International Comparison of Corporate Income Taxes, Consumption Taxes, and Capital Formation
To further the discussion as the 104th Congress debates incremental changes to the federal tax code-including a capital gains tax rate reduction, the phaseout of the corporate alternative minimum tax (AMT), and Individual Retirement Account expansion-the ACCF Center for Policy Research has prepared the following report. Interest in major tax restructuring, such as the Unlimited Saving Allowance Tax proposed by Senators Sam Nunn and Pete Domenici, Majority Leader Dick Armey’s flat tax, and others, is also growing. Given the interest in tax restructuring, it is all the more critical to examine U.S. tax policy to encourage new investment.
Investment and Economic Growth
Investment spending in the United States in recent years compares unfavorably with that of other nations as well as with our own past experience. From 1973 to 1992, gross nonresidential investment as a percent of Gross Domestic Product (GDP) was lower for the United States than for any of our major competitors (see Figure 1). Even more disturbing is the fact that net annual business investment in this country has in recent years fallen to only half the level of the 1960s and 1970s. Net private domestic investment averaged 7.4 percent of GDP from 1960 to 1980; since 1991 it has averaged only 3.0 percent.
The overwhelming importance of investment in plant and equipment for economic growth is emphasized in Harvard Professor Dale Jorgenson’s new book, Productivity: Postwar U.S. Economic Growth. This study analyzed economic growth between peaks in the business cycle over the 1948-1979 period.1 Allocating increases in output to three sources-growth in the capital stock, labor supply, and multifactor productivity-Professor Jorgenson found that increases in the capital stock had the strongest impact on growth in output.
Studies by Harvard Professors Bradford De Long and Lawrence H. Summers, now on leave at the U.S. Department of Treasury, concluded that investment in equipment is perhaps the single most important factor in economic growth and development.2 Their research provided strong evidence that for a broad cross section of nations, every 1 percent of GDP invested in equipment is associated with an increase in the GDP growth rate itself of one-third of one percent-a very substantial social rate of return.
Investment’s key role in advancing technological progress and productivity growth is also stressed in recent research by New York University Professor Edward N. Wolff.3 He argued that U.S. labor productivity growth rates are depressed by the recent slower growth in the capital-to-labor ratio-from a peak of 2.0 percent per year in the 1950s to 1.2 percent per year in the 1972-1992 period. Professor Wolff emphasized that the effects of the decline in U.S. capital-labor growth are perhaps even more pernicious than they appear at first glance. First, an increasing capital-labor ratio will increase labor productivity through capital deepening. Second, there appears to be an important and significant interaction effect between capital investment and technological advance.
U.S. manufacturing productivity growth lagged behind that of most major industrial countries over the 1979-1993 period. Labor productivity, or output per worker per hour, grew at only 2.4 percent in the 1979-1993 period compared to 4.3 percent in Japan and Belgium, and 4.1 percent in the United Kingdom (see Figure 2). Lagging U.S. labor productivity growth is a concern because of its role in helping to increase real living standards for U.S. workers.
Taxation of Investment
The user cost of capital is the pretax rate of return on a new investment that is required to cover the purchase price of the asset, the market rate of interest, inflation, risk, economic depreciation, and taxes. This capital cost concept is often called the “hurdle rate” because it measures the return an investment must yield before a firm will be willing to start a new capital project.
Economists are in broad agreement that capital costs are affected by tax policy. For example, John Shoven, Stanford’s Dean of the College of Arts & Sciences, estimated that in the U.S. about one-third of the cost of capital is due to taxes. In other words, hurdle rates are 50 percent higher than they otherwise would be due to the tax liability on the income produced by the investment. Thus, the higher the tax on new investment, the less investment that will take place.
Several measures show that the United States taxes new investment more heavily than most of our competitors. For example, according to a study by the centrist Progressive Foundation, the “think tank” affiliate of the Progressive Policy Institute, the marginal tax rate on domestic U.S. corporate investment is 37.5 percent, exceeding that of every country in the survey except Canada (see Figure 3). The tax rate calculations include the major features of each country’s tax code, including individual and corporate income tax rates, depreciation allowances, and whether the corporate and individual tax systems are integrated.
Tax rates on outbound investment, which are indicators of how much encouragement domestic firms are given to enhance their economic viability by expanding their operations abroad, again show the United States falling behind. The U.S. tax rate is 43.2 percent, substantially higher than Germany’s 25.4 percent and the United Kingdom’s 27.5 percent (see Figure 4).
Taxes on machinery and equipment investment, which Drs. De Long and Summers conclude are major factor in economic growth, are higher in the United States than in other industrialized countries (see Figure 5). Research by Professor Jorgenson shows that the United States taxes new investment in machinery at 18.5 percent, compared to 8.8 percent in Japan and 8.0 percent in the United Kingdom.4 Tax rates on machinery investment are negative in Italy, France, and Sweden due to generous capital cost recovery allowances.
Prior to the 1986 Tax Reform Act (TRA), the United States had one of the best capital cost recovery systems in the world. For example, the present value of the deductions for investment in modern and competitive continuous casting equipment for steel production under the strongly pro-investment tax regime in effect from 1981 to 1985 was close to 100 percent, according to a study by Arthur Andersen & Co.5 In contrast, under current law the present value of the capital cost recovery allowance for that same investment today is only 81 percent for a corporation paying the regular income tax. And if a corporation is subject to the corporate AMT, as many major steel companies are, the present value is only 59 percent (see Table 1).
The Arthur Andersen study also shows that the United States lags behind many of our major competitors in capital cost recovery for equipment that is technologically innovative, is crucial to U.S. economic strength, or helps prevent pollution. Capital cost recovery provisions for pollution-control equipment are much less favorable now than prior to TRA’s passage. For example, the present value of cost recovery allowances for wastewater treatment facilities used in pulp and paper production was approximately 100 percent prior to TRA. Under regular TRA income tax, the present value for wastewater treatment facilities dropped to 81 percent; for AMT payers the figure became 63 percent. Scrubbers used in the production of electricity fared even worse. Prior to TRA, the present value was only 55 percent; for AMT payers the figure dropped to 42 percent. As is true in the case of productive equipment, loss of the investment tax credit and lengthening of depreciable lives both raise effective tax rates.
U.S. manufacturing industries face higher marginal corporate tax rates than does manufacturing in other countries, according to Professor Jorgenson. New investment in the U.S. manufacturing sector faces a marginal tax rate of 34.0 percent, compared to 6.7 percent in Japan and 5.2 percent in Germany (see Figure 6). Italian and French manufacturers enjoy negative tax rates (subsidies) due to incentives for equipment purchases.
Capital Gains Taxes
To those who favor a truly level playing field over time for individual and business decisions to save and invest, stimulate economic growth, and create new and better jobs, capital gains (and other forms of saving) should not be taxed at all. This view was held by top economists in the past and is held by many mainstream economists today.
This is primarily because the income tax hits saving more than once-first when income is earned and again when interest and dividends on the investment financed by saving are received, or when capital gains from the investment are realized. The playing field is tilted because the individual or company that saves and invests pays more taxes over time than if all income were consumed and no saving took place. Taxes on income that is saved raise the capital cost of new productive investment for both individuals and corporations, thus dampening such investment. As a result, future growth in output and living standards is impaired.
Capital gains tax rates, both individual and corporate, and tend to be higher in the United States than in many of our competitor countries, thereby raising U.S. capital cost. While the statutory capital gains tax rate for U.S. individuals is 28 percent, the effective rate is 31.3 percent due to the phaseout of exemptions (assuming a family of four) (see Figure 7). Only the United Kingdom has a higher rate on portfolio securities than the United States, and U.K. residents are allowed to index their assets for inflation. Corporate capital gains rates in the United States are higher than in most other countries surveyed (see Figure 8). In addition to the countries listed in Figure 8, Belgium, Sweden, The Netherlands, Hong Kong, Malaysia, Singapore, South Korea, and Taiwan have lower (or no) taxes on individual capital gains than does the United States. All of the above countries tax corporate capital gains at a lower rate than the United States (with the exception of The Netherlands and Indonesia).
The United States ranks in the middle for corporate taxes as a percent of total government tax revenues (see Figure 9). Although the United States does not raise as large a share of tax revenue through corporate taxes as do some other industrialized countries, it does tax new investment and saving more harshly than most (see Figures 3-8).
Most countries tax consumption more heavily than does the United States. For example, consumption is taxed at an average rate of 22.1 percent in Germany and 14.6 percent in Canada, compared to only 6.2 percent in the United States (see Figure 10). Other countries also derive a much larger share of their total tax revenue from taxes on consumption. The average for the other G-7 countries is 26 percent, compared to 16.8 percent in the United States, according to the Progressive Foundation report.
The United States’ marginal tax rates on investment and equipment exceed that of all other countries in the survey even without factoring in the AMT. Inclusion of the AMT would raise the U.S. tax rate even higher under reasonable assumptions regarding debt finance and interest rates. Many analysts conclude that our relatively low rate of business investment is directly related to high U.S. taxes on new investment. Although the correlation between manufacturing productivity growth and low tax rates on new investment among the G-7 countries is not always perfect (e.g., Germany has lower taxes on investment than does the United States, yet has somewhat slower manufacturing productivity growth [1.9 versus 2.4 for the United States over the 1979-1993 period]), for the remainder of the G-7 the relationship holds.
While the differences in investment rates between the United States and most other countries surveyed may seem small, even a one percentage point increase in annual investment will have a significant impact on a country’s capital stock after fifteen to twenty years. Finally, the United States taxes consumption at a much lower rate (6.2 percent in 1991) compared to an average of 22.1 percent in other G-7 countries. Clearly, the first priority for U.S. tax reform should be a reduction in the taxation of saving and investment.
- Jorgenson, Dale, Productivity: Postwar U.S. Economic Growth (Cambridge, Mass.: MIT Press, 1995).
- J. Bradford De Long and Lawrence Summers, “Equipment Investment and Economic Growth,” Quality Journal of Economics 106:445-502.
- Edward N. Wolff, “Capital Formation and Productivity Growth in the 1970s and 1980s: A Comparative Look at OECD Countries,” in Tools for American Workers: The Role of Machinery and Equipment in Economic Growth. (Washington, D.C.: ACCF Center for Policy Research, December, 1992) pp. 46-76.
- Jorgenson, Dale, “Tax Reform and the Cost of Capital: An International Comparison,” Tax Notes International, April 19, 1993.
- Stephen R. Corrick and Gerald M. Godshaw, “AMT Depreciation: How Bad Is Bad?” in Economic Effects of the Corporate Alternative Minimum Tax (Washington, D.C.: American Council for Capital Formation Center for Policy Research, September 1991); and unpublished data incorporating the AMT provisions of OBRA 1993. Updated by Arthur Andersen LLP, Office of Federal Tax Services, Washington, D.C., January 1995.