology incorporates the ‘new’ view of corporate taxation, discussed briefly in Section 2.5 above. The weighted average rate of return for the corporate sector is based on the relative proportions of new issues of equity, retained earnings, and new issues of debt in financing corporate investment. Since retained earnings greatly predominate over new issues of equity, the resulting rate of return is very similar to a weighted average of rates of return for retained earnings and debt alone, which would be consistent with the new view, as presented by King (1977), Auerbach (1979), and Bradford (1981).56 The marginal effective tax rates that we have presented in this chapter must be carefully distinguished from the average effective tax rates introduced by Harberger (1962, 1966). Marginal and average tax rates differ substantially, since changes in tax laws usually apply only to new assets. New and existing assets are perfect substitutes in production in the model of capital as a factor of production presented in Chapter 1, so that only marginal rates are relevant to measuring distortions in the allocation of capital. Rosenberg (1969) has presented a set of average effective tax rates for the USA for the period 1953–9 that includes a breakdown by 45 industry groups. The average effective tax rate presented by Harberger (1962) included only corporate income taxes. Rosenberg also included property taxes, but not individual taxes on distributions to owners of equity from corporate and non-corporate business. Harberger (1966) included these individual taxes.57 Feldstein and Summers (1979) have presented average effective tax rates for the corporate sector that incorporate individual as well as corporate income tax liabilities. These tax rates are

56

Scott (1987) has suggested a modification of the King–Fullerton approach along these lines.

57

Harberger's (1966) estimates were revised and corrected by Shoven (1976).

EFFECTIVE TAX RATES

151

based on the ‘traditional’ rather than the ‘new’ view of corporate taxation and include taxes on dividends paid by the corporate sector as well as taxes on capital gains realized by holders of corporate equity. The estimates of Feldstein and Summers cover the period 1954–77 and are given separately for 20 two-digit industries within manufacturing. The estimates for the corporate sector as a whole have been updated and revised to cover the period 1953–78 by Feldstein (1982), the period 1953–79 by Feldstein, Dicks-Mireaux, and Poterba (1983), and the period 1953–84 by Feldstein and Jun (1987). Hulten and O'Neill (1982) have compared average and marginal effective corporate tax rates for the period 1952–80. Auerbach and Poterba (1987) have analysed the decline in average effective corporate tax rates over the period 1959–85. Fullerton (1984) has discussed the conceptual basis for the distinction between average and marginal effective tax rates. He concludes that empirical measures of effective tax rates based on these two different concepts are not closely related. King and Fullerton (1984)58 provide an estimate of the average effective tax rate for the corporate sector of the US economy in 1978–80. They compare their results with those of Feldstein, Dicks-Mireaux, and Poterba and with the earlier work of Rosenberg. It must be emphasized, however, that marginal effective tax rates or tax wedges do not provide a complete analysis of the distortionary effects of capital income taxation. The distortion of resource allocation depends on substitutability between assets as well as on the tax wedges. As an example, consider the allocation of capital between short-lived and long-lived depreciable assets in the corporate sector. Even if the inter-asset difference in tax treatment is large, the distortion of capital allocation can be small if the services of the two types of assets are not substitutable. Similarly, the distortion in the allocation of resources for consumption over time can be small if intertemporal substitutability in consumption is small. In Chapter 5 we provide an evaluation of the cost of capital approach to tax policy analysis. We describe opportunities for further research provided by unresolved issues in the analysis of tax policy. We also discuss applications of the cost of capital

58

Table 6.34, p. 265.

152

EFFECTIVE TAX RATES

approach in modelling economic behaviour. A general equilibrium analysis of the atemporal as well as the intertemporal effects of tax policy is required to measure the impact of tax-induced distortions in capital allocation. The model of capital as a factor of production presented in Chapter 1 is the key to dynamic general equilibrium modelling of the economic impact of tax policy.

5 Summary and Conclusion The purpose of this chapter is to evaluate the usefulness of the cost of capital approach as a practical guide to tax reform. Auerbach and Jorgenson (1980) introduced the key concept, the marginal effective tax rate, early in the debate over the Economic Recovery Tax Act (ERTA) of 1981. They employed this concept as a means of comparing the tax burdens among different types of assets under the provisions for capital cost recovery ultimately incorporated into the 1981 Tax Act. Jorgenson and Sullivan (1981) extended this comparison to all assets in the classification presented in Table 3.18 above. They also compared the tax burdens among 44 industry groups comprising the whole private sector of the US economy. The initial results of applying the cost of capital approach to the 1981 Tax Act had no effect on the final legislation. However, this approach spread very rapidly among the community of tax policy analysts, both inside and outside the US government. The initial impetus for the diffusion of the cost of capital approach was testimony by Jorgenson (1979a, 1979b) before the Committee on Finance of the US Senate on 22 October 1979 and the Committee on Ways and Means of the US House of Representatives on 14 November 1979.59 This testimony included the first presentation of marginal effective tax rates, based on the work of Auerbach and Jorgenson. An important milestone in the diffusion of the cost of capital approach was provided by the Conference on Depreciation, Inflation, and the Taxation of Income from Capital, held at the Urban Institute in Washington, DC, on 1 December 1980. The participants in this conference included tax analysts from universities, research institutions, the US Department of the Treasury, and the staff of the US Congress. Key papers in the implementation

59

These committees have responsibility for all tax legislation emanating from the US Congress.

154

SUMMARY AND CONCLUSION

of the cost of capital approach by Bradford and Fullerton, Hall, Hulten and Wykoff, and Jorgenson and Sullivan were presented at the conference. The publication of the conference proceedings in 1981 was followed shortly by presentation of the first official estimates of marginal effective tax rates by the President's Council of Economic Advisers (1982). The literature on the cost of capital approach developed at an explosive pace during the early 1980s, leading up to the presentation in November 1984 of the Treasury proposal analysed in Chapters 3 and 4. This proposal was accompanied by marginal effective corporate tax rates for different types of assets. A primary objective of the proposal was to ‘level the playing field’ by equalizing marginal effective tax rates on business assets. A second objective was to insulate the definition of capital income from the impact of inflation. In Section 4.4 we have shown that these objectives would have been realized if the Treasury proposal had been enacted into law. However, levelling the playing field between the household and business sectors was not included among the objectives of the Treasury proposal.60 The cost of capital approach provides the basis for the detailed quantitative description of US tax law for income from capital presented in Chapter 3. This description is subject to two types of objections—conceptual and empirical. In Section 5.1 we consider both conceptual and empirical limitations of our description of US tax law. Alternative conceptual approaches presented in the literature can be implemented by means of the data presented. With additional expense in time and effort, the empirical results of our study could be refined considerably. In Chapter 4 we pointed out that the economic impact of tax-induced distortions in capital allocation depends on the tax wedges that can be identified by means of the cost of capital. However, the effect of these tax wedges also depends on the elasticities of substitution along all the relevant margins. These can be combined into an overall evaluation of the impact of tax policy on the efficiency of capital allocation by means of a general equilibrium model of the US economy. In Section 5.2 we show that the model of capital as a factor of production

60

The political reasons for this crucial omission are discussed by McLure (1986).


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presented in Chapter 1 is the most appropriate starting point for construction of such a model.

5.1. Opportunities for Further Research Many of the most important issues in the implementation of marginal effective tax rates have been debated for nearly a quarter of a century, following the introduction of the cost of capital by Jorgenson (1963, 1965). The first of these issues is the incorporation of inflation in asset prices into the cost of capital. This was the focus of a detailed empirical comparison of the effects of alternative measures of the cost of capital on investment expenditure by Jorgenson and Siebert (1968a, 1968b). The assumption of perfect foresight or rational expectations of inflation emerged as the most appropriate formulation and has been used in almost all measures of marginal effective tax rates, including those of Jorgenson and Sullivan (1981), Jorgenson and Yun (1986b, 1990), and Chapter 4 above. A second empirical issue in the implementation of the cost of capital approach is the measurement of economic depreciation. In Section 3.6 above we reviewed alternative approaches to this issue based on the model of capital as a factor of production presented in Chapter 1. An intense debate emerged over the use of geometric decline in efficiency of assets with age during the 1970s. This debate is summarized by Biorn (1989) and Jorgenson (1989). The stability of patterns of decline in efficiency in the face of changes in tax policy and shocks such as the sharp rise in energy prices during the 1970s has been carefully documented by Hulten, Wykoff, and Robertson (1989, p. 255). They conclude that ‘the use of a single number to characterize the process of economic depreciation [of a given type of capital asset] seems justified in light of the results of this chapter’. A third empirical issue in the measurement of the cost of capital is the description of investment incentives, such as accelerated depreciation and the investment tax credit. The cost of capital formula originally employed by Jorgenson (1963, 1965) allowed for differences between tax and economic depreciation for all assets. The modelling of investment incentives for new assets was the crucial innovation in the papers of Hall and Jorgenson (1967, 1969, 1971). This important reformulation of the

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cost of capital has been adopted in almost all subsequent studies. Initially, the measurement of tax depreciation was based on the assumption that taxpayers choose among alternative formulas so as to minimize their tax liabilities. This assumption was used by Hall and Jorgenson and by Christensen and Jorgenson (1969, 1973). A detailed study of actual practices for calculating capital consumption allowances and the investment tax credit was carried out by Jorgenson and Sullivan (1981). The resulting description has been used in many subsequent studies, including Jorgenson and Yun (1986b, 1990) and Chapter 3 above. The resolution of major issues concerning the appropriate representation of inflation in asset prices, depreciation in the value of assets with age, and tax incentives for investment, such as capital consumption allowances and the investment tax credit, cleared the way for detailed measurement of marginal effective corporate tax rates by Jorgenson and Sullivan (1981), Hulten and Wykoff (1981a), and many others. However, the incorporation of individual taxes into the corporate cost of capital has raised a host of new issues. These issues initially surfaced in the debate over the ‘new’ view of corporate taxation introduced by King (1977), Auerbach (1979), and Bradford (1981) and summarized in Section 2.5 above.61 The first set of issues in corporate finance relates to the treatment of debt and equity in the corporate tax structure. In Jorgenson and Yun (1986b) we have assumed that debt–capital ratios are the same for all assets within the corporate sector. Bosworth (1985) and Gordon, Hines, and Summers (1987) have argued that different types of assets should be associated with different debt–equity ratios.62 Empirical evidence supporting the view that debt–equity ratios are independent of the composition of assets has been provided by Auerbach (1983a) and Gravelle (1987). The difference between the ‘traditional’ and the ‘new’ views of corporate income taxation hinges on the sources of funds for equity finance. In the traditional view the marginal source of equity finance is new issues, while in the new view it is retained

61

This debate is summarized by Atkinson and Stiglitz (1980) and Auerbach (1983b).

62

Sunley (1987) has disputed this assertion. Ballentine (1987) has suggested resolving this issue by making the debt–equity ratio endogenous.


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earnings. In fact firms use both sources of equity finance, sometimes simultaneously. In Jorgenson and Yun (1986b, 1990) and in Chapter 4 we have presented marginal effective tax rates based on the traditional view of corporate income taxation. King and Fullerton (1984) have developed an approach based on the actual distribution of new equity finance from new issues and retained earnings.63 Since retained earnings greatly predominate over new issues as a source of equity finance, this approach turns out to be empirically equivalent to adopting the new view. An important implication of the new view of corporate income taxation is that investment expenditures of the firm are independent of the rate of taxation of dividends at the individual level. Poterba and Summers (1983, 1985) have presented the results of tests of this hypothesis that support the traditional view. Auerbach (1984) has presented evidence that the cost of capital for new issues is higher than that for retained earnings. These findings support the new view. A satisfactory resolution of this important issue would require the formulation of a theory of corporate finance with endogenous determination of debt–asset and dividend pay-out ratios.64 The inclusion of taxes at the individual level on corporate distributions to holders of equity also raises more specific issues on the impact of inflation in asset prices. A comprehensive treatment of these issues is provided by Feldstein (1983). Since nominal interest expenses are deductible at the corporate level, while nominal interest payments are taxable at the individual level, an important issue is the impact of inflation on nominal interest rates. Feldstein and Summers (1979) have assumed that Fisher's Law holds, namely, that a change in inflation is reflected point-for-point in changes in nominal interest rates. We have used this assumption in Jorgenson and Yun (1986b, 1990) and in Chapter 2 above. King and Fullerton (1984) have used a modified version

63

Scott (1987) has argued in favour of endogenizing the effects of tax changes on corporate policy for new issues and dividends.

64

A possible approach for development of such a theory might be to require explicit incorporation of uncertainty about the returns from capital. The incorporation of uncertainty into measures of marginal effective tax rates by means of risk-adjusted rates of return has been discussed by Auerbach (1983a), Bulow and Summers (1984), and Fry (1984). Summers (1987) has argued in favour of discounting capital consumption allowances at the risk-free rate. Auerbach (1989) has presented effective tax rates incorporating costs of adjustment.

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of Fisher's Law in which nominal rates of return after-tax increase point-for-point with the rate of inflation. Empirical support for Fisher's Law is provided by Summers (1983).65 This issue is also unresolved and presents additional research opportunities. A second issue in the impact of inflation on the cost of capital is the relationship between accrual and realization of capital gains. We pointed out in Chapter 2 that capital gains in the USA are taxed when they are realized and not when they are accrued. However, capital consumption allowances for used assets reflect the price at which the asset is acquired. This presents opportunities for ‘churning’, that is, selling assets, realizing capital gains, and acquiring a higher basis for capital consumption allowances. Optimal strategies for churning are analysed by Gordon, Hines, and Summers (1987) and Gravelle (1987). Sunley (1987) argues that churning is negligible empirically and Gravelle (1987) provides empirical evidence to substantiate this view. However, additional empirical evidence on the relationship between accrual and realization of capital gains would be very valuable in analysing the impact of proposals to revise the tax treatment of capital gains taxation. A final set of unresolved issues in corporate finance relates to more detailed descriptions of the tax structure for capital income. These issues revolve around multi-period tax rules. For example, firms experiencing losses may be unable to avail themselves of the tax benefits of deductions for interest, depreciation, and so on. However, some of these benefits may be carried forward to periods in which the firms make profits. A general approach to this problem has been developed by Auerbach (1986) and implemented empirically for data on individual firms by Auerbach and Poterba (1987). Ballentine (1987) has argued for the incorporation of these and other tax provisions for specific assets into marginal effective tax rate calculations. Fullerton, Gillette, and Mackie (1987) have examined the importance of these provisions. They have concluded that the impact on marginal effective tax rates for industry groups is relatively modest. Obviously, the importance of this issue is much greater at the level of the individual firm.

65

However, see the debate between McCallum (1984, 1986) and Summers (1986).


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Our overall conclusion is that the marginal effective corporate tax rate introduced by Auerbach and Jorgenson (1980) has proved its usefulness in the analysis of tax policies for income from capital. Under the assumptions employed in Chapter 4, differences in effective tax rates among assets in the corporate sector can be attributed to differences in the component associated with the corporate income tax. The empirical basis for the measurement of marginal effective corporate tax rates has been successfully established by the work of Jorgenson and Siebert (1968a, 1968b), Hulten and Wykoff (1981b), and Jorgenson and Sullivan (1981). The analysis in Chapter 4 of tax reform proposals that preceded the adoption of the Tax Reform Act of 1986 has revealed the critical importance of comparing marginal effective tax rates for business and household assets. Another significant issue in tax policy is insulating the definition of capital income from the impact of inflation. The treatment of these issues requires the integration of corporate and individual tax provisions. We presented a model of the cost of capital that achieves this objective in Chapter 2. However, alternative models based on the ‘new’ view of the corporate income tax have also been proposed in the literature. Fortunately, the empirical basis for implementing these alternative models is the same as that developed for our model, which is based on the ‘traditional’ view. A satisfactory resolution of the outstanding issues in corporate income taxation requires a reformulation of the theory of corporate finance.66 An important objective of this reformulation is to endogenize the responses of debt–capital and dividend pay-out ratios to changes in tax policy at both corporate and individual levels. In addition, more detailed features of the tax structure, such as opportunities for ‘churning’ and, more generally, optimal realization of capital gains, must be encompassed by the theory. Finally, a more fine-grained description of tax statutes, including the complexities introduced by provisions for multi-period treatment of corporate income, tax deductions, and tax credits, must be utilized. Obviously, this is a formidable agenda for future research and can easily sustain the rapid pace

66

Tax policy and the theory of corporate finance have been reviewed by Auerbach (1983a) and Scholes and Wolfson (1988).

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of work on the cost of capital that has characterized the past decade.

5.2 Tax Policy Analysis The initial application of the cost of capital approach to tax policy analysis was based on the inclusion of investment functions incorporating the cost of capital in macroeconometric forecasting models. In fact, an investment function incorporating the cost of capital was first proposed for the Brookings quarterly econometric model of the USA by Jorgenson (1965).67 By the beginning of the debate over the Economic Recovery Tax Act of 1981 the investment equations for all major forecasting models for the US economy had incorporated the cost of capital.68 Simulations of alternative tax policies by means of these models had become the staple fare of debate over the economic impact of specific tax proposals.69 An important issue in this type of application is the modelling of expectations of future prices of investment goods. This is required in measuring the cost of capital and simulating the impact of changes in tax policy on investment expenditures. The resolution of this issue can be found in the model of capital as a factor of production presented in Chapter 1. The key dynamic relationships are the expression of capital stock as a weighted sum of past investments in equation (1.2) and the expression of the price of acquisition of investment goods as the sum of future rental prices of capital services in equation (1.4). Both of these relationships must be incorporated into the simulation of the effects of changes in tax policy. Macroeconometric models have incorporated the backward-looking equation for capital stock, but have omitted the forward-looking equation for the price of investment goods. The reasons for the omission of the forward-looking equation for the price of investment goods from macroeconometric models

67

A much more detailed version of this model was constructed by Jorgenson and Stephenson (1967a, 1967b, 1969) and Jorgenson and Handel (1971). A detailed review of the initial studies of investment behaviour incorporating the cost of capital is given by Jorgenson (1971a).

68

See, e.g., Chirinko and Eisner (1983) and Gravelle (1985).

69

Illustrations of this type of simulation study are provided by Jorgenson (1971b) and Gordon and Jorgenson (1976), using modifications of the DRI quarterly econometric model of the USA.


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is that such an equation would have required simulation techniques appropriate for perfect foresight or rational expectations. Such techniques were introduced by Lipton, Poterba, Sachs, and Summers (1982) and Fair and Taylor (1983) long after the methodology for constructing and simulating macroeconometric forecasting models had crystallized. In order to evaluate the economic impact of the 1981 tax reforms, we have constructed a dynamic general equilibrium model that incorporates both the backward-looking equation for capital stock in terms of past investment and the forward-looking equation for the price of acquisition of investment goods in terms of future prices of capital services in Jorgenson and Yun (1986a).70 In Jorgenson and Yun (1990) we have evaluated the economic impact of the 1986 tax reform, using a new version of our dynamic general equilibrium model.71 The model provides a highly schematic representation of the US economy. A single representative producer employs capital and labour services to produce outputs of consumption and investment goods. By modelling the substitution between consumption and investment goods in production, we are able to introduce costs of adjustment in the response of investment to changes in tax policy. We have simplified the representation of technology in the model by introducing a single stock of capital at each point in time. This capital is perfectly malleable and is allocated so as to equalize after-tax rates of return to equity in the corporate, non-corporate, and household sectors. Our model also incorporates a representative consumer that supplies labour services, demands consumption goods, and makes choices between consumption and saving. This model of consumer behaviour is based on an intertemporally additive utility function that depends on levels of full consumption in all time periods. Full consumption is an aggregate of consumption goods, household capital services, and leisure. To simplify the representation of preferences, we endow the representative consumer with an infinite lifetime and perfect foresight about future prices. We have fitted econometric models of producer and

70

As suggested by Lucas (1976), this model also includes expectations about future changes in tax policy.

71

By contrast the forward-looking equation of the price of investment goods is not included in the general equilibrium studies of the 1986 Tax Act by Fullerton, Henderson, and Mackie (1987) and Fullerton and Henderson (1989a, 1989b).

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consumer behaviour to data for the US economy covering the period 1947–86. The government sector of the US economy raises revenues through taxes on income from capital and labour services. Corporate capital income is taxed at both corporate and individual levels, non-corporate capital income is taxed only at the individual level, and household capital income is not taxed at either level. In addition, the government sector imposes sales taxes on the production of consumption and investment goods and property taxes on assets held by the business and household sectors. Taxes insert wedges between demand and supply prices for investment and consumption goods and for capital and labour services. These tax wedges distort private decisions and lead to losses in efficiency. In our model the equilibrium of the US economy is characterized by an intertemporal price system that clears the markets for all four commodity groups included in the model—labour and capital services and consumption and investment goods. Equilibrium at each point in time links the past and the future through markets for investment goods and capital services. Assets are accumulated as a result of past investments, while the prices of assets must be equal to the present values of future capital services. The time path of consumption must satisfy the conditions for intertemporal optimality of the household sector under perfect foresight. Similarly, the time path of investment must satisfy requirements for the accumulation of assets by both business and household sectors. In order to evaluate alternative tax policies, we first consider the intertemporal equilibrium associated with each policy. Under perfect foresight there is a unique transition path to balanced growth equilibrium for any tax policy and any initial level of capital. The growth path of the US economy consists of a plan for consumption of goods and leisure at every point in time by the representative consumer and a plan for production of investment and consumption goods from capital and labour services at every point in time by the representative producer. These plans are brought into consistency by the intertemporal price system. Associated with each tax policy and the corresponding intertemporal equilibrium is a level of welfare for the representative consumer. This level of welfare can be interpreted as a measure


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of economic efficiency corresponding to the potential level of welfare for society as a whole. The actual level of welfare also depends on the distribution of welfare among consuming units. To evaluate changes in tax policy in terms of efficiency, we translate changes in potential welfare into an equivalent variation in private national wealth. We first consider the time path of the price of full consumption associated with current tax policy. We then evaluate the difference in wealth required to attain levels of potential welfare before and after the change in tax policy at prices prevailing before the change. We have summarized the 1986 tax reform in terms of changes in tax rates, the treatment of deductions from income for tax purposes, the availability of tax credits, and provisions for indexing taxable income for inflation. We have also summarized proposals for tax reform that figured prominently in the debate leading up to the 1986 Tax Act. We have considered the Treasury and President's proposals in detail, since these proposals were instrumental in shaping the final legislation. The starting point for our discussion of the alternative proposals is the tax law in existence before the 1986 reform. We have analysed the tax burdens on capital income under four alternative tax policy regimes: the tax law in existence before the 1986 tax reform, the Treasury proposal, the President's proposal, and the Tax Reform Act of 1986. For this purpose we have utilized the concepts of marginal effective tax rates and tax wedges, defined in terms of differences in tax burdens imposed on different forms of income. Tax wedges represent gaps between the marginal products of different types of assets. In Chapter 4 we have used these gaps as indicators of the likely impact of substitutions among different kinds of capital induced by changes in tax policy. We have analysed the impact of each of the alternative tax policies on US economic growth. We have also evaluated the effects of changes in tax policy on economic efficiency by measuring the corresponding changes in potential economic welfare. The reference level of welfare, which serves as the basis of comparison among alternative tax policies, is the level attainable by the US economy under the tax law in effect before the 1986 tax reform. Finally, we have analysed losses in efficiency associated with tax wedges among different kinds of capital income. These tax

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wedges are the consequences of the corporate and personal income taxes, property taxes, and sales taxes on investment goods. We have found that much of the potential gain in welfare from the 1986 tax reform was dissipated through failure to index the income tax base for inflation. At rates of inflation near zero the loss is not substantial; however, at moderate rates of inflation, like those prevailing for the past decade, the loss is highly significant. Furthermore, the greatest welfare gains would have resulted from incorporating the income from household assets into the tax base, while reducing tax rates on income from business assets. The potential welfare gains from an income-based tax system, reconstructed along these lines, would have exceeded those from a consumption-based system. Our overall conclusion is that the cost of capital approach to tax policy analysis has proved its value as a guide to the formulation of proposals to improve the taxation of income from capital in the USA. The tax policy changes of the early 1980s, especially the 1981 Tax Act, increased barriers to efficient allocation of capital. By contrast, the 1986 Tax Act reduced these barriers substantially. Proposals for tax reform such as the Treasury proposal and the President's proposal analysed in Chapter 3 can serve as a guide to further improvements in tax policy by insulating the definition of capital income for tax purposes from the effects of inflation. The most important obstacle to be overcome by future tax reform is to equalize the treatment of capital in the business and household sectors. The initial focus of the cost of capital approach originated by Auerbach and Jorgenson was on the allocation of capital within the corporate sector. This focus also characterized the extensions of the cost of capital approach by Boadway, Bruce, and Mintz (1984) and King and Fullerton (1984). More recent work, such as Jorgenson and Yun (1986b, 1990), Fullerton (1987), and Fullerton, Gillette, and Mackie (1987), has also encompassed the allocation of capital between business and household sectors. The cost of capital approach to tax policy analysis will continue to be a useful guide to tax reform within the framework of the corporate and individual income tax. Income taxation remains the primary basis for taxation in the USA and many


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other countries. Empirical and theoretical research oriented towards refining the cost of capital approach is badly needed. In this book our objective has been to provide an extensive illustration of the work that has already been accomplished, using data sources of the type that are readily available for the USA and many other countries. Our hope is that this illustration will serve as a blueprint for tax analysts and an inspiration for policy-makers who share our goal of making the allocation of capital within a market economy more efficient.

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Author Index Aaron, Henry J., 92 Arrow, Kenneth J., 7 Atkinson, Anthony B., 36, 156 Auerbach, Alan J., 2, 36–38, 110, 149–151, 153, 156–159, 164 Bailey, Martin J., 47 Ballentine, J. Gregory, 156, 158 Barro, Robert J., 44 Berndt, Ernst R., 2 Biorn, Erik, 5, 108, 155 Birnbaum, Jeffrey H., 1 Boadway Robin, 36–37, 149–150, 164 Board of Governors, Federal Reserve System, 52, 87 Bosworth, Barry P., 156 Bradford David F., 36–37, 149–150, 154, 156 Bruce, Neil, 36–37, 149–150, 164 Bulow, Jeremy I., 157 Bureau of Economic Analysis (BEA), 76, 78, 87–88, 99 Chirinko, Robert S., 160 Christensen, Laurits R., 108, 156 Cilke, James M., 93 Coen, Robert, 107–108 Committee on Finance, US Senate, 153 Committee on Ways and Means, US House of Representatives, 153 Council of Economic Advisors, 149, 154 Dicks-Mireaux, Louis, 151 Diewert, W. Erwin, 4 Eisner, Robert, 107, 160 Fair, Ray C., 161 Feldstein, Martin S., 49, 51, 107, 113, 150–151, 157 Fisher, Irving, 9 Foot, David K., 107 Fry, Robert C. Jr., 157 Fullerton, Don, 2, 17, 33, 36–37, 43, 47, 49, 51, 83, 86, 93, 108, 109, 149–151, 154, 157–158, 161, 164 Gillette, Robert, 83, 93, 109, 150, 158, 164 Gordon, Roger H., 138, 156, 158, 160 Gorman, John A., 78 Gravelle, Jane G., 138, 149, 156, 158, 160 Haavelmo, Trygve, 7 Haig, Robert M., 73 Hall, Robert E., 7, 23, 36, 74, 149, 154–156 Handel, Sidney S., 160 Harberger, Arnold C., 2, 150 Harper, Michael J., 2 Henderson, Yolanda K., 161 Hines, James R. Jr., 138, 156, 158

Hirshleifer, Jack, 9 Hotelling, Harold S., 7 Hulten, Charles R., 4, 75–76, 78, 80, 82, 107–109, 149, 151, 154–156, 159 Jorgenson, Dale W., 1–2, 4–5, 23, 36–37, 76–77, 80–82, 108–110,

AUTHOR INDEX

116, 149–150, 153–157, 159–161, 164 Jun, Joosung, 151 King, Mervyn, 17, 33, 36–37, 43, 47, 49–50, 149–151, 156–157, 164 Kuh, Edwin, 107 Lipton, David, 161 Lucas, Robert E. Jr., 161 Mackie, James, 83, 93, 109, 150, 158, 161, 164 Malpezzi, Steven, 107 McCallum, Bennett T., 158 McLure, Charles E. Jr., 2, 37, 91, 154 Meyer, John, 107 Mintz, Jack M., 36–37, 149–150, 164 Murray, Alan S., 1 Musgrave, John C., 78 Musgrave, Richard A., 92 O'Neill, June A., 149, 151 Ozanne, Lawrence, 107 Pechman, Joseph, 2, 17, 42, 49, 92 Poterba, James M., 37–38, 151, 157–158, 161 Rasche, Robert, 107 Robertson, James W., 149, 155 Rosenberg, Leonard G., 150–151 Sachs, Jeffrey, 161 Sahasakul, Chaipat, 44 Samuelson, Paul A., 73 Scott, Maurice F.G., 150, 157 Siebert, Calvin D.155, 159 Simons, Henry C., 73 Scholes, Myron S., 159 Shoven, John B., 150 Stephenson, James A., 160 Stiglitz, Joseph E., 36, 38, 156 Strong, John S., 88 Stubbs, Eric, 80–81 Sullivan, Martin A., 2, 36, 76–77, 80, 82, 108–109, 116, 149, 153, 154–156, 159 Summers, Lawrence H., 24, 33, 37–38, 49, 51, 138, 150–151, 156–158, 161 Sunley, Emil M., 156, 158 Taubman, Paul, 107 Taylor, John B., 161 Terborgh, George, 107 Thibodeau, Thomas, 107 US Department of the Treasury, 91–92 Walras Leon, 4 Wolfson, Mark A., 159 Wood, David O., 2 Wyscarver, Roy A., 93 Wykoff, Frank C., 75–76, 78, 80, 82, 107–109, 149, 154–156, 159 Yun, Kun-Young, 1, 4, 37, 108, 150, 155–157, 161, 164

Zodrow, George R.2, 91

177

Subject Index Entries in italics are technical terms with definitions given at the first page reference. Abbreviations used in the text are listed alphabetically with brief definitions. A (All assets), 115 acquisition price of investment goods, 6 (see also: capital cost recovery); and tax policy analysis, 6, 160 ACRS (Accelerated Cost Recovery System), 1, 104 ADR (Asset Depreciation Range) system for capital recovery, 81 AGI (Adjusted Gross Income), 44 BEA (Bureau of Economic Analysis), 76 capital, as a factor of production, 8–11, 108; alternative approaches, 108, 161 capital consumption allowances, 23 (see also: capital cost recovery); and indexing, 30–31; present value, corporate, 27; present value, non-corporate, 24 (see also: US tax system) capital cost recovery, 1–2, 73–86 (see also: ACRS) (see also: ADR); alternative approaches, 108–109 (see also: capital consumption allowances); capital consumption allowances, corporate, 27; capital consumption allowances, noncorporate, 24 (see also: CCRS); estimates, 84–86 (see also: investment tax credit); investment tax credit, corporate, 27; investment tax credit, non-corporate, 24; and indexing, 30–31; as reduction in acquisition price of investment goods, 23; research opportunities, 155–156; and tax reform, 98–99, 102–103; under President's Proposal, 104; under Tax Reform Act of 1986, 105–106; under Treasury Proposal, 100–101 (see also: US tax system) capital gains taxation, 17, 27; accrual and realization, 158; corporate, 31; and indexing, 31, 97; non-corporate, 33; research opportunities, 158; special treatment, 18, 93; for corporate equity, 27,

SUBJECT INDEX

47; for household assets, 21; for non-corporate assets, 22, 67 (see also: tax rate, effective); and tax reform, 94, 141 capital income taxation, 13–16, 17–38; alternative approaches, 35–38; corporate, 26–30; household, 19–22 (see also: inflation); “new” vs “traditional” view, 37–38, 156–157; non-corporate, 22–26; research opportunities, 156–157; simplified model, 13–16; and tax reform, 30–35, 91–106 capital input, 6 capital stock, 6 cash flow constraint, 10, 12; corporate sector, 28; household sector, 20; non-corporate sector, 24 CCRS (Capital Cost Recovery System), 104 cost of capital, 4–8; approach to tax policy analysis, 2, 153–165; before taxes, 14; corporate, 29, 32; corporate, alterative approaches, 36–38; and dynamic general equilibrium modeling, 160–165; household, 21; non-corporate, 26; originated, 2 (see also: return, rate of); and tax reform, 18, 30–35 D (depreciable assets), 115 debt, 11 debt capacity, 11–12; corporate, 27; household, 19; noncorporate, 22 decline in efficiency, rate of, 5 DEFRA (Deficit Reduction Act of 1984), 49 depreciation, 7, 73–81; alternative approaches, 107–108; estimates, 76–81 (see also: income, economic definition of); and rate of return, 14, 21, 26, 30; research opportunities, 155; and vintage price functions, 73 depreciation, rate of, 7 dividends, 9, 28 (see also: US tax system) dynamic general equilibrium modeling, 161–164 (see also: cost of capital) equity, 9 (see also: return, rate of) ERTA (Economic Recovery Tax Act of 1981), 1, 81, 83, 120–121, 153; tax policy analysis, 161 GAP (tax wedge), 117 income, economic definition of, 73 indexing, 30–34 (see also: capital consumption allowances) (see also: capital cost recovery) (see also: capital gains taxation) (see also: inflation) (see also: tax reform) inflation, 7; alternative approaches, 149; and capital income taxation, 112–113; estimates, 114; and indexing, 18, 31, 97; and nominal interest rates, 32–33, 138; research opportunities, 155,

179

180

SUBJECT INDEX

157–158; and tax reform, 92–106, 149; under President's Proposal, 103, 145; under Tax Law 1985, 139; under Tax Reform Act of 1986, 148; under Treasury Proposal, 100, 142; and vintage price functions, 74–76 inflation, rate of, 7 insurance companies, 49–51, 93, 96 interest, rate of, 12 (see also: inflation) investment, 6 investment tax credit, 23 (see also: capital cost recovery) (see also: US tax system) L (long-lived assets), 115 LD (long-lived depreciable assets), 115 multi-period tax rules, 158; research opportunities, 158 ND (non-depreciable assets), 115 NRS (non-residential structures), 115 new share issues, 9 ownership distribution of assets, 51–73 (see also: US tax system) PDE (producer's durable equipment), 115 portfolio equilibrium, 9; corporate sector, 27; household sector, 20; non-corporate sector, 22 price-quantity duality, 7–8 production function, 8 profit of the firm, 10; corporate sector, 28; household sector, 25; non-corporate sector, 25 (see also: US tax system) relative efficiencies, 5 rental price of capital services, 6, 10; corporate sector, 28; household sector, 21; non-corporate sector, 25 replacement, 6 replacement, rate of, 6 RS (residential structures), 115 return, rate of, 6, 11–13; and cost of capital, 7 (see also: depreciation); and effective tax rate, 14; on equity, 9, 12; estimates, 110–130; on business assets, 117–118; on corporate assets, 122–124; on household assets, 129; on non-corporate assets, 125–127; on private assets, 130; private, 14; social, 14; and tax reform, 137–147; under President's Proposal, 144; under Tax Law, 1985, 139; under Tax Reform Act of 1986, 148; under Treasury Proposal, 142; and tax wedge, 14; weighted average, 13 return, rate of, on corporate assets, 28; and effective corporate tax rate, 30; and effective individual tax rate, 30; and effective tax rate, 30; private, 29; social, 29; and tax reform, 32–35; and tax wedge, 30; corporate tax wedge,

SUBJECT INDEX

30; individual tax wedge, 30; total tax wedge, 30; weighted average, 29 return, rate of, on household assets, 21; and effective tax rate, 22; private, 21; social, 21; and tax wedge, 22; weighted average, 22 return, rate of, on non-corporate assets, 25; and effective tax rate, 26; private, 25; social, 25; and tax wedge, 26; weighted average, 25 S (short-lived assets), 115 SD (short-lived depreciable assets), 115 tax liabilities, 20; corporate, 28; household, 20; noncorporate, 24 tax policy analysis, 160–165see also: acquisition price of investment goods) (see also: cost of capital) (see also: ERTA) (see also: tax reform) tax rate, 15, 41–51; average, 15; average marginal, 68–71; marginal, 15 (see also: US tax system) tax rate, effective, 14, 115–121; alternative approaches, 147–152, 155–160; average, 2, 150–151; on all assets, 15; capital gains, 47, 67; differences, 121–137; estimates, 110–130; on business assets, 117–119; on corporate assets, 122–124; on household assets, 129; on non-corporate assets, 125–127; on private assets, 130; introduced, 2, 36; marginal, 2; on new assets, 15 (see also: return, rate of); and tax reform, 137–147; under President's Proposal, 145; under Tax Law 1985, 139; under Tax Reform Act of 1986, 148; under Treasury Proposal, 142, 154 (see also: tax reform); and tax wedge, 14; by type of asset and industry, 36 tax rate, effective, on corporate assets, 30; corporate, 30; individual, 30; for debt and equity financing, 26 (see also: return, rate of, on corporate assets) tax rate, effective, on household assets, 21; for debt and equity financing, 22 (see also: return, rate of, on household assets) tax rate, effective, on non-corporate assets, 25; for debt and equity financing, 26 (see also: return, rate of, on non-corporate assets) tax reform, 30–35, 91–106, 137–147 (see also: capital cost recovery)

181

182

SUBJECT INDEX

(see also: capital income taxation) (see also: capital gains taxation) (see also: cost of capital); and deductibility of dividends, 31, 97; and deductibility of interest payments, 31, 33, 35, 97; and deductibility of property taxes, 31, 33, 35, 97; and effective tax rates, 137–147 (see also: ERTA); and indexing, 30–33 (see also: inflation); President Ronald Reagan, 1; President's Proposal, 101–104; and rate of return, 137–147 (see also: return, rate of) (see also: return, rate of, on corporate assets); Tax Law, 1985, 92–95; tax policy analysis, 161–165; Tax Reform Act of 1986, 1–2, 83, 104–106, 146–147; Treasury Proposal, 96101 (see also: tax rate, effective) (see also: tax wedge) (see also: US tax system) tax revenue, 14 tax wedge, 14; alternative approaches, 149–151; on corporate assets, 38; corporate, 30; individual, 30; total, 30; on household assets, 22; on non-corporate assets, 22; and distortions in capital allocation, 128–137; estimates, 117–135; on business assets, 117–119; on corporate assets, 122–124; on household assets, 129; on non-corporate assets, 125–127; on private assets, 130; inter-asset, 131; intersectoral, 133–135 (see also: return, rate of) (see also: return, rate of, on corporate assets) (see also: return, rate of, on household assets) (see also: return, rate of, on noncorporate assets) (see also: tax rate, effective); and tax reform, 139–148; under President's Proposal, 145; under Tax Law 1985, 139; under Tax Reform Act of 1986, 148; under Treasury Proposal, 142 tax-exempt owners, 47–48 TEFRA (Tax Equity and Fiscal Responsibility Act of 1982), 49 US tax system, 39–109; alternative approaches, 106–109; average marginal tax rates, 68–71; and capital cost recovery, 73–86; capital consumption allowances, 40, 81–86, 116–121; economic impact, 112–115; investment tax credit, 83–86; and debt-asset ratio, 90; and financial structure, 86–91; and ownership distribution of assets, 51–73; for corporate equity, 52–53, 55; for corporate debt, 56–57, 59–60; for household debt, 64–65, 66; for non-corporate debt, 60–61, 62; and profits and dividend

SUBJECT INDEX

payments, 89; property tax rates, 72; tax rates, 41–51; and tax reform, 91–106; under President's Proposal, 101–104; under Tax Law, 1985, 92–95; under Tax Reform Act of 1986, 104–106; under Treasury Proposal, 96–101; value of debt, 88 (see also: debt) value of equity, 9, 10, 12; corporate sector, 27 (see also: equity); household sector, 20; non-corporate sector, 23 value of outstanding shares, 9 vintage price functions, 73–76 (see also: depreciation); econometric model, 74–76 (see also: inflation)

183

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