Box 1. Effective marginal and average tax rates
Corporate income tax reforms and international tax competition
Article first published online: 4 OCT 2002
Volume 17, Issue 35, pages 449–495, October 2002
How to Cite
Devereux, M. P., Griffith, R. and Klemm, A. (2002), Corporate income tax reforms and international tax competition. Economic Policy, 17: 449–495. doi: 10.1111/1468-0327.00094
Consider a simple one period investment, in which a firm increases its capital stock for one period only. It does so by increasing its investment by 1 at the beginning of the period, and reducing it by 1 −δ at the end of the period, where δ represents economic depreciation. The higher capital stock generates a return at the end of the period of p +δ, where p is the financial return. The discount rate is r. Ignore inflation.
One unit of capital generates a tax allowance with a net present value (NPV) of A. So introducing tax reduces the cost of the asset to 1 −A, while the saving from the subsequent reduction in investment becomes (1 −δ)(1 −A). The total return p+δ is taxed at the tax rate τ.
The NPV of the investment with tax is therefore:
The cost of capital is the value of p, denoted p̃, for which the investment is marginal, i.e. R= 0. The effective marginal tax rate (EMTR) is (p̃ − r)/p̃.
We define the effective average tax rate (EATR) – for a given value of p– to be the NPV of tax payments expressed as a proportion of the NPV of total pre-tax capital income,
V* =p/(1 +r).
This is comparable to other commonly used measures of the average tax rate. For a marginal investment, EATR = EMTR. For a highly profitable investment, EATR approaches τ.
The cash flows are slightly different in the case of debt-financed investment, but the concepts of the EMTR and EATR are unchanged.
- Issue published online: 4 OCT 2002
- Article first published online: 4 OCT 2002
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