Instruments for the Measurement of Effective Tax Burdens of Companies Based on the Neoclassical Investment Theory (King/Fullerton and Devereux/Griffith)
Besides the European Tax Analyzer, instruments for the measurement of effective tax burdens based on the neoclassical investment theory are also available at the ZEW. On the one hand, this contains the approach developed by King and Fullerton, internationally well-known since 1984, and, on the other hand, the extended approach by Devereux and Griffith which was published in 1999.
These models take into account the most important rules of the national tax laws and the international tax treaties. Especially, the models consider tax rates of profit and capital taxes at the company and at the shareholder level, capital allowances, and valuation rules. In the case of cross-border investments the rules for withholding taxes and the methods for avoidance of double taxation are also included. Additionally, the national integration of the corporate income tax into the income taxation of individuals can be considered.
On the basis of these neoclassical investment theory approaches, we can estimate costs of capital, effective marginal tax rates and effective average tax rates for investment projects in an existing or proposed jurisdiction:
- Costs of capital denote the minimum pre-tax rate of return, which an investment must earn in order to still be realized by an investor.
- Effective marginal tax rates indicate the effective tax burden on a marginal investment which displays a low profitability.
- Effective average tax rates indicate the effective tax burden on a profitable, inframarginal investment.
Considering the assumptions of the neoclassical investment theory, the models assume an additional investment of a company and measure the variance of the investor's economic key figures, like the net present value and the rate of return, caused by taxation. We use two different ways to compute these indicators:
Calculation of the Effective Marginal tax Rate
For the calculation of the effective marginal tax rate, the post-tax net present value of the investment is set as zero and consequently the necessary rate of return, e.g. the cost of capital, is computed. Assuming decreasing marginal rates of return and infinitely separable investments, the capital stock should increase as far as the last capital unit earns still its costs of capital, and thus it obtains a net present value of zero.
Firstly, a statement is possible about the optimal investment level of a project, for example at a certain location or of a certain type of asset. The higher (lower) the costs of capital are, the lower (higher) is the theoretical optimal investment level.
Secondly, we can analyze distortions of financial decisions caused by taxation. Differences between the costs of capital indicate which kind of finance is more favorable or more expensive if we consider taxation.
Thirdly, we can analyze tax induced distortions of competition: The costs of capital are an indicator for the lower limit of selling prices. If two companies with different costs of capital compete in one market, the company with the lower cost of capital can supplant the other company because it is able to decrease the selling price below the lower price limit of the other company.
Calculation of the Effective Average tax Rates
For the calculation of the effective average tax rates, we fix the pre-tax rate of return of an additional investment and then we compute the post-tax net present value. A company should realize that investment, whose post-tax net present value is the highest one. If only investments with negative post-tax net present values exist, no investment should be realized. Such kinds of decisions concern the choice between two or more mutually exclusive projects, which display economic rents, e.g. a positive net present value. Examples for such decisions are the choice, where to locate a company, or the choice of a technology.
In cooperation with the chairs of taxation at the University of Mannheim (Prof. Dr. Ulrich Schreiber and Prof. Dr. Christoph Spengel) the ZEW performs analyses of the attractiveness of locations, of investment incentives, and of the systematics of existing and proposed tax systems on the basis of these approaches. The models are also used for further research reports.
We are constantly enhancing the models, both conceptually and the software systems. Recent developments in the area of international taxation such as IP Box regimes and international holding structures have been integrated. The results serve also as a data base for empirical studies about economic effects of taxation in national or international contexts. Since 1999 the members of our research teams have produced various publications based on these data.