Integration and Investment Incentives 

T. Nicolaus Tideman 

Comment 

Marshall E. Blume 
Integration and Investment Incentives 

T. Nicolaus Tideman 

Integration of corporate and individual taxes reduces the effective tax rate on the earnings of capital and, therefore, promotes 

investment. Since integr:ation operates only on the earnings of 

equity, it alters the optimal allocation of corporate liabilities in 

the direction of more equity financing and less debt. The earnings 

of equity may be divided into dividends, r.etained taxed earnings, 

and other retained earnings that are not included in taxable income because of inaccuracies 1 in tax accounting. Integration will 

alter the relative rates of taxation of the components of the income of equity, creating an incentive for an increase in the proportion of the earnings of equity that are paid out. It will also 

reduce the relative value of investments that promise a high proportion of their returns in capital gains that escape corporaite 

taxes. 

This paper develops the theoretical foundations of these effects 

and offers estimates of the magnitudes of the incentive effects in 

a disequilibrium context--assuming no behavioral responses. The 

methodology of the paper is to consider an economy with two assets, 

a $1 structure and a $1 item of equipment. The required rate of 

return for each item of capital is computed from a variety of assumed parameters dealing with characteristics of assets, the tax 

system, and investors. Two of the parameters are the returns that 

investors require, after all taxes, on debt and on equi.ty. The difference between the return that the asset earns and the return that 

investors receive is what the Government receives. The Government return, as a fraction of the total return on an asset, is a 

1 Tax accounting does not measure income accurately; for example, depreciation for tax purposes does not correspond to economic depreciation. 

T. NICOLAUS TIDEMAN i8 with the Center for Study, of Public Choice 

at Virginia Polytechnic Instiute and State University, Blacksburg. 

(285) 
286 COMPENDIUM OF TAX RESEARCH 

measure of the overall tax rate on the income from capital. Since 

the tax rate on debt and the proportion of debt in the capital 

structure are assumed to be known, the effective tax rate on 

equity can be calculated as a residual. Then, since the dividend 

rate and the tax rates on dividends and on retained (taxed) earnings are assumed to be known, it is possible to determine whether 

an assumed value for the proportion of the earnings of equity 

that are capital gains not taxed at the corporate level is consistent, 

and to search for a value that is consistent. 

The Required Rate of Return 

When markets are in equilibrium, the present value of the return to a $1 investment, P, net of the present value of corporate 

taxes, U, will equal the cost of the investment, $1, net of the investment tax credit, k, that the Government pays. Thus 

P-U=l-k. (1) 

Recognizing that taxes are levied at a rate of u on a base of the 

return to capital less interest and depreciation, equation ( 1) may 

be rewritten as 

P-u(P-1-Z) =1-k, (2) 

where I is the present value of interest payments and Z is the 

present value of the depreciation allowed for tax purposes. Solving equation (2) for P, 

p 1-k-u(Z+.l) (3) 1-u 

Letting p be the annual rental price of the services of the asset, 

and defining Y=P/p, where Y may be interpreted as the present 

equivalent of the years of service an asset will deliver, the rental 

price of the services of the asset is given by 

1-k-u(Z+l) 

p Y(l-u) . (4) 

If f is the fraction of corporate liabilities that are debt, r a is the 

market interest rate on debt, and re is the return to equity ( dividends plus anticipated capital gain) the market requires, then 

the discount rate at which the present values in equation ( 4) must 

be evaluated is 

(5) 

a weighted average of the rates that must be paid to the holders 

of debt and equity. However, the present value of interest pay-
INTEGRATION AND INVESTMENT INCENTIVES 287 

lllents cannot easily be calculated except in an indirect way. Since 

interest payments are deductible from taxable income, the Government, in effect, pays the proportion 'll of interest and the firm 

Pays the proportion (1-u). The equilibrium that results is the 

same as that which would occur if the return on debt were 

r d ( 1-u ) and interest were not deductible. Therefore, the price 

of the services of an asset may also be expressed as 

1-k-uZ* 

p Y* (1-w)' (6) 

Where the asterisks indicate that the present values are calculaited 

at a discount rate of 

(7) 

Which reflects the deductibility of interest. 

Now the present value of interest payments may be calculated 

by equating equations ( 4) and (6), yielding 

Y*(l-k-uZ)-Y(l-k-uZ*) 1 

uY* (8) 

In the special case of an asset with a service flow that depre.-

ciates exponentially at a rate of o, as is assumed for equipment, 

and with exponential price inflation at a rate of i, 

Y=looe-(R-iH>tdt- 1 . o R-i+o (9) 

The present value of depreciation allowances for equipment is 

calculated using the formula 

2[L(eR-1) -1 + e-LR] 

Z= ' (10) 

L (L + 1) R ( eR -1) 

Where L is the Iif e assigned to the asset for tax purposes. This 

represents sum-of-the-years-digits depreciation, under an assumption that each year's depreciation is taken continuously throughout the year. The pattern of partial payment dates for corporate 

taxes makes this not a bad assumption. 

The values of Y* and Z* can be calculated from equations (9) 

and (10), using R* rather than R, so that I can then be calculated from equation ( 4). The real rate of return, p, an item of 

equipment yields is the value of p that is a solution of 

£00 pe-rPH>tdt=l, (11) 
288 COMPENDIUM OF TAX RESEARCH 

namely 

(R-i+ o) (1- k-uZ-ul) (l2) p=p-8 -8. 

1-u 

Structures provide a pattern of services more like a "one-hoss 

shay." In this case 

1

A 1-e-(R-i)A Y = e-(R- iJtdt , 0 R-i 

(13) 

where A is the economic life of a structure. The present value of 

the depreciation allowances on a structure is calculated using 150 

percent declining-balance depreciation, with a switch to straightline after S years, where S = A/ 3, rounded up to an integer. The 

formula is 

z- 1.5 (eR-1) [1- (X/ eR) B] + xs (e-BR-e-LIR)' (14) 

L'R(eR-X) (L'-S)R 

where L' is the life assigned to a structure for tax purposes and 

X is the value left after one year of such depreciation, namely 

1- (1.5/L'). This formula again assumes that each year's depreciation is taken continuously. 

The required real return for a "one-hoss shay" with a constant 

real price is the p that is a solution of 

(15) 

or 

p p. (16) 

1-e-pA 

Substituting from equations (13) and (16) into equation (4) 

yields 

p 

1-e-pA 

(R-i) (1-uZ-ul) 

(1-u) (1-e-(R-OA) 

(17) 

as an implicit equation for the required real return on structures. 

Parameters of Present Institutions 

Table 1 shows the values of a number of parameters that are 

assumed for the analysis that follows. They are based on some 

combination of published statistics, the author's judgment, and 

Office of Tax Analysis studies. To my knowledge, the conclusions 
INTEGRATION AND INVESTMENT INCENTIVES 289 

TABLE 1.-Parameters assumed to be unaffected by integration 

L Tax life of equipment: 12 years 

a Depreciation rate of equipment: 18% per year 

!...: Tax life of structures : 30 years 

A ~conomic life of structures : 30 years 

Id Fraction of interest income that is taxed : 40 % 

/e Fraction of equity income that is taxed: 75% 

Mtt Average marginal tax rate of interest recipients: 12% (This is 

30% for the 40% that is taxed, and 0 for the other 60%.) 

Me Average marginal tax rate of equity owners: 30% (This is 40% 

for the 75% that is taxed, and 0 for the other 2_5%.) 

f , Effective average marginal tax rate on capital gains (taking account of deferral as well as exclu~ion) as a fraction of M. : 25%-

Inflation rate: 6% 

r d.. Real return to debt after taxes: 3% 

r... Real return to equity after all taxes: 8% 

v The dividend rate: 4% 

I The fraction of corporate capital that is debt: 40% 

Pe Proportion of producers' c;apital that is equipment: 50% 

M, Effective average marginal tax rate on capital gains: Mex/,, or 

7.5% 

re.. Real return after all taxes on the weighted average of debt and 

equity in a firm: frda.+(1-f)r.a., or 6% 

of the paper would be substantially the same if any combination 

of the parameters were chan~ed up or down by up to 15 percent. 

The assumption in table 1-that there are real returns to debt 

and equity that will be unaffected by integration-reflects the 

disequilibrium nature of the analysis. Under this assumption, 

changes in required real rates of return on equipment and structure can be calculated. The magnitudes of these changes measure 

the impact of integration. In the movement to equ_ilibrium, the 

real returns would rise to equate the supply and demand for investment funds, but no effort is made here to estimate the magnitude of those increases or to estimate the increase in investment 

in equilibrium. 

Another important assumption implicit in table 1 is that the 

distribution of marginal tax rates is unimportant; it is assumed 

that the investment process will work as if all participants had 

the average marginal tax rate. This is unrealistic, but a very complex model would be needed to avoid this simplification. 

Table 2 shows .parameters that do not depend on the e;haracteristics of assets, for present institutions and five integration 

options. The five options are: (1) full integration; (2) full integration with 48 percent withholding at the corporate level; (3) 
TABLE 2.-Parameters of alternative schemes not dependent on asset characteristics 

Full 

Present integration Integration Integration Integration Integration 

institutions option #1 option #2 1 option #3 1 option #4 11 option #5' 

Id 0.1200 0.1200 0.1200 0.1200 -0.0375 0.0435 

/.,, 0.0750 0.0000 -0.1154 0.0750 0.0750 0.0750 

/., 0.3000 0.0000 -0.1154 -0.1154 0.0469 0.0123 

u 0.4800 0.3000 0.4800 0.4800 0.3600 0.3900 

k 0.1000 0.0290 0.0410 0.0500 0.0400 0.0430 

rd 0.1023 0.1023 0.1023 0.1023 0.0867 0.0941 

p 1.0000 1.0000 1.0000 1.0000 0.0000 0.3623 

?'db 0.0123 0.1023 0.1023 0.1023 0.1355 0.1325 

Ud 0.0000 0.0000 0.0000 0.0000 0.3600 0.2896 

Nd 0.1200 0.1200 0.1200 0.1200 0.3360 0.3205 

Td 0.2903 0.2903 0.2903 0.2903 0.6029 0.5859 

1 Integration with 483 withholding. 2 483 corporation income tax; gross-up and credit for dividends. 3 333 corporation income tax with interest not deductible; gross-up and credit for interest and dividends. 

'373 corporation income tax with only the excess of interest over inflation deductible, and only that portion taxable as individual income. Gross-up and credit for dividends. 
INTEGRATION AND INVESTMENT INCENTIVES 291 

integration of dividends only, with withholding at 48 percent; 

( 4) treating interest and dividends the same way, with both subject to withholding, and the tax rate on retained earnings (and 

the withholding rate) reduced to 3'6 percent to keep the overall 

tax rate consfant; (5) indexation of interest (so that only the 

excess over the inflation rate would be deductible from corporate 

income and taxable as individual income), combined with integration of dividends only, and a withholding and corporate tax rate 

of 39 percent. 

The parameters are calculated as follows: Iu,, the individual 

tax rate on interest, is Ma unless interest is taxed at the corporate 

level. In option 4, the individual rate is calculated as (Mu,-Ufu,) I 

( 1-u) , an estimate of the underwithholding from taxed reci pients of interest as a fraction of interest received. For option 

5, Ia is calculated as Mu, multiplied by the proportion of interest 

that is taxable at the individual level. 

Under present institutions or options 3, 4, and 5, where retained 

earnings are not integrated, Iw, the individual tax rate on retained 

earnings, is M 0 , the marginal tax rate on capital gains. Under full 

integration, Iw is M e, and under scheme 3, lw is (Me-Ufe) I (1-u), 

the estimated underwithholding as a proportion of earnings after 

corporate taxes allocated to individuals. Similarly, Iv, the individual tax rate on dividends, is Me under present institutions or 

full integration, and (Me-ufe) I (1-u) under the other schemes, 

where dividends are integrated by withholding. 

The corporate tax rate, u, is a policy parameter. The values for 

options 4 and 5 were chosen to produce the effective real tax rate 

on structures ( 40 percent) that present institutions produce for 

a representative combination of structures and equipment. The 

investment tax credit, k, is also a policy parameter. The values 

illustrated, except for present institutions, were chosen to yield 

required returns to equipment equal to the corresponding required returns on structures. 

A brief digression: The present, step-function investment tax 

credit provides different stimuli for assets of different tax lives. 

This dismrtion could be eliminated while a uniform tax credit is 

maintained (assuming no distortions from inflation or inappropriate tax lives) by reducing allowed depreciation in each year 

to the fraction u-k of what would be appropriate in the absence 

u 

of a tax credit. The distortion from inflation can be eliminated 

by raising depreciation allowances in each year by the ratio of 

price level at the time the depreciation is taken to price level at 
292 COMPENDIUM OF TAX RESEARCH 

the time of purchase. For an asset with service that decays exponentially at a rate of 8, inflation-adjusted economic depreciation has a present value of 8/ (R*-i+8). Adding the adjustment 

for the investment tax credit, the required rate of return for any 

asset will be 

(

1-k-uu-k 8 ) 

(R*-i+8) --;;:- R*-i+8 

1-u 

(R*-i+8) (1-k) - (u-k)8-8(1-u) 

1-u 

( R * - i) ( 1 - k) + 8 - 8 k - u8 + k8 - 8 + u8 

1-u 

_ (R*- .)1-k - i --, 

1-u 

which is independent of 8. 

This is a variation on a point made by Harberger-that neutrality can be achieved by permitting investors to expense some portion, x, of investment and to depreciate the portion 1- x in the 

pattern of economic depreciation. Expensing the portion x is 

equivalent to taking a tax credit of ux. 

Yet another way of achieving neutrality is to vary the amount 

of the investment tax credit with economic depreciation. In particular, an investment tax credit of x/ (R*--i+ 8) is neutral. End 

of digression. 

The market return to debt, rd, is calculated as ( r da + i) I ( 1-Id). 

The proportion of interest that is deductible for corporations, a, 

is 1 for the first three options, 0 for option 4, and (rd-i)/ra for 

option 5. 

The nominal return to debt before taxes, r db' is calculated as 

rd[a+ (1-a) I (1-u)]. The effective corporate tax rate on debt, 

ud, is then calculated as (rab-rd) /rdb· The nominal tax rate on 

debt, combining corporate and individual taxes, Nd, is calculated 

as (rdb-raa-i) /rdb, while the real or true tax rate on debt Td, combining corporate and individual taxes, is calculated as ( r db - r da -i) I 

(rdb-i). 

Table 3 shows parameters of alternative integration schemes 

that may be affected by asset characteristics. Two basic assets are 

considered: (a) a structure with a 30-year tax life, a 30-year economic life, and a flow of services like a "one-hoss shay," and (b) 

an equipment asset with a 12-year fax life and an 18 percent, 

exponential decay of services. The equipment is analyzed with and 
INTEGRATION AND INVESTMENT INCENTIVES 293 

without an investment tax credit. Two combinations of assets are 

analyzed as well. Each combination is composed of structures and 

equipment in equal proportions. However, .the equipment in the 

first combination receives an investment tax credit while the 

equipment in the second combination does not. 

The market return to equity, re, is calculated to be that that 

yields a real return of r ea after all taxes. The equation used is 

· r +i-v(l-1) -g(l-J) re ea v g + V + g. 

1-lw 

The required rates of return for equipment and structures (the 

p's) are calculated by equations (12) and (17) respectively. The 

nominal tax rate on debt and equity combined, Ne, is calculated 

as (p-rca)/(p+i). The real or true tax rate on debt and equity 

combined, Tc, is calculated as (p-rca) IP· 

The nominal return to equity before taxes, re.,,, can be calculated 

from the fact that the nominal return . on an asset, p + i, is a 

weighted · average of the nominal return to debt before taxes, r ab, 

and the nominal return to equity before taxes, reb· The resulting 

formula is 

re.,,= (p+i-fra.,,) I (1-f). 

The nominal tax rate on equity, Ne, may then be calculated as 

( r eb - i - r ea) Ir eb· The real or true tax rate on equity, Te, is calculated as (re.,,-i-rea)/(re.,,-i). 

To calculate the effective rate of the corporation income tax 

on equity (taking account of the investment tax credit) one must 

know the present value of the tax base without an investment tax 

credit, 7f. This may be calculated as pY -z -1, where I is calculated from equation (8). The effective tax rate with an investment 

tax credit, Ue, is then calcula~ as w [ ( 71' - k) I 7f] • 

The nominal tax rate on ret.ained earnings, N w, is I w + Ue - I wUe. 

Similarly, the nominal tax rate on dividends, Nv, is lv+Ue-lvue. 

With this information, the implied rate of capital gain not accounted for by retained earnings, g, can be computed as [re.,,Ne 

- (vNv+WNw) I (1-ue) ]/10 • This formula come.s from the fact 

that nominal tax rate on equity must be an appropriate weighted 

average of the nominal tax rates on dividends, retained earnings, 

and other capital gains. The computer program used for this work 

started with an assumed value of g and then searched for a value 

that, when assumed, satisfied the check condition above. The 

whole set of relationships was checked by setting tax depreciation equal to economic depreciation for equipment, namely 
TABLE 3.-Parameters of alternative integration schemes that may depend on asset characteristics N> 

co 

ii::.. 

(c) (e) (c) (e) 

(b) Avg. of (d) Avg. of (b) Avg. of (d) Avg. of 

(a) Equip. (a) and Equip. (a) and (a) Equip. (a) and Equip. (a) and 

Struc. w/ITC 1 (b) w/o ITC (d) Struc. w/ITC (b} w/o ITC (d) 

Present institutions Full integration 

r. 0.1611 0.1611 0.1611 0.1611 0.1611 0.1472 0.1464 0.1468 0.1442 0.1457 

p 0.1104 0.0897 0.1000 0.1355 0.1229 0.0823 0.0822 0.0822 0.0901 0.0862 c 

No 0.2957 0.1984 0.2502 0.3860 0.3439 0.1567 0.1559 0.1563 0.2007 0.1793 0 

a= To 0.4564 0.3311 0.4002 0.5570 0.5118 0.2710 0.2697 0.2704 0.3343 0.3041 ~ ro" 0.2158 0.1813 0.1985 0.2576 0.2367 0.1690 0.1688 0.1689 0.1820 0.1755 z 

No 0.3512 0.2279 0.2949 0.4565 0.4085 0.1715 0.1704 0.1710 0.2310 0.2024 t::l 

1-1 

c::: To 0.4864 0.3406 0.4226 0.5951 0.5472 0.2660 0.2644 0.2652 0.3445 0.3075 a= Uo 0.4800 0.3234 0.4320 0.4800 0.4800 0.3000 0.2685 0.2880 0.3000 0.3000 0 N.,, 0.5190 0.3742 0.4746 0.5190 0.5190 0.3000 0.2685 0.2880 0.3000 0.3000 ~ 

N,, 0.6360 0.5264 0.6024 0.6360 0.6360 0.3000 0.2685 0.2880 0.3000 0.3000 1-3 

> 

0.1018 0.1188 0.1103 0.0566 0.0792 0.0965 0.0856 0.0910 0.0559 0.0762 ~ g ~ Geo 0.0497 0.0286 0.0392 0.0763 0.0630 0.0243 0.0248 0.0246 0.0345 0.0294 tr.:! 

00 Gt10 0.0007 -0.0205 -0.0099 0.0272 0.0139 -0.0063 -0.0059 -0.0061 0.0038 -0.0013 

Go, ~ 0.0779 0.0567 0.0673 0.1044 0.0911 0.0543 0.0577 0.0560 0.0754 0.0648 ~ 

G"' 0.0416 0.0204 0.0310 0.0681 0.0548 0.0346 0.0350 0.0348 0.0447 0.0396 c 

::rl 

ro 0.1413 0.1376 0.1395 0.1344 0.1379 0.1431 0.1431 0.1431 0.1431 0.1431 

p 0.0927 0.0927 0.0927 0.1071 0.0999 0.0942 0.0944 0.0943 0.1163 0.1052 

No 0.2139 0.2142 0.2141 0.2817 0.2493 0.2219 0.2229 0.2224 0.3192 0.2738 

To 0.3524 0.3529 0.3527 0.4396 0.3992 0.3633 0.3646 0.3639 0.4839 0.4299 'l'e1' 0.1862 0.1864 0.1863 0.2103 0.1982 0.1889 0.1892 0.1890 0.2256 0.2072 

No 0.2483 0.2487 0.2485 0.3342 0.2938 0.2587 0.2600 0.2594 0.3794 0.3244 

To 0.3663 0.3668 0.3666 0.4676 0.4213 0.3792 0.3807 0.3800 0.5169 0.4566 

Uo 0.4800 0.4214 0.4592 0.4800 0.4800 0.4800 0.4089 0.4549 0.4800 0.4800 
--- - - - - - - - - - -

N. 0.4200 0.3547 0.3438 0.4200 0.3646 0.5190 0.4532 0.4958 0.5190 0.5190 

N,, 0.4200 0.3547 0.3438 0.4200 0.3646 0.4200 0.3407 0.3395 0.4200 0.3646 

g 0.0927 0.0706 0.0816 0.0523 0.0725 0.0936 0.0765 0.0850 0.0538 0.0737 

Geo 0.0437 0.0467 0.0452 0.0637 0.0537 0.0442 0.0449 0.0445 0.0677 0.0560 

GdO -0.0054 -0.0024 --0.0039 0.0146 0.0046 -0.0049 -0.0042 -0.0045 0.0186 0.0069 ..... Ge• 0.0454 0.0434 0.0444 0.0563 0.0508 0.0483 0.0491 0.0487 0.0719 0.0601 z 

Gtt• 0.0355 0.0385 0.0370 0.0555 0.0455 0.0360 0.0367 0.0364 0.0595 0.0478 1-3 

~ 

0.1501 0.1501 0.1501 0.1501 0.1501 0.1486 0.1486 0.1486 0.1486 0.1486 Cl re ~ p 0.1000 0.1000 0.1000 0.1153 0.1077 0.1002 0.1002 0.1002 0.1172 0.1087 1-3 

Ne 0.2499 0.2502 0.2500 0.3156 0.2842 0.2509 0.2508 0.2508 0.3227 0.2886 ..... 

0 

To 0.3998 0.4002 0.4000 0.4798 0.4427 0.4011 0.4010 0.4010 0.4880 0.4480 z 

Tob 0.1763 0.1764 0.1763 0.2019 0.1891 0.1787 0.1786 0.1787 0.2070 0.1928 > z 

Ne 0.2057 0.2062 0.2060 0.3065 0.2595 0.2165 0.2163 0.2164 0.3237 0.2740 t:i 

..... Te 0.3118 0.3126 0.3122 0.4361 0.3801 0.3259 0.3257 0.3258 0.4558 0.3978 z Ue 0.3600 0.3224 0.3473 0.3600 0.3600 0.3900 0.3446 0.3744 0.3900 0.3900 ;] 

N. 0.4080 0.3732 0.3963 0.4080 0.4080 0.4357 0.3937 0.4213 0.4357 0.4357 00 

1-3 

N., 0.3900 0.3541 0.3942 0.3900 0.4069 0.3975 0.3526 0.3867 0.3975 0.4023 ts: 

t:r.:l 

g 0.1037 0.0950 0.0993 0.0582 0.0809 0.1017 0.0916 0.0966 0.0573 0.0795 z 

Geo 0.0352 0.0353 0.0352 0.0506 0.0429 0.0380 0.0381 0.0381 0.0554 0.0467 t-3 

..... Gtto 0.0352 0.0353 0.0352 0.0506 0.0429 0.0247 0.0248 0.0248 0.0421 0.0334 z 

Ge• 0.0487 0.0488 0.0487 0.0641 0.0564 0.0495 0.0497 0.0496 0.0669 0.0582 C'l 

t:r.:l 

Gtt• 0.0406 0.0407 0.0406 0.0560 0.0483 0.0383 0.0385 0.0384 0.0557 0.0470 z 

1-3 

..... 1 ITC=investment tax credit. ;] 2 Integration with 483 witholding. 00 

3 483 corporation income tax; gross-up and credit for dividends. 

• 36% corporation income tax with interest not deductible; gross-up and credit for interest and dividends. 5 39% corporation income tax with only the excess of interest over inflation deductible, and only that portion taxable as individual income. Gross-up and credit for dividends. ~ 

c.o 

01 
296 COMPENDIUM OF TAX RESEARCH 

o/ (R-i+ o), setting the rate of inflation equal to zero, and seeing 

that the computed value of g was zero, as it ought to be. 

The marginal Government receipts from $1 of tax-exempt funds 

invested in equity, in present value terms, is u(pY-Z) -k. To 

turn this into a rate of return, one can divide it by 

Yt= (pY-1)/p-i-R), 

which is the ratio of the Government receipts to its rate of return. 

Thus the Government's rate of return on a marginal. dollar of taxexempt funds invested in equity, Geo, is calculated as [u(pY-Z) 

-k] ! Yt. The Government's rate of return on a marginal dollar 

of tax-exempt funds invested in debt, Gdo, can then be calculated 

as Ge0 -urda. The Government's rate of return on funds of an 

individual with a 40 percent marginal tax rate, invested in debt 

or in equity, Ge4 and Gd4, can then be calculated by adding appropriate individual taxes to Geo and Gdo respectively. 

The averages in table 3 [columns (c) and (e)] are calculated 

assuming that the proportion Pe of the value of capital ·is equipment and the remainder is structures. This means that all rates 

of return, re, p, reb, g, Geo, Gdo, Ge4' and Gdo are computed as 

Pe times the number applicable to equipment plus 1-Pe times the 

number applicable to structures. The tax rates are then computed 

by the same formulas used to compute them for equipment and 

structures separately. -

Important Differences Among Integration Schemes 

An important virtue of integration is that it reduces the discrimination against equity financing. Under present institutions, 

the real tax rate on equity, combining equipment and structures, 

is 42.3 percent compared with 29.0 percent for debt. Full integration combined with elimination of the investment tax credit leaves 

the rate on debt unchanged and reduces the rate of equity to 26.5 

percent. However, full integration would eliminate the substantial taxes that tax-exempt entities now pay on their equ-ity holdings. This revenue loss can be avoided by adopting option 2, which, 

through its withholding feature, _ provides that nonfiling entities 

such as tax-exempt organizations and foreigners would be taxed 

on their retained earnings and dividends at the withholding rate. 

A feature of option 2 that is likely to generate political opposition is its treatment of retained earning as income of shareholders. Many people believe that retained earnings are not in-
INTEGRATION AND INVESTMENT INCENTIVES 297 

come of shareholders, and they will oppose this feature even 

though it reduces taxes for anyone whose marginal tax rate is 

less than 4u/ (u+3), about 55 percent when u=48 percent. Option 

3 avoids this difficulty by preserving the double taxation of retained earnings (taxed first as corporate income, then as capital 

gains). 

There is a significant distortion that is not removed by option 

3. That is the fact that the debt holdings of tax-exempt entities 

effectively escape taxation. This shows up in the fact that Gdo is 

much smaller than Geo, Gd4 ()r Ge4. This distortion increases the 

reliance on debt financing, which increases the risk of bankruptcy, and motivates individuals to hold an inefficient proportion 

of their wealth as life insurance and pension rights. The distortion 

can be eliminated by eliminating the deductibility of interest. To 

avoid increasing the tax ,burden on capital, the corporation tax 

rate can be reduced at the same time, as in option 4. The corporation tax rate shown there, 36 percent, produces the same rtrue tax 

rate on structures, namely 40 percent, as present institutions pro--

duce for the capital stock as a whole. When an investment tax 

credit of 4 percent is employed, the effective tax rates on equipment and on .structures are equated as well. 

The biggest problem with option 4 is that tax-exempt entities 

will oppose the increase in the levies on their capital earnings. 

This might be handled by permitting tax-exempt entities to file 

for partial or total refunds (and raising taxes on other owners of 

capital) ; another compromise that Il)ight be considered is option 

5. This reduces taxes on debt by providing that only the excess of 

interest above inflation is deductible at the corporate level, and 

only that portion is taxable at the individual level. This is an indexation feature. The nondeductibility of the portion of interest 

corresponding to inflation is justified by the fact that such a payment, in term of "real accounting," is a return of capital rather 

than interest. It might be considered rather strange to adoprt only 

this feature of indexation, but it would mean that the portion of 

the interest income of tax-exempt entities that was real interest 

would be untaxed, thereby reducing the effective tax rate on such 

entities. At the same time, it would preserve some of the discrimination of present institutions in favor of debt finance. 

It may seem that options 4 and 5 would discriminate against 

debt finance, since the tax rates on debt that are shown are so 

much higher than those on equity. However, the appropriate test 

of nondiscrimination is whether a shift between debt and equity 

finance (to which invest.ors, at the margin, would be indifferent) 
298 COMPENDIUM OF TAX RESEARCH 

changes Government revenue. Any change in Government revenue 

from a marginal change in financing indicates a distortion from 

taxation, since it indicates a hypothetical possibility of increasing 

Government revenue (by a marginal change in financing) without 

making investors worse off. 

The paradox is resolved when it is understood that if investors 

are indifferent between a return of 3 percent on debt or 8 percent 

on equity, then the two returns have equal utility value (because 

of the security of debt returns and the inaccessibility of unrealized capital gains). 

Conclusion 

The taxation of capital introduces many opportunities for distortions-between saving and consumption, corporate and noncorporate activity, dividends and retained earnings, debt and 

equity financing, individual and institutional financing, and among 

types of assets. The distortions among assets types can be avoided 

by making tax depreciation equal to economic depreciation, or by 

other manipulations of depreciation raties and the investment tax 

credit. Elimination of the distortion in favor of debt requires that 

the deductibility of interest be eliminated. 

The discrimination against dividends is removed by full integration or option 2, while options 3, 4, and 5 involve discrimination 

in favor of dividends for taxpayers with marginal tax rates below approximately 55 percent when the corporate tax rate is 48 

percent, and slight discrimination against dividends for taxpayers 

with marginal rates above that level. Similarly, full integration 

and option 2 generate no distortion with respect to decisions between corporate and noncorporate forms of organization, while 

options 3, 4, and 5 discriminate against corporate activity for 

taxpayers with low marginal tax rates and promote corporate 

organization for individuals with high marginal tax rates. 

The only way to tax capital without distorting saving-consumption decisions would be to impose a never-to-be-repeated capital 

levy that would be believed to be just that-one time only; it 

would be difficult to create such a belief. If one accepts the savingconsumption distortion, the simplest tax that eliminates all other 

distortions is a property tax. While the schemes described in this 

paper differ considerably in the extent to which they approximate 

full neutrality, none comes as close to full neutrality as a property tax. 
INTEGRATION AND INVESTMENT INCENTIVES 299 

References 

Harberger, Arnold C. "Tax Incentives to Investment in Bolivia." In 

Richard A. Musgrave (Ed.), Fiscal Reform in Bolivia: Staff Papers, 

vol. 2, ch. 22. Ministry of Finance, Bolivia, 1977. 
300 COMPENDIUM OF TAX RESEARCH 

COMMENT 

Marshaii E. Blume, University of Pennsylvania 

The paper "Integration and Investment Incentives" raises some 

interesting and important issues. However, the basic evaluation 

model used in estimating the values of different tax variables 

U;nder various integration schemes is marred at the theoretical 

level because of the basic evaluation model used and its implications for the discount rates for bonds and stocks. The problem is 

discussed below. Without redoing the author's complete analysis, it 

is difficult to assess the s,ensitivity of his results to this theoretical 

defect. 

Potentially the most useful analyses Tideman carries out are 

those that estimate the total taxes paid by both corporations and 

investors as a group on income generated by specific kinds of 

investments. It is, of course, this total which should be of prime 

concern to an investor-not how this total is split between the 

corporate and investor level. 

Too often, one hears the cry of "double taxation" in support of 

a reduction in the tax rate on dividends paid by corporations. 

There is nothing inherently wrong with taxing income at two or 

more levels : it happens all the time. Nonetheless, proponents 1of a 

reduction of taxes on dividends have sometimes tried to justify 

such a reduction by appealing to the supposed unfairness of a 

double tax. Now, it may well be that the total taxes on income 

generated through equity investment should be reduced, but not 

for reasons of double taxation. The principal concern should be 

the total taxes paid and not how these taxes are allocated between 

corporations and investors. While Tideman does provide su~h an 

allocation, his main analyses are based-as they should be-upon 

total taxes. 

In examining the question of neutrality, Tideman employs an 

interesting construct. This construct is the total tax generated by 

a one dollar investment-what he calls the Government's rate of 

return on a marginal investment dollar. This rate of return would, 

of course, vary according to whether the investment dollar was 

placed in debt or equity and whether the investor was tax-exempt 

or taxable and if taxable, at what rate. Using an average marginal 

rate for taxable investors, Tideman calculates these Government 
--- - -

INTEGRATION AND INVESTMENT INCENTIVES 301 

rates of return for tax-exempt investors in both bonds and equities and for taxable investors in both bonds and stocks. 

Tideman's estimates indicate that the equity holdings of taxexempt investors are implicitly taxed, the reason being their share 

of the corporate tax. Thus, a legitimate concern in any reform of 

the tax system is the impact on taxes paid implicitly by tax-exempt 

institutions. 

While it " is probably preferable to consider both corporate and 

investor taxes together as here, one could go a step farther ( theoretically, at least) by adjusting for the participants' abilities to 

shift the tax burden to other participants. For example, if a corporation (or a tax-exempt institution) could pass its tax burden 

to consumers through higher prices, the effective tax rate borne 

by capital would be reduced. Such tax rates, fully adjusted for the 

incidence of the tax system, would give a fairer assessment of any 

tax reform; but in practice, such adjusted rates would be quite 

tenuous and thus probably not as useful as Tideman's combined 

rat.es. 

Tideman argues that neutrality requires that any marginal shift 

of corporate financing between debt and equity should involve no 

change in Government revenue. This condition would be satisfied 

if the Government's rate of return on a marginal investment dollar were the same for all sources of financing and it would produce neutrality in a world of uncertainty in which both debt and 

equity would by default have the same risk characteristics and 

thus be perfect substitutes. In a world of uncertainty, there is no 

generally accepted concept of neutrality because most of the work 

on neutrality was done before the development of modern risk 

theory. 

For instance, one could.mean by neutrality that a change in tax 

policy would not affect the proportions that investors place in 

bonds and stocks. If all investors had utility functions displaying 

constant absolute risk aversion, Tideman's condition would probably produce neutrality. If, however, as seems more likely, investors 

have utility functions displaying constant proportional risk aversion,1 Tideman's condition would not lead to neutrality. Obviously, 

more work needs to be done on the concept of neutrality in a world 

of uncertainty. Until such a theory is developed, equity and the impact on incentives may be the beSt operational criteria in evaluating different tax schemes. 

1 Irwin Friend and Marshall E. Blume, "The Demand for Risky Assets," 

American Economic Review (December 1975). 
302 COMPENDIUM OF TAX RESEARCH 

Tideman's model is marred by a theoretical defect in that his 

model discounts all after-tax cash outflows of a corporation at the 

same rate and assumes that all such flows are of the same risk. 

Until it is determined how sensitive his numerical estimates are 

to this flaw, how much confidence can be placed in these estimates, 

presented in his tables 2 and 3, is not known. 

Specifically, his model appears to discount all corporate aftertax cash flows at the same rate, a weighted average of the cost of 

debt and equity capital. Thus, at least in one case (S=O, i=O), the 

value of debt is determined as the value of the debt payments discounted by this weighted average cost of capital. Bond values in 

the market, however, are determined by the value of the coupons 

and principal discounted at a rate appropriate to bonds, which 

would generally be closer to the long term Government rate than 

this weighted average cost of capital. Tideman's value of debt 

therefore appears to be understated and the value of equity 

overstated. 

Moreover, the financial literature has usually treated the deductibility of interest as equivalent to a tax scheme in which the 

Government taxed a firm's cash flow as if there were no deductions and then gave the firm a subsidy equal to the product of the 

tax rate and the interest payments. The risk associated with this 

subsidy is generally considered to be low, so that this subsidy 

should be discounted at something close to the long-term Government rate. The use of debt thus increases the value of the firm, so 

that for this reason, Tideman's estimate of the value of equity 

would· be understated. The determination of the size of this understatement relative to the previously mentioned overstatement 

would require further study of a nature not appropriate to a comment. The same argument could presumably be applied to depreciation expense.