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Effective Marginal Tax Rates, Not Average Tax Rates, Are the Most Relevant for International Comparisons of Tax Rates

2 min readBy: Robert Carroll

A recent analysis by Chye-Ching Huang with the Center on Budget and Policy Priorities (PDF) correctly states that the U.S. has a low average tax rateThe average tax rate is the total tax paid divided by taxable income. While marginal tax rates show the amount of tax paid on the next dollar earned, average tax rates show the overall share of income paid in taxes. (ATR), reflecting its relatively narrow tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates. . Despite the high statutory corporate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. rate, the various special corporate provisions result in a low ATR.

Several things, however, need to be considered. First, the best measure for considering the competitiveness of the United States is neither the statutory corporate tax rate nor the ATR, but the effective marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. (EMTR). This measure is typically the focus of economists as relevant to a firm's decision of whether to invest another dollar or where to locate that dollar of investment. This measure is derived from an investment's cost of capital and shows the share of an investment's economic income needed to cover taxes over its lifetime.

What is important here is that the EMTR has been falling abroad, but has remained largely unchanged in the United States (see Figure 2 in Tax Foundation Fiscal Fact #143). Indeed, the trends we see in comparisons of the statutory corporate tax rate are very similar when considering trends in the EMTR. Some focus on the statutory corporate tax rate because it is emblematic of changes in the EMTR.

Second, most international comparisons of the ATR do not account for the large non-corporate sector in the United States as compared to other countries. Failing to account for the large non-corporate sector in the United States understates the U.S. ATR. Roughly one-third of business taxes in the U.S. are collected from owners of flow-through entities—partnerships, S corporations, and sole proprietorships—when they file their individual tax returns. Indeed, a back-of-the-envelope calculation that includes the roughly $150 billion in taxes paid on the business income reported by owners of flow-through entities increases the U.S. ATR (measured here as corporate revenue divided by gross domestic product) from about 2.2 percent to 3.3 percent, which is close to the OECD average of 3.5 percent, not dramatically below it.

Third, about one-half of the "narrowness" in the U.S. tax base can be attributed to accelerated depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and discouraging investment. for investment in equipment. Accelerated depreciation lowers the EMTR for investment by partially removing the tax on the return to investment at the margin. It also imbeds a VAT-type feature in our income tax. Indeed, this provision moves the U.S. income tax base towards that of a consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. . The hybrid nature of the U.S. income tax base conflates international comparisons of ATRs for corporate income taxes because the U.S. has, in effect, chosen to imbed VAT-type features in its income tax, while other nations have tended to impose more pure income taxes and stand-alone VATs.