Effective Tax Rate Model

The Office’s effective tax rate model is used to determine how uniformly and heavily the 

federal government taxes capital income and how that taxation would be affected by changes 

in tax policy. It is based on the effective tax rate/cost of capital methodology described in 

Fullerton, Gillette, and Mackie (1986), Gravelle (1994), Mackie (2002), and Ozanne and 

Burnham (2006), among others.1

Overview: Marginal effective tax rates are hypothetical tax rates showing the total fraction of 

capital costs, excluding economic depreciation, needed to pay taxes over the lifetime of a 

marginal investment (i.e., an investment assumed to just break even). If applied to economic 

income, they summarize the investment incentives implied by major provisions of the tax 

code. Those major provisions include federal tax rates on corporate and noncorporate business 

income, accelerated tax depreciation, business interest deductions, investment tax credits, the 

home mortgage interest deduction, the real estate taxes paid deduction, and various 

individual-level taxes (e.g., tax rates on capital gains, dividend income, interest income, 

distributions of nonqualified annuities). All else being equal, the higher the effective tax rate 

is the lower the incentive to save and invest. 

The calculation of marginal effective tax rates begins with the Hall-Jorgenson user cost of 

capital.

2 The user cost of capital ( ) c is the real before-tax rate of return that a marginal 

investment must earn to recover the cost of the investment, pay taxes on business income, and 

pay an expected after-tax rate of return on marginal saving. The user cost of capital net of 

economic depreciation is a function of the firm’s real discount rate 

(1) ( ) ( ) ( ) rc δπδ tz 11 tk −−−−⋅+−=− δ , 

where r is the firm’s nominal discount rate, π the expected inflation rate, δ the economic 

depreciation rate, t the statutory business income tax rate, z the present value of tax 

depreciation allowances, and k an investment tax credit rate. In (1), r − π is the weighted 

average of a required real return on equity ( ) E and a nominal market interest rate ( )i . Thus, 

(2) π ( )( ) ( ) 1 tifr πλ 1−+−−=− Ef , 

where f is the fraction of marginal investment financed with debt and λ the share of 

business interest expenses that can be deducted. 

1 Don Fullerton, Robert Gillette, and James Mackie, “Investment Incentives under the Tax Reform Act of 1986” 

in Compendium of Tax Research 1987 (1987), Washington, DC: Department of the Treasury, Office of Tax 

Policy, pp. 131-171; Gravelle, Jane G., The Economic Effects of Taxing Capital Income (1994), Cambridge, MA: 

The MIT Press; James Mackie, “Unfinished Business of the 1986 Tax Reform Act: An Effective Tax Rate 

Analysis of Current Issues in the Taxation of Capital Income,” National Tax Journal (June 2002), Vol. 55(2), pp. 

293-337; Larry Ozanne and Paul Burnham, “Computing Effective Tax Rates on Capital Income,” Congressional 

Budget Office Background Paper (December 2006).

2 Robert Hall and Dale W. Jorgenson, “Tax Policy and Investment Behavior,” American Economic Review (June 

1967), Vol. 57(3), pp. 391-414.

Office of Tax Analysis 

U.S. Department of the Treasury 

July 2014

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Subtracting c − δ from the overall after-tax return to marginal saving ( )s gives the tax 

wedge. Dividing that tax wedge by c − δ gives an effective total tax rate ( ) ETTR of 

(3) ETTR ( ) −= s ρρ

for new investment, where c −= δρ . In (3), s reflects weighted averages of the marginal 

saver’s returns to debt and equity holdings in fully taxable accounts (directly-held corporate 

stocks and bonds, savings accounts), temporarily-deferred accounts (annuities, whole-life 

insurance policies), and nontaxable accounts (pension funds). If (3) is rewritten to capture 

only the single layer of taxes paid by the firm and to ignore the individual-level taxes paid by 

the marginal saver, the result is an effective tax rate ( ) ETR for new investment given by

(4) ETR −= ( )( ) r′ − ρπρ . 

In (4), r′ − π is the weighted average of the real returns paid on debt-financed investments 

and equity-financed investments after the firm has paid business income taxes. 

The effective tax rate model calculates marginal effective tax rates using both (3) and (4). 

Model Parameters. The cost-of-capital model is used to obtain effective marginal tax rates for 

76 depreciable assets (equipment and structures), land, inventories, and intangibles.3 For each 

asset, effective marginal tax rates are calculated separately for the corporate sector, the 

noncorporate sector, and the owner-occupied housing sector. For the corporate sector, they 

are also calculated separately for new investments financed with corporate debt and new 

investments financed with corporate equity. 

In the model, some key parameters, including tax rates, the inflation rate, the nominal interest 

rate, and the real before-tax return on equity, are constant across all sectors and assets (see 

Table 1). However, the fraction of marginal investment financed with debt as well as the 

percentage of marginal savings exempted or deferred varies among the corporate, 

noncorporate, and owner-occupied housing sectors. In addition, economic depreciation rates 

and the tax depreciation methods used to calculate z vary across assets (see Table 2). 

Economic depreciation rates are taken from Hulten and Wykoff (1981) and BEA (2003).4

 

The assignment of tax life and tax recovery method by asset type and industry is largely 

guided by IRS Publication 946.

5

 Under current law, tax depreciation generally has a higher 

present value than does economic depreciation. 

3 Stock values for most categories of assets are taken from BEA’s detailed fixed asset tables. See 

http://www.bea.gov/national/FA2004/Details/Index.html. The cost-of-capital model assumes that firms expense 

system integrators, custom software, and own-account software. 4 Charles R. Hulten and Frank C. Wykoff, “The Measurement of Economic Depreciation” in Depreciation, 

Inflation, and the Taxation of Capital Income (1981), Washington, DC: The Urban Institute, pp. 81-125; US 

Department of Commerce, Bureau of Economic Analysis, “Fixed Assets and Consumer Durable Goods in the 

United States, 1925-1997” (September 2003), available at 

http://www.bea.gov/national/pdf/Fixed_Assets_1925_97.pdf. For an update of BEA’s September 2003 

depreciation estimates, see http://www.bea.gov/national/FA2004/Tablecandtext.pdf. 5 US Department of the Treasury, Internal Revenue Service, Publication 946 How to Depreciate Property, for 

Use in Preparing 2009 Returns, available at http://www.irs.gov/pub/irs-pdf/p946.pdf. The present value of tax 

Office of Tax Analysis 

U.S. Department of the Treasury 

July 2014

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Owner-Occupied Housing. The effective tax rate model uses (1) to calculate the real beforetax return on new equipment and structures in the corporate and noncorporate sectors. It uses

(5) h hh −−= λπρ twr

to obtain the real before-tax return on owner-occupied housing. In (5), w is a property tax 

rate, λh the fraction of real estate taxes deducted by home owners, and ht the tax rate 

applying to marginal investments in owner-occupied housing.6

Equation (5) reflects several differences in the tax treatment of owner-occupied housing. For 

example, income from an investment in owner-occupied housing is not taxed ( ) t = 0 , and no 

depreciation deductions are permitted for owner-occupied housing ( ) z = 0 . Home owners 

who itemize can deduct property taxes. The value of the real estate tax deduction is given by 

hh λ tw . Home owners who itemize can also deduct home mortgage interest expenses. From

(2), the value of the home mortgage interest deduction is given by hhh λ tif . 

Limitations of the Effective Tax Rate Model. The effective tax rate model omits features of 

the federal tax code that may influence incentives to save and invest. For example, the 

effective tax rate calculations exclude federal estate and gift taxes. They generally ignore

special credits, deductions, rates, and other tax provisions intended to encourage investment in

specific assets or industries. They assume that firms use all available deductions and credits

when such deductions and credits are likely to be of little use to a firm in a loss position or 

with a stock of unused tax losses and credit carry-forwards. However, the effective tax rate 

model can include taxation of capital income at both the federal level and at the state and local 

levels, taking into account the effects of state and local income taxes, sales taxes, and property 

taxes on investment incentives. 

The effective tax rate model also assumes that all savers and investors are subject to federal

taxes. However, foreign savers do not pay federal individual-level taxes, and U.S. firms with

investments abroad do not pay federal business income taxes unless profits are repatriated.

This means that preferential capital gains rates, lower federal corporate income tax rates, and 

other tax measures intended to reduce US marginal effective tax rates on new investment may 

have less of an influence in an economy that is open to international capital flows. 

depreciation is calculated by asset and industry for each sector. Table 3 is the result of aggregating the present 

value of tax depreciation by asset across industries using 2008 capital stock weights.

6 In the model, λh equals to the fraction of home mortgage interest that is deducted. ht is a weighted average of 

income-weighted federal marginal income tax rates calculated for the home mortgage interest deduction and the 

real estate taxes paid deduction.

Office of Tax Analysis 

U.S. Department of the Treasury 

July 2014

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Table 1. Key Model Parameters

Market Rates of Return

Inflation Ratea π 0.0189

Real Return on Equity E 0.0660

Nominal Interest Rateb i 0.0610

Current-Law Federal Tax Rates

Statutory Corporate Income Tax Ratec c t 0.3404 

Individual-Level Tax Rates on:d

 Dividend Income div t 0.2206 

 Long-term Capital Gains lcg t 0.2006 

 Short-term Capital Gains scg t 0.3213 

 Interest Income int t 0.2751 

 Home Mortgage Interest and Real Estate Tax Deductionse ht 0.2031 

 Noncorporate Business Income nt 0.3126 

 Distributions of Nonqualified Annuities td t 0.2293 

Fraction of Marginal Investment Financed with Debt (by Sector)f

 C-Corporations c f 0.4059

 Noncorporate Business n f 0.2734

 Owner-Occupied Housing h f 0.5952

Notes: Values for π and i are taken from the Administration’s fiscal-year (FY) 2014 mid-session review

baseline forecast. E is a long-term historical average (real) rate of return to large company stocks. It is taken 

from the Ibbotson 2010 Classic Yearbook. Tax rates are taken from current-law baseline revenue forecasts done 

for the FY 2014 mid-session review. Current-law tax rates assume no change in tax provisions or tax rates unless 

such a change is already included in current law. 

a. Average GDP deflator between 2014 and 2023. 

b. Average prime rate between 2014 and 2023. 

c. The statutory corporate income tax rate includes the domestic production activities deduction.

d. Average of 2014-2023 income-weighted federal marginal tax rates from the Individual Tax Model.

e. A weighted average of income-weighted federal marginal income tax rates calculated for the home mortgage 

interest deduction and the real estate taxes paid deduction.

f. Calculated using 2013 Flow of Funds data. 

Office of Tax Analysis 

U.S. Department of the Treasury 

July 2014

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Table 2: Cost Recovery Parameters

Asset

Economic 

Depreciation 

Rate a

Tax Depreciation Methodb

Tax Life 

(Years)

Tax Recovery 

Method

Nonresidential Equipmentc

 Mainframes 0.4532 5 DBSL (200)

 PCs 0.4009 5 DBSL (200)

 Printers 0.3656 5 DBSL (200)

 Terminals 0.2341 5 DBSL (200)

 Storage devices 0.3896 5 DBSL (200)

 System integratorsd 0.0000 NA NA

 Prepackaged software 0.5500 3 SL

 Custom softwared 0.3300 NA NA

 Own-account softwared 0.3300 NA NA

 Communications equipment 0.1125 7 DBSL (200)

 Nonelectro medical Instruments 0.1350 7 DBSL (200)

 Electro medical instruments 0.1834 7 DBSL (200)

 Nonmedical instruments 0.1350 7 DBSL (200)

 Photocopy and related equipment 0.1800 5 DBSL (200)

 Office and accounting equipment 0.3119 5 DBSL (200)

 Nuclear fuel 0.2672 5 DBSL (200)

 Other fabricated metal products 0.0917 7 DBSL (200)

 Steam engines 0.0516 15 DBSL (150)

 Internal combustion engines 0.2063 7 DBSL (200)

 Metal-working machinery 0.1076 7 DBSL (200)

 Special industrial machinery 0.1023 7 DBSL (200)

 General industrial equipment 0.0998 7 DBSL (200)

 Electric transmission and distribution 0.0500 15 DBSL (150)

 Light trucks (including utility vehicles) 0.1925 5 DBSL (200)

 Other trucks, buses and truck trailers 0.1725 5 DBSL (200)

 Autos 0.3333 5 DBSL (200)

 Aircraft 0.0687 5 DBSL (200)

 Ships and boats 0.0611 10 DBSL (200)

 Railroad equipment 0.0589 7 DBSL (200)

 Household furniture 0.1375 5 DBSL (200)

 Other furniture 0.1179 7 DBSL (200)

 Other agricultural machinery 0.1179 7 DBSL (200)

 Farm tractors 0.1452 7 DBSL (200)

 Other construction machinery 0.1550 7 DBSL (200)

 Construction tractors 0.1633 7 DBSL (200)

 Mining and oilfield machinery 0.1500 7 DBSL (200)

 Service industry machinery 0.1526 7 DBSL (200)

 Household appliances 0.1650 5 DBSL (200)

 Other electrical equipment 0.1834 7 DBSL (200)

 Other nonresidential equipment 0.1473 7 DBSL (200)

Residential Equipment 0.1500 5 DBSL (200)

Office of Tax Analysis 

U.S. Department of the Treasury 

July 2014

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Table 2: Cost Recovery Parameters, Cont’d.

Asset

Economic 

Depreciation 

Rate a

Tax Depreciation Methodb

Tax Life 

(Years)

Tax Recovery 

Method

Nonresidential Structures

 Office 0.0247 39 SL

 Hospitals 0.0188 39 SL

 Special care 0.0188 39 SL

 Medical buildings 0.0247 39 SL

 Multimerchandise shopping 0.0262 39 SL

 Food and beverage establishments 0.0262 15 SL

 Warehouses 0.0222 39 SL

 Mobile structures 0.0556 39 SL

 Other commercial 0.0262 39 SL

 Manufacturing 0.0314 39 SL

 Electric power structurese 0.0211 20/15 DBSL (150)

 Gas structures 0.0237 20 DBSL (150)

 Petroleum pipelines 0.0237 15 DBSL (150)

 Wind and solar 0.0303 5 DBSL (200)

 Communication 0.0237 15 DBSL (150)

 Petroleum and natural gas 0.0751 5 DBSL (200)

 Mining 0.0450 7 DBSL (200)

 Educational and vocational 0.0188 39 SL

 Lodging 0.0281 39 SL

 Amusement and recreation 0.0300 7 DBSL (200)

 Air transportation 0.0237 39 SL

 Other transportation 0.0237 39 SL

 Other railroad 0.0176 20 DBSL (150)

 Track replacement 0.0249 7 DBSL (200)

 Local transit structures 0.0237 39 SL

 Other land transportation 0.0237 5 DBSL (200)

 Farm 0.0239 20 DBSL (150)

 Water supply 0.0225 25 SL

 Sewage and waste disposal 0.0225 25 SL

 Public safety 0.0237 39 SL

 Highway, conservation, and 

development 0.0225 15 DBSL (150) 

Residential Structures

 Owner-occupied buildings 0.0146 NA NA

 Tenant-occupied buildings

 Corporate ownership 0.0166 27.5 SL

 Noncorporate ownership 0.0165 27.5 SL

Source: U.S. Department of the Treasury, Office of Tax Analysis

Notes: NA = not applicable. Assets are depreciated using the modified accelerated cost recovery system 

(MACRS). Under MACRS, tax life and tax recovery method jointly determine the depreciation schedule for an 

asset. The cost-of-capital model assigns one of nine different tax lives to each asset—3, 5, 7, 10, 15, 20, and 25 

years for equipment and certain nonresidential structures; 27.5 years for residential rental property; and 39 

years for most nonresidential real property. It also assigns one of three different tax recovery methods—straight 

Office of Tax Analysis 

U.S. Department of the Treasury 

July 2014

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line (SL), 150 percent declining balance with a switch to straight line (DBSL (150)), and 200 percent declining 

balance with a switch to straight line (DBSL (200)). Tax life and tax recovery method can vary by industry. For 

example, the tax life of structures owned by farm businesses is limited to 20 years; farm businesses are assumed 

to depreciate all equipment and structures using the 150-percent declining balance method. Table 6 gives the 

tax lives and tax recovery methods that the cost-of-capital model generally assigns to depreciable assets owned 

by nonfarm businesses.

a. Economic depreciation rates are taken from Hulten and Wykoff (1981) and BEA (2003).

b. IRS Publication 946 largely determines the assignment of tax life and tax recovery method by asset and 

industry. 

c. Tape drives and disk access storage devices DASD are omitted from the listing of nonresidential 

equipment because their stock values had fallen to zero by 2008.

d. We assume that firms expense system integrators, custom software, and own-account software.

e. In calculating the present value of tax depreciation, almost 80 percent of electric power structures are 

assumed to have a recovery period of 20 years and just over 20 percent to have a recovery period of 15 

years.

See Charles R. Hulten and Frank C. Wykoff, 1981, “The Measurement of Economic Depreciation” in 

Depreciation, Inflation, and the Taxation of Capital Income, Washington, DC: The Urban Institute, pp. 81-125; 

U.S. Department of Commerce, Bureau of Economic Analysis, 2003, “Fixed Assets and Consumer Durable 

Goods in the United States, 1925-1997” (September), available at 

http://www.bea.gov/national/pdf/Fixed_Assets_1925_97.pdf; U.S. Department of the Treasury, Internal 

Revenue Service, Publication 946 How to Depreciate Property, for Use in Preparing 2012 Returns, available at 

http://www.irs.gov/pub/irs-pdf/p946.pdf. 

Office of Tax Analysis 

U.S. Department of the Treasury 

July 2014

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