During the past six years, Congress enacted a series of tax bills that included provisions altering the effective tax rate on various types and forms of capital. Not only do these changes significantly affect business tax liabilities, but they also alter the decisions businesses make about investment. Changes ranged from broad but temporary stimulus, to efforts targeted at small and medium business, to asset-specific tax treatment changes.
These changes matter for industry trade groups, corporate CFOs and shareholders, because strategies for business growth can be significantly altered by opportunities for tax-motivated activities or restricted by tax-induced disincentives. Increasingly, decisions among capital investment opportunities or about where to locate investments are affected by tax law, particularly the tax treatment of capital.
All of these provisions were enacted in a difficult political environment that required policy compromises and political concessions. Many provisions became law only on a temporary basis due to budget constraints and procedural legislative hurdles. Some of these tax code provisions will be renewed; some will not. Some may be made permanent; most will not. Understanding when and how changes will be made to these provisions is crucial to developing any well-constructed business plan. Knowing how to positively effect change in this area — whether modifying and extending existing provisions or creating new ones — can create significant business growth opportunities.
In addition, how the U.S. tax code taxes capital is a critical question for economists concerned about economic growth. The distortions caused by unequal tax treatment of capital lead to misallocation of resources, and the overall tax burden on capital has had a significant effect on suppressing investment. This report discusses the importance of evaluating tax policy from the perspective of capital taxation, summarizes recent changes in taxes from this perspective and concludes with an outlook for the future.
The basic current structure
Under the current income tax system, capital is taxed differently depending on the organizational form (e.g., corporate, non-corporate, household), its method of financing (e.g., debt or equity) and firm size. As a result, average debt-financed business assets face a negative effective tax rate (i.e., they generate corporate tax refunds), average equity-financed corporate assets face an average effective tax rate of 36 percent and non-business (pass-through entity) assets face an average effective tax rate of 20 percent.1 The effective tax rate measures the fraction of the pre-tax return on an investment that is absorbed in taxes.
The differential treatment of corporate and non-corporate income has significant economic effects as assets are widely distributed across business type: 17 percent of all business equipment and 24 percent of all non-residential buildings are held by non-corporate firms. In addition, different asset types face different effective tax rates because tax depreciation rules do not uniformly relate to an asset's economic depreciation. The following table illustrates the wide variation in effective tax rates across asset types. Inventories, computers and peripheral equipment and manufacturing buildings face effective tax rates above 30 percent, while railroad equipment, mining structures and petroleum and natural-gas structures face effective tax rates near 10 percent.
|Average Effective Tax Rates by Asset Type
Tax Rate (%)
|Equipment (all types, weighted)
|Computers and Peripheral Equipment
|Mining and Oil-Field Machinery
|Medical Equipment and Instruments
|Structures (all non-residential, weighted)
|Office building, including medical
|Petroleum and Natural-Gas Structures
Source: Congressional Budget Office, "Background Paper: Computing Effective Tax Rates
on Capital Income," December 2006.
Why taxing capital matters
In the most common economic growth model, production (or economic output) is a function of two inputs: labor and capital.2 More output (i.e., economic growth) requires more input (more labor, more capital or both) and/or increases in technology/productivity. From this growth-model framework of the economy, taxes play a role to the extent that they affect the supply of labor or capital and/or discourage innovation, technology or productivity enhancements.
The politics of tax policy tends to favor tax relief that directly affect voters as taxpayers, such as marriage-penalty relief or child tax credits. The reason is simple: People vote; capital doesn't. Similarly, high-income individuals are always under pressure to have their tax burdens increased in a progressive tax system because they have more disposable income and in a democracy, there are fewer of them.
Capital taxes (including ordinary individual income taxes and corporate income taxes) unambiguously raise the cost of capital. While the effect of a change in price on the supply of capital is an empirical question, the emerging consensus among economists is that the response in the change in price is quite large. For example, attempts to stimulate investment in 2002 and 2003 by allowing faster depreciation of equipment have been estimated to have increased output 0.1 to 0.2 percent and created 100,000 to 200,000 jobs.3 The reduction in the dividend tax rate in 2003 has been linked to an increase in the number of corporations paying dividends, a significant increase in dividend payments by many firms already paying dividends and an increase in the number of one-time dividend payments.4 In addition, as global capital flows increase and money moves with greater ease across borders, the allocation of capital is becoming increasingly sensitive to differences in tax structures around the world.5 A consensus has formed from the empirical evidence that suggests that a 1 percent decrease in the cost of capital for business equipment raises equipment investment between 0.5 and 1 percent.6
What are the recent changes?
Among the dozens of tax bills and hundreds of tax provisions enacted into law in recent years, a subset has had a direct impact on the taxation of capital. The following section highlights the largest of those changes.
2001 — Section 179 Small Business Expensing — Raised limit on the total amount a small business can immediately expense (write-off) from $25,000 to $100,000 and raised the phase-out of this provision to include all businesses with investments of less than $400,000 in a given year. In 2007, the limit was raised to $125,000 and the phaseout threshold raised to $500,000. The higher limit and threshold expires after 2010.
2001 — Lower marginal rates on income; estate tax repeal — Tax rates affecting businesses organized as pass-through entities include the ordinary income tax rates, which were lowered in 2001 and 2003. In addition, estate tax law changes have reduced the tax rate on estates and increased the exemption amount. However, in both cases, these changes are temporary and expire after 2010.
2002 — 30 percent Accelerated (Bonus) Depreciation — In 2002, Congress enacted legislation intended to stimulate business investment by allowing assets with depreciation lives less than 20 years to immediately expense 30 percent of the cost in addition to the ordinary depreciation schedule. This rule applied for investments made after September 10, 2001, and before September 11, 2004.
2003 — 50 percent Accelerated Depreciation — In 2003, the bonus depreciation provision from 2002 was increased to 50 percent and extended through the end of 2004.
2003 — 15 percent tax on dividends and capital gains — Also in 2003, the tax rate on dividends and capital gains was reduced to 15 percent. Previously, dividends had been taxed as ordinary income, and long-term capital gains had been taxed at 20 percent. These provisions were originally enacted through 2008, and in 2006 were extended through 2010.
2004 — Section 199, Manufacturing rate cut — Phased in rate cut on "production income" (broadly defined) from 35 percent to 32 percent. Lower rate is available for corporate and non-corporate income.
A number of smaller, targeted changes affecting the effective tax rate on specific assets have occurred, as well. For example, race track complexes, self-created musical works and qualified cellulosic ethanol plants have had their tax treatment changed favorably.
According to the Bureau of Economic Analysis (BEA) the combined effects of the 2002 and 2003 tax bills were significant in terms of after-tax corporate profits. For 2004, total after-tax corporate profits were increased 3.5 percent or $29.9 billion as a result of these two bills.7 Much of this effect is a timing shift in tax liabilities due to changes in depreciation schedules but corporate cash-flow was increased significantly and the benefit of deferred taxes can be significant itself.
Where do we stand among our trading partners?
As global capital markets grow and cross-border capital mobility increases, the U.S. tax code vis-à-vis our neighbors and trading partners is increasingly important. According to the consulting firm KPMG8, the U.S. corporate tax rate, currently 35 percent, is the second-highest in the industrialized world, behind Japan. The average corporate tax rate in Europe is 25 percent. But as explained above, depreciation rules matter for determining the effective tax rate on capital. International comparative analysis that combined tax depreciation rules with other corporate tax rules concludes that the U.S. effective marginal tax rate on equity-financed machinery is still among the highest in the industrialized world, although the dispersion of these tax rates is much lower than for statutory rates globally. For investments in industrial structures, the marginal effective tax rate in the United States is second-highest.
What does the future hold?
Aggregating across business types and financing types, effective tax rates on capital were the lowest in 2004, due primarily to the temporary accelerated depreciation provision that expired at the end of that year (and low interest rates). Tax rates on capital today remain lower than they were prior to the tax cuts that began in 2001, particularly for businesses with annual capital investment of less than $400,000, namely those that benefit from Section 179 Small Business Expensing. Tax rates on capital are the highest for larger corporations in the service industry and are little changed from the 1990s.
Four key points to keep in mind about possible future trends in this area:
- Under current law, tax rates on capital are scheduled to rise. The lower tax rate on capital gains and dividends, lower ordinary income tax rates and the repeal of the estate tax all expire at the end of 2010.
- Current budget rules (pay-as-you-go) and a strong desire for budget discipline in Congress may lead tax committees to work to "level the playing field" by increasing effective tax rates on those types of capital now more favorably taxed. Already, the U.S. House of Representatives has voted to raise tax rates on energy production, one of the more lightly taxed types of capital.
- The ownership of capital is highly concentrated among the wealthiest Americans. To the extent that Congress seeks to increase the progressiveness of the tax code, raising capital taxes (while harmful for growth) can be a targeted and effective tool.
- The forces of global competition are increasingly affecting U.S. tax policy, and as the awareness of these pressures increase in Congress, the likelihood of a reduction in corporate tax rates (although perhaps not tax burdens) will rise.
1 Congressional Budget Office. "Background Paper: Computing Effective Tax Rates on Capital Income" and accompanying data files, December 2006. Available at: http://www.cbo.gov/ftpdoc.cfm?index=7698&type=2, accessed May 25, 2007.
2 More elaborate models include additional types of inputs to production such as land or energy and/or different types of labor.
3 See House, Christopher and Matthew Shapiro, "Temporary Investment Tax Incentives: Theory with Evidence from Bonus Depreciation," National Bureau of Economic Research, Working Paper 12514, September 2006.
4 See Chetty, Raj and Emmanuel Saez, "Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut," Quarterly Journal of Economics 120(3), 791-833, 2005.
5 See Altshuler, Roseanne, Harry Grubert and T. Scott Newlon, "Has U.S. Investment Abroad Become More Sensitive to Tax Rates?" National Bureau of Economic Research, Working Paper 6383, January 1998.
6 See "Tax Policy and Business Investment," Handbook of Public Economics, v. 3 ed. Alan Auerbach and Martin Feldstein (2002), pp. 1293-1343.
7 See "Combined Effects of the Tax Acts of 2002 and 2003 on Selected Measures of Corporate Profits," available at http://www.bea.gov/national/index.htm#corporate, accessed May 25, 2007.
8 "KPMG's Corporate Tax Rates Survey: An international analysis of corporate tax rates from 1993 to 2006" (2006), accessed May 25, 2007.