The tax reforms of the early 1980s substantially reduced the burden of taxation on capital income. However, these policy changes also heightened the discrepancies among tax burdens born by different types of capital. These discrepancies gave rise to concerns in Congress about the impact of tax-induced distortions on the efficiency of capital allocation. In the State of the Union address in January 1984, President Reagan announced that he had requested a plan for further reform from the Department of the Treasury, setting off a lengthy debate that eventuated in the Tax Reform Act of 1986. (Yun 1990) Congress has passed about 11 major tax laws between 1975 and 1993 to bring the federal budget into balance. The balanced budget was accomplished through significant tax increases in the 1980s, and there were five major revisions, including the landmark overhaul Tax Reform Act of 1986.
The tax wedge and the effective tax rate on corporate assets can be divided into two components — a component that can be attributed to taxation at the corporate level, and an additional component attributable to taxation at the individual level. This separation is useful in comparing effective tax rates with statutory rates. The effective tax rate on corporate assets is the sum of the effective corporate and individual tax rates.
Features of Tax Reform Proposals
Turning to features of tax reform proposals considered in the debate over the Tax Reform Act of 1986, it is observed that indexing capital consumption allowances for inflation requires a simple modification of our expressions for the cost of capital for non-corporate and corporate businesses. This modification involves adjusting the present value of capital consumption allowances for non-corporate assets and the corresponding value for corporate assets to permit these allowances to depend on inflation. Typically, these allowances are adjusted to reflect the change in the price of an asset between the time of acquisition and the time that capital consumption is deducted from income for tax purposes.
Indexing interest payments and interest income and indexing capital gains require modifications of our expressions for the cost of capital and the rate of return in corporate and non-corporate businesses and households. Similarly, the limitation of deductions for state and local taxes in defining taxable income at the federal level changes the expressions that have been derived. Finally, the introduction of a deduction for dividends paid by corporations into the definition of taxable income at the corporate level would alter our expressions for the cost of capital and the rate of return for the corporate sector.
By contrast with the corporate income tax, liabilities under the individual income tax are a steadily rising proportion of the income of each taxpayer. Accordingly, the individual income tax is progressive at both federal and state and local levels. State and local personal income tax payments are deducted from revenue in defining individual income for tax purposes at the federal level. The concept of the average marginal tax rate may be employed to summarize the progressive rate schedules for the individual income tax. Average marginal tax rates under the individual income tax can be estimated by assuming that the amounts of income subject to tax at various marginal rates will increase or decrease in the same proportion.
Estimation of Average Marginal Tax Rates
In order to estimate average marginal tax rates on individual income from debt and equity, alternative forms of legal ownership by individuals can be distinguished. This makes it possible to incorporate differences in the tax treatment of different types of income such as dividends and interest. The Tax Reform Act of 1986 has substantially reduced the former tax savings benefits of employee leasing, but for firms which lease employees for reasons of better benefits packages and more professional personnel administration, leasing remains a viable alternative. (Fullerton, 1987) Shifting the burden of personnel administration to a leasing firm provides opportunities for more productive time use, and access to a better benefits package may enable firms to attract better employees and to reduce turnover rates.
Tax Reform: Historical Background
The Tax Revenue Act of 1975 temporarily increased the regular credit from 7 to 10 per cent and the credit for eligible public utility property from 4 to 10 per cent. The temporary credit was to expire at the end of 1980, but the Revenue Act of 1978 made the 10 per cent credit permanent. Previously, the 10 per cent regular credit was allowed for assets with a useful lifetime of seven years or more, two-thirds for assets with a useful lifetime of five or six years, and one-third for assets with a useful lifetime of three or four years. ERTA made the 10 per cent credit available for personal property with five-year, ten-year, and fifteen-year tax lifetimes and other tangible assets such as elevators. It also increased the credit for property with a three-year tax lifetime to 60 per cent of the regular credit. The Tax Reform Act of 1986 resultantly revoked the venture tax credit for properties obtained after 31 December 1985.
Tax incentives have significant effects on the investment decisions of foreign affiliates. In particular, affiliates whose parents were eligible for foreign tax credits were hurt not helped, by the Tax Reform Act of 1986: investment by foreign affiliates with foreign tax credits fell more than 10% relative to U.S. firms. In addition, foreign affiliates appear to locate their borrowing–and, therefore, their interest deductions–in relatively high tax jurisdictions, a practice consistent with tax incentives: the 12 percentage point reduction in U.S. corporate tax rates in 1986 discouraged local borrowing by foreign affiliates, reducing their debt to value ratio by some 10 %.( Slemrod. 1997)
The Effects of 1986Tax Reforms on Domestic Investment
The predictions regarding the effects of tax reforms on domestic investment are intuitive. Increasing depreciation allowances and increasing the investment tax credit unambiguously reduce the firm’s cost-of-capital by reducing the after-tax cost of investments, and should therefore spur investment. Increasing the corporate tax rate, however, lowers the after tax benefit of additional investments and so reduces the incentive for domestic firms to invest in new capital.
The total tax liability for a foreign-owned firm depends on whether the parent corporation is taxed on its foreign earnings and, if so, whether the parent may claim a credit for tax payments made to the host government. (Maki, 1995) To clarify the important distinction between tax rates and tax base, the examples here also assume that profits from the U.S. affiliate are repatriated annually. In reality, parent corporations are not taxed on the earnings of incorporated foreign affiliates until the affiliates’ earnings are repatriated in the form of dividends. The ability to defer home country taxes lowers the present discounted value of the residual tax liability owed on foreign-source income. However, David Hartman shows, in his 1985 paper on tax policy and foreign direct investment, that because taxes owed on repatriation amount to a withdrawal tax on foreign investments, deferral should not alter a firm’s decision to invest or repatriate income. (Hartman, 1988)
TRA-86 Impact on Foreign Trade
If the foreign parent is eligible for foreign tax credits, its total tax liability will be the highest of the host country tax rate and the home country tax rate. The firm is said to have deficit foreign tax credits if creditable foreign taxes do not exceed domestic tax liability on foreign source income; this will typically happen if the home country imposes taxes at a higher rate than the host country. The firm has excess credits if creditable foreign taxes exceed the home country tax liability on foreign source income; in this case, the home country remands no additional tax payments from the parent with respect to the foreign source income. Hence, a parent with excess foreign tax credits is taxed as if the home country exempts foreign income from domestic taxation. For a foreign affiliate with excess foreign tax credits at home, the predicted effects of a tax reform will have the same direction, though not the magnitude, as for a domestic firm.
The effects of a tax reform on a foreign affiliate with deficit foreign tax credits are quite different. Changing the tax rate or the investment tax credit no longer affects the user cost-of-capital. Since the total tax liability is determined by the home country tax rate, changing these aspects of the host country tax code influences only the share of tax revenue received by each government, not the total amount paid by the firm (assuming that the tax reform does not shift the parent corporation from a deficit to an excess foreign tax credit position). Simply put, the presence of deficit foreign tax credits in the home country effectively insulates foreign-affiliated firms from changes in the tax rates or tax credits of the host country. (James, 1988) Scholes and Wolfson explain how the insulation potential of foreign tax credits could create a tax advantage to foreign investors: the Tax-Reform Act of 1986 increased tax payments by U.S. businesses, but foreign tax credit investors could have these higher taxes essentially refunded (through lower tax payments to their home governments). The resulting reduction in the foreign investors’ cost-of-capital, relative to that of U.S. investors, creates a tax advantage for foreign investors, and should encourage foreign investment in the United States.
This intuition is perhaps most easily illustrated with an example. Suppose that a company had $100 of taxable income in 1985, and faced a U.S. corporate tax rate of 46%. That company, regardless of the nationality of its principal shareholder, would pay $46 to the U.S. Treasury. After the corporate tax rate declined to 34% in 1988, the same company with $100 in taxable income would pay only $34 to the U.S. Treasury. (Henderson, 1987)
In 1988, this foreign owned firm would have a residual tax liability of $14.40 ($35 – $34 – $6.60). Although tax payments to the United States have gone down, the total liability of the firm remains $55, because the relevant tax rate for a firm with deficit foreign tax credits is the maximum of the tax rate imposed at home and abroad. Foreign affiliated companies with deficit foreign tax credits did not receive the same benefit from the tax rate reductions that purely domestic firms do. Of course, this also means that a foreign-owned firm will not see its tax bill increase when the United States raises its tax rate, either.
Tax Liability Enhancement Feature of TRA-86
From this example it would be simple to conclude that, because the TRA 86 increased the tax liability of domestic corporations, foreign corporations with deficit tax credits would not feel the extra bite from the tax-man in the same way that domestic corporations would. Although it is true that there is a one-to-one correspondence between increasing tax rates and increasing the tax base for purely domestic corporations, this correspondence falls apart when applied to deficit foreign tax credit firms. The weakness of the Scholes Wolfson hypothesis is in not recognizing that there are three distinct channels through which the government may raise tax payments: it may raise tax rates, reduce tax credits or lower depreciation allowances (or otherwise change the tax base). Foreign tax credits shelter firms only from the first two changes. Reducing depreciation allowances, by contrast, increases the firm’s taxable income in both the host and home countries, and so will increase the firm’s total tax liability and, therefore, its cost-of-capital. (Scholes &Wolfson, 1990)
Whether a particular tax reform will have a greater effect on domestic or foreign corporations depends on the magnitude and mix of tax policy instruments. A reform that merely changed tax rates or investment tax credits would have no effect on deficit foreign tax credit firms, but would affect domestic corporations. However, a reform that increased the speed at which firms can depreciate capital would affect both foreign and domestic firms. Moreover, because deficit foreign tax credit firms are likely to face a higher total tax rate than domestic corporations, innovations to depreciation allowances (the benefit of which depends on the tax rate at which allowances are deducted) are likely to have a larger impact on the foreign corporations than on the domestic corporations. (Harry, 1993)
In 1986, Congress reduced depreciation allowances and eliminated the investment tax credit (previously 10%) which had been applicable to purchases of new machinery and equipment. The Tax Reform Act of 1986 (TRA86) also reduced corporate tax rates; rates fell from 46% in 1986 to 40% in 1987 and finally to 34% in 1988. These changes work in opposite directions: less generous depreciation allowances and the loss of the investment tax credit raise the cost-of-capital, thereby discouraging investment; but lower corporate tax rates reduce the cost-of-capital, inducing firms to increase investment. Alan Auerbach shows in his 1987 article that the lower corporate tax rates introduced in TRA86 did not fully compensate firms for the reductions in depreciation allowances, so that, on balance, TRA86 increased tax payments. (Alan, 1987)
Scholes and Wolfson reasoned that, for foreign tax credit affiliates, the increase in tax payments to the U.S. government would be directly offset by lower home country tax payments, giving these foreign affiliates an advantage over domestic firms. However, foreign tax credits do not insulate firms from tax rule changes that increase taxable income. Hence, there is no ambiguity about the direction of the effect of TRA86 on affiliates from foreign tax credit countries. As long as their parents maintained deficit foreign tax credits, the home country corporate tax rate remains the relevant marginal rate: the reduction in the U.S. corporate tax rate had no effect on the firms’ total tax liability. Although foreign tax credits would spare foreign affiliates the increase in the cost-of-capital caused by the removal of the investment tax credit, these tax credits also prevent foreign affiliates from taking advantage of lower corporate tax rates; the only aspect of TRA86 that is relevant for foreign tax credit affiliates–the reduction in depreciation allowances–increases firms’ cost-of-capital.
Whether TRA86 created tax advantages for foreign tax credit affiliates some link to domestic or other foreign investors depends on the relative magnitude of the increases in the cost-of-capital. If there were no change in the investment tax credit, it is clear that the foreign firms would have been at a relative disadvantage. Both foreign and domestic firms were hit by the reduced depreciation allowances, but the domestic firms received compensation in the form of lower tax rates, a benefit that foreign tax credits would prevent foreign firms from sharing. So, for investment in plant and equipment, where the investment tax credit did not apply, the prediction is clear: foreign firms were placed at a relative tax disadvantage by the Tax Reform Act of 1986. For investment in assets where the investment tax credit was available, the picture is more complicated, since removal of the investment tax credit would increase the tax liability of domestic firms without affecting the foreign tax credit firms. Nevertheless, for reasonable assumptions about the mix of investments, the Tax Reform Act of 1986 would be expected to favor domestic corporations over corporations with foreign tax credits. Moreover, the relative effects should be larger for investments in machinery and equipment, where the changes in depreciation allowances are large.
Firms affiliated with foreign tax credit countries should increase their capital stock after 1981, relative to other affiliates and to domestic firms, and reduced their capital stock after 1986. The growth rates of machinery and equipment lend some credence to this view: in the middle period (1982-1986), foreign tax credit affiliates added to their machinery and equipment stocks faster than both the comparison groups–about 4% faster than domestic firms and at nearly twice the speed of exemption affiliates. After 1986, the situation reversed: foreign tax credit affiliates added to their machinery stock at only half the rate of other firms.
Consistent with the predictions in this analysis, foreign firms which were likely to have deficit foreign tax credits invested 10% more than their domestic competitors and nearly 16% more than other foreign corporations which did not have foreign tax credits in the aftermath of the tax reform act of 1981. After 1986, the sign pattern is reversed: foreign firms with access to deficit tax credits reduced their capital demands by more than 20% over and above the reductions taken by both domestic firms and foreign firms who did not have deficit foreign tax credits. These estimates suggest that the changes in depreciation allowances in 1981 and again in 1986 had a substantial impact on the growth of firms with access to deficit foreign tax credits relative to other U.S. corporations. In the first instance, the foreign affiliates received a competitive boost from U.S. tax policy. In the second case, however, the foreign firms were at a comparative disadvantage, and that is revealed in the reduced investment by foreign affiliates relative to other corporations.
The reality is that, outside the United States, foreign tax credit countries only impose these stringent anti-avoidance rules regarding income recalculation for investments in particular low tax locations. Foreign investments in the United States are exempt from these requirements. Thus, the foreign tax credits granted to affiliates operating in the United States can shield foreign investors from changes in the U.S. corporate tax rate, but can offer no protection from tax reforms that alter the definition of taxable income, such as the 1986 reduction in depreciation allowances.
In addition to lowering depreciation allowances, TRA86 lowered the corporate tax rate. The foreign tax credit firms with deficit foreign tax credits received no benefit from this tax reduction; however they did bear the burden of the depreciation rule changes. On balance, then, TRA86 created a competitive advantage for domestic investors and foreign investors who were not eligible for foreign tax credits. Firms affiliated with Japan and the UK, the two largest countries offering foreign tax credits, have grown about 12% more slowly than their competitors in wake of TRA86, ceteris paribus. Moreover, foreign tax credit firms’ investments in machinery and equipment have dropped almost 20% relative to those of their competitors. With respect to firms’ financing decisions, the estimated effect of differences in corporate tax rate on borrowing by foreign affiliates is significant: lowering the U.S. corporate tax rate by 10 percentage points, while holding foreign tax rates fixed, is associated with a 5% drop in the debt-to-value ratio of foreign affiliates in the United States. This is consistent with firms engaging in tax arbitrage–locating debt and therefore interest deductions in relatively high tax locations.
Much attention has recently been given to the low taxable income of foreign firms in the United States. Since the United States has become a low tax location relative to many other industrial countries, the tendency should be for firms to locate their borrowing in higher tax locations. Hence, recent efforts to prevent foreign firms from shielding taxable income by increasing borrowing in the United States are likely to be of limited consequence.
Alan J. Auerbach (1987), “‘The Tax Reform Act of 1986 and the Cost of Capital'”, Journal of Economic Perspectives, 1(1):73-86.
Fullerton Don and Gillette Robert, and Mackie James (1987), ‘Investment Incentives under the Tax Reform Act of 1986’, in Office of Tax Analysis, 131-72
Harry Grubert, Timothy Goodspeed and Deborah Swenson, “Explaining the Low Taxable Income of Foreign-Controlled Companies in the United States,” in Studies in International Taxation, Alberto Giovannini, R. Glenn Hubbard and Joel Slemrod, eds. (Chicago: University of Chicago Press, 1993).
Hartman, David “Tax policy and Foreign Direct Investment,” Journal of Public Economics 26(1), (1988): 107-121
Henderson Yolanda K., and Mackie James (1987), ‘Investment Allocation and Growth under the Tax Reform Act of 1986’, in Office of Tax Analysis, 173-202.
James R. Hines, Jr., “Taxation and U.S. Multinational Investment,” in Tax Policy and the Economy 2, Lawrence H. Summers, ed. (Cambridge, MA: MIT Press, 1988)
Maki, D.M. 1995. Household Debt and the Tax Reform Act of 1986. CEPR Policy Paper No. 436. Stanford University, Center for Economic Policy Research.
Scholes Myron S. and Mark A. Wolfson, Taxes and Business Strategy: A Planning Approach (Englewood Cliffs, NJ: Prentice Hall, 1990).
Slemrod. J and Auerbach, A.J: 1997, The Economic Effects of the Tax Reform Act of 1986, Journal of Economic Literature XXXV (2):589-632.
Yun Kun-Young: (1990), “‘Tax Reform and US Economic Growth'”, Journal of Political Economy, 98(5), 151-193.