The recent opening up of markets in many countries places new and greater demands on the tax structure. More integrated financial markets make the allocation of resources more sensitive to differences in national tax rates. Differences in tax regimes between countries can result in capital flows across countries affecting both the location of investments and ownership of capital. Taxation of income from business activities as well as taxation of financial flows across countries has therefore received much more attention now than it did only a few years ago. As the previously centrally planned economies embark on economic reforms, their tax structures need to promote a more efficient allocation of capital between sectors within their countries and across borders. In the tax reform process, it is important to consider which tax parameters have a large impact on the net rate of return paid to the investor. However, it is also important to take into account the overall complexity of the tax system and whether it is possible to administer the tax rules. During the 1980s, the pace of tax reform was rapid in OECD countries. Countries which had centrally planned economies now have a unique opportunity to opt for the simplified broad-based tax systems which the Western countries have introduced.
Economic Efficiency
Tax reform efforts in most West European countries have focused on capital income taxation and taxes on consumption. The top marginal income tax rates have been reduced, and in some cases drastically, to mitigate adverse effects on labor supply. With high taxes on wage income in the past, untaxed economic activities, leisure activities, and black market activities tended to increase and erode the tax base.
To create an efficient system of capital taxation, policy makers must consider the effects of taxation on savings and investment. A reduction in the after-tax return to capital, for instance by taxing interest and dividend income, is equivalent to making future consumption relatively more expensive and therefore tends to decrease savings. Income taxes also affect savings by lowering private disposable income causing a reduction in both present consumption and savings. For a net borrower, taxes lower the after-tax cost of borrowing which tends to increase borrowing and increase consumption. The overall effect on private savings of taxation of capital income is ambiguous and the effect on national savings depends on how the government uses its tax revenues.
If the tax system results in a decrease in the level of household savings and if the economy is closed, the equilibrium interest rate will rise which will decrease the demand for investment capital. In an open economy, however, capital can flow in from abroad so the investment level depends on the prevailing world market interest rate and not only on domestic savings. Taxes on the return to savings will therefore have only a limited impact on the investment level. However, the ownership of capital may be affected.
The tax system also affects investment. Different tax treatment for different types of assets is likely to have a large impact on investment opportunities and the composition of the investor’s portfolio. Estimates of the size of misallocation of resources owing to different tax treatment in different sectors are in the range of less than one percent of GNP up to several percent of GNP. Since the growth rate of the economy may be affected, the distortions are believed to be substantial and very costly, both in terms of allocation of resources and in revenue terms.1
Empirical evidence of taxes’ impact on savings and investment and the resulting capital flows across countries indicate the part of the flow of portfolio capital from Japan to the United States during the 1980s that can be attributed to tax factors. Japan taxed the use of capital more heavily than the United States, while the United States taxed its residents more heavily on their savings than Japan did. The tax systems therefore encouraged capital to flow from Japan to the United States.2
To assess whether a tax system encourages savings and investment relative to the tax system of other countries, a framework has been developed which permits evaluation of the overall impact of taxes and of various tax incentives on the rate of return of capital. By incorporating and combining different taxes and by including tax provisions and the economic environment in which the tax system operates, the impact of each tax system on incentives to locate investments in various countries can be illustrated. Such a methodology is described below.
The User Cost of Capital
To assess the impact of taxation on incentives to invest, three different layers of taxes must be considered. First, the taxes at the corporate level, second, shareholder taxes, and, third, for investment flows across borders, taxes imposed on foreign investors.
At the corporate level, besides the statutory corporate tax rate, the rules of how to calculate taxable profits are very important for the after-tax return the investor can receive. Interest payments are generally deductible when calculating taxable profits, while dividend payments are not. This leads to the so-called double taxation of dividends. Dividends are paid out of after-tax profits, and dividends are then taxable at the shareholder level. Most OECD countries allow for some double taxation relief for equity-financed investments. Tax depreciation for fixed assets also plays a major role in determining the after-tax return for the investor. Other important factors at the corporate level are investment grants and different methods of deferring tax payments through allocation funds (such as investment funds). The use of grants and funds have, however, been drastically reduced in the OECD countries during the 1980s.
At the shareholder level, taxes on interest, dividend income, and capital gains matter. Changes in these tax rates may cause the investor to prefer to receive his return in a different form. It has, for instance, been argued that the increase in the capital gains tax rate in the United States in connection with the Tax Reform Act of 1986 encouraged distribution of profits rather than retention of profits.3
The third level of taxation that affects investment decisions is taxes imposed on foreign investors. Many countries levy withholding taxes on dividend and interest remittances from the source (host) country to the resident (home) country of the investor. These withholding taxes may in some cases be credited against tax liabilities in the home country when foreign-source income is subject to further taxation at home. Several EC countries and the United States adhere to the residence principle, taxing income wherever it is derived from, but the foreign tax credit is typically limited to the residence country’s own tax rate on the same kind of income. For portfolio investment there is typically no credit for the underlying foreign corporate income tax. The final tax liability may also depend on the form in which the investment income is received. Interest income and dividend income are often taxed at an equal rate while capital gains, in particular capital gains from exchange gains and losses, may escape further taxation.
By combining several different taxes and by incorporating tax provisions in a consistent way, it is possible to develop a framework that permits evaluation of the overall impact of taxes and of possible tax changes on the required rate of return on the last unit of fixed capital.4 Such calculations attempt to capture the effect of the tax system and do not incorporate the effect of other potential factors in the investment decision, such as the availability of a suitable labor force or the quality of infrastructure, and more important, the effect of differential risk. However, it is possible to see the impact of broad interaction of the tax system and the macroeconomic environment.
For a given after-tax rate of return, the before-tax rate of return can be expressed as an explicit function of tax parameters and the resultant difference between the two rates of return can be used to calculate the effective marginal tax rate. The difference between the before-tax rate of return and the after-tax rate of return is often referred to as a tax wedge. The tax wedge can be explained by defining three rates of return: the required before-tax rate of return on investment, p, the market return (after corporate taxes), r, and the after-tax rate of return to the saver, s. All these returns are measured in real terms. In the case of debt finance, the market return corresponds to the real interest rate, and for equity financing, it amounts to the real return on equity (taking into account dividends and expected capital gains) before shareholder taxes. The total tax wedge, wt, can therefore be thought of as consisting of two parts:
where wc denotes the corporate tax wedge and wi the investor’s wedge.
When cross-border investments are considered, it is more useful to separate the total tax wedge into a host country tax wedge and a home country tax wedge. The host country levies corporate taxes but often also withholding taxes on dividend and interest payments. The home country, in turn, either exempts or taxes these returns, typically subject to some form of double taxation relief.
The corporate tax wedge is derived from the neoclassical theory of investment behavior, where firms carry out investments until the before -tax rate of return, p, is at least sufficient to cover the cost of finance and the tax payments. 5 In general, the corporate tax system tends to favor debt financing while capital gains taxation at the investor’s level often leads to a favorable tax treatment of the part of investment financed with retained earnings. The framework used here allows us to incorporate these effects and compare tax wedges for different sources of financing.
A Cross-Country Comparison
Figure 1 (and Table 1 in the appendix) shows that Hungary and Poland have the largest total tax wedge for an equity-financed investment in machinery among the countries included in the study.6 A similar picture is found for many of the economies in transition. Both Hungary and Poland provide relatively conservative depreciation rules for tax purposes and the depreciation allowances are calculated by using the straight-line method based on historical costs.7 The same method is used in Austria, Greece, Portugal, and Spain, while the others permit declining-balance depreciation. However, Austria allows an additional 20 percent in depreciation allowances in the initial year and Spain has an investment tax credit of 5 percent. These provisions are very important in present value terms for the user cost of capital. Ireland has very generous depreciation allowances, but since the corporate tax rate is only 10 percent, the decrease in tax liability is limited. Finland and Turkey allow for accelerated depreciation and in Turkey the value of the depreciation allowances is enhanced by indexation of the depreciable base.
Total Tax Wedge on Investments in Machinery, 1990
Effective Taxation of Income from Investment in Machinery, 1990
(With uniform inflation rate and after-tax rate of return)1
Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value: corporate tax rate as a percent of taxable income: and withholding tax rate is in percent of taxable remittance. Interest and inflation rates are shown in annual percentage changes.
Only undistributed profits are liable to the corporate tax.
SL = straight-line method: DB = declining-balance method.
Determines to what extent an acquired asset is depreciable when acquired A value of 1 indicates that a whole year’s depreciation is allowed whenever purchased. A value of 0.5 indicates that the purchases are prorated, with on average half a year’s deduction.
In addition to regular first-year depreciation.
Effective Taxation of Income from Investment in Machinery, 1990
(With uniform inflation rate and after-tax rate of return)1
Austria | Finland | Greece | Hungary | Ireland | Poland | Portugal | Spain | Turkey | ||||||||||||
---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | |||
Required rate of return | 17.18 | 19.34 | 15.87 | 19.59 | 17.44 | 19.93 | 17.12 | 21.10 | 18.33 | 18.05 | 18.42 | 21.60 | 18.23 | 20.61 | 18.23 | 19.51 | 16.59 | 20.95 | ||
After-tax rate of return | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | ||
Total tax wedge | 0.18 | 2.34 | −1.13 | 2.59 | 0.43 | 2.92 | 0.12 | 4.10 | 1.33 | 1.05 | 1.43 | 4.61 | 1.22 | 3.61 | 1.25 | 2.51 | −0.42 | 3.94 | ||
Host tax wedge | −1.82 | 1.62 | −3.13 | 1.86 | −1.57 | 2.20 | −1.88 | 3.37 | −0.67 | 0.32 | −0.57 | 3.88 | −0.78 | 2.88 | −0.77 | 1.78 | −2.42 | 3.21 | ||
Corporate tax wedge | −1.82 | 1.56 | −3.13 | 1.82 | −2.68 | 2.13 | −1.88 | 3.37 | −0.67 | 0.32 | −1.68 | 3.84 | −2.54 | 2.85 | −1.88 | 1.75 | −3.58 | 3.21 | ||
Withholding tax wedge | — | 0.06 | — | 0.04 | 1.11 | 0.07 | — | — | — | — | 1.11 | 0.04 | 1.76 | 0.03 | 1.11 | 0.03 | 1.16 | — | ||
Home tax wedge | 2.00 | 0.72 | 2.00 | 0.73 | 2.00 | 0.72 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | ||
Corporate tax rate | 30.00 | 30.00 | 42.00 | 42.00 | 40.00 | 36.002 | 40.00 | 40.00 | 10.00 | 10.00 | 40.00 | 40.00 | 40.00 | 40.00 | 35.00 | 35.00 | 47.80 | 47.80 | ||
Host withholding tax rate | ||||||||||||||||||||
Dividends | 20.00 | 20.00 | 15.00 | 15.00 | 25.00 | 25.00 | — | — | — | — | 15.00 | 15.00 | 12.00 | 12.00 | 10.00 | 10.00 | — | — | ||
Interest | — | — | — | — | 10.00 | 10.00 | — | — | — | — | 10.00 | 10.00 | 15.00 | 15.00 | 10.00 | 10.00 | 10.00 | 10.00 | ||
Tax depreciation rate | 10.00 | 10.00 | 30.00 | 30.00 | 16.80 | 16.80 | 12.00 | 12.00 | 10.00 | 10.00 | 10.00 | 10.00 | 12.50 | 12.50 | 10.00 | 10.00 | 20.00 | 20.00 | ||
Method3 | SL | SL | DB | DB | SL | SL | SL | SL | DB | DB | SL | SL | SL | SL | SL | SL | DB | DB | ||
First year convention4 | 0.75 | 0.75 | 1.00 | 1.00 | 0.50 | 0.50 | 0.40 | 0.40 | 1.00 | 1.00 | 0.50 | 0.50 | 1.00 | 1.00 | 0.50 | 0.50 | 1.00 | 1.00 | ||
Initial deduction5 | 20.00 | 20.00 | — | — | — | — | — | — | 30.00 | 30.00 | — | — | — | — | — | — | — | — | ||
Investment tax credit | — | — | — | — | — | — | — | — | — | — | — | — | — | — | 5.00 | 5.00 | — | — | ||
Nominal interest rate | ||||||||||||||||||||
(endogenous) | 10.00 | 10.00 | 10.00 | 10.00 | 11.11 | 11.11 | 10.00 | 10.00 | 10.00 | 10.00 | 11.11 | 11.11 | 11.77 | 11.77 | 11.11 | 11.11 | 11.11 | 11.11 | ||
Expected rate of inflation | ||||||||||||||||||||
Host country | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | ||
Home country | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 |
Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value: corporate tax rate as a percent of taxable income: and withholding tax rate is in percent of taxable remittance. Interest and inflation rates are shown in annual percentage changes.
Only undistributed profits are liable to the corporate tax.
SL = straight-line method: DB = declining-balance method.
Determines to what extent an acquired asset is depreciable when acquired A value of 1 indicates that a whole year’s depreciation is allowed whenever purchased. A value of 0.5 indicates that the purchases are prorated, with on average half a year’s deduction.
In addition to regular first-year depreciation.
Effective Taxation of Income from Investment in Machinery, 1990
(With uniform inflation rate and after-tax rate of return)1
Austria | Finland | Greece | Hungary | Ireland | Poland | Portugal | Spain | Turkey | ||||||||||||
---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | Debt | Equity | |||
Required rate of return | 17.18 | 19.34 | 15.87 | 19.59 | 17.44 | 19.93 | 17.12 | 21.10 | 18.33 | 18.05 | 18.42 | 21.60 | 18.23 | 20.61 | 18.23 | 19.51 | 16.59 | 20.95 | ||
After-tax rate of return | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | 2.00 | ||
Total tax wedge | 0.18 | 2.34 | −1.13 | 2.59 | 0.43 | 2.92 | 0.12 | 4.10 | 1.33 | 1.05 | 1.43 | 4.61 | 1.22 | 3.61 | 1.25 | 2.51 | −0.42 | 3.94 | ||
Host tax wedge | −1.82 | 1.62 | −3.13 | 1.86 | −1.57 | 2.20 | −1.88 | 3.37 | −0.67 | 0.32 | −0.57 | 3.88 | −0.78 | 2.88 | −0.77 | 1.78 | −2.42 | 3.21 | ||
Corporate tax wedge | −1.82 | 1.56 | −3.13 | 1.82 | −2.68 | 2.13 | −1.88 | 3.37 | −0.67 | 0.32 | −1.68 | 3.84 | −2.54 | 2.85 | −1.88 | 1.75 | −3.58 | 3.21 | ||
Withholding tax wedge | — | 0.06 | — | 0.04 | 1.11 | 0.07 | — | — | — | — | 1.11 | 0.04 | 1.76 | 0.03 | 1.11 | 0.03 | 1.16 | — | ||
Home tax wedge | 2.00 | 0.72 | 2.00 | 0.73 | 2.00 | 0.72 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | 2.00 | 0.73 | ||
Corporate tax rate | 30.00 | 30.00 | 42.00 | 42.00 | 40.00 | 36.002 | 40.00 | 40.00 | 10.00 | 10.00 | 40.00 | 40.00 | 40.00 | 40.00 | 35.00 | 35.00 | 47.80 | 47.80 | ||
Host withholding tax rate | ||||||||||||||||||||
Dividends | 20.00 | 20.00 | 15.00 | 15.00 | 25.00 | 25.00 | — | — | — | — | 15.00 | 15.00 | 12.00 | 12.00 | 10.00 | 10.00 | — | — | ||
Interest | — | — | — | — | 10.00 | 10.00 | — | — | — | — | 10.00 | 10.00 | 15.00 | 15.00 | 10.00 | 10.00 | 10.00 | 10.00 | ||
Tax depreciation rate | 10.00 | 10.00 | 30.00 | 30.00 | 16.80 | 16.80 | 12.00 | 12.00 | 10.00 | 10.00 | 10.00 | 10.00 | 12.50 | 12.50 | 10.00 | 10.00 | 20.00 | 20.00 | ||
Method3 | SL | SL | DB | DB | SL | SL | SL | SL | DB | DB | SL | SL | SL | SL | SL | SL | DB | DB | ||
First year convention4 | 0.75 | 0.75 | 1.00 | 1.00 | 0.50 | 0.50 | 0.40 | 0.40 | 1.00 | 1.00 | 0.50 | 0.50 | 1.00 | 1.00 | 0.50 | 0.50 | 1.00 | 1.00 | ||
Initial deduction5 | 20.00 | 20.00 | — | — | — | — | — | — | 30.00 | 30.00 | — | — | — | — | — | — | — | — | ||
Investment tax credit | — | — | — | — | — | — | — | — | — | — | — | — | — | — | 5.00 | 5.00 | — | — | ||
Nominal interest rate | ||||||||||||||||||||
(endogenous) | 10.00 | 10.00 | 10.00 | 10.00 | 11.11 | 11.11 | 10.00 | 10.00 | 10.00 | 10.00 | 11.11 | 11.11 | 11.77 | 11.77 | 11.11 | 11.11 | 11.11 | 11.11 | ||
Expected rate of inflation | ||||||||||||||||||||
Host country | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | ||
Home country | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 | 6.00 |
Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value: corporate tax rate as a percent of taxable income: and withholding tax rate is in percent of taxable remittance. Interest and inflation rates are shown in annual percentage changes.
Only undistributed profits are liable to the corporate tax.
SL = straight-line method: DB = declining-balance method.
Determines to what extent an acquired asset is depreciable when acquired A value of 1 indicates that a whole year’s depreciation is allowed whenever purchased. A value of 0.5 indicates that the purchases are prorated, with on average half a year’s deduction.
In addition to regular first-year depreciation.
The results for Ireland deserve closer scrutiny. In contrast to other countries, a debt-financed investment in Ireland carries a larger tax burden than equity-financed investment owing to the combination of a small subsidy at the corporate level and the relatively heavy home taxation of interest income as compared with taxation of equity capital at the investor’s level. The Irish case therefore clearly demonstrates the importance of the statutory corporate tax rate; the higher the tax rate, the larger is the value of interest deductions and the larger the subsidy for debt-financed investment at the corporate level.
Broad-Based System Versus Special Incentives
In order to promote investment, many countries have introduced special tax preferences for some investors or types of investments. As it turns out, investment tax credits, capital expensing, and accelerated depreciation are very effective in lowering the cost of capital but they may induce windfall gains to investors and they tend to erode the tax base. The proliferation of tax preferences undermines the tax system’s revenue collecting capacity and may lead to allocative distortions, and a very careful examination is therefore necessary before any such preferences are introduced. As they embark on tax reform, formerly centrally planned economies have a golden opportunity to avoid the experience of West European countries that made extensive use of investment tax preferences from the 1950s through the 1970s. Instead, these countries may opt for broader tax bases with low tax rates in order to limit national as well as international distortions in the allocation of resources and to protect their revenue base. The cost of capital framework allows us to assess which types of tax incentives are most effective in lowering the user cost of capital. As an example of how the user cost of capital framework can be used to evaluate tax policy options for economies in transition, let us look at Hungary as a case study. The results are, however, generally applicable to economies in transition.
Hungary has undertaken major tax reform efforts during the last three years. The personal income tax and value-added tax were introduced on January 1, 1988, followed by the enterprise profit tax, effective January 1, 1989. Hungary has a statutory corporate income tax rate of 40 percent, a straight-line depreciation method for investments in machinery and buildings and provides a two-year loss carryover. The overall system of corporate taxation imposes a relatively heavy burden on investments since the tax depreciation rules for fixed assets are conservative with a relatively long assets life for tax purposes.8
To offset the restrictive treatment of tax losses and depreciation, Hungary has granted tax preferences to foreign-owned enterprises. Foreign investors receive tax concessions ranging from a 20 percent reduction in the corporate tax rate to a complete five-year tax holiday. In addition, accelerated depreciation has been increased to 30 percent (from 20 percent earlier) and the eligible asset categories have been broadened to include most advanced industrial equipment. Hungary also gives foreign-owned companies a rebate equal to the underlying tax on the reinvested profits of the foreign shareholder.
The relatively heavy tax burden on domestic investments led in 1990 to the introduction of special rules for private entrepreneurs. Under this legislation, Hungarian businessmen can opt for special tax treatments which enable them to depreciate assets over as short a period as two years and to reduce their tax rate by 50 percent. The resulting tax system is complex with similar assets having different tax treatment depending on form of business and ownership. The tax system gives rise to large distortions of the allocation of investments and capital. Eventually, more and more of the businesses will be transformed into tax-favored enterprises with adverse revenue implications.
Some Possible Tax Policy Measures
The possible designs of tax incentives are virtually unlimited. A common form of tax incentives is the investment tax credit. It is earned as a percentage of eligible expenditures. If Hungary were to introduce a general tax credit of 1 percentage point, the total tax wedge of 4.1 percentage points would be reduced to 3.8 percentage points, a reduction by some 6.6 percent (see Figure 2). The effect is relatively large since the tax credit is received up front. The tax credit is usually applicable only to new investments and the cost of capital for old, existing capital is therefore not affected. There is no windfall gain to existing capital owners.
Decrease in Total Tax Wedge, Equity Financed Investment
Note: For the corporate tax and the income tax, a 1 percentage point decrease, for the investment grant a 1 percentage point increase, and for asset life a reduction by one year. For first year convention, an increase from on average 40 percent deductability to 100 percentIf the useful life of an asset for tax purposes is shortened by one year, the total tax wedge is reduced by almost 8 percent. Incentive deductions differ from tax credits in that they reduce the income subject to tax rather than the actual tax payment. It is, however, administratively difficult to separate new investments from old existing capital. If this is attempted, there is a need to keep track of the rules in force at the time an asset was purchased or installed. The United States is one country that applies different depreciation rules depending on the prevailing rules at the time of purchase. Complicated rules have had to be enacted to prevent abuse in form of sell-lease-back arrangements and swaps of assets between firms. Given the limited resources for tax administration and the large demands for information and control, especially for the numerous newly formed enterprises in economies in transition, it does not seem advisable to have different tax treatment of different vintage capital. Allowing short asset life for tax purposes for certain investors or certain activities creates similar administrative difficulties and should therefore also be resisted.
Another aspect of depreciation of fixed assets for tax purposes is to what extent depreciation during the purchase year is allowed. Many countries prorate depreciation and limit depreciation to the period the asset has been owned or installed. By allowing full depreciation irrespective of date of purchase, the tax depreciation period can be shifted forward and therefore increase in present value terms. If Hungary applied this method, as Finland and Ireland among others do, the total tax wedge would be reduced by over 10 percent. Only new investments would be affected, thereby avoiding any windfall gain to existing owners of capital. If introduced, the rule should be applied to all sectors of the economy, minimizing sectoral distortions.
An important component in the tax system, especially for the international allocation of capital, is the statutory corporate tax rate. It has a direct impact on financial marginal source decisions and the allocation of taxable income from multinational firms. Since interest charges are deductible when ascertaining corporate profits, interest charges tend to be deducted in jurisdictions with a high statutory corporate tax rate while profits subject to transfer pricing tend to be allocated in jurisdictions with a low statutory corporate tax rate. A 1 percentage point lower statutory corporate tax rate in Hungary would reduce the total tax wedge on an equity-financed investment by some 3.5 percentage points and the difference between debt and equity-financed investments would decrease. The reason for this is that the value of interest deductions would decrease as the corporate tax rate is reduced. If the income tax rate at the shareholder level is lowered by 1 percentage point on interest income, dividend income, and capital gains, the total tax wedge would decrease by a similar 3.5 percentage points.
Another form of incentives which would lower the user cost of capital includes preferential tax rates for particular sources of income. A related measure is tax holidays for certain types of ventures. Administrative problems occur in identifying what is a new business since existing businesses can restructure to appear as new businesses. These incentives make the tax system more complex and cause uncertainty about the stability of the tax structure. New measures may be introduced for competing industries and long-term planning may therefore become more difficult.
Effectiveness Versus Efficiency
From the calculations above, it is clear that there is a need to decrease the total tax wedge on investments in Hungary and in Poland. Introducing an investment tax credit, accelerated depreciation, or preferential tax rates would indeed reduce the tax wedges significantly and increase investment incentives. However, even if these measures are effective in lowering the cost of capital it doesn’t mean that they are efficient means. The arguments against preferential tax treatment for some investors or investment projects are well known from the economic literature. It is difficult for the government to pick “the winners,” and it can be questioned whether the winners really need any tax concessions. Tax preferences lead to a less efficient allocation of resources and result in a need for other taxes to be higher to compensate for forgone revenues. The heavier tax burden on other sectors of the economy tends to make the tax system more distortionary. The different tax treatment across sectors and types of businesses also leads to extensive tax planning and rearrangements to qualify for tax preferences. For instance, if foreign investors are given preferential tax treatment, there is an incentive for domestic investors to undertake their investments with the help of a foreign partner. The decrease in tax liability can then be divided up between the domestic and foreign partners. In general, more educated and well informed citizens will be more able to make use of tax preferences.9
The international experience is that tax incentives may generate less investment than the government loses in revenues.10 An important reason for the cost inefficiency of tax incentives is the fact that they are available to all qualifying investments. A large part of investments would have occurred in any event. Measures that target marginal investments have been hard to implement. If the cost of misallocation of resources is included, tax incentives become even less attractive. Similar results have been found for tax holidays.
Furthermore, preferential tax treatment inevitably makes the tax system more complex. This aspect is particularly important for economies in transition. Their capability to administer a new tax system with numerous new taxpayers is naturally limited in the short run. It takes time to train tax inspectors and to form an appropriate organization to provide tax information to the public, assess tax payments, audit returns, and collect taxes. It is a difficult task to form an appropriate organization, and an excessively complex tax system could make the tax system inoperable for several years. The need to report information to the authorities results in reporting costs for taxpayers, and the registration of such information with the tax authorities can become an overwhelming task, leaving fewer resources for actual tax control and tax audits.
Another justification for simple broad-based taxes is the uncertainty created by a tax system full of special rules. Political pressure groups will form over time and, as a consequence, tax concessions may be eroded or extended to competitors. The perceived fairness of the tax system will almost certainly be questioned and activity in the underground economy could increase. As a result, governments may be forced to implement second best solutions, such as minimum taxes, which add to the complexity of the tax system and themselves may be arbitrary and distortionary.
Tax preferences tend to proliferate, and as the revenue base decreases, higher taxes have to be imposed on other sectors of the economy. There is often a good reason behind each single new tax concession. Usually, the concessions show that the entire tax system needs to be overhauled, yet the proliferation of concessions is harmful to economic efficiency. The rules of the game are changing and tax changes will affect both asset values and income flows. Eventually, when all sectors have received preferential tax treatment, what has been achieved is a tax system with lower rates, but the tax base may not be the appropriate one. A more efficient tax system with low rates and a broad base could generally be achieved with lower economic and administrative costs, if not introduced in a piecemeal fashion.
If special tax incentives are dismissed, other tax measures may have to be used. While the average total tax wedge for the seven European economies included in Figure 1 (excluding Hungary and Poland) was some 2.7 percentage points, Hungary had a total tax wedge around 4.1 percentage points and Poland around 4.6 percentage points. The large tax wedges in Poland and Hungary can to some extent explain why these countries have found it necessary to introduce a number of tax concessions, in particular for foreign investors. Given a certain revenue requirement, other investors, primarily domestic investors, have had to pay even higher taxes.
The Hungarian tax system could be reformed in a number of ways to achieve a total tax wedge similar to that in other European countries, without resorting to tax concessions for certain investors. The main reason for the large tax wedge in Hungary and in Poland is the assumed long asset life time for tax purposes. If Hungary introduced a first year convention allowing full depreciation the first year irrespective of purchase date, and if a faster depreciation method was introduced, twice the straight line method in combination with a statutory corporate tax rate of 35 percent (40 percent at present), the total tax wedge would be reduced from 4.1 percentage points to 2.7 percentage points, the average for the other seven European countries in Figure 1.
Such a proposal may be costly in revenue terms and therefore calls for careful consideration before it could be put forward. However, it serves as an illustration that broad-based, non-distortionary measures are a good alternative to specific incentives to attract certain types of investors or investments. Tax concessions are also costly in revenue terms and they hamper economic efficiency. The introduction of tax preferences also makes it more difficult to reform the tax system since some of the concessions are of a contractual nature and can therefore not be taken away in a tax reform. A country entering a transitional period is therefore well advised to opt for a broad-based low rate tax system rather than introducing preferences and facing a difficult reform process later on.
Other Aspects of the Tax System
Although the cost of capital calculations capture key aspects of the tax system, a number of important features have been left out. One such feature is the treatment of losses. Most countries allow for carry-forward of losses to future years and some allow for carry-back to previous tax years. Restrictions usually apply to the time period during which losses may be carried over and sometimes also to the amounts which may be claimed. The provision of carry-forward of losses is especially important for countries in transition, where new areas of economic activity are opening up and private enterprises may incur initial losses in an uncertain investment climate.
Another important aspect of the tax system is the tax treatment of inventory. Some countries allow LIFO valuation, for instance Austria (if not contradicted by the facts), Belgium, Germany, Greece, Portugal, and the United States. In a period of rising prices, the cost of supplies is higher, and therefore net income lower, under LIFO than under FIFO, and hence LIFO results in lower taxes. It is, however, beyond the scope of this study to assess the impact of inventory evaluation on the user cost of capital.
Perhaps the most important factors for the investment environment in economies in transition are, however, overall macroeconomic conditions and the stability and transparency of rules and regulations. The tax system can contribute to this by allowing general rather than specific provisions, thereby ensuring that the revenue base is not eroded, which inevitably leads to destabilizing tax changes in the future. Also, the tax system, as well as other regulatory provisions, should be transparent in the eyes of the investor, with no scope for a negotiated settlement of tax liabilities, as was the practice formerly in centrally planned economies. Once the institutions are established and markets are integrated the tax system may play an increasing role in the ability of these countries to attract capital and to promote adequate domestic levels of saving and investment. If domestic savers bear a relatively heavy tax burden, more investment is financed abroad and a larger share of the capital stock is owned by foreigners. Furthermore, if saving and investment decisions are influenced to a large extent by tax considerations, the resulting low level of savings reflects an inefficient allocation of resources.
Conclusions
The opening up of markets in formerly centrally planned economies could result in increased worldwide competition for capital. A central question is to what extent the tax system should contribute to a favorable investment climate. Some countries have chosen to offer a variety of tax concessions, especially to foreign investors, while maintaining a relatively large tax burden for domestic investors. From the points of view of revenue and efficiency, it would be better to introduce a uniform, stable, and transparent tax treatment of all investors. However, the cost of capital calculations undertaken in this study serve to illustrate the need for further tax reform in countries such as Poland and Hungary, to achieve a more efficient allocation of resources and a more competitive tax system. Since many others of the economies in transition are in a similar situation, these tax policy suggestions may be applicable to other countries as well.
Economies in transition should adopt realistic and simple capital cost recovery allowances (in line with economic depreciation), and some kind of loss carryover provision should be allowed. Further, consideration could be given to lower statutory tax rates as permitted by revenue constraints, and to indexation of both assets and liabilities for tax purposes, so as to reduce the distortionary bias of high rates of inflation in favor of debt-financed investment in short-lived assets (including inventories) and against equity-financed longer-lived fixed assets. The alternative approach, followed in certain countries of lowering investment costs by providing up-front investment grants or the reliance on tax holidays, is to be avoided. It creates distortion between different types of investments and forms of businesses and ownership. Valuable resources would be spent on tax planning rather than making appropriate market decisions and the allocation of resources would be distorted.
The administrative and institutional constraints in economies in transition are such that a complex tax system with special treatment for different investors, sources of finance, or investment projects should be resisted. The use of tax preferences results in vast resources being used to inform the public and control details on tax forms, and expensive staff time is spent on assessing whether a taxpayer qualifies for special treatment. It is important to use available tax inspectors for audits and on site inspections to assess whether revenue and cost figures are reasonable. The credibility of the tax system will to a large extent depend on how it is enforced. The expansion of the private sector with many new private entrepreneurs and small businesses presents a particular problem which would be greatly exacerbated by detailed and complex tax rules. Furthermore, as international experience shows, incentives can easily proliferate, are very difficult to target, and result in revenue erosion. The formerly centrally planned economies should therefore carefully consider whether a simplified broad-based tax system with relatively low rates is not better suited for their economic development than preferential tax treatment for various investors.
Appendix Assumptions in the Calculations of the User Cost of Capital
The calculations11 presented below focus on portfolio investment by a “typical European investor” (undertaken by individuals or institutions). Such investment is likely to be more sensitive to the after-tax rate of return than direct investment.12 The study examines the minimum gross rate of return necessary for an investment to yield a given uniform after-tax rate of return. The corresponding tax wedges for both an equity-financed and a debt-financed investment are presented for investment in machinery.
As an illustration, it is assumed that the expected rate of inflation is equal across countries while the nominal interest rate is endogenous, so as to accommodate effective tax rate differentials. Thus, the nominal interest rate is calculated so that investments yield the same after-tax real rate of return to the investor irrespective of the country in which he invests. This assumption enables us to highlight differences in the required gross rate of return to yield a given real net rate of return.13 It is assumed that the investor receives the same after-tax real rate of return on a debt-financed investment and on an equity-financed investment, thus ignoring the presumed higher risk associated with equity financing. The fraction of new shares in an equity-financed investment is assumed to be 10 percent in all countries. This assumption means that taxes levied on dividends are relatively unimportant since 90 percent of an equity-financed investment is assumed to be in the form of retained earnings. Increasing the share financed by issuing new equity (which is equivalent to assuming a higher dividend payout ratio), the overall level of taxes on equity capital would be higher.14
The investor is assumed to face the same home country tax liability irrespective of the country in which he invests. The tax rate on dividend income is assumed to be 20 percent, equal to the tax rate on interest income. The accrued capital gains tax rate is assumed to be 8 percent, the same as the capital gains tax rate on exchange gains and losses.15 These tax rates chosen are broadly in line with marginal tax rates faced by a typical European investor. In practice, an infinite number of investment channels exist, resulting in a wide range of marginal tax rates. Although each investor would have different tax rates and his particular profit or loss situation (including income from other sources) may also influence his effective tax rate, the intent is only to present a broad view of the effects of the tax systems on investment, and not to evaluate the precise tax implications for any particular investor.16
It is assumed that the investor has a sufficient home country tax liability to credit foreign withholding taxes. Furthermore, integration of corporate and personal taxes have only been taken into account in those cases where such integration extends to a foreign investor. Economic depreciation is assumed to occur at a constant geometrically declining annual rate of 15 percent. Depreciation for tax purposes has been incorporated explicitly, including the extent to which depreciation is allowed during the year of purchase.17 The generosity of investment grants has decreased in all of the countries and only Spain among the countries considered still allows for a general investment grant. Almost all the countries in the sample allow for accelerated rates of tax depreciation or investment grants for specific types of investments or investments in certain regions. These industry-specific and regional provisions have not been included in the study.
In Table 1, five tax wedges are presented: the corporate tax wedge; the withholding tax wedge; the resulting host tax wedge; the home tax wedge; and the total tax wedge. The required pre-tax real rate of return, which consists of the cost of finance, p, gross of the economic rate of depreciation, δ, and the real rate of return after all taxes, s, are also presented. The tax wedges are calculated as the difference between the before- and after-tax rate of return. A negative number indicates a net subsidy through the tax system. Table 1 also provides a summary of the different countries’ tax systems.
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For a survey of different models for tax policy, see Pereira and Shoven (1988).
The impact of dividend taxation on the cost of capital depends on which view on dividend taxation is believed to be most relevant. According to the “new” view of dividend taxation, assuming that corporations generally adopt profit retentions rather than new share issues as the marginal source of equity finance, dividend taxes do not distort investment decisions and amount to a lump-sum tax on existing rather than new capital. According to the “old” view of dividend taxation, dividend taxes do matter since new share issues are assumed to be the marginal source of equity finance. It is an empirical question which view more closely resembles corporate behavior, See Sinn (1987 and 1990).
See, for example, King and Fullerton (1984).
The expression for p is derived from the equality between the after-tax marginal benefit and the marginal cost of an investment project: (1 − tc)(p + δ) = (1 − k − tc × z) (τ − π + δ). Therefore p = (1 − k − tc × z) (τ + δ − π)/(1 − tc) − δ where tc = statutory corporate tax rate, k = investment grant, z = present value of depreciation allowances, τ = nominal discount rate, δ = economic rate of depreciation, π = expected rate of inflation, and p= required before-tax real rate of return.
The rate of depreciation used for Hungary is 12 percent. The average rate of depreciation for investment in machinery may be as low as 6.5 percent. This would make the total tax wedge for Hungary considerably larger.
This is a feature shared by almost all formerly centrally planned economies. See the paper on Income Tax Reform by Leif Muten in this volume.
This aspect of the tax system should not be underestimated. During the 1970s and 1980s, high income earners in Sweden made such extensive use of deductions for interest payments that the government would have raised more revenue by not taxing capital income at all. Low-income earners reported taxable capital income while high-income earners invested in low-taxed or tax-exempt assets while fully deducting interest payments on loans taken to finance these investments. See Andersson (1987).
A Canadian study evaluating an investment tax credit for the Cape Breton Island found that a generous three-year tax credit of 60 percent generated only $75 of investment for every $100 of government revenue cost. See Canadian Department of Finance (1990).
For a more detailed description of assumptions, see Andersson (1991 b).
It can be argued that decisions to undertake direct investment are also influenced by market strategies and long term planning.
Real after-tax rates of return are not necessarily equalized across countries. Nevertheless, the assumption serves to illustrate the size of the tax wedges when a common requirement is made on the net rate of return.
For a discussion of factors influencing the dividend payout ratio, see Andersson (1991a).
Capital gains are normally taxed upon realization and not as they accrue. The accrued capital gains tax rate has been calculated from the statutory capital gains tax rate, and by assuming a rate of realization of 10 percent of the gains per year. The accrued capital gains tax rate is, in present value terms, assumed equal to the capital gains tax upon realization.
Given the assumption that the investor faces the same home tax country liability irrespective of the country in which he invests, the chosen tax parameters are of little practical significance when evaluating relative investment incentives across countries.
The so-called first year convention may have a relatively large impact on the cost of capital since a larger depreciation in the first year is worth more in present-value terms than a deferred depreciation allowance.