December 18th, 2014
from the Congressional Budget Office
The federal tax treatment of capital income affects investment incentives, both for the amounts invested and for allocations among assets. When tax rates are high, investors require higher before-tax rates of return and thus forgo investments with lower returns that they otherwise would have made. Current law produces significant variations in the taxation of capital income from different investments, thus leading investors to require higher before-tax rates of return on some investments than on others. Those differences reduce economic efficiency—the extent to which resources are allocated to maximize before-tax value.
An effective marginal tax rate (hereafter referred to as an effective tax rate or ETR) measures an investor’s tax burden on returns from an investment. An ETR combines a statutory tax rate with other features of the tax code (various deductions and credits, for example) into a single percentage that applies to before-tax capital income realized over an investment’s lifetime. (In this report, capital income consists of receipts minus the cost of goods sold, operating expenses, interest paid, and an allowance equal to the decline in value of capital assets because of economic depreciation—that is, wear and tear or obsolescence.) The higher the ETR, the greater the distortion in investments, holding all else equal; thus, the greater the variation (or nonuniformity) of ETRs among different investments, the less likely it is that resources will be used efficiently.
For this report, CBO estimated ETRs on income from marginal investments (those expected to earn just enough, after taxes, to attract investors) in such tangible capital assets as equipment, structures, land, and inventories (assets held for resale). In considering both corporate and individual taxation—but only with respect to the permanent features of federal income tax law in 2014—CBO arrived at the following conclusions:
- The ETR on capital income is, on average, 18 percent;
- The ETR on income from owner-occupied housing is close to zero; and
- The ETR on capital income generated by businesses is, on average, 29 percent.
How Do Effective Tax Rates Differ Among Investments?
Federal tax law distinguishes among different forms of capital income, and ETRs vary significantly as a result. For example, rent paid to a property owner is subject to income taxes, but the income "generated" by owner-occupied housing is not. (Calculations of personal income for the national income accounts and for the analysis in this report count, as income to a homeowner, the amount a tenant would pay in rent for that home, even though no cash transaction occurs.) The profits of some types of business (called pass-through entities because their profits are "passed through" to their owners) are taxed only under the individual income tax, whereas the profits of others (called C corporations for a section of the tax code) are taxed under the corporate income tax and, to some extent, under the individual income tax. Tax law also distinguishes between income from debt- and equity-financed investments.
Those and other factors create a wide range of ETRs among investments. Furthermore, the estimated ETRs presented in this report by form of organization and source of financing are, for the most part, averages that mask considerable variation among industries and asset types (and even those presented for specific industries mask variation by asset type, and those presented for specific asset types mask variation by industry).
Rates by Form of Organization and Source of Financing. C corporations face an ETR on income from debt-financed investments of –6 percent, which represents a subsidy (see Figure below). By contrast, C corporations face an ETR of 38 percent on equity-financed investments. The range of ETRs faced by pass-through entities is not quite as large: The ETR is 8 percent on debt-financed investments and 30 percent on equity-financed investments.
Rates by Asset Type. The significant variation seen in ETRs for various asset types arises from differences between the rates at which the tax code allows businesses to deduct the cost of assets (known as tax depreciation) and the rates at which those assets actually wear out or become obsolete (economic depreciation). The greater the acceleration in tax depreciation relative to economic depreciation, the lower the ETR. The top statutory tax rate for C corporations is 35 percent, but because of the depreciation rules, ETRs range from 12 percent (for railroad track) to 42 percent (for nuclear fuel). Pass-through entities’ ETRs are generally lower, although the range is similar. (In this report, ETRs for any given asset type are estimated to be independent of the mix of industries that invest in that asset.)
Rates by Industry. Variations in ETRs by industry arise mainly because of differences in eligibility for and use of the deduction for domestic production activities and in industry-specific rules for depreciation. Among industries, C corporations’ ETRs range from 30 percent to 33 percent—a much smaller range than among asset types. For pass-through entities the range in ETRs among industries is negligible. (ETRs for any given industry are estimated to be independent of the mix of assets used in that industry.)
How Would Various Policy Options Change Effective Tax Rates?
CBO examined three sets of policy options for changing the taxation of capital income. The options in the first group would lower the overall ETR on capital income; those in the second group would eliminate the current favorable tax treatment for certain types of capital income and raise the overall ETR on capital income; and those in the third group would narrow the disparities between the tax rates for various investments while leaving the overall ETR unchanged. CBO’s analysis does not account for changes in taxpayers’ behavior in response to those options.
Reduce the Tax on Capital Income. CBO analyzed three options in this category. Option 1, to reduce the top corporate tax rate from 35 percent to 25 percent, would lower the ETR on capital income by 3 percentage points—from 18 percent to 15 percent. Option 2, to exempt dividends and capital gains from the individual income tax, would reduce the ETR by 2 percentage points. Both would promote uniformity in the taxation of capital income, but the first would do more than the second. Option 3, to allow businesses to deduct the entire cost of capital acquisitions in the year of purchase, would reduce the overall ETR approximately to zero, providing greater uniformity among asset types and industries. But it also would generate large negative ETRs on income from debt-financed investment, which would reduce uniformity between sources of financing.
Reduce or Eliminate Tax Preferences for Capital Income. All three options in this category would reduce uniformity in taxation. Option 4, to tax dividends and capital gains at the rates that apply to wages, interest, and the profits of pass-through entities, would boost the ETR by 2 percentage points; it would not significantly promote uniformity of taxation among capital investments in any way. Option 5, to disallow new contributions to tax-favored retirement plans, would raise the ETR on capital income by 5 percentage points and increase uniformity by, for example, reducing the difference between the ETRs on income from debt- and equity-financed investments, but it would reduce uniformity by widening the difference between ETRs faced by C corporations and pass-through entities on income from equity-financed investments. Option 6, to require that depreciation deductions match economic depreciation, would increase the ETR by 3 percentage points and promote tax rate uniformity among asset types and industries.
Narrow Specific Disparities Among Tax Rates Without Changing the Overall ETR. The final pair of options would lessen disparities in taxation by other means. Option 7, to end deductions for mortgage interest and property taxes (but provide an offset through a reduction in individual income tax rates), would reduce the differences between the ETRs for owner-occupied housing and business investment. However, it also would widen the difference between the ETRs on debt- and equity-financed investments by C corporations and in owner-occupied housing. Option 8, to limit deductions for business interest (with offsetting cuts in other tax rates), would narrow the differences in ETRs for debt and equity financing for C corporations and pass-through entities.