Investment Decisions and Tax Revenues Under an Allowance for Corporate Equity

Abstract

Die Discussion Papers dienen einer möglichst schnellen Verbreitung von neueren Forschungsarbeiten des ZEW. Die Beiträge liegen in alleiniger Verantwortung der Autoren und stellen nicht notwendigerweise die Meinung des ZEW dar.Discussion Papers are intended to make results of ZEW research promptly available to other economists in order to encourage discussion and suggestions for revisions. The authors are solely responsible for the contents which do not necessarily represent the opinion of the ZEW.Download this ZEW Discussion Paper from our ftp server:ftp://ftp.zew.de/pub/zew-docs/dp/dp0247.pdf Non-technical SummaryIn recent years, a number of European countries have relied on elements of an allowance for corporate equity (ACE) in the design of their tax systems. Making use of an allowance for corporate equity, firms may deduct an imputed rate of return -the so-called protective interest rate -on their equity for the determination of taxable income. Furthermore, a pure ACE-based tax system would be designed as a personal consumption tax. Income from interest payments at arm's-length-conditions would therefore be exempt from personal income taxation.The effective tax burden thus varies with the rate of return of an investment. This variation has an effect on the firms' cost of capital, i.e. the pre-tax rate of return at which an investor is indifferent between investing and not investing. Besides this minimum rate of return and the effective marginal tax rate (EMTR), which can be derived thereon, the prominent role of effective average tax rates (EATR) is more and more recognised in economics and business management. EATRs denote the effective tax burden on inframarginal investments, i.e. investments that earn more than the minimum rate of return.This paper investigates the basic effects of corporate tax systems which rely on an allowance for corporate equity on rates of return, EMTRs, and EATRs. By relying on a simple model, we show how neutrality with respect to investment decisions -which exists under some strict assumptions -is lost in case the protective interest rate deviates from the market interest rate.Also, we show how the relevance of the allowance for corporate equity decreases with an increasing rate of return. We conclude that a country might weaken its position in tax competition for very profitable investments by switching towards an ACE-tax, supposed the country cannot adjust headline tax rates to be in accordance with those of competing countries which have a broader tax base. These findings might theoretically explain why some countries have recently turned away from the ACE-concept.Besides, by relying on our model we can gain interesting insights into the revenue effects of an ACE-based tax system. We find that some robust revenues seem to be generated by combinations of low protective interest rates and medium statutory tax rates, which, however, should not exceed the statutory tax rates of competing locations. Investment Decisions and Tax Revenues Under an Allowance for Corporate Equity Lotha...

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