Taxation and the Cost of Capital in Hungary and Poland: A Comparison with Selected European Countries

The effective rates of taxation faced by a representative investor located in a major capital exporting country for investments in machinery and buildings in nine capital importing European countries are compared. Poland and Hungary are found to have relatively high effective tax rates on equity-financed investment. The analysis suggests that both countries would benefit from streamlining allowances for capital cost recovery and possibly lowering statutory corporate tax rates—as permitted by the revenue constraint—rather than providing tax preferences for foreign investors.

Abstract

The effective rates of taxation faced by a representative investor located in a major capital exporting country for investments in machinery and buildings in nine capital importing European countries are compared. Poland and Hungary are found to have relatively high effective tax rates on equity-financed investment. The analysis suggests that both countries would benefit from streamlining allowances for capital cost recovery and possibly lowering statutory corporate tax rates—as permitted by the revenue constraint—rather than providing tax preferences for foreign investors.

Europe appears to be moving toward increased integration, leading to new investment opportunities. The opening up of markets in Central and Eastern Europe and closer cooperation within Western Europe could result in an unprecedented expansion of the European market. More integrated financial markets in Europe make the allocation of resources more sensitive to differences in national tax rates. Taxation of income from business activities, as well as taxation of financial flows across countries, is therefore receiving much more attention now than it did only a few years ago. In particular, initiatives are under way to harmonize indirect taxation, especially value-added taxes, and capital income taxation in the European Community (EC),1 with possible extension to European Free Trade Association (EFTA) member countries.

This paper compares the effective rate of taxation faced by a “representative” investor located in a major capital exporting country on a marginal investment in Hungary and Poland with an investment in seven other European countries: Austria, Finland, Greece, Ireland, Portugal, Spain, and Turkey.2 The paper assesses the need for tax reform in Poland and Hungary to achieve a more efficient allocation of resources and a more competitive tax system. By combining several different taxes and by incorporating tax provisions in a consistent way, the paper develops a framework that permits evaluation of the overall impact of taxes on the required rate of return on the last unit of fixed capital. An attempt is made to capture the effect of the tax system without incorporating the effect of other potential factors in the investment decision, such as the availability of a suitable labor force or the quality of infrastructure, or more important, the effect of differential risk. However, one section considers the broad interaction of the tax system with the macroeconomic environment.

The focus is on portfolio investment (undertaken by individuals or institutions), which is likely to be more sensitive to the after-tax rate of return than direct investment.3 The study examines the minimum gross rate of return necessary for an investment to yield a given uniform after-tax rate of return, and alternatively, the after-tax rate of return required by the investor under the actual interest rates and expected inflation rates prevailing in each host country. The corresponding tax wedges for both an equity-financed and a debt-financed investment are also presented. All calculations are performed separately for investment in machinery and buildings.

Three different scenarios are discussed. The first scenario assumes that nominal interest rates and expected rates of inflation are equal across countries. The focus is thereby entirely on the countries’ tax systems and not on the economic environment in which each system operates. In this case, the net real rate of return for the investor will vary across countries only on account of differences in the tax treatment in the host country. The second scenario retains the assumption that the expected rate of inflation is equal across countries, while making the nominal interest rate 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 or she invests. This assumption makes it possible to highlight differences in the required gross rate of return to yield a given real net rate of return.4

A third scenario stresses the interaction between the economic environment and the tax system by using actual interest rates and by making an approximation of the expected rate of inflation in each country. In all scenarios, the investor is assumed to receive the same after-tax real rate of return on a debt-financed investment as on an equity-financed investment, thus ignoring the presumed higher risk associated with equity financing. Furthermore, expectations about exchange rate changes are assumed to coincide with inflationary expectations.

I. Background

Corporate income taxes vary widely from country to country as does the taxation of individual and institutional investors. The general, almost worldwide, trend in the 1980s has been toward broader tax bases and lower tax rates (Table 1). Hungary and Poland were the first countries in Eastern Europe to reform their enterprise income tax systems, followed on January 1, 1991, by the former German Democratic Republic and the U.S.S.R. In Hungary, major tax reforms have been undertaken over 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. Poland, which also adopted a uniform enterprise income tax on January 1, 1989, is currently engaged in a general tax reform, and major changes in the tax system are expected. Both countries impose a statutory corporate income tax rate of 40 percent—a straight-line depreciation method for investments in machinery and buildings. Hungary provides a two-year loss carry-over for losses, while Poland does not allow for any carry-over.

Table 1.

Selected Countries: Corporate Income Tax Rates and Carry-Over Provisions

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Sources: International Bureau of Fiscal Documentation, Coopers and Lybrand, Price Waterhouse, and various national sources.Note: Combined national and local tax rates. Several countries have a split-rate or an imputation system, resulting in a lower tax rate on distributed profits (these include, among others, Germany, Greece, and the United Kingdom).

As a percent of taxable income.

Tax losses reflecting depreciation charges may be carried forward without any time limit.

Losses arising in the first five years of a new business are deductible until the end of the tenth year of business.

Tax losses reflecting depreciation charges may be carried forward without any time limit. Companies may elect a form of carry-back if in either the three preceding years or in the previous year the company realizes net investment in depreciable assets at least equal to the depreciation charged for those reference years.

The first DM 10 million of losses must be carried back for two years. There is no limitation on carry-forward of losses of the year 1985 or afterwards.

Since the statutory tax rate is only one component of the taxation of capital, for a comparison of the effective tax burden on investment income in different countries, it is also necessary to examine the definition of the tax base. Capital cost recovery allowances and investment grants vary substantially for different assets within a country as well as across countries. The tax treatment of financing costs, in particular the tax treatment of equity capital, also takes many forms. Furthermore, several countries have a lower effective tax rate on distributed profits in order to lessen the double taxation of dividends (see Andersson (1991)).

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 global income but limiting the foreign tax credit to the home 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.

In order to promote investment, many countries have introduced special tax preferences for foreign investors. As it turns out, investment tax credit, capital expensing, and accelerated depreciation are very effective in lowering the cost of capital, but as is well known in Western European countries, they may induce windfall gains to the investor and they tend to erode the tax base. Thus, since the proliferation of tax preferences undermines the tax system’s revenue-collecting capacity and may lead to allocative distortions, a careful examination is necessary before any such preferences are introduced. As they embark on tax reform, Central and East European countries have a golden opportunity to avoid the experience of Western European countries that made extensive use of investment tax preferences from the 1950s through the 1970s. Instead, these countries can opt for broader tax bases with low tax rates to limit national as well as international distortions in the allocation of resources and to protect their revenue base.

II. Taxation and the User Cost of Capital

A methodology has been developed to calculate effective tax rates taking into account a number of tax provisions, as well as some macroeconomic variables like interest rates and inflation rates (see, for example, King and Fullerton (1984), Alworth and Fritz (1988), and Devereux and Pearson (1989)). 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. Despite the simplicity of the concept, it does not give rise to a unique definition of the effective tax rate, since the measure depends on the chosen level of after-tax rate of return. Since a number of tax parameters are included in the calculations, but more important, because it represents the key price signal for investment decisions, the user cost of capital provides a more relevant base for comparing the relative incentive to invest than would a single tax parameter (for instance, the statutory corporate tax rate). The following section outlines some of the basic assumptions and relationships in the calculation of the user cost of capital.

The present study uses the methodology described above to derive effective tax rates.5 The essential concept used in the estimation of the tax rate on capital income is the 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; for equity financing, it amounts to the real return on equity (taking into account dividends and expected capital gains), before personal taxes. The total tax wedge, wt, can therefore be thought of as consisting of two parts:

wt=wc+wi=(pr)+(rs)=ps,(1)

where wc denotes the corporate tax wedge, and wi denotes the investor’s wedge.

When cross-border investments are considered, it is more useful to separate the total tax wedge into a tax wedge for the host country and a tax wedge for the home country. The host country levies not only corporate taxes but often withholding taxes on dividend and interest payments as well. The home country, in turn, either exempts or taxes these returns, typically subject to some form of double taxation relief.

From identity (1), effective tax rates can be derived:

en = wt/s

and

eg=wt/p,(2)

in terms of the after-tax rate of return and gross required rate of return, respectively.

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 burden:6

p=(1ktcz)(τ+δπ)/(1tc)δ,(3)

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

  • p = required before-tax real rate of return.

The company’s discount rate depends on the source of financing. If an investment is debt financed, debt-servicing costs are usually deductible when the corporate tax liability is calculated, thereby reducing the company’s financing costs. However, under the classical corporate tax system, no relief is given for investments financed by equity capital. Assuming that the tax is borne by the investor, the discount rate will therefore be higher in this case, and the present value of depreciation allowances, z, will therefore be lower, and the user cost of capital, correspondingly higher. The difference in financing cost between debt and equity financing will only decrease if an imputation system or some kind of split-rate system is applied. In general, the corporate tax system tends to favor debt financing, while taxation of capital gains at the level of the investor often leads to favorable tax treatment of the part of investment financed with retained earnings. The framework used in this paper makes it possible to incorporate these effects (including the difference in discount rate for different types of financing) and compare tax wedges for different sources of financing.

At the investor’s level, the taxation of dividend and interest income can differ. Hence, two rates of return need to be defined: one for equity-financed investment, and the other for debt-financed investment. Assuming that movements in nominal exchange rates reflect the inflation differential, the real after-tax rate of return on debt-financed investment can be expressed as

sd=(1m)(1w)φ(r+πhost)+ce(πhostπhome)πhost,(4)

where

  • m = marginal tax rate on capital income at the investor’s level

  • w = withholding tax rate

  • ϕ = parameter representing relief for (foreign) withholding taxes and/or corporate taxes

  • ce = capital gains tax rate on accrued exchange gains and losses.

For an equity-financed investment the real after-tax rate of return is

Se={α(1m)(1w)φ+(1α)(1c)}(μπhost)cπhost+cd(πhostπhome),(5)

where

  • α = fraction of real earnings on equity paid as dividends (or fraction of an equity-financed investment financed by new share issues)

  • μ = nominal return on equity before taxes at the investor’s level

  • c = tax rate on accrued capital gains.7

By imposing an arbitrage condition at the investor’s level, it is possible to calculate the tax wedges at the same after-tax rate of return on a debt-financed investment as on an equity-financed investment. Some studies include an exogenous risk premium on equity (see, for example, Feldstein (1986)). An alternative approach is to use observed price-earnings ratios on shares (see Boadway, Bruce, and Mintz (1987)). If the arbitrage condition is imposed at the corporate level, resulting in the same net cost for the firm regardless of the source of finance, the investor will typically receive a lower rate of return for an equity-financed investment than for a debt-financed investment. Clearly, the user cost of capital is affected by the applied arbitrage assumption.

From the above formulation of the user cost of capital, it is obvious that the concept of effective tax rate is limited in several respects: it considers only explicit taxes or subsidies on capital income; it ignores restrictions and nontax policies (for example, regulations);8 it is based on assumptions that tend to make the calculations of cost of capital static; it often does not take into account expected future changes in interest rates and tax rates; and it often abstracts from risks.

In many countries, the effective tax rate depends on the type of investment or investor. Some agents are even tax exempt or are able to influence the effective tax rate by elaborate tax avoidance schemes. Furthermore, the effectiveness of any tax system will ultimately depend on how it is administered and to what extent tax rules can be enforced. The user cost of capital therefore gives only a broad picture, and its measurement—particularly across different countries—should be interpreted with some caution. In general, the more complex the tax system and the larger the number of tax brackets and provisions, the more difficult it is to summarize the effective tax rate in one indicator. By the same token, a highly complex system is likely to be exploited by investors in different ways, and the variance of the effective rate may be so large as to render an average summary measure meaningless. A low effective tax rate at the margin in this case does not mean that investment decisions are not heavily influenced by taxes. At the same time, a complex tax system will lead investors to base investment decisions on gross yields—incorporating a significant “tax premium”—and then minimize tax liabilities ex post. These considerations are left out in a simple cost of capital calculation.

III. Assumptions

The double taxation of dividends and the difference in tax treatment for different forms of financing may affect incentives and create distortions. 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. For the corporate sector to attract capital from the noncorporate sector, double taxation of retained profits rather than distributed profits may be more important. According to Sinn (1987), a reduction of the corporate tax rate on retentions, a reduction of the personal capital gains tax rate, or an increase in the personal tax rate that applies to interest income shareholders can earn in the capital market are more efficient in affecting investment decisions than a reduction of the degree of double taxation of dividends. Applying the new view of dividend taxation, the fraction of new shares in an equity-financed investment is assumed to be 10 percent in all countries.9 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, if the “old” view of dividend taxation had been assumed) would raise the overall level of taxes on equity capital.10 The minimum required rate of return after all taxes is assumed to be equal for an equity-financed investment—excluding a risk premium—and for a debt-financed investment in a specific country. The corresponding tax wedges would be correspondingly larger, in a nonlinear way, if a risk premium had been included.

The investor is assumed to face the same home country tax liability irrespective of the country in which he or she invests.11 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 rate on exchange gains and losses. These chosen tax rates 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 each individual’s profit or loss situation (including income from other sources) might also influence his or her effective tax rate, the purpose of this study is to present a broad view of the effects of tax systems on investment, not to evaluate the precise tax implications for any particular investor.12

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 has 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 for machinery and 7 percent for buildings in all countries. Depreciation for tax purposes has been incorporated explicitly, including the extent to which depreciation is allowed during the year of purchase.13 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 and/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 Tables 2 through 7, 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 pretax 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 in the tables. 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 2.

Effective Taxation of Income from Investment in Machinery: Selected Countries, 1990

(With uniform interest and inflation rates)

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Sources: International Bureau of Fiscal Documentation, Coopers and Lybrand, Price Waterhouse, and various national sources.Note: Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value; corporate tax rate is expressed 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, a one-half-year deduction.

In addition to regular first-year depreciation.

Table 3.

Effective Taxation of Income from Investment in Buildings: Selected Countries, 1990

(With uniform interest and inflation rates)

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Sources: International Bureau of Fiscal Documentation, Coopers and Lybrand, Price Waterhouse, and various national sources.Note: Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value; corporate tax rate is expressed 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, a one-half-year deduction.

In addition to regular first-year depreciation.

Table 4.

Effective Taxation of Income from Investment in Machinery: Selected Countries, 1990

(With uniform inflation rate and after-tax rate of return)

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Sources: International Bureau of Fiscal Documentation, Coopers and Lybrand, Price Waterhouse, and various national sources.Note: Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value; corporate tax rate is expressed 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, a one-half-year deduction.

In addition to regular first-year depreciation.

Table 5.

Effective Taxation of Income from Investment in Buildings: Selected Countries, 1990

(With uniform inflation rate and after-tax rate of return)

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Sources: International Bureau of Fiscal Documentation, Coopers and Lybrand, Price Waterhouse, and various national sources.Note: Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value; corporate tax rate is expressed 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, a one-half-year deduction.

In addition to regular first-year depreciation.

Table 6.

Effective Taxation of Income from Investment in Machinery: Selected Countries, 1990

(With actual interest and inflation rates)

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Sources: International Bureau of Fiscal Documentation, Coopers and Lybrand, Price Waterhouse, and various national sources.Note: Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value; corporate tax rate is expressed 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.

In Turkey, assets are revalued for depreciation purposes. This has been taken into account in the calculations.

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, a one-half-year deduction.

In addition to regular first-year depreciation.

Table 7.

Effective Taxation of Income from Investment in Buildings: Selected Countries, 1990

(With actual interest and inflation rates)

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Sources: International Bureau of Fiscal Documentation, Coopers and Lybrand, Price Waterhouse, and various national sources.Note: Rates of return, tax wedges, tax depreciation rate, initial deduction, and investment credit are expressed in percent of asset value; corporate tax rate is expressed 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, a one-half-year deduction.

In addition to regular first-year depreciation.

IV. Results

Under the assumption that the nominal interest rate is 10 percent and the expected rate of inflation is 6 percent in all countries, differences in tax wedges only reflect differences in the various countries’ tax systems. Also, by definition, with a uniform inflation rate, there are no exchange gains and losses.

Uniform Interest and Inflation Rates

Table 2 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. 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.14 The same method is used in Austria, Greece, Portugal, and Spain; 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 important in present value terms for the user cost of capital. Ireland has 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.15

The results for Ireland deserve closer scrutiny. The low corporate tax rate contributes to a small subsidy at the corporate level for a debt-financed investment (the corporate tax wedge is only −0.67, compared to −1.88 in Hungary and −3.13 in Finland), and Ireland has the highest required rate of return on a debt-financed investment in machinery. Furthermore, in contrast to other countries, debt-financed investment ca