President

able to defer $35 of tax liability for 1 year. The value to the firm of deferringthe tax until next year is $1.75 (5 percent of $35). However, next year, thefirm must pay $3.50 in additional taxes. Thus, the firm has effectively paid atax of $1.75 (the $3.50 of additional taxes minus the $1.75 value of deferral),which represents a tax of 35 percent on the $5 supra-normal return. Note thattaxing the supra-normal return does not result in any distortions, because thefirm’s decision to undertake the investment does not depend on the tax. Ifthe normal return were instead 10 percent, then the deferral of tax would beworth $3.50 to the firm, and there would be no effective tax on the investmentreturn. In contrast to expensing, a corporate tax rate cut lowers the taxon both normal and supra-normal returns.The efficiency of the business tax structure in the United States is particularlyimportant as other countries undertake major corporate tax reforms. Capitalis mobile across international borders, and the business tax environment isimportant in ensuring that the United States continues to attract investmentfrom abroad, and that U.S. firms can compete effectively in foreign countries.In the mid-1980s, the average statutory corporate tax rate (weighted byGDP) across OECD countries was 44 percent. The U.S. tax reform of 1986,which reduced the corporate tax rate from 46 percent to 34 percent, madethe United States a relatively low-tax country at the time of the reform. Sincethat time, however, the OECD-average corporate tax rate has fallen belowthat of the United States. These comparisons refer to statutory tax rates. TheUnited States has relatively generous accelerated depreciation provisions anda multitude of business-level exemptions and deductions that reduce thetax burden on investment below the statutory rate. However, the effectivemarginal tax rate on corporate investment is still high: compared to otherG7 countries (France, Germany, the United Kingdom, Canada, Italy, andJapan), the United States imposes an above-average marginal effective taxrate on corporate investment for domestic debt and equity holders in thetop individual income tax bracket. In contrast, the U.S. average corporate taxrate (the total amount of corporate taxes paid as a percentage of corporateoperating surplus) is low relative to other countries. This fact highlights theinefficiency and complexity of the corporate tax system. The marginal tax raterepresents the additional tax burden a firm faces when it undertakes a newinvestment; therefore, it is the relevant tax rate for new investment decisions.This distortion is larger in the United States than in other countries. Despitethe larger distortion, the corporate tax raises less revenue in the United Statesthan in other countries, as evidenced by the fact that the average tax rateis lower. The implication is that investment incentives could be improvedwithout a reduction in government revenue.Chapter 5 | 135