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CRS Calculates Marginal Tax Rates on Capital Income From 1953 to 2003

JAN. 12, 2004

CRS Calculates Marginal Tax Rates on Capital Income From 1953 to 2003

DATED JAN. 12, 2004
DOCUMENT ATTRIBUTES

 

CRS Report for Congress

 

Received through the CRS Web

 

 

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. This report will be updated as warranted.

 

[1] 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.

[2] Table 1 shows the estimated tax rates from 1953-2003. 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.

              Table 1: Marginal Effective Tax Rates on

 

                     Capital Income (Percent)

 

 _________________________________________________________________

 

 Year   Corporate    Corporate      Non-      Owner-    U.S. Total

 

        Firm-Level     Total     Corporate   Occupied

 

 _________________________________________________________________

 

 1953      63           70           37         -1          58

 

 1954      50           57           23         -1          43

 

 1955      51           58           24         -1          44

 

 1956      53           60           25         -1          46

 

 1957      55           61           27         -1          48

 

 1958      55           61           26          1          47

 

 1959      52           58           25          1          45

 

 1960      49           55           23          1          42

 

 1961      49           55           22          1          42

 

 1962      42           48           17          1          35

 

 1963      41           47           16          1          34

 

 1964      38           44           14          0          31

 

 1965      37           42           13          1          29

 

 1966      37           42           14          1          30

 

 1967      40           45           17          1          33

 

 1968      44           50           20          3          37

 

 1969      52           58           28          5          45

 

 1970      48           54           26          5          42

 

 1971      43           50           21          5          38

 

 1972      44           51           21          5          38

 

 1973      43           51           21          5          38

 

 1974      48           55           25          7          42

 

 1975      51           56           27         11          44

 

 1976      46           53           23          7          40

 

 1977      41           49           23          6          40

 

 1978      50           58           26         10          46

 

 1979      47           57           29         11          45

 

 1980      51           60           33         15          48

 

 1981      37           48           24         12          38

 

 1982      35           43           22          9          35

 

 1983      39           46           20          8          34

 

 1984      38           44           20          7          33

 

 1985      38           44           20          7          33

 

 1986      38           45           19          6          33

 

 1987      35           44           22          4          33

 

 1988      35           43           22          4          33

 

 1989      34           43           22          4          33

 

 1990      33           42           22          3          31

 

 1991      32           41           22          3          30

 

 1992      32           41           22          3          30

 

 1993      33           42           22          2          31

 

 1994      32           41           22          2          30

 

 1995      32           42           22          2          31

 

 1996      32           42           22          2          31

 

 1997      31           41           23          2          31

 

 1998      31           41           22          2          30

 

 1999      30           40           23          2          30

 

 2000      31           41           23          2          31

 

 2001      32           41           22          2          30

 

 2002      30           39           21          2          29

 

 2003      27           32           18          2          23

 

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      Source: See text for method of calculation.

 

 

[3] 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 nonitemizers 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. These changes, which are currently temporary, result in a historically low tax rate.1

[4] 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 -- in recent years by about 8 percentage points without the lower rates (particularly on dividends and capital gains) enacted recently; about six percentage points for 2003.2

 

Methodology for Calculating Effective Tax Rates

 

 

[5] The basic formula for calculating the effective tax rate is (r-R)/r, where r is the 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.

[6] 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+[D])(1-uz-k(1-auz))/(1-u) - [D]

where u is the firm's statutory tax rate (either the individual or corporate rate), [D] is the 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.

[7] 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 (i(1-u)-[pi]) where i is the interest rate and [pi] is the 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 (i(1-t)-[pi]), where t is the individual tax rate, and 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 1, R is the discount rate of the corporate firm (before personal level taxes).

[8] The tax rate for owner-occupied housing omits the effect of depreciation and taxes on profit -- the pre tax return is simply R +f(1-n)t-ntp, where f is the debt share, 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.

[9] 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 2.1, p. 20.3

[10] Tax rates for 1990-2003 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 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 1990-2003. 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 December 15, 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 1990-2003 Tax Rates in Table 1 (Percent)

 

 _______________________________________________________________________

 

 Year    Individual Tax   Corporate Tax   Inflation Rate   Interest Rate

 

             Rate             Rate

 

 _______________________________________________________________________

 

 1990         23               34               4.2            10.3

 

 1991         23               34               4.1             9.8

 

 1992         23               34               3.2             9.0

 

 1993         24               35               2.7             7.9

 

 1994         24               35               2.4             8.6

 

 1995         25               35               2.4             8.2

 

 1996         25               35               2.3             8.0

 

 1997         26               35               1.9             7.9

 

 1998         26               35               1.4             7.2

 

 1999         27               35               1.5             7.9

 

 2000         26               35               1.9             8.4

 

 2001         25               35               2.3             8.0

 

 2002         25               35               1.8             7.8

 

 2003         24               35               1.6             6.8

 

 _______________________________________________________________________

 

 

      Source: See text.

 

FOOTNOTES

 

 

1For a more detailed discussion of the recent tax revisions see CRS Report RS32099, Capital Income Tax Revisions and Effective Tax Rates, by Jane G. Gravelle.

2See discussion in CRS Report RS32099, op. cit.

3Note 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.

 

END OF FOOTNOTES
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