Capital Income Tax Revisions and Effective Tax Rates

Publication Date: October 2003

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

Type:

Abstract:

Several temporary provisions affecting the taxation of capital income were adopted in the 2001-2003 period, and further changes may be considered. These provisions include lower individual tax rates, bonus depreciation (which allows part of the cost of equipment to be deducted upon acquisition), and lower individual income tax rates on dividends and capital gains. To assist Congress in evaluating proposals to make some or all of these revisions permanent, this study measures their effect on tax burdens on income from different prospective investments, differentiated by physical type, form of finance, and sector. Further proposals for tax cuts contained in several bills (H.R. 1769, S. 970, H.R. 2896, S. 1475, and S. 1637) to eliminate the extraterritorial income (ETI) provision, ruled an illegal export subsidy by the World Trade Organization (WTO), are also discussed.

Effective tax burdens are determined by the statutory tax rate and value of depreciation deductions. Although the 1986 depreciation revision left income from equipment and structures investments taxed at close to the statutory rate (now 35% for large corporations), the fall in inflation and legislative changes led to a growing differential between these assets, with equipment taxed at 26% and buildings taxed slightly above 35%. Bonus depreciation widens that discrepancy, lowering the equipment tax rate to 20% (15%) for 30% (50%) bonus depreciation. The distortions between debt and equity finance within the corporate sector and between the corporate and non-corporate sector investment are narrowed, but only slightly, by the changes, especially if tax exempt financial holdings (through pensions and IRAs) are considered. This small effect occurs because bonus depreciation covers all types of equipment investment (whether financed by debt or equity and regardless of sector), and while dividend and capital gains relief benefits corporate equity, individual rate cuts benefit non-corporate investment and debt-financed corporate investment. There is a significant reduction in the differential rates on retained earnings and dividends, however. The reduction in the total tax rate on investment income in the economy is about two to four percentage points for all individual tax changes and two to four percentage points for 30% to 50% bonus depreciation.

The temporary provisions have mixed effects. All changes reduce the total tax rate and the current favorable treatment of owner-occupied housing. Within the business sector, the dividend relief provisions lead to a more neutral tax system as well, but the effects of bonus depreciation lead to less efficiency because the benefits are confined to equipment. Tax changes in ETI bills include proposals to extend (but not make permanent) bonus depreciation and provisions directed at the manufacturing sector (accelerated depreciation for manufacturing equipment and rate cuts). The tax cuts directed at manufacturing would lower tax rates in that industry by about 1.5 percentage points but they would have a negligible effect on the total tax rate (lowering it by less than a quarter of a percentage point). Some of these bills also contain other provisions (e.g. benefitting foreign source investment and small business) which would lower tax rates, but also include repeal of the ETI which would raise rates. For the aggregate economy, these effects are small, although the changes favor some assets and sectors over others. This report will be updated for legislative changes.