CONGRESS OF THE UNITED STATES

CONGRESSIONAL BUDGET OFFICE

A

PAPER

OCTOBER 2005

Taxing Capital 

Income:

Effective Rates 

and Approaches

to Reform

CBO

© Eyewire/GettyImages and © JupiterImages

The Congress of the United States O Congressional Budget Office

CBO

Taxing Capital Income:

Effective Rates and Approaches to Reform

October 2005

A

PAPER
Note

Sample equations and sums of numbers in the text and tables of this report may not equal 

totals because of rounding.
Preface

This Congressional Budget Office (CBO) paper, prepared at the request of the Chairman 

of the House Ways and Means Committee, examines the taxation of capital income under 

current law and explores some potential alternatives to that system. In its analysis, CBO used 

the framework of effective tax rates to determine how heavily and uniformly capital income is 

taxed. It also used that framework to assess scenarios that would ultimately move the present 

system toward one that does not tax capital income. In keeping with CBO’s mandate to provide objective, impartial analysis, the paper makes no recommendations.

Paul Burnham and Larry Ozanne of CBO’s Tax Analysis Division wrote the paper under the 

direction of Roberton Williams and G. Thomas Woodward. David Weiner and Ed Harris 

provided input from the microsimulation model of individual income taxes. Within CBO, 

Robert Dennis, Douglas Hamilton, and William Randolph provided useful comments and 

assistance. In addition, Jane G. Gravelle, Kenneth L. Judd, and James B. Mackie III reviewed 

the results and provided valuable criticism and suggestions. (The assistance of external reviewers implies no responsibility for the final product, which rests solely with CBO.)

Loretta Lettner edited the manuscript, and Janey Cohen proofread it. Denise Jordan-Williams 

prepared early drafts of the text. Maureen Costantino prepared the report for publication and 

designed the cover. Lenny Skutnik produced the printed copies, and Annette Kalicki and 

Simone Thomas prepared the electronic version for CBO’s Web site (www.cbo.gov).

Douglas Holtz-Eakin

Director

October 2005

Summary and Introduction 1

Capital Income and Its Taxation 2

Taxation of Capital and Economic Efficiency 2

Two Ways to Achieve Nontaxation of Capital Income 3

Differences in the Two Approaches 3

Revenue Effects of Reducing the Tax Rate on Capital 4

Other Ancillary Effects of Reducing the Tax Rate on Capital 4

How Is Capital Income Currently Taxed? 5

Income of C Corporations 5

Other Business Income 6

Owner-Occupied Housing 6

Capital Income of Savers 6

Effective Tax Rates on Capital Income 6

Rates Under the Base Case 7

Eliminating the Tax on Capital Income:

An Illustrative Sequential Approach 9

Appendix A: The Methodology Behind Effective Tax Rates 15

Defining Effective Tax Rates 15

Calculating Effective Tax Rates 16

Implementing Effective Tax Rates 18

Appendix B: Alternative Assumptions 25

The Effects of the Expiration of EGTRRA and JGTRRA 25

Old and New Views of Taxes on

Dividends 26

Sources of Marginal Saving 29

Appendix C: Alternative Proposals 31

Restore 30 Percent Partial Expensing 31

Allow $5,000 Annual Contributions to Lifetime Savings Accounts 32

Allow Unlimited Contributions to IRAs 34

Partially Integrate the Individual-Level and Corporate-Level Taxes 35

CONTENTS
vi TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Tables

1. Effective Tax Rates on Capital Income and Measures of

Tax Rate Uniformity 8

2. Effective Tax Rates on Capital Income of C Corporations,

by Asset Type 10

3. Successive Steps Toward Eliminating the Tax on

Capital Income 12

4. Alternative Combinations of Steps Toward Eliminating the

Tax on Capital Income 13

A-1. Distribution of Assets in 2002, by Type and Form of

Organization 19

A-2. Assumed Rates of Return 20

A-3. Distribution of Assets and Marginal Saving, by Tax Status 22

A-4. Average Statutory Marginal Tax Rates 23

B-1. The Effect of the Expiration of EGTRRA and JGTRRA 26

B-2. Old and New Views of Dividend Taxes 28

B-3. Alternative Assumptions About Sources of Marginal Saving 30

C-1. Selected Proposals to Reduce the Tax on Capital Income 32

C-2. The Effect of Partial Expensing on C Corporations, by

Asset Type 33

C-3. Distribution of Marginal Saving Under Selected Proposals,

by Tax Status 34
Taxing Capital Income:

Effective Rates and Approaches to Reform

Summary and Introduction

In the United States, roughly 60 percent of federal receipts derive from what are termed income taxes—either 

the individual income tax or the corporate income tax. 

Income taxes generally include income generated by capital as well as labor. A number of analysts argue that taxing 

capital income imposes significant costs on the overall 

economy because such taxation affects investment and 

the allocation of that investment. As a result, proposals 

for comprehensive tax reform at the federal level typically 

include options such as value-added taxes, retail sales 

taxes, and the so-called flat tax—none of which tax capital income—as possible replacements for income taxes.

Despite their nominal characterization, the individual 

and corporate income tax systems already possess a number of features that exempt some capital income from taxation. In effect, those features render the current system a 

hybrid—a mix of treatments that fully taxes some capital 

income while fully or partially exempting the rest. The 

system’s hybrid nature and recurring interest in changing 

it lead to questions about the degree to which capital income is actually taxed under the present federal income 

tax system and the extent to which various alternative 

steps—such as providing for tax-exempt savings accounts 

or permitting the expensing of capital purchases—would 

move the system entirely away from the taxation of capital income.

In addition to analyzing the level of taxation currently applied to capital income, the Congressional Budget Office 

(CBO) considered the composition of capital income 

taxes: how uniformly capital is taxed under the present 

system and how potential steps toward eliminating the 

tax on capital income would affect that uniformity. A lack 

of uniformity can signal the potential for distortion in 

economic decisions.

The analysis detailed in this study informs those issues 

by computing effective tax rates for a broad range of 

investments in tangible capital.1

 CBO’s findings are 

summarized below:

B Under a tax regime that assumes the indefinite extension of provisions in place in 2008 (the base case), the 

overall effective tax rate on income from capital is 

13.8 percent, about midway between the zero percent 

tax rate under a consumption tax or a wage tax and the 

average statutory marginal rate in the current income 

tax (approximately 27 percent for noncorporate business income).2

B Effective tax rates on capital income under the base 

case are highly uneven. For instance, whereas the 

effective tax rate on debt-financed corporate investment is -6.4 percent, it is 36.1 percent on equityfinanced corporate investment. Using typical mixes of 

debt and equity financing, the effective tax rate on 

corporate investment is 5.7 percentage points higher 

than that on noncorporate investment, and the rate 

on tenant-occupied housing is 23.3 percentage points 

higher than that on owner-occupied housing. Effective tax rates also differ significantly across different 

asset types. 

1. The effective tax rates in this paper apply to new (or marginal) 

investment. In other CBO reports, the term “effective tax rates” 

refers to total taxes paid in a year relative to total income—an 

average tax rate. Tangible capital consists of equipment, structures, 

land, and inventories. Intangible assets, such as cumulative knowledge and brand recognition, are not considered in this paper. For 

additional details, see Appendix A.

2. More specifically, the base case incorporates those provisions of 

the Economic Growth and Tax Relief Reconciliation Act of 2001 

(EGTRRA) and of the Jobs and Growth Tax Relief Reconciliation 

Act of 2003 (JGTRRA) that have not already expired and assumes 

that they will be extended indefinitely. Current law calls for a 

reversion to pre-EGTRRA law in 2011.
2 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

B Eliminating individual-level taxes on capital income 

and allowing businesses to expense new investments 

would produce an effective tax rate of -15.1 percent 

because of the continued deductibility of interest by 

businesses and homeowners. Thus, instead of taxing 

the return on capital investment, the tax system 

would, on balance, subsidize it.

B The above combination would also alter the unevenness of capital taxation. Not taxing capital income at 

the individual level would reduce the difference in tax 

rates that exists between corporate and noncorporate 

investment but would increase the difference between 

equity-financed and debt-financed corporate investment and between tenant-occupied and owner-occupied housing. Furthermore, adding the full expensing 

of the acquisition cost of capital assets would significantly increase the difference in rates between equityfinanced and debt-financed corporate investments, 

although it would eliminate the variance across asset 

types.

B Eliminating the deduction for interest expenses in 

tandem with the above combination would set effective tax rates on all capital income to zero and achieve 

complete uniformity.

Capital Income and Its Taxation

Much of the interest that policymakers express regarding 

the tax treatment of capital income stems from concerns 

about economic efficiency. However, other considerations, such as compliance, fairness, and administrative 

costs, also enter any evaluation. The analysis detailed in 

this paper is restricted to the issue of efficiency.3

Taxation of Capital and Economic Efficiency

A perfectly efficient tax would raise revenue without 

affecting society’s choices about how to allocate its resources. Inevitably, however, the tax system renders some 

endeavors more attractive than others. Those tax-induced 

distortions shift production and purchase patterns away 

from decisions driven purely by an activity’s costs and 

benefits. A tax system’s relative efficiency depends on the 

extent of the tax-induced distortions to prices and rates 

of return and on the responsiveness of taxpayers to both 

of those factors. In the absence of consensus about the 

degree to which taxpayers respond, analysts often use the 

degree to which taxes create distortions in relative prices 

as a good starting point for measuring the potential of a 

tax system to create inefficiency.

Among its impacts, an income tax distorts the relative 

cost of consuming now versus waiting to consume in the 

future. In effect, taxing capital income reduces the return 

on saving, thereby increasing the cost of future consumption compared with current consumption. That distortion could result in reduced levels of saving (the means of 

shifting income to future consumption) and therefore a 

lowered rate of capital accumulation than would occur in 

the absence of the tax. Analysts disagree about the extent 

to which saving is distorted. 

There is greater consensus that income derived from all 

types of capital should be taxed alike. Failure to do so distorts the relative returns on different forms of capital—

some investments offer a higher rate of return purely for 

tax reasons—which can result in the inefficient allocation 

of capital. One straightforward method of ensuring uniformity is to not tax capital income at all, a strategy that 

is the primary focus of this report. A pure income tax 

(that is, one that is consistently applied), by contrast, 

would achieve uniformity by levying a single tax rate on 

capital income after allowing depreciation deductions 

equal to an asset’s actual decline in value. Moving the federal tax system in such a direction would necessitate adjusting tax-depreciation rules, eliminating various capital 

income exemptions that exist under current law, indexing 

capital income for inflation, and integrating the corporate 

income tax with the individual income tax. In principle, 

it is possible to design a hybrid system that treats capital 

both favorably (relative to labor) and uniformly.

In some instances, the inefficiency of taxing capital income at different rates is the direct result of other policy 

goals. At present, lower effective tax rates are levied on 

savings that are channeled to state and local governments, 

homeowners, retirement plans, certain life insurance policies, college students and their families, and particular 

health care plans. In each case, eliminating the differential taxation, perhaps by not taxing capital income at all, 

would raise economic efficiency at the expense of a competing policy objective.

3. For a broader discussion of the issues involved in switching from 

the current income tax to a consumption tax, see Harvey S. 

Rosen, Public Finance, 7th ed. (New York: McGraw-Hill Irwin, 

2005), pp. 473-490.
TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM 3

Two Ways to Achieve Nontaxation of Capital Income

Capital income is generated by business entities and 

received by savers. Producers purchase and employ capital 

assets in business endeavors. Those producers are then 

taxed on the profits (net of depreciation and interest 

paid) earned by using the capital asset. By buying either 

stock or debt instruments, savers provide funds for investment and ultimately pay taxes on the resulting interest, 

dividends, and capital gains. Taxes on capital income 

at either the saver or producer level will introduce 

distortions.

Two basic approaches could effectively eliminate the tax 

on capital income within the structure of the current 

tax system. The first focuses on the uses of income and 

removes from the tax base saving or the purchase of an 

asset—a consumed income tax approach. The second 

focuses on the sources of income and taxes only income 

that derives from labor—a labor income tax approach.

The Consumed Income Tax Approach. The structure of 

the traditional individual retirement account (IRA) serves 

as a model for a consumed income tax. That structure 

allows immediate deductions for contributions and does 

not tax capital income earned within the account—that 

is, it taxes only consumed income. To capture consumption financed by savings, it taxes all withdrawals. Under 

a consumed income tax, traditional IRA-style accounts 

would have to be available to all and allow unlimited 

contributions and unrestricted withdrawals. The tax 

base would be income minus net saving, which equals 

consumption.

For business entities, the corresponding treatment of capital income would be achieved by allowing the immediate 

expensing of newly acquired capital assets. Proceeds from 

any subsequent sale of such assets, however, would be 

fully taxable. Rental income would be taxable, and the 

expense of renting a capital asset would be deductible. 

Business entities would be allowed no deductions for 

interest and dividends paid.4

The Labor Income Tax Approach. The structure of the 

Roth IRA serves as a model for a labor income tax. That 

structure allows no deductions for contributions (that is, 

all labor income is taxed), but it does not tax capital income earned within the account and levies no tax on 

withdrawals (that is, only labor income is taxed). Under 

the labor income tax approach, Roth-type accounts 

would have no restrictions on eligibility, contributions, or 

withdrawals. The resulting tax base would consist primarily of wages but would also include other compensation, 

such as the labor portion of self-employment income. 

An analogous approach to not taxing returns on capital, 

although difficult to implement, could also be applied to 

business entities. Under that approach, the sale of capital 

assets would be a nontaxable event. In other words, sellers 

(or, in the case of new assets, manufacturers) would not 

include the proceeds in their tax base, and buyers would 

not deduct the cost of the asset from their tax base. Similarly, the rental of a capital asset would not increase the 

tax base of the lessor or reduce that of the lessee.

Differences in the Two Approaches 

Compared with an income tax system, those two approaches would both eliminate taxation of the expected 

return on capital. When the actual return differed from 

the expected return, however, the approaches would no 

longer be equivalent. Furthermore, the two approaches 

differ in how they would treat capital income derived 

from assets and savings in place at the time the approach 

was implemented.

The expected return on capital is the discount rate used 

to convert future income streams into present value.5

As a result, the value of capital today is worth the present 

discounted value of income that it is expected to generate 

in the future. Hence, eliminating the tax on the initial 

amount saved and invested (that is, the consumed income tax approach) equals the present discounted value 

of not taxing all future years’ income expected from that 

investment (that is, the labor income tax approach).

4. As a practical matter, people’s investments in their own homes 

could not be taxed the same as investments by business. Investments in homes do not generate a cash rent that could be taxed. 

As a result, proposals for consumed income taxes typically do not 

allow a deduction for home purchases. This treatment is the same 

as that allowed under the labor income tax approach.

5. Present value refers to the amount that must be invested today at a 

specified rate of return to equal an amount that becomes available 

at a specified time in the future. For example, if $110 is to become 

available in one year, and the rate of return is 10 percent, then the 

present value of that future payment is $100. That is, $100 

invested for one year will yield $110. The rate of return is said to 

discount the future payment to its present value and so is referred 

to as the discount rate. Interest rates are often used as discount 

rates.
4 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

However, because the consumed income tax is levied 

when the income is consumed in the future, it collects a 

tax on the actual return. By contrast, the labor income tax 

does not tax the actual return. If savings earn an unexpectedly high return, the consumed income tax collects 

more revenue than a labor income tax because it taxes 

withdrawals. The reverse happens if savings earn belownormal returns or lose money. A labor income tax collects 

the same amount in either case because that tax is levied 

on labor income before it is saved or consumed. 

Similarly, the consumed income tax is imposed on returns that are higher than normal because of monopolistic profits. Those profits are not part of the average 

expected return on investment but are additional earnings that result from limited supply (a typically temporary occurrence). A labor income tax would not capture 

those additional returns.

Another important difference between the two approaches is that in moving away from an income tax, the 

consumed income tax would still collect taxes on capital 

income derived from past investments. That would occur, for example, when savings accounts in existence at 

the time a consumed income tax was introduced became 

subject to a tax on withdrawals or when businesses could 

no longer claim depreciation deductions on assets already 

in service. Since those investments would already exist, 

there would be no potential distorting incentive effect 

from taxing them.6

Revenue Effects of Reducing the Tax Rate on Capital 

Because both total consumption and total wages are 

smaller than total income, there would be a potential revenue loss associated with reducing taxes on capital.7 If the 

tax system were to collect the same amounts of revenue, 

higher tax rates would be required. Increasing tax rates on 

labor, however, would exacerbate another distortion that 

affects overall efficiency: taxes on labor alter the relative 

attractiveness of working versus leisure. In that case, the 

desirability of not taxing capital income would hinge on 

the relative responsiveness to changes in the tax rate of 

the two taxed endeavors: labor and saving. Roughly 

speaking, if labor responded more negatively to higher 

taxes than saving did, it might be more efficient to maintain the tax on capital income. If saving responded more 

negatively, then the gain from reducing the tax on capital 

income could be greater than the loss from taxing labor 

income more heavily.

Eliminating existing tax breaks not directly related to capital income could reduce the need for a higher tax rate. 

For example, employer-provided health insurance could 

be included in the tax base of either a consumed income 

tax or a labor income tax. Furthermore, under a consumed income tax, the ability to tax capital income from 

past investments could mitigate the required tax rate increase. The need to maintain revenue neutrality could be 

lessened by reducing government spending. How that 

would affect efficiency depends on what types of spending would be cut. Finally, if not taxing capital income 

stimulated additional investment, then consumption and 

labor income—and hence tax revenues—would eventually rise. But evidence indicates that such an offset would 

represent only a fraction of the forgone revenue.

Other Ancillary Effects of Reducing the Tax Rate on 

Capital

Although moving toward the elimination of taxes on 

capital income would mean cutting taxes overall, the 

alteration of relative taxation would set in motion economic shifts that would generate losses for certain types 

of individuals and institutions and gains for others. There 

are two principal mechanisms by which those burdens 

would be imposed.8

First, as explained earlier, a consumed income tax approach would raise taxes on income from existing capital. 

Since the value of an existing asset is based on the expected flow of after-tax income, such assets would lose 

value relative to new ones. That would impose temporary, but significant, burdens on owners of existing financial and tangible assets.

6. Rules governing the transition to a consumed income tax could 

eliminate the taxation of capital income from past investments, 

thus approximating a labor income tax. Conversely, it would be 

possible to augment a labor income tax with other features that 

approximate the consumed income tax’s levy on capital income 

from past investments.

7. Some analysts estimate that switching to a consumption tax would 

reduce revenues currently collected from taxing capital income 

by modest amounts. See Roger Gordon, Laura Kalambokidis, 

Jeffrey Rohaly, and Joel Slemrod, “Toward a Consumption Tax, 

and Beyond,” The American Economic Review, vol. 94, no. 2 

(May 2004), pp. 161-165.

8. More detailed discussion can be found in David Bradford, 

“Consumption Taxes: Some Fundamental Transition Issues,” in 

Michael J. Boskin, ed., Frontiers of Tax Reform (Stanford, Calif.: 

Hoover Institution Press, 1996), pp. 123-150.
TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM 5

Second, as noted above, either approach to eliminating 

the taxation of capital income would mean that existing 

preferred investments were no longer favored. Even if 

taxed at the same rate as before, the loss of relative advantage would mean that less saving would be directed to 

such investments. Specifically, owner-occupied houses, 

tax-exempt state and local bonds, employment-based 

retirement plans, certain products of life insurance companies, various education savings programs, and health 

savings accounts would all lose their tax advantages.

Those ancillary effects would introduce additional considerations to any decision about whether and how to 

eliminate the taxation of capital income. To begin with, 

while the imposition of a burden on existing assets would 

not distort the return on new investment, it would raise 

issues of fairness. And mitigating those temporary burdens with transitional relief would lower government revenue (equivalent to making the consumed income tax 

more like a labor income tax). In essence, reducing the 

tax on new capital investment would entail either burdening the owners of existing capital or incurring larger 

short-term revenue loss. Furthermore, existing tax preferences for various kinds of saving reflect efforts to pursue 

particular policy goals, and eliminating the tax on capital 

income altogether would effectively neutralize those policy efforts. If those policy goals were to be implemented 

through spending programs, that too would generate 

additional costs.

How Is Capital Income Currently 

Taxed?

The federal government taxes capital income at different 

rates depending on the circumstances of the producer 

and the saver. Producers can be organized as C corporations—essentially, corporations that are subject to the 

corporate income tax—or other forms of businesses, or 

they can be homeowners. The tax system treats their investments differently depending on the legal form of 

organization, or in the case of housing, the tenure of the 

occupant. Savers can choose from a variety of account 

types. The income from those accounts may be fully taxable, taxable at lower-than-normal rates, or nontaxable.

Income of C Corporations

Corporations are subject to their own income tax. The 

federal corporate tax base consists generally of gross business receipts less deductions for the cost of raw materials, 

employee compensation, and normal operating expenses. 

A portion of the cost of acquiring a capital asset is generally deductible each year (until the total acquisition cost 

is reached) to compensate for the depreciation of the asset 

as a result of wear and tear or obsolescence.9 Although 

graduated rates apply to lower net incomes, the maximum statutory corporate tax rate of 35 percent applies to 

the return on most investment.

Depreciation deductions allowed in current law do not 

necessarily match the actual decline in the value of the 

productive asset (economic depreciation), thus causing 

the statutory tax rate to deviate from the effective rate of 

taxation. Researchers have found that the allowed tax 

depreciation for most types of equipment is faster than its 

economic depreciation but that the allowed tax depreciation for most types of nonresidential buildings is slightly 

slower than their economic depreciation.10

Corporations that finance their capital acquisitions 

through debt—by issuing a bond or taking out a loan—

may deduct the interest paid on the debt. By contrast, 

corporations that finance capital acquisitions through equity—by issuing new stock or reinvesting their profits—

may not deduct their dividend payments, nor can they 

adjust their net income to reflect any increase in the value 

of their stock. The absence of any adjustment at the corporate level for dividends or capital gains raises the tax on 

income derived from equity-financed investments above 

that generated by debt-financed investments.

At the individual level, interest earned and dividends received are generally taxable, and capital gains are taxable 

when a stock is sold. Current law partially offsets the 

higher corporate tax on income derived from equityfinanced investments by capping the individual tax rate 

on dividends and capital gains at 15 percent.11 In addition, deferral of any tax on capital gains until the stock is 

sold tends to further reduce the effective tax rate.

9. Small firms are allowed to expense capital investment up to certain 

amounts.

10. See Jane G. Gravelle, Capital Income Tax Revisions and Effective 

Tax Rates, CRS Report RL32099 (Congressional Research Service); and Department of the Treasury, Report to the Congress on 

Depreciation Recovery Periods and Methods (July 2002).

11. Starting in 2009, when the Jobs and Growth Tax Relief Reconciliation Act is scheduled to expire, dividends will be taxable at regular individual statutory rates. The tax rate on capital gains will also 

increase, but it will still be lower than the regular individual statutory rate.
6 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Other Business Income

Sole proprietorships, partnerships, and S corporations 

calculate net business income, including depreciation 

deductions, in the same way that C corporations do.12

However, instead of being subject to their own income 

tax, all of their income is treated as if received by the 

firm’s owners, regardless of whether any is retained within 

the firm for reinvestment. In effect, noncorporate profits 

are taxed only at the individual level, whereas equityfinanced corporate profits are also taxed at the level of the 

business entity itself. Currently, the top individual statutory marginal tax rate is equal to the top corporate rate, 

but most noncorporate profits are taxed at lower rates 

because of the graduated rate structure.13

Owner-Occupied Housing

Although most homeowners do not view themselves as 

producing housing services, the incentives they face and 

the decisions they make with respect to investment in 

housing are analogous to those of other producers. If the 

house is a rental unit, for instance, the tenant pays the 

owner, and that rent, less expenses, is considered income. 

When the owner and the tenant are the same person, the 

economics are identical even though no cash changes 

hands. Homeowners, whether they live in their houses or 

not, are producers who make investment choices that are 

influenced by the tax treatment of their implied income.

Nonetheless, taxable income associated with owneroccupied housing is calculated very differently from that 

generated by other noncorporate business. In essence, 

owner-occupants exclude their implicit gross receipts 

(that is, the rental value of the home) from taxable income and may not claim most deductions, including 

depreciation. Owners may, however, deduct mortgage 

interest and property tax payments if they itemize their 

deductions. Most capital gains from the sale of an owneroccupied house are also exempt.

Capital Income of Savers 

As a general rule, capital income that savers receive in the 

form of interest, dividends, or capital gains is taxed under 

the individual income tax. However, a variety of provisions in the tax code reduce the rates of taxation on particular types of capital income. Those provisions take several forms, most of which do not tax capital income in 

special accounts established for a specific purpose (such as 

retirement, education, or health care). Some apply the 

consumed income tax approach, some apply the labor income tax approach, and some simply defer the tax on 

capital income rather than eliminate the tax altogether.

The consumed income tax approach to eliminating the 

tax on capital income currently applies only to retirement 

saving.14 Specifically, contributions to traditional IRAs 

and employment-based retirement plans are made from 

pre-tax income; investment returns are not taxed, but tax 

must be paid on withdrawals. 

Eliminating the tax on capital income using the labor 

income tax approach requires after-tax contributions but 

allows investment income to accrue tax-free. Withdrawals 

are not taxed. Principal examples of that approach include Roth IRAs, Roth 401(k)s (beginning in 2006), 

Coverdell Education Savings Accounts, 529 plans for 

higher education, and bonds issued by state and local 

governments.

Both approaches are used simultaneously in health savings accounts, which results in not just a zero tax rate for 

capital income, but a subsidy. Partial taxation of capital 

income can be found in vehicles that defer the tax on 

interest, dividends, or capital gains until funds are withdrawn. The most prominent examples are whole life 

insurance (and newer variants, such as universal life and 

variable life) and nonqualified annuities.

Effective Tax Rates on Capital Income

Effective tax rates are commonly used as a metric to evaluate the potential distorting effect of taxes on economic 

activity. The effective tax rate combines statutory tax rates 

with other features of the tax code into a single tax rate 

that applies to economic income over the life of an investment. In the context of capital income, the effective tax 

rate framework is applied to marginal investments; that 

12. Other business (that is, noncorporate) income typically covers 

income from sole proprietorships and partnerships. In this paper, 

however, it includes S corporation income but excludes the 

portion of partnership income attributable to partners that are 

C corporations.

13. Beginning in 2011, when the Economic Growth and Tax Relief 

Reconciliation Act is slated to expire, the top individual rate will 

exceed the top corporate rate.

14. For further details, see Congressional Budget Office,CBO’s OnLine Guide to Tax Incentives for Retirement Saving (August 2003).
TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM 7

is, prospective investments that are expected to earn just 

enough before taxes to pay taxes due and the return that 

savers anticipate receiving.15 The higher the effective tax 

rate, the greater the potential distortion to overall investment. The more variation in effective tax rates across different kinds of investment, the more potential there is for 

capital to be misallocated.

Because of the different tax treatments summarized in the 

previous section, effective tax rates vary by form of business organization, method of financing, asset type, and in 

the case of housing, the tenure of the occupant. To gauge 

the potential efficiency effects related to the disparate 

treatment of different kinds of investment, effective tax 

rates and measures of tax rate uniformity were computed 

in this analysis across those various dimensions. For most 

of the categories, the uniformity measure is simply the 

difference between the rates being compared. In the case 

of different types of corporate assets (there are 49), the 

measure is an interquartile range.16 For all measures of 

uniformity, higher absolute values (that is, values farther 

from zero in either direction) signal less uniformity; a 

score of zero indicates complete uniformity.17 The measures listed do not exhaust the dimensions across which 

effective tax rates could vary.

Between 2006 and 2011, the taxation of capital income is 

scheduled to change under current law as a result of the 

phasing in and expiration of different statutory tax rates 

and other features that influence effective tax rates. To 

simplify the analysis, the effective tax rates presented here 

were computed under the assumption that any provisions 

of the Economic Growth and Tax Relief Reconciliation 

Act of 2001 (EGTRRA) and the Jobs and Growth Tax 

Relief Reconciliation Act of 2003 (JGTRRA) that had 

not already expired by 2008 would be made permanent. 

That assumption served to provide a constant tax law as a 

base.18

Those base-case effective tax rates on capital income were 

then reduced to zero in a series of three sequential simulations. Two of the steps correspond broadly to proposals to 

reduce the tax on income from capital for producers and 

savers. The third raises the after-tax cost of borrowing 

and effectively increases the tax on capital income. The 

simulations illustrate the impact on overall tax rates and 

on tax rate uniformity of implementing some of the steps 

but not others.19

Rates Under the Base Case

The overall effective tax rate on capital income under the 

base case is 13.8 percent (see Table 1). That rate, however, is strongly influenced by a negative rate on the implicit income from owner-occupied housing. For capital 

income generated by business, the overall effective tax 

rate is 24.2 percent. However, the tax rate on the return 

on business investment varies significantly depending on 

the type of asset, the form of business organization, and 

the source of financing.

In the corporate sector, the overall effective tax rate for all 

asset types is 26.3 percent, and the interquartile range 

among asset types is 12.3 percentage points. The variation among asset types generally arises from tax-depreciation rules that deviate from economic depreciation unevenly. The top quartile consists entirely of computers 

and peripheral equipment, inventories, manufacturing 

buildings, and land. The bottom quartile contains 19 different asset types. The major asset types with the lowest 

15. This paper generally follows existing conventions in constructing 

its effective tax rates but expands on those conventions in its treatment of saving incentives. Existing conventions capture major 

features of the federal tax code and investment environment, but 

they abstract from many other features, such as the estate tax and 

international capital movements. See Appendix A for details of 

the calculation and Appendix B for an analysis of alternative 

assumptions.

16. An interquartile range is the difference between the effective marginal tax rates at the 75th and 25th percentiles. Half of all assets 

have rates within that range, one-quarter have higher rates, and 

one-quarter have lower rates. This measure is not sensitive to 

changes at the extremes, nor does it pick up changes that occur 

within the middle two quartiles. Thus, although it is a good overall indicator of potential distortions across asset types, it is not a 

comprehensive indicator of all possible such distortions.

17. Research has generally found that efficiency is increased by substantially reducing differences in tax rates along the dimensions 

identified here. See, for example, Jane G. Gravelle, The Economic 

Effects of Taxing Capital Income (Cambridge, Mass.: MIT Press, 

1994), pp. 76-90, and Don Fullerton, Yolanda K. Henderson, and 

James B. Mackie III, “Investment Allocation and Growth Under 

the Tax Reform Act of 1986,” Compendium of Tax Research 1987

(Department of the Treasury, Office of Tax Analysis), pp. 173-

203.

18. Average statutory tax rates under the base case are shown in 

Appendix A. All represent federal taxes only. State and local taxes 

are treated in this analysis like any other operating expense.

19. Four stand-alone simulations representing other proposals are 

presented in Appendix C.
8 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table 1.

Effective Tax Rates on Capital Income 

and Measures of Tax Rate Uniformity

Source: Congressional Budget Office.

a. The base case assumes that the tax provisions in place in 2008 

under the Economic Growth and Tax Relief Reconciliation Act of 

2001 and the Jobs and Growth Tax Relief Reconciliation Act of 

2003 will be permanently extended instead of being allowed to 

expire by 2011.

b. An interquartile range is the difference between the effective tax 

rates at the 75th and 25th percentiles. Half of all assets have 

rates within that range, one-quarter have higher rates, and onequarter have lower rates.

rates are mining structures, petroleum and natural-gas 

structures, railroad equipment, aircraft, specialized industrial machinery, fabricated metal products, ships and 

boats, and construction machinery (see Table 2).

The effective tax rates were computed assuming the currently observed mix of debt and equity financing in the 

corporate sector. To show the differences between the two 

sources of financing, effective tax rates were recomputed 

assuming either all equity or all debt financing.20 The resulting rate on equity-financed corporate capital income 

is 36.1 percent and that on debt-financed corporate capital income is -6.4 percent, a difference of 42.5 percentage 

points. The rate on equity-financed corporate capital income is higher than the statutory corporate tax rate because of the extra tax imposed on dividends and capital 

gains at the individual level.21 That effect is mitigated, 

however, by the fact that some of that capital income is 

received via retirement accounts. Considering only the 

corporate-level tax, the rate on equity-financed corporate 

capital income is 30.6 percent, lower than the statutory 

corporate rate by virtue of favorable depreciation rules.

The effective tax rate on debt-financed corporate capital 

income is negative in part because accelerated depreciation and interest payments generate tax deductions in excess of taxable income, which leads to corporate tax refunds. Taxes paid by savers on interest received do not 

entirely offset those refunds; again, much of that interest 

income is received in various accounts in which it is not 

taxed.22 In addition, even fully taxable interest is taxed at 

an average marginal rate of 22 percent because substantial 

interest income is earned by those taxed at less than the 

top rate, whereas corporations deduct interest at the 

35 percent marginal tax rate. 

On noncorporate capital income, the effective tax rate is 

20.6 percent, 5.7 percentage points lower than the rate 

on corporate capital income. That difference arises for 

Base Casea

Effective Tax Rates (Percent)

Overall 13.8

Business 24.2

Corporate 26.3

Debt financed -6.4

Equity financed 36.1

Noncorporate 20.6

Housing

Tenant occupied 18.2

Owner occupied -5.1

Measures of Tax Rate Uniformity

(Percentage points)

Interquartile range across asset types—

corporateb 12.3

Difference between equity financed and debt 

financed—corporate 42.5

Difference between corporate and 

noncorporate 5.7

Difference between tenant- and owneroccupied housing 23.3

Difference between all business and owneroccupied housing 29.3

20. Note that this is not the same as calculating the tax rate on assets 

that are actually equity financed versus those that are actually debt 

financed. Sufficiently detailed data were not available to perform 

that calculation.

21. The effective tax rates were computed under the assumption that 

the tax rate on dividends matters in proportion to the fraction of 

after-tax profits that are paid out as dividends (57 percent). Effective tax rates computed under an alternative view, which gives less 

weight to the dividend tax rate and more to the capital gains tax 

rate, are presented in Appendix B. Effective tax rates computed 

under both views are similar when the Jobs and Growth Tax Relief 

Reconciliation Act is in effect, as in the base case, because that law 

equalizes the statutory tax rates on dividends and capital gains. 

Rates computed under both views are also similar under some 

proposals to integrate the corporate and individual income taxes 

(see Appendix C).

22. If marginal saving occurs only outside of retirement accounts (as a 

result of contribution limits or withdrawal constraints), the effective tax rate on the return on debt-financed investment would be 

positive. Complete results reflecting that assumption are presented 

in Appendix B.
TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM 9

two reasons: first, there is no extra tax imposed on the income from equity-funded noncorporate investments; and 

second, in the graduated rate schedule of the individual 

income tax, most noncorporate business income 

(whether from equity-financed or debt-financed investments) is taxed at a rate lower than the statutory maximum. However, income from noncorporate capital (especially equity financed) is much less likely to be received in 

a retirement account than is income from corporate capital, making the difference less than it otherwise would be.

The effective tax rate on income from tenant-occupied 

houses is 18.2 percent, whereas the rate on the implicit 

income from owner-occupied houses is -5.1 percent, a 

difference of 23.3 percentage points. The negative rate on 

owner-occupied housing arises because most mortgage 

interest and property tax payments are deductible even 

though the (implicit) gross receipts are not taxable.23

Furthermore, the recipients of the interest payments receive some of that income via accounts in which capital 

income is nontaxable. Even the rate on tenant-occupied 

housing is low relative to that paid on other business investment, however, because such structures are overwhelmingly noncorporate investments and are subject to 

more-generous depreciation rules.

Eliminating the Tax on Capital Income:

An Illustrative Sequential Approach

The current hybrid tax system could be transformed, in a 

series of incremental steps, into one that does not tax capital income. For illustrative purposes, the approach is analyzed using the following three sequential steps:

1. Remove contribution, eligibility, and withdrawal 

restrictions on retirement accounts;

2. Allow the full expensing of capital acquisitions; and

3. Disallow interest deductions.

The first step would lower effective tax rates on capital 

income at the individual level, the next step would lower 

rates at the business-entity level, and the final step would 

increase the rates at both levels. The effects of reordering 

the sequence are discussed below.

The analysis holds constant the total amount of investment and saving, the allocation of investment among asset types, the corporate-noncorporate split, the share of 

investment that is debt financed, and the share of housing 

that is owner occupied. All of those elements would 

change if behavioral responses were incorporated into the 

estimates.

Step 1: Remove Contribution, Eligibility, and Withdrawal 

Restrictions on Existing Retirement Accounts. This step 

could be undertaken using either the consumed income 

tax or the labor income tax approach described above. It 

would consist of expanding existing IRA-type accounts 

so that anyone could have them, allowing contributions 

to be made without limit, and allowing unrestricted 

withdrawals.

Expansion of the accounts in that way would reduce the 

overall effective tax rate on capital by 8.3 percentage 

points, to 5.5 percent (see Table 3). The rate on corporate 

capital would drop by 9.2 percentage points, to 17.1 percent. Because depreciation rules would be unaffected, the 

variation in rates across asset types would not change. 

Statutory tax rates on dividends and capital gains are 

lower than those on interest income under the base case. 

Therefore, eliminating the individual-level tax on all capital income would lower the effective tax rate on equity 

income by less than that on debt income. Because the rate 

on income from debt-financed investments is already the 

lower of the two, the difference between the two sources 

of financing would increase by 16.0 percentage points, to 

58.5 percentage points.

The difference in effective tax rates on capital income 

from corporate investment and that from noncorporate 

investment would decline from 5.7 percentage points to 

1.3 percentage points. That result would occur because 

noncorporate investment is more likely to be equity 

financed, and this provision would not affect income 

from such investment (because it could not be held in 

either the existing or expanded accounts). Thus, the overall rate on income from noncorporate investment would 

decline by less (4.8 percentage points) than the higher 

rate on income from corporate investment (9.2 percentage points).

23. Owners of tenant-occupied housing can also deduct their property taxes, but they can pass those costs on to the tenants. That 

increases the owner’s taxable income, offsetting the tax deduction. 

Owner-occupants cannot pass the cost of the property tax on to 

anybody else, so the deduction is not offset by any additional 

taxable income.
10 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table 2.

Effective Tax Rates on Capital Income of C Corporations, by Asset Type

Continued

The effective tax rate on the implied income from owneroccupied housing would decline by about 4 percentage 

points more than that on income from tenant-occupied 

housing, increasing the difference between them to 27.4 

percentage points. The step has no impact on equityfinanced investment in either type of housing (income 

from owner-occupied housing is not taxed now, and virtually no tenant-occupied housing is held in corporate 

form), and owner-occupied housing is significantly more 

likely to be debt financed than is noncorporate business 

investment in general.24

Step 2: Allow Full Expensing of Capital Acquisitions. The 

second step would allow the full expensing of all tangible 

business capital, both equipment and structures. This 

step would reduce the overall effective tax rate on capital 

income by an additional 20.6 percentage points, to 

-15.1 percent. That rate is a composite of a zero rate on 

equity-financed investment and a substantial negative 

rate on debt-financed investment—that is, income from 

equity-financed investment would not be taxed, and that 

from debt-financed investment would be substantially 

subsidized.

Asset Type Effective Tax Rate Cumulative Percentage of Assets in 2002

Computers and Peripheral Equipment 36.9 1.2

Inventories 34.4 11.8

Manufacturing Buildings 32.2 19.1

Land 31.0 33.5

Other Buildings 30.6 36.1

Commercial Buildings 30.4 44.5

Office Buildings (Including Medical) 30.2 51.2

Automobiles 29.7 52.2

Other Structures 29.5 53.4

Software 29.1 55.9

Hospitals and Special Care 28.4 56.6

Educational Buildings 28.4 56.9

Office and Accounting Equipment 28.4 57.0

Internal Combustion Engines 27.3 57.0

Electric Transmission and Distribution 24.9 59.4

Other Electrical Equipment 24.8 59.5

Residential Buildings 23.8 60.0

Steam Engines 22.9 60.5

Farm Tractors 22.7 60.6

Service Industry Machinery 22.2 61.2

Mining and Oil-Field Machinery 21.9 61.4

Other Equipment 21.5 62.5

Farm Structures 20.8 62.7

Medical Equipment and Instruments 20.4 63.4

Agricultural Machinery 20.2 63.6

Railroads 20.1 65.9

24. The computations assume that tenant-occupied housing would be 

debt financed in the same proportion that other noncorporate 

businesses are. If debt financing of tenant-occupied housing is 

more extensive than for other forms of noncorporate business, 

however, this difference might be overstated.
TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM 11

Table 2.

Continued

Source: Congressional Budget Office and Department of Commerce, Bureau of Economic Analysis. 

Note: In addition to buildings, “structures” can include entities such as dams, mine shafts, petroleum pipelines, radio-transmission towers, 

and railroad tracks. 

The zero rate on income from equity-financed investment arises because allowing the cost of an asset to be 

deducted in the year that it is purchased reduces taxes in 

that year by the same amount—after accounting for the 

time value of money—that taxing the resulting profits in 

later years would be expected to generate. That result 

holds for both corporate and noncorporate investments.

In the corporate sector, the effective tax rate on debtfinanced investment would drop to -87.5 percent.25 That 

effective subsidy arises from the continued deductibility 

of interest. The cost of the investment is deducted by the 

business (through expensing), but the capital income 

generated by the investment yields no tax at either the 

business-entity level (because it is offset by interest expenses) or the individual level (because of unrestricted accounts in which capital income is not taxed). 

Because expensing is permitted for all types of assets, the 

interquartile range of tax rates across asset types would 

Asset Type Effective Tax Rate Cumulative Percentage of Assets in 2002

Nonmedical Instruments 20.0 66.7

Metal-Working Machinery 19.0 68.4

Other Power Structures 19.0 70.5

Photocopy and Related Equipment 18.8 70.8

Electric Structures 18.6 76.2

Other Furniture 18.5 77.7

Other Trucks, Buses, and Truck Trailers 18.2 78.6

Light Trucks (Including Utility Vehicles) 18.2 79.9

Communications Equipment 17.8 83.7

Household Appliances 17.5 83.8

Construction Tractors 17.4 83.8

General Industrial Equipment 17.3 86.8

Communication Structures 17.0 89.7

Construction Machinery 16.7 90.3

Ships and Boats 16.5 90.8

Residential Equipment 16.2 90.8

Fabricated Metal Products 15.5 91.6

Household Furniture 15.1 91.6

Specialized Industrial Machinery 14.9 93.8

Aircraft 14.5 95.8

Railroad Equipment 11.4 96.5

Mining Structures 9.5 96.8

Petroleum and Natural-Gas Structures 9.2 100.0

25. Such a subsidy would create a strong incentive to use debt financing more heavily. Corporations would be encouraged to expand 

their debt-financed investments until their interest deductions 

offset their taxes on all existing investment. Noncorporate businesses would be encouraged to expand their debt-financed investments until their interest deductions offset not only their taxes on 

existing investments but also the taxes that their owners pay on 

labor income. 
12 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table 3.

Successive Steps Toward Eliminating the Tax on Capital Income

Source: Congressional Budget Office.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

b. An interquartile range is the difference between the effective marginal tax rates at the 75th and 25th percentiles. Half of all assets have 

rates within that range, one-quarter have higher rates, and one-quarter have lower rates.

fall to zero. Of necessity, the zero effective tax rate on all 

equity-financed investment would produce that result, 

but the same conclusion would hold for debt-financed 

investment because all asset types would be subject to the 

same depreciation rules.

Expensing would have no effect on owner-occupied 

housing but would reduce the rate on tenant-occupied 

housing. Those factors would reduce the difference in effective tax rates between the two types of housing tenure 

by 23.9 percentage points, to 3.5 percentage points. 

Step 3: Disallow Interest Deductions. This step would 

disallow the deduction of interest expenses by businesses 

and homeowners (and of property tax payments by 

homeowners). That change, combined with the first two, 

would eliminate the subsidy for debt-financed investment, rendering a zero effective tax rate for such investment income. Because the tax rate on equity-financed investment would have been reduced to zero by the 

previous step, eliminating interest deductions would 

eliminate the difference in effective rates for different 

sources of financing. Furthermore, without interest deductions, the different tax rates at the corporate and noncorporate levels would no longer matter. Therefore, this 

step would also eliminate the difference in rates that exists between different forms of business organization. 

The differences that occur in effective tax rates between 

owner-occupied and tenant-occupied housing were 

largely eliminated in the previous step. Disallowing the 

property tax deduction for owner-occupants would 

complete the elimination of that difference.

Base Casea

Step 1:

Eliminate 

Individual-Level 

Taxes

Step 2:

Allow Full 

Expensing

Step 3:

Eliminate 

Interest 

Deductions

Effective Tax Rates (Percent)

Overall 13.8 5.5 -15.1 0

Corporate 26.3 17.1 -19.5 0

Debt financed -6.4 -28.0 -87.5 0

Equity financed 36.1 30.5 0 0

Noncorporate 20.6 15.8 -10.5 0

Owner-occupied housing -5.1 -14.1 -14.1 0

Measures of Tax Rate Uniformity (Percentage 

points)

Interquartile range across asset types—

corporateb 12.3 12.3 0 0

Difference between equity financed and 

debt financed—corporate 42.5 58.5 87.5 0

Difference between corporate and 

noncorporate 5.7 1.3 -9.0 0

Difference between tenant- and owneroccupied housing 23.3 27.4 3.5 0
TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM 13

Table 4.

Alternative Combinations of Steps Toward Eliminating the Tax on Capital Income

Source: Congressional Budget Office.

Note: ** = between -0.05 percentage points and 0.05 percentage points.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

b. An interquartile range is the difference between the effective marginal tax rates at the 75th and 25th percentiles. Half of all assets have 

rates within that range, one-quarter have higher rates, and one-quarter have lower rates.

Changing the Sequence of the Steps. The analysis detailed in steps 1 and 2 showed the distortions that would 

be introduced if capital income were not taxed while interest remained deductible. Reversing the order of steps 1 

and 2 would reduce the distortions caused by expensing 

but would increase those caused by expanding retirement 

accounts, leaving the same net impact from the two steps. 

Other illustrative partial steps would pair the ending of 

interest deductibility with either an expansion of retirement accounts or full expensing (see Table 4). Combining steps 1 and 3 would increase the effective tax rate on 

capital income to 18.0 percent but would apply the tax 

only at the business level, thereby eliminating the bias 

against equity financing. Combining steps 2 and 3 would 

eliminate the business-level tax but would leave interest, 

dividends, and capital gains taxed at the individual level. 

That option would reduce the effective tax rate on capital 

income to 9.3 percent and substantially move the tax system toward uniformity along all four dimensions considered here. Nevertheless, neither alternative would achieve 

the same level of uniformity as combining all three steps.

Base Casea

Steps 1 and 2:

Exempt Capital 

Income, Retain 

Interest Deduction

Steps 1 and 3:

Tax Capital 

Income Only at 

Business-Entity 

Level

Steps 2 and 3:

Tax Capital 

Income Only at 

Individual Level

Effective Tax Rates (Percent)

Overall 13.8 -15.1 18.0 9.4

Corporate 26.3 -19.5 30.6 11.1

Debt financed -6.4 -87.5 30.6 16.9

Equity financed 36.1 0 30.6 8.0

 Noncorporate 20.6 -10.5 23.9 8.3

 Owner-occupied housing -5.1 -14.1 0 8.6

Measures of Tax Rate Uniformity

(Percentage points)

Interquartile range across asset 

types—corporateb 12.3 0 12.3 0

Difference between equity financed and 

debt financed—corporate 42.5 87.5 ** -8.9

Difference between corporate and 

noncorporate 5.7 -9.0 6.7 2.8

Difference between tenant- and owneroccupied housing 23.3 3.5 21.9 -2.1

A

The Methodology Behind Effective Tax Rates Appendix A: The Methodology Behind Effective Tax Rates

The methodology of effective tax rates shows how 

features of the tax code interact with one another and 

with the economy to affect the rate of return on new 

investment. Because of differences in the way the tax code 

treats investors, correct application of the rates distinguishes between investments by corporations, unincorporated businesses, and individuals investing in their own 

homes.1 Whenever possible, the analysis utilized data 

from 2002 (the latest year such information was available) but gathered that data from a wide variety of 

sources.

Defining Effective Tax Rates

Taxes on capital income are most easily analyzed in terms 

of their effect on the rate of return on capital. For example, a tax that takes 2 percentage points of a 6 percent 

before-tax rate of return leaves the investor with a 4 percent after-tax rate of return. The tax rate would be 33 

percent, measured as (.06-.04)/.06. The 2 percentage 

point difference between the before-tax rate of return and 

the after-tax rate of return is referred to as the tax wedge. 

The term “effective” distinguishes those tax rates from 

statutory tax rates. Statutory tax rates apply to taxable 

income in a given year; effective tax rates summarize in 

a single measure provisions of the tax code that apply to 

economic income over the entire life of an investment. 

Specifically, an effective tax rate is a constant rate that, if 

applied to the return on an investment over its lifetime, 

would yield the same after-tax rate of return as applying 

statutory rates to taxable income according to the law. 

For example, federal law allows trucks used locally for 

commercial purposes to be depreciated by 35 percent of 

their purchase price during the first year they are placed 

in service.2 Under normal usage, the value of those trucks 

would depreciate by about 15 percent during that time, 

based on studies of used-truck prices. Because tax depreciation exceeds economic depreciation in the first year, 

taxable income from the investment would be less than 

economic income. That would reduce taxes and raise the 

after-tax return from what it would be if tax rates were 

applied to economic income. The situation would reverse 

itself in later years. Tax law allows trucks to be fully depreciated after five-and-a-quarter years, although they 

normally would still retain some value by that time. 

Trucks that remain in use after five years would receive no 

tax-depreciation deductions even though they would 

continue to depreciate. That imbalance would raise taxable income from the trucks above economic income, 

which would raise taxes and reduce after-tax returns relative to what would occur if tax rates were applied to economic income. Effective tax rates provide a constant tax 

rate applied to economic income over the life of the 

trucks that evens out the overstated and understated tax 

burdens in particular years.

Depreciation allowances are not the only source of differences between effective tax rates and statutory rates. The 

deferral of taxation of capital gains and traditional individual retirement account (IRA) contributions is another 

example. Furthermore, inflation causes differences for 

many types of capital income.

APPENDIX

1. For further explanation of the methodology and examples of its 

use, see Jane G. Gravelle, The Economic Effects of Taxing Capital 

Income (Cambridge, Mass.: MIT Press, 1994), and James B. 

Mackie III, “Unfinished Business of the Tax Reform Act of 1986,”

National Tax Journal, vol. 55, no. 2 (June 2002), pp. 293-338.

2. In the example, trucks are assumed to be placed in service at the 

middle of the first quarter of a year. That is done to match a convention of tax-depreciation rules that allows seven-eighths of a full 

year’s tax depreciation for assets placed in service during the first 

quarter of a year. For simplicity, the example also assumes that the 

rate of inflation is zero.
16 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

In this analysis, effective tax rates were computed for a 

prospective investment that would just break even. That 

is, the cost of the investment is expected to just equal the 

present value of the return that the business would have 

to distribute to its investors after paying the taxes that 

would be due on the profits. Such tax rates are an important factor in the decision to invest. Businesses tend to invest in the most profitable projects first and continue investing in others of declining profitability until they reach 

the break-even or marginal project. Additional projects 

are not undertaken because they would not be profitable. 

A reduction in the effective tax rate on the marginally 

profitable new investment would make more investment 

projects profitable, encouraging such investment, whereas 

an increase in the tax rate on a marginal investment 

would make fewer projects profitable.

Prospective marginal tax rates are better guides to investment incentives than are average tax rates computed from 

actual taxes paid by businesses on profits in a past year. As 

noted above for trucks, existing profits on old capital can 

be understated or overstated because the age of existing 

assets may place them in more or less accelerated portions 

of the tax-depreciation schedule. Inflation distorts taxable 

profits so that average tax rates do not reflect effective tax 

rates, even on existing activities. Recent changes in tax 

laws will make average tax rates from earlier years inapplicable; even changes in law from several years ago can 

cause average tax rates in recent years to differ from the 

rates on new investment because existing investments or 

activities can be protected from subsequent legislative 

changes. Finally, average tax rates on current profits can 

fluctuate depending on the losses that profitable businesses carry into the current year and the losses that unprofitable businesses carry back to earlier years. 

Just as the business investments considered here are those 

that are marginal, so too are the sources of saving new or 

marginal. Thus, the tax rates that apply to them can differ from those paid on existing savings. Consider an individual who has saved up to the limit in his or her retirement savings account. The investment earnings within 

the account are not taxable, but if the individual saves an 

additional dollar, it cannot be within that account, so the 

investment returns on that dollar will be taxed.

Calculating Effective Tax Rates

Different calculations of effective tax rates were applied to 

C corporations, noncorporate businesses, and homeowners. Like any summary measure, however, the calculations 

do not capture the full complexity of tax laws or the investment environment.

C Corporations

A corporation considering an investment must expect to 

earn enough to pay investors the rate of return that they 

could obtain from other investments. In particular, a 

market interest rate must be paid on borrowed funds, and 

a competitive rate of profit must be expected on equity 

raised from new stock sales or reinvestment of profits 

from previous investments.3

 (Profits from the investment 

under consideration would be returned to stockholders 

through some combination of dividends and additional 

reinvestment intended to enhance the value of the stock.) 

In addition to paying investors the return they demand, 

the expected earnings on an investment must be sufficient to recover the capital contributed by investors and 

to pay any corporate income taxes. The rate at which the 

initial contribution must be recovered depends on how 

fast the asset’s earning power depreciates. The amount 

needed to cover the corporate income tax depends on the 

corporate tax rate, the value of allowable depreciation deductions, and how the investment is financed. To the extent that it is financed with equity, it must earn enough 

to pay the corporate tax on the profits. To the extent that 

funds are borrowed, the return need not cover the corporate tax because interest expenses are deductible. The 

anticipated inflation also affects the required return. 

Inflation raises the return by reducing the value of depreciation deductions; it lowers the return by raising the 

interest deductions relative to earnings. 

3. The real return (that is, the return net of inflation) required by 

investors—r—can be expressed as a weighted average of the real 

interest rate and the real return on equity. The real interest rate is 

measured here as the market interest rate less the inflation rate.

Where is the fraction of the investment financed by debt,

 is the market interest rate,

 is the inflation rate, and

 is the real return on equity.

r = f • ( ) i – π + ( ) 1 – f •E

f

i

π

E
APPENDIX A THE METHODOLOGY BEHIND EFFECTIVE TAX RATES 17

An investment whose return is just sufficient to cover 

those costs is the marginal investment. Its return, net of 

cost recovery, is that which is necessary to cover both the 

corporate tax and the return to investors.4 The difference 

between that real before-tax return and the real return 

paid to investors is the corporate tax wedge. Finally, the 

effective tax rate is the tax wedge relative to the before-tax 

return. Algebraically, when represents the real beforetax return on the marginal investment and represents 

the real return paid to investors, the tax wedge is 

and the effective tax rate, or ETR, is: 

The pretax rate of return and the ETR typically vary 

among asset types because of differences in the relationship between economic and tax depreciation. The more 

accelerated an asset’s tax-depreciation allowances are relative to its economic depreciation, the lower its required 

return before-tax and the lower its effective tax rate. In 

two important cases, however, the ETRs will be uniform 

for all asset types. One instance occurs when tax depreciation equals economic depreciation for all asset types, and 

the other occurs when tax deprecation is replaced with an 

immediate deduction (expensing). Furthermore, for investments financed by equity, the uniform effective tax 

rate in the former case would be the statutory tax rate and 

in the latter case would be zero. 

The earnings of the corporate investment are generally 

taxed again when paid out to savers. That introduces a 

second level of tax on corporate profits. The rate of taxation on such payouts depends on their form: interest, dividends, or retained profits. It also depends on inflation. 

Inflation raises nominal interest payments and capital 

gains above their real values, thereby raising tax rates on 

real earnings.5

 The form in which people save also affects 

taxation of the investment. Capital income in certain accounts established for retirement, education, or health 

care is not taxed; the tax on capital income in nonqualified annuities or whole life insurance is temporarily deferred; and other capital income is immediately taxed.6

The real after-tax return that individuals end up with on 

the marginal investment, therefore, depends on how the 

marginal investment is financed and the type of account 

in which the marginal dollar of saving is deposited. Specific distributions of financing and saving are described 

later; here the average real after-tax return of savers is simply labeled as . That label allows CBO to define the total tax wedge as and the marginal effective total tax 

rate (ETTR) as:7

Noncorporate Businesses

Investments by noncorporate businesses also need to pay 

investors competitive rates of return. For debt finance, 

that would be the market interest rate. For equity, the 

investor-operator of a noncorporate business will want to 

earn on a marginal investment as much after tax as he or 

she could earn by buying corporate equity. Given those 

earnings requirements and the tax law, the rate of return 

required before tax to just break even can be computed in 

a parallel fashion to the before-tax rate of return on a 

4. The real before-tax rate of return covering the costs discussed in 

the text can be expressed as: 

Where is the corporate 

discount rate, which reflects the deductibility of

interest.

 is the corporate tax rate,

 is the rate at which the economic value of the asset 

depreciates, and

 is the present value of tax-depreciation allowances 

measured as a share of investment.

Other terms are as defined in the previous footnote.

The expression is the cost of paying the investor’s return 

and recovering capital. The expression adjusts those costs 

for the value of tax depreciation. Their product divided by 

gives the profit that must be earned before tax to cover taxes, 

investor return, and cost recovery. Subtracting limits the profit 

to just that needed to cover investor return and corporate taxes.

ρ = (r′ + δ )(1 – uz ) ⁄ ) (1 – u – δ

r′ = f i • [ (1 – u ) – π ] + (1 – f) • E

u

δ

z

r′ δ +

1 – uz

1 – u

δ

ρ

r

ρ – r

ETR ρ – r

ρ = -----------

( ) ρ

5. Anticipated inflation raises market interest rates to compensate for 

the erosion of a loan’s repayment. That inflation premium reduces 

corporate income taxes through higher deductions for interest 

paid and raises taxes for savers through higher nominal interest 

income. The net effect is a reduction in tax because individuals, 

on average, pay the tax on interest at a lower marginal rate than 

corporations deduct it.

6. Retained earnings of corporations are an exception to the immediate taxation of other capital income. They are taxed as capital 

gains when the saver sells the corporation’s stock.

7. References in the main text, tables, and other appendixes to effective tax rates of corporations are to ETTRs unless explicitly noted 

otherwise.

s

ρ – s

ETTR ρ – s

ρ = ----------
18 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

marginal investment in the corporate sector . No tax 

is imposed directly on the noncorporate business, but the 

interest and profits paid out are subject to tax at the individual level. 

The after-tax return received by marginal lenders is not 

generally the same as that received by marginal lenders to 

corporations because funds loaned to noncorporate businesses are less likely to be held in nontaxable vehicles.8

Because of that difference for lenders, the average real

after-tax return on savings invested in the noncorporate 

sector need not be the same as that invested in the corporate sector (labeled s above). Although the values for 

and are different for noncorporate investments than 

they are for corporate investments, the formulas for calculating the tax wedge and effective tax rate are similar.

Owner-Occupied Housing

A homeowner making a marginal investment in his or her 

house also has to pay the market interest rate on debt financing. As for equity financing, it is assumed that owners want to earn the same benefit from equity invested 

in their home that they would get in their other equity 

investments. The main difference in computing the required pre-tax rate of return is that no tax is owed on 

equity earnings, and no depreciation deductions are allowed. Another difference is that interest is deductible 

only for homeowners who itemize. A third difference is 

that federal income taxes are reduced to the extent property taxes are deductible. Those features mean that the 

before-tax rate of return needs to be only a little higher 

than the return paid to savers (just enough higher to 

cover the portion of interest that is not deductible) and 

can be lower (if the deduction for property tax payments 

is large enough). The tax wedge, therefore, typically will 

be much closer to zero than it is for marginal investments 

in the other two sectors, and it may even be negative. 

Limitations of the Effective Tax Rate Framework

The effective tax rate framework necessarily omits many 

features of the tax code that factor into the investment 

decision. One limitation is that it assumes all savers and 

investors are subject to the U.S. income tax. That would 

mean that foreigners supply no savings and that investments are located in the United States. Foreign savers are 

not subject to the U.S. individual income tax, so allowing 

foreigners to funnel savings to investments in the United 

States would mean that changes in the individual income 

tax in the United States would not necessarily influence 

the effective total tax rates on U.S. businesses. Furthermore, investments located abroad are not subject to the 

U.S. income tax unless and until profits are brought back. 

Including investments abroad in this analysis would 

mean that U.S. business tax laws would not necessarily 

affect effective tax rates faced by businesses. The simplification of a closed economy still provides useful insights 

because the U.S. economy is so large that most savings invested in the United States originate with U.S. residents. 

The growing globalization of businesses and capital flows, 

however, is lessening the validity of the closed economy 

assumption.9

Narrowing the focus to individuals and firms in the 

United States still leaves a broader range of taxation than 

can be addressed within the scope of the effective tax rate 

framework. The effective tax rate framework omits estate 

and gift taxes, self-employment contributions to Social 

Security, and many features of the tax code affecting specific industries, assets, or types of activities. Furthermore, 

all investments are assumed to be fully compliant with 

the tax law. The analysis also excludes state and local taxes 

to focus on the incentive effects of federal tax options. 

Because of the above limitations, it is best to think of effective tax rates as examples of how the main features of 

the federal tax system affect investment incentives.

Implementing Effective Tax Rates

To calculate numerical effective tax rates, a host of assumptions must be made. Presented here are the major 

assumptions involving which investments are made, 

which businesses make them, how they are financed, 

what returns investors require, how marginal savings are 

held, and what statutory tax rates apply.

8. The marginal equity-financed investment in noncorporate businesses cannot be held in a nontaxable account. That difference 

from savings supplied to corporations is reflected in the before-tax 

rate of return that the noncorporate business must earn.

( ) ρ

ρ

s

9. For an analysis of the international implications of corporate 

income taxation and effective tax rates, see Congressional Budget 

Office, An International Comparison of Corporate Income Tax Rates

(forthcoming).
APPENDIX A THE METHODOLOGY BEHIND EFFECTIVE TAX RATES 19

Table A-1.

Distribution of Assets in 2002, by Type and Form of Organization

(Percentage of total, all types)

Source: Congressional Budget Office calculations based on data from Department of Commerce, Bureau of Economic Analysis; Department 

of Labor, Bureau of Labor Statistics; and Internal Revenue Service, Statistics of Income Division.

Notes: n.a. = not applicable.

In addition to buildings, “structures” can include entities such as dams, mine shafts, petroleum pipelines, radio-transmission towers, 

and railroad tracks. 

a. The eight types of equipment are aggregated from 32 of the categories listed in Table 2.

b. The four types of structures are aggregated from 15 of the categories listed in Table 2.

c. Owner occupied.

The Investments 

In this analysis, the Congressional Budget Office (CBO) 

considered investments in 49 types of assets, which represent the full range of equipment, inventories, land, software, and structures that make up private tangible capital 

stock in the United States.10 Residential buildings comprised the largest category, accounting for about 40 percent of the total value of the capital stock (see Table A-1). 

Land was next, at 23 percent, followed by structures 

other than residential buildings, at 19 percent, and equipment and software, at 13 percent. Inventories accounted 

for 5 percent.

Most of the effective tax rates reported in this paper combine those 49 asset types into a single aggregate statistic 

(rates on housing are the only exception). The aggregates 

were constructed by averaging before-tax rates of return 

for asset types within a category (for example, corporations). The averages weight each individual asset type by 

its share of the existing capital stock in the category. 

Intangible assets, such as cumulative knowledge and 

brand allegiance that comes from advertising, were omitted because little is known about their value and rates of 

depreciation. One study suggests that omitting intangible 

Corporate Noncorporate Housingc Total

All Equipmenta 10.7 2.3 n.a. 13.0

Computers and software 1.3 0.2 n.a. 1.5

Communications equipment and instruments 1.9 0.3 n.a. 2.2

Office equipment and furniture 0.7 0.3 n.a. 1.0

Automobiles 0.4 0.1 n.a. 0.4

Other vehicles and transportation equipment 1.8 0.3 n.a. 2.1

Machinery 1.9 0.6 n.a. 2.6

Fabricated metal products and general industrial equipment 1.3 0.2 n.a. 1.5

Other equipment 1.4 0.2 n.a. 1.7

All Structuresb 15.4 11.7 31.5 58.6

Residential buildings 0.2 7.9 31.5 39.6

Nonresidential buildings 9.0 2.9 n.a. 11.9

Mining and drilling structures 1.2 0.1 n.a. 1.3

Other structures 4.9 0.9 n.a. 5.8

Inventories 3.7 1.4 n.a. 5.1

Land 5.0 5.7 12.7 23.3

All Types 34.8 21.1 44.1 100.0

10. Values for most categories of capital stock were obtained from the 

Bureau of Economic Analysis in the Department of Commerce. 

Figures pertaining to land came primarily from the Bureau of 

Labor Statistics in the Department of Labor. The capital stock was 

measured as of 2002.
20 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

assets makes the reported effective tax rates a few percentage points too high and alters the impacts of most policy 

changes by smaller amounts.11

The Producers

Investments were distributed among C corporations, 

noncorporate businesses, and homeowners. Businesses 

that invest were assumed to be profitable, and unincorporated investors (whether businesses or homeowners) were 

assumed to have positive taxable income.12 Marginal investments were assumed to be undertaken by different investor types in proportion to their ownership of existing 

assets. 

Corporations accounted for about 80 percent of the existing stock of equipment and nonresidential structures, and 

about 70 percent of inventories (see Table A-1).13 Their 

share of residential structures, in contrast, was less than 1 

percent; other businesses accounted for about 20 percent, 

and homeowners accounted for about 80 percent. Land 

was more evenly divided, with corporations and other 

businesses holding between one-fifth and one-fourth each 

and homeowners holding a bit over half. 

Financing and Rates of Return

Corporations funded more of their assets with debt than 

did noncorporate businesses but not quite as much as 

homeowners. Corporations financed 41 percent of their 

assets through debt, compared with 32 percent for noncorporate businesses and 43 percent for homeowners.14

Marginal investments were assumed to be financed in 

Table A-2.

Assumed Rates of Return

Source: Congressional Budget Office.

Note: GDP = Gross domestic product.

proportion to those existing patterns of finance. C corporations were assumed to pay out about 57 percent of their 

after-tax profits on equity-financed investments as dividends and to reinvest the remaining 43 percent.15

Interest rates, inflation rates, and returns paid by C corporations on equity were set at levels consistent with 

trends in the recent past and with CBO’s macroeconomic 

forecast for the decade 2006-2015 (see Table A-2).16 The 

interest rate and real equity return are higher than the interest rate on 10-year Treasury bonds of 5.5 percent (or 

3.7 percent after inflation). The Treasury bond rate is 

lower because the government has a much lower risk of 

default than do businesses and homeowners. The methodology for computing effective tax rates does not adequately treat the taxation of risky returns, so some analysts recommend a rate with less risk, such as the yield on 

Treasury bonds. Use of the Treasury bond rate would not 

change the qualitative findings of the report, although the 

differences in effective tax rates between equity-financed 

and debt-financed investments would be larger.

Sources of Marginal Savings

At the individual level, the return on saving can be 

treated in one of three ways: nontaxable (as in IRAs and 

employment-based retirement plans), temporarily deferred (as in nonqualified annuities and whole life insurance), and fully taxable. Within the nontaxable category, 

however, some accounts, particularly IRAs and 401(k)s, 

have binding contribution limits and others, such as 

11. See Mackie, “Unfinished Business of the Tax Reform Act of 

1986,” p. 310.

12. Including investments by unprofitable firms and individuals with 

no taxable income would complicate the computation of average 

statutory tax rates in ways that would shed little light on effective 

tax rates.

13. Ownership by form of business organization was estimated on the 

basis of data obtained from the Bureau of Economic Analysis in 

the Department of Commerce and from the Internal Revenue

Service.

14. The percentages of assets that are debt financed were derived from 

the Flow of Funds Accounts of the Federal Reserve Board for 

2002. 

Percent

Baa Corporate Bond Rate (i) 7.2

Inflation Rate Measured by GDP Deflator 1.8

Real Equity Return After Corporate Tax (E) 7.0

15. The percentages paid out and retained are determined on the basis 

of returns earned by common stocks and the growth rates of the 

corporate capital stock. 

16. Congressional Budget Office, The Budget and Economic Outlook: 

Fiscal Years 2006-2015 (January 2005).

( ) π
APPENDIX A THE METHODOLOGY BEHIND EFFECTIVE TAX RATES 21

defined-benefit plans, do not.17 In general, marginal saving was assigned to each of the four groups in proportion 

to the distribution of assets in 2002.18 However, the statutory limits on contributions to IRAs and 401(k)s require 

that an exception be made to that rule: that once the statutory limit has been hit, marginal saving otherwise destined for such an account must be directed elsewhere.

Prior to the enactment of the Economic Growth and Tax 

Relief Reconciliation Act of 2001 (EGTRRA), the number of families constrained by contribution limits and 

their share of marginal saving were estimated using the 

2001 Survey of Consumer Finances (SCF).19 According 

to that simulation, 46 percent of marginal saving was 

done by families constrained by a limit. Their saving was 

reshuffled so that the amount that would ordinarily have 

been assigned to the constrained account was redirected 

to the fully taxable and temporarily deferred groups. For 

the 54 percent of marginal saving done by families that 

were not constrained by a limit, the distribution among 

groups was left unchanged (see Table A-3).

Consider, for example, saving in corporate equity. Approximately 24 percent of the return on such assets was 

nontaxable in accounts with binding limits, 16 percent 

was nontaxable in accounts without binding limits, 5 percent was temporarily deferred, and 55 percent was fully 

taxable. The following equations show how marginal 

saving was distributed among those groups separately 

for the constrained and unconstrained families, then 

reaggregated:

To represent the base case, the higher contribution limits 

under EGTRRA had to be incorporated. Implementing 

the exception to the general rule under such circumstances required estimating how saving would have been 

distributed under those higher limits. First, unconstrained contributions to 401(k)s were estimated on the 

basis of an age-specific percentage of income, then reestimated as if the EGTRRA limits had been in place. Next, 

IRA contributions in 2002 were estimated on the basis of 

actual IRA deductions reported in 2002, then extrapolated to represent unconstrained contributions and those 

under the fully phased-in EGTRRA limits. Under 

EGTRRA, the percentage of marginal saving done by 

families constrained by a limit dropped from 46 percent 

to 29 percent. That 29 percent was redistributed so that 

amounts that would otherwise have been saved in constrained accounts were directed to fully taxable or temporarily deferred accounts. That left 17 percent switching 

from being constrained to unconstrained. It was estimated that the higher limits under EGTRRA would 

stimulate a 57 percent increase in contributions to nontaxable accounts, so the existing distribution of assets 

among the groups was adjusted to shift that amount from 

the fully taxable and temporarily deferred groups into the 

nontaxable group. The remaining 54 percent of marginal 

saving was unaffected by EGTRRA, so its distribution 

among groups did not change.

Statutory Tax Rates

All of the actual and proposed tax laws considered in this 

paper keep the federal corporate tax rate schedule that 

was in effect just before EGTRRA was enacted. Furthermore, taxable profits from a marginal investment made 

under that structure were assumed to be subject to the 

top statutory rate of 35 percent because that rate is the 

marginal rate for most corporate profits. The analysis 

omitted the recently enacted deduction for productive 

17. Private defined-benefit plans are subject to limits on the amount 

of benefit that can be funded with before-tax dollars, but those 

limits are high enough that contributions are rarely affected.

18. The distribution of savings by type of account was derived from 

the 2002 Flow of Funds.

19. The Survey of Consumer Finances does not cover IRA contributions, so such contributions were imputed based on percentages 

calculated using CBO’s microsimulation model of individual 

income taxes. Marginal saving was assumed to be distributed 

in proportion to the sum of capital income and 401(k) 

contributions.

Unconstrained Constrained Total

Nontaxable/

Binding Limits

(0.54*0.24) + (0.46*0.00) = 0.13

Nontaxable/

No Binding Limits

(0.54*0.16) + (0.46*0.16) = 0.16

Temporarily 

Deferred

(0.54*0.05) + [(0.46*(0.05+0.02)] = 0.06

Fully Taxable (0.54*0.55) + [(0.46*(0.55+0.22)] = 0.64
22 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table A-3.

Distribution of Assets and Marginal Saving, by Tax Status

(Percent)

Source: Congressional Budget Office based on data from Federal Reserve Board, Flow of Funds Accounts (March 10, 2005) and the Survey of 

Consumer Finances (2001); and Internal Revenue Service, Statistics of Income—2002: Individual Income Tax Returns (2004).

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

activity that essentially reduces the tax rate to 32 percent 

for many investments by corporations. 

Individual income tax rates were set according to two alternative schedules: one representing the base case, and 

an alternative representing pre-EGTRRA law that is 

scheduled to resume in 2011 (see Table A-4). The tax rate 

on a particular type of capital income was set at the average of the tax brackets faced by taxpayers with both positive amounts of that particular source and positive taxable 

income overall. The rate is referred to as an average marginal tax rate. For example, before EGTRRA was enacted, 

the average recipient of dividends with positive taxable 

income paid a tax rate of 28 percent on additional dividends. That rate was below the top individual rate of 

39.6 percent because many recipients were in lower tax 

brackets. Under the base case, the average recipient of 

dividends was estimated to pay 12 percent on additional 

dividends, reflecting the new 5 percent and 15 percent 

rate structure. Note also that before EGTRRA was enacted, homeowners who deducted their mortgage interest 

payments had an average marginal tax rate of 22 percent, 

which was lower than the rate for people with interest 

income of 26 percent. The latter tended to have higher 

taxable incomes than the former.

Assets Marginal Saving

2002 Flow of Funds Base Casea

Current Law 

After 2010

Corporate Equity

Nontaxable 40.4 35.8 29.4

Temporarily deferred 5.4 5.8 6.4

Fully taxable 54.2 58.4 64.2

Corporate Debt 

Nontaxable 35.7 32.7 28.8

Temporarily deferred 20.4 21.3 22.5

Fully taxable 43.9 46.0 48.7

Noncorporate Debt 

Nontaxable 18.5 16.7 14.5

Temporarily deferred 13.9 14.2 14.6

Fully taxable 67.6 69.1 70.9

Homeowner Debt 

Nontaxable 23.0 21.3 19.4

Temporarily deferred 7.0 7.1 7.3

Fully taxable 70.0 71.6 73.3
APPENDIX A THE METHODOLOGY BEHIND EFFECTIVE TAX RATES 23

Table A-4.

Average Statutory Marginal Tax Rates

(Percent)

Source: Congressional Budget Office based on its microsimulation 

model of individual income taxes at 2002 income

levels.

a. The base case assumes that the tax provisions in place in 2008 

under the Economic Growth and Tax Relief Reconciliation Act of 

2001 and the Jobs and Growth Tax Relief Reconciliation Act of 

2003 will be permanently extended instead of being allowed to 

expire by 2011.

b. The short-term rate is applied to 3.6 percent of total gains. The 

long-term rate is applied to 48.2 percent of total gains. The 

remaining 48.2 percent of gains are assumed to avoid taxation 

by being held until the taxpayer’s death.

c. The rate is applied only to amounts paid by itemizers, which are 

estimated to be 94 percent of all mortgage interest paid on the 

basis of data from Department of Commerce, Bureau of Economic Analysis; and Internal Revenue Service, Statistics of 

Income Division.

Source of Income

Base 

Casea

Current Law 

After 2010

Corporate Profits (u) 35 35

Dividends 12 28

Long-Term Capital Gainsb

 15 20

Short-Term Capital Gainsb 28 34

Interest Income 22 26

Mortgage Interest Deductionsc 19 22

Unincorporated Business Income 27 31

Distributions from Nonqualified 

Annuities 21 24

B

Alternative Assumptions Appendix B: Alternative Assumptions

The implications of three assumptions underlying 

the Congressional Budget Office’s (CBO’s) main analysis 

warrant further investigation. One such assumption is 

that the Economic Growth and Tax Relief Reconciliation 

Act of 2001 (EGTRRA) and the Jobs and Growth Tax 

Relief Reconciliation Act of 2003 (JGTRRA) will be 

made permanent. Another assumption involves the way 

that dividend taxes are handled in the analysis. The last 

affects how marginal saving is allocated among nontaxable, temporarily deferred, and fully taxable accounts. 

The Effects of the Expiration of 

EGTRRA and JGTRRA

EGTRRA is scheduled to expire after 2010. Although

its extension has been widely debated, multiple tax bills 

since 2001 have not altered that expiration date. In fact, 

when JGTRRA was enacted, some of its provisions were 

scheduled to expire even earlier. Hence, the possibility 

that those laws will expire as scheduled should be 

considered.

Under the tax law in place prior to the enactment of 

EGTRRA (which would resume were EGTRRA to expire), the overall effective tax rate on capital income 

would be 17.4 percent, 3.6 percentage points higher than 

under the base case (see Table B-1). For corporate capital 

income only, the effective tax rate would be 31.9 percent, 

5.6 percentage points higher than under the base case. In 

both instances, the higher effective tax rates would result 

from the expiration of the following provisions:

B The general reduction in individual income tax rates; 

B The additional reduction in the rates on dividends and 

capital gains under JGTRRA; and 

B The higher caps on retirement-account contributions.

Neither EGTRRA nor JGTRRA addressed depreciation 

deductions, which account for most of the variation in 

effective tax rates across asset types. Therefore, the interquartile range of effective tax rates among asset types in 

the corporate sector would remain unchanged at 12.3 

percentage points. 

The reduced statutory tax rates on dividends and capital 

gains under JGTRRA were intended to help level the 

playing field between debt- and equity-financed corporate capital. In isolation, they reduced the difference in 

effective tax rates by approximately 4 percentage points, 

but other provisions of EGTRRA and JGTRRA nearly 

offset that improvement. For example, the general rate reduction lowered the statutory tax rate on interest from 26 

percent to 22 percent. The higher caps on retirement 

plan contributions also favored debt financing because 

the resulting individual income tax reduction was greater 

for debt (dropping from 22 percent to zero) than for 

equity (in the case of dividends, dropping from only 

12 percent to zero). The net result is that expiration of 

EGTRRA and JGTRRA would increase the difference in 

effective tax rates between income derived from debt- and 

equity-financed corporate capital by only 0.3 percentage 

points, to 42.8 percentage points.

APPENDIX
26 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table B-1.

The Effect of the Expiration of EGTRRA and JGTRRA

Source: Congressional Budget Office.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 

(EGTRRA) and the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) will be permanently extended instead of being 

allowed to expire by 2011.

b. An interquartile range is the difference between the effective marginal tax rates at the 75th and 25th percentiles. Half of all assets have 

rates within that range, one-quarter have higher rates, and one-quarter have lower rates.

The reduced statutory tax rates on dividends and capital 

gains met with more success in shrinking the tax differential between corporate and noncorporate investment. If 

EGTRRA and JGTRRA were to expire, the difference in 

effective tax rates between income from corporate and 

noncorporate investments would increase by one-third, 

to 7.6 percentage points. Two factors would help magnify 

the difference:

B Because income generated by corporate investments is 

more likely to be nontaxable or deferred in retirement 

accounts than is income from noncorporate investments, reducing the cap on contributions would raise 

the effective tax rate on corporate capital income by 

more than that on noncorporate capital income; and

B Eliminating the special reduction in the statutory rate 

on dividends and capital gains would increase the extra layer of tax on corporate capital income but have 

little impact on noncorporate capital income.

Eliminating the general reduction in statutory tax rates, 

however, would tend to reduce the difference between 

corporate and noncorporate effective tax rates because it 

applies only to individual income taxes, which are lower 

than corporate taxes.

Finally, the difference in effective tax rates between income from owner-occupied and tenant-occupied housing 

would increase by 3.7 percentage points to 27.0 percentage points. Eliminating the general reduction in individual tax rates would increase the tax on income from noncorporate tenant-occupied housing and simultaneously 

reduce the tax on the implicit income from owneroccupied housing by increasing the value of the mortgage 

interest and property tax deductions claimed by owneroccupants. 

Old and New Views of Taxes on

Dividends 

The analysis of effective tax rates presented in the main 

text of the paper and the discussion in Appendix A treat 

the dividend tax along with all other taxes as a contributor to the tax wedge. That approach, which views the dividend tax as part of the disincentive to save and invest 

Base Casea

Current Law 

After 2010 Difference

Effective Tax Rates (Percent) 

Overall 13.8 17.4 3.6

Corporate 26.3 31.9 5.6

Debt financed -6.4 -1.1 5.3

Equity financed 36.1 41.7 5.7

Noncorporate 20.6 24.2 3.6

Owner-occupied housing -5.1 -5.7 -0.6

Measures of Tax Rate Uniformity (Percentage points)

Interquartile range across asset types—corporateb 12.3 12.3 0

Difference between equity financed and debt financed—corporate 42.5 42.8 0.3

Difference between corporate and noncorporate 5.7 7.6 2.0

Difference between tenant- and owner-occupied housing 23.3 27.0 3.7
APPENDIX B ALTERNATIVE ASSUMPTIONS 27

through corporate equities, has been known as the “old 

view” since the development of an alternative “new view” 

in about 1980. The new view holds that investments 

funded through reinvested earnings are not deterred by 

the tax on dividends. If profits are paid as dividends when 

earned, the dividend tax must be paid immediately. If, instead, profits are reinvested and increase future profits 

and dividend payments, the dividend tax must be paid 

then. After accounting for the time value of money, the 

tax on dividends is the same in both cases. Therefore, under the new view, reinvesting profits does not increase the 

tax on dividends.1 It does increase the tax on capital 

gains, however. Reinvested profits raise the price of the 

firm’s stock to reflect the increased value of the firm, so 

when individuals sell shares, they face a higher capital 

gains tax. Under the new view then, only the capital gains 

tax reduces the return on investing with retained earnings. Although the dividend tax does not reduce the return on reinvested earnings under the new view, it does 

reduce the value of corporate stock because it reduces the 

after-tax amount of dividends that stockholders retain.2

The logic of the new view does not apply to investment 

funded through the sale of new shares. Investing elsewhere would avoid the tax on dividends; thus, the dividend tax is a barrier to investment that is funded through 

the issuing of new shares. As a result, under the new view, 

the weight given to the tax rate on dividends in determining the effective tax rate was not the total share of corporate profits after tax that is paid out as dividends (57 percent), but rather the share of investment that is funded 

through new share issues. CBO’s analysis offers an illustration of the new view by assuming that 10 percent of 

new equity funding in the corporate sector is financed by 

issuing new shares.3

As long as the tax rate on capital gains is less than the tax 

rate on dividends, the effective tax rate on corporate

equity will be lower under the new view than it would be 

under the old view. That lower tax on corporate equity 

reduces the size of the disadvantage that investments in 

corporate equity face relative to investments in corporate 

bonds, noncorporate businesses, and owner-occupied 

housing. Thus, under the new view, the double taxation 

of corporate equity creates a smaller disincentive.

Applying the new view’s weighting of dividends and capital gains to effective tax rates under the alternative case in 

which EGTRRA and JGTRRA expire most starkly illustrates the magnitude of the new view’s implications. The 

most direct repercussion would be that the tax rate on 

corporate equity would be lower: the effective tax rate on 

income from corporate equity would be 41.7 percent under the old view and 37.4 percent under the new view 

(see Table B-2). Both views find the same tax rate on income from debt-financed investment in the corporate 

sector, so the new view shows a smaller difference between equity and debt financing. The lower tax rate on 

income from corporate equity would also lead to a lower 

tax rate on investment income in the corporate sector financed by the normal mix of debt and equity. The effective tax rate on investment income in the corporate sector 

with the average mixture of debt and equity would be 

28.5 percent under the new view instead of 31.9 percent. 

That difference alone implies a smaller disincentive imposed by the corporate-level tax relative to that placed on 

investment in noncorporate activity or owner-occupied 

housing. Likewise, a slightly higher effective tax rate on 

investment income in noncorporate activity and owneroccupied housing implies a smaller disincentive. Those 

higher rates reflect a higher required return on equity in 

the two sectors to compete with the higher return earned 

in the corporate sector under the new view. Finally, the 

effective tax rate on all investment income would be 

1. That conclusion rests on the assumption that profits cannot be 

paid out to stock owners without paying the dividend tax. The 

validity of that assumption has been challenged by the growing 

practice of companies of repurchasing their shares—a practice that 

has exceeded new-share issues almost continuously since 1984. 

Repurchases are an alternative way for companies to distribute 

profits to shareholders that avoids the dividend tax but incurs the 

capital gains tax. In fact, the new view could be restated in terms 

of share repurchases and their associated capital gains taxes instead 

of dividend payments and their associated taxes. The implications 

are basically the same. 

2. Like the tax on dividends under the new view, the property tax 

on land can, in some circumstances, reduce the price developers 

pay for land rather than adding to the cost of development. Those 

circumstances consist primarily of land development (or redevelopment) occurring in an environment with a significant number 

of similar jurisdictions competing for the development. In such 

cases, it would be appropriate—in the context of the new view—

to ignore a portion of the property tax deduction in the effective 

tax rate formula for owner-occupied housing. The effect, however, 

would be small and geographically uneven.

3. The share of investment funded by new-share issues is difficult to 

measure. The illustrative value picked is the same as that used in 

James B. Mackie III, “Unfinished Business of the Tax Reform Act 

of 1986,” National Tax Journal, vol. 55, no. 2 (June 2002), p. 326.
28 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table B-2.

Old and New Views of Dividend Taxes

Source: Congressional Budget Office.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

lower under the new view (15.8 percent) than under the 

old view (17.4 percent).

The importance of which view is correct diminishes as 

the difference between the tax rates on dividends and capital gains shrinks. EGTRRA and JGTRRA narrow that 

difference so they also reduce the impact on effective tax 

rates from changing views. Before enactment of 

EGTRRA and JGTRRA, the average marginal tax rate on 

dividends was 28 percent, and the average marginal tax 

rate on capital gains was 15 percent, about half as big.4

Under the base case (with both laws fully in place), the 

statutory tax rate on dividends equals that on capital 

gains, thus eliminating most of the advantage of realizing 

capital gains. The average marginal tax rate on dividends 

falls to 12 percent and that on capital gains falls to 11 

percent, leaving the gains rate almost as high as the dividend rate.

With the lower differential under EGTRRA and 

JGTRRA, the assumptions of the new view lead to an effective tax rate on income from equity-financed investment in the corporate sector of 34.8 percent instead of 

36.1 percent under the old view (see Table B-2). That 1.3 

percentage point difference is less than a third of the 4.4 

percentage point difference under tax law before 

EGTRRA and JGTRRA. Correspondingly small impacts 

under the new view appear on the effective tax rate for investment income with mixed debt and equity financing 

in the corporate sector and in the overall effective tax rate 

on investment income.

Finally, the impacts of EGTRRA and JGTRRA differ under the new view. The reduction in tax rates on dividends 

in JGTRRA has a smaller effect on the effective tax rate 

for corporate equity under the new view than under the 

old view, while the reduction in the tax rate on capital 

gains has a greater effect. Because the latter was the 

smaller change, the net impact of EGTRRA and 

JGTRRA is smaller under the new view than under the 

old view. Under the new view, those two tax laws reduce 

the effective tax rate on income from corporate equity by 

Base Case Lawa Current Law After 2010

Old View: 

Base Case

New 

View Difference

Old 

View

New 

View Difference

Effective Tax Rates (Percent) 

Overall 13.8 13.4 -0.4 17.4 15.8 -1.6

Corporate 26.3 25.3 -1.0 31.9 28.5 -3.4

Debt financed -6.4 -6.4 0 -1.1 -1.1 0

Equity financed 36.1 34.8 -1.3 41.7 37.4 -4.4

Noncorporate 20.6 20.7 0.1 24.2 24.5 0.2

Owner-occupied housing -5.1 -5.0 0.1 -5.7 -5.4 0.3

Measures of Tax Rate Uniformity (Percentage points) 

Interquartile range across asset types—corporate 12.3 12.3 0 12.3 12.3 0

Difference between equity financed and debt 

financed—corporate 42.5 41.2 -1.3 42.8 38.5 -4.4

Difference between corporate and noncorporate 5.7 4.6 -1.0 7.6 4.0 -3.6

Difference between tenant- and owner-occupied 

housing 23.3 23.3 0 27.0 27.0 0

4. The effective tax rate on capital gains includes the effects of taxing 

long-term gains at lower rates than dividends and short-term 

gains, the benefits of deferral and step-up in basis at death, and 

the disadvantage of taxing inflationary gains. 
APPENDIX B ALTERNATIVE ASSUMPTIONS 29

2.6 percentage points (from 37.4 percent to 34.8 percent 

in Table B-2). Under the old view, the laws reduce that 

tax rate by 5.6 percentage points (from 41.7 percent to 

36.1 percent). 

Sources of Marginal Saving 

The actual source of marginal saving is not particularly 

clear cut. The results presented so far assume that marginal saving would be distributed in proportion to existing assets except when contribution limits prevent that. 

Alternative assumptions could range between two extremes: that marginal saving would come entirely from 

taxable accounts; or that they would be distributed in 

proportion to existing assets without regard to contribution limits. 

The latter assumption would not be dramatically different in its execution from the base-case assumption that 

recognizes contribution limits. The assumption that marginal saving would come entirely from taxable accounts, 

however, generates markedly different results from those 

reported in Table B-1, producing higher effective tax 

rates across the board. Overall, the effective tax rate under 

the base case would be 4.0 percentage points higher (17.8 

percent) and the corresponding rate for income from 

corporate investments would be 5.6 percentage points 

higher (31.9 percent, see Table B-3). Most notable is the 

change in the effective tax rate for income derived from 

debt-financed corporate investment from negative to 

positive—a difference of 16.1 percentage points. That 

difference, coupled with the much smaller difference in 

the effective tax rate for income from equity-financed 

corporate investment of 2.6 percentage points, narrows 

the gap between income from equity-financed and debtfinanced corporate investment by 13.6 percentage points 

to 28.9 percentage points. The difference between effective tax rates for corporate and noncorporate investment 

income, however, would be 9.7 percentage points—

4.1 percentage points higher than under the base case. 

Under the assumption that marginal saving comes from 

taxable accounts, the expiration of EGTRRA would have 

larger effects, increasing the corporate effective tax rate 

by 7.6 percentage points instead of 5.6 percentage points. 

The effect of the expiration of EGTRRA on the noncorporate effective tax rate, however, would be virtually unchanged by the assumption about the source of marginal 

financing.
30 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table B-3.

Alternative Assumptions About Sources of Marginal Saving

Source: Congressional Budget Office.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

b. According to the distribution of marginal saving in Table A-3 on page 22.

Base Case Lawa Current Law After 2010

From All 

Types of 

Accountsb

(Base Case)

From Taxable 

Accounts Only Difference

From All 

Types of 

Accountsb

From Taxable 

Accounts Only Difference

Effective Tax Rates (Percent) 

Overall 13.8 17.8 4.0 17.4 22.7 5.3

Corporate 26.3 31.9 5.6 31.9 39.5 7.6

Debt financed -6.4 9.7 16.1 -1.1 16.5 17.6

Equity financed 36.1 38.7 2.6 41.7 46.4 4.6

Noncorporate 20.6 22.2 1.6 24.2 26.0 1.7

Owner-occupied housing -5.1 -1.9 3.2 -5.7 -1.9 3.8

Measures of Tax Rate Uniformity 

(Percentage points) 

Interquartile range across 

asset types—corporate 12.3 12.3 0.0 12.3 12.3 0.0

Difference between equity 

financed and debt 

financed—corporate 42.5 28.9 -13.6 42.8 29.8 -13.0

Difference between corporate 

and noncorporate 5.7 9.7 4.1 7.6 13.5 5.9

Difference between tenant- and 

owner-occupied housing 23.3 21.8 -1.5 27.0 25.0 -2.0
C

Alternative Proposals Appendix C: Alternative Proposals

Many recent proposals for reducing taxes on capital income would maintain the structure of an income 

tax but adopt features of a consumption tax or a wage tax. 

Using the framework of effective tax rates, the Congressional Budget Office (CBO) analyzed four such proposals, assessing each independently of the others:

B Restore the 30 percent expensing provisions from the 

Job Creation and Worker Assistance Act of 2002 

(JCWAA);

B In addition to the retirement plan contributions 

allowed in the base case, allow $5,000 annual 

contributions to lifetime savings accounts (LSAs), as 

detailed in the President’s 2006 budget;

B Allow unlimited contributions to individual 

retirement accounts (IRAs); and

B Integrate the corporate and individual taxes by 

eliminating the individual-level tax on dividends and 

reducing the capital gains tax by 60 percent.

Restore 30 Percent Partial Expensing

JCWAA allowed businesses to expense 30 percent of the 

acquisition cost of assets with an assumed life of 20 years 

or less that were purchased between September 10, 2001, 

and May 6, 2003. Firms would depreciate the remainder 

of the acquisition cost as usual. The Jobs and Growth Tax 

Relief Reconciliation Act of 2003 (JGTRRA) increased 

the proportion to 50 percent and extended the time period for acquisitions to be placed in service through the 

end of 2004. Although the provision as enacted was intended to stimulate the economy during a downturn, this 

proposal would restore and make permanent 30 percent 

expensing.

The proposal would lower the overall effective tax rate on 

capital income relative to the base case by 1.3 percentage 

points, to 12.5 percent (see Table C-1). The rate on corporate capital income would drop by 2.4 percentage 

points, to 23.9 percent.

This proposal would also increase the variation in effective tax rates across asset types, raising the interquartile 

range of effective tax rates by 6.2 percentage points, to 

18.5 percentage points. The proposal would indeed make 

effective tax rates more uniform across the affected asset 

types (for example, equipment, utility structures, mining 

and drilling structures, railroad structures, and farm 

structures), but those asset types have lower rates to begin 

with than do asset types with longer lives. Thus, the provision would increase the difference between the affected 

assets and those not eligible for partial expensing (see 

Table C-2). That increased difference between short- and 

long-lived assets would outweigh the reduction in difference across shorter-lived assets affected by the proposal, 

thus increasing the interquartile range of effective tax 

rates over all types of assets.

The difference in effective tax rates between income from 

equity-financed and debt-financed corporate investments 

would increase by 1.5 percentage points, to 44.0 percentage points. That small difference is largely an artifact of 

the effective tax rate formula and does not represent a 

significant change in investment incentives. 

The difference in effective tax rates between corporate 

and noncorporate investment income would decrease by 

1.8 percentage points, to 3.9 percentage points. That result occurs because the proposal would cover a much 

larger share of corporate than noncorporate assets. Assets 

of the real estate industry in general, and tenant-occupied 

housing in particular, are held overwhelmingly by the 

APPENDIX
32 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table C-1.

Selected Proposals to Reduce the Tax on Capital Income

Source: Congressional Budget Office.

Notes: LSA = lifetime savings account; IRA =individual retirement account.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

noncorporate sector and would be unaffected by the proposal. Because the effective tax rate on corporate investment income exceeds that on noncorporate investment 

income to begin with, the larger decrease in the former 

would reduce the difference between the two.

Allow $5,000 Annual Contributions to 

Lifetime Savings Accounts 

The President’s 2006 budget calls for the creation of 

LSAs. Those accounts would be structured like Roth 

IRAs—that is, contributions would be from after-tax 

income but withdrawals would be tax-free—except that 

the funds could be withdrawn without tax or penalty 

at any time and for any reason. Also, instead of being 

limited to workers and their spouses, accounts could be 

established by parents for their children. Annual contributions would be limited to $5,000 per account and 

would be in addition to existing retirement accounts.1

 As 

is the case with IRAs, LSAs could not hold noncorporate 

equity, including the participant’s house.

Using the 2002 Survey of Consumer Finances, CBO estimated that the proposed LSAs would exempt 47 percent 

of the capital income that would become nontaxable unBase 

Casea

Allow 30 Percent 

Expensing of 

Equipment

Allow $5,000 LSA 

Contributions

Allow Unlimited

IRA Contributions

Partially Integrate

Individual and

Corporate Taxes

Effective Tax Rates (Percent) 

Overall 13.8 12.5 9.2 12.7 12.5

Corporate 26.3 23.9 21.1 24.4 23.2

Debt financed -6.4 -10.0 -18.4 -9.9 -6.4

Equity financed 36.1 34.0 32.9 34.6 32.1

Noncorporate 20.6 20.0 17.9 20.3 20.8

Owner-occupied housing -5.1 -5.1 -9.8 -5.7 -4.9

Measures of Tax Rate Uniformity

(Percentage points)

Interquartile range across asset 

types—corporate 12.3 18.5 12.3 12.3 12.3

Difference between equity 

financed and debt financed—

corporate 42.5 44.0 51.3 44.5 38.5

Difference between corporate 

and noncorporate 5.7 3.9 3.2 4.1 2.4

Difference between tenant- and 

owner-occupied housing 23.3 23.3 25.2 23.5 23.4

1. Actually, the President proposed consolidating most IRAs into a 

single type of plan known as a retirement savings account (RSA). 

Similarly, the budget proposed consolidating most types of 

defined-contribution plans sponsored by employers into a single 

type of plan known as the Employee Retirement Savings Account 

(ERSA). Because RSAs would be virtually indistinguishable from 

Roth IRAs, and ERSAs would be virtually indistinguishable from 

401(k)s—both of which are already represented in the data—the 

analysis excludes them.
APPENDIX C ALTERNATIVE PROPOSALS 33

Table C-2.

The Effect of Partial Expensing on C Corporations, by Asset Type

Source: Congressional Budget Office.

Note: In addition to buildings, “structures” can include entities such as dams, mine shafts, petroleum pipelines, radio-transmission towers, 

and railroad tracks.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

b. Not eligible for partial expensing.

der step 1 in the main text—a scenario that, in an effective tax rate framework, is equivalent to allowing unlimited contributions to LSAs. Therefore, the parameters for 

the percentage of marginal saving coming from fully taxable and temporarily deferred accounts were reduced by 

47 percent of the reduction (to zero) in step 1. The parameters for the percentage of marginal saving coming 

from nontaxable accounts were increased to exactly offset 

those reductions (see Table C-3).

The overall effective tax rate on capital income under the 

President’s proposal for LSAs would be 9.2 percent, 4.6 

percentage points lower than the base case but 3.7 percentage points higher than with unlimited LSAs (see 

Table C-1 and the second column of Table 3 on page 12). 

Similarly, the effective tax rate on corporate capital income would be 21.1 percent—a reduction of 5.2 percentage points from the base case but 4.0 percentage points 

higher than the unlimited version.

The differences in effective tax rates would be as follows: 

B Between income from equity-financed and debtfinanced capital, 51.3 percentage points;

B Between income from corporate and noncorporate 

investments, 3.2 percentage points; and

B Between income from tenant-occupied and owneroccupied housing, 25.2 percentage points. 

Effective Tax Rates

Percentage of 

Corporate Assets Base Casea

With 30 Percent 

Expensing

of Equipment

All Equipment 30.8 20.8 14.2

Computers and software 3.7 31.8 23.6

Communications equipment and instruments 5.4 18.5 12.4

Office equipment and furniture 2.0 18.9 12.7

Automobiles 1.0 29.7 21.8

Other vehicles and transportation equipment 5.3 15.8 10.3

Machinery 5.6 17.7 11.7

Fabricated metal products and general industrial equipment 3.7 16.9 11.1

Other equipment 4.1 23.8 16.8

All Structures 44.2 26.1 24.4

Residential buildingsb 0.5 23.8 23.8

Nonresidential buildingsb 26.0 30.8 30.8

Mining and drilling structures 3.5 9.2 5.1

Other structures 14.2 19.7 14.3

Inventoriesb 10.6 34.4 34.4

Landb 14.3 31.0 31.0

All Types 100.0 26.3 23.9
34 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

Table C-3.

Distribution of Marginal Saving Under Selected Proposals, by Tax Status 

Source: Congressional Budget Office, based on data from Federal Reserve Board, Flow of Funds Accounts (March 10, 2005) and Survey of 

Consumer Finances (2001); and Internal Revenue Service, Statistics of Income—2002: Individual Income Tax Returns (2004).

Notes: LSA = lifetime savings account; IRA = individual retirement account.

a. The base case assumes that the tax provisions in place in 2008 under the Economic Growth and Tax Relief Reconciliation Act of 2001 and 

the Jobs and Growth Tax Relief Reconciliation Act of 2003 will be permanently extended instead of being allowed to expire by 2011.

All of those differences fall roughly halfway between the 

base case and the unlimited LSA scenario (see step 1 in 

Table 3). Only the difference between corporate and noncorporate investments would represent an improvement 

over the base case. The explanations are the same as those 

offered in the discussion of step 1 in the main text.

Allow Unlimited Contributions to IRAs

This proposal would eliminate three restrictions on IRA 

contributions: the eligibility restrictions on the deductibility of contributions to traditional IRAs; the eligibility 

restrictions on contributing to a Roth IRA; and the dollar 

caps on allowable IRA contributions of either type. Withdrawal restrictions would continue to impose significant 

liquidity constraints, so not all marginal saving would be 

directed to fully sheltered accounts. Eliminating the withdrawal restrictions in addition to the restrictions on contributions would be the equivalent of step 1 in the main 

text.

The simulation of this proposal distributed the marginal 

saving of the 71 percent of families that were not constrained by contribution limits under the Economic 

Growth and Tax Relief Reconciliation Act of 2001 

(EGTRRA) among types of accounts in proportion to existing assets. The remaining 29 percent were freed of constraints. Using the imputations of unconstrained contributions described in Appendix A, the analysis estimated 

that lifting those constraints would stimulate a 114 percent increase in contributions to nontaxable accounts relative to pre-EGTRRA law. Therefore, a corresponding 

Base Casea

Allow $5,000

Contributions

to LSAs

Allow Unlimited

IRA Contributions 

Allow Unlimited

Contributions to LSAs or

Unrestricted

Withdrawals from

Unlimited IRAs

Corporate Equity

Nontaxable 35.8 72.3 53.0 100.0

Temporarily deferred 5.8 2.5 4.2 0

Fully taxable 58.4 25.2 42.8 0

Corporate Debt 

Nontaxable 32.8 70.0 43.5 100.0

Temporarily deferred 21.3 9.5 17.9 0

Fully taxable 45.9 20.5 38.6 0

Noncorporate Debt 

Nontaxable 16.7 62.0 23.1 100.0

Temporarily deferred 14.2 6.5 13.1 0

Fully taxable 69.1 31.5 63.8 0

Homeowner Debt 

Nontaxable 21.3 64.1 26.8 100.0

Temporarily deferred 7.1 3.2 6.6 0

Fully taxable 71.6 32.7 66.6 0
APPENDIX C ALTERNATIVE PROPOSALS 35

amount of marginal saving previously allocated to the 

fully taxable and temporarily deferred groups was shifted 

to the nontaxable group (see Table C-3).2

By allowing more marginal saving to be directed to nontaxable accounts, this proposal would reduce the overall 

effective tax rate on capital income to 12.7 percent, 1.1 

percentage points lower than in the base case (see 

Table C-1). The effective tax rate on corporate capital income would drop to 24.4 percent (a reduction of 1.9 percentage points). The fact that those drops are much 

smaller than the declines resulting from step 1 (see Table 

3 on page 12) implies that restricting withdrawals from 

retirement plans imposes a greater tax burden on capital 

income than does capping contributions.

The differences in effective tax rates under this proposal 

would be as follows:

B Between income from equity-financed and debtfinanced capital, 44.5 percentage points;

B Between income from corporate and noncorporate

investment, 4.1 percentage points; and

B Between income from tenant-occupied and owneroccupied housing, 23.5 percentage points. 

Only the difference between corporate and noncorporate 

investment represents an improvement over the base case. 

The other two would represent only about a 5 percent 

shift in the direction of IRAs with unrestricted withdrawals (the equivalent of step 1 in the main text). The explanations are the same as those offered in the discussion of 

step 1.

Partially Integrate the Individual-Level 

and Corporate-Level Taxes

Investments in corporate equity face taxation at both the 

corporate and individual level, as discussed in the main 

text of the paper, typically placing them under a higher 

tax burden than other investments. In early 2003, the 

President proposed reducing the tax burden on corporate 

equity to a single level, often referred to as integrating the 

two taxes. His proposal would accomplish integration by 

allowing individuals to exclude from their adjusted gross 

income all dividends paid out of profits that had been 

taxed at the corporate level. Furthermore, the proposal 

would increase the basis of an investor’s corporate stock 

to reflect the corporate-level tax. On average, that increase should reduce the taxable capital gain to the portion caused by inflation. Later in 2003, the Congress 

moved partway toward the President’s proposal by including provisions in JGTRRA that lowered the tax rates on 

dividends and corporate equity to 5 percent or 15 percent, through 2008. Details of the President’s proposal 

are complicated, but in the effective tax rate framework 

the simulation was straightforward—the tax rate on dividends was reduced to zero and that on capital gains was 

reduced to two-fifths of its value under JGTRRA (that is, 

the inflation component of the capital gain).

Eliminating the second layer of tax on corporate equity 

would reduce the effective tax rate on income from corporate equity by 4.0 percentage points, to 32.1 percent, 

compared with the base case (see Table C-1). By reducing 

the tax rate on income from corporate equity, integration 

would also reduce the advantage of corporate debt finance to 38.5 percentage points and the advantage of 

noncorporate investment over corporate investment to 

2.4 percentage points.

The increased uniformity of taxation brought about by 

the integration proposal would be larger if the base case 

did not already include a reduction in the tax rates on 

dividends and capital gains to 5 percent or 15 percent. 

If the 5 percent and 15 percent rates expire as scheduled 

in 2009, the effective tax rate on income from corporate 

equity, for example, would rise to 41.7 percent (see Table 

B-1 on page 26) and the integration proposal would reduce it to 32.1 percent, a 9.6 percentage point reduction. 

(Compare effective tax rates under pre-EGTRRA law 

in Table B-1 to those of the integration proposal in 

Table C-1.)

The increased uniformity of taxation achieved by the integration proposal, particularly relative to the law before 

EGTRRA and JGTRRA were enacted, depends on the 

importance given to the taxation of dividends. Under the 

old view, dividends account for 57 percent of the tax burden on corporate equity at the individual level and under 

the new view, only 10 percent (see Appendix B). Thus, 

under the old view, integration would reduce the effective 

tax rate on income from corporate equity by 9.6 percentage points, as noted above, but under the new view it 

2. Under the alternative assumption that all marginal saving comes 

from fully taxable accounts (see Appendix B), this proposal would 

have no impact on effective tax rates.
36 TAXING CAPITAL INCOME: EFFECTIVE RATES AND APPROACHES TO REFORM

would reduce the effective tax rate by 5.3 percentage 

points (compare Tables B-2 and C-1). In essence, the 

double taxation of income derived from corporate equity 

creates less of a distortion under the new view, so integration would accomplish less.

By reducing the tax rate on dividends and capital gains, 

the integration proposal would encourage people to place 

more of their interest-earning assets and fewer of their 

corporate stocks in nontaxable or temporarily deferred 

accounts. Interest earned outside those accounts would 

be subject to tax, but dividends and capital gains would 

be largely exempt. The effective tax rates under the integration proposal in Table C-1 ignore the likely reshuffling 

of debt and equity investments between taxable and nontaxable or deferred accounts and therefore somewhat 

understate the overall reduction in tax rates that the 

integration proposal would cause.