Capital Income Tax Revisions and Effective Tax Rates

Prepared for Members and Committees of Congress

Several temporary provisions affecting the taxation of capital income were adopted in the 2001-
2003 period. 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. Bonus depreciation has expired, but there are
some indications such provisions might be included as part of a major tax reform; the other
provisions remain currently in effect. This study measures their effect on tax burdens on income
from different prospective investments, differentiated by physical type, form of finance, and
sector. Further provisions of a permanent nature enacted in 2004 in a bill 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 the 2004 tax bill
include provisions directed at the manufacturing sector. 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). The
bill also contains other provisions (e.g. benefitting foreign source investment) 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.

Effective Federal Tax Rates and Capital Allocation........................................................................2
Differential Federal Taxes Across Asset Types...............................................................................3
The Debt Equity Distortion.............................................................................................................4
Corporate Versus Non-corporate Distortions..................................................................................7
Distortions of Payout Decisions......................................................................................................8
Total Effective Federal Tax Rates....................................................................................................8
Tax Provisions in Bills Addressing ETI..........................................................................................9
Effects on Efficiency and Tax Neutrality......................................................................................12
Table 1. Effective Tax Rates by Asset Type, Non-Residential Fixed Investment With and
Without Bonus Depreciation........................................................................................................5
Table 2. Weighted Average Effective Firm Level Tax Rates (Assuming No Debt).........................6
Table 3. Weighted Average Effective Tax Rates on Debt vs. Equity, Corporate and
Individual Taxes...........................................................................................................................7
Table 4. Weighted Effective Total Tax Rates on Corporate and Non-corporate Sectors,
Equipment and Structures............................................................................................................7
Table 5. Total Effective Tax Rates...................................................................................................9
Table 6. Effective Tax Rates on Manufacturing Equipment with Shorter Lives in H.R.
2896 ............................................................................................................................................ 10
Appendix. ...................................................................................................................... ................ 14
Author Contact Information..........................................................................................................15

everal temporary provisions affecting the taxation of capital income were adopted in the
2001-2003 period, and further changes may be considered. The 2001 tax cuts provides a
phased-in reduction of individual tax rates (typically around three percentage points), S

which are scheduled to sunset in 2010. The 2002 tax provides bonus depreciation for equipment,
allowing 30% of investment to be deducted immediately (with the remainder depreciated under
standard rules). This bonus depreciation provision was enacted as a temporary stimulus
applicable only to acquisitions before 2005. The bonus depreciation share was increased to 50%
by the 2003 tax cut. This provision has now expired, but it might be considered for reinstatement
if fundamental tax reform is considered. Temporary tax reductions on dividends and capital gains
received by individuals were also adopted in 2003. The top capital gains tax rate was reduced
from 20% to 15%, and dividends were also made eligible for these lower tax rates. The 2003 tax 1
cut also accelerated some of the planned individual rate reductions in the 2001 tax cut.
While bonus depreciation was explicitly enacted as a temporary provision to stimulate investment
in the short run, proposals have been made for a further extension. The dividend and capital gains
relief proposal was originally proposed by the President to be permanent, and its temporary
status, like the temporary status of individual tax provisions, may be reconsidered. Individual rate
reductions enacted in the 2001 tax cut, which were sunsetted, but accelerated in 2003, would
affect tax burdens of unincorporated businesses directly and of all businesses indirectly through
their effects on interest income.
Congress also enacted general corporate tax cuts in a bill that terminated the extraterritorial
income (ETI) provision of the tax law that has been found to be an illegal export subsidy by the
World Trade Organization (WTO). The European Union, which brought the claim, is currently
levying countervailing tariffs on U.S. goods imported into its member states if the tax provision 2
remains. After a number of proposals were introduced, H.R. 4520 which phased out the ETI
provision and introduced a deduction for manufacturing and certain other production activities. 3
This tax revision also included a number of other provisions largely directed at business.

1 For a summary of the 2001 and 2002 tax cuts see CRS Report RS20264, Tax Activity in the 107th Congress, by Jane
G. Gravelle. For a summary of the 2003 tax cut see CRS Report RL31907, Tax Cut Bills in 2003: A Comparison, by
David Brumbaugh and Don Richards.
2 See CRS Report RL31660, A History of the Extraterritorial Income (ETI) and Foreign Sales Corporation (FSC)
Export Tax-Benefit Controversy, by David L. Brumbaugh.
3 Early legislative proposals include a bill cosponsored by Reps. Crane and Rangel (H.R. 1769) that included a proposal
to provide a general corporate tax cut for domestic production, a cut that is larger the greater the fraction that domestic
production is of worldwide production. S. 970 (Hollings) was a similar bill in the Senate. Chairman Thomas of the
Ways and Means Committee had proposed a bill (H.R. 2896) which would have extended bonus depreciation for a year
and provided for shorter useful lives for equipment used in manufacturing, as well as make a variety of changes
benefitting firms that invest abroad and small businesses. Sen. Hatch had introduced a bill (S. 1475) that contained
many of the provisions of H.R. 2896; this bill would not only extend bonus depreciation for a year but would increase it
to 100%. Then, the Finance Committee Chairman Grassley and Ranking Member Baucus introduced S. 1637, which
would, among other provisions, reduce the tax rate for manufacturing by 9% through a deduction. The House bill, H.R.
4520, eliminated the bonus depreciation and depreciation for equipment and substituted a corporate rate reduction that
had effects similar to the deduction but was limited to corporations; the bill also defined eligible firms more broadly.
The final bill was based on the Senate deduction but included the House bill’s broader industry coverage.

A number of issues are associated with these tax provisions. Many of them were directed at short
term fiscal stimulus. Indeed, bonus depreciation was expected to work more effectively because it
was temporary, encouraging firms to invest earlier than they might otherwise have done to take
advantage of a temporary tax benefit. However, a standard way of evaluating the effects of
permanent tax changes that affect the returns to investment is to examine their effects on the
allocation of capital. The method for examining this issue usually begins with measuring the
effective tax rate on the returns to capital invested in different types of assets. In the absence of
external effects or other “market failures,” capital is allocated most efficiently when all returns 4
are taxed in at the same rate and when financial choices are not influenced by the tax code.
This report focuses on estimating the effects of these basic proposals on effective tax rate (or tax
burden) on earnings, and comparing the resulting tax rates across asset types, organizational form
(e.g. corporations versus unincorporated businesses), and source of finance. Effective tax rates
presented in this report are estimated effective rates on income from prospective investments;
they take into account the timing of deductions and the fact that a tax benefit received today is
more valuable than a tax benefit received in the future because of the time value of money (i.e.
money received today can be invested and yield more money in the future). (See appendix for a
more detailed explanation.) These effective tax rates can differ substantially from average tax
rates in the economy because the timing of deductions has a different (and in the long run, more
powerful) effect on tax burdens on new investment than is reflected in average tax rate measures.
Indeed, it is possible for effective tax rates on new investments to be negative, while average tax
rates are positive. However, it is the effective tax rates on new investment that affect the
allocation and size of the capital stock. Aside from the statutory tax rate, the main provision
affecting the tax burden on new investment is how quickly the cost of the asset is recovered via
depreciation deductions.
When tax depreciation matches economic depreciation, the effect is to tax the return to capital
(investment income) in each period and the effective tax rate is the statutory rate. The same effect
occurs as long as the present discounted value of depreciation deductions are equal to the present 5
discounted value of economic depreciation deductions. Two opposing forces can affect
depreciation (and therefore effective tax rates). Because depreciation is based on historical
acquisition cost, the real value of depreciation deductions is undermined by inflation. Thus, 6
higher inflation means higher effective tax rates. This inflation effect, other things equal, raises
the effective tax rate more for shorter lived investments than for longer lived ones. However,
depreciation deductions are generally allowed more quickly than the rate that would be justified
by economic decline and that tendency is particularly pronounced in the case of equipment,
which increases the deductions value and leads to a lower effective tax rate. Most equipment
assets, for example, have their costs deducted in five to seven years, although they last a much

4 Market failure is a technical term which indicates not that markets do not function, but that they do not function
perfectly so that prices represent true resource costs. In practice, market failures are numerous, but in most cases are
small, or cannot be easily determined and quantified, and thus make effective government intervention difficult or
capable of worsening rather than improving the market failures.
5 The present discounted value is the value of a future dollar discounted by dividing it by (1+r)t, where r is the interest
rate and t is the time period. For depreciation, all of the values are summed up.
6 Higher inflation can, however, benefit debt financed investment if the tax rate of the firm is higher than the tax rate of
the creditor, because nominal rather than real interest is deducted.

longer period of time. The Internal Revenue Code specifies that buildings are deducted over 39
years (although residential structures are deducted over 27.5 years).
Tax rates can be measured in different ways. The tax rate at the corporate level on equity financed
investment, which is calculated in the next section, shows the effects of depreciation rules across
assets types (e.g., computing equipment, buildings). Effective corporate tax rates can also be
measured as the total tax at both the corporate and personal level, which also reflects the
deductibility of interest by corporations and the imposition of individual income taxes on interest,
dividends, and capital gains. This measure indicates the change in the total burden on corporate
investment. It can also be compared with tax rates on noncorporate investment to measure the
differential between the total tax on investment in the corporate and noncorporate sectors, as well
as federal income taxes on owner-occupied housing (which tend to be around zero). Tax rates can
also be separated into total rates on debt financed and equity financed investment, to examine the
degree of distortion that favors debt finance. Tax rates also affect the dividend payout choice,
arising from differential treatment of retained earnings (which give rise to capital gains) and
dividends. Finally, the overall tax rate in the economy, which requires weighting by asset type,
can affect savings decisions.

One of the objectives of the Tax Reform Act of 1986 was to tax the earnings from different types
of capital investment more evenly than had been the case in the past. Before 1986, with the
statutory corporate income tax rate at 46%, effective tax rates on earnings (taking into account
depreciation and statutory tax rates but not debt finance) were less than 10% for most equipment
assets, while they were about 35% to 40% for buildings. After the 1986 act, the statutory rate was
reduced to 34%, but depreciation was altered and the investment tax credit repealed. As a result,
equipment tax rates were only slightly below the statutory rate (about 32%) and buildings slightly
above it (still about 35% to 40%). (Oil and gas structural investments, which include investment
in the acquisition of reserves, though purchase or lease, and exploration and intangible drilling 7
costs continued their favorable historical treatment.)
The rationale for equal taxation is straightforward. Private markets will allocate investment to
different types of capital to produce the highest after-tax returns. Absent external effects, these
private market choices will lead to the most productive capital stock only if returns to assets are
taxed at the same rates; in that case, the pretax or social rates of return will be equal across
investments and no increase can be achieved by shifting investment from one type to another.
In the ensuing 17 years since the passage of the 1986 act, tax legislation and economic effects
have re-introduced a significant difference between tax burdens on earnings from investments in
equipment and structures. This differential is increased by bonus depreciation which would
further favor the allocation of capital to equipment. (A temporary subsidy should not have lasting

7 The beneficial treatment of mineral investment, largely in oil and gas, arises from provisions that allow much of the
cost, including unproductive tracts and wells, as well as all intangible drilling costs (supplies, labor, etc) to be deducted
immediately. The deduction of losses, while consistent with accounting rules, is a subsidy because the cost of
unproductive tracts and wells is part of the cost of finding productive ones and should be, in theory, deducted over the
useful life of productive properties.

effects on the allocation of capital, so this argument applies only to making bonus depreciation
Legislative changes increased effective tax rates, especially for buildings. In 1993, the top
corporate tax rate was increased by one percentage point, a relatively neutral change that raised
most tax rates by approximately one percentage point. The 1993 legislation also, however,
increased the useful life for non-residential buildings (commercial structures and some industrial
structures) from 31.5 years to 39 years. Although this change was large in terms of the write-off
period, its effect on effective tax rates on earnings from the affected assets was relatively small,
raising the tax rates of these assets by another percentage point. Tax rates on earnings for all
assets fell, however, because of the decline in inflation, which now averages around 2% but was
projected to be around 5% in 1986. The fall in inflation rate reduces the effective tax rate on the
return to short lived assets much more than on long lived assets, and thus favors equipment. Thus,
while the corporate rate increase was relatively neutral, the depreciation change penalized
buildings, and the drop in inflation, while benefitting all assets, benefitted equipment and shorter 8
lived assets the most.
The resulting effective tax rates reflecting permanent depreciation rules are shown in the first
column of effective tax rates in Tables 1 and 2. While buildings are taxed at rates slightly above
the statutory rate, equipment is taxed at rates well below it. On average equipment effective tax
rates are only 26%, or about three quarters of the statutory rate. Structures overall are taxed at
32% but that average reflects favorable treatment for mining, farm and public utility structures
(the latter are generally treated as equipment in the tax law). Buildings are taxed at rates in excess
of the statutory rate.
Tables 1 and 2 also illustrate the effects of the various levels of bonus depreciation. The 30%
bonus depreciation reduces effective tax rates for equipment, on average, from 26% to 20%; the

50% bonus depreciation reduces the rate to 15%. Unlike incentives such as investment credits,

bonus depreciation cannot reduce tax rates on equity investment below zero; 100% bonus
depreciation leads to a zero rate.

Another issue particularly related to dividend and capital gains relief is the differential tax
treatment, within the corporate sector, of debt versus equity financed capital. Debt is favored at
the corporate level because corporations deduct interest payments. However, equity is favored at
the individual level because capital gains tax rates are lower, taxes are deferred (not due until the
stock is sold), and are never paid if shares are passed on at death. Individual taxes on the return to
capital are also reduced because they are imposed on profits after the corporate tax and thus the
corporate tax is effectively deductible from the individual tax base. For an individual in the 30%
tax bracket, for example, the tax on interest income is 30% for a dollar of earnings, but the

8 That the large shift in depreciation lives has a relatively modest effect on structures and the inflation drop is more
beneficial for short lived assets may seem counterintuitive. However, an absolute change in the present value of
depreciation has a larger effect on short lived assets tax burdens than on long lived ones. (One way of thinking about
this is to consider that a short lived asset has to be replaced more frequently and any burden or benefit repeated more
often.) Thus even though the effect of increasing useful life has a significant effect on present value, its effect on a long
lived asset is still limited. Similarly, even though inflation reduces the present value of depreciation absolutely more for
longer lived assets, its effect on tax burden is still greater than for shorter lived assets.

additional individual tax on equity is only 20% (0.3 X (1-0.35)). The recent temporary revisions
lowered the tax rate on capital gains (for most recipients) from 20% to 15 % and extended these
lower tax rates to dividends – a change favoring equity investment. There was also a temporary
benefit to debt finance, from the individual tax rate reductions, so that one cannot be sure of the
direction of the effect.
Table 1. Effective Tax Rates by Asset Type, Non-Residential Fixed Investment With
and Without Bonus Depreciation
Asset Type Permanent 30% Bonus 50% Bonus
Autos 34 27 21
Office/Computing Equipment 31 24 18
Trucks/Buses/Trailers 29 22 17
Aircraft 29
Construction Machinery 23 18 13
Mining/Oilfield Equipment 28 22 16
Service Industry Equipment 28 22 16
Tractors 27 20 15
Instruments 28 21 16
Other Equipment 27 20 15
General Industrial Equipment 25 19 15
Metalworking Machinery 23 18 13
Electric Transmission Equipment 33 26 20
Communications Equipment 19 14 10
Other Electrical Equipment 24 18 13
Furniture and Fixtures 23 17 13
Special Industrial Equipment 21 16 12
Agricultural Equipment 21 16 12
Fabricated Metal 29 22 17
Engines and Turbines 36 28 22
Ships and Boats 17 13 9
Railroad Equipment 18 13 10
Mining Structures 7 7 7
Other Structures 40 40 40
Industrial Structures 37 37 37
Public Utility Structures 27 20 16
Commercial Structures 36 36 36
Farm Structures 26 20 15
Source: Congressional Research Service. See appendix for method of computation and assumptions.

The effective tax rate on debt vs. equity is complicated by the existence of tax favored forms of
individual investment, through pensions and IRAs, where individual tax rates are effectively zero.
If these effects are taken into the account, current tax rates are lower and the effect of changes in
individual tax rates less important. Since these pension funds and IRA account managers (whether
or not self directed) can also choose between debt and equity, the case with these effects
incorporated is probably more realistic.
Table 2. Weighted Average Effective Firm Level Tax Rates (Assuming No Debt)
Asset Type Permanent Law 30% Bonus 50% Bonus
Equipment 26 20 15
Structures 32 30 29
Total 30 27 24
Source: Congressional Research Service. See appendix for method of computation and assumptions.
Note: Structures reflect a weighted average of the last six rows of Table 1. The remaining assets are
Table 3 presents estimated effective tax rates on debt and equity under a variety of scenarios. The
first four rows consider the case without tax favored forms of individual investment, comparing
debt and equity under permanent tax rates and those enacted in the 2001 and 2003 tax cuts. The
last four average in the tax favored forms. The columns consider the effects of bonus depreciation
in each case. In each case, the debt-equity distortion has been reduced, but the reduction is small
because both debt and equity benefit from lower individual tax rates and from bonus depreciation.
In comparing tax rates with large discrepancies and particularly negative rates, a more meaningful
comparison is the tax wedge, or the excess by which the pretax return must exceed a fixed after
tax return, which is measured by t/(1-t), where t is the tax rate. Thus under current law without
considering pension effects, a debt financed return must exceed the after tax return by 19%
(0.16/(1-0.16)) while an equity financed return must exceed the after tax return by 82% (0.45/(1-
0.45)). The difference between those is 63% of after tax return. The new rates (first column of
rates) reduce the difference to 52%, which is a change of 11% (closing about one sixth of the 9
gap). The effect of bonus depreciation is a change of about 7%. The combined change is 15%.
If pensions and IRAs are taken into account, the differentials are smaller (in fact negligible for the
individual rate changes). The initial gap change is about the same, but the change is 2%, which
closes about one thirtieth of the gap. The effect of bonus depreciation is about 5% and the
combined effects about 11%. If the pension and IRA case is taken to be the most reasonable one,
then there is a very minimal effect on the distortion between debt and equity due to individual
rate changes not only because they benefit both debt and equity but also because the changes are
quite small.

9 Not too much attention should be given to the precise measures, as contrasted with general magnitudes, because these
amounts can be affected by the rounding of the tax rates prior to calculation.

Table 3. Weighted Average Effective Tax Rates on Debt vs. Equity, Corporate and
Individual Taxes
Asset Type No Bonus 30% 50%
Depreciation Bonus Bonus
Debt, Permanent Individual Rates 16 12 10
Equity, Permanent Individual Rates 45 42 40
Debt, Lower Individual Rates 11 7 4
Equity, Lower Individual Rates, Dividend Relief 39 36 34
Debt, Permanent Individual Rates, With Pensions and IRAs -7 -12 -15
Equity, Permanent Individual Rates, With Pensions and IRAs 37 34 32
Debt, Lower Individual Rates, With Pensions and IRAs -13 -15 -18
Equity, Lower Individual Rates, Dividend Relief, With Pensions and
IRAs 34 30 8
Source: Congressional Research Service. See appendix for method of computation and assumptions.

Aside from the distortion between debt and equity, the corporate tax also discourages investment
in the corporate sector. Table 4 examines the total effective tax rate in the corporate sector as
compared with the non-corporate sector under the different tax regimes.
As in the case of the debt vs. equity case, calculations are also done taking into account the lower
individual tax rates for pensions and IRAs. Since these entities would not invest directly in
unincorporated businesses (such as sole proprietorships and partnerships), the non-corporate
numbers consider only the case when the providers of loans are not fully subject to tax. However,
since non-corporate investment is not a viable alternative for passive investment entities such as
pension plans, the more relevant measure may be the tax rates without incorporating these effects,
since it is among taxable accounts that choices might be made about investing directly in
businesses rather than financial instruments.
Table 4. Weighted Effective Total Tax Rates on Corporate and Non-corporate
Sectors, Equipment and Structures
Asset Type Permanent 30% 50%
Depreciation Bonus Bonus
Corporate: Permanent Individual Rates 39 36 33
Corporate: Dividend Relief 34 31 28
Corporate: Permanent Rates, With Pensions and IRAs 29 26 23
Corporate: Dividend Relief, With Pensions and IRAs 26 23 20
Non-corporate: Permanent Individual Rates 22 20 19
Non-corporate: Lower Individual Rates 19 18 17

Asset Type Permanent 30% 50%
Depreciation Bonus Bonus
Non-corporate: Permanent Individual Rates, With Pensions
and IRAs for Debt Finance 17 15 14
Non-corporate: Lower Individual Rates, With Pensions and
IRAs for Debt Finance 14 13 12
Source: Congressional Research Service. See appendix for method of computation and assumptions.
This analysis suggests a reduction in the tax differential between corporate and non-corporate
investments, but that reduction is relatively small regardless of the rules on bonus depreciation.
That effect is again because the tax bill provided reductions for all four forms of investments:
corporate debt, corporate equity, non-corporate debt, and non-corporate equity. All forms of
business investment benefit from bonus depreciation. The dividend relief provisions (and slightly
lower capital gains tax rates) benefit corporate equity, but the lower individual tax rates benefit
corporate and non-corporate debt and non-corporate equity.

The dividend relief provision will significantly reduce the favorable treatment of retained
earnings by lowering the tax rate on dividends to the tax rate on capital gains. Under permanent
law, the tax on a dollar of dividends was the marginal tax rate of the individual which could be as
high as 39.6%. The top tax on capital gains is fixed at 20% (for those in the permanent 28% or 10
higher brackets). However, the effective rate on gains is lowered because tax is deferred until
the stock is sold; deferring the tax by an estimated average of five years leads to a tax rate of 11
18%. Moreover, since CRS has found that approximately half of these gains are held until death
and not taxed, the rate is about 9%.
This spread is greatly narrowed by the dividend relief provision, which lowers both rates to 15%.
The tax rate on capital gains falls to about 7%, but the gap between the 15% dividend rate and the
new 7% rate is much smaller than the gap between the 28% to 39.6% rates and the 9% rate in
prior law. However, these pre-existing distortions and the magnitude of the reduction due to the
dividend rate would be reduced by half if the assets held in non-taxable accounts such as pensions
and IRAs were included.

The overall effective tax rate for new investment needs to account for tax rates on the assets
already considered (corporate and non-corporate investment in plant and equipment) and also
owner-occupied housing as well as business inventories. Business inventories tend to be taxed at

10 Gains held over five years and acquired after a certain date are eligible for an 18% tax rate, although this rate had not
yet become effective.
11 Note that this is a tax rate on nominal gains, which is appropriate to compare with a marginal dollar of dividends. In
calculating other tax rates in this analysis, the tax rate on real (inflation adjusted) gains is used, which is higher.

slightly higher rates, while owner occupied housing is generally subject to a zero tax.12 The
effective tax rates depend on whether the lower individual tax rates on funds invested in pensions
and IRAs are marginal (affecting new investment) or infra-marginal as well as how much
individuals are willing to substitute between savings within and outside the plans. Table 5 reports
tax rates calculated two ways, one with individual tax rates, assuming no marginal investment
takes place in these plans, and the other weighting the tax burdens between tax favored and
regular savings accounts 50/50, reflecting the approximate shares of current earnings in these
As this table indicates the effect of the individual tax rates is, as expected, about twice as large in
the case where no infra-marginal investment is in pensions – reducing (under permanent
depreciation rules) the overall effective tax rate from 30% to 26% or four percentage points. With
IRAs and pensions, tax rates are much lower (about 22%) and the reduction is two percentage
points, to 20%. Thus, the individual rate reductions reduce effective tax rates on all capital, on
average, by about 10% to 15%. Bonus depreciation has about the same percentage point effect
regardless of the tax regime – about two percentage points for 30% bonus depreciation and about
four for 50% bonus depreciation. It reduces effective tax rates by 7% to 9% for 30% bonus
depreciation and 13% to 19% for 50% bonus depreciation. If both the rate reductions and 50%
bonus depreciation are considered, the percentage point reduction is six to eight percentage
points, reducing overall effective tax rates by a quarter to a third.
Table 5. Total Effective Tax Rates
Tax Regime Permanent Law 30% Bonus 50% Bonus
Permanent Individual Rates 30 28 26
Lower Individual Rates 26 24 22
Permanent Individual Rates with IRAs and Pensions 22 20 18
Lower Individual Rates with IRAs and Pensions 20 18 16
Source: Congressional Research Service. See appendix for method of computation and assumptions.

Several bills introduced to repeal the Extraterritorial Income Tax (ETI) provision, found to be an
illegal export subsidy according to the World Trade Organization (WTO), contain broadly
applicable provisions affecting corporations. This sections examines the effect, not only of the
provision finally enacted, but also of some of the other proposed provisions on some of the tax
rates discussed above.
Chairman Thomas’s 2003 bill, H.R. 2896, included two provisions that have general effects: a
provision allowing manufacturing equipment a shorter recovery period (by two years) and a
provision extending the 50% bonus depreciation for a year. Effects of bonus depreciation have

12 The inability to deduct mortgage interest for non-itemizers (which is required to achieve a zero tax rate) results in a
slight positive tax, which is offset by the ability of itemizers to deduct property taxes (which should not be deducted to
obtain a zero tax). Of course, the estimates considered concern only federal individual income taxes and not state and
local taxes including property taxes, which apply more heavily to structures than to equipment and inventories.

already been discussed. Table 6 calculates the effects of the shorter depreciation lives on some
typical types of manufacturing equipment.
Typically the shorter lives reduce effective tax rates about five percentage points under permanent
law, about four percentage points for 30% bonus depreciation, and about three percentage points
for 50% bonus depreciation. The provision would have increased the differences between
equipment and structures within manufacturing as well as favor manufacturing in general. The
overall effects on tax burdens are small, however, because these provisions would have covered
only manufacturing equipment, estimated to be about 20% to 25% of equipment assets, and about
10% of combined equipment and structures. For manufacturing overall, equipment is about a
third of reproducible capital so the overall rate reduction in the industry is about 1.5 percentage
points with no bonus depreciation. (See appendix for data sources on asset allocation). Since
manufacturing represents about 25% of the overall corporate capital stock, the overall corporate
tax rate would fall by less than a half a percentage point with no bonus depreciation, and even
less with bonus depreciation. Corporate assets are in turn about 50% of the total capital stock, so
the overall effect would be quite small (i.e., less than a quarter of a percent).
Table 6. Effective Tax Rates on Manufacturing Equipment with Shorter Lives in H.R.
Asset Type Permanent Law 30% Bonus 50% Bonus
Instruments 22 17 13
Other Equipment 21 16 12
General Industrial Equipment 21 14 12
Metal Working Machinery 18 14 10
Special Industrial Equipment 16 12 9
Fabricated Metal Products 27 21 16
Source: Congressional Research Service. See appendix for method of computation and assumptions.
H.R. 2896 also contained some other provisions relating to multinational corporations that would
lower effective tax rates, but they do not apply to investment in general. These provisions would
reduce effective tax rates, and there would also be an offset due to the repeal of the ETI.
Senator Hatch’s bill, S. 1495, was similar to H.R. 2896 but proposed 100% expensing, which
would reduce equipment investment tax rates to zero. As in H.R. 2896, however, this provision
would be a temporary extension.
A bill co-sponsored by Representatives Crane and Rangel, H.R. 1769 (and a similar Senate bill, S.
970 (Hollings)), would have provided a deduction of up to 10% percent of income from domestic
production. The deduction would have been multiplied by the share of the total business that is
domestic. Thus, the deduction for total income would be multiplied by the share domestic
squared. If 50% of a firms output was domestic, its effective rate for domestic earnings would be 2
5% and the effective deduction overall would be 2.5% (10% X(0.5)). (Tax paid on foreign source
income is often received by the foreign government rather than the U.S. government, but the
effects on marginal tax rates still occur.) Based on data from the Internal Revenue Service (see
appendix), controlled foreign corporations in manufacturing accounted for 82% of receipts and
87% of assets of American manufacturing corporations in 1998. Thus, the effective rate is from

67% to 76% as large – the midpoint results in an effective tax rate of 32.5% (0.35X(1-0.1X0.71).

S. 1637 (Grassley and Baucus) proposed a general rate cut that would lower the tax rate on
manufacturing by 9%, or to approximately 32%, and since it applies to domestic income will be
similar to the rate in the Crane and Rangel bill.
A reduction in corporate tax rate to 32% would reduce effective tax rates on manufacturing
structures by close to three percentage points. It would reduce the rate on manufacturing
equipment by about 2.5 percentage points with no bonus depreciation and by 1.6 percentage
points under 50% bonus depreciation. For this industry, therefore it would narrow the difference
between equipment and structures, while, of course, favoring investment in domestic
manufacturing in general. Since about a third of manufacturing assets are in equipment and a
third in structures, the overall effect on manufacturing plant and equipment investment would be
similar to the depreciation provisions in the 2003 Thomas bill at the firm level. Investment in
inventories would, however, also benefit; at the same time the depreciation provision applies to
debt financed investment but the rate reduction does not benefit debt. Overall manufacturing
investment would have a reduction in effective tax rate of about 1.5 percentage points – about the
same as the depreciation speedup; thus, as in the case of the depreciation provision, the reduction
in the total tax rate in the economy would be less than a quarter of a percent.
The final bill would have a slightly larger overall reduction in tax rate in the economy because it
would apply to a broader range of productive. Qualified production activities income is allowed a
deduction from taxable income of 9% (3% in 2005-2006, 6% in 2007-2009). The deduction
cannot exceed total taxable income of the firm and is limited to 50% of wages. Production
property is property manufactured, produced, grown or extracted within the United States and
includes domestic film, energy, and construction, and engineering and architectural services. The
law specifically excludes the sale of food and beverages prepared at a retail establishment,
transmission and distribution of electricity, gas, and water, and receipts from property leased,
licensed, or rented to a related party. The 50% wage limit excludes sole proprietorships where no
wages are paid.
In a letter dated September 22, 2004 to Mark Prator and Patrick Heck, responding to a query
about the similar (although slightly different) Senate version of the provision, the Joint Tax
Committee indicated that three quarters of the benefit would have gone to corporations, 12%
would have gone to Subchapter S firms (smaller incorporated firms that elect to be treated as
partnerships) and cooperatives, 9% would have gone to partnerships, and 4% to sole
proprietorships. Based on the revenue estimates ($3 billion for 2006) and projected corporate tax
receipts of $249 billion for that year, the implication is that around a third of corporate activity
qualifies. Thus the overall effect on the economy is somewhat larger, perhaps closer to ½ of one
percent – although still quite small.
The effects of these two approaches – faster depreciation of equipment as compared to a rate cut –
are similar in some ways. They are about the same aggregate size and both relatively small for the
economy as a whole. Both provisions reduce taxes in the manufacturing sector (and favor that
industry over others) but since manufacturing is largely corporate, both measures reduce
corporate taxes overall whether the corporate rate itself is specified or more general tax reduction
allowed. While the magnitudes of the bills’ reduction on manufacturing and on the economy in
general are similar, the approaches differ in some ways. The accelerated depreciation for
equipment increases the favoritism for equipment relative to structures in this sector and does
nothing to reduce the debt-equity distortion, while the corporate rate cut reduces the differences
between tax rates across assets as well as reducing the distortion for debt. The Crane-Rangel bill
would have also encouraged more investment in the United States relative to the other proposals,

which may or may not be desirable.13 The depreciation provision would, however, be much easier
to administer and would have more “bang for the buck” (i.e. decrease tax burdens at a smaller
revenue cost) because it would apply only to returns to new investment.
Note, however, that this comparison relates only to these two aspects of the proposals. The bills
contained provisions in several other areas, including repeal of ETI. The extension of bonus
depreciation has already been noted, but the 2003 House bill would also have reduced the
depreciation period for leasehold improvements and restaurants, which would lower tax rates on
this group of structures’ investments (which are currently subject to relatively high rates); these
effects are difficult to measure but would be small. This provision was included, on a temporary
basis in the final legislation. There were provisions in the 2003 House bill aimed at small
business including a lower inframarginal corporate tax rate and a temporary increase in the
amount of equipment investment that can be deducted on acquisition. These provisions are
inframarginal for some firms and would not have effects on investment: the rate reduction would
encourage investment in small corporations, and the extension of expensing would favor
investment in equipment for certain small businesses. This extension of expensing was made, on
a temporary basis, in the final legislation (but the lower corporate rate cuts were not). To the
extent that small businesses tend to be unincorporated, the favorable treatment of the
noncorporate sector would be increased, as would the favorable treatment of equipment in those
businesses. There are a number of provisions that would significantly reduce the tax on income
from investment overseas (foreign investments are currently favored in some cases and penalized
in others), and would address some tax shelter issues. Finally there are provisions affecting
carryovers of losses, application of the alternative minimum tax, and temporary extension of the
R&D tax credit. It is very difficult to quantify these effects. S. 1637 also contained additional
provisions, but the focus on a more limited number of foreign tax revisions. Overall, H.R. 2896
lost $128 billion over 10 years according to the Joint Committee on Taxation, while S. 1637 is
roughly revenue neutral. The final bill was roughly revenue neutral and contained a number of
international provisions.

The 2001-2003 temporary tax cuts have a mixed effect in that they magnify some existing 14
distortions while reducing others. All capital income tax cuts reduce the distortion that favors
consumption over investment, although it is by no means clear that tax cuts for capital income 15
increase saving (because of offsetting income and substitution effects) and debt financed tax

13 This issue is beyond the scope of this paper, but basically if the objective is to maximize U.S. economic welfare, a
provision to encourage domestic investment would help to achieve that objective. If the objective is to maximize
worldwide efficiency, the incentive to invest abroad may or may not reduce efficiency, depending on how heavily
capital income is taxed abroad relative to its tax burden in the United States.
14 Distorting taxes may be considered appropriate to maximize economic efficiency if there are external effects that
justified these interventions;. however, there is little consensus that these effects are significant or can be determined in
a way that could inform policy. A full discussion is outside the scope of this paper, but see the discussion of
justifications for nonneutral taxation in Jane G. Gravelle, The Economic Effects of Taxing Capital Income, Cambridge,
MIT Press, 1994, pp. 60-73.
15 While the higher rate of return with a lower tax has a price effect that encourages individuals to substitute future
consumption for present consumption, the higher overall incomes allow both present and future consumption to
increase. The effect on savings is ambiguous in theory and has not been settled by empirical evidence.

cuts could well reduce the national (government plus private) savings rate. Any capital income
tax cut also reduces the favorable treatment of owner occupied housing.
In looking at the allocation of business capital, the dividend relief provision seems most
consistent with economic efficiency, because it reduces distortions affecting payout choices,
choice of finance, and sectoral allocation, without magnifying any existing distortions. Reducing
individual tax rates magnifies existing distortions, by favoring debt finance and noncorporate
investment. Bonus depreciation, if made permanent, has aspects that detract from efficiency, by
expanding the favorable treatment of the returns from equipment investments relative to returns
from investment in structures, while doing little to reduce financial or sectoral distortions.
The revisions in the bills addressing the ETI provision favor manufacturing and other eligible
activities. When accomplished via equipment depreciation, they would have expanded the
favorable treatment of equipment within that sector. The overall effects outside of that sector are
very small, however.
Of course, there are other issues aside from the efficiency considerations that might be considered
in making the temporary provisions permanent or in enacting new ones. Many of these
provisions, particularly bonus depreciation, were originally aimed at short run stimulus of the
economy. An investment subsidy such as bonus depreciation is a more effective stimulus if it is
temporary, and making it permanent might undermine the credibility of the government and
hamper its ability to manage fiscal policy in the future. That is, the effectiveness of a temporary
investment stimulus depends on investors believing it to be temporary, and if the government
transforms the current temporary stimulus into a permanent one, firm managers may be less likely
to believe that another temporary stimulus enacted in the future will actually be temporary.
Capital income taxes play an important role in the revenue base and the overall distribution of tax
burdens, which might be considered. Some tax revisions may add to administrative costs while
others reduce those costs, and others (such as changing rates) are largely neutral. For example, tax
rate cuts confined to manufacturing create a classification issue for firms (or related firms) that
engage in activities both within and without manufacturing. These tax rate cuts require allocation
rules that may add significantly to both administrative costs and opportunities for tax sheltering.

The tax rates in this paper are calculated by first determining, given a required after-tax return and
an expected rate of decline in productivity of the asset due to depreciation, how much the
investment must initially produce in order for the sum of profits after tax over time, discounted by
the after-tax return, to equal the individual investment outlay (i.e., to break even). Then all of the
tax payments and deduction are eliminated and the before profit flows are used to determine what
pre-tax discount rate would sum the flows to original cost. The effective tax rate is the pretax rate
of return minus the after tax rate of return, divided by the pretax rate.
Discounting means dividing each flow by a discount factor; for a flow earned a year from now, 2
the discount factor is (1 + r), for a flow earned two years from now (1 + r), for a flow three years 3
from now (1 + r), where r is the discount rate. In practice, however, the analysis uses a
continuous time method with continuous compounding. The formula derived from this method is
(1) r = (R + d)(1 – uz) / (1 – u) - d
where r is the pre-tax return, R is the after tax-discount rate of the corporation, d is the economic
depreciation rate, u is the statutory tax rate and z is the present value of depreciation deductions
(discounted at R + pi, where pi is the inflation rate). The effective tax rate for equity at the firm
level is (r – R) / r. When including individual level taxes and debt finance, the tax rate is
measured by determining r as above, where R = f(i(1 – u) – pi) + (1 – f)E, where f is the share debt
financed, i is the nominal interest rate, and E is the real return to equity before individual tax but
after corporate tax. E is equal to D + g, where D is the dividend rate and g is the growth rate. The
after tax real return, R∗, is f(i(1 – t) – pi) + (1 – f)(D(1 – t) + g(1 – c)), where t is the effective
individual tax rate and c is the effective capital gains tax rate. The total tax rate is (r – R∗) / r.
For a more complete description of the methodology and data sources, including useful lives for
depreciation purposes, formulas for measuring z, and the allocation of assets in the economy see
Jane G. Gravelle, The Economic Effects of Taxing Capital Income, Cambridge, MA, MIT Press,


For purposes of this analysis, the following assumptions were made: the interest rate is 7.5%, the
inflation is 2%, and the real return to equity before individual taxes is 7% , with a 4% (or 57% of
real profits) paid as dividends. The corporate rate is 35%, the average individual marginal tax rate
on investment income is 26% under permanent law and 23% under the lower individual rates
(data consistent with calculations in the National Bureau of Economic Research TAXSIM model).
Tax rates on dividends fall from 26% to 15% and the statutory tax rate on capital gains falls from
20% to 15%. One half of corporate stock is sold (and the remaining half held until death); the
holding period is five years. Half of financial assets are held in tax exempt forms such as pensions
and IRAs.
Data to calculate domestic shares of income for purpose of analyzing the Crane-Rangel bill data
on receipts and assets for controlled foreign corporations were taken from John Comisky,
“Controlled Foreign Corporations, 1998,” Statistics of Income Bulletin, Winter 2002-2003, pp.
47-86. Data for U.S. corporations overall were taken from Internal Revenue Service, Statistics of
Income 1998, Corporation Income Tax Returns, Washington DC, 2000.

Jane G. Gravelle
Senior Specialist in Economic Policy, 7-7829