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Tax System

Tax systems encourage firms to use debt rather than equity finance, and more generally to economize on dividend payments to shareholders.

From: International Encyclopedia of the Social & Behavioral Sciences, 2001

Related terms:

Tax Revenue

Income Tax

Sales Tax

Corporate Taxation

Taxation Procedure

Revenue

Environmental Tax

Marginal Tax Rate

Tax Rate

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Taxation framework for private equity and fiscal impact for equity investors

Stefano Caselli, in Private Equity and Venture Capital in Europe, 2010

6.4.4 Taxation in Spain

The standard corporate tax rate in Spain is 30%, which may be reduced for SMEs. Dividend and capital gains are subject to this rate, even though the participation exemption rules or tax treaties may reduce the effective amount of tax. When applicable, tax exemption is equal to 100% and, to exploit all benefits, Spanish companies must hold a participation of at least 5% (or more than €6 million) and for at least 12 months. Incentives are available for investments and export activities, and the tax system allows companies to carry forward losses up to 15 years, but it does not allow carry back.

The withholding tax system is particularly complicated because of the presence of domestic rules, tax treaties, and EC directives that may reduce the applied rate. Generally, dividends4 and interest paid to non-residents are taxed at 18%, while royalties are taxed at a rate of 24% by law. There is also a branch remittance tax equal to 18%. The Spanish personal taxation system is based on a general progressive rate from 24 to 43%, and saving incomes, such as capital gains, are taxed at 18%. Taxation concerns only income and no net wealth or net worth tax is applied.

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Environmental Taxation and Regulation*

A. Lans Bovenberg, Lawrence H. Goulder, in Handbook of Public Economics, 2002

3.3.2.5 Inefficient factor taxation

If the initial tax system involves differences in the marginal excess burdens of various taxes, an environmental tax reform can boost private incomes by shifting the tax burden away from factors with high marginal excess burdens to factors with low marginal excess burdens [see Christiansen (1996), Bovenberg and Goulder (1997), and Goulder (1995a)]. The gross cost of a revenue-neutral environmental tax will be lower to the extent that:

(1)

in the initial tax system, the differences in marginal efficiency costs (of various tax instruments) are large,

(2)

the burden of the environmental tax falls primarily on the factor with relatively low marginal efficiency cost, and

(3)

revenues from the tax are devoted to reducing tax rates on the factor with relatively high marginal-efficiency cost.

These conditions ensure that the efficiency gains from shifting the tax burden from the overtaxed to the undertaxed factor are sufficiently large to offset the costs associated with a cleaner environment.

These considerations may be especially relevant for the mix between capital and labor taxation. Most applied general equilibrium models of the US economy suggest that, compared to taxes on labor income, taxes on capital income tend to produce larger marginal efficiency losses. The most direct way to improve the efficiency of the tax system as a revenue-raising device would be to finance a cut in capital taxes with higher taxes on labor. However, if the government does not want to adopt labor taxes, it can use environmental taxes that are primarily borne by labor30.

The suboptimality of the initial tax system raises the question why governments have not reformed their tax systems to deal with these inefficiencies. The efficiency rationale for such a tax reform is independent of environmental concerns. However, in some instances, political constraints (perhaps stemming from distributional concerns) may prevent the government from introducing strictly non-environmental tax reforms that enhance the efficiency of the tax system as a revenue-raising device. Under these circumstances, there may be advantages to introducing a package deal in which environmental taxes generate revenues that are used to eliminate particularly inefficient taxes. This combination of environmental and non-environmental tax reforms may be necessary to generate sufficient political support for either type of reform. In situations like this, environmental taxes are the lubricating oil that makes possible a tax reform to eliminate particularly "bad" taxes.

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Cross-Border Mergers and Acquisitions

Donald M. DePamphilis Ph.D., in Mergers, Acquisitions, and Other Restructuring Activities (Ninth Edition), 2018

Selecting the Correct Marginal Tax Rate

Global businesses generally pay taxes using either the worldwide or territorial tax regimes. The current worldwide or global tax system taxes businesses on income earned in their home country and on the income they earn in foreign countries. In contrast, the territorial tax system taxes income earned by both domestic and foreign firms operating within a country's borders only on what they earn in that country and excludes most foreign-earned income. That is, only profits earned by domestic and foreign firms in that country are taxed under the territorial tax system.

Multinational firms headquartered in countries with a worldwide tax system can be put at a significant competitive disadvantage to those incorporated in countries using a territorial tax system. For example, Proctor & Gamble and Unilever both sell soap worldwide but their profits are taxed quite differently. US based P&G has to pay taxes on its worldwide profits while Unilever pays taxes mostly in the United Kingdom and the Netherlands, where it has coheadquarters. Consequently, P&G is at a competitive disadvantage since its tax burden is significantly higher.

The US worldwide system taxes the domestic and foreign income of businesses with US headquarters. Businesses can claim a "foreign tax credit" for taxes that their foreign subsidiaries pay in other countries. This credit limits double taxation. Where the foreign tax rate exceeds the US rate, no US liability is generated. In the more common circumstances where the US tax rate is greater, US businesses owe a residual tax on their foreign earnings equal to the difference between the US tax rate (35% at the time of this writing)39 and the tax that their subsidiaries paid in the foreign country where they earned the income.

Instead of a pure territorial system, most countries use an exemption system under which foreign income is mostly exempt from taxation. The exemption is generally 95% of foreign earnings. Consequently, most foreign firms pay only a small token tax if they bring their after-tax profits back to their home country. US firms must pay the difference between the US tax rate and the tax that they have already paid. For example, French and US firms investing in Ireland pay a corporate tax of only 12.5%. The French firm can then repatriate its after-tax profit to France by paying 5% on those repatriated profits. The US firm has to pay an effective marginal tax rate of 22.5% equal to the difference between the US 35% corporate tax and the 12.5% Irish tax. The huge difference provides a major incentive for US firms to retain foreign earned profits outside the United States.

The selection of the right marginal tax rate for valuation purposes thus depends on where most of the taxes are actually paid. If the acquirer's country exempts foreign income from further taxes (or applies only a token tax rate) once taxed in the foreign country, the correct tax rate would be the marginal tax rate in the foreign country because that is where taxes are paid. If the marginal tax rate in the acquirer's country is higher than the target's country rate and taxes paid in a foreign country are deductible from the taxes owed by the acquirer in its home country, the correct tax rate would be the acquirer's marginal effective tax rate. That is, the difference between the acquirer's marginal tax rate in its home country less the tax rate paid in a foreign country.

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Economic Growth and Income (Re)distribution

Rongxing Guo, in Understanding the Chinese Economies, 2013

8.4.1 China's Existing Tax System

As the most important source of fiscal revenue, tax is a key economic player of macro-regulation in China's economic and social development. Since the 1994 tax reform, China has preliminarily set up a tax-sharing system (see subsection 6.5.2 of Chapter 6).

Under the current tax system, China now has 26 types of taxes, which, according to their nature and function, can be divided into the following eight categories:

●

Turnover taxes. These include three kinds of taxes, namely, Value Added Tax (VAT), Consumption Tax, and Business Tax. The levies of these taxes are normally based on the volume of turnover or sales of the taxpayers in the manufacturing, circulation, or service sectors.

●

Income taxes. These include Enterprise Income Tax and Individual Income Tax. These taxes are levied on the basis of the profits gained by producers or dealers, or the income earned by individuals.

●

Resource taxes. These consist of Resource Tax and Urban and Township Land Use Tax. These taxes are applicable to those engaged in natural resource exploitation or to the users of urban and township land.13

●

Taxes for special purposes. These taxes include City Maintenance and Construction Tax, Farmland Occupation Tax, Fixed Asset Investment Orientation Regulation Tax, Land Appreciation Tax, and Vehicle Acquisition Tax. These taxes are levied on specific items for special regulative purposes.

●

Property taxes. These taxes encompass House Property Tax, Urban Real Estate Tax, and Inheritance Tax (not yet levied).

●

Behavioral taxes. These taxes include Vehicle and Vessel Usage Tax, Vehicle and Vessel Usage License Plate Tax, Stamp Tax, Deed Tax, Securities Exchange Tax (not yet levied), Slaughter Tax, and Banquet Tax. These taxes are levied on specified behavior.

●

Agricultural taxes. Taxes belonging to this category are Agriculture Tax (including Agricultural Specialty Tax) and Animal Husbandry Tax which are levied on the enterprises, units and/or individuals receiving income from agriculture and animal husbandry activities.

●

Customs duties. Customs duties are imposed on the goods and articles imported into and exported out of the territory of the People's Republic of China, including Excise Tax.

It seems that China's introduction of, and reform on, the income tax system was to promote the development of industrial enterprises during the early period of reform. For example, prior to January 1, 2008, there was a more favorable (and sometimes even exemption of) tax applicable to foreign invested enterprises, in parallel to a relatively higher one applied to such domestic enterprises as state-owned enterprises, collectively owned enterprises, private enterprises, joint operation enterprises, and joint equity enterprises. This can be witnessed by the declining ratios of enterprise income tax to China's total GDP from 1985 to 2000; since the early 2000s, China has increasingly levied taxes on enterprises.

View chapterPurchase book

RESOURCES

D. Lund, in Encyclopedia of Energy, Natural Resource, and Environmental Economics, 2013

The Relation to Other Taxes

If a neutral rent tax system is applied as the only tax in a sector, some projects will be profitable in this sector which would not be profitable as equity financed under a standard corporate income tax. To avoid this intersectoral nonneutrality, some countries apply both a rent tax, intended to be neutral, and a corporate income tax. Clearly, if the rent tax is a BT, it will not cause additional distortions. Those projects that are (un)profitable under the corporate income tax will still be. If the rent tax is modified with interest accumulation, as described above, the question arises what interest rate to use. In this connection, if all investment opportunities are taxed, one would use an after-tax interest rate. But in an open economy, the relevant interest rate is the nominal (host country currency) after-tax discount rate for risk-free cash flows in the hands of the marginal investor, who may be a foreign (natural or legal) person, who may be untaxed on alternative investments.

Multinational companies worry that they will be taxed both in the host countries where they extract resources and in their home countries. There exist bilateral treaties to avoid double taxation, and some countries also have unilateral provisions with the same intention. The rules typically require that the host country tax system resembles that of the home country, by, for example, allowing similar deductions for costs, including depreciation and net financial costs. This has motivated some host nations to design their tax systems in ways which they might otherwise not, to be able to attract foreign companies in spite of relatively high tax rates. The concern for creditability may also influence a host nation's choice between, for example, a PSA, state equity participation, or taxation.

View chapterPurchase book

handbook of public economics, vol. 5

Thomas Piketty, Emmanuel Saez, in Handbook of Public Economics, 2013

6.4 Family Taxation

In practice, the treatment of families raises important issues. Any tax and transfer system must make a choice on how to treat singles vs. married households and how to make taxes and transfers depend on the number of children. There is relatively little normative work on those questions, in large part because the standard utilitarian framework is not successful at capturing the key trade offs. Kaplow (2008), Chapter 8 provides a detailed review.

Couples. Any income tax system needs to decide how to treat couples vs. single individuals. As couples typically share resources, welfare is best measured by family income rather than individual income. There are two main treatments of the family in actual tax (or transfer) systems. (a) The individual system where every person is taxed separately based on her individual income. In that case, couples are treated as two separate individuals. As a result, an individual system does not impose any tax or subsidy on marriage as tax liability is independent of living arrangements. At the same time, it taxes in the same way a person married to a wealthy spouse vs. a person married to a spouse with no income. (b) The family system where the income tax is based on total family income, i.e., the sum of the income of both spouses in case of married couples. The family system can naturally modulate the tax burden based on total family resources, which best measures welfare under complete sharing within families. However and as a result, a family tax system with progressive tax brackets cannot be neutral with respect to living arrangements, creating either a marriage tax or a marriage subsidy. Under progressive taxation, if the tax brackets for married couples are the same as for individuals, the family system typically creates a marriage tax. If the tax brackets for married couple are twice as wide as for individuals, the family system typically creates a marriage subsidy.99

Hence and as is well known, it is impossible to have a tax system that simultaneously meets three desirable properties: (1) the tax burden is based on family income, (2) the tax system is marriage neutral, and (3) the tax system is progressive (i.e., the tax system is not strictly linear). Although those properties clearly matter in the public debate, it is not possible to formalize their trade off within the traditional utilitarian framework as the utilitarian principle cannot put a weight on the marriage neutrality principle.

If marriage responds strongly to any tax penalty or subsidy, it is better to reduce the marriage penalty/subsidy and move toward an individualized system. This issue might be particularly important in countries (such as Scandinavian countries for example), where many couples cohabit without being formally married and as it is difficult (and intrusive) for the government to observe (and monitor) cohabitation status.

Traditionally, the labor supply of secondary earners—typically married women—has been found to be more elastic than the labor supply of primary earners—typically married men (see Blundell & MaCurdy, 1999 for a survey). Under the standard Ramsey taxation logic, this implies that it is more efficient to tax secondary earners less (Boskin & Sheshinski, 1983). If the tax system is progressive, this goal is naturally achieved under an individual-based system as secondary earners are taxed on their sole earnings. Note however that the difference in labor supply elasticities between primary and secondary earners has likely declined over time as more and more married women work (Blau & Kahn, 2007).

In practice, most OECD countries have switched from family based to individual-based income taxation. In contrast, transfer systems remain based on family income. It is therefore acceptable to the public that a spouse with modest earnings would face a low tax rate, no matter how high the earnings of her/his spouse are.100 In contrast, it appears unacceptable to the public that a spouse with modest earnings should receive means-tested transfers if the earnings of his or her spouse are high. A potential explanation could be framing effects as direct transfers might be more salient than an equivalent reduction in taxes. Kleven, Kreiner, and Saez (2009b) offer a potential explanation in a standard utilitarian model with labor supply where they show that the optimal joint tax system is to have transfers for non-working spouses (or equivalently taxes on secondary earnings) that decrease with primary earnings. The intuition is the following. With concave utilities, the presence of secondary earnings make a bigger difference in welfare when primary earnings are low than when primary earnings are large. Hence, it is more valuable to compensate one earner couples (relative to two earner couples) when primary earnings are low. This translates into an implicit tax on secondary earnings that decreases with primary earnings. Such negative jointness in the tax system is approximately achieved by having family based means-tested transfers along with individually based income taxation.

Children. Most tax and transfer systems offer tax reductions for children or increases in benefits for children. The rationale for such transfers is simply that, conditional on income z, families with more children are more in need of transfers and have less ability to pay taxes. The interesting question that arises is how the net transfer (additional child benefits or reduction in taxes) per additional child should vary with income z. On the one hand, the need for children related transfers is highest for families with very small incomes. On the other hand, the cost of children is higher for families with higher incomes particularly when parents work and need to purchase childcare.

Actual tax and transfers do seem to take both considerations into account. Means-tested transfers tend to offer child benefits that are phased-out with earnings. Income taxes tend to offer child benefits that increase with income for two reasons. First, the lowest income earners do not have taxable income and hence do not benefit from child-related tax reductions. Second, child-related tax reductions are typically a fixed deduction from taxable income which is more valuable in upper income tax brackets. Hence, the level of child benefits tends to be U-shaped as a function of earnings. Two important qualifications should be made.

First, as mentioned in Section 5.3.3, a number of countries have introduced in-work benefits that are tied to work and presence of children. This tends to make child benefits less decreasing with income at the low income end. In the United States, because of the large EITC and child tax credits and small traditional means-tested transfers, the benefit per child is actually increasing with family earnings at the bottom. Second, another large child benefit often subsidized or government provided is pre-school child care (infant child care, kindergarten starting at age 2 or 3, etc.). Such child care benefits are quantitatively large and most valuable when both parents work or for single working parents. Hence, economically, they are a form of in-kind in-work benefit which also promotes labor force participation (see OECD, 2006, chap. 4, Figure 4.1, p.129 for an empirical analysis). It is perhaps not a coincidence that cash in-work benefits for children are highest in the US and the UK, countries which provide minimal child care public benefits. Understanding in that context whether a cash transfer or an in-kind child care benefit is preferable is an interesting research question that has received little attention.

Child-related benefits raise two additional interesting issues.

First, families do not take decisions as a single unit (Chiappori, 1988). Interestingly, in the case of children, cash transfers to mothers (or grandmothers) have larger impacts on children's consumption than transfers to fathers. This has been shown in the UK context (Lundberg, Pollak, & Wales, 1997) when the administration of child tax benefits was changed from a reduction in tax withholdings of parents (often the father) to a direct check to the mother. Similar effects have been documented in the case of cash benefits for the elderly in South Africa (Duflo, 2003). This evidence suggests that in-kind benefits (such as child care or pre-school) might be preferable if the goal is to ensure that resources go toward children. As mentioned above, primary education is again the most important example of in-kind benefits designed so that children benefit regardless of how caring parents are.

Second, child benefits might promote fertility. A large empirical literature has found that child benefits have sometimes positive but in general quite modest effects on fertility (see Gauthier, 2007 for a survey). There can be externalities (both positive and negative) associated with children. For example, there can be congestion effects (such as global warming) associated with larger populations. Alternatively, declines in populations can have adverse effects on sustainability of pay-as-you-go pension arrangements. Such externalities should be factored into discussions of optimal child benefits.

View chapterPurchase book

Taxes and Corporate Finance

John R. Graham, in Handbook of Empirical Corporate Finance, 2008

Taxesandcapitalstructure—the U.S.tax system 62

2.1.

Theory and empirical predictions 62

2.2.

Empirical evidence on whether the tax advantage of debt increases firm value 68

2.2.1.

Exchange offers 68

2.2.2.

Cross-sectional regressions 70

2.2.3.

Marginal benefit functions 71

2.3.

Empirical evidence on whether corporate taxes affect debt vs. equity policy 73

2.3.1.

Nondebt tax shields, profitability, and the use of debt 74

2.3.2.

Directly estimating the marginal tax rate 75

2.3.3.

Endogeneity of corporate tax status 77

2.3.4.

Time-series and small-firm evidence of tax effects 78

2.4.

Empirical evidence on whether personal taxes affect corporate debt vs. equity policy 79

2.4.1.

Market-based evidence on how personal taxes affect security returns 81

2.5.

Beyond debt vs. equity 86

2.5.1.

Leasing 86

2.5.2.

Pensions 87

2.5.3.

Debt maturity 88

View chapterPurchase book

handbook of public economics, vol. 5

Wojciech Kopczuk, in Handbook of Public Economics, 2013

6.3 Unrealized Capital Gains

One of the important features of the US capital gains tax is the step-up in basis at death. Consider an asset with the basis of p that by the time of death of the owner is worth p·(1+r). If sold just before taxpayer's death, proceeds would be subject to the capital gains tax tG and then to the estate tax τ, resulting in the overall bequest of p·1+r·(1-tG)·(1-τ). If held until death without realizing the gain, the basis of the asset is reset to its value at the time of death and the overall value of a transfer is p·(1+r)·(1-τ). In particular, this is the liquidation value of the bequest if the recipient/estate chooses to realize the gain immediately after taxpayer's death.

This feature of the tax system gives rise to a strong incentive to hold capital gains until death. The distortion to the holding period is present even in the absence of step-up in basis, reflecting benefits from deferral of taxation on realized capital gains,53 but the step-up in basis introduces a particularly strong form of the associated lock-in effect. The literature on capital gains realizations (for example, Auerbach, Burman, & Siegel, 2000; Burman & Randolph, 1994; Burman, 1999; Dai, Maydew, Shackelford, & Zhang, 2008) focused on distortions to the holding period and related tax avoidance strategies.

A small number of papers analyzed the interaction of estate tax and capital gains taxation. Poterba (2001) shows that taxpayers with larger unrealized capital gains are less likely to make inter vivos gifts, thereby providing indirect evidence of the lock-in effect being present in practice. On the other hand, Auten and Joulfaian (2001) present evidence that higher estate tax weakens the magnitude of the lock-in effect by encouraging capital gains realizations earlier in life. One possible channel is via the estate tax encouraging consumption or charitable bequests; another theoretical possibility is that in the presence of the estate tax, the effective capital gains marginal tax rates associated with rebalancing of taxpayer's portfolio are smaller than otherwise because they reduce taxable estate and hence tax liability. Finally, taxpayers may want to realize capital gains early as part of their tax avoidance strategy.

Poterba and Weisbenner (2001) use the SCF data to analyze distributional implications of replacing the estate tax by constructive realization of capital gains at death. While revenue estimates are dated, because of changes in rates and exemptions since then, the paper documents significant heterogeneity in the importance of unrealized gains and hence distributional implications of such a policy switch. Indeed, the 2010 "repeal" highlighted some of these issues in practice. The elimination of the estate tax was associated with basis carryover (rather than constructive realization that Poterba & Weisbenner (2001), assumed).54 Reduction in tax liability generated by differences in marginal tax rates under capital gains and estate taxation was not uniform, because (among other reasons) the distribution of unrealized capital gains is not uniform. Naturally, many taxpayers dying with capital gains are not subject to the estate tax but they still do benefit from step-up. Hence, the replacement of carryover provision could actually increase their tax burden relative to the estate tax. This has been mitigated by allowing for up to $1.3 million of assets to continue to benefit from the step-up. Still, given the 2009 exemption of $3.5 million and availability of deductions for marital bequests (among other things) that change would have resulted in an increase in tax burden for some otherwise non-taxable taxpayers.55 While the retroactive repeal made this issue moot for 2010, distributional implications of the relative estate tax vs capital gains treatment will continue to be an important issue in considering future reform proposals.

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Managing Corporate Risk*

Clifford W. SmithJr., in Handbook of Empirical Corporate Finance, 2008

3.3 Taxes

With progressivity in the tax structure, after-tax payoffs are concave; thus, hedging reduces the expected tax liability, increases after-tax liability, and increases after-tax cash flows and value (Mayers and Smith, 1982; Smith and Stulz, 1985). In their analysis of more than 80,000 COMPUSTAT firm-year observations, Graham and Smith (1999) find that in approximately 50 % of the cases, corporations face convex effective tax functions and thus have tax-based incentives to hedge. In approximately 25% of the cases, firms face linear tax functions and thus have no tax-related incentives to hedge. The remaining firms face concave effective tax functions, which provide a tax-based disincentive to hedge. Of the cases with convex tax functions, roughly one-quarter of the firms have potential tax savings from hedging that appear material; in extreme cases savings exceed 40% of the expected tax liability. For the remaining firms, the tax savings are fairly small. Thus, the distribution of potential tax savings from hedging appears quite skewed.

Firms most likely face convex tax functions when (1) their expected taxable incomes are near the kink in the statutory tax schedule (i.e., taxable income near zero), (2) their incomes are volatile, and (3) their incomes exhibit negative serial correlation (hence the firm is more likely to shift between profits and losses).

The Graham/Smith methods also allow them to decompose the basic structure of the tax code to examine the incremental impact of statutory progressivity, net operating loss carrybacks and carryforwards, investment tax credits, the alternative minimum tax, and uncertainty in taxable income. They find that most of the convexity is induced by the asymmetric treatment of profits and losses in the tax code. Carryback and carryforward provisions effectively allow firms to smooth their losses, thereby reducing tax function curvature at its most convex points but making the function convex over a broader range of taxable income. In contrast, the alternative minimum tax and investment tax credits have only modest effects on the convexity of the tax function.

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Taxation and Corporate Financial Policy*

Alan J. Auerbach, in Handbook of Public Economics, 2002

3.3.1 Limits on interest deductions

As discussed above, tax systems typically provide less than full loss offset, not giving a tax refund to those investors with negative current taxable income. However, this does not imply that prospective incremental interest deductions have no value in such circumstances. First of all, firms that borrow do not necessarily know, ex ante, that they will have negative taxable income in a given year. One would wish to weight the value of interest deductions in any state by the probability of that state occurring, evaluated at the time of the borrowing decision. Second, even if interest deductions cannot be taken immediately, this does not mean that they can never be used. Rather, unused deductions typically can be carried forward for possible use in a subsequent year and, in some countries, carried back to a prior tax year. For several years in the United States, including the period considered by the research discussed below, the carry-forward period was 15 years and the carry-back period 3 years13.

Carrying deductions forward reduces their value, because deductions carried forward do not earn interest and may expire unused. Carrying deductions back (by recomputing a prior year's tax liability) produces an immediate deduction. However, the existence of a carry-back provision complicates calculations because it attaches an option value to taxable income, associated with the possibility that the firm may wish to carry future losses back to the current year. This, in turn, reduces the value of an immediate deduction when the firm is taxable.

To solve for the value of interest deductions in this environment, some assumptions are necessary. Imposing the restriction that firm transitions between taxable and non-taxable states follow a second-order Markov process, Auerbach and Poterba (1987) derived an algorithm to solve for the present-value tax liability associated with a dollar of taxable income. (This calculation also measures the value of a one-dollar reduction in taxable income due to an interest deduction). Altshuler and Auerbach (1990) extended this methodology to take account of intermediate states in which firms may deduct some but not all expenses14. The general methodology of these two papers can be understood by considering a simplified case in which transitions follow a stationary first-order Markov process between two states (taxable and non-taxable) and losses may be carried back only one year. In this case, the "shadow" value (in terms of reduced taxes) of a dollar to be deducted (or the cost of a dollar of extra taxable income) is the statutory tax rate multiplied by

(3.9)w=∑i=1LβiπNNi−1πNT1−υinstateN,1−υ=1−βπTN1−winstateT,

where N is the non-taxable state, T is the taxable state, β is the one-year discount factor, L is the number of years after which loss carry-forwards expire, and πij is the transition probability from state i to state j.

The first of expressions (3.9) says that the value of a dollar tax deduction for a firm not currently taxable is based on the distribution of dates when that deduction can first be used. The probability of its use one year hence is πNT; the probability of its use two years hence is πNNπNT; and so on. Payments at each future date must be discounted and adjusted by the term v to account for the fact that reducing taxable income also reduces the option value of subsequent carry-backs. The second of expressions (3.9) says that a dollar deduction when taxable has its value reduced by the extent to which it precludes subsequent carry-back, the value of which, in turn, is the difference between immediate use and eventual use, (1 − w).

Using US corporate tax returns from the period 1970–82 to estimate transition probabilities, Altshuler and Auerbach estimated 1982 shadow values of marginal interest deductions ranging from 19 percent for firms with two successive years of tax losses to 39 percent for firms with two successive years facing no tax constraints. Their asset-weighted sample average was 32 percent, well below the statutory corporate rate of 46 percent prevailing at the time. Thus, the calculations suggested that tax asymmetries were quantitatively important for the corporate sector as a whole and that there was also considerable heterogeneity with respect to the value of interest deductions.

More recently, an alternative approach has been to simulate distributions of tax payments using a large number of random draws based on the assumption that a firm's taxable income follows a random walk. Doing so, Graham (1996) estimated a slightly lower mean value (30 percent) for 1982 than Altshuler and Auerbach for an unweighted sample of COMPUSTAT firms, but a higher value (40 percent) weighting by market value. The gap between the weighted estimates of these two studies may be attributable not only to methodological differences, but also to weighting scheme (market value weights placing more weight on successful firms than asset weights) and also perhaps to sample differences. Altshuler and Auerbach found that their estimates of the incidence of tax losses was higher in actual tax returns than in the corresponding COMPUSTAT records considered by Auerbach and Poterba. For the last year in his sample, 1992, Graham's unweighted and value-weighted estimates of the average marginal tax rate were 20 percent and 28 percent, respectively, compared to that year's statutory rate of 34 percent15.

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