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Congressional Budget Office (CBO)

 

TAXING CAPITAL INCOME: EFFECTIVE MARGINAL TAX RATE UNDER 2014 LAW AND SELECTED POLICY OPTIONS [18 December 2014]

http://www.cbo.gov/publication/49817?

or

http://www.cbo.gov/sites/default/files/cbofiles/attachments/49817-Taxing_Capital_Income_0.pdf

[full-text, 53 pages]

 

[excerpt]

The federal tax treatment of capital income affects investment incentives, both for the amounts invested and for allocations among assets. When tax rates are high, investors require higher before-tax rates of return and thus forgo investments with lower returns that they otherwise would have made. Current law produces significant variations in the taxation of capital income from different investments, thus leading investors to require higher before-tax rates of return on some investments than on others. Those differences reduce economic efficiency—the extent to which resources are allocated to maximize before-tax value.

An effective marginal tax rate (hereafter referred to as an effective tax rate or ETR) measures an investor’s tax burden on returns from an investment. An ETR combines a statutory tax rate with other features of the tax code (various deductions and credits, for example) into a single percentage that applies to before-tax capital income realized over an investment’s lifetime. (In this report, capital income consists of receipts minus the cost of goods sold, operating expenses, interest paid, and an allowance equal to the decline in value of capital assets because of economic depreciation—that is, wear and tear or obsolescence.) The higher the ETR, the greater the distortion in investments, holding all else equal; thus, the greater the variation (or nonuniformity) of ETRs among different investments, the less likely it is that resources will be used efficiently.

For this report, CBO estimated ETRs on income from marginal investments (those expected to earn just enough, after taxes, to attract investors) in such tangible capital assets as equipment, structures, land, and inventories (assets held for resale). In considering both corporate and individual taxation—but only with respect to the permanent features of federal income tax law in 2014—CBO arrived at the following conclusions:

·         The ETR on capital income is, on average, 18 percent;

·         The ETR on income from owner-occupied housing is close to zero; and

·         The ETR on capital income generated by businesses is, on average, 29 percent.

Contents

Summary 1

How Do Effective Tax Rates Differ Among Investments? 1

How Would Various Policy Options Change Effective Tax Rates? 3

The Taxation of Capital Income 4

Income of C Corporations 4

Income of Other Types of Business Entities 5

Income From Owner-Occupied Housing 5

Capital Income of Individual Investors 6

Measuring Effective Tax Rates on Capital Income 6

Estimating ETRs and Their Dispersion 7

Uses and Limitations of the ETR Framework 7

Simplifications of the Analysis 8

Effective Tax Rates Under Current Law 9

Business ETRs by Form of Organization and Source of Financing 9

Variation Among Business ETRs, by Asset Type 11

Variation Among Business ETRs, by Industry 13

ETRs on Owner-Occupied Housing 13

Policy Options for the Taxation of Capital Income 14

CBO’s Approach to Evaluating the Options 15

Options That Would Reduce the Tax on Capital Income 16

Options That Would Reduce or Eliminate Tax Preferences for Capital Income 19

Options That Would Narrow Specific Disparities Among Tax Rates Without

Changing the Overall ETR 23

Appendix A: CBO’s Methodology for Estimating Effective Tax Rates 27

Appendix B: The Sensitivity of Estimates of Effective Tax Rates to Certain Analytical Choices 37

Appendix C: Changes in CBO’s Estimates of Effective Tax Rates Since 2005 45

List of Tables and Figures 48

About This Document 49

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