Tax Reform and the Cost of Capital: An International Comparison.

This volume of ten essays by leading tax experts from various countries presents the latest research on capital income taxation in nine key industrialized democracies. This indispensable reference work provides detailed comparative information on marginal effective tax rates by country by type of capital asset for 1980, 1985 and 1990, an index, a good working bibliography in the form of the separate chapter references, an introductory chapter by Jorgenson explaining the issues and findings, and a methodological appendix to that chapter by Jorgenson explaining the Jorgenson cost of capital [2] and marginal effective tax rate [1; 3] concepts (the latter refining Harberger's notion of the effective tax rate) and the King-Fullerton framework [4] for calculating the cost of various types of capital.

The essays study the relationship between tax policy and the cost of different types of capital in the "Group of Seven" (G-7) industrialized nations (Canada, France, Germany, Italy, Japan, U.K., U.S.) along with Australia and Sweden. Many of these countries experienced major tax reform efforts in the 1980s. Each country is the subject of a chapter by specialists. (King is coauthor of the U.K. essay; Fullerton is coauthor of the U.S. essay.) The reader should proceed with first the preface and then the "Appendix: King-Fullerton Framework" to chapter 1 by Jorgenson, followed by that chapter.

Capital income taxation involves a complicated web of issues. The conceptual framework of the annualized rental cost of capital and the marginal effective tax rate on capital income "facilitates the representation of the economically relevant features of highly complex tax statutes in a very succinct form" [p. 4]. Cost of capital is affected by asset price inflation, measurement of economic depreciation (reflecting the decline in asset efficiency over time), tax code provisions for capital-cost recovery, and the capital market interest rate. Computation of the potentially complex family of marginal effective tax rates must incorporate various types of capital income and wealth taxes at both the business and personal levels in order to measure the overall burden of taxation. The capital allocation process is also highly complicated. The market economy allocates capital among corporate, noncorporate and owner-occupied housing sectors; types of fixed capital (equipment, construction, inventories); types of investment financing (equity, debt, retained earnings); types of savings ownership (private households, tax-exempt institutions, life insurance companies). One important policy result is that investment incentives are often not at all clear. Both capital structure of the economy and capital income tax policy vary by country.

The chief methodology for applying this conceptual approach has been the King-Fullerton framework for comparing marginal effective tax rates for different types of assets in different countries. The essential methodology is to calculate a marginally effective tax rate taking into account definition of taxable income and statutory tax rate (including corporate and personal tax treatments) for representative types of assets (including depreciation treatments and inflation indexing). The resulting calculations allow examination of inter-asset tax nonneutrality and time trends in marginally effective tax rates by asset types. The King-Fullerton methodology essentially identifies the numerous types of investment projects defined by the various combinations of these dimensions: type of asset, industry, source of financing, ownership.

This volume reflects two different developments. One development was the growing consensus among tax economists and policy analysts that capital taxation reform should focus on equalizing marginal effective tax rates among different types of assets so as to end severe tax nonneutrality significantly affecting efficiency of capital allocation through distortion by uneven investment incentives. This development led to an effort at systematically applying the Jorgenson cost-of-capital approach to comparative tax policy analysis. The King-Fullerton study covered only the corporate sector in Sweden, the U.K., the U.S. and West Germany for 1960, 1970 and 1980. This framework has been implemented in some form for most industrialized countries; and the World Bank has been applying the framework to developing countries. Previous Organization for Economic Cooperation and Development (OECD) and Commission of the European Communities (CEC) studies cited in chapter 1 focused on the manufacturing sector. The general objective of these various efforts has been to provide a comparative data base for examination of capital taxation inefficiencies in order to influence policy efforts at improved horizontal equity and market efficiency.

The second development was the political movement for tax reform in the 1980s, a movement that operated in parallel with deregulation, privatization and tax reduction movements. There is a wide range of different national systems for capital taxation. Although initially barely influenced in the early 1980s by the intellectual development for horizontal equity, this political movement narrowed corporate and noncorporate tax rates [p. 22]. The later 1980s probably reflected greater influence by the intellectual developments in the taxation field. An undesirable shift toward expenditure as a tax base in lieu of income intended to provide capital investment incentives was reversed in the 1980s [pp. 1, 41].

Capital taxation policy involves a number of difficult issues: income base definition, overall tax burden, investment incentive policy, and nonneutrality of marginal effective tax rates. The general findings of the study are$that effective corporate tax rates are well below statutory rates in all nine countries. Effective rates have been highly negative in some years in France, Italy and Sweden. Policy changes in the 1980s generally broadened income tax base, reduced tax rates, and narrowed marginal effective tax rates to greater or lesser degree. However, substantial intranational and international disparities in the latter persist.

There is a wide range of national approaches to integration of corporate and personal taxes for the tax treatment of dividends and capital gains [p. 45]. The classical corporate income tax system of the U.S. neither collects nor refunds additional tax when dividends are paid out. The partial imputation system of France and the U.K. provides a personal tax credit or a lower personal tax rate on dividends. (The U.S. Treasury Department recommended in the 1980s shifting to a partial imputation system.) The full imputation system of Australia, Germany and Italy allows full deductibility of dividends and interest from the corporate tax base and full personal taxation of those dividends and interest. Canada, Japan and Sweden afford some measure of partial tax relief for shareholders.

Duane Windsor Rice University

References

1. Auerbach, Alan and Dale W. Jorgenson, "Inflation-Proof Depreciation of Assets." Harvard Business Review, September-October 1980, 113-18.

2. Jorgenson, Dale W., "Capital Theory and Investment Behavior." American Economic Review, May 1963, 366-78.

3. ----- and Kun-Young Yun. Tax Reform and the Cost of Capital. New York: Oxford University Press, 1991.

4. King, Mervyn A. and Don Fullerton. The Taxation of Income from Capital. Chicago: The University of Chicago Press, 1984.