Part 1 - AL-Tax

International Taxation HandbookMarginal ETRsForward-looking ETRsETRsBackward-looking ETRsAverage ETRsAverage ETRsMicro dataMacro dataMarginal ETRsFigure 2.1ETRs classification2.2 Forward-looking ETRsThe forward-looking indicators intend to summarize the various provisions ofthe tax codes in a single measure, which assesses the real tax burden on a hypotheticalproject. Given the complexity of tax systems, a central question is whetherwe can obtain an accurate estimate. Before attempting an answer, let us show howthey are constructed.2.2.1 The cost of capitalThe main concept surrounding the marginal ETR is a summary statistic, knownas the ‘cost of capital’, which tries to capture all the features of the tax system. Thecost of capital defines the rate of return that a firm must earn on an investment projectbefore taxes just to break even.Following Auerbach (1983) and Alworth (1988), we present an expression forthe cost of capital from the neoclassical Jorgenson (1963) model. Though the costof capital can be derived from a discrete time model, we will use the more commoncontinuous time formulation. Let us assume a firm producing output using asingle capital input (F(K) and F 0, F 0). The capital goods decay exponentiallyat a constant rate δ. Thus, the capital stock at time t is:teKtδ( ts)∫ Isd s,(2.1)where I s is investment at date s t. By differentiation of the above equation withrespect to t, we obtain the net investment transition equation:iK I δ K .t t t(2.2)The firm’s optimization problem consists of choosing the investment plan at eachtime that maximizes the wealth of its owners. However, since the determination14