Several temporary provisions affecting the taxation of capital income were adopted in the 2001-2003 period, and further changes may be considered. Congress also enacted general corporate tax cuts in a bill that terminated the extraterritorial income (ETI) provision of the tax law that has been found to be an illegal export subsidy by the World Trade Organization (WTO). This tax revision also included a number of other provisions largely directed at business. This measure indicates the change in the total burden on corporate investment. It can also be compared with tax rates on noncorporate investment to measure the differential between the total tax on investment in the corporate and noncorporate sectors, as well as federal income taxes on owner-occupied housing (which tend to be around zero). While buildings are taxed at rates slightly above the statutory rate, equipment is taxed at rates well below it. The 30% bonus depreciation reduces effective tax rates for equipment, on average, from 26% to 20%; the 50% bonus depreciation reduces the rate to 15%. If these effects are taken into the account, current tax rates are lower and the effect of changes in individual tax rates less important. If the pension and IRA case is taken to be the most reasonable one, then there is a very minimal effect on the distortion between debt and equity due to individual rate changes not only because they benefit both debt and equity but also because the changes are quite small. All forms of business investment benefit from bonus depreciation. The dividend relief provisions (and slightly lower capital gains tax rates) benefit corporate equity, but the lower individual tax rates benefit corporate and non-corporate debt and non-corporate equity. Distortions of Payout Decisions

The dividend relief provision will significantly reduce the favorable treatment of retained earnings by lowering the tax rate on dividends to the tax rate on capital gains. Bonus depreciation has about the same percentage point effect regardless of the tax regime – about two percentage points for 30% bonus depreciation and about four for 50% bonus depreciation. The overall effects on tax burdens are small, however, because these provisions would have covered only manufacturing equipment, estimated to be about 20% to 25% of equipment assets, and about 10% of combined equipment and structures. Overall manufacturing investment would have a reduction in effective tax rate of about 1.5 percentage points – about the same as the depreciation speedup; thus, as in the case of the depreciation provision, the reduction in the total tax rate in the economy would be less than a quarter of a percent. The bills contained provisions in several other areas, including repeal of ETI. The extension of bonus depreciation has already been noted, but the 2003 House bill would also have reduced the depreciation period for leasehold improvements and restaurants, which would lower tax rates on this group of structures' investments (which are currently subject to relatively high rates); these effects are difficult to measure but would be small. Reducing individual tax rates magnifies existing distortions, by favoring debt finance and noncorporate investment.
Several temporary provisions affecting the taxation of capital income were adopted in the 2001-2003 period. These provisions include lower individual tax rates, bonus depreciation (which allows part of the cost of equipment to be deducted upon acquisition), and lower individual income tax rates on dividends and capital gains. Bonus depreciation has expired, but there are some indications such provisions might be included as part of a major tax reform; the other provisions remain currently in effect. This study measures their effect on tax burdens on income from different prospective investments, differentiated by physical type, form of finance, and sector. Further provisions of a permanent nature enacted in 2004 in a bill to eliminate the extraterritorial income (ETI) provision, ruled an illegal export subsidy by the World Trade Organization (WTO), are also discussed.
Effective tax burdens are determined by the statutory tax rate and value of depreciation deductions. Although the 1986 depreciation revision left income from equipment and structures investments taxed at close to the statutory rate (now 35% for large corporations), the fall in inflation and legislative changes led to a growing differential between these assets, with equipment taxed at 26% and buildings taxed slightly above 35%. Bonus depreciation widens that discrepancy, lowering the equipment tax rate to 20% (15%) for 30% (50%) bonus depreciation. The distortions between debt and equity finance within the corporate sector and between the corporate and non-corporate sector investment are narrowed, but only slightly, by the changes, especially if tax exempt financial holdings (through pensions and IRAs) are considered. This small effect occurs because bonus depreciation covers all types of equipment investment (whether financed by debt or equity and regardless of sector), and while dividend and capital gains relief benefits corporate equity, individual rate cuts benefit non-corporate investment and debt-financed corporate investment. There is a significant reduction in the differential rates on retained earnings and dividends, however. The reduction in the total tax rate on investment income in the economy is about two to four percentage points for all individual tax changes and two to four percentage points for 30% to 50% bonus depreciation.
The temporary provisions have mixed effects. All changes reduce the total tax rate and the current favorable treatment of owner-occupied housing. Within the business sector, the dividend relief provisions lead to a more neutral tax system as well, but the effects of bonus depreciation lead to less efficiency because the benefits are confined to equipment. Tax changes in the 2004 tax bill include provisions directed at the manufacturing sector. The tax cuts directed at manufacturing would lower tax rates in that industry by about 1.5 percentage points but they would have a negligible effect on the total tax rate (lowering it by less than a quarter of a percentage point). The bill also contains other provisions (e.g. benefitting foreign source investment) which would lower tax rates, but also include repeal of the ETI which would raise rates. For the aggregate economy, these effects are small, although the changes favor some assets and sectors over others. This report will be updated for legislative changes.