The 'benchmark' income tax base discussed in the framework papers offers minimal impact on decisions to invest in marginal assets within a nominal income tax system. Risk aside, a marginal asset provides a pre-tax return matching that available from financial markets. The benchmark tax base reduces the pre-tax return from the marginal asset and that from financial markets by a proportion equal to the investor's tax rate - or, equivalently, the zero pre-tax net present value (NPV) of the investment (with discounting at the pre-tax going interest rate) remains zero after tax (with discounting at the pre-tax discount rate reduced in proportion to the investor's tax rate). The investment that is marginal before tax remains marginal after tax.
How is this neutrality outcome affected in circumstances where a depreciable asset is offering an above marginal return (that is, an inframarginal asset)?
The benchmark base maintains the zero pre-tax NPV of marginal investments, thus achieving investment neutrality. The benchmark base would not, however, be expected to maintain the pre-tax NPV of inframarginal investments. Imagine, though, if the effect of the benchmark base were to reduce the pre-tax NPV of inframarginal assets by the investor's tax rate just like its effect on returns from marginal assets. In that case, the NPV of all possible investments - marginal and inframarginal (and submarginal) alike - would be cut in proportion to the investor's tax rate. For marginal investments, zero before tax reduced by the investor's tax rate remains zero after tax. In these circumstances, the benchmark base would be expected to leave investment decisions after tax pretty much as they would have been in the absence of income taxation.
Against this background, the focus on the achievement of a neutral effect of income tax on investment decisions turns to the question whether the benchmark base has a proportional effect on pre-tax returns of inframarginal assets and the nature of that proportion.
INFRAMARGINAL DEPRECIABLE ASSETStart with the marginal depreciable asset depicted in Table 13 (from MyProject). This marginal depreciable asset costs the investor $1000 at the start of period 1. Its value (and its net receipts stream) declines at 15% per period. The investor sells it at the end of period 5 for $443.7. Before tax, the asset’s net receipts steam and sale value discount to the start of period 1 to $1000 using a discount rate of 10% (the going interest rate from financial markets). The before-tax NPV of the asset is therefore zero. Risk aside, the asset is marginal before tax. The 10% it returns is the same as the going interest rate.
Depreciation for income tax purposes, applied to the $1000 purchase price, is allowed at 15% per period on a declining balance basis. The per period depreciation allowances therefore match the per period decline in asset value (or economic depreciation). Moreover, there are sufficient net receipts each period to fully absorb available depreciation deductions. Nominal interest is included in the income tax base.
The features of the taxation situation in this example are consistent with a non-distortive benchmark income tax base incorporating nominal interest. Thus, with the investor facing a 50% tax rate, the 10% pre-tax IRR is reduced to 5% after tax and the NPV of the investment remains zero (with discounting at 5%). Risk aside, the project remains marginal after tax. The 5% return is the same as the after-tax return that the investor could get from the financial markets.
Inframarginal asset
Instead of paying the $1000 up front for the asset in Table 13, the investor is fortunate enough to be able to acquire it for $500 even though the investor knows the asset will still produce the net receipts stream shown in Table 13 in the use the investor has for the asset. Thus, with the asset’s net receipts and sale value unchanged, the asset has been converted from a marginal to an above marginal (inframarginal) asset. In discounted terms, the asset is still worth $1000 to the investor but the investor pays only $500 for it.
Inframarginal asset with difference between asset value and purchase price ignored
Table 14 shows the cash flows of this inframarginal asset acquired by our taxpayer on a 50% tax rate with economic depreciation allowed for tax purposes starting with the $1000 up-front value of the asset based on the asset's future cash flows produced in the use to which the investor puts the asset. Thus, the stream of (economic) depreciation allowances in Table 14 is unchanged from Table 13 even though the investor only pays $500 fro the asset. Consistent with discounting principles – see Mayo (1984), Appendix 1 – applicable in the context of economic depreciation, the asset now has a NPV of $500 before tax (with discounting at 10%) and the after tax NPV (with discounting at 5%) remains at the $500 computed before tax. The wrinkle here, however, is that while the depreciation allowances reflect the true $1000 up-front asset value of the asset in the use the investor has for it, the $500 benefit to the investor (immediate income to the investor) of paying only $500 for the asset has not been taken into account.
What would be the effect of taxing up front the difference between the $500 asset cost and $1000 asset value?
Inframarginal asset with difference between asset value and purchase price in tax base
Table 15 shows the effect of applying the full effect of the benchmark treatment to our inframarginal asset. This is the same as applying immediate mark-to-market arrangements for tax purposes which would capture not only year-by-year asset value changes but also the up-front value differential. The year-by-year change in asset value (economic depreciation) is still allowed for tax purposes as in Tables 13 and 14. But, in Table 15, the economic income reflected in a $500 payment for a $1000 asset is incorporated up front. Thus, the taxpayer on a 50% tax rate pays an extra $250 tax up front.
The effect of this is to reduce the $500 before-tax NPV of the investment (with discounting at 10%) in proportion to the investor’s 50% tax rate to $250 after tax (with discounting at 5%). A neat result supportive of neutrality of investment decisions after tax as discussed in Mayo (1984) where the impracticability of taxing the difference between up-front cost and value is also noted. Beyond the impracticability of this, in practice, the 15% declining balance depreciation applicable to the type of asset involved would be applied to the $500 that the investor paid for the asset - not some theoretical $1000 reflecting the value to the investor of the asset in the investor's intended use for it. The key practical question becomes: what are the implications of 15% declining balance being applied to the $500 cost of the asset when the economic value of this inframarginal asset is $1000 (and declining at 15%)?
Inframarginal asset with declining balance depreciation applied to purchase price
Table 16 shows our inframarginal investment with 15% declining balance depreciation (the depreciation arrangements that would match economic depreciation if applied to the $1000 up-front value of the asset) applied to the $500 paid by the investor for the asset. This time the $500 pre-tax NPV is reduced after tax by less than the 50% tax rate proportion. The post-tax NPV is $291 a reduction of 41.8% from the $500 pre-tax level.
The 0.582 ratio of the investment's $291 post-tax NPV to its $500 before-tax NPV matches that ratio predicted from equation (11) in Mayo (1984, Appendix 3) revised by substituting into equation (11) relevant details from Table 16: the 50% tax rate, the 15% rate of asset value decline and the 5 years that the inframarginal asset is held by the investor. Equation (11) in Mayo (1984, Appendix 3) revised shows that the proportional reduction in NPV after tax depends only on the going interest rate and the investor’s tax rate and, if the asset is held for longer than one period, on the rate of asset value decline and the period held.
Thus, so long as rates of write-off allowed depreciable assets approximate rates of decline in actual value, the proportional reduction in pre-tax NPV of inframarginal depreciable assets is independent of the unique characteristics of each asset in terms of cost, net receipts stream and sale value - and depends on the investor's tax rate, the going interest rate and the period the asset is held. Again, this points to after-tax investment decisions relating to inframarginal assets being broadly in line with what decisions would have been in the absence of tax (though with some push towards longer holding of assets).
OVERVIEWSay an investment has a pre-tax NPV of zero at a discount rate of 10% and therefore a pre-tax return of 10%. With the 'benchmark' income tax base in play, the post-tax NPV should stay at zero with a discount rate of 10x(1-investor’s tax rate)% – and therefore the 10% pre-tax return should be reduced in proportion to the investor’s tax rate to 10x(1-investor’s tax rate)%. Ignoring risk, the project remains marginal after tax.
More generally, the investment might have a NPV greater than zero before income tax at a discount rate of 10% (and an return greater than 10%). Risk aside, the project is more profitable than a marginal investment before tax. In other words, the present value of the future cash flows of the project is more than the up-front capital costs faced by the investor. The question of interest is how the 'benchmark' income tax base affects the post-tax NPV of the inframarginal project in the context of a post-tax discount rate of 10x(1-investor’s tax rate)%:
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