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Article Excerpt
INTRODUCTION
In a competitive economy, rates of return on investments direct profit-maximizing savers to invest in projects with the highest social return. Output is maximized when marginal rates of return are equalized across all investment alternatives.
Taxes introduce a wedge between the return earned by an investment and the return received by savers. In the presence of taxes, profit-maximizing savers will allocate their savings to earn the highest after-tax return, and their return is maximized when after-tax returns are equated on all investments. As long as taxes reduce rates of return on all investments equally, savings are still allocated efficiently--that is, to maximize output. (1) To the extent taxes reduce returns unequally, savings will be allocated inefficiently, so that output is not maximized.
The current tax system is far from uniform in its taxation of investment returns. Taxes that are neutral with respect to investment exist in theory, however, as "pure" income, consumption, or wage taxes. The first taxes all returns at an equal positive rate; the second and third do not tax marginal returns at all. Enacting one of the pure systems appears to require steps that are politically infeasible. Partial steps to increase uniformity may be the most reform that can be enacted.
In this paper, we investigate five actual proposals that have been made since 2001 that fall short of fundamental reform, but that would increase uniformity for at least some aspect of the tax on capital income. Our base case is the law in place prior to 2001 (which--except for provisions covered by the Pension Protection Act of 2006--would be restored in 2011 in the absence of further Congressional action). The five proposals are as follows: (2)
1. Extend the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) indefinitely; 2. Allow 30 percent expensing of equipment, per the Job Creation and Worker Assistance Act of 2002 (JCWAA);
3. Allow $5,000 annual contributions to lifetime savings accounts (LSAs), per the President's 2007 Budget;
4. Partially integrate the individual-level and corporate-level taxes, per the President's 2004 Budget; and
5. Convert the mortgage interest deduction to a credit, per the November 2005 report of the President's Advisory Panel on Federal Tax Reform.
Our goal is to determine whether those partial reforms really would increase the uniformity with which capital income is taxed and, therefore, improve the signals for efficient allocation of saving among alternative investments.
We use the methodology of effective tax rates to evaluate the potential distorting effect of taxes on economic activity. An effective tax rate combines statutory tax rates with other features of the tax code into a single tax rate that applies to the real rate of return over the life of an investment.
Under pre-EGTRRA law, effective tax rates vary by form of organization, method of financing, asset type and, in the case of housing, the tenure of the occupant. To gauge the potential efficiency effects related to the disparate treatment of different kinds of investment, we computed effective tax rates and measures of tax rate uniformity across those various dimensions. For most of the categories, the uniformity measure is simply the difference between the rates being compared. In the case of different types of corporate assets (there are 49), the measure is an interquartile range. For all measures of uniformity, higher absolute values signal less uniformity; a score of zero indicates complete uniformity.
Not all differences in effective tax rates necessarily contribute to the misallocation of saving among investment alternatives. (3) Nonetheless, in our paper we only introduce features of the tax code and economy that we believe are likely to lead to distorting signals for the allocation of investment in a closed version of the U.S. economy. As disagreement exists about which features are distorting, we introduce alternative assumptions about two areas of uncertainty: the taxation of dividends, and the use of nontaxable accounts (primarily for retirement saving). Although we consider differences in assumptions, we always interpret differences in effective tax rates as evidence of distorted signals for investment.
METHODOLOGY
Defining Effective Tax Rates
Statutory tax rates apply to taxable income in a given year; effective tax rates summarize in a single rate provisions of the tax code that apply to economic income over the entire life of an investment. Specifically, an effective tax rate is a constant rate that, if applied to the return on an investment over its lifetime, would yield the same after-tax rate of return as applying statutory rates to taxable income according to the law.
Effective tax rates are computed for a marginal investment. That is, the cost of the investment is expected to just equal the present value of the return that the business would have to distribute to its investors, after paying the taxes that would be due on the profits. The sources of saving are marginal as well. Thus, the tax rates that apply to them can differ from those paid on existing saving. Consider an individual who has saved up to the limit in his or her retirement savings account. The investment earnings within the account are not taxable, but if the individual saved an additional dollar, it could not be deposited into that account, so the investment returns on that dollar would be taxed.
Calculating Effective Tax Rates
As noted above, taxes create a wedge between the rate of return an investment earns before tax and the rate of return savers end up with after tax. An effective tax rate (ETR) is computed as the tax wedge relative to the before-tax return, or:
[1] ETR - [rho]-s/[rho].
In the equation, [rho] is the real before-tax rate of return and s is the real after-tax rate of return. The details behind the calculation of those two variables differ for C corporations, noncorporate businesses, and homeowners. (4)
C Corporations
The real before-tax rate of return a corporation must expect to earn on a marginal investment can be expressed as:
[2] [[rho].sub.c] = r - [pi] + [delta] / 1 - u (1 - uz) - [delta], where
[rho] is the nominal cost of funds to the corporation (and its discount rate),
[pi] is the rate of inflation,
[delta] is the rate of economic depreciation,
u is the corporate tax rate, and
z is the present value of tax depreciation allowances measured as a share of acquisition cost.
The cost of funds to the corporation is the rate of return it must pay savers for use of their savings, adjusted to reflect the cost to the business. The rate of return is the market interest rate on debt and the expected profit rate on other equity investments. The corporation can deduct interest payments, so the cost of funds can be expressed as:
[3] r = f [i(1 - u) - [pi]] + (1 - f)E,
where
f is the fraction of the investment financed by debt,
i is the market interest rate, and
E is the real return on equity.
Corporations pay their equity return to savers directly as dividends or indirectly by reinvesting profits in the firm. The reinvested profits should raise the price of the firm's stock, creating a capital gain for the saver.
The interest, dividends, and capital gains generated by the corporation's investment are subject to the individual income tax when received by savers, which introduces a second level of tax on corporate profits. The size of the second bite depends on myriad features of the individual income tax; we focus on four:
1. The regular statutory tax rates under the individual income tax;
2. The type of income received: interest income (taxed at regular rates), dividends (currently taxed at lower rates), or capital gains (benefitting from both deferral until realization and lower rates);
3. The type of account through which the saving is supplied: nontaxable (employment-based pension plans, IRAs, and special accounts for education or health), temporarily deferred (nonqualified annuities and whole life insurance), or fully taxable (all other capital income); and
4. Inflation, because taxes are levied on nominal returns.
What is left after the second level of taxation--the real return on corporate investment for the saver--we label [s.sub.c], and specify below. The portion of that return attributable to debt finance, [s.sub.c,d], we express as:
[4] [s.sub.c,d] = [[alpha].sub.c,d,ft] [i(1 - [t.sub.int]) - [pi]] + [[alpha].sub.c,d,td][s.sub.c,d,td] + [[alpha].sub.c,d,nt] (i - [pi]),
where
[[alpha].sub.c,d,ft] is the share of marginal saving in corporate debt instruments that is held in fully taxable accounts,
[t.sub.int] is the marginal statutory tax rate on interest income,
[[alpha].sub.c,d,td] is the share of marginal saving in corporate debt instruments that is held in temporarily deferred accounts,
[s.sub.c,d,td] is the real after-tax return adjusted for the effects of temporary deferral, and
[[alpha].sub.c,d,nt] is the share of marginal saving in corporate debt instruments that is held in nontaxable accounts.
We label the real after-tax return remaining after individual income taxes on corporate equity [s.sub.c,e] and express it as:
[5] [s.sub.c,e] = [[alpha].sub.c,e,ft] [(1 - m)E(1 - [t.sub.div]) + g] + [[alpha].sub.c,e,td] [s.sub.c,e,td] + [[alpha].sub.c,e,nt]E,
where
[[alpha].sub.c,e,ft] is the share of marginal saving in corporate equity that is held in fully taxable accounts,
m is the fraction of the return on corporate equity reinvested by the corporation,
[t.sub.div] is the marginal statutory tax...
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