Measuring Marginal Tax Rate on Capital Assets

October 30, 2017
Update (11/9/2017): The Tax Foundation was recently made aware of a calculation error in some of the estimates in this paper. The Tax Foundation is working on updating the figures in this report as soon as possible.

Key Findings:

  • The United States has the highest statutory corporate tax rate in the industrialized world at 35 percent (39.1 percent when including the average state corporate tax rate). However, our research concludes that each new $1 in corporate investment is actually taxed at a rate of 53.6 percent.
  • This report estimates the marginal effective tax rate (METR) for eight different types of business investment. This includes additional taxes–such as property taxes and state and local business income taxes–that businesses must account for when they decide if a new plant or piece of equipment will be profitable. It also includes taxes paid by shareholders while subtracting for depreciation allowances and pertinent tax credits.
  • While federal taxes weigh significantly on the cost of capital, state and local taxes—especially property taxes—comprise roughly one-third of the total tax on new capital investment, according to the report.
  • Under this methodology, the proposed 20 percent corporate rate under consideration in tax reform negotiations would lower the METR on corporate investment to 45.9 percent, a 14.3 percentage point decrease.

The literature on measuring the impact of tax policy on altering new business investment behavior is based on the concept of user cost of capital raised by Jorgenson (1963) and Hall and Jorgenson (1967). Changes in taxation, including but not limited to changes in the statutory corporate tax and personal income tax, would change the user cost of capital and change the impact of tax on marginal investment decisions. Marginal effective tax rates are commonly used to measure this impact.  This study will show how Tax Foundation’s Taxes and Growth (TAG) model measures marginal tax rates on different capital investment.

The Measurement of Service Price

The service price of capital is also sometimes referred to as the user cost of capital.  It is the cost for employing or obtaining one unit of capital asset over a defined period of time. The user costs of capital is the minimum rate of return that an investment must accomplish to cover all kinds of taxes, economic depreciation (loss of value over time due to wear and tear or obsolescence), and the opportunity cost or minimum required rate of return (Jorgenson, 1963). (“Service price” usually includes all costs, including economic depreciation. The term “user cost of capital” usually includes all costs other than economic depreciation.)

Corporate and noncorporate businesses, the two main business sectors specified in the TAG model, have different equations for service price since the tax regimes vary by sector.[1]

To illustrate how the service price is calculated in the TAG model, we begin with a cash flow statement of business receipts for noncorporate capital expressed as in equation (1). The gross after-tax return for all noncorporate capital can be expressed as tax-inclusive business income subtracting all taxes. Taxes under consideration in this study include federal business (corporate or noncorporate) income taxes, the federal gift and estate tax, as well as all kinds of taxes at the state and local level, such as property taxes, business income taxes, and gift and estate taxes.

(1) 

where Snc  is the service price for noncorporate capital; K is the capital stock in the noncorporate sector;  is the real after-tax return of rate; te is the combined federal and state estate and gift tax rate; tp,nc  is the property tax on noncorporate capital assets at the state level; δ is the rate of economic depreciation; and z is the cost reduction from tax depreciation deduction allowances and investment credit (if any). That is, (1-z) is the remaining cost of the assets after tax deductions and credits.

The service price of noncorporate capital asset i can be formulated as equation (2) by dividing both sides of Equation (1) by K  

(2)

where i is an indicator for capital asset i; itc is the rate of any investment tax credit taken against all capital assets; tnc,f is the noncorporate income tax rate at the federal level; zi,f is the net present value of cost recovery for asset i at the federal level; and tncs and zi,f  are the corresponding values for the state level. The term tnc is combined business income tax rate at the federal and state level and can be expressed as .

Unlike the noncorporate sector, the corporate sector has a second layer of taxes: the shareholder tax on capital gains and dividends. Therefore, the rate of return for the corporate sector needs to be grossed up to cover the additional individual taxes.

Following the same approach for the noncorporate sector, the service price of capital for corporate asset  can be expressed as follows

(3)

 

where tic is the combined federal and state personal income tax rate on corporate income; tp,c is the property tax on corporate capital assets at the state level; tc,f is the corporate income tax rate at the federal level; zi,f is the net present value of cost recovery for asset  at the federal level; tc,s and zi,s are the corresponding values for the state level. The term tc is the combined corporate income tax rate at the federal and state level and can be expressed as tc = tc,f +tc,s(1 – tc,f ).

Weighted Average Marginal Effective Tax Rates

The weighted average marginal tax rate is a summary measure of the tax burden across all assets under the user cost of capital framework. It is the difference (tax wedge) between the real pretax and after-tax user costs observed in the real world, divided by the real pretax user cost. That is, the TAG model calculates the marginal tax rate as the difference between the real pretax user cost (= service price net of the economic depreciation rate) and the real after-tax rate of return, measured as a percent of the pretax user cost.

The Weighted average marginal effective tax rate for noncorporate capital ( ) and corporate capital ( ) can be expressed respectively as follows:

(4)

(5)

For example, if the minimum required service price to engage an investor is 20 percent, the economic depreciation is 5 percent, and the post-tax rate of return on capital is 5 percent, the marginal tax rate would be 66.7 percent. (That is: [(20 – 5) – 5]/(20 – 5) = 10/15 = .667.

Effective Tax Rates by Asset Types and Business Form

Table 1 is the calculated marginal effective tax rate across different types of capital assets. It is worth noting that corporate capital assets face higher taxes than noncorporate capital assets. On a weighted average basis, new corporate investment faces a marginal effective rate of 53.6 percent, while noncorporate capital investment faces a marginal effective rate of only 39.1 percent. The large difference can be explained by the two layers of taxation levied on the corporate returns.

  Corporate Noncorporate
Table 1. Weighted Average Marginal Effective Tax Rates, Current Law
Equipment & software 52.7% 32.8%
Nonresidential structures 53.8% 35.6%
Intellectual property 47.1% 28.2%
Residential structures 53.5% 36.0%
Inventories 56.5% 41.8%
Commercial land 56.5% 41.8%
Nonfarm land 56.5% 41.8%
Farm land 56.5% 41.8%
Weighted average 53.6% 39.1%

Based on the “Big Six” Tax Framework released by Republican leadership, the federal corporate income tax rate would be lowered from 35 to 20 percent. The TAG model shows that a 20 percent corporate tax rate would reduce the marginal effective tax rates for most capital assets by around 14 percent (see Table 2). (That is 14 percent of the tax, not 14 percentage points. For example, the weighted average corporate tax rate would fall from 53.6 percent to 45.9 percent, a 7.3 percentage point drop in the 53.6 percent tax, equal to a 14.3 percent reduction in the tax.)

  Current law corporate 20% corporate rate (% change)
Table 2.  Weighted Average Marginal Effective Tax Rates under 20% Corporate Income Tax Rate
Equipment & software 52.7% 45.2% -14.3%
Nonresidential structures 53.8% 46.1% -14.4%
Intellectual Property 47.1% 41.2% -12.4%
Residential structures 53.5% 45.9% -14.3%
Inventories 56.5% 48.0% -14.9%
Commercial land 56.5% 48.0% -14.9%
Nonfarm land 56.5% 48.0% -14.9%
Farm land 56.5% 48.0% -14.9%
Weighted average 53.6% 45.9% -14.3%

 Apart from reducing the statutory rate on corporate income, speeding cost recovery for capital investments to encourage business to invest more is another well-researched component of fundamental business tax reform. Compared to current law, full expensing of capital investment (immediate write-off instead of depreciation) would reduce the weighted average marginal effective tax rate for corporate assets by 15.5 percent, and reduce weighted average METR for capital assets in the noncorporate sector by 4.4 percent (see Table 3). 

  Corporate Noncorporate
  Current law Full expensing (% change) Current law Full expensing (% change)
Table 3.  Weighted Average Marginal Effective Tax Rates under Full Expensing
   Equipment & software 52.7% 43.3% -17.9% 32.8% 24.6% -25.1%
   Nonresidential structures 53.8% 40.3% -25.2% 35.6% 22.2% -37.7%
   Intellectual property 47.1% 45.9% -2.6% 28.2% 26.7% -5.3%
   Residential structures 53.5% 40.2% -24.9% 36.0% 22.3% -38.0%
   Inventories 56.5% 56.5% 0.0% 41.8% 41.8% 0.0%
   Commercial land 56.5% 56.5% 0.0% 41.8% 41.8% 0.0%
   Nonfarm land 56.5% 56.5% 0.0% 41.8% 41.8% 0.0%
   Farm land 56.5% 56.5% 0.0% 41.8% 41.8% 0.0%
Weighted average 53.6% 45.3% -15.5% 35.8% 34.2% -4.4%

 The marginal tax results are impacted by different business tax provisions, both at the federal level and at the state and local level. To focus on the role of federal tax policies only, we recalculate these METRs by zeroing out all state and local taxes impacting service prices while fixing the rate of return for capital investments.

Table 4 shows the METRs due to federal taxes only. On a weighted average basis, the numbers are 36.1 and 26.8 percent for corporate and noncorporate respectively, or around 30 percent lower than the combined federal, state, and local baseline level, which indicates that ignoring state and local taxes in calculating METRs would distort the picture considerably.

  Corporate Noncorporate
  Current law No state and local taxes (% change) Current law No state and local taxes (% change)
Table 4. Weighted Average Marginal Effective Tax Rates excluding State and Local Tax Impact
Equipment & software 52.7% 33.1% -37.2% 32.8% 15.8% -52.0%
Nonresidential structures 53.8% 38.3% -28.9% 35.6% 22.7% -36.4%
Intellectual property 47.1% 16.0% -66.1% 28.2% 5.0% -82.1%
Residential structures 53.5% 37.8% -29.4% 36.0% 23.1% -35.9%
Inventories 56.5% 42.4% -24.9% 41.8% 30.8% -26.4%
Commercial land 56.5% 42.4% -24.9% 41.8% 30.8% -26.4%
Nonfarm land 56.5% 42.4% -24.9% 41.8% 30.8% -26.4%
Farm land 56.5% 42.4% -24.9% 41.8% 30.8% -26.4%
Weighted Average 53.6% 36.1% -33.2% 35.8% 26.8% -32.2%

Conclusion

This study demonstrates how Tax Foundation’s TAG model calculates the weighted average METRs for different capital assets in the corporate and noncorporate sectors. The high marginal rates of up to 53 percent in the corporate sector illustrate why there is an urgent need for business tax reform.


[1] Data for the corporate sector in the TAG model includes both C corporations and S corporations. Due to data constraints from the Bureau of Economic Analysis, we cannot separate C corporations from their data report on corporate.


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