Download Location, investment and regional policy

44th European Congress of the European Regional Science Association,
Regions and Fiscal Federalism,
Porto, Portugal, 25th-29th August 2004
Location, investment and regional policy:
the contribution of the average effective tax rate theory*
Nathalie EYCKMANS
Olivier MEUNIER
Michel MIGNOLET**
Centre de Recherches sur l’Economie Wallonne (CREW),
University of Namur,
8 Rempart de la Vierge,
B-5000 Namur, Belgium.
This draft: Augustus 2004
ABSTRACT
For decades, most industrialised countries have implemented some forms of fiscal and
financial incentives to stimulate fixed capital formation. Tax cuts and capital grants are
commonly used in regional policy. Since these instruments mobilise huge amounts of
public resources the issue of their efficiency is of particular interest for policymakers.
The impact of taxation on investment income was traditionally apprehended through
models measuring the effective tax rate on marginal investments. However recent
literature, especially Devereux and Griffith (2002), showed the interest of resorting to
an alternative tax measure – the effective average tax rate (EATR) - when firms face
discrete investment choices that are expected to generate a positive economic rent
before tax. This effective average tax rate is defined by the difference between the net
present value of the rent of the investment before and after taxes scaled by the net
present value of the pre-tax income stream. In this sense, the effective average tax rate
*
A former version of this paper has been presented at the international conference of the Regional Studies
Association (RSA), Angers, 15th-16th April 2004.
**
[email protected]; [email protected]; [email protected].
1
developed by Devereux and Griffith (2002) seems to be particularly relevant to shed a
new light on the relative effectiveness of tax cuts and capital subsidy grants.
In this paper we intend to compare the public costs associated to a lowering of the
corporate tax rate or the granting of a capital subsidy. These public costs are directly
affected by the variation of the after-tax revenue earned by the shareholder. The extent
to which each policy must be implemented depends on the objective that is pursued by
the government to stimulate investment. We pay attention to two of these objectives: a
reduction of the capital cost and a lowering of the EATR. In order to illustrate the
relevance of our approach, a numerical example is then developed for the Belgian case.
JEL Classification: H25, H32 and R58
1. Introduction
Economic development is uneven over space. Regions are characterised by
performance disparities in factor productivity: some regions are ahead, whereas others
lag behind. This discrepancy gives rise to unbalanced patterns of economic growth, with
firms deserting underproductive areas to locate in more productive regions. This
grounds a regional policy aimed at achieving a better geographical distribution of
economic activities. Indeed, as Thisse (2000) points out, most regional policy debates in
industrialised countries implicitly assume that there is too much spatial concentration in
economic activity. Moreover the cumulative nature of agglomeration economies still
reinforces the need for some public intervention. Conversely, the efficiency of regional
policy remains a much debated issue.
By and large, the government will seek to promote investments in lagging regions by
decreasing the costs of the production factors. Such a policy is expected to affect
regional economies in a double way: on the one hand, public intervention might
strengthen indigenous growth by expanding local firms’ investment demand. On the
other hand, it might improve the attractiveness of lagging regions so as to induce nonregional firms to relocate their activities there. The former case refers to the so-called
2
investment creation effect, whereas the second is related to the investment diversion
argument. The government may be sensitive to one or the other argument when it
formulates its regional policy mix so that the effectiveness of public aid will
accordingly vary. In this paper, we intend to assess the regional policy efficiency first
when the government aims at expanding investment demand of local firms and secondly
when it seeks to act on firms’ location decisions. In this preliminary version, we only
consider a domestic framework, leaving aside international analysis for a latter stage.
To achieve their objectives, regional policymakers have numerous instruments at their
disposal. We have chosen to restrict the analysis to the direct fiscal and financial
investment incentives, so neglecting for example public expenditures in infrastructure.
More precisely, we will concentrate on two broad categories of aid: a corporate tax cut
and the granting of a capital subsidy.
Models of effective taxation have proved to be an appropriate framework to assess the
impact of fiscal and financial incentives on firm’s investment decisions. Based on the
seminal work of King and Fullerton (1984), this approach provides an indicator – the
effective marginal tax rate (EMTR) – of the distortion of tax system on the marginal
investment decisions of the firm. A marginal investment generates a return after tax that
is just sufficient to persuade the investor to make the outlay. This minimum return
required by the shareholder is the cost of capital. Recently, Devereux and Griffith
(2003) showed the interest of resorting to an alternative tax measure – the effective
average tax rate (EATR) – when firms face discrete investment choices that are
expected to generate a positive economic rent before tax. In this respect, as regional
markets are by nature imperfectly competitive, the EATR model provides certainly a
valuable tool for spatial economics analysis. In addition, as emphasized by Giannini and
Maggiulli (2002), it has the advantage of allowing the computation of both effective
marginal and average tax rates within a single framework.
Nevertheless, the average approach does not make the marginal analysis obsolete. Both
approaches are complementary. Indeed as explained by Devereux and Griffith (2003),
conditional on the choice of location, the size of the investment depends on the EMTR,
but the choice of location is related to the level of the EATR. In this respect, the
government willing to promote regional endogenous economic development will assess
3
regional policy according to its impact on the EMTR (and its underlying concept, the
cost of capital). If the authorities are more sensitive to the argument of the investment
diversion risk, they will rather seek to lower the EATR. The extent and consequently
the efficacy of public incentives therefore depend upon the policymakers’ objectives.
However in order to compare policies whose effects are rather different in kind and are
costly in various ways, the efficacy of public incentives alone does not constitute an
appropriate indicator for policy makers. Public authorities would instead consider the
efficiency of their intervention, that is, for a given level of efficacy, the extent of public
expenses associated with the granting of fiscal and financial incentives. Intuitively, the
cost for the public sector corresponds to the fiscal revenue forgone due to the policyinduced reduction of the effective tax rate. Using Devereux and Griffith (2003)’s
framework, we derive the public cost expressions by measuring the sensitivity of the
post-tax economic rent to the variation of the public aid.
The layout of this paper is as follows. Section 2 displays Devereux and Griffith (2003)’s
theoretical framework. The effective average tax rate is defined by the difference
between the net present value of the rent of the investment before and after tax scaled
by the net present value of the pre-tax income stream. The post-tax economic rent is the
key parameter in Devereux and Griffith (2003)’s model. By calculating the sensitivity
of this parameter to the policy instruments, Section 3 derives the public cost associated
with the granting of a tax cut and a capital subsidy. Section 3 also investigates how to
determine the extent of both incentives first when on the one hand the government is
willing to encourage the investment formation by indigenous regional entrepreneurs and
on the other hand when it seeks to attract extra-regional activities. Accordingly, we
measure the extent to which the tax rate has to be changed and a capital subsidy has to
be granted so as to reduce by a same percentage the EMTR or the EATR, respectively.
In Section 4, a numerical example is developed in order to illustrate our approach and
its relevance. Section 5 concludes.
4
2. The model of Devereux and Griffith (1999 and 2003)
The extent to which a tax on income from capital affects the firms’ behaviour has
been traditionally analysed through neo-classical models. In these models, firms will
invest up to equalise the marginal productivity and the marginal cost of capital. The
mainstream of the economic literature focuses on marginal investments. A marginal
investment yields a rate of return after tax that is just sufficient to persuade investors to
make the initial outlay. This rate of return (also called the cost of capital 1) and the
effective marginal tax rate (EMTR) that is a derived indicator enable to measure the
impact of taxation and public incentives on the investment decision. King and Fullerton
(1984) define the EMTR as the ratio of the tax wedge on the capital cost 2. The tax
wedge is the difference between the pre-tax rate of return earned by the firm on the
marginal investment and the post-tax rate of return earned by the supplier of funds.
The capital cost and the marginal effective tax rate have proved to be appropriate
indicators to determine the optimal level of investment. This issue requires a marginal
calculation. Conversely, a location decision has to discriminate between some discrete
choices that are mutually exclusive. In the presence of economies of scale or imperfect
competition, the various options may yield different levels of economic rent i.e. some
rates of return that are above the minimum required after-tax rate of return. As some
recent contributions pointed out, especially Devereux and Griffith (1998, 1999 and
2003), such a matter calls for an approach in terms of effective average tax rate
(EATR)3. This section briefly describes the proposed measure of the EATR. It aims at
providing the reader with an insight of the model for a domestic setting. The
international setting is outlined at the end of the section.
2.1. The domestic setting
The EATR sets out to apprehend the total tax burden that is actually paid by the firm
and its shareholders. For a domestic setting, it is defined by expression (1) that is the
ratio of two terms. The numerator measures the difference between the net present value
1
For pioneering developments, see Jorgenson (1963) or Hall and Jorgenson (1967).
See also Alworth (1988), OECD (1991) or Ruding (1992) for international settings.
3
See also EEC (2001).
2
5
of the economic rent before tax, R*, earned by the investment and its equivalent after
tax, R. The denominator expresses the net present value of the pre-tax total income
stream, Y*:
EATR =
R* - R
Y*
(1)
The model developed by Devereux & Griffith (2003) is based on the calculation of the
value of the firm. It considers a one-period perturbation of the capital stock. Investment
is up one unit in period t and reduced in period t+1 so that the capital stock is left
unchanged in any other periods. This investment generates a real financial return, p, in
period t+1.
Therefore, if we denote the real market interest rate as r, the net present value of the pretax economic rent R* is equal to:
R* =
p-r
(1 + r )
(2)
The discounted value of the pre-tax total income stream, net of depreciation, Y*, is
measured as:
Y* =
p
(1 + r )
(3)
The net present value of the post-tax economic rent, R, is the key parameter in
Devereux and Griffith (1999)’s approach. It captures in a summary statistics the major
features of the tax system, including the investment subsidy, which might affect the
decision of the firm, as well as the economic parameters such as the economic
depreciation rate, the real financial return of the investment or the inflation rate.
Moreover, it is defined in some different terms depending on the financing choice.
Devereux and Griffith (2003) show that the value of the post-tax economic rent can be
broken up into two terms, depending on whether the investment is financed by retained
earnings or by raising external funds (a loan or the issue of new shares). The external
finance generates additional cash flows which come in addition to the rent associated
with a financing by undistributed profits. Accordingly, the post-tax economic rent R can
be expressed as :
R = RRE + F
(4)
where RRE is the after-tax rent for a financing by retained earnings and F stands for the
additional cash flows arising from the use of external finance. The change in the firm’s
6
market value that is induced by the one-period change of the capital stock provides
Devereux and Griffith (1999) with the following expression of the post-tax economic
rent, when the investment is financed by retained earnings:
RRE = -(1-A) +
γ
[(1+)(p+)(1-)+(1+)(1-)(1-A)]
1+ ρ
(5)
In expression (5),  is the tax discrimination between new equity and distributions. In
analytical terms,  is equal to (1-md)/(1-c)(1-z) where md is the personal tax rate on
dividend income, c is the rate of tax credit on dividend paid and z denotes the capital
gain tax. The variable  symbolizes the shareholder’s nominal discount rate with  = (1mi)i/(1-z) where mi is the personal tax rate on interest income.  is the one-period cost
of depreciation of the asset,  measures the expected inflation rate,  is the corporate tax
rate and A expresses the discounted value of any public allowances.
Effective tax models traditionally distinguish three main categories of public incentives:
standard depreciation allowances, immediate expensing and capital grants. The present
value of public allowances per unit of investment can be therefore expressed as
A = Ad +  + g. The term Ad is the present value of tax savings from depreciation
allowances,  expresses the proportion of investment expenditure which is entitled to
immediate expensing and g is the rate of capital grant.
What is the meaning of RRE? The firm finances the investment by reducing dividends in
the first period (period t). This operation is thereafter offset in period t+1 by a
corresponding increase of distributed dividends. In time t, the cost of the investment in
net present value amounts to (1-A). In period t+1, the additional dividend is accordingly
equal to (1-A)(1+)(1-). The after-corporate-tax nominal return of the investment in
period t+1 is equal to (p+)(1+)(1-). The revenue generated in period t+1 is then
taxed at the rate γ, which reflects the various aspects of the personal taxation. Finally, it
is discounted at , the shareholder’s nominal discount rate.
The financing of the investment by an issue of new equity or by debt generates
additional cash flows, F, that affect the post-tax net present value of the economic rent.
In the case of new equity finance, the shareholder’s contribution rises by (1--g), i.e.
the cost of the investment reduced by the immediate tax rebate and the investment
7
subsidy. In period t+1, the firm repurchases the new shares, generating an increased net
income equal to (1--g). The expression of additional cash flows when the investment
is financed by new equity is therefore written as follows:
FNE = -
ρ(1 - γ)
(1--g)
(1 + ρ)
(6)
When the investment is financed by debt, the firm borrows the amount (1--g) in
period t, giving the shareholder an additional income equal to (1--g). In the second
period, the firm repays the debt with interest, that is (1--g)(1+i). However, the interest
payments are tax deductible, what reduces the financial cost by (1--g)i. Combining
this, the additional cash flows in case of debt financing are expressed as:
FD =
γ(1 - φτ - g)
[-i(1-)]
(1 + ρ)
(7)
Finally, it is a major advantage of the Devereux and Griffith (2003)’s framework to
permit to calculate easily the cost of capital, that is the pre-tax financial rate of return
that is required to generate a post-tax economic rent equal to zero. We therefore obtain
the following expression for the capital cost, denoted ~p :
~
p=
(1 A)
[ρ + δ(1 + π)
(1 τ)(1 + π)
π] -
F(1 + ρ)
-δ
γ(1 τ)(1 + π)
(8)
where F corresponds to FNE or FD, depending on the source of finance, respectively new
equity or debt. When the firm uses retained earnings, FRE is equal to zero.
Expression (8) of the capital cost is quite similar to the traditional King and Fullerton
(1984)’s formulation, except that the net present value (NPV) of depreciation
allowances A is calculated using the shareholder’s discount rate  (instead of the
financial cost) and that the immediate tax expensing () plays a role, rather than
simply the net present value of allowances.
2.2. The international setting
Devereux and Griffith (2003) have also extended their model to International Direct
Investments. The basic approach is identical to that in the domestic setting. It considers a
multinational company located in a home jurisdiction which undertakes an investment in a
host jurisdiction through a wholly-owned subsidiary. The parent company is owned by
8
individual shareholders resident in the same home country.4 The subsidiary may choose
either an autonomous financing policy, using retained profits or a parent-dependent one
The parent company endows its foreign subsidiary with the funds either by granting a
loan or buying its shares. In turn, the parent raises the funds by borrowing, using
retained profits or issuing new shares. This setting introduces an additional term,
comparable to F, which captures the tax implication of the source of finance used by the
subsidiary. Accordingly, the post-tax economic rent, R, is now split into three parts: the
rent attributable to the investment in the subsidiary financed by retained earnings ( R RE
n ),
the additional cost of the parent raising external finance ( Fj ) and the additional cost of the
subsidiary of raising finance from the parent ( Fn ). 5 The post tax economic rent is now
RE
given by R n = R RE
n + Fj + Fn . The first element R n , corresponds to the economic rent
generated by a perturbation in the capital stock financed by retained earnings. It is
measured as follows:
R RE
n = j(1-jn){-(1-A) +
1
1+ ρ
[E(1+n)(pn+)(1-n)+E(1+n)(1-)(1-A)]}
(9)
Where the parameters have the same meaning as in the Section 2.1., except that the
subscript n indicates that it refers to the host country. There are some new parameters. The
exchange rate between the host and the home countries, which is normalized at unity in
period t, takes the value E in period t+1. The overall corporate tax rate levied on dividend
payments from the subsidiary to the parent is denotes by jn. It also captures various
mechanisms alleviating international double taxation. Another tax parameter, jn, measures
the overall corporate tax rate levied on interest payments from the subsidiary to the parent.
It is used to measure of the additional cost associated with the financing of the subsidiary
by borrowing. Table 1 shows the values of the parameters Fj and Fn for the various
sources of finance.
4
5
Devereux and Griffith (2003), p. 115.
Devereux and Griffith (1999), p. 45.
9
TABLE 1: Values of the additional cost of the parent company (Fj) and the subsidiary (Fn)
raising external funds
Source of parent finance
Retained earnings
F RE = 0
j
ρ(1 - γ j )
(1-nn-g)
(1 + ρ)
γ j (1 - φ n τ n - g)
Debt
FD =
[-I(1-j)]
j
(1 + ρ)
Source of subsidiary finance
New equity
F NE = -
Retained earnings
FnRE = 0
New equity
FnNE =
Debt
FnD
j
γ jσ jn
(1-nn-g)[E-(1+)]
(1 + ρ)
γ j (1 - φ n τ n - g)
=
{jn[E(1+i(1-n))-(1+)]-Ejni}
(1 + ρ)
Finally, this allows Devereux and Griffith (2003) to measure the EATR for international
investment as:
R*n - R n
EATR n =
E(1 + π n )pn
1+ i
Where R n is defined above and R *n , the pre-tax economic rent, is obtained as follows:
R *n =
pn - r
(1 + r )
In section 3, we will use Devereux and Griffith (2003)’s analytical framework to derive
the cost for the public authorities to grant investment incentives.
3. Assessing the impact of public policy
By and large, public authorities use both fiscal and financial incentives to directly
stimulate capital formation. In this paper we pay attention to two of these incentives that
are commonly used in regional policy, i.e. lowering the corporate tax rate and granting a
capital subsidy. These two instruments necessarily affect the public treasury. In order to
evaluate their relative efficiency, we develop a methodology aimed at measuring the
amount of public expenses associated with a lowering of the corporate tax rate and the
granting of a capital subsidy.
10
3.1 The public costs
In Devereux and Griffith (2003)’s analytical framework public policies affect the
post-tax economic rent R earned by the shareholder, whereas the pre-tax economic rent
R* principally depends on the real financial return of the investment project, which is
exogenous in the model. Accordingly any change of the corporate tax rate or of the
capital grant modifies the tax wedge between the pre- and post-tax economic rent. This
change in the tax wedge corresponds to the variation of the tax revenue for the
government and therefore represents the public cost generated by the policies. However,
since the pre-tax economic rent remains constant whatever the policy, the costs for the
public authorities to grant a tax cut or a capital grant can be derived from the sensitivity
of the NPV of the post-tax economic rent respectively to the corporate tax rate and the
rate of capital subsidy. Let us consider first the costs associated with a variation of the
tax rate before deriving the costs for the government to grant a capital subsidy.
Table 2 presents the analytical expressions of the public cost generated by a lowering of
the corporate tax rate () in a domestic setting. The cost varies according to the
investment financing used by the firm: retained earnings, new equity or debt. As we
consider the viewpoint of public authorities, the discount rate used is the public
opportunity cost,  * .
TABLE 4: Public cost of lowering the corporate tax rate (C) – domestic setting
Retained
Earnings
CRE 




RtRE

d 
( Ad   )  *   (1   )    ( p   )(1   ) d

1 *




New Equity
 R RE F NE
CtNE   t  t
 




* ( 1   )
*
d 
(
A


)



(
1


)



(
p


)(
1


)

 d
d

1  *
1  *

Debt
 R RE F D 

C D   t  t d 
( Ad   ) *   ( 1   )    ( p   )( 1   )  ( 1    g )i   *  i( 1   ) d
 
 
1  *






For the public authorities, the costs incurred in modifying the corporate tax rate by d is
determined by the sensitivity of the post-tax economic rent in present value to the
corporate tax rate, R/. The extent of the tax cut, d, will be discussed further.6
6
See Table 5.
11
For all sources of investment finance, the direct effect of lowering the corporate tax
rate7 is to increase the before-personal tax revenue of the investment. However, this
effect is indirectly lessened by a reduction of the tax savings due to immediate
expensing
( A
d

as
well

as
to
depreciation
allowances.
The
term

  )  *   (1   )    ( p   )(1   ) d in the expressions above reflects both direct and
indirect effects.
When the firm uses external finance, i.e. new equity or debt, additional cash flows
(respectively FNE and FD) modify the economic rent and, therefore, the public costs. For
both new equity and debt, a lower corporate tax rate reduces the value of the immediate
tax allowance ( ) that can be claimed on the additional cash flows. In case of debt
financed investment, this effect is still reinforced by the declining of tax savings due to
the deductibility of interests from the tax base (1-)i.
Table 3 now shows the analytical expressions of the public cost associated with the
granting of a capital subsidy in a domestic setting. The capital subsidy is defined net of
any corporate tax.
TABLE 2: Public cost of granting a capital subsidy (Cg) – domestic setting


RtRE

dg 
 *   ( 1   )   dg
*
g
1 
Retained Earnings
C gRE 
New Equity
 R RE F NE
C gNE   t  t
 g
g

Debt
 R RE F D
C gD   t  t
 g
g




 
* ( 1 
*
dg  



(
1


)




*


1 *
1  



)

dg




dg  
 *   ( 1   )     *  i( 1   ) dg
*

1



In Table 3, dg stands for the extent of the capital grant. Compared with the former
policy, the public cost is here independent of the real financial return, p. The rate of
capital subsidy only applies to the value of the investment effectively used by the firm,
which is the difference between the investment value in periods t and t+1. This is
expressed by 1-[(1-δ)(1+π)/(1+ρ*)]. However, since the capital subsidy is granted in the
7
That is d < 0.
12
first period, it can be used to finance a proportion of the investment, therefore reducing
the amount of external finance the firm has to raise.
Similarly, we derive the analytical expressions of the public costs associated with both
incentives in an international setting. Firstly, when the subsidiary finances the
investment using retained profits, the cost for the public authorities to grant a corporate
tax cut and a capital subsidy is respectively equal to:
C RE
nτ =
∂R RE
n
∂τ n
d=
γj
1 + ρ*
{(1-jn)[(Ad+n)[(1+*)-E(1-)(1+)]-E(pn+)(1+)]-[(1-n)E(pn+)(1+n)-
(1-A)[(1+n)-E(1-)(1+n)]]
∂
σ jn
∂
τn
}d
(10)
(1-jn)[(1+*)-E(1-)(1+)]g dg
(11)
and
C RE
ng =
∂R RE
n
∂g
dg=
γj
1+ ρ
*
where * stands for the public discount rate.
Table 4 displays the expressions of the sensitivity of Fj and Fn for various sources of
investment finance. Public costs associated with a corporate tax cut and a capital
subsidy (granted in the host country) are then respectively worked out by
C nτ =
∂
Fj ∂
Fj ∂
∂
R RE
Fn
∂
R RE ∂
Fn
n
and C ng = n +
.
+
+
+
∂
τn
∂
τn ∂
τn
∂
g
∂
g
∂
g
13
TABLE 3: Values of the additional cost of the parent company (Fj) and the subsidiary (Fn)
raising external funds – sensitivity to a host country corporate tax rate and capital subsidy
Source of parent finance
Retained
earnings
New
equity
Debt
∂
F RE
∂
F RE
j
∂
τn
∂F jNE
∂τ n
∂F D
j
∂τ n
j
=0
=
ρ * (1 - γ j )
(1 + ρ * )
=–
∂F jNE
n
∂g
γ j (ρ * - i(1 - τ n )
(1 + ρ * )
n
Source of subsidiary finance
∂F RE
Retained
n
=0
earnings
∂τ
∂τ n
New
equity
=
∂τ n
Debt
[
∂
σ jn
∂
τn
=
∂g
ρ * (1 - γ j )
(1 + ρ * )
=–
γ j (ρ * - i(1 - τ n )
(1 + ρ * )
n
∂g
=0
γ j [E - (1 + ρ * )]
(1-nn-g)
∂FnNE
∂F D
j
=
∂F RE
n
∂FnNE
=0
∂
g
∂FnNE
(1 + ρ * )
∂
σ jn
∂
τn
γj
1 + ρ*
Z-(jn+
-jnn
{(1-nn-g)
∂ω jn
∂τ n
∂g
∂FnNE
∂g
)Ei]-n[jnZ-Eijn]
=–
=
γ j σ jn
(1 + ρ)
[E-(1+*)]
γ j (1 - φ n τ n - g)
(1 + ρ * )
{jn[E(1+i(1-n))-(1+*)]-Ejni}
(1) Z = [E(1+i(1-n))-(1+*)];
(2) The sensitivity of jn to a corporate tax change is equal to zero for both the exemption and
deduction systems. It is equal to [(j-n)-(1-n)]/(1-n)2 for the tax credit method with deferral, in
ω jn ∂
τ n = –n for all
the absence of excess credit (i.e. j>n). For interests remittances, ∂
international tax relief methods.
The effects on the public cost of granting a corporate tax cut or a capital subsidy in an
international setting can be interpreted in a similar way as in the domestic investment
case.
In addition to the sensitivity of the NPV of the post-tax economic rent, the public cost
associated to a tax cut or the granting of a capital subsidy is determined by the extent of
these incentives, respectively noted dτ and dg. This extent obviously depends on the
objective adopted by the government, as well as on the ability of the policy instruments
to achieve this objective. This is discussed in Section 3.2.
14
3.2 The extent of public incentives
Traditionally, the effectiveness of investment incentives has been apprehended through
their impact on the effective marginal tax rate. Some recent works show however that if
the EMTR proves to be an appropriate indicator of the level of investment, discrete
investment decisions principally depend on the average effective tax rate. So, as pointed
out by Giannini and Maggiulli (2002), both average and marginal approaches are
important but they serve different purposes: the former captures the effects of taxation
on the location decisions (and other discrete choices) while the latter detremines the size
of investment, once the location decision has been made. In terms of regional policy,
whether it seeks to attract non-local firms’ investment projects or rather to expand
investment demand of firms already settled in the region, the government will pay
attention to the effective average or marginal tax rates, respectively. Both objectives are
considered in this contribution. Accordingly the extent of public interventions,
expressed by d and dg respectively for lowering the corporate tax rate and granting a
capital subsidy, can be analytically apprehended first by the differential of the EMTR
(dEMTR) and then by the differential of the EATR (dEATR). For the sake of simplicity,
each investment incentive will be examined separately. The expressions of the
differentials and the extent to which each policy has to be implemented are shown in
Table 5.
TABLE 4: Calculating the extent of public incentives (d and dg)
Differential
EMTR
dEMTR 
(marginal approach)
EATR
(average approach)
dEATR 
EMTR
EMTR
d 
dg

g
EATR
EATR
d 
dg

g
Extent of the policy
 EMTR 
d  dEMTR

  
1
 EMTR 

dg  dEMTR
 g 
1
 EATR 
d  dEATR

  
1
 EATR 

dg  dEATR
 g 
1
A numerical example will help us go further in the analysis.
15
4. Applications
In order to illustrate the relevance of our approach and to solve the indetermination
of the analytical expressions derived in Section 2, we shall consider the following
scenario, which captures the main tax devices in force in Belgium. The corporate tax
rate () amounts to 33.99% for distributed profits as well as for retained earnings and
there is no double tax relief for dividends (the classical system is implemented). The
personal tax rates are equal to 15% both for interest (mi) and dividend income (md).
Capital gains are not taxed at the individual level. The pattern allowed for tax
depreciation is the straight-line method. We suppose that the life-time of capital is 10
years. We also consider that an immediate tax allowance can be claimed at the rate of
10% (). Finally, the following parameters are used to characterise the economic
environment: the real interest rate (r) and the inflation rate () are respectively equal to
6% and 1.5%. The capital depreciation rate () is supposed to be exponential and equal
to 20% and the public opportunity cost (*) is set at 4%.
As already mentioned the cost for the public authorities to grant a tax cut or a capital
subsidy depends on two elements. The first one is the unit cost associated to each of
both policies. It is the increase generated by a one-percent-change of the corporate tax
rate or the rate of the capital subsidy. The second element measures the variation of
both public instruments. This variation depends on the objectives pursued by the
government to stimulate investment, either the lowering of the EMTR or of the EATR
to a determined percentage. The results will therefore be presented successively
according to these channels.
4.1 Lowering the effective marginal tax rate
Table 6 shows the public costs associated with a tax cut and a capital subsidy, when
the government aims at lowering the effective marginal tax rate by one point of
percentage. We distinguish but the three sources of finance, various real financial
returns of the investment.
16
TABLE 5: Public cost (in cents) associated with a corporate tax cut and a capital subsidy, when
the government aims at lowering the EMTR by one point of percentage
Investment profitability (p)
Corporate tax cut
(C)
Capital
subsidy grant
(Cg)
Cost of capital
20%
40%
Retained Earnings
0.075
0.184
0.355
New Equity
0.109
0.226
0.437
Debt
0.008
-0.174
-0.417
Retained Earnings
0.052
0.052
0.052
New Equity
0.078
0.078
0.078
Debt
0.029
0.029
0.029
What are the main results? As shown in Table 6, the public cost associated with the
granting of a capital subsidy (Cg) is invariant whatever the profitability of the
investment is. It only depends on the value of the investment and therefore is not
affected by the rate of return of the investment. For debt financing, the public cost is
equal to 0.029 cent per euro invested. It rises to nearly 0.078 cent for an issue of new
shares. An investment financed by retained earnings induces a cost of 0.052 cent per
euro of private capital.
On the contrary, the public cost associated with a corporate tax cut (C) varies with the
profitability of the investment. This result was expected because the corporate tax rate
applies to the total capital income. It is useful to distinguish according to the source of
investment financing. For retained earnings and new equity, the higher is the real
financial return of the investment, the more expensive is the public policy generated by
a lowering of the corporate tax rate. When the investment is financed by debt, the
results in Table 6 show an opposite pattern. The cost borne by the public authorities
becomes lower as the financial return of the investment increases. Positive for the
marginal investment, the public cost becomes even negative as the financial return rises
to 20% and 40%, which means that the policy generates an additional fiscal revenue for
the government.
How to explain these latter outcomes? Broadly speaking, whatever the source of
finance, lowering the corporate tax rate has a direct impact on the firm’s tax liability.
However, this effect is lessened by the reducing of the tax savings due to immediate
expensing and depreciation allowances. In addition, when the investment is financed by
17
new equity or by debt, other indirect effects occur. By reducing the value of the tax
rebate which can be immediately claimed on external finance, the tax cut increases the
amount of new equity and debt the firm has to raise. Finally, this negative effect is still
reinforced in case of debt financing: it reduces the tax savings due to the deductibility of
interests from the tax base. In this respect, it is a priori difficult to determine which
effect will prevail.
In our scenario, as shown in Table 7, the government willing to reduce by one point of
percentage the effective marginal tax rate of an investment financed by retained
earnings or new equity has to lower the corporate tax rate by 1.03 or 1.27 point of
percentage, respectively. However, in case of debt financing, we observe paradoxical
results. The addition of the various indirect effects of a tax change (on immediate
expensing, depreciation allowances and deductibility of interests from the tax base)
invites the government to rise the corporate tax rate by 1.47 point of percentage. Table 7
shows the extent of the capital grant change (dg) and of the corporate tax rate change
(d) required to reduce the EMTR by one point of percentage.
TABLE 6: Corporate tax rate change and capital subsidy required for a lowering of one point of
percentage of the EMTR
Corporate tax rate change (d)
Capital subsidy (dg)
Retained Earnings
- 1.03
+ 0.28
New Equity
- 1.27
+ 0.41
Debt
+ 1.47
+ 0.15
The values for dg and d are expressed in points of percentage.
The same conflicting effects affect the unit cost of changing the corporate tax rate.
However, the unit public cost also depends on the financial return of the investment.
Combining the direct and indirect effects of the corporate tax cut on the extent of the
policy and on its unit cost, as well as the level of the investment profitability, explains
the results shown in Table 6. Especially, for an investment financed by debt and
generating a pre-tax financial return equal to 20% or 40%, the increase of the corporate
tax rate provides the public authorities with an additional fiscal revenue, respectively
equal to 0.174 and 0.417 cent per euro invested. However, when the investment
18
profitability is equal to the cost of capital, the public cost associated with the rise of the
corporate tax rate is close to zero. More precisely, it amounts to 0.008 cent per euro
invested. In this latter case, the tax base is large enough so that to equalize the
additional tax revenue the increase of the tax allowances value resulting from a higher
corporate tax rate.
What is the most efficient investment incentive when the government aims at lowering
the effective marginal tax rate? When the investment is financed by retained earnings or
by new equity, granting a capital subsidy is the least costly policy. The public cost
associated with a tax cut is superior to that of a capital grant and increases with the
profitability of the investment. In case of debt financing, the results are quite different:
whatever the rate of profit of the investment, raising the corporate tax rate is more
efficient than granting a financial subsidy. For the projects, whose profitability is just
sufficient and accordingly returns are close to the capital cost, raising the corporate tax
rate implies a positive public cost, but this cost rapidly becomes negative as the real
financial return of the investment increases. Therefore, in no case, our results show that
decreasing the corporate tax rate is an efficient approach to expand local investment
demand.
19
4.2 Lowering the effective average tax rate
Alternatively, public authorities can choose to reduce the effective average tax rate
in order to attract non-regional firms’ activities. As shown by Devereux and Griffith
(2003), discrete investment choices do depend on the level of the average effective
taxation, while the effective marginal tax rate is expected only to affect the size of the
project. However, policies aiming at raising regional attractiveness towards “foreign”
investors is obviously targeted (at least partially) to foreign direct investments (FDI),
which are typically productive of an economic rent.8 Accordingly, we shall consider
now investment undertaken by the subsidiary of a foreign multinational company.
However, we shall firstly consider as an intermediate step the domestic setting. This
should enable to make the transition to an international setting easier.
4.2.1. The domestic setting
Table 8 shows respectively the public cost associated with a corporate tax cut and with a
capital subsidy in a domestic setting. Both incentives are granted in order to lower the
effective average tax rate by one point of percentage. We still consider three sources of
finance (retained earnings, new equity and debt) and various real financial returns of the
investment.
TABLE 7: Public cost (in cents) associated with a corporate tax rate cut and a capital subsidy,
for a lowering of one point of percentage of the effective average tax rate – domestic setting
Investment profitability (p)
Corporate tax cut
(C)
Capital
subsidy grant
(Cg)
8
Cost of capital
20%
40%
Retained Earnings
0.090
0.213
0.406
New Equity
0.106
0.213
0.406
Debt
0.013
0.220
0.407
Retained Earnings
0.063
0.174
0.349
New Equity
0.076
0.172
0.344
Debt
0.049
0.193
0.386
More often than not, FDI is indeed undertaken to exploit some firm specific advantage, such as a patent.
20
As shown in Table 8, whatever the source of finance of the domestic firm, public costs
associated with a corporate tax cut and with a capital subsidy rise as the profitability of
the investment increases. These results significantly differ from the public costs
presented in Table 6.
How to explain these differences? As mentioned before the public costs are the result of
the product of two elements: the unit cost and the extent of the policy. The former,
which corresponds to the measure of the post-tax economic rent, is invariant whether
the policymakers seek to lower the EMTR or rather the EATR. Conversely the extent of
public intervention does depend on the variable chosen by the government to stimulate
investment. Table 9 shows the extent of public incentive (d and dg) required to reduce
the EATR by one point of percentage.
TABLE 8: Public policies that are required to lower the effective average tax rate of one point
of percentage
Investment profitability (p)
Corporate tax
cut (d)
Capital subsidy
grant (dg)
Cost of capital
20%
40%
Retained Earnings
-1.235
-1.189
-1.176
New Equity
-1.238
-1.195
-1.180
Debt
2.478
-1.862
-1.432
Retained Earnings
0.336
0.936
1.872
New Equity
0.395
0.895
1.791
Debt
0.253
0.992
1.985
The values for d and dg are expressed in points of percentage.
From Table 9 and unlike the previous case, i.e. when the government aims at lowering
the effective marginal tax rate, we notice that the change in each instrument that is
required to lower the EATR of one point of percentage varies with the investment
profitability. On the one hand, the extent of the capital subsidy augments when the rate
of the real financial return of the investment increases. In other words, the sensitivity of
the EATR to the rate of capital subsidy lowers when the investment profitability
increases. Conversely, the extent of the tax cut always decreases as the predicted return
of the project becomes higher.
21
These results derive from an interesting property of the EATR highlighted by Devereux
and Griffith (2003). As the rate of the investment profitability increases, the EATR
becomes more and more determined by the rate of corporate taxation. This is intuitive:
“for very profitable investment projects, allowances become insignificant: the only
relevant factor is the rate at which income is taxed”.9 Therefore, lowering the EATR
requires a more and more higher capital subsidy as the rate of profit increases.
Conversely, the more profitable is the investment, the lesser should be the extent of the
corporate tax cut. However, for poorly profitable investments financed by debt, the
government should actually raise the corporate tax rate in order to obtain a reducing of
the EATR by one point of percentage.
This property of the EATR directly accounts for the results in Table 8 relative to the
public costs of the policy instruments. A capital subsidy is more costly as the financial
return of the investment increases. On the other hand, we observe that the public cost
associated to a lowering of the corporate tax rate also increases with the level of profit.
Although the required extent of the tax cut may be less important, the fiscal losses are of
growing importance as the rate of profit of the investment grows.
As before, granting a capital subsidy appears to be a better policy choice than lowering
the corporate tax rate. However, for marginal and lightly profitable investments
financed by debt, the public authorities should raise the corporate tax rate. This effect,
previously explained, comes from the greater extent of the tax change on the various
allowances than on the tax liability.
4.2.2. The international setting
Is foreign direct investment determined by tax policy and public incentives? As
Morisset and Pirnia (2001) point out, once other fundamental factors (such as political
and economic climates, availability of labour, infrastructure, etc.) have provoked the
decision to set up production facilities in a broad area, the more precise location
decision may be strongly affected by fiscal and financial incentives. 10 Devereux and
Griffith (1998), in an earlier study regarding US multinationals, show similarly that the
9
Devereux and Griffith (2003), p. 113.
Morisset and Pirnia (2001), p. 10.
10
22
effective average tax rate is a significant factor in location decisions in regional or subregional level, conditional on producing in Europe.11 Accordingly, public authorities
willing to attract FDI within their region should seek to reduce the effective average tax
rate (EATR).
Table 10 shows the cost for the public authorities to grant a corporate tax cut and a
capital subsidy to a subsidiary of a foreign multinational company. 12 We choose to
locate the parent firm in a home country, that is subjected to the tax system that is
defined below. This should allows us to assess in particular the effects of principal
methods of (international) double tax relief. The parent company is owned by individual
shareholders; both are located in the same home jurisdiction. The corporate tax rate at
40% in the parent company. The personal tax rates are equal to 25% both for interest
and dividend income. Individual shareholder are however entitled to a tax credit
representing half of the net dividends. Finally, the following three methods alleviating
international double taxation will be considered: the exemption, imputation (with
deferral) and deduction systems.13
11
Devereux and Griffith (1998), p. 362.
Both incentives are granted in order to lower the effective average tax rate by one point of percentage.
13
We assume that there is no exchange rate variation between period t and period t+1.
12
23
TABLE 10: Public cost (in cents) associated with a corporate tax rate cut and a capital subsidy,
for a lowering of one point of percentage of the effective average tax rate – the case of foreign
direct investment
Corporate tax cut (C)
Capital
cost
Capital subsidy grant (Cg)
40%
Capital
cost
20%
40%
0.3972
0.3570
0.3972
0.0538
0.0538
0.0538
0.1785
0.1785
0.1785
0.3570
0.3570
0.3570
(2) the parent retains funds and issues new equity to the subsidiary
Exemption
0.0724
0.2056
0.3972
0.0538
Credit with deferral
0.0124
0.0411
0.0823
0.0538
Deduction
0.0742
0.2067
0.3982
0.0524
0.1785
0.1783
0.1736
0.3570
0.3567
0.3473
(3) the parent retains funds and lends to the subsidiary
Exemption
0.0160
0.2132
0.4001
Credit with deferral
0.0048
0.0411
0.0823
Deduction
0.0160
0.2152
0.4013
0.1769
0.1783
0.1718
0.3539
0.3567
0.3435
(4) the parent raises new equity and purchase new equity from the subsidiary
Exemption
0.0635
0.2054
0.3970
0.0460
0.1797
Credit with deferral
0.0099
0.0388
0.0777
0.0460
0.1795
Deduction
0.0653
0.2063
0.3979
0.0448
0.1751
0.3593
0.3590
0.3501
(5) the parent raises new equity and lends to the subsidiary
Exemption
0.0103
0.2129
0.3999
Credit with deferral
0.0027
0.0388
0.0777
Deduction
0.0103
0.2146
0.4009
20%
(1) The subsidiary uses retained profits
Exemption
0.0724
0.2056
Credit with deferral
0.0538
0.1785
Deduction
0.0724
0.2056
0.0205
0.0206
0.0199
0.0125
0.0126
0.0121
0.1782
0.1795
0.1733
0.3564
0.3590
0.3465
(6) the parent borrows and purchases new equity from the subsidiary
Exemption
0.0602
0.2039
0.3955
0.0474
Credit with deferral
0.0122
0.0494
0.0988
0.0474
Deduction
0.0610
0.2041
0.3956
0.0474
0.1917
0.1917
0.1917
0.3835
0.3835
0.3835
(7) the parent borrows and lends to the subsidiary
Exemption
0.0093
0.2106
0.3981
Credit with deferral
0.0030
0.0494
0.0988
Deduction
0.0094
0.2110
0.3982
0.1917
0.1917
0.1917
0.3835
0.3835
0.3835
0.0117
0.0117
0.0117
n = 33.99%; j =40%; m in = m dn = z n = 25% ; individual shareholder tax credit = 50% of the net
dividend.
As shown in Table 10, public costs of policies aiming at attracting a foreign direct
investment show a similar pattern to that of incentives implemented in a domestic
setting. What are the main characteristics of our findings? Firstly, public costs
associated with both a corporate tax cut or a capital subsidy increase with the level of
investment profitability. Note however that the size of the tax cut tends to decrease as
the return of the investment increases.14 Secondly, for the host jurisdiction, granting a
capital subsidy is more often than not the efficient incentive compared with a lowering
This comes from the property of the Devereux and Griffith (2003)’s model we mentioned in Section
4.2.1. Appendix shows the extent of both public incentives (d and dg) required to reduce the EATR of a
foreign direct investment by one percentage point.
14
24
of the corporate tax rate. However, for a marginal and a lightly profitable investment,
when the subsidiary is financed by debt, the tax change is the least costly policy. In this
case indeed, policymakers should increase the corporate tax rate.15 As it has been
explained above, the impact of a tax rate change on various tax allowances dominates
the effect on the tax base. These results stand whatever the method mitigating
international double taxation.
On the other hand, when the parent country applies a tax credit system with deferral,
corporate tax cut appears also to be the best policy choice for all sources of investment
financing, apart for the subsidiary using retained profits. Intuitively, this result may be
easily explained. If there is no excess credit16, tax changes in the subsidiary country
only affect the tax base of the multinational firm – via tax credit and allowances – and
leave the global corporate tax rate unchanged. This latter remains indeed equal to the
parent country’s tax rate. Therefore, the only tool the host country’s authorities can still
use to reduce the effective tax burden of the multinational firm consists in raising tax
allowances, i.e. in increasing the corporate tax rate. This seems to be an important result
considering that the tax credit system (with deferral) is precisely implemented in some
major capital export countries such as the United-States17, the United Kingdom or
Japan.
5. Conclusion
For decades, most industrialised countries have implemented some forms of fiscal
and financial instruments to promote local capital formation. This paper has
investigated the efficiency of two instruments commonly used in regional policy: a tax
cut and a capital subsidy. These incentives are expected to produce a double effect on
the economic development of regions: on the one hand, they can expand local firms’
investment demand and on the other hand, they can help attract non-regional firms’
15
See Appendix.
That is when the parent country corporate tax rate is higher than the host country tax rate.
17
By lowering the corporate tax rate and introducing the “income baskets” approach, the U.S. Tax reform
Act of 1986 caused many multinationals to switch to an excess credit position. In this case, the tax regime
is simply transformed in an exemption mechanism. Fiscal policy changes in the home country could
therefore affect the efficacy of source country investment incentives. See Altshuler and Fulghieri (1994).
16
25
activities. In choosing its policy, the government can be sensitive to one or the other of
these objectives. Accordingly, the effectiveness of a tax cut or of a capital grant cannot
be assessed disregarding the option chosen by the government.
Effective marginal and average tax rates have proved to be appropriate indicators to
evaluate the impact of taxation and public incentives on firms’ investment decisions.
The size of the investment directly depends on the effective marginal tax rate, whereas
the average approach is adequate to determine the location choice (or any other discrete
investment decisions generating an after-tax positive economic rent).
The model of effective average taxation, recently developed by Devereux and Griffith
(2003), provides an adequate framework to analyse the efficiency of public incentives.
It allows the calculation of both effective marginal and average tax rates.
Calculating the sensitivity of the expected after-tax economic rent of the investment to
the public incentives, we have derived the analytical expressions of the public cost
associated with a lowering of the corporate tax rate or the granting of a capital subsidy.
This public cost necessarily depends on the effective tax rate – either marginal or
average – that the government aims at lowering to influence firms’ investment
decisions.
The results suggest that, whatever the public authorities’ objective, lowering the
corporate tax rate do not appear to be an efficient policy tool in comparison with the
granting of a financial aid, which is generally the least costly instrument. However,
depending on the level of the project profitability, it should be better for the government
to increase the corporate tax rate in case of debt financing. It is also the case regarding a
foreign direct investment, when the home jurisdiction of the multinational company
applies a tax credit system to relief international double taxation. These outcomes are
explained by the complex interplay of various direct and indirect effects of a tax cut and
the granting of a capital subsidy on the post-tax economic rent of the investment, both
for domestic and international settings.
26
6. References
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on Multinational Corporations”, National Tax Journal, vol. XL, VII, 2, 349-362.
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DEVEREUX, M.P. and R. GRIFFITH (1998), “Taxes and the location of production:
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DEVEREUX, M.P. and R. GRIFFITH (1999), The Taxation of Discrete Investment
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DEVEREUX, M.P. and R. GRIFFITH (2003), Evaluating Tax Policy for Location
Decisions, International Tax and Public Finance, 10 (2), 107-126.
EEC (2001), Company Taxation in the Internal Market, SEC (2001) 1681 Final,
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europa.eu.int/comm/taxation_customs/publications/official_doc/IP/ip1468/comp
any_tax_study_en.pdf
GIANNINI, S. and C. MAGGIULLI (2002), “Effective Tax Rates in the EU
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28
Appendix
Public policies that are required to lower the effective average tax rate of one point of
percentage – the case of foreign direct investment
Corporate tax cut (d)
Tax credit
Capital
cost
20%
40%
(1) The subsidiary uses retained profits
Exemption -0.9411
-0.8926
Credit with deferral -0.9557
-3.1679
Deduction -1.4478
-1.3733
-0.8828
-6.3359
-1.3582
Capital subsidy grant (dg)
Capital grant
Capital
cost
20%
40%
0.2183
0.2217
0.3359
0.7237
0.7350
1.1134
1.4475
1.4700
2.2269
(2) the parent retains funds and issues new equity to the subsidiary
Exemption -0.9411
-0.8926
-0.8828
0.2183
Credit with deferral 2.0439
6.7753
13.5506
0.2209
Deduction -1.5303
-1.3948
-1.3686
0.2985
0.7237
0.7323
0.9896
1.4475
1.4647
1.9792
(3) the parent retains funds and lends to the subsidiary
Exemption 0.3969
-1.3865
-1.0716
Credit with deferral 0.7839
6.7753
13.5506
Deduction
0.5764
-2.1855
-1.6640
0.8089
0.7323
1.0918
1.6179
1.4647
2.1836
(4) the parent raises new equity and purchase new equity from the subsidiary
Exemption -0.9417
-0.8898
-0.8814
0.1902
0.7429
Credit with deferral 1.7780
6.9432
13.8863
0.1926
0.7520
Deduction -1.5356
-1.3879
-1.3653
0.2627
1.0258
1.4859
1.5040
2.0516
(5) the parent raises new equity and lends to the subsidiary
Exemption 0.2061
-1.3797
-1.0695
Credit with deferral 0.4867
6.9432
13.8863
Deduction 0.3033
-2.1686
-1.6591
0.0936
0.0847
0.1263
0.0584
0.0527
0.0796
0.8330
0.7520
1.1361
1.6660
1.5040
2.2721
(6) the parent borrows and purchases new equity from the subsidiary
Exemption -0.9419
-0.8892
-0.8811
0.1844
Credit with deferral 1.7232
6.9777
13.9555
0.1867
Deduction -1.5369
-1.3865
-1.3646
0.2552
0.7469
0.7560
1.0334
1.4938
1.5121
2.0668
0.8380
0.7560
1.1454
1.6759
1.5121
2.2907
(7) the parent borrows and lends to the subsidiary
Exemption 0.1743
-1.3784
-1.0691
Credit with deferral 0.4255
6.9777
13.9555
Deduction 0.2571
-2.1653
-1.6581
The values of d and dg are expressed in points of percentage.
0.0511
0.0461
0.0698
29