Working paper

Taxation and the User Cost of Capital: An Introduction (WP 15/02)

Formats and related files

Table of Contents

  • Abstract
  • Acknowledgements
  • Disclaimer
  • Executive Summary
  • 1 Introduction
  • 2 User Cost: The Simplest Case
  • 3 Allowing for Taxation
    • 3.1 Taxation of Corporations
    • 3.2 Depreciation and Tax Credits
    • 3.3 User Cost in Terms of the After-Tax Nominal Interest Rate
    • 3.4 User Cost in Terms of Before-Tax Real Interest Rate
    • 3.5 User Cost in Terms of Before-Tax Nominal Interest Rate
  • 4 The After-Tax Real Interest Rate
  • 5 The Effective Marginal Tax Rate
    • 5.1 The User Cost and the EMTR
    • 5.2 A Formal Statement
    • 5.3 Variation in EMTRI with Interest and Inflation Rates
    • 5.4 Variation in EMTRI with the Statutory Tax Rate
      • 5.4.1 The Role of the Nominal Interest Rate
      • 5.4.2 The Role of Fiscal Depreciation and Tax Credit Rates
  • 6 An Effective Average Tax Rate
  • 7 Investment and the User Cost
  • 8 Conclusions
  • Appendix A: Derivation of the Basic Hall and Jorgensen Result
  • Appendix B: Allowing for Uncertainty
  • Bibliography

Authors: John Creedy and Norman Gemmell

Abstract#

The aim of this paper is to provide an introduction to the concept of user cost and its determinants. Particular attention is given to the influence of taxation. The concept of user cost relates to the rental, the rate of return to capital, that arises in a profit maximising situation in which further investment in capital produces no additional profit. This paper sets out in some detail the range of assumptions involved in obtaining alternative expressions for the user cost. The user cost refers to a before-tax capital rental, the rate of return that ensures that the(after-tax) cost of capital is equal to the post-tax returns over its life. Hence, associated with the user cost measure is an effective marginal tax rate. This can differ substantially from the statutory marginal rate applicable to the investor. A related effective average tax rate is also defined.

Acknowledgements#

We should like to thank Martin Keene, Helen Miller and Florian Misch for their comments on an earlier draft.

Disclaimer#

The views, opinions, findings, and conclusions or recommendations expressed in this Working Paper are strictly those of the author(s). They do not necessarily reflect the views of the New Zealand Treasury or the New Zealand Government. The New Zealand Treasury and the New Zealand Government take no responsibility for any errors or omissions in, or for the correctness of, the information contained in these working papers. The paper is presented not as policy, but with a view to inform and stimulate wider debate.

Executive Summary#

The concept of user cost relates to the rate of return to capital, referred to as the rental, that arises in a profit maximising situation. This is one in which further investment in capital produces no additional profit. Despite this apparently simple statement, the concept gives rise to a complex range of cases which need to be distinguished.

The importance of taxation and the link with optimising behaviour by firms means that the user cost concept has a central role in investment and location decisions. Differences in tax regimes among countries can influence the decision regarding where to locate production and the head office of multinational firms. The relevant features of tax regimes relate not only to the treatment of companies but to the individuals who are the ultimate owners. Any change in a tax rate or tax structure which implies an increase in the user cost of capital implies that firms need to obtain a higher pre-tax rate of return or rental for an investment to be worthwhile.

The aim of this paper is to provide an introduction to the concept of user cost and its determinants, paying particular attention to the influence of taxation. This paper sets out in some detail, using a consistent terminology, the range of assumptions involved in obtaining alternative expressions for the user cost.

The user cost refers to a before-tax capital rental, the rate of return that ensures that the (after-tax) cost of capital is equal to the post-tax returns. Hence, associated with the user cost measure is an effective marginal tax rate. This can differ substantially from the statutory marginal rate applicable to the investor. Particular attention is given in this paper to the properties of the effective marginal tax rate in different circumstances, drawing attention to the difference between tax-inclusive and exclusive rates. It is shown that the relationship between the statutory tax rate and the effective tax rate can vary substantially, depending on the rate of interest.

A related effective average tax rate is also defined for the context in which the firm obtains economic rents (that is, earnings above those needed for it to remain in its present position). This may be important in the context of multinational investment where the firm is operating below its profit maximising output.

The link between the user cost, effective tax rates and investment is also briefly discussed.