Measures based on the current tax code

The most basic measure of corporate income taxation is the statutory tax rate. A major advantage of statutory tax rates is that data are readily available, both over time and across countries. However, it has to be noted that defining this tax rate is less straightforward than might be expected: Corporate taxes are often applied at more than one level of government, i.e. central and regional governments impose their own statutory tax rate on the same investment13_.

There may also be temporary or permanent surcharges to these taxes which have to be taken into account14_.

A high statutory tax rate does not necessarily imply high tax payments. Statutory tax rates include neither different depreciation allowances nor any other specifics of the national tax code. Effects of the tax base are typically omitted. Therefore, statutory tax rates not more than a first indicator for the tax burden of real (productive) investments. However, there might be two possibilities why the statutory tax rate is nevertheless important: One possibility is that firms do not in fact consider the more complex measures developed below. The second and more likely possibility is that firms undertake income shifting. For a given level of allowances, the statutory tax rate equals the marginal rate of tax applied on any additional income. It is therefore likely to be relevant in determining the incentives for income shifting.

Effective marginal tax rates

More encompassing tax measures are so-called effective tax rates. Broadly speaking, effective tax rates take into account the differences between the theoretical concept of pure economic profits and the taxable income, the tax base, which firms are actually charged under the tax code of a given country. In the presence of special tax breaks, accelerated depreciation schemes and similar tax incentives, the tax base may be substantially lower than pure economic profits, leading to diverging measures for statutory tax rates on the one hand and effective tax rates on the other.

The first theoretically founded concept for effective tax rates, the effective marginal tax rate (EMTR) that is based on neoclassical investment theory, was developed by Hall and Jorgensen (1967) and later extended by King and Fullerton (1984)15_{. The EMTR measures the tax burden of an entirely new}

investment project that earns zero profits at the margin. To be realised, a marginal investment project has to earn a rate of return, p, that is equal to its

costs, i.e. the interest rate r. With corporate taxation, however, the post-tax rate of return will decrease. To redeem this negative effect, the project has to earn a larger pre-tax rate of return, pˆ . The idea of the EMTR is to calculate the required pre-tax rate of return of the investment, given the tax code of the country. When calculating the pre-tax rate of return, the EMTR does not only take into account the corporate statutory tax rate, t, but also other relevant tax provisions such as taxation at the personal level and the net present value of current and future tax allowances, A (assuming future tax laws to be unchanged). Beside the information about the tax code, the calculation makes use of assumptions regarding interest rates, the financing structure of the firm and so on. Therefore, EMTRs can be calculated for different asset and financing policies. As this calculation is not only based on the current period but is also based on future periods, particularly with respect to A, the EMTR can be seen as a forward-looking tax measure.

To give an example, let us assume that a firm makes a marginal investment of 1€ and has to pay an interest rate r of eight percent16_{. In the absence of taxes,}

the required return of the investment project p equals r. Now, suppose the firm has to pay a statutory tax rate of t =0.5 but at the same time can make use of tax allowances A. These allowances account for two cents in tax savings, e.g. half of the interest payments can be deducted. The required pre-tax rate of return pˆ is then 12 percent:

(

)

Given that taxation increases the required pre-tax rate of return, the difference between post-tax and pre-tax rate of return, the so called “tax wedge”, p pˆ− , can be thought of as a measure for the tax burden. As can be seen from equation (2.1), while a statutory tax rate will increase pˆ and therewith the tax wedge, the opposite holds if depreciation allowances A increase. The

16 _{In this simple one period example we abstract from depreciation, i.e. the only cost of the} investment project is the interest paid.

proportionate difference between the pre-tax and the post-tax rate of return is then defined as the EMTR. Using this definition, the EMTR in our example

becomes: 1

3

ˆ ˆ

(p p p− ) / = . The EMTR of 1/3 implies that the pre-tax rate of return required to achieve a zero-profitability has to be 33 percent higher than the rate necessary when the investment is untaxed. Hence, the higher the EMTR, the lower is the incentive for investment. Since the EMTR is based on the assumption of a marginal investment project, it is a good measure for the tax burden of adjustment decisions such as plant expansions. Alternatively, if a firm has already decided to invest in a country, this measure can determine the scaling of investment.

Effective average tax rates

Typically, when investing abroad, multinational firms can not split their investment across several countries but have to choose between two or more mutually exclusive locations in which the investment project gains positive profits. Examples for such discrete (or inframarginal) investment choices are alternative production locations or investments in the case of financial constraints, i.e. where only one investment project can be realised. By construction, the impact of taxes on discrete investment choices that earn a positive rent is not captured by the framework of the EMTR. As an example, think of an investment neutral cash-flow tax which is only levied on the economic rent. In this case, the EMTR would be zero, implying that there is no tax burden at all. To deal with this shortcoming, the concept of effective average tax rates has been developed.

Devereux and Griffith (1998a, 1998b, 2003) extend the concept of effective marginal tax rates by allowing investments to be profitable. The main difference between their measure of an effective average tax rate (EATR) and the EMTR stems from the calculation of the required pre-tax and post-tax rate of return. Instead of calculating these rates of return for a marginal profitability of zero, they are calculated for different levels of profitability, R. For our simple example from above, profitability can be incorporated by introducing R in the numerator of equation (2.1) which leads to:

(

)

As depicted by Figure 2.1., and analysed in more detail algebraically by Devereux and Griffith (2003), the EATR increases with the level of profitability. For a profitability of R=0, it is equal to the EMTR. For larger levels of profitability, it converges towards the statutory tax rate17_{. So, as a}

result, the EATR can be simply thought of as a linear combination of the latter two measures.

Figure 2.1.

Effective average tax rates at different levels of profitability

Source: Own representation, based on Devereux and Griffith (2003).

17 _{In their analysis, Devereux and Griffith (2003) do also incorporate taxation at the shareholder} level. With this specification of the EATR, they show that it converges to an “adjusted”

statutory tax rate if profitability increases.

EMTR R=0 Statutory tax rate R infinite EATR

To give an intuition for the connection between these measures, think again of our example. If increased profitability is not affecting the level of A, then any additional profit made will be taxed at the statutory tax rate. The overall level of taxation then depends on the fraction of pre-tax profits for which the marginal tax rate is given by the EMTR and the fraction of profits for which it is given by the statutory tax rate. For a profitability of four percent, equation (2.2) calculates a pre-tax rate of return of 20 percent for our example. While 60 percent of the pre-tax profits of the firm (12 cents out of 20) are taxed with the EMTR of 33 percent, the remaining 40 percent are taxed with the statutory tax rate of 50 percent. This leads to an EATR of 40 percent. Hence, for any given level of tax allowances, the EATR will increase with the profitability of the investment project18_.

In principle, the EATR, as well as the EMTR, can be calculated for a variety of different investment projects by adjusting the model used. Taking into account the tax code of the source and the target country of an investment, it would even be possible to calculate the tax burden of international investments19_.

However, as the results are derived from models, the measured impact of taxation is only valid under the assumptions of these models. If these assumptions, i.e. on the profitability of the firm and the financing mix, are invalid, these measures will not give us a proper picture of the actual tax burden of an investment.

18 _{In line with empirical findings we assume here that the marginal tax rate is lower than the} actual statutory tax rate levied on pure profits. However, it may also be possible that the EMTR is higher than the statutory tax rate. In this case, the EATR will decrease with the level of profitability.

19 _{An alternative method to calculate effective average tax rates that is not further pursued here} is to use a model firm approach (see Jacobs and Spengel, 2000). The basic approach is to assume an industry specific mix of assets and liabilities of a firm and to calculate future pre-tax profits on the basis of estimates for future cash receipts and costs. Comparing the net present value of the firm for the case with and without taxation gives a measure for the effective tax

2.2.3. Measures based on past tax codes