Cost of Capital and Effective Tax Rate : A Comparison of U.S. and Japanese Manufacturing Industries

Abstract

The purpose of this paper is to compare the effects of taxation on the cost of capital and the effective corporate tax rate between U.S. and Japanese munufacturing industries. Since the 1970s the U.S. has strengthened fiscal incentives to investment: in 1971 capital consumption allowances were accelerated and in 1981 still more liberal treatment of depreciable assets was introduced by Accelerated Cost Recovery System (ACRS); and the investment tax credit, which was first enacted in 1962, was reinitiated in 1971 after a short suspension since 1969 (Pechman (1987), and Jorgenson and Sullivan (1981)). Recent tax reform of 1986 repealed the investment tax credit, but reduced the rate of corporate income tax substantially to level off distortions in capital allocation. Japan has been no exception in this regard and in both corporate and personal taxes various measures have been taken to foster capital accumulation. In corporate income tax, accelerated depreciation has been adopted since the beginning of the 1950s, though the degree of its acceleration has been moderated gradually. In addition to it, tax-free reserves, which postopone tax payments of certain types of income, have been extensively employed. And on the personal side capital income has been separated from income of other sources, and special (sometimes almost zero) tax rates have been applied to it (Tajika and Yui (1988)). We would like to compress these differences in tax structures of the two countries into the cost of capital and the effective tax rate, and to examine how these indexes have been affected by tax policies. The derivation and estimation of them is hardly a new undertaking. However, it has been tackled extensively these days, motivated strongly by the recognition that the allocation of capital has been distorted by incomplete income tax policies. The contributions which we seek in the theoretical part of our paper are twofold. The first is to explicate the relation between personal capital income taxes and the cost of capital. This line of research has been pursued by Auerbach (1979, 1983), King and Fullerton (1984), and Boadway, Bruce and Mintz (1984). Methodologically we will adopt the wealth maximization approach of Auerbach, and present the optimization problem of equity owners explicitly. We will then solve the problem to get the desired formulas under the assumption that invest-

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