WHICH EFFECTIVE TAX RATE?

Abstract

An effective tax rate for capital income may be calculated for average or for marginal income, and it may include only corporate taxes or the total of corporate, personal, and property taxes. This paper categorizes effective tax rates into four basic types, and it discusses eleven separate reasons to expect the effective tax on marginal investment to differ from the observed tax on the past or average investment. For each type of rate, we discuss its measurement and appropriate use. Even within one of these categories, there exist different kinds of effective tax rates with different interpretations. In particular, the effective tax on a marginal increase in the return to a given investment can be considerably greater than the effective tax on the marginal income from a new investment which receives new credits and deductions. While the former concept might be useful for measuring income flows, this paper argues that the latter concept is a better measure of the incentive to invest. This distinction is also used to reconcile part of the difference between the 37 percent effective total tax rate of King and Fullerton and the 66 percent effective total tax rate of Feldstein and Summers.

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