January 15, 2020

Measuring Marginal Effective Tax Rates on Capital Income Under Current Law

Key Findings

  • This paper updates the user cost of capital calculation in Tax Foundation’s General Equilibrium model by including the split of equity and debt financing by businesses and separating out savers’ required rate of return from the user cost of capital for businesses.
  • This paper computes the marginal effective tax rate for eight types of business investments under current law. We find that the marginal effective tax rates (METRs) for corporate assets is slightly higher than for noncorporate assets.
  • The comparison of METRs under the Tax Cuts and Jobs Act (TCJA) against pre-TCJA indicates that TCJA temporarily reduces METRs for all asset types and business formations.
  • The phaseout of the TCJA’s temporary provisions will increase the marginal effective tax rates on all asset types, especially in the noncorporate sector. Starting in 2026, the weighted average marginal effective tax rate in noncorporate sectors will be around 1.6 percentage points higher than corporate sectors.
  • This study first examines marginal effective tax rates for the federal tax system and then includes state and local taxes, such as property taxes and state business income taxes, to compute marginal effective tax rates. The addition of state and local taxes significantly increases the METRs across all asset types.

Introduction

The literature on measuring the impact of tax policy on altering new business investment behavior is based on the concept of the user cost of capital developed by Dale Jorgenson (1963)[1] and Robert Hall and Dale Jorgenson (1967).[2] The marginal effective tax rate (METR), a tax burden measurement built on the concept of the user cost of capital, is commonly used to summarize the impact of tax systems on business investment decisions.

Changes in taxation, including but not limited to changes in the statutory rates of the corporate income tax and personal income tax, would change the user cost of capital and thereby impact investment decisions at the margin. The Tax Cuts and Jobs Act (TCJA) of 2017 made a long list of changes to the federal tax system, not only to individual income provisions but also to provisions affecting business income. 

This study will update how the Tax Foundation’s General Equilibrium Model[3] measures METRs s on different types of capital investment and how this measurement has changed under current law due to the TCJA.[4] In this paper, we first describe updates made to our measurement for the marginal effective tax rate through two changes in the user cost of capital calculation. First, the split between debt and equity financing of investment is incorporated in our model framework; second, the framework for the user cost of capital is deconstructed into two layers: business and individual capital income savers.

The changes in METRs across different asset types under current law and over the next decade are presented both with and without state and local taxes. The comparison of METRs across different asset types and business forms are discussed as under pre-TCJA law, current law, and over the next decade.

Read the Full Paper

[1] Dale W. Jorgenson, “Capital Theory and Investment Behavior,” The American Economic Review 53:2 (May 1963): 247-259.

[2] Robert E. Hall and Dale W. Jorgenson, “Tax Policy and Investment Behavior,” The American Economic Review 57: 3 (June 1967): 391-414.

[3] Stephen J. Entin, Huaqun Li, and Kyle Pomerleau, “Overview of the Tax Found foundation’s General Equilibrium Model,” Tax Foundation, April 2018, https://files.taxfoundation.org/20180419195810/TaxFoundaton_General-Equilibrium-Model-Overview1.pdf.

[4] For a full list of the TCJA changes we consider in this paper, see Appendix A.

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