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Part 2  
Evaluation Report

Marginal Effective Tax Rates on Business Investment: Methodology and Estimates for Canadian and US Jurisdictions

Introduction

The decision to invest is highly sensitive to the rate of return generated by the asset. Taxes imposed on businesses affect the rate of return and hence the amount of investment undertaken. While the statutory corporate income tax rate is a key indicator of how the tax system is affecting investment, it does not paint a complete picture. The effective tax rate on investment can be different because of deductions and credits available through the corporate income tax system as well as other taxes paid by corporations, such as capital taxes.

These considerations have led to the development of what are known as marginal effective tax rates (METRs) in order to provide a comprehensive indicator of the impact of the corporate tax system on the decision to invest. METRs can also give a perspective on how the tax system is affecting the allocation of investment by type of asset and by industry. Finally, a comparison of METRs in various jurisdictions provides an indicator of how taxes are affecting the distribution of investment within Canada and of the international competitiveness of the Canadian tax system.

Since 2000, the federal government has substantially reduced taxes on business investment while improving the tax structure. The motivation for these tax reductions has been to increase investment and productivity and ultimately raise incomes and living standards of Canadians.

In a globalized economy, the impact of tax reductions on internationally mobile capital is a key determinant of their effectiveness. Implemented and planned tax reductions would result in a combined federal-provincial-territorial statutory tax rate that is considerably lower than its US equivalent by 2010. But when all elements of the tax system are taken into consideration, the Canadian advantage narrows significantly. In addition, the overall advantage hides large differences across jurisdictions in both countries, making it more difficult to assess the overall impact of the corporate tax system on competitiveness.

Recent federal tax policy initiatives have improved the tax structure by:

The analysis undertaken in this study indicates, however, that variations remain in the tax burden on new investment across jurisdictions, assets and industries. These variations can distort investment choices, which harms economic performance.

Marginal Effective Tax Rates-Methodology

A marginal effective tax rate is a forward-looking indicator of the tax burden on new investment. It includes not only the statutory tax rate but also deductions and credits associated with purchasing capital goods (e.g. interest expense and capital cost allowance) and other taxes paid by corporations, such as capital taxes. A METR measures the extra return on an investment required to pay corporate-level taxes, expressed as a percentage of the total return on the investment.[1]

Tax Parameters

The METRs presented in this study capture the following elements of the tax system:

  • Statutory income tax rates.
  • Research and development (R&D) tax incentives.
  • Interest deductibility.
  • Investment tax credits.
  • Capital cost allowances.
  • Capital taxes.
  • Inventory accounting methods.
  • Retail sales taxes on capital goods.

The METRs exclude property taxes and other business taxes imposed by municipal governments[2]. The main reason for their exclusion is that part of local taxes represents a fee for services received, but data limitations preclude determination of the fee-for-service element.

Most of the items listed above are well-known elements of the tax system, but some background information on capital cost allowances, inventory accounting and retail sales taxes is helpful in understanding their impact on METRs.

Capital cost allowance

(CCA) is a deduction for tax purposes that recognizes the annual expense resulting from the depreciation of a capital asset over its useful life. CCA rates will therefore have an impact on the METR only to the extent that they do not accurately reflect the useful lives of assets. In the METR model, the useful lives of assets are approximated by economic depreciation rates developed by Statistics Canada.

The choice of inventory accounting methods can influence tax liabilities. There is usually a lag between when goods are produced and when they are sold. Under first-in, first-out (FIFO) accounting, the cost of goods sold is determined by the cost of the oldest inventory item, i.e. the first in. As a result, in an inflationary environment, company profits and taxable income are higher than if the cost of goods sold were determined by current production costs, which would be well approximated by the last item placed in inventory, as it is in the last-in, first-out (LIFO) inventory accounting convention. This difference in taxable income results in a higher METR under FIFO accounting than under LIFO. Firms are permitted to use LIFO accounting for tax purposes in the US but not in Canada.

Retail sales taxes

are imposed not only on consumer spending but also on intermediate materials and capital goods used by businesses. Most retail sales tax structures provide some exemptions for capital goods, particularly for machinery and equipment. Nevertheless, the effective retail sales tax rate on capital inputs was about half of the nominal rate in both Canada and the US in 2000. As a result, retail sales taxes have a substantial impact on the METR on capital. In contrast, under value-added taxes (such as the goods and services tax/harmonized sales tax and the Quebec sales tax) the effective tax rate on capital goods is virtually zero.[3]

The federal, provincial and territorial tax parameters used in the model are presented in Annex A and their US counterparts are presented in Annex B.

Economic Assumptions and Caveats

Calculation of METRs also requires making assumptions about the financial cost of capital and a number of other economic variables. The financial cost of capital is a weighted average of the return on debt and equity paid by firms. The weights are determined by the economy-wide debt-equity ratio of approximately two-thirds. The returns on debt and equity are measured in real terms (i.e. observed returns are reduced by the inflation rate, assumed to be 2%) and adjusted for risk. The adjustment for risk recognizes that suppliers of capital require a premium for investing in riskier assets, but in the long run expect to obtain the same real, risk-adjusted rate of return on all investments.[4] Note that these economic assumptions are used to develop estimates for both Canada and the US in order to restrict Canada-US comparisons to differences in the tax systems in the two countries. That is, the comparisons examine the impact of applying the Canadian and US corporate tax systems to the same investment in Canada.

While METRs are the most comprehensive measure of the impact of corporate taxes on the rate of return and hence the decision to invest, they do have two important limitations.

The METRs presented in this study exclude mining and the extraction of oil and natural gas as well as financial institutions.[5] In addition, the aggregate estimates exclude the impact of R&D tax incentives since a relatively small number of firms receive most of the benefits. R&D incentives are discussed in the context of their impact on METRs in industries that invest intensively in R&D. Finally, the estimates apply to large firms only.

Measuring the Competitiveness of a Tax System

The statutory tax rate on corporate income is often used as an indicator of how the tax system is contributing to retaining and attracting internationally mobile capital. It is readily available for international comparisons, highly visible and easily understood. In addition, comparisons of statutory rates provide a key measure of the incentive for multinational enterprises to shift taxable income across international boundaries.

The marginal effective tax rate combines in a single measure the key elements of the overall corporate tax structure, including the statutory tax rate that applies on corporate income, factors that affect the tax base such as capital cost allowances, and profit-insensitive taxes such as capital and sales taxes. As a result, it is a more comprehensive indicator of tax competitiveness than the statutory rate.

There are, however, circumstances in which the statutory rate is a more relevant indicator of competitiveness. A key assumption underlying the METR calculations is that the investment has an expected rate of return, adjusted for risk and inflation, equal to the minimum return required by the suppliers of financial capital. While this appears to be a reasonable assumption for firms already active in the Canadian market, it has been argued that foreign direct investment generates rates of return that are above the minimum required rate. As noted in the text, firms investing with the expectation of earning substantially more than the minimum return would be particularly sensitive to differences in statutory rates.

These considerations suggest that it is important to consider both the statutory rate and the marginal effective tax rate when assessing the competitiveness of a tax system.

Evolution of the National METR in Canada

In 2000, the combined federal-provincial-territorial effective tax rate on a typical marginal investment by a large firm was estimated to be approximately 45% (Chart 1). Policy decisions since 2000, together with those proposed in the 2005 federal budget, would have the effect of reducing the METR at the end of the federal government's five-year planning horizon in 2010 by about a quarter, to just under 33%. Federal initiatives would reduce the METR by 9.7 percentage points, which amounts to 80% of the total decline from 2000 to 2010. The statutory tax rate reductions proposed in Budget 2005 would contribute 2.4 percentage points to the decline in the METR.

Chart 1 - Impact of Recent Corporate Tax Reductions on the Canadian METR*

Since 2000, the federal government has:

In Budget 2005, the federal government proposed a reduction in the general corporate income tax rate of a further 2 percentage points to 19% in 2010 and the elimination of the 4% corporate income surtax (equivalent to a 1.12-percentage-point reduction in the general rate) in 2008.

Key tax reduction initiatives at the provincial level have been:[6]

As a result of these initiatives, the structure of taxation in Canada will improve substantially by 2010. Capital taxes, which are a particularly damaging way to raise revenues,[7] will add 2 percentage points to the national METR in 2010, down from 6.4 percentage points in 2000 (Chart 2).[8] Note also that the federal corporate income tax METR will decline by a third from 2000 to 2010.

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Canada-US Comparison

The statutory rate reductions implemented since 2000, coupled with the proposed reductions announced in Budget 2005, would give Canada a 6.2-percentage-point advantage over the US by 2010 (Table 1). METR calculations show that Canada's advantage is reduced to about 2 percentage points when the effect of other elements of the tax system on business investment is factored in[9] (Chart 3). Canada's statutory rate advantage is eroded by other elements of the corporate tax system, notably provincial/state capital taxes, investment tax credits and inventory accounting practices. Note also that the Canadian statutory tax rate advantage is reduced by interest deductibility, since deductibility is worth more in the US given the higher statutory tax rate.

Table 1
Statutory Tax Rates on Corporate Income-Canada and the US Combined Federal/Provincial/Territorial-State


Canada

US

Difference 
(Canada-US)


(%)

(% pts)

2000

General income

43.4

39.4

4.1

Manufacturing

34.7

39.4

-4.7

Combined

39.5

39.4

0.1

2010

General income

32.2

39.4

-7.1

Manufacturing

31.2

36.5

-5.3

Combined

31.9

38.0

-6.2


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In both countries, capital cost allowances are, on average, somewhat higher than warranted by the useful lives of assets, thereby putting downward pressure on the METR.[10] This effect is slightly more pronounced in the US than in Canada, which causes an erosion of 0.4 percentage points in Canada's statutory rate advantage.

As discussed earlier, firms are permitted to use LIFO inventory accounting for tax purposes in the US but not in Canada. Survey information indicates, however, that LIFO inventory accounting is used by less than half of US firms, in part because only taxable firms experiencing rising inventory values can reduce tax liabilities by adopting LIFO inventory accounting. Further, there are disadvantages associated with switching accounting methods, so a potential reduction in taxable income may not be sufficient to induce firms to adopt LIFO accounting.[11] In the absence of solid information on the use of LIFO accounting, the estimates in this study are based on the somewhat arbitrary assumption that half of taxable US firms use LIFO. As a result, the increased flexibility in inventory accounting gives the US an METR advantage of 0.9 percentage point.

In Canada, five provincial governments impose capital taxes, while in the US about one-third of the states have capital taxes. As a result, capital taxes subtract 1.4 percentage points from Canada's statutory rate advantage in 2010.[12]

Almost all US states impose retail sales taxes that affect the price of capital goods, while only five Canadian provinces do so. Although sales taxes add to the Canadian advantage overall, they put the five provinces that levy retail sales taxes at a disadvantage relative to most US states-the average effective sales tax rate on capital goods is 3.5% in the five Canadian provinces compared to 2.8% on average in the US.

In Canada, investment tax credits (ITCs) offered by the federal government (the Atlantic investment tax credit) and by Saskatchewan, Manitoba and Prince Edward Island reduce the national METR by 0.9 percentage points. In the US, 19 states offer ITCs,[13] which reduce the US national METR by 1.5 percentage points.

US tax reductions since 2000 have played only a minor role in reducing Canada's statutory rate advantage. While the US did introduce temporary increases in tax depreciation, the only permanent change has been a 3.15-percentage-point reduction in the tax rate on manufacturing and processing income, which will reduce the US overall METR by 1.1 percentage points by 2010.

The statutory income tax rate reductions proposed in the 2005 federal budget would make a substantial contribution to the improvement in Canada's competitive position. In the absence of these reductions, Canada's 1.9-percentage-point advantage would be transformed into a slight disadvantage (see box below).

Planned Policy Changes Would Create a Canadian Advantage

Planned corporate tax reductions would establish a Canadian METR advantage by 2010 (see chart). Legislated and proposed policy initiatives are projected to reduce the Canadian METR by 5.1 percentage points from 2005 to 2010.

  • At the federal level, completing the phase-out of the capital tax by 2008 and implementing the tax cuts in Budget 2005 would trim 4.2 percentage points from the METR by 2010.
  • At the provincial level, Ontario's decision to halve its capital tax by 2010 (and eliminate it by 2012) would subtract 0.7 percentage points from the METR while Quebec legislation reducing its capital tax by 50% (and making up the revenue loss through a higher corporate income tax rate) would cause the national METR to fall 0.2 percentage points by 2010.

The US METR is projected to decline 0.7 percentage points from 2005 to 2010, when a 3.15-percentage-point reduction in the federal tax rate on manufacturing and processing income is fully implemented. The net impact of planned tax reductions would therefore be to change a 2.4-percentage-point Canadian disadvantage in 2005 to a 1.9-percentage-point Canadian advantage in 2010.

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Estimates by Asset and Sector

There is substantial variation in METRs for the major asset groupings (machinery and equipment (M&E), non-residential buildings, engineering structures and inventories) under the US tax system, but the variance is much less pronounced in Canada (Chart 4). In the US, the highest effective rate is on buildings, reflecting a large gap between tax and economic depreciation rates. M&E is subject to substantially higher taxation via sales taxes than buildings and engineering assets. This non-neutral treatment distorts the composition of investment, which harms economic efficiency. The relative uniformity of effective tax rates in Canada reflects the net outcome of several factors: differences in the extent of accelerated depreciation, which raises the METR for buildings; retail sales taxes that fall disproportionately on M&E; and the absence of LIFO inventory accounting.

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Since asset use is not the same across industries, the differences in effective tax rates by asset contribute to the substantial variability in METRs by industry observed for both countries (Chart 5). Other factors contributing to sectoral variability of METRs include:

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Tax competitiveness in manufacturing is often a particular concern since a substantial portion of both international trade and foreign direct investment occur in that sector. This concern may, however, be overstated given the strong linkages between manufacturing and a wide range of service industries, as manufacturers work with designers, software companies and other service sector firms to bring products to market.

With these linkages and the benefits of avoiding tax-induced distortions in mind, the federal government's approach to tax competitiveness is to provide low, common income tax rates for firms in all sectors while improving the tax structure by, for example, eliminating the particularly damaging capital tax. This approach was evident in the Government's proposal in Budget 2005 to implement further broad-based statutory rate reductions in response to the US tax reduction for manufacturing and processing industries.

As in the case of the aggregate METR, Canada's statutory tax rate advantage in manufacturing is eroded by provincial/state capital taxes, less generous investment tax credits and the absence of LIFO accounting. Canada's advantage in manufacturing METRs widens when R&D incentives are included[14] (Chart 6). But as stated earlier, most of these incentives are received by a relatively small number of firms operating in a narrow range of manufacturing industries.

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In recognition of the substantial spillovers on the rest of the economy, investment in R&D is subsidized by the tax system (as indicated by significant negative METRs on R&D in Table 2)[15] in Canada and the US. In particular, labour and other current expenditures, which together represent much of the R&D asset, are eligible for an R&D tax credit in both countries. The net tax subsidy is much larger in Canada largely because the investment tax credits in the US are generally limited to current expenditures exceeding a firm-specific base amount, whereas the credits apply to all current and capital R&D expenditures in Canada. In addition, all Canadian jurisdictions except Quebec allow the immediate write-off of capital assets (except buildings) purchased in order to undertake R&D while normal tax depreciation schedules apply in the US. Note, however, that purchases of eligible tangible capital account for less than 10% of R&D expenses. The substantial subsidy provided to R&D results in a negative total METR for R&D intensive industries in Canada and a total METR for these industries that is less than half the rate in other manufacturing industries in the US (Chart 6). The impact of procurement policies and government grants on R&D is not included in this comparison.

Table 2
Canada and US METRs for R&D Intensive Industries


Canada

US

Difference (Canada-US)


(%)

(% pts)

METRs

Total assets

-3.4

11.4

-14.8

Tangible assets 31.7 29.8 1.9
R&D -53.7 -17.0 -36.7

Sensitivity Assessment

The METR estimates for Canada and the US presented above are developed from a common set of assumptions about inflation, the financial structure of firms, the required rate of return on investment, and the useful lives of assets. Assumptions must also be made about how best to model the impact or utilization of various tax measures in the two countries.

Changes in the common assumptions will affect Canada-US comparisons because they interact with the tax system. Differences in statutory rates play a particularly important role in this context. For example, a lower required rate of return would decrease tax payable in both countries, but relatively more in the US because of a higher statutory rate. As a result, the Canadian advantage declines slightly to 1.5 percentage points with a 1-percentage-point decrease in the required rate of return (Chart 7). Similarly, the deductibility of interest expense reduces the after-tax cost of debt financing, so a decrease in the share of debt relative to equity would increase the METR in both countries, but relatively more in the US because of the higher statutory rate. With 100% equity financing, which is an assumption often used by firms to assess specific projects,[16] Canada would have a more substantial advantage over the US (Chart 7).

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The financial cost of capital to firms is calculated assuming that Canadian personal taxes affect the required return to savers.[17] Given the global nature of capital markets, however, it could be argued that the marginal supplier of financial capital to Canadian firms is a foreign saver, such as a taxable individual from the US. The relationship between the personal tax rate on interest and the rate on equity in the US is, however, quite similar to that in Canada, so there would be little impact on the required return to suppliers of financial capital from making this change. Given the large pool of capital held in tax-exempt accounts (pension funds and registered retirement savings plans), it would also be plausible to assume that the marginal supplier is non-taxable. Making such an assumption would increase the rate of return and, as indicated in the previous paragraph, slightly widen the Canada-US advantage (Chart 7).

Changes in the inflation rate have more complex interactions with the tax system. Higher inflation causes nominal interest rates to rise, which lowers the METR in both countries (but relatively more in the US) through the impact on interest deductibility.[18] Higher inflation also reduces the real value of CCA, which is specified in nominal terms, thereby boosting the METR. The net effect arising from interest deductibility and CCA expressed in nominal terms is a small rise in the METR in both countries, but the absence of LIFO accounting puts additional upward pressure on the METR in Canada, causing the Canada-US gap to edge down (Chart 7).

The METR estimates are sensitive to the gap between CCA rates and useful lives, which are approximated in the model by economic depreciation rates provided by Statistics Canada. Based on the official Statistics Canada estimates, CCA rates in both Canada and the US are on average more than adequate to reflect useful lives. These depreciation rates are, in part, based on analytical work undertaken in the 1980s and hence do not reflect recent developments.[19]

Statistics Canada therefore launched a review of economic depreciation rates in order to make use of more recent data gathered by the agency. Analysis undertaken to date strongly suggests that the official economic depreciation rates are too low, which means that useful lives of assets are overstated.[20] While these updated results are preliminary, further revisions are likely to be small compared to the observed increase relative to the current official estimates. As a result, the METRs reported in this study are based on the preliminary updated estimates of economic depreciation rather than the official estimates. The revised rates raise the Canadian METR by 11 percentage points[21] and result in much more uniform METRs across assets (Chart 8). Note that CCA rates remain, on average, adequate to reflect useful lives.

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The provisions of the alternative minimum tax (AMT) may also affect the US estimates. The METR methodology assumes that firms are able to make immediate use of all deductions and credits related to capital investment; but in some cases the AMT will cause firms to delay using deductions and credits, thereby reducing their value and increasing the effective tax rate.[22] The AMT affects firms that control a material portion of the capital stock, but these firms are subject to the AMT for only a short period of time,[23] which would result in a relatively small impact on the effective tax rate.

Sensitivity Analysis: Summary

METR estimates are sensitive to the assumptions made about:

  • Economic variables such as the inflation rate.
  • The financial structure of the firm, particularly the extent of debt financing or leverage.
  • The real rate of return earned on the marginal project.
  • The best way to model the impact or utilization of the various tax measures in the two countries.

As a result, the METRs presented in this paper should be viewed as reasonable estimates within a range of possible values.

Estimates for Provinces, Territories and States

METRs are highly variable across jurisdictions in Canada, ranging from approximately 14% to almost 40% (Chart 9). Investment tax credits are important in the Atlantic provinces, reflecting the federal Atlantic investment tax credit (AITC) as well as an additional ITC provided by Prince Edward Island.[24] The federal corporate income tax METR is not the same in all jurisdictions, even excluding the AITC, due to differences in the composition of investment, while the variance in the provincial income tax METR reflects differences in tax rates. Capital taxes and sales taxes on capital inputs add considerably to variability across jurisdictions. Note that the METR in Ontario will decline by 2 percentage points in 2012 when the phased elimination of the provincial capital tax is completed.

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The manufacturing METR in most jurisdictions is below the US average (Chart 10). Investment tax credits are generally restricted to manufacturing and natural resource industries, so they have a dramatic impact on tax competitiveness: the federal AITC reduces the manufacturing METR in Atlantic Canada by 30 percentage points on average while Manitoba's ITC trims the METR almost 25 percentage points.

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There is also considerable variation in manufacturing METRs across US states. The variance primarily reflects the impact of investment tax credits, sales taxes and capital taxes, all of which are implemented at the state level. Chart 11 shows manufacturing METRs for nine US regions (see Annex C for state METRs presented by region). State ITCs have a substantial impact on the METRs in five regions, reducing the METR in these regions by approximately 6 percentage points on average.

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Conclusion

This paper reports estimates of METRs for all jurisdictions in Canada and the US. The key findings flowing from this analysis are:

These conclusions come with a number of important caveats. First, METRs apply to large taxable firms making an investment that is small relative to the ongoing operations of the firm. Second, the investment is assumed to earn just enough to pay suppliers of financial capital the minimum rate of return.Third, the Canada-US comparison is affected by changes in economic assumptions. Despite these limitations, METRs are a useful summary indicator of how the tax system affects the return on an investment and hence the decision to invest.


Notes:

1. A detailed description of the METR methodology is available in Patry, A. and D. Lemay, "Marginal Effective Tax Rates for Canadian and US Jurisdictions: Methodology and Estimates," Department of Finance Canada Working Paper, forthcoming. The pioneering work on Canadian METRs is presented in: Boadway, R., N. Bruce, and J. Mintz (1984), "Taxation, Inflation, and the Effective Marginal Tax Rate on Capital in Canada," Canadian Journal of Economics, vol. 17, p. 262-79. The methodology and estimates are also discussed in McKenzie, K., M. Mansour, and A. Brûlé (1998), "The Calculation of Marginal Effective Tax Rates," Working Paper 97-15, prepared for the Technical Committee on Business Taxation, Department of Finance Canada; Jung, J., "The Calculation of Marginal Effective Corporate Tax Rates in the 1987 White Paper on Tax Reform," Working Paper 89-6, Department of Finance Canada. [Return]

2. In contrast to Canada, municipalities in some US states impose sales taxes or corporate income taxes as well as broad-based property taxes. This is an issue in at least nine states, including California, New York and Pennsylvania. The amount of revenue raised appears, however, to be small relative to total corporate taxes imposed by the federal and state governments. [Return]

3. The only exceptions to the zero-tax status of capital goods are road vehicles less than 3,000 kg. used by business in Quebec. [Return]

4. The risk-free rate of return on debt is assumed to be 6%, which is the average return on Government of Canada 10-year bonds over the 10-year period ending in 2004. The risk-free return on equity is not observed in the marketplace. It can however, be estimated by imposing the long-run condition that the return on debt and equity, net of personal taxes, be equal and then calculating the implicit gross-of-tax return on equity. Average personal tax rates of 24.9% on bonds and 16.2% on equity (dividends plus the effective rate on capital gains), along with 6% return on debt, imply a gross-of-tax risk-adjusted return on equity of 5.4%. Given a 60% share for equity financing, the weighted average return to suppliers of financial capital is 5.6% in nominal terms and 3.6% in real terms. [Return]

5. Modelling natural resource industries and financial institutions raises a number of unique issues that are still under review. The estimates will be made public when this review is complete. [Return]

6. Mesures proposed after September 15, 2005, are not included. [Return]

7. See "Taxation and Economic Efficiency: Results From a General Equilibrium Model," Tax Expenditures and Evaluations, 2004, Department of Finance Canada. [Return]

8. Since no substantial changes to provincial retail sales taxes on capital goods are expected over the 2000-2010 period, they become a larger share of the total tax burden. [Return]

9. Recall that Canadian economic assumptions are used to develop METRs for both the US and Canada. [Return]

10. This comparison does not include the impact of inflation on the real value of CCA. [Return]

11. A survey of 600 large publicly traded firms conducted by the American Institute of Certified Public Accountants (AICPA) indicates that the share of firms using LIFO accounting for some or all of their inventories declined from 47% in 2000 to 42% in 2003. Less than 4% of firms in the sample used LIFO exclusively while 14% used LIFO for less than 50% of inventories on average over the 2000 to 2003 period. See AICPA, Accounting Trends and Techniques, 58th edition, 2004, p. 177. For a discussion of reasons why firms choose particular inventory accounting methods, see Cushing, Barry E. and Marc J. Leclere, "Evidence on the Determinants of Inventory Accounting Policy Choice," The Accounting Review (April 1992), p. 355-66. Reasons cited by taxable firms for choosing FIFO (or average cost) over LIFO include concerns about reporting lower net income and a lower value of inventories on the balance sheet; declining inventories from either price or volume effects; and higher bookkeeping costs. [Return]

12. Elimination of Ontario's capital tax in 2012 will narrow this gap to roughly 0.5 percentage points. [Return]

13. ITCs designed to promote regional development within a state are not included. [Return]

14. 65% of R&D spending takes place in manufacturing industries. [Return]

15. The METR is not calculated in the same way for R&D assets as for other capital assets. The reason for the difference is that R&D is an asset produced, not purchased, by firms. R&D is undertaken using labour (researchers), capital (scientific equipment and buildings) and current expenditures on such items as heating and lighting. The tax treatment of all three inputs determines the METR on R&D. In the absence of any tax incentives, the METR on R&D labour and other current expenses is zero since they are deductible expenses, and the METR on R&D capital is similar to that on other purchased capital assets. The tax credit payable on labour and other current expenditures results in negative METRs for these inputs. In Canada, the combination of tax credits and immediate deductibility results in a negative METR for capital costs as well. [Return]

16. Project analysis differs from the METR framework in two other important respects. First, required rates of return are typically not adjusted for risk. Second, the project is a stand-alone investment, so the entity undertaking it cannot take immediate advantage of all deductions and credits during the early years of operation, when profits are non-existent or low. This increases the effective tax rate on the project relative to the METR framework, which assumes the investment is small relative to the ongoing operations of the firm. [Return]

17. More precisely, the relationship between taxes on interest income and equity determines the relationship between the gross-of-tax rates of return on bonds and equity. See footnote 4. [Return]

18. Note that higher inflation does not directly affect the required real return on financial capital. [Return]

19. A case in point is the depreciation rate for computers. The official Statistics Canada data indicate that the depreciation rate for computers is 30%, which implies a useful life of approximately seven years. There is, however, widespread recognition that useful lives of computers are substantially shorter. Budget 2004 therefore increased the CCA rate on computers to 45%, which is broadly consistent with a useful life of five years. [Return]

20. See Gellatly, G., M. Tanguay, and Y. Beiling (2002), "An Alternative Methodology for Estimating Economic Depreciation: New Results Using a Survival Model," Productivity Growth in Canada, Statistics Canada, Cat. #15-204-XPE; Tanguay, M. (2005), "Linking Physical and Economic Depreciation: A Joint Density Approach"; and Patry, A. (2005), "Economic Depreciation and Retirements of Canadian Assets: A Comprehensive Empirical Study," Statistics Canada Working Paper, forthcoming. [Return]

21. The rise in the US METR is somewhat greater. The increase in economic depreciation (net of CCA) raises the required return, which has a bigger impact on the METR given the higher statutory tax rate in the US. [Return]

22. More precisely, the AMT may cause firms either to pay more than their regular tax liability, for which they will obtain a credit against future tax liabilities, or to delay claiming deductions and credits when determining their "regular" tax liabilities. [Return]

23. Firms affected by the AMT are estimated to have accounted for about a quarter of all corporate assets in 1998, down from almost 50% of corporate assets in 1990. The duration on the AMT was, however, no more than two years for about half of affected firms over the 1993-98 period. See Carlson, Curtis P., "Who Pays the Corporate Alternative Minimum Tax? Results from Panel Data for 1987-98," National Tax Association Proceedings, 94th Annual Conference on Taxation (p. 349-356). [Return]

24. ITCs have a large impact on METRs, even when set at an ostensibly low rate of 5% or 10%. The explanation is that the credit provides an upfront benefit based on the purchase price of a capital good, while tax liabilities are related to the profits generated by the asset, which generally amount to a small fraction of the purchase price. [Return]

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