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5 INVESTMENT INCENTIVES UNDER 

THE TAX REFORM ACT OF 1986 

Don Fullerton, Robert Gillette, and James Mackie 

I. INTRODUCI'ION 

The Tax Reform Act of 1986 significantly changes the taxation of income 

from tangible capital. It lowers the top statutory marginal corporate income 

tax rate from 46 percent to 34 percent. It also lowers income tax rates on 

interest income, noncorporate business income, and dividends. In contrast, 

however, tax reform eliminates the 60 percent exclusion on long term capital 

gains. Thus, the effective rate on capital gains is increased by tax reform. 

In addition, tax reform alters capital cost recovery provisions, perhaps most 

dramatically by repeal of the investment tax credit, and it improves the 

matching of income and expense in accounting for multi-period production. 

These changes in capital income taxation can affect marginal investment 

incentives in complicated ways. Rate reduction can. for example, partially 

offset changes in recovery allowances. Furthermore, different assets, industries, and sectors are likely to be affected differently. In order to capture 

the effect of simultaneous changes in corporate rates, individual rates, and 

recovery allowances, we measure investment incentives using a cost of capital 

framework. The cost of capital provides a comprehensive, forward looking 

measure of marginal investment incentives. It is the pre-tax return on a 

marginal investment needed to earn a given net of tax return, and captures 

the effects of depreciation, credits, and statutory rates. In addition, the 

standard cost of capital model can be adapted to include the effects of 

accounting rules for multi-period production. Finally. costs of capital for 

individual assets can be weighted together to obtain measures of investment 

incentives for more aggregate assets (equipment vs. structures). industries. 

Tlr~ authors thank Jane Gravelle and J. Gregory Bafle111i11e .for help{ltl discussio11s of lilt' e.Dec1 

of accouming n1/~s on investmellf ince111ives. and C01hai11C' Ford. Conni<' Ha.Jiman. 0011110 

Harrell, Geraldine Huggins. and /Jar/Jara /'arsons for assillancc in 1hc preparalion of 1/ze 

manuscript and tables. Special 1hanks go 10 Yolanda Hc•ndason ll'ho made subsla1uial 

contributions to th~ dtvt'lopmtnt of the mode•/. 

131 
132 Don Fullerton/Robert Gillette/James Mackie 

and sectors, as well as to obtain overall economy wide measures of investment 

incentives. 

We find that tax refonn generally reduces investment incentives. Our 

analysis further indicates, however. that tax reform has been successful in 

"leveling the playing field." Regardless of its effect on overall investment 

and savings incentives, tax reform reduces the disparity in the taxation of 

alternative assets and investors. Thus. investment choices will be more 

efficient. Our analysis also shows that there is no unique set of effective 

tax rates (or costs of capital) associated with either prior law or tax 

refonn . Instead, magnitudes and sometimes even signs depend on parameter 

values and modeling choices. Under some scenarios tax reform lowers overall 

effective tax rates. We also find that modeling accounting rules has only a 

small effect on the magnitude of our results. 

In this paper we do not consider the ultimate effect of tax reform on the 

allocation of resources. Rather. we simply measure its effect on incentives 

to change the allocation of capital, incentives which will eventually affect 

resource allocation in general. A comprehensive analysis of the effect of the 

capital taxation provisions of tax refonn on the allocation of resources is 

provided in this volume by Fullerton. Henderson and Mackie (1987). They use 

the computable general equilibrium model developed by Fullerton and Henderson 

( 1986) to analyze the effect of changes in capital taxation on growth, 

resource allocation, and welfare. 

The remainder of our paper is organized as follows. Section II briefly 

describes the cost of capital model. Section Ill describes the data we use to 

implement our analysis. In particular, in the third section we describe a 

very disaggregate capital stock which allows us to consider great detail in 

measuring and weighting reform induced changes in the taxation of different 

assets. Sections IV-VII present our results, including sensitivity analyses. 

In Section VIII we model accounting rules. We conclude in Section IX with a 

summary of our findings and suggestions for future work. 

II. THE MODEL OF INVESTMENT INCENTIVES 

We use the model developed in Fullerton ( 1987) and Fullerton and Henderson 

( 1984) to measure investment incentives. Their model abstracts from issues 

related to risk, and is based in tum on the neo-classical rental rate 

approach of Hall and Jorgenson ( 196 7). It captures the effects of personal and 

corporate income taxes and property taxes at the federal. state, and local 

levels, as well as depreciation allowances. and credits. 1 

A. The Discount Rate, Personal Taxes, and Arbitrage 

In calculating the discount rate. r. we follow Fullerton and Henderson 

( 1984) and consider two alternative arbitrage scenarios. The first scenario is 

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Investment Incentives Under Tax Reform 133 

individual arbitrage, which requires that all ultimate savers earn the same 

after all tax return, s, on investments in all sectors (corporate, noncorporate business. and owner-occupied housing). Savers (investors) trade off 

between debt and other investments until the net of all tax return on all 

investment equals the net of all tax return on debt: 

s = s = s = ~ = i(l-T )-n c nc n d (5.1) 

where s , s , and ~ are the net returns to ultimate savers for investment in c nc n 

the corporate, noncorporate, and owner-occupied housing sectors, respectively, 

i is the nominal interest rate, 'td is the tax rate on interest income, and n 

is the inflation rate. 

The after al1 tax return to savers. s, and the inflation rate, n, are 

specified exogenously, and (once 'td is specified below) equation (5. 1) is used 

to solve for the interest rate. The discount rate for each sector can then be 

determined as a function of the interest rate. personal tax parameters, and 

financing shares. 

Corporations can finance real investment by new debt, retained earnings, or 

new share issues. Corporate debt financed investment in real capital must 

earn the after-tax interest cost, i( 1-u), where u is the statutory marginal 

tax rate on corporate income. Corporate investment financed by retentions 

must earn a return r such that ultimate savers are indifferent between 

interest payments and the capital gains such re-investment will yield: 

r(I -Tre) must equal i(l-Td), where 'tr• is the personal tax on accrued capital 

gains. Similarly, new share issues must earn a return such that investors are 

indifferent between interest payments and dividends: r( I -'tns) must equal 

i(J -'td) where 'tn• is the personal tax on dividends. The corporate nominal 

discount rate is a weighted average of the three discount rates: 

[ cd . l •(1 -u) + c [i(J-'td) l + c [i(l-'td) l 

re ( l-'t ) n • (1-"C ) re n a 

(5 .2) 

where cd' cr.' ens ' are the fractions of corporate investment financed by 

debt, retentions, and new shares, respectively. 

Similarly, noncorporate finns have an after-tax interest cost of i(I -T ), n c 

and their equi.ty must earn i(l-'td) after taxes where 't is the tax rate on nc 

noncorporate business income. Thus. the overall discount rate for the 

noncorporate firm is 

nd(i(l-'t )]+n [i(l-"Cd)] n c • (5 .3) 

where nd. and n. are the fractions of noncorporate investment financed by debt 

and equity. respectively. Identical logic gives 

hd (i( I -'th) J +h. [i( l-Td) J (5.4) 
134 Don Fullerton/Robert Gillette/ James Mackie 

as the discount rate for owner-occupied housing, where h4 and h. are the 

fraction of investment in owner-occupied housing financed by debt and equity, 

respectively and -rh is the income tax rate at which homeowners deduct interest 

payments. 

With individual arbitrage. ultimate investors earn the same after-tax real 

return on all investments. However, firms earn different returns on debt 

financed than on equity financed investment. As an alternative, we consider 

arbitrage between debt and real capital at the firm level. Under this 

alternative assumption, net-of-tax returns are equated for the firm, and so 

the firm uses the cost of debt, i(l-u), as the discount rate for all investments, regardl.ess of the actual source of finance. In this case, however, 

net-of-tax returns differ for ultimate savers depending on whether the 

investment is in the corporate business, noncorporate business, or owneroccupied housing sector. In a perfect certainty model such as this, either 

firm or individual arbitrage is possible, but not both at the same time. 

Thus, we report results for each alternative arbitrage assumption. 

B. Cost of Capital and Effective Tax Rate 

The neo-classical approach exploits the competitive profit maxamazmg 

condition that the marginal investment will yield a cash flow whose present 

value is just sufficient to cover its acquisition price. This equilibrium 

condition is solved for the social return on investment, gross of tax but net 

of economic depreciation, which equals the marginal product of capital, and 

is referred to as the (financial) cost of capital. For a corporate firm the 

cost of capital on a marginal investment of $1 , p c: , may be written as 

p c: = {(r-n+6)/(l-u)}(l-k-auz)+w-6 (5.5) 

where r is the nominal discount rate for corporate investment (as determined 

above), n is the constant rate of inflation. cS is the constant rate of 

economic depreciation. u is the statutory rate on income generated by the 

marginal corporate investment, k is the rate of investment tax credit, z is 

the present value of tax depreciation allowances on $1 of depreciable basis, a 

is the percentage of basis entitled to statutory depreciation, and w is the 

local property tax rate. The discount rate. inflation rate, and statutory 

corporate income tax rate are constant across assets in the corporate sector. 

However, the other parameters (k. z. w, and o) vary by asset. The cost of 

·capital for noncorporate investment may be written as in (5.5) by replacing u 

with -r • the personal tax rate on noncofP-Orate business income. and using nc: 3 

the appropriate noncorporate discount rate. 

We also measure incentives for investment in owner-occupied housing. Such 

investment is entitled to neither an investment tax credit nor capital 

recovery allowances. However. the rents generated by the investment are not 

taxed. while property taxes are deductible. The cost of capital for investment 

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Investment Incentives Under Tax Reform 135 

in owner-occupied housing may be written as 

(5.6) 

where -rh is the tax rate at which home owners deduct property taxes and X i6 

the fraction of property taxes deducted. 

Many of our results are shown using the cost of capital. However, we also 

present results based on effective tax rates. The effective tax rate, t, is 

defined as the difference between the cost of capital (i.e. the real pre-tax 

return), p. and the required real after tax return on investment, s. as a 

percentage of the cost of capital: t =(p-s)/p. In some cases, the effective 

tax rate is more easily interpreted than is the cost of capital. 4 The 

effective tax rate shows the total proportion of capital costs attributable to 

taxes at both the personal and corporate levels and can be compared with 

statutory rates. 

III. DATA AND PARAMETERS 

Our analysis considers the tax treatment of many depreciable assets, plus 

nondepreciable land and inventories. used in the corporate and in the noncorporate sectors of each of 60 private industries, as well as structures and 

land in an owner-occupied housing sector. In order to compute each asset's 

cost of capital and effective tax rate we must specify an economic depreciation rate as well as the relevant tax parameters and financing shares. To 

calculate summary measures of incentives by industry and sector, as well as 

measures of overall economy wide investment incentives, we need a set of 

weights. We first describe in Pan A the detailed capital stock data we use 

as weights for our summary measures. Pan A also discusses our assumptions on 

economic depreciation. Next, we describe our determination of the parameters 

which are affected by tax reform: capital cost recovery allowances in Pan B 

and statutory income tax rates in Part C. We conclude with an explanation of 

our determination of parameters which do not change as a consequence of tax 

reform: financing shares in Pan D and property taxes in Pan E. 

A. Asset Definition, Capital Stock Weights, and 

Economic Depreciation 

Earlier studies (Auerbach ( 1983a). Fullerton ( 1987), Fullerton and 

Henderson (1984), Gravelle (1982)) typically consider the 34 types of 

depreciable property shown in Table 5. I . The most detailed of these (Fullerton 

(I 987) and Fullerton and Henderson ( 1984)) compute the cost of capitaJ for 

each asset for both corporate and noncorporate firms. as well as for owneroccupied housing. These disaggregate costs of capital are then weighted to 

obtain summary measures of investment incentives in the corporate sector. the 

noncorporate business sector. and for the economy as a whole.

5 
136 Don Fullenon

/Roben Gillette/James Mackie 

Table 5. I 

Cost Recovery Periods in Fullerton (1987) 

I. Furniture and Fixtures 

2. Fabricated Metal Products 

3. Engines and Turbines 

4. Tractors 5. Agricultural Machinery 6. Construction Machinery 

7. Mining and Oil Field Machinery 

8. Metalworking Machinery 9. Special Industry Machinery 

I 0. General Industrial Equipment 

I I . Office and Computing Machinery 

12. Service Industry Machinery 

13. Electrical Machinery 

14. Trucks, Buses. and Trailers 

15. Autos 

16. Aircraft 

I 7. Ships and Boats 

18. Railroad Equipment 

I 9. Instruments 

20. Other Equipment 

21 . Industrial Buildings 

22. Commercial Buildings 

23. Religious Buildings 

24. Educational Buildings 

25. Hospital Buildings 

26. Other Nonfarm Buildings 

27. Railroads 

28. Telephone and Telegraph 

29. Electric Light and Power 

30. Gas Facilities 

3 I . Other Public Utilities 

32. Farm Structures 

33. Mining. Shafts and Wells 

34. Other Nonbuilding Facilities 

Source: Fullen on (I 987) 

Prior Law 

Recovery 

Period 

5 

5 

5 

5 

5 

5 

5 

5 

5 

5 

5 

5 

5 

5 

3 

5 

5 

5 

5 

5 

19 

19 

19 

19 

19 

19 

15 

15 

15 

10 

10 

19 

5 

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Investment Incentives Under Tax Reform 137 

Although these studies incorporate much disaggregation, in at least two 

respects they over-simplify the tax treatment of different assets. First, the 

34 assets in Table 5 . I are themselves composed of moredisaggregate components 

which may not receive uniform cost recovery allowances. Second, and relatedly. these earlier studies did not allow for the industry specific determination of cost recovery allowances. Instead. they gave each asset the same 

tax treatment in all industries. However, both prior law and the Tax Reform 

Act of 1986 are based on the Asset Depreciation Range system (ADR) which 

classifies some types of personal property on an industry basis. We build on 

earlier work by using a more disaggregate set of assets and by allowing for 

industry specific cost recovery allowances. 

We begin our analysis with 50 types of nonresidential and 11 types of 

residential depreciable property used in 60 different private industries, as 

tracked by the Bureau of Economic Analysis (BEA). Table 5.2 lists the 50 

depreciable nonresidential BEA assets. Asset number 51, residential structures. in Table 5.2 is an amalgamation of the 11 types of BEA residential 

rental assets. Based on unpublished BEA data. we divide investment flows in 

each asset in each industry into a corporate and a noncorporate component. 

Next. we use an algorithm developed by the Joint Committee on Taxation (JCT) 

and the Office of Tax Analysis (OT A) to further disaggregate investment in 

each of the 61 BEA assets in each sector of each industry into components 

based on ADR midpoint lives. 6 

For example. investment in BEA asset number20, 

trucks, buses, and truck trailers (whose ADR classification does not vary by 

industry) is disaggregated into its components: buses, with an ADR midpoint of 

9 years; light general purpose trucks. with an ADR midpoint of 4 years: heavy 

general purpose trucks, with an ADR midpoint of 6 years: over the road tractor 

units. with a 4 year ADR midpoint; and trailers and trailer mounted containers 

with a 6 year ADR midpoint. In addition, the algorithm assigns industry 

specific ADR midpoints where appropriate. For example, under the ADR system, 

most personal property used in the mining industry has an ADR midpoint of 10 

years. while if used in the construction industry the same property would have 

a midpoint of 6 years. The algorithm takes this into account and, for 

instance, assigns BEA asset number 7. construction tractors, a 10 year ADR 

midpoint in the coal mining industry, but a 6 year ADR midpoint in the 

construction industry. 

After computing the cost of capital for each component of each asset in 

each industry based on ADR life, we wish to aggregate up so that our results 

are more accessible. This requires a set of weights. Two common weights are 

investment flows (see, for example the International Trade Commission ( 1986)) 

and capital stocks. We follow Fullerton ( 1987) and Fullerton and Henderson 

(1984) in using capital stock weights. Fundamentally. we are concerned with 

the size of the capital stock and its allocation across different assets and 

sectors. Investment is important , but primarily as the means through which 

changes in the stock of capital are realized. Thus, a marginal change in our 

analysis is a proportional expansion of the existing capital stock. Therefore 
I 

138 Don Fullerton/Robert Gillette/James Mackie I 

Table 5.2 Cost Recovery Parameters 

in the Corporate Sector I 

I Economic ~ost Recover~ 

Asset Depreciation M'C ACRS Tax Reform 

Rate lTC Reco~ Period Recovery Period 

I. Furniture & Fixtures (Household) 

. 110 .100 s.oo S.20 I 

2. Furniture & Fixtures (Other) 

.110 .100 s.oo 

7.00 

3. Fallricated Metal Products .090 .100 S.40 6.49 

4. Steam Engines and Turbines 

.080 .100 10.67 1S.30 

s. Internal Combustion Engines 

.076 .100 8.01 11

.70 I 

6. Farm Tractor~ .161 .100 HIO 

6.S2 

7. Construction Tractors 

.163 .100 s.oo S. 1S 

8. Other Agricultural Machinery .097 .100 

s.oo 

7.00 

9. Other Construction Machinery .170 .100 

s.oo S.36 

10. Mining And Oilfie

ld Machinery . 168 .100 s.oo 7.00 I 11. Metalworking Machinery . 123 .091 ·U3 S.86 

12. Special Industry Machinery . 102 .098 4.89 6.60 

13. General Indus

trial Equipment . 122 .098 S.2$ 7.26 

14. Oftlce Computing Machinery 

.273 .100 s.oo s.oo 

IS. Service Industry Machinery .166 .100 S.12 5.24 I 

16. Communications Equipment 

.liS .100 

7.73 

9.99 

17. Elec. Trans .• Dist.. & Indus. Appar. 

.081 .099 

7.74 10.34 

Ill. Electric Household Appliances 

. 1111 

.100 s.oo 

s.oo 

19. Other Electrical Equipment 

.116 .100 s.oo S.23 I 20. Trucks, Buses and Truck Trailers .253 .071 3.S6 s.oo 

21. Auto~ 

.333 .060 3.00 s.oo 

22. Aircrafl .183 .100 s.oo 7.00 

23. Ships and Boats .075 .100 5.00 9.88 

24. Railroad Equipment 

.066 .100 5.00 

7.00 I 25. Scientific & Engin. lnnruments .139 .100 6.32 7.78 

26. Photographic Instr

uments 

.146 .100 

4.98 S.20 

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27. Other Nonresidential Equipment . 146 . 100 5.00 5.32 

28. Industrial Buildings 

.036 

.025 15.SJ 2S.49 

29. Mobile Commercial Oftlces 

.080 .000 19

.00 31.50 I 30. Commercial Office Buildings .02S .000 19.00 31.50 

31. Commercial Warehouses .025 .000 19.00 31.50 

32. Other Commercial Buildings 

.026 .067 

9.67 14.34 

33. Religious Buildings 

.019 .000 19.00 3UO 

1 . 

34. Educational Buildings .019 . 000 19.00 31.50 

35. Hospital and lnstltut. Buildings 

.023 .000 19.00 31.SO 

36. Hotels and Motels 

.04S 

.000 19.00 31.50 

37. Amusement and Recreational .044 

.100 10

.00 13.47 

38. Other Nonfarm Buildings 

.045 

.000 19.00 31.50 I 39. Railroads .030 .100 5.00 7.00 

40. Telephone and Telegraph .032 

.076 IO.S6 12.S9 

41. Electric Light and Power 

.032 

.100 13

.00 18.00 

42. Gas 

.032 .051 12.71 20.22 

43. Local Transit 

.032 .100 !1.00 5.00 I 44. Petroleum Pipelines .032 .100 5.00 15.00 

45. Farm 

.024 .000 19

.00 20.00 

46. Oil & Gas Explor. Shafts & WeUs 

.OS6 

.100 s.oo 7.00 

47. Other Mining Shafts and WeUs 

.OS6 .100 5.00 7.00 

48. Other Nonresidential Structures 

.029 .000 19.00 31.50 I 49. Railroad Replacement Track .032 . 100 s.oo 7.00 

so. Nucle11r Fuel 

.250 .100 5.00 s.oo 

51. Residential Structures 

.036 .001 18.94 27.45 

Source: Described in the text. I 

*These are averages weighted by capital stocks. They differ from statutory lTC allow-

ances or recovery periods because each numerical asset may contain components wi

th differing 

lTC allowances or recovery periods. I 

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Investment Incentives Under Tax Refonn 139 

we compute the capital stock for each component of each asset used in the 

corporate and noncorporate sector of each industry. 7 Using these stocks as 

weights, we aggregate to the 50 types of nonresidential depreciable property 

plus residential rental property shown in Table 5.2. These capital stock 

weights are also used to compute summary measures of investment incentives by 

industry. by sector, as well as economy wide averages. 

In addition to depreciable assets. we measure investment incentives for 

nondepreciable land and inventories. These are included in overall average 

measures using stock weights based on those used by Fullerton (1987). 

We compute economic depreciation rates for each component of our disaggregate depreciable assets based on rates computed by Hulten and Wykoff ( 1981) 

and Jorgenson and Sullivan (1981). The weighted average rate is shown in 

Table 5. 2 for each of the 51 depreciable assets used in the corporate sector. 

B. Capital Cost Recovery: The Investment Tax Credit and 

Depreciation Allowances 

Prior law provides a 6 percent investment tax credit (lTC) for autos. light 

trucks. and certain short lived special manufacturing equipment, and a 10 

percent lTC for other types of equipment and for public utility property. 

Real property does not receive the lTC. Tax reform would eliminate the lTC 

for aJI investment. 

It is apparent from the Hulten-Wykoff economic depreciation rates of Table 

5 .2 that different assets depreciate at very different rates. Tax law. 

however. tends to group assets into a limited number of depreciation classes. 

thus generating nonneutralities.1 Prior law Accelerated Cost Recovery System 

(ACRS) groups assets into five classes. Recovery is based on historic cost, 

and recovery periods range from 3 to 19 years. Assets in classes l-4 (personal 

property-equipment-and public utility property) receive recovery allowances 

based on 150 percent declining balance, with an optimal switch to straight 

line. Real propeny (class .5) receives J 7.5 percent declining balance. with an 

optimal switch to straight line, over a 19 year recovery period. Depreciable 

basis is reduced by one-half of the lTC. Thus, in equation (5.5) a equals 

(l-.5k). 

Using a JCT-OTA algorithm, we assign an lTC rate and an ACRS cost recovery period to each ADR component of each asset in each industry.

9 Table 5.2 

shows the average lTC rate and the average ACRS recovery period for each of 51 

depreciable assets in the corporate sector. These lTC rates and recovery 

periods can differ from statutory allowances because they are capital weighted 

averages of components with differing statutory allowances. 

Table 5. 1 shows the prior law ACRS classification of assets used by 

fullerton (1987). Comparison with our classification in Table 5.2 highlights 

several differences. Among types of equipment (assets 1-27 of Table 5.2) we 

show some assets with a longer recovery period than fullerton ( 1987). and some 

with a shorter recovery period. For example. our classification of engines 
140 Don Fullerton/Robert Gillette/ James Mackie 

and turbines (assets 3 and 4 in Table 5.2) gives a recovery period averaging 

between 8 and II years, longer than the 5 year period used by Fullerton 

( 1987). We give other assets, such as metal working machinery, a shorter ACRS 

recovery period than in Fullerton ( 1987). On the whole, for equipment we 

differ from Fullerton ( 1987) more often by using a longer than a shorter 

recovery period. This is partly due to the fact that some components of 

assets 1-27 of Table 5.2 are 19 year real property under ACRS, and some 

components are 10 year or 15 year public utility property under ACRS. 

Our classification of structures indicates somewhat shorter ACRS recovery 

periods than those used by Fullerton ( 1987). Our data indicates that not all 

investment in industrial buildings (asset 28 in Table 5.2), for example, is 

treated as investment in real property for tax purposes. Instead, a portion 

is personal property and receives a shorter recovery period. Thus, we show an 

average recovery period of 15.5 years, while Fullerton (1987) treats all 

investment in industrial buildings as investment in real property, and 

consequently assigns it a 19 year recovery period. 

The International Trade Commission (1986) has computed the cost of capital 

and effective tax rates under prior law and several reform proposals for each 

of the 51 assets in Table 5.2. However, their cost recovery classification is 

a simple mapping from Fullerton ( 1987). Thus, our classification captures 

considerably more detail than that used by the International Trade Commission. 

Furthermore, the Commission's analysis compares prior law with reform proposals which differed substantially from the final version of the Tax Reform Act 

of 1986.10 

Tax reform expands the number of recovery classes from five to eight. 

Based on ADR midpoints, personal property is assigned a recovery period 

ranging from 3 to 20 years. Property with recovery periods of 3, 5, 7, or 10 

years receives allowances based on the 200 percent declining balance method, 

with an optimal switch to the straight-line method. Property with recovery 

periods of 15 and 20 years (primarily public utility property under ACRS), 

receives allowances based on the 150 percent declining balance method, with an 

optimal switch to the straight line method. Residential real property receives straight line over 27.5 years and nonresidential real property receives 

straight line over 31 .5 years. As under prior law, recovery allowances are 

based on historic cost. The average recovery period in the corporate sector 

for each of 51 types of depreciable property is shown in Table 5.2. In 

general, tax reform lengthens recover periods. However, this effect is 

somewhat offset for most equipment by the generous 200 percent declining 

balance method allowed under tax refonn. 

c. Corporate and Individual Income Tax Rates 

11 

Under prior, or pre-tax reform law, the top federal statutory rate was 46 

percent. State corporate income taxes average .066 (King and Fullertqn 

( 1 984)). Deductibility of state taxes at the federal level implies an overall 

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Investment Incentives Under Tax Reform 141 

statutory rate of .46+.066(1-.46), which equals .495. Tax reform lowers the 

top Federal statutory rate to .34. Thus, the overall corporate statutory rate 

for tax reform is .34+.066(1-.34), which equals .383. 

Personal income taxes under prior law are based on a progressive structure 

composed of 14 brackets with a 50 percent maximum rate. Tax reform reduces 

the number of brackets to two with statutory rates of 15 and 28 percent. The 

top statutory rate, however, is 33 percent because a 5 percent surcharge is 

used to remove the benefits of the 15 percent rate and the personal exemption 

for high income taxpayers. Using the Treasury Individual Tax Model12 James 

Cilke calculated the weighted average marginal personal income tax rates at 

the Federal level for interest, dividend, long-term capital gains, and noncorporate business income, as well as the rate at which households take deductions. for both prior law and tax reform. The results of these tabulations 

are shown in the "Federal Only" column of Table 5.3. 

Tax reform generally lowers federal average marginal personal tax rates on 

capital income. An important exception, however, is the tax rate on realized 

long-term capital gains. Because 60 percent of long term gains are excluded 

under prior law, realized long-term gains are taxed at a maximum rate of 20 

percent. Tax reform eliminates this exclusion and taxes realized long-term 

capital gains as ordinary income, with a maximum statutory rate of 33 percent. 

Thus. the average marginal rate on realized gains rises accordingly, from 16.4 

percent under prior law to 26.7 percent under tax reform. 

Tax refonn also reduces the number of itemizers. Thus, the fraction of 

property taxes deducted on federal income tax returns. >.., falls from .48 under 

prior law to .41 under tax reform. 

The personal tax rates from the Treasury Individual Tax Model are modified 

as in King and Fullerton ( 1984) to reflect taxation at the state and local 

level, deferral of capital gains, and the taxation of banks, life insurance 

companies, and nonprofit institutions.13 The adjusted persona.! rates used in 

our cost of capital calculations are shown in the "After Adjustment" column of 

Table 5.3. As with the unadjusted rates, tax reform lowers the adjusted personal tax rates on all types of capital income except accrued capital gains. 

Table 5. 3 Personal Tax Rates 

Federal Only After Adjustment 

Type of Income Prior Law Tax Reform Prior Law Tax Reform 

Interest 

Dividends 

Capital Gains 

Noncorporate 

Housing Deductions 

.255 

.329 

.164 

.250 

.209 

.216 

.258 

.267 

.210 

. 175 

.219 

.285 

.074 

.300 

.259 

Source: Trco.asury Individual Tax Model, as described in the text. 

.194 

.232 

. 125 

.260 

.225 
142 Don Fullerton/Robert Gillette/James Mackie 

D. Financing Shares 

Financing shares are assumed invariant in the face of tax reform. For most 

calculations, we assume that firms finance marginal investments in the same 

way they as they financed the existing capital stock. Fullerton and Henderson 

( 1984) cite data which suggests that noncorporate fmns and homeowners fmance 

one third of investment using debt and two thirds using equity. King and 

Fullerton ( 1984) indicate that corporations also finance using one third debt 

and two thirds equity. Corporate equity, in tum, is 93 percent retentions 

and 7 percent new share issues. Because of the small weight put on new share 

issues, these corporate sector financing shares are consistent with the new 

view of Auerbach (1979), Bradford (1981) and King (1977) that the dividend tax 

is not an important additional source of distortion in the allocation of 

investment between the corporate sector and the rest of the economy. This view 

of the dividend tax is controversial, and others argue that dividend payout 

rates affect the cost of capital, and that there is significant double 

taxation of corporations because profits are taxed once at the firm level and 

again when distributed as dividends (McLure ( 1979)). Therefore, we consider 

an alternative financing assumption which puts more weight on new share 

issues. Results for several additional financing arrangements also are 

reported below. 

E. Local Property Taxes 

Like capital stock weights, economic depreciation rates, state income tax 

rates, and financing shares, local property tax rates are assumed unchanged by 

tax reform. Based on Fullerton and Henderson ( 1984) we use economy wide 

averages of .008 for equipment and inventories, .011 for business land and 

structures. .016 for public utilities, and .018 for residential land and 

structures. 

IV. INVESTMENT INCENTIVES BY ASSET, SECTOR, AND 

INDUSTRY: PRIOR LAW COMPARED WITH 

THE TAX REFORM ACT OF 1986 

In this section we first present detailed results on investment incentives 

for each of 54 assets under prior Jaw and tax reform. To keep the discussion 

manageable, these asset specific results are reported only for the corporate 

sector. Next, we report more aggregate results showing relative investment 

incentives for broad asset categories, as well as overall. in the corporate 

sector. the noncorporate sector. and the owner-occupied housing sector. 

Finally. we discuss marginal investment incentives for each of 60 private 

industries under both prior law and tax reform. 

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Investment Incentives Under Tax Reform 143 

A. Present Value of Recovery Allowances by Asset 

Table 5.4 s~ows the present value of depreciation allowances (columns 1 and 

2), the present value of total cost recovery allowances under prior Jaw 

(column 3), and the present value of allowances based on real economic 

depreciation (column 4) for each of 51 depreciable assets in the corporate 

sector. These calculations abstract from the effect of income tax rates on the 

discount rate by using a common 8 percent nominal discount rate for both prior 

law and tax reform. The present value of real economic depreciation is 

calculated using a 4 percent real rate of return. 

Column 1 of Table 5.4 shows the present value of depreciation under prior 

law. Comparing column I with column 4 shows that prior law generally gives 

depreciation allowances more generous than allowances based on economic 

depreciation. This is true for both equipment (assets 1-27) as well as 

structures like assets (28-51 ). 

For equipment. tax reform has a relatively small, but variable, effect on 

the present value of depreciation allowances. compared with those under prior 

law. For types of equipment such as office computing machinery (asset 14). 

which maintain the same recovery periods under tax reform as under prior law. 

but receive allowances based on the more generous 200 percent declining 

balance method, tax reform raises the present value of depreciation allowances. For other categories of equipment, such as construction tractors (asset 

7) and photographic instruments (asset 26), the effect of the more generous 

method is offset partially by a longer life, and the present value of depreciation allowances rise, but by a slightly smaller amount. For other types of 

equipment, such as farm tractors (asset 6) and railroad equipment (asset 24 ). 

the more generous method is insufficient to offset the longer recovery period, 

and the present value of allowances fall. In addition, certain components of 

equipment-like assets ( J -27) are real property (or ACRS public utility 

property) for which tax reform reduces the present value of allowances. as 

discussed below. On the whole, for equipment, tax reform reduces the present 

value of depreciation allowances more often than it raises the present value 

of depreciation allowances. However. allowances typically remain more generous 

than those based on economic depreciation. 

In contrast to its effect on equipment. tax reform sharply reduces the 

present value of depreciation allowances for most structure-like assets 

(27-51). compared with prior law levels. This largely is due to the combination of a long recovery period for real property (raised from 19 to 27.5 

years for residential real property and from 19 to 31.5 years for nonresidential real property). and the switch from the 175 percent declining balance 

method to the straight line method. For components of certain public utility 

structures (assets 40-44) the reduction in the present value of depreciation 

allowances also reflects the longer lives assigned to some 150 percent 

declining balance utility property. as well as the reclassification of some 

property from 150 percent declining balance over 15 years under ACRS to 
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144 Don Fullerton/Robert Gillette/ James Mackie I 

Table 5.4 Present Value of Cost Recovery 

Allowances for Corporate Assets • I 

Present Value of Present Value of I DeprecilltiCKl Total Cost Recovery Present Velue 

Allow ant-es Allowances b of Economlcb 

Assets Prior l:aw Tax Qorm Under Prior Law Depreciation 

I. Furnhure & Fixtures (Household) .1146 .864 1.006 .733 I 2. Furnhure & Fixtures (Other) .1146 .819 1.006 .733 

3 . Fahricated Metal ProductS .837 .834 .997 .692 

4. Steam Engines and Turhines .713 .624 .879 .667 

5. Internal Combustion Engines .776 .710 .939 .655 I 6 . Fann Tractors .1146 .831 1.006 .801 

7. Construction Tractors .846 .86.5 1.006 .803 

8. Other Agricultural Machinery .846 .819 1.006 .708 

9. Other Construction Machinery .846 .860 1.006 .810 

10. Mining and Oilfield Machinery .1146 .820 1.006 .808 I II. Metelworking Machinery .861 .849 1.006 .1SS 

12. Special Industry Machinery .849 .830 l.OOS .718 

13. General Industrial Equipment .841 .815 .998 .753 

14. Office Compullng Machinery .846 .869 1.006 .1172 I I.S. Service Industry Machinery .1143 .863 1.003 .1106 

16. Communications Equipment .784 .746 .947 .742 

17. Elec. Trans . . Dist .• & Indus. Appar. .784 .748 .94.5 .669 

18. Electric Household Appliances .846 .869 1.006 .747 

19. Other Electrical Equipment .846 .864 1.006 .744 I 20. Trucks. Buses and Truck Trailers .893 .869 1.00~ .1163 

21. Autos .911 .869 l.OOS .1193 

22. Aircntft .846 .819 1.006 .821 

23. Ships & BoatS .846 .156 1.006 .652 

24. Railroad Equipment .1146 .1119 1.006 .623 I 25. Scientific & Engin. InStruments HI~ .804 .976 .777 

26. Photographic Instruments .847 .1164 1.007 .78.5 

27. Other Nonresident.iel Equipment .1146 .861 1.006 .78.5 

211 . lndu~trial Buildings .643 .477 .68.5 .474 

29. Mobile Commercial Offices .S1S .365 .S1S .667 I 30. Commercial Office Buildings .515 .365 .S1S .38.5 

31. Commercial Warehouses .57.5 .365 . .S1S .38.5 

32. Other Commercial Buildings .7.56 .688 .866 .394 

33. Religious Buildings .515 .365 . .57.5 .322 I 34. Educational Buildings .S1.S .36.5 .S1S .322 

3.5. Hosnital 11nd lnstitut. Buildings . .57.5 .36.5 . .57.5 .36.5 

36. Hotels and Motels .575 .365 .515 .529 

37. Amusement anct Recreational .722 .678 .888 ..524 

38. Other Nonfarm Buildings . .575 .365 .57.5 .529 I 39. Railroads .846 .819 1.006 .429 

40. Telephone and Telegraph .73 1 .690 .857 .444 

41. Electric Light and Power .661 .567 .1130 .444 

42. Gas .688 .SS6 .784 .444 

43. Local Transit .1!46 .869 1.006 .444 I 44. Petroleum Pipelines .846 .615 1.006 .444 

45. Farm .515 .S3S .S1S .375 

46. Oil & Gas Explor, Shafts & Wells .846 .819 1.006 ..51!3 

47. Other Mining Shafts and WeUs .846 .819 1.006 .583 I 41!. Other Nonresidential Structures .575 .365 575 .420 

49. RailroAd Replacement Track .R46 .1119 1.006 .444 

so Nuclear Fuel .846 .869 1.006 .862 

Sl. Residential Structures .576 .405 .578 .474 

Source: Authors' calculahons as descnbed m the text. I 

•calculations use an 8% nominal discount rate, composed of a 4 percent inflation rate and a 4 

percent real return. I b 

Computed as a z + (k/ u) . 

c Uses depreciation rates from Table 2. Economic depreciation allowances are indexed for 

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Investment Incentives Under Tax Refonn 145 

straight line over 31.5 years under tax refonn. For several types of structures, such as commercial office buildings (assets 29 and 30) and hotels 

(asset. 36), tax refonn reduces the present value of depreciation allowances 

below that based on economic depreciation. 

Table 5.4 also shows the present value of total capital cost recovery 

allowances under prior law. Total recovery allowances measure the value of 

both depreciation and the investment tax credit. Due to the lTC, the present 

value of total prior law recovery allowances exceeds the present value of 

prior law depreciation allowances alone. Comparing column 3 (total recovery 

allowances) with column 4 (economic depreciation allowances) shows that prior 

law total cost recovery allowances are generally much more generous than those 

justified by real economic decay, especially for equipment. Indeed, for many 

types of equipment the present value of total recovery allowances slightly 

exceeds unity, so cost recovery is slightly more generous than expensing. 

As tax refonn repeals the lTC. total recovery allowances are equal to 

statutory depreciation allowances. Thus. tax refonn reduces total cost 

recovery allowances more than depreciation allowances, compared to prior law 

levels. Compared with prior law. tax refonn pushes total cost recovery 

allowances towards real economic allowances for all depreciable assets. 

although it overshoots the mark for a few types of equipment and for several 

types of structures. 

· B. Investment Incentives by Asset in the Corporate Sector 

In the interest of tractability. we limit our presentation of cost of 

capital/effective tax rate results to those based on: (1) individual arbitrage. (2) new view financing assumptions, (3) inflation at a 4 percent rate. 

and (4) a 5 percent real required after all tax rate of return. There is 

nothing especially compelling about this particular set of assumptions. and 

results for a variety of alternative assumptions are considered below. 

Table 5.5 shows the cost of capital (columns I and 2) and effective tax 

rate (columns 3 and 4) for each of 54 assets (51 depreciable assets plus 

inventories and two types of land) in the corporate sector. In contrast to the 

presenr value of depreciation allowances. the cost of capital or effective tax 

rate is a comprehensive measure of investment incentives. It fully captures 

the effects of corporate and personal income taxes at the Federal, state, and 

local levels, as well as the effects of depreciation allowances, tax credits, 

and property taxes. 

Under prior law, costs of capital in the corporate sector range from a low 

of 5.3 percent for investment in autos (asset 21) and railroad equipment 

(asset 24), to a high of II. I percent for investment in mobile commercial 

office buildings (asset 29). Similarly. effective tax rates are lowest for 

autos (6.3 percent) and railroad equipment (6.5 percent. where the difference 

from autos is due to rounding). and highest for mobile commercial office 

buildings (55 percent). Table 5 .5 also shows that because of generous total 
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146 Don Fullerton/Robert GiiJette/James Mackie I 

Table 5.5 Asset Specific Investment Incentives I in the Corporate Sector* 

I <:ost oF Ca~ital ~ffectlve TIll Kate 

Asset lirlor Caw Tax llefonn frlor tiw Tu Rel'orm 

I. Furniture & Fixtures (Household) .054 .075 .068 

.335 

2. Furniture & Fixtures (Other) 

.054 

.080 .068 .377 I 

3. Fahrictue<l Metal Products .054 .075 

.080 

.337 

4. Steam Engines and Turhines 

.068 .092 .267 

,4, 

S. Internal Comhustlon Engines 

.059 .082 .159 

.393 

6. Farm Tractors .054 

.085 

.070 

.•410 

7. Construction Tractors 

.054 .080 .070 

.37S I 

8. Other Agricultural Machinery .054 .079 .067 .364 

9. Other Construction Machinery .054 

.081 

.071 

.315 

10. 

Mining and OiUield Machinery .054 

.088 .071 .429 

11. Metalworking Machinery 

.054 .078 

.066 .356 

12 . Special Industry Machinery 

.054 .078 .067 

.358 I 13. General Industrial Equipment .054 .081 .081 .380 

14. Oftke Compu

ting Machinery 

.054 .090 .076 .443 

IS. Service Industry Machinery .054 .080 .075 .377 

16.' Communications Equipment .063 .088 .200 .433 I 17 . Elec. Trans .• Dist. . & Indus. Appar. .058 .080 .141 .374 

I 8. Electric Household Af"IPiiances .054 .07S .068 .338 

19. Other Electrical Equipment 

.054 

.076 

.068 ~ 

20. Trucks, Buses and Truck Trailers .054 .0811 

.066 

.432 

21. Autos .053 .095 .063 .476 I 22. Aircraft .054 .0119 .072 .441 

23. Ships & Boats .054 

.0111 

.066 .384 

24. R11ilro11d E'!Uiprnent 

.053 

.075 .065 .331 

25. Scientific & Engin. Instruments .057 

.083 

. 121 

.397 

26. Photographic Instruments .054 .079 .069 

.364 I 27. Other Nonresidential Equipment .054 .079 .070 .367 

28. Industrial Buildings .080 

.091 

.373 

.453 

29. Mohile Commercial Oft1ces .Ill 

.119 .550 

.579 

30. Commercial Oftice Buildings 

.OK7 

.096 

.427 

.477 I 31 . Commercial Warehouses .0117 .096 .427 .477 

32. Other Commercial Buildings .065 .078 .228 .358 

33. Religious Buildings .OilS 

.093 .408 .461 

34. Educational Buildings .OilS 

.093 .408 .461 

35. Hospital and lnstitut. Buildings .086 

.095 .421 

.473 I 36. HNels and Motels .096 .104 .479 .520 

37 . Amusement and Re

creation11l .0611 

.082 

.262 .394 

311. Other Nonfarm Buildings 

.096 . 104 

.479 

.520 

39. Railroads 

.057 .074 .122 

.322 

40. Telephone and Telegraph .073 .085 

.315 .415 I 41. Electric Light ami Powe1· .075 .092 .334 .458 

42. Gas 

.079 .093 .365 .460 

43. Local Transit .061 

.075 

.183 .337 

44. Petroleum Pipelines 

.061 .090 .183 .443 

45. Farm 

.0117 

.087 

.424 

.427 I 46. Oil & Gas Explor. , Shafts & Wells .057 .077 . 123 .351 

47. Other Mining Shafts and Wells 

.057 .077 .123 .351 

48. Other Nonresidential Structures 

.0119 

.097 

.438 

.486 

49. Railroad Replacement Track 

.0!17 .074 .122 .324 I so. Nude11r Fuel .05K .091 .133 .452 

!II . Residential Structures .099 

. lOS .495 .525 

!12 Nonresidential Land 

.101 .096 .506 

.471 

53. Residential Land 

.108 

. 103 .539 

.514 

54, 

Inventories 

.0911 

.092 .4118 

.458 

Source: Authors· calculations as discussed in the text. I 

*Calculations assumes= .05. n=

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Investment Incentives Under Tax Reform 147 

cost recovery allowances (accelerated depreciation plus the lTC) effective tax 

rates on equipment tend to be lower than on those on other assets. 

For structures which generally do not receive the lTC (assets 28-39 and 

45-51), effective tax rates tend to be higher and less diverse than for 

equipment. Public utility structures (assets 40-44), many of which are 

eligible for the lTC under prior law, generally have effective tax rates 

somewhere between those on equipment and those on other structures. 

Finally. nondepreciable land and inventories (assets 52-54) receive neither 

accelerated depreciation nor the lTC. Thus, they have costs of capital and 

effective tax rates which are higher then those on most types of depreciable 

property (assets l -51). 

Table 5.5 shows that tax reform raises the cost of capital and effective 

tax rate for corporate investment in all types of depreciable property. Thus. 

for equipment and structures •• the effect of less generous cost recovery 

allowances combined with a higher capital gains tax rate offsets the combined 

effect of reductions in the corporate income tax rate and in the rate on 

dividends.

14 Effective tax rates tend to rise most dramatically for equipment, due to lTC repeal. Nonetheless. equipment still generally faces lower 

effective tax rates than those on other assets. 

In contrast to its effect on depreciable property, tax reform lowers the 

cost of capital and effective tax rate for investment in nondepreciating land 

and inventories. These assets benefit from the J J .2 percentage point reduction 

in the statutory rate on corporate income. but are not penalized by less 

generous cost recovery allowances. However, these assets still face higher 

effective tax rates than on most types of depreciable property. 

c. Investment Incentives by Sector and Industry 

Table 5.6 shows summary measures of investment incentives for broad asset 

categories. as well as overall. in the corporate. noncorporate business. and 

owner-occupied housing sectors. These summary measures are caJculated using 

capital weighted averages of the cost of capital, and are useful in highlighting a number of points. 

In particular, Table 5.6 shows that the overall average effective tax rate 

in the corporate sector was 38.7 percent under prior law, substantially below 

the 49.5 percent statutory rate. In the noncorporate sector the overall 

average effective rate was lower than in the corporate sector, 33 .2 percent. 

but above the 30.0 percent statutory rate on noncorporate business income. The 

effective tax rate on owner-occupied housing was lower still. 22.5 percent (it 

is positive due to property taxes). 

In the corporate sector. tax reform increases the overall average effective 

rate by 5.7 percentage points (or 14.7 percent) to a 44.4 percent rate. which 

is now above the statutory rate of 38.3 percent. In the noncorporate sector 

the overall average effective rate rises more modest I y. by 0. 7 percentage 

points (or 2. J percent). to a 33.9 percent rate. but stays above the new 

statutory rate on noncorporate business income of 26.0 percent. 
148 Don Fullerton/Robert Gillette/ James Mackie 

Table 5.6 Summary Measures• 

Corporate Sector Tax Rates 

Equipmentb 

Structures 

Non-residentialc 

Residentiald 

Public Utility• 

Inventories 

Land 

Non-residential 

Residential 

Overallf 

Noncorporate Tax Rates 

E . b qUJpment 

Structures 

Non-residentia( 

Residentiald 

Public Utilit/ 

Inventories 

Land 

Non-residential 

Residential 

Overallt 

Owner-Occupied Housing Tax Rate 

f Overall Tax Rate 

Prior Law 

.100 

.344 

.495 .326 

.488 

.506 .539 

.387 

-.119 

.278 

.382 

.221 

.330 .361 

.414 

.332 

.225 

.333 

Standard Deviation of Cost of Capital .0150 

Source: Authors' calculations as described in the text. 

•calculations assume s=0.05 and n =0.04. 

Tax Reform 

.396 

.431 

.525 

.445 

.458 .478 

.514 

.444 

.254 

.314 

.406 

.336 

.305 

.338 

.395 

.339 

.237 

.365 

.0114 

bEquipment includes all assets 1-27. even though components of 

several of these assets can be identified as real property. 

c Non-residential structures includes all assets 28-39 and 45-50, 

even though components of several are not treated as real property. 

dThis is asset 51 . 

•This includes assets 40-44. 

f Asset 50, nuclear fuel. is included in the overall average. even 

though it is not an element of any subcategory. 

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Investment Incentives Under Tax Reform 149 

We also see from Table 5.6 that under prior law investment incentives in 

both the corporate and the noncorporate sector were biased in favor of depreciable property, especially equipment, compared to nondepreciable property: 

an exception is residential structures in the noncorporate sector. 

Tax reform has a qualitatively similar influence on average effective tax 

rates in both the corporate and the noncorporate sector. Effective rates on 

depreciable property, especially equipment, are increased by tax reform, while 

the effective rates on nondepreciating land and inventories are reduced due to 

rate reduction. On average. in both sectors, equipment remains the most 

favored investment after tax reform. and depreciable property (other than 

residential structures) is favored compared to investment in nondepreciable 

land. Inventories. which are predominantly a corporate sector asset, continue 

to be taxed at an above average rate in the corporate sector, but at a below 

average rate in the noncorporate sector. Finally, residential structures. 

which are predominantly used in the noncorporate sector, continue to be taxed 

at an above average rate. 

Because of rate reduction and a reduction in the number of itemizers, tax 

reform increases the effective tax rate on owner-occupied housing by 1.2 

percentage points (5.3 percent), to a 23.7 percent rate under tax reform. 

Thus, in all three sectors overall average effective tax rates rise as a 

result of tax reform. However, as under prior law, corporate sector investment tends to face higher effective tax rates than those on investment in 

other sectors. Overall. tax reform increases the economy wide average effective tax rate by 3.2 percentage points (9.6 percent), from a 33.3 percent rate 

under prior law to a 36.5 percent rate. This suggests that corporate and 

personal rate reduction is insufficient to offset the effects of JTC repeal. 

less generous depreciation allowances. and the taxation of capital gains as 

ordinary income. Table 5.6 includes a calculation of the capital stock 

weighted standard deviation of the cost of capital across all assets and 

sectors. Under a perfectly uniform tax system, the cost of capital would not 

vary across alternative investments, and capital would be efficiently allocated across assets and sectors. In this case the standard deviation in the 

cost of capital would be zero. All else constant, increases in the standard 

deviation reflect reductions in uniformity .

15 

Under prior law and tax reform. nonneutralities exist due to differential 

taxation of assets within each sector, as well as differences in the tax 

treatment of investments in different sectors. lnterasset and intersectoral 

distortions combine to give a standard deviation in the cost of capital of 

0.0150 under prior law. 

Our calculation suggests that tax reform reduces deviations in the cost of 

capital across assets and sectors by 24 percent. to 0. 0 I 14. This is the result 

of four primary influences. First. repeal of the lTC reduces existing biases 

in favor of equipment. Second. less generous total cost recovery allowances 

reduce existing biases in favor of depreciable property relative to land and 

inventories. Third. because there is no offsetting fall in the value of 
150 Don Fullerton/Robert Gillette/ James Mackie 

depreciation allowances (uz), rate reduction primarily benefits non-depreciating land and inventories. This further reduces the (relative) advantage of 

depreciable compared with nondepreciable investment. Fourth, the reduction in 

personal rates and in the number of itemizers reduces the tax advantages of 

owner-occupied housing compared with investment in the noncorporate sector. 

However, some effects work in the opposite direction. Tax reform widens the 

difference between the overall average effective tax rate in the corporate 

sector compared with that in the noncorporate sector and that in the owneroccupied housing sector. In addition, tax reform increases the diversity in 

the tax treatment of various types of equipment, especially within the 

corporate sector. Nonetheless, on the whole capital is allocated more 

efficiently under tax reform than under prior law, as shown by a lower 

standard deviation of the cost of capital. 

Table 5. 7 shows the cost of capital and effective tax rate for each of 60 

industries. Under prior law, effective tax rates range from 14 percent in the 

water transportation industry to 43.8 percent in the production of transportation equipment other than motor vehicles. In general, under prior law rates 

tend to be higher in heavily corporate industries, such as manufacturing, than 

in noncorporate industries. such as services. 

Tax reform would generally raise industry effective tax rates, while 

changing the relative treatment of industries and tightening the distribution. 

The lowest effective rate is 33.1 percent in agriculture, reflecting the benefit of rate reduction for nondepreciable land. The highest effective tax rate 

is 45.9 percent for the insurance industry. In general, heavily corporate 

industries, such as manufacturing, continue to face above average effective 

tax rates. 

V. THE EFFECfS OF THE COMPONENTS OF TAX REFORM 

The net effect of the 1986 tax reform act on investment incentives is a 

combination of the effects from corporate rate reduction, lTC repeal, changes 

in depreciation allowances, and personal rate reduction. It is interesting to 

look at the effect on investment incentives of each of these separate components of tax reform. The results of this analysis are reported in Table 5.8. 

The first column of Table 5. 8 reprints the prior law column of Table 5. 6. Each 

succeeding column in Table 5.8 shows the effective tax rate for the change 

indicated by the column heading. 

A. Corporate Rate Reduction 

These calculations maintain the lTC. ACRS. and prior law personal tax 

rates. The tax rate on corporate income is lowered. however. by 11.2 percentage points (or 22.6 percent) to its 38.3 percent rate under tax reform. 

With the lower statutory corporate rate, the overall average effective tax 

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Table 5. 7 Cost of Capital and Effective 

I Tax Rate by Industry* 

Pnor l:iiw Tax Reform 

Cost ol EftectJve Cost ol Enective 

I lndustr:~: Ca~ltal Tax Rate Ca(!ltal Tax Rate 

I. Farms .076 .340 .07!5 .331 

2. ~rlcultu re Serv .. Fore5try & Fish .077 .3!52 .0711 .361 

3. etal Mining .07!5 .329 .091 .449 

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4. Coal Mining .069 .271 .089 .431 

!5 . Oil and Gas Extraction .06!5 .226 .080 .376 

6. Nonmetalic Minerals .072 .307 .089 .439 

7. Construction .0114 .403 .086 .411 

8. Lumher and Wood ProductS .079 .369 .088 .429 

9. Furniture and Fixtures .011!5 .409 .091 .4!52 

I 10. Stone, a~ and Glass Products .OK2 .393 .090 .443 

II. Primary eutl Industries .0116 .419 .0119 .441 

12. Fabricated Meutl Products .0116 .416 .090 .44!5 

13. Nonelectrical Machinery .OK6 .417 .090 .44!5 

14. Electric and Electronic Equip. .OK6 .417 .090 .447 

I 1!5. Other Vehides and pment .OliO .374 .089 .431 

16. Other Transportation quipment .0119 .438 .091 .449 

17 . Instrument~ .0117 .42S .091 .449 

18. Misc. Manufacturi~ Industries ,070 .288 .087 .42!5 

19. Food and Kindred roducts Oil~ .411 .090 .44!5 

I 20. Tobacco Manufacturers .08!5 .413 .090 .444 

21. Textile MiU Products .OIB .397 .089 .437 

22. Apparel .0112 .390 .088 .429 

23 Paper Products .076 .338 .087 .426 

24. Printing and Publishing .077 .3!51 .088 .430 

2!5 . Chemicals .073 .312 .083 .397 I 26. Petroleum and Coal Products .07!5 .330 .087 .426 

27. Rubber and Misc. Plastic Products .0711 .361 .088 .431 

28. Leather .084 .407 .089 .440 

29. Railroad Transportation .060 .161 .076 .342 

30. Land Passeny,r Transportation .065 .230 .079 .367 

I 31. Trucki~ an Warehousing .066 .237 .0112 .387 

32 Water ransportation .05K .140 .080 .376 

33. Airlines .061 .175 .090 .447 

34. Nonga~ Pipelines .064 .2111 .090 .444 3~ . Transportation Services .060 .164 .015 .333 

I 36 Telephone and Tel~raph .070 .284 .087 .427 

37. Rlldio and TV Broa astln~ .066 .242 .087 .424 

38. Electric Utilities .074 .324 .088 .435 

39. Gas Utilities .07K .361 .092 .456 

40. Sanitation Utilities .079 .369 .0115 .414 

41. Wholesale Trade .079 .365 .OK I .380 I 42. Retail Trade .OK6 .416 .0116 .417 

43 Commercial and Mutual Banks .073 .312 .088 .430 

44 Other Credit Agencies .06ll .264 .086 .420 

4!5 . Security and Commodity Services .0711 .360 .082 .394 

46. Insurance Carriers .0711 .363 .092 .4!59 

I 47. Insurance Agents and Services .076 .344 .078 .358 

48. Re11l Estate .0111 .386 .083 .396 49. Investment and Holding Co. .075 .335 .078 .362 

so. Hotels and Motels .OR2 .391 .092 .455 

51. Personal Services .069 .271 .080 .373 

I 52. Business Services .062 .192 .08$ .412 

53. Auto Rep11ir Services 0~9 . lSI .0113 .3911 54. Misc. Rerair Servit:es .063 .211 .077 .350 

55. Motion Pictures .064 .219 .OR3 .39!5 

56. Amusement & Recreational Services .063 .209 .079 .366 

I 57. He•lth Services .06H .265 .081 .382 

58 Legal Services .06ll .265 .076 .338 59. Educational Services .064 .222 .ORJ .396 60. Social & Professional Servi<.~ .075 .337 .0114 .404 

I Source: Authors· calculation as described in the text. 

*Calculations are for a capital weighted average of the corporate and non corporate sectors of 

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152 Don Fullerton/Robert Gillette/James Mackie 

Table 5.8 Components of Tax Reform* 

Change From Prior Law 

Prior Corp. Rate lTC 1986 Act Pers. Rate 

Law Reduction Repeal Depreciation Reduction 

Corporate Tax Rates 

Equipment . 100 .063 .396 . 145 .149 

Structures 

Non-residential .344 .319 .385 .417 .373 

Residential .495 .459 .495 .557 .515 

Public Utility .326 .307 .412 .383 .355 

Inventories .488 .435 .488 .488 .513 

Land 

Non-residential .506 .457 .506 .506 .529 

Residential .539 .496 .539 .539 .559 

Overall .387 .343 .447 .414 .416 

Noncorporate Tax Rates 

Equipment -.119 -. 119 .265 -.100 -.142 

Structures 

Non-residential .278 .278 .293 .321 .263 

Residential .382 .382 .383 .426 .366 

Public Utility .221 .221 .326 .254 .208 

Inventories .330 .330 .330 .330 .305 

Land 

Non-residential .361 .361 .361 .361 .338 

Residential .414 .414 .414 .4 14 .395 

Overall .332 .332 .349 .345 .311 

Owner-Occupied Housing Tax Rate .225 .225 .225 .225 .233 

Overall Tax Rate .333 .312 .368 .350 .341 

Standard Deviation of Cost of Capital .0150 .0125 .0124 .0162 .0161 

Source: Authors' calculations as described in the text. In each column, only one component 

is simulated. 

*Calculations assume s=0.05, n =0.04. 

rate in the corporate sector falls by 4.4 percentage points ( 1 1.4 percent), 

from a 38.7 percent rate under prior law to a 34.3 percent rate. This relatively small fall in the effective tax rate is due in part to issues involving 

debt finance. While corporate rate reduction lowers the taxation of earnings. 

it also reduces the benefit of interest deductibility on the one-third of 

corporate investment that is financed by debt. If instead we assume 100 

percent equity financing. then the effective tax rate in the corporate sector 

would fall more substantially. from a 52 percent effective rate under pri9r 

Jaw to a 44 percent effective rate under tax reform (a reduction of 15.4 

percent). 

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Investment Incentives Under Tax Reform 153 

For two reasons corporate rate reduction also promotes neutrality, as 

indicated by a fall in the standard deviation of the cost of capital, compared 

to prior law. First, rate reduction lowers effective tax rates in the 

corporate sector compared with the already lower effective tax rates in the 

noncorporate and owner-occupied housing sectors. Second, because statutory 

rate reduction lowers the value of accelerated depreciation allowances, it 

reduces the cost of capital for depreciable assets by a smaller proportional 

amount than it reduces th~ cost of capital for land and inventories. Thus, a 

fall in the statutory corporate rate reduces corporate sector incentives to 

invest in equipment and structures relative to land and inventories. 

B. lTC Repeal 

For these calculations prior law is maintained except for the lTC, which is 

eliminated for all assets. lTC repeal by itself significantly raises effective 

tax rates on equipment and public utility property, compared to prior law. 

This is especially important in the corporate sector where most equipment and 

public utility property is employed. lTC repeal raises the overall corporate 

effective rate by six percentage points ( 15.5 percent) to a 44.7 percent rate 

from the 38.7 percent rate under prior law. Thus. the increase in corporate 

sector effective tax rates due to lTC repeal more than offsets the fall in 

corporate sector effective tax rates due to statutory rate reduction. 

Because of the smaller weight on equipment and public utility property, lTC 

repeal has a less dramatic effect in the noncorporate sector, and the overall 

effective tax rate there rises by only 1. 7 percentage points (5. 1 percent). 

The overall economy wide average effective tax rate rises by 3.5 percentage 

points (10.5 percent), from a 33.3 percent rate to a 36.8 percent rate. 

By itself, lTC repeal also promotes uniform taxation of capital, compared 

to prior law, as shown by the reduction in the standard deviation of the cost 

of capital. In particular, lTC repeal goes a long way towards equalizing the 

tax treatment of equipment relative to structures, as well as depreciable 

property relative to land and inventories. 

16 

C. Depreciation Allowances 

For this comparison, ACRS recovery classes are replaced by the 1986 Act 

cost recovery classes. but the lTC is maintained. In generaL tax reform 

recovery allowances are Jess generous than ACRS allowances. Not surprisingly. 

then. effective tax rates for depreciable property rise compared to prior law 

levels. Their increase is more dramatic in the corporate sector where depreciation allowances are valued at the relatively high 49.5 percent (combined) 

statutory tax rate. than in the noncorporate sector. where depreciation 

allowances are valued at the lower 30 percent rate on noncorporate business 

income. The new depreciation allowances raise the overall average effective 

tax rate in the corporate sector by 2. 7 percentage points (7 .0 percent) to a 

41.4 percent rate. The overall average rate in the noncorporate sector rises 
154 Don Fullerton

/Robert Gillette/James Mackie 

less significantly, by 1.3 percentage points (3.9 percent). The smaller 

increase in the noncorporate compared with the corporate sector is due to the 

lower noncorporate statutory tax rate and the smaller ratio of depreciable to 

nondepreciable assets in noncorporate sector. The overall economy wide 

effective tax rate rises by 1. 7 percentage points (5. I percent) to a 35

.0 

percent rate. 

By themselves, the new recovery allowances (without lTC repeal) slightly 

widen the dispersion of the cost of capital, compared with prior Jaw. One 

reason for this is slightly larger intersectoral distortions. In addition, the 

new depreciation allowances generate further differences in the tax treatment 

of some disaggregate types of depreciable property (especially equipment), 

compared to prior law. D. Personal Rate Reduction 

For these calculations, prior law personal rates on capital income are 

replaced by the personal taxes obtained under tax refonn . Somewhat surpris

-

ingly, personal rate "reduction" increases the overall average effective tax 

rate in the corporate sector by 

2. 9 percentage points (7 .5 percent), to a rate 

of 41.6 percent. This increase is due to the emphasis given to retentions as a 

source of financing, in combination with the large (68. 9 percent) increase in 

the tax rate on capital gains income. Since the tax rate on dividends falls. 

effective tax rates in the corporate sector could faJJ, rather than rise as 

indicated in Table 5.8, if new share financing represented a larger proportion 

of corporate equity financed investment.1 7 

In the noncorporate sector. the overall average effective tax rate falls to 

by 2. 1 percentage points (6.3 percent) to a rate of 31. I percent. This is due 

to the reduction in the statutory tax rate on noncorporate business income. 

The effective tax rate on owner-occupied housing rises slightly, to 23.3 

percent, due to a reduction in the rate at which property taxes are deducted 

and to a reduction in the fraction of homeowners who itemize. The overall 

average rate for the economy rises by 

0.8 percentage points (2.4 percent), 

from 33.3 percent to 34.1 percent. 

On the whole, personal rate reduction slightly increases the nonneutral-

ities. This is due in large part to the increase in the rate on accrued 

capital gains. which substantially increases effective tax rates in the 

corporate sector compared to those in the noncorporate and owner

-occupied 

housing sectors. In addition. the reduction in the rate on noncorporate 

business income further expands differences in the taxation of 

corporate 

sector investment compared with investment in the noncorporate sector. 

VI. RESULTS FOR ALTERNATIVE ARBITRAGE, 

PROFITABILITY AND FINANCING ASSUMPTIONS 

In this section we explore the effects of alternative arbitrage. rate of 

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Investment Incentives Under Tax Reform ISS 

return. and financing assumptions on our measurement of investment 

incentives. 

A. Individual vs. Firm Arbitrage 

All calculations above use individual arbitrage. Table S.9 compares 

effective tax rates based on individual arbitrage with those based on firm 

arbitrage. For both prior law and tax reform, overall average effective tax 

rates are reduced by using firm instead of individual arbitrage. In general, 

however, the more important are arbitrage assumptions, the larger is the 

disparity in the tax treatment of alternative investors. Tax reform improves 

neutrality. Thus, the choice of arbitrage assumptions has a smaller influence 

on overall average effective tax rates under tax reform than it did under 

prior law. This means, however, that the choice of arbitrage assumptions can 

be important in evaluating tax reform.18 

Table S.9 Individual Arbitrage Compared with Firm Arbitrage* 

Inaiviaual Ar6ltrage 

Prior taw Tax Reform 

Firm Ar6hrafe 

Prior taw ax Reform 

Corporate Tax Rates 

Equipment . too .396 -.104 .389 

Structures 

Non-residential .344 .431 .288 .423 

Residential .495 .525 .482 .531 

Public Utility .326 .445 .286 .444 

Inventories .488 .458 .422 .435 

Land 

Non-residential .506 .478 .453 .463 

Residential .539 .514 .506 .511 

Overall .387 .444 .313 .432 

Noncorporate Tax Rates 

Equipment -. 119 .254 -. 100 .240 

Structures 

Non-residential .278 .314 .263 .301 

Residential .382 .406 .361 .388 

Public Utility .221 .336 .201 .320 

Inventories .330 .305 .320 .296 

Land 

Non-residential .361 .338 .348 .326 

Residential .414 .395 .396 .379 

Overall .332 .339 .319 .326 

Owner-Occupied Housing Tax Rate .225 .237 . 189 .207 

Overall Tax Rate .333 .365 .281 .335 

Standard Deviation of Cost of Capital .0150 .0114 .0177 .008 

Source: Authors' calculations as aescri!Jea in the text. 

*Calculations assume s=O.OS and 0 .04. 
156 Don Fullerton/Robert Gillette/ James Mackie 

Compared with prior law, tax reform causes a smaller rise in corporate 

effective tax rates under individual arbitrage (5. 7 percentage points or 14.7 

percent) than under firm arbitrage (I l. 9 percentage points or 38 percent). On 

average, the comparison between noncorporate sector effective rates under 

prior law with those under tax reform is unaffected by arbitrage assumptions. 

The rate on owner-occupied housing rises more for firm arbitrage than for 

individual arbitrage. Consequently. compared to prior Jaw, tax reform increases the overall economy wide average. effective rate more sharply under 

firm arbitrage (5.4 percentage points or 19.2 percent) than it does under 

individual arbitrage (3.2 percentage points or 9.6 percent). Under either 

arbitrage assumption, however. tax reform improves neutrality. as indicated by 

a lower standard deviation in the cost of capital. 

B. Required Real After-Tax Return 

Table 5. J 0 shows effective tax rates under prior law and tax reform for a 

low. 2 percent, return and a high. 8 percent, return, in addition to the 5 

percent return assumed in earlier calculations. Lowering s from 5 percent to 

2 percent raises overall average effective tax rates in all sectors under both 

prior law and tax reform. An increase in s from 5 percent to 8 percent lowers 

overall average effective tax rates in all sectors. Tax refonn causes a 

smaller rise (both absolutely and on a percentage basis) in effective tax 

rates. compared to prior law levels. the higher is the real required net-oftax return on investment. For aJJ three values of s. tax refonn improves 

neutrality compared with prior law. 

c. Financing Assumptions 

The calculations above assume marginal investments are financed like the 

existing capital stock. All sectors finance new investments with one-third 

debt and two-thirds equity. In addition. corporate equity is obtained mostly 

from retained earnings (93 percent). and less significantly from new share 

issues (7 percent), consistent with the "new view" that dividend taxation is 

relatively unimportant. However, we do not know how the marginal investment 

is financed, and therefore it seems desirable to explore the effects of 

alternative specifications. Fortunately. the Fullerton-Henderson model allows 

us to incorporate alternative financing arrangements simply by changing the 

weights in equations (5.2)-(5.4). In Table 5.11 we present results based on 

several alternative financing assumptions. For purposes of comparison. 

however. the first column of Table 5 . I I shows effective tax rates for the 

one-third debt. two-third equity new view case analyzed earlier in Table 5.6. 

Stiglitz ( 1973) has argued that marginal investments may be totaJiy debt 

financed. Under both prior law and tax reform. debt financed investment in 

all three sectors is subsidized because interest payments are deducted at 

higher rates than those applied to subsequent interest receipts. In the 

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Investment Incentives Under Tax Reform 157 

Table 5.10 Alternative ReaJ Rates of Return* 

Low ~S=~%~ Prior Tax 

Mi(J<Jie {S""'~~~ 

Prior Tax Ri~~ ~S=R~1 Pnor Tax 

Law Reform Law Reform Law Reform 

Corporate Tax Rates 

Equipment -.034 .530 .100 .396 . 145 .356 

Structures 

Non-residential .445 .554 .344 .431 .329 .397 

Residential .621 .656 .495 .525 .460 .480 

Public Utility .460 .582 .326 .445 .300 .405 

Inventories .516 .528 .488 .458 .481 .437 

Land 

Non-residential .554 .565 .506 .478 .493 .450 

Residential .615 .623 .539 .514 .515 .476 

Overall .435 .551 .387 .444 .381 .412 

Noncorporate Tax Rates 

Equipment -.448 .395 -.119 .254 -.048 .213 

Structures 

Non-residential .410 .450 .278 .314 .245 .275 

Residential .546 .568 .382 .406 .329 .348 

Public Utility .388 .498 .221 .336 .175 .286 

Inventories .399 .384 .330 .305 .310 .281 

Land 

Non-residential .457 .445 .361 .338 .331 .304 

Residential .545 .537 .414 .395 .368 .344 

Overall .439 .462 .332 .339 .301 .300 

Owner-Occupied Housing Tax Rate .429 .443 .225 .237 .149 .159 

Overall Tax Rate .435 .497 .333 .365 .305 .323 

Standard Deviation of Cost of Capital .0081 .0056 .0150 .0114 .0235 .0183 

Source: Aut~ors' calculations as <Jescribed in the text. 

*Calculations assume n =0.04 and individual arbitrage. 

corporate sector under prior law interest payments are deducted at the 49.5 

percent combined statutory rate. Corresponding interest receipts, however, are 

subject to taxation at a lower 21 .9 percent rate, implying that corporate 

sector debt finance enjoys a subsidy equal to 27.6 percent of nominal interest 

payments. In the noncorporate sector. the subsidy equals 8. 1 percent, and in 

the owner-occupied housing sector the subsidy equals 4 percent. Tax reform 

reduces to I 8. 9 percent the subsidy to corporate debt since it narrows the 

spread between the statutory corporate income tax rate (38.3 percent) and the 

tax rate on interest income (19.4 percent). Similarly. tax reform lowers the 

subsidy in the noncorporate sector to 6.6 percent. In the owner-occupied 

housing sector the subsidy falls to 3. I percent as a result of tax reform. 

Column 2 of Table 5. II shows effective total tax rates for investments 

financed using debt alone. With 100 percent debt finance. effective tax rates 

are reduced substantially below those in column one. where the subsidy on debt 
.. 

Table 5.11 Alternative Financing • 

One-Third Debt, 

Two-Thir~ Equity. 

New View AU Debtc Eq . d 

Prior Law Tu Reform PriOfi:iw 

AU _ UI!}' 

Tu Reform Prior Law 

Corrar~te Tu Rates 

.100 .396 · 1.399 qu•pment 

Structures 

Non-residential .344 .431 ·.326 Residential .495 .52.5 .086 Puhlic Utility .326 .44.5 -.297 Inventories .488 .4.58 -. 144 Land 

Non-residential . .506 .478 -.057 Residenti11l . .539 .514 .081 Over aU .387 .444 -.339 

Noncorporate Tu Ra tes Equipment 

Struc ture:. ·.119 .2.54 - 316 

Non-residential .278 .314 . 188 Residentia l .382 .406 .314 Pulllic Utility .221 .336 .127 Inventories .330 .30.5 .240 Lanu 

Non-reside ntial .361 .338 .279 RtJ.identiHI .414 .39.5 .346 Overall .332 .339 .248 

Ownl'r· Oc.:c.:upied Housing Tu Rate .225 .237 . 187 

Overa ll Tax Rate .333 .36.5 .067 

Standurd Devi11tion of Rho .01.50 .0114 .0 160 

Source: Authors· calculations as described in the text. 

•calculations assumes s =0.05. n =0.04. and individual arbitrage. b 

c cd = 0.34. cr ... 0.61. ens = 0.05 

d cd = 1.00. cr. = 0.00. CDS = 0.00 

• cd = 0.00. cr. = 0.93 . ens = 0.07 

f c d = 0.34. cr. ,. 0.33. ens = 0.33 

cd = 0.34. cr. = 0.00. ens = 0.66 

.().42 .323 

.092 .483 .280 .592 . 136 .46.5 .082 .600 

.139 .612 .233 .632 .099 . .522 

.184 -.040 

.2.50 .317 .3.56 .412 .278 .261 .234 .368 

.274 .39.5 .342 .443 .277 .368 

.209 .243 

.196 .418 

.0073 .022.5 

.. • .. .. ~ .. - .. .. .. 

'VI 

00 

One 

TwoThird Thirds 

Debt, 

Equity, :s 

~ 

Old View• External Fin•nce t ., 

Tu Reform Prior Law Tu Reform Prior Law Tu R.ef'orm E. 

(i" 

::l .493 .24.5 .433 .366 .471 0 

:s . .524 .433 .467 . .512 .503 -~ . .596 . .5.57 . .5.52 .613 . .580 0 . .532 .414 .478 .494 . .513 g- . .5.51 . .561 .494 .623 . .530 ::l 

Cl . .56.5 .574 . .511 .633 . .546 . .590 . .598 . .543 .6.51 . .573 c.: . .53.5 .474 .479 . .549 . .51.5 n 

-

--

n .285 - 119 .2.54 -.119 .2.54 -....... 

.342 .278 .314 .278 .314 9 .428 .382 .362 .221 .406 .. 382 .406 ~ .336 .221 .336 .336 .330 .30.5 ..330 .30.5 ~ Sill .366 .361 .338 .361 .338 (') 

.418 .414 .395 .414 .395 2!: .366 .332 .339 .332 .339 n 

.250 .22.5 .237 .225 .237 .427 .377 .384 .423 .40.5 .0184 .019.5 .0140 .0260 .0172 

.. -~ .. .... ... 
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Investment Incentives Under Tax Reform 159 

only applies to 33 cents on a one dollar marginal investment. For both tax 

regimes, debt finance reduces effective total tax rates more in the corporate 

sector than in the noncorporate sector because the higher statutory rate on 

corporate income means a larger subsidy in the corporate sector. However, tax 

reform reduces the subsidy to debt in all sectors. Thus, even with 100 percent 

debt finance, property taxes insure that effective total tax rates in all 

sectors remain positive under tax reform. In contrast, under prior law the 

overall influence of the subsidy to debt outweighs the influence of property 

taxes on corporate sector investment, and the corresponding overall average 

effective total tax rate is negative. The third column of Table 5. I I shows 

effective total tax rates for the other extreme of all equity financed 

marginal investments. 

Charles McLure (1979), among others, has argued that dividend payout rates 

are important, and that the double taxation of dividends represents a significant disincentive to corporate sector investment. This perspective has been 

called the "old view" of dividen~ taxation. Initially, arguments against the 

old view and in favor the new view that dividend payout rates are unimportant 

were well received. However, subsequent empirical work has not given decisive 

support to either perspective on the importance of dividend taxes.

19 

During the 1980's, dividends as a fraction of after-tax corporate profits, 

the dividend payout ratio, have varied between . 39 and . 77 (Economic Report 

of the President, 1986, Table B-84). After refining the measure of profits by 

adjusting for the effect of inflation on the real cost of debt, Shoven (1986) 

finds that the long run equilibrium dividend payout ratio has varied between 

.30 and .37 over the period from 1960 to 1982. 

We choose a 50 percent payout ratio as our interpretation of the old view 

that dividend taxes matter, and err on the side of a generous difference 

between discount rates under the old compared with the new view. To implement 

an analysis consistent with findings under the old view for a 50 percent 

dividend payout ratio we give equal weight to new share issues and retained 

earnings as sources of corporate equity. One third of corporate sector 

marginal investment remains financed using debt, 2 0 and financing in the 

noncorporate and owner-occupied housing sectors remains one-third debt and 

two-thirds equity. 

The results of our old view calculations are shown in the fourth column of 

Table 5.11. Both for prior law and tax reform, the larger emphasis given to 

dividends relative to capital gains raises effective total tax rates in the 

corporate sector (and consequently for the entire economy), compared with new 

view levels. However, the spread between the dividends tax rate and the 

capital gains tax rate is wider under prior law than it is under tax reform. 

Thus, the corresponding increase in effective tax rates is greater under prior 

law (the overall corporate effective tax rate rises from .387 based on the new 

view to .474 based on the old view). than it is under tax reform (where old 

view assumptions raise the overall total effective tax rate in the corporate 

sector from .444 to .479). Furthermore. tax reform actually lowers the 
160 Don Fullerton/Robert Gillette/ James Mackie 

dividend tax compared to prior law. Thus, based on old view assumptions, tax 

reform only increases the overall average effective tax rate in the corporate 

sector by a scant 0.5 percentage points (1.1 percent), from a 47.4 percent 

rate under prior law to a 47.9 percent rate under tax reform. As a consequence, the overall economy wide average effective rate only rises by J .9 

percent, or about 20 percent of the 9.6 percent increase obtained under the 

new view. Therefore, neutrality is improved at the expense of a much smaller 

reduction in overall average incentives to save and invest under the old view 

than it is under the new view. Tax reform compares more favorably with prior 

law when dividend taxes are more important. 

The fifth column of Table 5.11 shows effective total tax rates when 

retained earnings are unavailable as a source for financing marginal investments. It may be, for example, that required dividend payments make retained 

earnings unavailable for financing extra investment, at least for some 

corporations. These corporations must finance new marginal investment 

externally, by issuing either new shares or debt. In these ~alculations. we 

assume that corporate financing of real investment is one-third debt and twothirds new share issues. Investment in the noncorporate business sector and 

the owner-occupied housing sector remains one-third debt, two-thirds equity. 

When marginal corporate investments are financed externally, tax reform 

actually reduces the overall total corporate sector effective tax rate from 

54.9 percent under prior law to 51.5 percent. This 3.4 percentage point 

reduction is due to the reform-induced fall in the dividend tax. 

VII. INFLATION, EFFECI1VE TAX RATES, AND INDEXATION 

So far, we have performed all calculations using a 4 percent inflation 

rate. It is important, however. to see how variations in inflation affect 

investment incentives. 

A. Influence of Inflation on Effective Tax Rates Under Prior Law 

and Tax Reform 

Under both prior law and tax reform, inflation influences effective tax 

rates through at least three channels. First. inflation reduces the real 

value of recovery allowances, which are based on historic cost and not indexed 

for inflation. This increases effective tax rates on depreciable property. 

Second, in the corporate sector inflation increases effective tax rates 

because purely inflationary distributions and retained earnings are subject to 

tax. However. a third effect works in the opposite direction. In all three 

sectors. nominal interest payments are deducted at a higher rate than applied 

to interest receipts. and therefore are subsidized. Since inflation increases 

nominal interest payments. it increases this subsidy to debt, thus lowering 

effective tax rates. 

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Investment Incentives Under Tax Refonn 161 

Panel I of Table 5. 12 shows that prior law effective tax rates exhibit 

varying responses to rising inflation. Because recovery allowances are 

unindexed. effective tax rates on depreciable property rise with inflation. 

The effective tax rate on corporate equipment, for example. increases from 

-8.9 percent to +21.4 percent as inflation rises from a zero percent to an 8 

percent rate. In contrast to depreciable property, effective tax rates on 

nondepreciable land and inventories fall with inflation, due to the rising 

Table 5.12 Influence of Inflation on Effective Tax Rates· 

Inflation Rate 

l. Prior Law 

Effective Tax Rates 

Corporate Sector 

Equipment 

Non-residential Structures 

Non-residential Land 

Inventories 

Overall 

Noncorporate Sector 

Overall 

Owner-Occupied Housing 

Overall 

Standard Deviation in the 

Cost of Capital 

2. Tax Reform 

Effective Tax Rates 

Corporate Sector 

Equipment 

Non-residential Structures 

Non-residential Land 

Inventories 

Overall 

Noncorporate Sector 

Overall 

Owner-Occupied Housi.ng 

Overall 

Standard Deviation in the 

Cost of Capital 

Source: Authors' calculations as described in the text. 

0% 

-.089 

.286 

.525 

.508 

.366 

.334 

.233 

.325 

.0175 

.312 

.375 

.469 

.448 

.405 

.338 

.243 

.346 

.0097 

4% 8% 

.100 .214 

.344 .373 

.506 .486 

.488 .467 

.387 .398 

.332 .326 

.225 .217 

.333 .334 

.0150 .0133 

.396 .454 

.43 1 .465 

.478 .486 

.458 .466 

.444 .472 

.339 .335 

.237 .231 

.365 .378 

.0114 013~ 

• Calculations assume s ""0. OS and individual arbitrage. 

bAt 8 percent inflation, the standard deviation is greater for tax reform than for prior law. 

This does not mean, however. that tax reform worsens neutrality. A better measurement of 

dispersion might be the coefficient of variation . which equals the standard deviation divided by 

the mean. (Neither is a perfectly correct measure of neutrality.) The coefficient of variation 

for prior law (at 8 percent inflation) is .0398. Tax reform (at 8 percent inflation) lowers this 

to .0357. Thus, tax reform may still improve neutrality. At some higher inflation rate. however. 

assets may be taxed more uniformly under prior law than tax reform. 
I 62 Don Fullerton/Robert Gillette/ James Mackie 

benefit of nominal interest deductions. Overall, effective tax rates in the 

corporate sector slightly increase with inflation, rising from 36

.6 percent 

when there is no inflation to 39.8 percent at an inflation rate of 8 percent. 

Because of the relative importance of non-depreciable land, the overall average effective tax rate in the noncorporate sector falls as inflation rises. 

The effective rate on owner-occupied housing falls slightly as inflation 

rises, due to the increasing subsidy on debt. 

Under prior law the overall economy wide average effective tax rate rises 

slightly (by 2.8 percent) as inflation increases from 0 percent to 8 percent. 

Thus, the effects due to unindexed cost recovery allowances and the taxation 

of purely nominal corporate profits outweigh the benefit arising from the 

subsidy to debt. This result is similar t9 that obtained by Feldstein and 

Summers ( 1979), and in contrast to that obtained by Fullerton (1987), who uses 

a similar model. In our model, (and in Fullerton

's) the influence of inflation 

on the overall effective tax rate depends on such parameters as personal tax 

rates and capital stock weights. It also depends on the arbitrage assumption. 

Indeed, this is an important factor explaining the difference between our 

result and Fullerton ·s. When our analysis is redone using the finn arbitrage 

assumption of Fullerton ( 1987), we also find that prior law effective tax 

rates fall slightly with inflation. This ambiguity aside, it is clear that 

inflation can cause arbitrary unintended changes in effective tax rates across 

assets and sectors. Thus. to the extent that effective tax rates at some 

target rate of inflation reflect tax policy, an unindexed tax system will not 

fulfill Congress' intent if inflation changes unexpectedly. 

Panel 2 of Table 5. 12 shows how effective tax rates under tax refonn 

respond to changes in inflation. Because tax refonn increases the tax rate on 

capital gains and reduces the subsidy to debt, the taxation of inflationary 

capital gains is more important than the deduction of inflationary interest 

payments in the corporate sector. Thus. in contrast with prior law, corporate 

sector effective tax rates on nondepreciable assets rise with inflation. For 

the same reason, as well as the erosion of depreciation allowances defined in 

nominal terms. effective tax rates on depreciable assets continue to rise with 

inflation. Thus. the effective tax rate on all corporate assets rises with 

inflation. so the overall average effective rate in the corporate sector rises 

with inflation under tax reform. 

The overall average effective tax rate in the noncorporate sector. as well 

as the effective rate on owner-occupied housing. falls as inflation rises from 

zero to an 8 percent rate. As under prior law. this reflects the rising 

benefits of subsidized interest payments in the noncorporate and owner

-

occupied housing sectors. The overall average effective tax rate for the 

entire economy. however. rises by 3.2 percentage points (9

.2 percent) as 

inflation increases from 0 to 8 percent. This increase is sharper than that 

obtained under prior law (as is the rise in the overall average rate in the 

corporate sector). and the difference is due to the higher tax rate imposed on 

purely nominal capital gains. the reduced suhsidy to debt. and the slower cost 

recovery provisions of the Tax Reform Act of 1986. 

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Investment Incentives Under Tax Reform 163 

B. Indexation of Depreciation and Capital Gains for the 

Effects of Inflation 

Our analysis above shows that effective tax rates are sensitive to inflation. Of particular concern to many policy analysts is the erosion in the 

value of depreciation allowances due to inflation. Indeed, the original 

Treasury proposal for tax reform, the President's proposal, and the House Bill 

all would have provided some indexation of depreciation allowances for 

inflation. 

The first panel of Table 5. 13 shows effective tax rates when depreciation 

allowances are fully indexed for inflation. Comparing these rates with those 

Table 5.13 Indexation and Effective Ta:x Rates* 

Inflation Rate 0~ ;J~ R~ 

1. Tax Reform with Indexed 

Depreciation Allowances 

Effective Tax Rates 

Corporate Sector 

Equipment .312 .323 .335 

Non-residential Structures .375 .385 .395 

Non-residential Land .496 .478 .486 

Inventories .448 .458 .466 

Overall .405 .415 .424 

Noncorporate Sector 

Overall .338 .325 .311 

Owner-Occupied Housing .243 .237 .231 

Overall .346 .346 .345 

Standard Deviation in the 

Cost of Capital .0097 .0104 .0112 

2. Tax Reform with Indexed Depreciation 

Allowances and Indexed Capital Gains 

Effective Tax Rates 

Corporate Sector 

Equipment .312 .278 .241 

Non-residential Structures .375 .344 .311 

Non-residential Land .469 .445 .418 

Inventories .448 .422 ·.393 

Overall .405 .377 .345 

Noncorporate Sector 

Overall .338 .325 .311 

Owner-Occupied Housing .243 .237 .23 I 

Overall .346 .327 .307 

Standard Deviation in the 

Cost of Capital .0097 .0086 .0076 

Source: Authors· calculations as described in the text. 

*Calculations assume s =0.05 and individual arbitrage. 
164 Don Fullerton/Robert Gillette/ James Mackie 

for unindexed tax reform in panel 2 of Table 5. 12 shows that indexing depreciation allowances sharply reduces effective tax rates on depreciable property. and makes these rates Jess sensitive to inflation. Consequent! y. the 

overall average effective tax rate in the corporate sector is lower and rises 

less sharply with inflation than when depreciation is not indexed. In the 

noncorporate sector. the overall average rate is lower and falls more rapidly 

than when allowances are not indexed (with indexation there is no offset to 

the rising subsidy on debt). Overall, with depreciation indexation the economy 

wide average effective tax rate is almost constant as inflation varies from 0 

percent to 8 percent, in contrast to a 3.2 percentage point increase when 

depreciation aUowances are not indexed for inflation. 

If we compare these effective tax rates for tax reform plus indexed depreciation with those for (unindexed) prior Jaw in panel I of Table 5. 12, we see 

that tax reform would have caused a much smaller increase in effective tax 

rates on depreciable property. as well as in the overall average effective tax 

rate for the corporate sector and the economy as a whole. had depreciation 

been indexed. In the noncorporate sector with depreciation indexing the 

overall average rate is below its prior law level. Furthermore, for positive 

inflation rates, the standard deviation in the cost of capital is reduced by 

indexing depreciation allowances. and neutrality is improved, compared with 

prior law and (unindexed) tax reform. In part, this is due to a reduction in 

the differential between tax rates on business investment in depreciable 

property compared to that on owner-occupied housing. 

The 60 percent exclusion of long-term capital gains under prior law has 

been justified as compensation for the failure to adjust taxable gains for 

inflation. Tax reform repeals the exclusion, and treats capital gains as 

ordinary income. This treatment as ordinary income sharply increases the tax 

rate on accrued gains compared to its prior law level, and is a primary reason 

for higher corporate and overall economy wide average effective tax rates 

under tax reform than under prior law. Commentators have suggested that tax 

reform could be improved upon by indexing capital gains form inflation. 

Yolanda Henderson21 has stated that the principal weakness in the Tax Reform 

Act of J 986 is the failure to index both depreciation and capital gains for 

the effects of inflation. The second panel of Table 5. 13 provides the results 

of our analysis of this issue.2 2 

For positive inflation rates. indexing both capital gains and depreciation 

allowances further reduces corporate sector effective tax rates. With both 

depreciation and capital gains indexing the overall average effective tax rate 

in the corporate sector, as well as the overall average economy wide effective 

rate. are below their (unindexed) prior law levels for inflation rates of 4 

and 8 percent. Due to a reduction in the effective rates in the corporate 

sector compared to the already lower rates in the noncorporate and owneroccupied housing sectors. taxation is more uniform with both depreciation and 

capital gains indexation than for (unindexed) prior law. the actual (unindexed) tax reform act. or tax reform plus depreciation indexing. 

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Investment Incentives Under Tax Reform 165 

Finally, we note that the combined effects of depreciation and capital 

gains indexing cause effective taxes in the corporate sector to fall with 

inflation. Indexing removes the effective tax rate increasing influences of 

the erosion of the value of depreciation allowances and the taxation of purely 

nominal corporate retained profits, but leaves the tax reducing influence of 

higher nominal interest deductions. Overall average effective tax rates in all 

sectors now fall with inflation. Thus, while these indexing provisions reduce 

effective ta.x rates and improve neutrality for a given inflation rate, they do 

not eliminate uncertainty due to unexpected changes in the inflation rate. 

VIII. EFFECI'S OF ACCOUNTING PROVISIONS ON 

MEASURED INVESTMENT INCENTIVES 

The effective tax rate model we have employed captures the influence of 

changes in statutory income tax rates, investment tax credits, and depreciation allowances on investment in 5 I depreciable and 3 nondepreciable assets 

in the corporate and noncorporate sectors of 60 different industries. as well 

on investment in owner-occupied housing. The model, however, is not exhaustive. It has been criticized for omitting the effect of several important 

business tax provisions which are substantially tightened by tax reform (see. 

for example, BaJJentine ( 1986)). Thus, the model has been accused of systematically understating the increase in effective ta.x rates caused by tax 

reform. 

In this section. we present a tentative analysis of the effect on marginal 

investment incentives of major reforms in accounting rules. We conclude that 

many "omissions" have no influence on marginal investment incentives of the 

type measured in this paper. They do not affect taxes paid on income generated by a uniform expansion of the existing capital stock. However. cost 

capitalization rules for multi-period accounting do affect marginal investment 

incentives. Our estimates suggest that including these rules causes tax 

reform to compare somewhat less favorable with current law than when these 

rules are ignored. For the economy as a whole, however, this effect is small . 

First consider installment sales. Rules regarding installment sales are 

sometimes said to affect marginal investment incentives. In contrast, 

however. we would argue they have no influence on investment incentives. To 

take a simple example, a department store under prior law could deduct the 

cost of a good at the time of sale, even though it included the customer's 

payments as received over some period of time. This deferral certainly 

reduced the effective tax paid by the department store. but it was not an 

incentive to expand inventories or any other real investment. Instead. this 

provision reduced the effective cost of the good sold and is best modeled as 

an output subsidy. Under tax reform. income from saJes using the installment 

method must be recognized at the time of sale. rather that deferred as under 

prior law. Thus, an output or sales subsidy has been reduced. There has been 
I 66 Don Fullerton/Robert Gillette/ James Mackie 

no direct change in the tax treatment of income from investment in real 

assets. 

Second, tax reform also repeals provisions which allowed both financial and 

nonfinancial firms to accelerate the deduction of losses due to bad debts. 

This change reduces interest free loans from the government to the taxpayer, 

thus effecting the matching of income and expense. Again, however, these 

provisions are not associated with the incentives to make new real investment. 

For nonfinancial corporations, bad debt reserves are associated with their 

lending, usually to purchasers, and could thus be modeled as an output tax or 

subsidy. They are not associated with borrowing to buy new real investment. 

For financial corporations, bad debt reserves are associated with the provision of their output, financial services, and not with their own real investment (e.g . . bank buildings and vaults). The only effect that these provisions 

might have on the cost of capital for new real investment is an indirect 

effect through raising the cost of financial services that might be a necessary component of financing and making new real investment. However, this 

indirect effect requires general equilibrium changes in output prices. (In 

this case the price of banks' output is the interest rate differential they 

charge.) Moreover, as noted in Neubig and Sullivan (1987, this volume), banks 

benefit from rate reduction so the net effect of tax reform on the price of 

financial services is ambiguous at best. It does not directly affect the tax 

treatment of income from our marginal real investment, and thus has no direct 

effect on investment incentives. 

Changes in multi-period production accounting rules are projected to raise 

$35 billion in corporate revenue over the 1987-1991 period. In contrast to 

other accounting rule changes, these changes can affect investment incentives. 

This estimate includes some one-time revenue, however. so the effect on 

marginal investment incentives might be overstated by looking only at revenue 

estimates. Under the new rules, firms must capitalize into basis certain 

costs which previously could be expensed. such as some pension costs, accelerated depreciation, and general and administrative costs. 

New "uniform" capitalization rules affect investment in inventory and selfconstructed real estate. Data from a variety of sources (Commerce. IRS. and 

industry representatives) suggest that roughly 20 percent of the costs of 

inventory and self-constructed real estate is expensed under prior law. 

Revenue estimates suggest that tax reform would reduce this fraction to about 

5 percent. 

Data from similar sources suggest that in most industries perhaps 20 

percent of structures investment is treated as self-constructed for tax 

purposes. In a few industries. however. such as utilities. casual evidence 

suggests that as much as 80 percent of structures might be considered selfconstructed for tax purposes. 

Tighter rules also apply to assets constructed under long-term contract. 

Prior law allowed use of the completed contract method of accounting for 

long-term contracts. Under this generous accounting system perhaps I 0 percent 

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Investment Incentives Under Tax Reform 167 

of costs could be expensed. Tax reform reduces expensible costs to perhaps 3 

percent of contract costs. In addition tax reform requires that 40 percent of 

any long-term contract use the percentage of completion method, which provides 

proper income tax treatment for all expenditures. We thus assume that tax 

reform allows expensing of only 2 percent of costs associated with long term 

contracts. 

We divide inventory into two components. The first component is affected by 

uniform capitalization rules. The second is affected by changes in accounting 

for long term contracts. Based on data from Standard and Poor's Industry 

Surveys, Construction Review, the Survey of Current Business, and unpublished 

Commerce surveys, we estimate that about 10 percent of our stock of inventories might be affected by accounting rules covering long- term contracts. We 

assume that the remaining 90 percent of inventory is affected by changes in 

uniform capitalization rules. 

Table 5. 14 shows how our modeling of multi-period accounting rules affects 

our results. For comparison purposes, the first two columns reproduce 

standard results from Table 5.6 for prior law and tax reform. For structures 

and inventory, expensing is more generous than regular tax treatment, and the 

next two columns show that our modeling of accounting rules lowers the effective tax rates on structures and inventory, compared to those obtained when 

these rules are ignored. As a consequence, neutrality is also slightly 

improved. (Equipment is affected because some real property is included in BEA 

definitions of equipment.) 

Because tax reform tightens multi-period accounting rules. it raises 

effective tax rates by a slightly larger amount compared to prior law when 

such rules are modeled than it does when accounting rules are ignored. The 

overall average rate in the corporate sector rises by 5. 7 percentage points 

(or 14.7 percent) when accounting rules are ignored, compared to a higher 7. 7 

percentage point (or 21.2 percent) rise when accounting rules are included. 

For the economy as a whole, with accounting rules the average effective tax 

rate rises by 4.4 percentage points (13.8 percent). instead of the 3.2 

percentage point (9.6 percent) increase estimated when accounting rules are 

left out of the analysis. Thus, including accounting rules suggests that tax 

reform will cause a somewhat larger rise in effective tax rates than when 

these rules are ignored. Nonetheless. even with the accounting rule changes. 

tax reform encourages a more productive allocation of investment by evening 

the tax treatment of different investments. 

IX. DISCUSSION 

The cost of capital model we employ includes the effects of personal and 

corporate tax rates. ITCs. depreciation allowances. and multi-period accounting rules on investment incentives for a large number of depreciable assets. 

as well as land and inventories. Our modeling of depreciation allowances is 

more complete than elsewhere in the literature. However. further development 
168 Don Fullerton/Robert Gillette/ James Mackie 

Table 5. 14 Accounting Rules for Multi-period Production* 

Without Accounting With Accounting 

Rules Rules 

Prior Law Tax Reform Prior Law Tax Reform 

Corporate Tax Rates 

Equipment .100 .396 .095 .395 

Structures 

Non-residential .344 .431 .337 .430 

Residential .495 .525 .488 .524 

Public Utility .326 .445 .310 .442 

Inventories .488 .458 .440 .449 

Land 

Non-residential .506 .478 .506 .478 

Residential .539 .514 .539 .514 

Overall .387 .444 .363 .440 

Noncorporate Tax Rates 

Equipment -. I 19 .254 -.120 .254 

Structures 

Non-residential .278 .314 .273 .312 

Residential .382 .406 .377 .404 

Public Utility .221 .336 .217 .334 

Inventories .330 .305 .294 .297 

Land 

Non-residential .361 .338 .361 .338 

Residential .414 .395 .414 .395 

Overall .332 .339 .327 .337 

Owner-Occupied Housing Tax Rate .225 .237 .225 .237 

Overall Tax Rate .333 .365 .319 .363 

Standard Deviation of Cost of Capital .0150 .0114 .0135 .0111 

Source: Authors' calculations as described in the text. 

*Calculations assume s=0.05. n =0.04. 

is possible . For example, we do not include the effect of the special treatment of farm structures and certain expensible assets used in mineral production. It would also be possible to include a more complete modeling of 

financial institutions. Furthermore. other statutory provisions, such as the 

treatment of pollution control equipment. are ignored. Finally, we do not 

attempt to model passive loss rules. the alternative minimum tax, or the tax 

treatment of research and development. 

In addition. there are problems with the basic model itself. For example. 

it may be inappropriate to ignore risk. as we do in this perfect certainty 

model. In addition, it might be said that there are inherent inconsistencies 

in our modeling. Firms are assumed to minimize taxes by using the most 

generous depreciation allowances and LIFO inventory accounting. However. they 

use both debt and equity financing when debt is always cheaper. These issues 

await further analysis. but they imply that the numerical results in this 

paper need to be interpreted in the context of the type of model used to 

generate them. 

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Investment Incentives Under Tax Reform 169 

Overall, our results suggest that tax reform will cause a slight increase 

in effective tax rates. However, due in large pan to lTC repeal and corporate rate reduction, the relative tax treatment of different assets and 

investors is ·improved. Thus, a more efficient allocation of investment is 

likely to result. 

FOOTNOTES 

1 Accounting rules are considered in Section VIII below. The model ignores changes in the 

minimum tax, passive loss rules, and the treatment of research and development. 2 See Fullerton ( 1987) for more on firm arbitrage. 3 For a variety of reasons not captured here. firms may not always minimize their taxes by 

taking the earliest possible deductions. In order to concentrate on the tax wedge and to insure 

comparability across tax regimes, however. calculations here assume tax minimizing behavior. 

including use of LIFO methods for inventory accounting. 4 This is especially true for calculations based on the assumption of firms arbitrage. With 

that arbitrage assumption. personal taxes are not fully reflected in the cost of capital, but 

are fully reflected in the effective tax rate. 5 Gravelle (1982) assumes that all is by corporations. and Auerbach (1983b) explicitly 

considers only the corporate sector. 

6

The algorithm also allows for the classification of assets, especially real property, which 

do not have ADR midpoint lifetimes . 

., The capital stocks are computed using the perpetual inventory method. 8 These non neutralities are due to deviations of total cost recovery allowances from economic 

deP.reciation. Thus, the lTC also contributes to these inefficiencies. 9 Certain industry specific features of the tax code are not accounted for in our modeling. 

For example. we ignore the special tax treatment of farm structures and petroleum mining shafts 

and wells. 1 0

The International Trade Commission's study also differs from ours by using investment 

flows rather than (the more appropriate) capital stocks as weights in aggregating up to industry 

and sectoral levels. 11 We do not consider any induced change in income tax rates at the state level. Thus. to the 

extent that states lower their statutory income tax rates in response to federal base broadenin~. our estimatesoverstate effective tax rates under tax reform. 

1 See Cilke and Wyscarver ( 1987. this volume) for more detail on this model. 

13 Fullerton. Henderson, and Mackie (1987. this volume) also provide a detailed description 

of these adjustments. 14 For debt financed investment. corporate rate reduction can increase the cost of capital and 

effective tax rate. as discussed below. 

15 The standard deviation in the cost of capital is not a perfect measure to use in comparing 

dispersion across tax regimes. It does not adjust for differences in scale, as for example. the 

coefficient of variation does. In addition. it does not measure the welfare cost due to nonneutralities. Nonetheless. for the results in our paper. a lower standard deviation is 

associated with a lower coefficient of variation (except in one case that is noted) so the 

standard deviation provides relevant information on dispersion. 16 An interesting side point illustrated by Table 5.8 is that for prior law it is the lTC. as 

opposed to accelerated depreciation. which gives a tax advantage to investment in equipment 

relative to nonresidential structures. Without the ITC. the effective tax rate on equipment is 
170 Don Fullerton/Robert Gillette/James Mackie 

larger than the effective tax rate on nonresidential structures. However, comparing our results 

to those in Fullerton (1987) suggests that this conclusion might depend on arbitrage 

assumptions. 1 7 Forcorporateinvestmentfinanced entirely through new share issues, tax reform reduces the 

overall average effective tax rate in the corporate sector from 67 percent to 61 percent. If 

corporate equity is obtained equally from new share issues and retained earnings, and one-third 

of all investment is debt financed, then the overall average effective tax rate on investment in 

the corporate sector rises only modestly from 47.4 percent under prior law to 47.9 percent under 

tax reform (see Table 5. 11 below). 1 8

This is also true for some unenacted proposals. For example, Fullerton (1987) finds that, 

compared with prior Jaw. the President's proposal would reduce the overall average effective tax 

rate in the corporate sector under individual arbitrage, but increase it under firm arbitrage. 1 9 Thenewviewreceivedempirical supportinAuerbacb ( 1984), buttheoldviewwasfoundmore 

com~atible with historical evidence in Poterba and Summers (1983, 1985). 2 In equation (5.2). under the old view cd is .333, c is .333, and c is .333. 

21 r• n• See Brookes (1986) as well as Henderson (1986). 2 2 See Fullerton (1987) for the modeling of the indexation of capital gains. 

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Investment Incentives Under Tax Refonn 171 

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