Historical Effective Marginal Tax Rates on Capital Income
CRS Report for Congress
Historical Effective Marginal Tax Rates on
Capital Income
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Summary
Effective marginal tax rates on investment are forward-looking estimates that
project over the lifetime of an investment what share of the return will effectively be
paid in taxes. These rates can differ significantly from average tax rates measured by
dividing tax liability by income, because they are affected by timing. Effective tax rates
fell from the early 1950s through the mid-1960s, rose until the early 1980s, and then
dropped. They have stayed about the same until relatively recently, when they fell to
an all-time low with bonus depreciation, relief of double tax on dividends, and lower
marginal tax rates. The end of bonus deprecation and higher inflation rates increased
the tax rates in the past two years. This report will be updated as warranted.
The tax rates which determine investment activity are marginal tax rates on new
investment. They are calculated by projecting the path of a new investment and
discounting the flow of income and taxes. They take into account the effects of statutory
tax rates, depreciation rules, investment subsidies, and inflation. The method is to
compare the internal rate that discounts the flow to the current value of investment with
taxes (the after-tax return) and the rate without taxes (the pre-tax return); the difference
between these rates divided by the pre-tax return is the effective tax rate.
Table 1 shows the estimated tax rates from 1953 to 2005. Column 2 presents
estimates of the corporate firm-level tax; if depreciation were allowed at economic rates
and there were no subsidies, this rate would equal the corporate statutory tax rate.
Column 3 reports estimates of the total rate on corporate investment, accounting for the
deductibility of interest at the firm level and the taxation of interest, dividends, and capital
gains at the individual level, as well as depreciation and subsidies. Column 4 presents
the estimated rates for unincorporated business (proprietorships and partnerships). These
business tax rates reflect investments in equipment, structures, and inventory. Column
5 presents estimated tax rates for owner-occupied housing, which is normally close to
zero because of the exclusion of implicit net rent from income. Column 6 provides a
weighted economy-wide tax rate.
Congressional Research Service ˜ The Library of Congress
Table 1. Marginal Effective Tax Rates on Capital Income
(percent)
YearCorporateFirm-LevelCorporateTotal Non-CorporateOwner-OccupiedU.S. Total
1954505723-143
1955515824-144
1956536025-146
1957556127-148
1958556126147
1959525825145
1960495523142
1961495522142
1962424817135
1963414716134
1964384414031
1965374213129
1966374214130
1967404517133
1968445020337
1969525828545
1970485426542
1971435021538
1972445121538
1973435121538
1974485525742
19755156271144
1976465323740
1977414923640
19785058261046
YearCorporateFirm-LevelCorporateTotal Non-CorporateOwner-OccupiedU.S. Total
19805160331548
19813748241238
1982354322935
1983394620834
1984384420733
1985384420733
1986384519633
1987354422433
1988354322433
1989344322433
1990334222331
1991324122330
1992324122330
1993334222231
1994324122230
1995324222231
1996324222231
1997314123231
1998314122230
1999304023230
2000314123231
2001324122230
2002303921229
2003273218223
2004303521226
2005344123230
Source: See text for method of calculation.
As shown in Table 1, tax rates for business investment fell from the early 1950s to
the mid-1960s, reflecting more accelerated depreciation, investment credits, and lower
statutory tax rates. Rates rose towards the end of the 1960s with the repeal of the
investment credit, which was restored in 1971 and led to lower rates. Rates then began
to rise in the mid-1970s as inflation resulted in a smaller value of depreciation deductions
by firms; inflation also caused the penalty for not deducting mortgage interest for non-
itemizers to become more severe. Increases in depreciation and lower rates adopted in
1981, which were followed by more restrictive depreciation but lower corporate and
individual rates in 1986 and slowing inflation, led to lower tax rates in the 1980s and
1990s. The most recent reductions in tax rates arose from the lower tax rates adopted in
the 2001-2003 legislation, the adoption of bonus depreciation in 2002 which was
expanded in 2003, and the lower rates on dividends and capital gains adopted in 2003.1
These changes resulted in a historically low tax rate. The tax rate rose in 2004 due to
higher inflation rates, and rose again in 2005 due to the end of bonus depreciation. Lower
rates on capital gains are technically temporary (expiring in 2010), but may be made
permanent.
The tax rates in Table 1 do not account for the tax benefits to investments through
pensions and individual retirement accounts (where tax rates are generally effectively
zero); about half of passive income (interest, dividends, and capital gains on stock) is
received in tax exempt form. These provisions affect marginal tax rates only if they affect
the return to the marginal saving decision. Many investments in these forms are made up
to the maximum contribution limit, many pension plans are not under individual control,
and even where investments are not at the limit all marginal investments may still not
flow through the tax-favored account. All of these factors suggest not including these tax
benefits in marginal calculations. However, there is probably some marginal effect, and
if the individual income tax rate on these passive forms of income is set to one half of its
value to reflect the share of non-taxed investment returns, tax rates would be reduced
substantially — by about eight percentage points without the lower rates (particularly on
dividends and capital gains) enacted recently; about six percentage points otherwise.2
Methodology for Calculating Effective Tax Rates
The basic formula for calculating the effective tax rate is , where r is the()rRr−/
pre-tax return, or internal discount rate for an investment with no taxes, and R is the after-
tax discount rate that discounts all flows to the cost of the investment with taxes.
For a business depreciable investment, the relationship between r and R, with R the
firm’s discount rate, derived from an investment with geometric depreciation and
continuous time, is the standard formula:
(1) () ( )()()r R uz k auz u=+ −− − −−δδ11 1/
1 For a more detailed discussion of the recent tax revisions, see CRS Report RL32099, Capital
Income Tax Revisions and Effective Tax Rates, by Jane G. Gravelle.
2 See discussion in CRS Report RL32099.
where u is the firm’s statutory tax rate (either the individual or corporate rate), is theδ
economic depreciation rate, z is the present discounted value of depreciation deductions,
k is the investment tax credit, and a is a determinant of the basis adjustment, set at one,
0.5, and zero if there is a full basis adjustment (i.e. depreciation allowed only on cost net
of the credit), half basis adjustment, or no basis adjustment respectively.
The formula in (1) is applied to obtain firm-level tax rates (the firm-level corporate
rate in column 2 and the non-corporate rate in column 4), with R a weighted average of
the after-tax real interest rate where I is the interest rate and is the()iu1−−ππ
inflation rate and the required real return on equity before individual tax. Debt is
weighted one-third. In the case of total corporate tax rates in column 3, the pre-tax return
R is derived from equation (1) but is compared with the return after personal taxes to
individuals (the same discount rate used for non-corporate business), a weighted average
of the after-tax real return on debt , where t is the individual tax rate, and()it1−−π
the after-tax return on corporate equity (which is net of taxes on capital gains and
dividends). In the case of the firm level corporate tax rate in the second column of Table
The tax rate for owner-occupied housing omits the effect of depreciation and taxes
on profit — the pre tax return is simply , where f is the debt share,()Rfntntp+−−1
n is the share of investments with individuals who itemize on their tax returns, p is the
property tax rate, and R is the after-tax discount rate. If all mortgage interest deductions
were allowed, but no property tax deductions, the tax rate would be zero because there is
no tax on the imputed net rent. A slight positive or negative tax may arise because of the
inability to deduct mortgage interest by non-itemizers and the ability to deduct property
taxes by itemizers.
The mathematical formulas and assumptions used to calculate tax rates, including
depreciation methods and lives, investment credits, inflation rates, and statutory tax rates,
as well as the tax rates themselves for 1953-1989, can be found in Jane G. Gravelle, The
Economic Effects of Taxing Capital Income, Cambridge: MIT Press, 1994, Appendix B,
pp. 287-301. The statutory tax rates, interest and inflation rates for 1953-1989 are in Table
Tax rates for 1990-2005 incorporate a number of assumptions and tax law changes.
These include the increase in the tax life for structures from 31.5 to 39 years in 1993, the
lowering of the capital gains tax rate to 20% in 1997, the introduction of bonus
depreciation (expensing of a share of investment) at 30% for 2002 and 50% for 2003 and
2004, and the reduction in the tax rate for capital gains and dividends from 20% and the
regular tax rate respectively to 15%. Individual and corporate statutory tax rates and
inflation and interest rates are reported in Table 2 for 1990-2005. The pattern of change
in individual tax rates is based on the rate reported for the NBER simulation model, which
can be found at [http://www.nber.org/~taxsim/mrates/mrates3.html], visited November
3 Note that this table inadvertently reports the values for 1959, in the row for 1960, and omits
the 1960 values of 28, 52, 2.0, and 5.2 for the individual tax rate, corporate tax rate, inflation rate
and interest rate.
20, 2003. Tax rates are assumed to continue at the current year’s rate; slightly lower rates
would occur for 2001 and 2002 if the permanent long term rates enacted in 2001 were
assumed, although rates might also rise due to real bracket creep as well. Inflation rates
are a 1/3 weight of the prior year and a two-thirds weight of the current year. The interest
rate is the Baa Bond rate.
Table 2. Tax, Inflation, and Interest Rates Used to Calculate
1990-2005 Tax Rates in Table 1
(percent)
YearIndividual Tax RateCorporate TaxRateInflation RateInterest Rate
199123344.19.8
199223343.29.0
199324352.77.9
199424352.48.6
199525352.48.2
199625352.38.0
199726351.97.9
199826351.47.2
199927351.57.9
200026351.98.4
200125352.38.0
200225351.87.8
200324351.66.8
200424353.46.4
200523353.46.1
Source: See text.