The Congressional Research Service (CRS) released a report (R48153) on 13 August 2024, examining tax rate differences by asset, sector, and source of finance. The report also evaluates the relative incentives for investment.
The Tax Cuts and Jobs Act (TCJA) made significant changes that impacted taxes on new investments. Some provisions enacted by the TCJA, such as a reduction in the corporate tax rate and five-year amortisation of research and experimentation costs, are permanent.
This report examines the differentials in tax rates by asset, sector, and source of finance, as well as the relative incentives for investment under four tax regimes:
- Current law under the TCJA in 2024;
- Law prior to the enactment of the TCJA in 2017;
- Law when the most generous provisions of TCJA were in place in 2018; and
- Tax law in 2027 when all temporary provisions will have expired, reflecting permanent tax law absent changes.
The report analyses tax rate differentials using the marginal effective tax rates (METR) concept, which estimates the share of the expected return from an investment that will be paid in taxes.
Marginal effective tax rates
Marginal effective tax rates account for the major features of the tax law that affect incentives to invest. The METR is the share of the return on the investment that is paid in taxes.
For example, if the after-tax return is 5% and the pretax return is 7.5%, the effective tax rate is a third, or 33.3% (7.5% minus 5%, divided by 7.5%). In other words, out of the pretax return of 7.5%, a third is paid in taxes, leaving a 5% after-tax return. Lower marginal effective tax rates tend to increase investment, all else equal.
The METR is calculated by comparing the pretax return on an investment with its after-tax return. The pretax return is the return necessary to pay taxes and to earn the required after-tax return necessary to compensate investors through returns to equity for owners and interest payments for creditors. The after-tax return is the break-even return on an investment for investors.
Expiring and delayed provisions in the TCJA
The TCJA (P.L. 115-97) made significant changes to the tax treatment of investment income starting in 2018. Some new provisions are permanent and took effect immediately, some provisions were temporary provisions subject to phaseouts, some were existing provisions in prior law that were phased out, and some new provisions are scheduled to expire after 2025. Most provisions reduced taxes.
These investment-related provisions included:
- Corporate and individual statutory tax rates;
- Expensing for equipment, software and research and experimentation;
- Non-corporate pass-through deductions;
- Production activity deductions;
- The standard deduction; and
- Limits on interest deductibility and itemised deductions for state and local taxes and mortgage interest.
While most of these provisions have a direct effect on the METR by changing the tax rate and deductions from business income, two have an indirect effect: the increased standard deduction and the dollar limit on itemised deductions for state and local taxes. These provisions reduce the number of individual taxpayers who itemise their deductions, and therefore make deducting mortgage interest and property taxes for investments in owner-occupied housing worthwhile for fewer households.
The Report evaluates METRs across these tax regimes, which are as follows:
- Broad asset types (equipment, intangibles, business structures, inventories);
- Equity-financed and debt-financed investments; and
- METRs by both economy-wide and sector-wide.
Effects on incentives to invest
The effect of tax changes on investment incentives is based on changes in the user cost of capital, also called the rental price of capital. This measure reflects all the costs of using depreciable assets: the after-tax rate of return, which is assumed to be common to all assets; taxes; and the decline in value as the asset is used up, or economic depreciation.
This measure could be thought of as the price that would have to be paid to rent the asset and is the price of capital inputs in the production process in the same way that wages are the price of labour inputs.
The Report ends by mentioning three general types of distortions brought on by tax provisions that affect the allocation of capital: differences across assets within a sector, differences across sectors, and the favourable treatment of debt finance compared to equity finance.
The effective tax rate calculations for the TCJA provisions indicate that the provisions continued to favour equipment and most intangible assets over structures, a longstanding feature of the tax law, although this favouritism was somewhat reduced with the end of expensing for research in 2022, and the phaseout for equipment, software, and public utility structures by 2027.
The Report mentions the favourable treatment of debt-financed investment over equity-financed investment was reduced by the corporate rate reduction and restrictions on interest deductions, both of which affect the value of the interest deduction.
Another potential distortion is the overall rate of taxes on savings in the economy.
The changes comparing 2017 to 2027 were small, 11.5% compared to 11.4%. Tax cuts are most effective in increasing investment by increasing direct investment subsidies rather than reducing tax rates since lower tax rates cause a gain for the return to preexisting capital.
However, preserving a full deduction for nominal interest while allowing expensing leads to negative effective tax rates on these investments.
