NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Pitfalls in the Construction and Use of Effective Tax Rates

David F. Bradford, Don Fullerton

NBER Working Paper No. 688 (Also Reprint No. r0317)
Issued in June 1981
NBER Program(s):   PE

A cost of capital formula can be a useful tool in estimating the effective tax rate on a dollar of marginal investment in a particular industry. There are a number of procedural issues, however, which can greatly affect the resulting estimates. First, tax rate estimates vary with the interest rate used in the formula. Second, the nonlinearity of tax rate formulas may lead to anomalous results. For example, an investment that is actually subsidized may appear to bear a positive tax. Or, tax rates may become arbitrarily large when the project's rate of return approaches zero. Third, effective tax rate results depend on the assumed relationship between inflation and nominal interest rates. Our conclusion is that much sensitivity analysis and specificity are required in studies that undertake to estimate effective tax rates.

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Document Object Identifier (DOI): 10.3386/w0688

Published: Bradford, David F. and Fullerton, Don. "Pitfalls in the Construction and Use of Effective Tax Rates." Depreciation and the Taxation of Income from Capital, edited by Charles R. Hulten, pp. 251-278. Washington, D.C.: The Urban Institute Press, 1981.

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