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79~ World Bank Discussion Papers
Analyzing Taxes onBusiness Income withthe Marginal EffectiveTax Rate Model
David DunnAnthony Pellechio
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79 I World Bank Discussion Papers
Analyzing Taxes onBusiness Income withthe Marginal EffectiveTax Rate Model
David DunnAnthony Pellechio
The World BankWashington, D.C.
Copyright © 1990The World Bank1818 H Street, N.WWashington, D.C. 20433, U.S.A.
All rights reservedManufactured in the United States of AmericaFirst printing April 1990
Discussion Papers are not formal publications of the World Bank. They present preliminary andunpolished results of country analysis or research that is circulated to encourage discussion andcomment; citation and the use of such a paper should take account of its provisional character. Thefindings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) andshould not be attributed in any manner to the World Bank, to its affiliated organizations, or to membersof its Board of Executive Directors or the countries they represent. Any maps that accompany the texthave been prepared solely for the convenience of readers; the designations and presentation of materialin them do not imply the expression of any opinion whatsoever on the part of the World Bank, itsaffiliates, or its Board or member countries concerning the legal status of any country, territory, city, orarea or of the authorities thereof or concerning the delimitation of its boundaries or its nationalaffiliation.
Because of the informality and to present the results of research with the least possible delay, thetypescript has not been prepared in accordance with the procedures appropriate to formal printed texts,and the World Bank accepts no responsibility for errors.
The material in this publication is copyrighted. Requests for permission to reproduce portions of itshould be sent to Director, Publications Department, at the address shown in the copyright noticeabove. The World Bank encourages dissemination of its work and will normally give permissionpromptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permissionto photocopy portions for classroom use is not required, though notification of such use having beenmade will be appreciated.
The complete backlist of publications from the World Bank is shown in the annual Index of Publications,which contains an alphabetical title list and indexes of subjects, authors, and countries and regions; it is ofvalue principally to libraries and institutional purchasers. The latest edition is available free of chargefrom Publications Sales Unit, Department F, The World Bank, 1818 H Street, N.W, Washington, D.C.20433, U.S.A., or from Publications, The World Bank, 66, avenue d'Iena, 75116 Paris, France.
David Dunn is a consultant to the World Bank; Anthony Pellechio is an economist in the Bank's AsiaRegional Office, Country Department III.
ISSN 0259-210X
Library of Congress Cataloging-in-Publication Data
Dunn, David, 1958-Analyzing taxes on business income with the marginal effective tax
rate model / David Dunn, Anthony Pellechio.p. cm. -- (World Bank discussion papers ; 79)
Includes bibliographical references.ISBN 0-8213-1521-81. Business enterprises--Taxation--Developing countries-
-Mathematical models. I. Pellechio, Anthony J. II. Title.III. Title: Marginal effective tax rate model. IV. Series.HJ2351.7.D86 1990336.24'17'091724--dc20 90-12307
CIP
- iii -
Abstract
Many countries tax business income. Often the statutory tax ratediffers substantially from the effective tax rate because of the many featuresinvolved in calculating taxable income and the frequent use of credits andother taxes on investment. The marginal effective tax rate (METR) model wasdeveloped for calculating the effective tax rates implied by business taxsystems in developing countries. METR has evolved into a flexible tool thatcan calculate effective tax rates for a wide variety of tax policies,investments, and economic scenarios. Studying effective tax rates helps toidentify important relationships and biases created by the business tax code.
METR satisfies Samuelson's (1964) fundamental theorem of taxinvariance and Musgrave's (1959) theorem that the effective tax rate of thecash flow tax is zero. Also any combination of the Samuelson and Musgravecases yields invariant effective tax rates. Departing from these specialcases of neutral taxation, METR reveals some interesting patterns for ordinarytax systems:
* With zero inflation, the statutory tax rate closely approximates theeffective tax rate for ordinary tax systems. But even at a moderaterate of inflation, this approximation deteriorates.
* Indexation restores the close relationship between the effective taxrate and the statutory rate, if the indexation is complete.Indexing depreciation while failing to index capital gains orinterest deductions still leads to highly distorted effective taxrates.
i As one would hope, investment incentives reduce the effective taxrates, but the strength of the incentives depend on some fine pointsin the calculation of taxes.
* Effective tax rates tend to fall when the initial investment ispartially financed with debt. There is a notable exception to thisin the case of the tax holiday.
METR can have practical application for analyzing the effects of business taxsystems in a wide range of countries.
The goal of this paper is to make METR more widely available toindividuals responsible for analysis of taxes on business income. The authorsmay be contacted about obtaining a copy of METR or adapting it to particularsituations. By working with the model while progressing through the paper,the reader should soon be able to design and perform his own studies usingMETR.
- iv -
Acknowledgements
The authors are grateful to the early users of the marginaleffective tax rate model for their comments and encouragement. In particular,we would like to thank Timothy Condon, Abel Mateus, Steven Mink, Ivan Rivera,Roberto Rocha, and Gerardo Sicat. We are especially grateful to Sweder VanWijnbergen, whose exceptional insight into tax policy is responsible for somerecent improvements in the model. Finally, the authors wish to thankArnold C. Harberger and members of the Public Finance Workshop at theUniversity of Chicago for their constructive suggestions. Errors are solelythe responsibility of the authors.
Table of Contents
Page No.
Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Section 1: A Brief Overview of METR . . . . . . . . . . . . . . 5
A. The Parameter Settings and Results . . . . . . . . . . 6B. The Cash Flow and the Marginal Effective Tax Rate
Calculation .... . . . . . . . . . . . . . . . 9
Section 2: Some Insights into Business Income Tax Policy . . . . 11
A. Theoretical Cases with Neutrality Properties . . . . . 13B. Nonindexed Depreciation ... . . . . .... . . . . . 15C. Explicit Indexation . . . . . . . . . . . . . . . . . . 18D. Reduced Capital Gains Taxes . . . . . . . . . . . . . . 20E. Investment Incentives . . . . . . . . . . . . . . . . . 21F. Debt Financing . . . . . . . . . . . . . . . . . . . . 24G. The Sensitivity of Effective Tax Rates to Inflation . . 26H. Policy Implications ... . . . . . .... . . . . . . 27
Section 3: The Model . . . . . . . . . . . . . . . . . . . . . . 29
A. Setting Parameters .29The Physical Investment . . . . . . . . . . . . . 30Operation .32Financing . . . . . . . . . . . . . . . . . . . . 33Inflation . . . . . . . . . . . . . . . . . . . . 35Taxes on Income .35Standard Deductions . . . . . . . . . . . . . . . 38Depreciation . . . . . . . . . . . . . . . . . . . 39Indexation .46Treatment of Debt . . . . . . . . . . . . . . . . 49Treatment of Capital Gains . . . . . . . . . . . . 50Treatment of Losses and Unused Credits . . . . . . 52Treatment of Dividends . . . . . . . . . . . . . . 55Treatment of Retained Earnings . . . . . . . . . . 59Import Taxes . . . . . . . . . . . . . . . . . . . 61Other Taxes .62
Cash Flow Tax .62Excess Profits Tax . . . . . . . . . . . . . 62Property/Wealth Tax . . . . . . . . . . . . . 62
Treatment of Investors . . . . . . . . . . . . . . 63Investment incentives . . . . . . . . . . . . . . 64
Investment Deductions and Tax Credits . . . . 64Tax Holidays on Business Income Taxes . . . . 65
General Tips on Setting Parameters . . . . . . . . 66
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Page No.
B. The Cash Flow .... . . . . . . . . . . . . . . . . . 67The Before and After Tax Cash Flows . . . . . . . 68Supporting Calculations . . . . . . . . . . . . . 69Depreciation Calculations . . . . . . . . . . . . 70
C. Miscellaneous .... . . . . . . . . . . . . . . . . . 72
Section 4: Reproducing the Study .73
A. Surveying the Model .73B. The Base Case .75C. Nonindexed Depreciation .77D. Explicit Indexation .79E. Reduced Capital Gains Taxes . . . . . . . . . . . . . . 80F. Investment Incentives . . . . . . . . . . . . . . . . . 80G. Other Cases. 82H. Theoretical Results .83I. Operating the Macros . . . . . . . . . . . . . . . . . 84
Conclusion .87
Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . 91
Appendix 1: Other Studies that can Benefit by Using METR . . . . 92
Appendix 2: Some Useful Lotus Instructions for Operating METR . 94
Tables . . . . . . . .. 98
Figures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
INTRODUCTION
Many countries tax business income because it is politically
feasible and generates revenue. Despite the widespread use of taxes on
business income, they are difficult taxes to analyze. In fact, before
performing any tax analysis, it is difficult to answer the basic question,
"What is the rate of taxation?' Often the statutory tax rate differs
substantially from the effective tax rate because of the many features
involved in calculating taxable income and the frequent use of credits and
other taxes on investment. Also, economic factors, such as inflation, can
alter the effective tax rate. This paper presents the marginal effective tax
rate (METR) model, a model that calculates effective tax rates.
The authors developed the METR model for their survey work on the
taxation of business income in developing countries. Before long, several
authors of World Bank studies and country reports also found the METR model
useful for their work.l/ Studying effective tax rates helps to identify
important relationships and biases created by the business tax code. Further,
effective tax rates are valuable for making clear, straightforward
presentations on business taxes. And with its history of applications to over
40 countries, METR has evolved into a flexible tool that can calculate
effective tax rates for a wide variety of tax policies, investments, and
economic scenarios.
1/ See the World Bank studies and reports listed in the bibliography.
- 2 -
The principle behind METR is basic. The user specifies a
hypothetical project with a particular internal rate of return before taxes.
METR generates a cash flow for the project, applies the appropriate tax policy
to the cash flow, and then calculates the internal rate of return for the
after tax cash flow. The effective tax rate is the difference between the
before and after tax rates of return, expressed as a percentage of the before
tax rate of return (see Figure 1). This is a contemporary technique and
similar methods have been employed by many economists.2/
The goal of this paper is to make METR more widely available to
individuals responsible for analysis of taxes on business income. The
approach we take simulates the teaching methods we have used with previous
METR users. First we present a brief overview of the model. We then perform
a typical study of business income taxes to show how METR can contribute to
tax analysis. Next, we explain in detail METR's features and provide a self-
tutorial so that the user can develop some operating skills.
METR is a Lotus 123 spreadsheet. Upon request, the authors will
provide a copy of METR. By working with the model while progressing through
the paper, the reader should soon be able to design and perform his own
studies using METR.
The paper is organized as follows. Section 1 contains the overview
of the model. Section 2 presents a study of business income tax policies,
including both theoretical and "real world" cases. The main purpose of this
2/ Most notably, King and Fullerton (1984).
section is to demonstrate METR's usefulness. In fact, in this basic study,
METR provides some unanticipated insights that have important policy
implications.
Section 3 explains each feature of the model. Not only is this
section instructive about METR, but it also points out some interesting
methodological differences in tax policy across countries. This section also
serves as a reference for later work with the model. Section 4 contains the
self-tutorial. It walks the reader through the steps needed to reproduce the
results in Section 2, providing a learning-by-doing opportunity.
The conclusion of the paper discusses the current state and the
potential future of the model. In particular it suggests modifications that
could be pursued to transform METR into a tool for project evaluation or for
cost of capital calculations. It also points to several caveats regarding
METR that the user should be aware of. Two appendices follow the conclusion.
Appendix 1 supplements Section 2, by presenting a list of studies that can
benefit from METR's calculations. This appendix also suggests ways to
approach these studies. Appendix 2 offers some basic Lotus 123 tips for
operating the model.
For the reader who is not particularly interested in operating METR,
yet is interested in gaining some insight into the effects of inflation and
debt financing on effective tax rates, reading Section 2 should be of
interest. A casual reading of Sections 1 and 3 might also be fruitful.
- 4 -
Finally, we should emphasize that METR is still evolving. The
authors have benefited greatly from past suggestions and criticisms. Further
comments are not only welcome, but may very well influence the future
direction of the project. Nevertheless, we believe that METR already has much
to offer. We hope that the following pages are successful in familiarizing
you with METR.
SECTION 1: A BRIEF OVERVIEW OF METR
This overview serves two purposes. First it surveys the model,
making our discussion of METR's features more tangible. Second, it gives us a
chance to run through the effective tax rate calculation. This should remove
any mysterious, "black box" aspects that surround the model's results. In
reading this section, remember that Section 3 covers this material in
detail.3/
METR consists of two parts: the parameter settings and results (see
Table 1) and the cash flow (see Tables 2a-c).4/ The user specifies the
physical project, its operation and financing, inflation, and the tax policy
in the parameter section of the model. METR then generates the cash flow
section from which it calculates the effective tax rate. The results are
reported alongside the parameter settings.
The example in Tables 1 and 2a-c is for the base case in the study
presented in Section 2. The base case represents an ordinary, nonindexed tax
system using the straight-line method for calculating depreciation allowances.
All the "real world" cases in Section 2 are built upon this case. The
parameter settings in Table 1 describe the base case and the hypothetical
project in detail.
3/ If questions arise from the brevity of this discussion, look in Section 3for answers.
4/ Though the volume of parameters may appear daunting at first glance, METRis really quite manageable. The numerous parameters are a sign of METR'sversatility and not a sign of complexity. Most studies using METRrequire the manipulation of only a few parameters. It does not take longbefore the typical user is quite adept with the model.
- 6 -
A. The Parameter Settings and Results
We begin the survey with the parameter settings. The parameters are
grouped together by their general function. Column I contains the parameters
that specify the project and the inflation rate. The project parameters are
divided into physical investment, operation and financing parameters.
The physical investment parameters indicate that the project
consists of four assets: land, buildings, machinery and equipment, and
vehicles. The last three assets depreciate over time and the firm conducts
investment to replace them as they wear out, thus keeping the original
investment intact.
The operation parameters indicate that the firm operates the project
for ten years and then sells it, yielding a before tax rate of return of 20
percent. The firm distributes all of the after tax profits to the investors
during each year of operation. In the year the project is sold, the entire
sale proceeds are used to purchase investors' equity. These last two
parameters allow us to include taxes on dividends, retained earnings and
investors' capital gains in studies using METR.
In Section 2, the above parameters remain fixed at the current
settings. Thus, all the effective tax rates in our study are calculated for
this particular project.
In the example presented in Table 1, the financing parameters
indicate that the investors finance the project entirely from their own
sources (that is, all equity financing), leaving the share of the project
financed with debt equal to zero. In Section 2, we look at results for both
all equity financing and 50 percent equity - 50 percent debt financing. Also
in the current example, inflation is equal to 10 percent per year. In Section
2, we study results for zero and 50 percent inflation as well.
Columns II through IV contain the tax parameters. Basically, these
parameters allow the user to set the rates and define the bases of the taxes
that are being studied. The tax parameters are divided into the main elements
of a business tax system: taxes on income, standard deductions, treatment of
debt, capital gains, losses and credits, dividends, and retained earnings,
import and other taxes, and the treatment of investors. Also, the
depreciation parameters, located below the tax parameters, allow the user to
specify depreciation allowances for each asset.
The tax policy for the base case is fairly straightforward.
Continuing the survey at the top of column II, we see that the statutory tax
rate on income is 45 percent and there are no surtaxes or minimum tax
liabilities. In calculating taxable income, the standard deductions for
wages, cost of materials and depreciation are all allowed.5/ Depreciation
allowances are not indexed for inflation.
5/ For simplicity, we set the wage and materials expenses equal to zero forthe study in Section 2.
- 8 -
As is typical in most market economies, interest paid on debt is
deductible from taxable income, while payments on principal are not. The
current example also treats capital gains as ordinary income, implying that
the capital gains tax rate equals the income tax rate and capital losses can
offset other taxable income. Neither the interest deduction nor the base for
capital gains is indexed for inflation.
The losses and credits parameters at the top of column III indicate
that the firm can carry losses and unused tax credits forward for later use.
Losses can be carried forward for up to five years, while unused credits can
be carried forward indefinitely.6/ Neither of these carryforward provisions
is indexed for inflation.
The remaining tax policy parameters are set equal to zero, implying
that we are not using these features in our analysis.
The depreciation parameters allow the user to specify the
depreciation method and rates individually for each asset. The base case uses
the straight-line method to calculate depreciation allowances for all the
depreciable assets. The depreciation rates and depreciable lives differ
across assets and represent fairly typical values.
The investment incentive parameters are located at the bottom of the
parameter settings. METR allows for investment deductions and credits, as
6/ The maximum duration of a project in the model is 30 years. Thus,setting the carryforward of unused credits equal to 30 years implies thatthese credits never expire.
well as tax holidays. For the base case, these incentives are switched off,
but for other cases studied in Section 2, we activate these incentives. METR
is capable of including other investment incentives in its calculations
through the appropriate setting of various parameters. Section 3 presents
numerous examples of this.
Wrapping up our survey of the parameter page, we find the results
are presented in column V. Here, the effective tax rate is 56.0 percent,
derived from the real before and after tax rates of return ((20.0-8.8)/20.0 x
100Z).
B. The Cash Flow and the Marginal Effective Tax Rate Calculation
The cash flow is divided into three parts: the derivation of the
before and after tax cash flows (see Table 2a), supporting calculations (see
Table 2b), and depreciation calculations (see Table 2c). The parameter
settings for the base case in Table 1 determine the cash flow in Tables 2a-c.
As noted above, the project is operated for ten years and is then sold, thus
producing a cash flow through year 10. In general, METR can analyze projects
operated for up to thirty years.
Here, we limit ourselves to a brief description of the first part
of the cash flow, saving a more thorough discussion of the entire cash flow
for Section 3. Table 2a outlines the procedure for the effective tax rate
calculation. First, based on the project parameters (column I of Table 1),
METR generates a before tax cash flow (lines 3 to 10).
- 10 -
METR then calculates taxable income (lines 12 to 32). The
components of taxable income are added together (lines 12 to 15) and the
deductions are subtracted off (lines 16 to 24) to derive ordinary taxable
income. Line 28 contains restricted deductions that are only allowed to the
extent that there is positive income to offset. That is, these deductions
cannot generate losses. Deductions for dividends are included in this line.
Next, METR adjusts taxable income for losses (lines 30 and 31) to yield actual
taxable income in line 32.
In lines 34 to 44, METR calculates the business income tax, other
taxes that may affect the return to investors and tax credits. Combining the
before tax cash flow (line 10) with total taxes due (line 40) and total
credits available (line 44) yields the net cash flow before distribution (line
46). These profits are then distributed to the investors, through dividends
and purchases of equity, or retained by the firm and distributed in the sale
year (lines 48 to 54). Note that lines 53 and 54 are taxes imposed on
investors.
The after tax cash flow (line 56) reflects the actual payments and
receipts of investors. METR derives the effective tax rate from the rates of
return for the before tax cash flow (linte 10) and the after tax cash flow
(line 56), adjusted for inflation (see lines 66 and 67 in Table 2b).
- 11 -
SECTION 2: SOME INSIGHTS INTO BUSINESS INCOME TAX POLICY
This section presents a study on business income taxes that
demonstrates the usefulness of METR. The original motive for this study was
to provide an example of a study that used various features of the model. But
as the analysis developed, some insights, not fully anticipated by the
authors, became evident. The most noteworthy one is that the effective tax
rate can be highly sensitive to inflation, especially at low and moderate
rates of inflation. Also, the effect of inflation on the real value of
depreciation allowances and on capital gains taxes are responsible for the
high effective tax rates reported in this study. These insights have
important policy implications.
There are three basic ways in which METR assists the user. First,
by generating effective tax rates, one can look for patterns in the results.
In this way, the user can expose relationships and biases in the tax system.
Second, by studying the actual cash flows generated by METR, the user may
discover specific factors that lead to particular results. This is especially
useful when results are not intuitively obvious. The third way is by
isolating a single element in the effective tax rate calculation to determine
how sensitive the results are to changes in this factor. This section
demonstrates all three techniques.
This study evaluates the performance of different business income
tax policies. The cases studied represent five broad categories of tax
policies: theoretical cases with neutrality properties, nonindexed
depreciation, explicit indexation, reduced capital gains taxes, and typical
- 12 -
investment incentives. The "real world" cases are based on actual tax
policies found throughout the developing world.
As we vary the tax policy, the project (described in Section 1) and
the statutory tax rate (45 percent) remain fixed. We produce results for
annual inflation rates of zero, 10 percent and 50 percent and for two methods
of financing, all equity and 50 percent equity - 50 percent debt. Though we
restrict ourselves to this particular line of investigation, the procedure
should still prove to be an enlightening example of how METR performs.71
Table 3 contains the effective tax rates for all equity financing
and Table 4 contains the results for debt financing. At a glance, we can see
that the effective tax rates in Tables 3 and 4 vary substantially, despite the
constant statutory tax rate. Looking more closely at these results, some
interesting patterns arise.
* With zero inflation, the statutory tax rate closely approximates the
effective tax rate for ordinary tax systems. But even at a moderate
rate of inflation, this approximation deteriorates.
* Indexation restores the close relationship between the effective tax
rate and the statutory rate, if the indexation is complete.
Indexing depreciation while failing to index capital gains or
7/ Appendix 1 suggests a number of other studies that can benefit fromMETR's calculations.
- 13 -
interest deductions still leads to highly distorted effective tax
rates.
* As one would hope, investment incentives reduce the effective tax
rates, but the strength of the incentives depend on some fine points
in the calculation of taxes.
* Effective tax rates tend to fall when the initial investment is
partially financed with debt. There is a notable exception to this
in the case of the tax holiday.
We now investigate the tax policies more thoroughly to determine the
important factors leading to these results. The analysis follows Tables 3 and
4. We conclude the analysis with some policy implications.
A. Theoretical Cases with Neutrality Properties
The three theoretical cases serve three purposes. First, they test
the model. Successful duplication of theoretical results assures us that
various features of METR are performing well. Second, these cases represent
neutral systems with invariant tax rates. That is, the effective tax rate
remains unchanged for investments in different assets, inflationary
environments, and levels of debt financing. Thus, these theoretical cases
represent ideal tax systems in the sense that the tax does not bias the choice
of investment or financing. The third purpose concerns the Samuelson result.
This case serves as a good measuring stick in evaluating actual tax policies.
- 14 -
The Samuelson result on tax invariance,8/ simply put, says that if
the tax base is equivalent to real economic income, the statutory rate, 45
percent, equals the effective tax rate. To achieve this result, deductible
expenses must equal real expenses. In particular, depreciation deductions
must equal the real economic depreciation of the assets and interest
deductions must equal real interest payments. A difference in the effective
tax rate from the statutory rate implies that the tax system fails to track
real economic income accurately. For actual tax systems, METR can help locate
the features responsible for such deviations.
The second theoretical case is the cash flow tax. Here, all
outflows of cash are deducted from the tax base during the period in which
they occur, including investment spending and payments on principal as well as
interest. Similarly, all inflows of cash are added to the tax base, including
revenue, the full sale price of assets and borrowed funds. With this tax, the
government, in effect, becomes a silent partner in the project. For example,
with the 45 percent statutory rate, the government virtually owns a 45 percent
share of the investment. The return to the government is equal to the rate of
return to the firm and the effective tax rate is zero.
The idea of a neutral tax with a zero effective tax rate, where the
government essentially becomes a silent partner in the project is attributed
to Musgrave.9/ Musgrave proved his result for the case where the project is
8/ Paul A. Samuelson, "Tax Deductibility of Economic Depreciation to InsureInvariant Valuations," Journal of IPolitical Economy, 72 (December 1964):604-606.
9/ R. A. Musgrave, The Theory of Public Finance (New York: McGraw-Hill,1959), p. 343.
- 15 -
financed entirely with equity. In his proof, investment spending is fully
expensed and the full sale price of the assets is taxed. The cash flow tax is
an extension of his result to allow for debt financing.
In both the Samuelson and cash flow cases, METR performs well. The
effective tax rates remain unchanged as inflation and financing vary. In
fact, under these theoretical cases, the effective tax rates would remain
constant if we were to vary the project itself. Also any combination of the
Samuelson and Musgrave cases yields invariant effective tax rates.l0/ In
Tables 3 and 4, the Harberger neutrality result represents a half and half
combination of these neutral cases. The result is an invariant effective tax
rate of 29.1 percent.ll/
B. Nonindexed Depreciation
Returning to the "real world" cases, we first look at the results
for tax systems with nonindexed depreciation. Outside of Latin America, most
tax systems are not indexed f1or inflation. The tax systems in this category
10/ Harberger (1978), "Tax Neutrality in Investment Incentives,' p. 12.
ll/ The effective tax rate, te, in this case is equal to
te = t 5 (1-a)/(l-at 5 ),
where t5 = the statutory tax rate anda = the share of the investment subject to the cash flow tax.
This relationship results from the fact that the annual after taxincome derived by the investor remains constant, while theinvestor's initial costs decrease as the share of the investmentsubject to the cash flow tax increases. Note that with the cashflow tax, the government reimburses the investors for a portion ofthe initial costs.
- 1.6 -
contain characteristics commonly found in the absence of explicit indexation.
The first two cases in this group represent ordinary tax systems with no
special features. The first, the base case,12/ uses the straight-line method
for calculating depreciation allowances, while the second uses the declining
balance method. The remaining three cases in this group allow for accelerated
depreciation allowances, that is, the shifting of allowances toward the
beginning of an asset's useful life. These accelerated methods are commonly
used to adjust a tax system for inflation, short of explicit indexation.
The results for this group sh:'w that in a noninflationary
environment, ordinary tax systems performq quite well, in that the tax base
closely approximates real economic income and hence the statutory tax rate is
approximately equal to the effective tax rate. The effective tax rates for
the base case and the case with declining balance depreciation are 44.1
percent and 45.8 percent, respectively, with zero inflation and all equity
financing (see Table 3). Similarly, with debt financing, these effective tax
rates are 43.6 percent and 46.3 percent, respectively (see Table 4).
This approximation deteriorates with inflation. The ordinary tax
systems overestimate real economic income and effective tax rates exceed the
45 percent statutory rate. Effective tax rates of the ordinary tax systems
increase by about 11-12 percentage points with all equity financing and 8
percentage points with debt financing as inflation goes from zero to 10
percent, and by roughly 30 percentage points with all equity financing and 20
12/ The other cases in this study are built upoIl the base case. See Section1 for a more detailed description of' the base case.
- 17 -
percentage points with debt financing as inflation goes from zero to 50
percent.
Accelerated depreciation methods compensate the investor to some
extent, but the effective tax rates for these cases are still quite sensitive
to inflation. Here, we look at results for three types of accelerated
depreciation: double declining balance with a switchover to straight-line, a
20 percent initial allowance with full straight-line depreciation, and a 20
percent initial allowance with an adjustment to depreciation and capital
gains.13/ The results show that effective tax rates for these cases are less
than the tax rates for the ordinary cases, but they also increase by roughly
the same magnitude as do the results for the ordinary cases when inflation
increases.
Our first suspicion was that the erosion of the real value of
depreciation allowances caused by inflation was responsible for this
phenomenon. Using METR, we can observe inflation's impact on depreciation
allowances. Figure 2a shows the decline in the real value of depreciation
allowances for the base case as inflation increases.14/ At a zero rate of
inflation, straight-line depreciation allowances actually exceed true economic
depreciation for most of the operating period. For a 10 percent inflation
rate, depreciation allowances slightly underestimate economic depreciation.
This underestimation becomes more severe for a 50 percent inflation.
13/ See the discussion on depreciation in Section 3 for a more detaileddescription of these methods.
14/ The data for evaluating depreciation allowances are generated in the cashflow section of METR.
- 18 -
Figure 2b shows that at a 10 percent rate of inflation, the
accelerated depreciation methods are generous compared to economic
depreciation. But due to their inflexibility with respect to inflation, these
methods underestimate economic depreciation when inflation increases to 50
percent annually (see Figure 2c).
Given this information, the effective tax rates for the nonindexed
depreciation cases indicate that the cleterioration of depreciation allowances
is not the only important factor in the large distortions created by
inflation. For all equity financing, effective tax rates for the accelerated
depreciation cases range from 49.3 percent to 51.7 percent when inflation
equals 10 percent (see Table 3). These rates are above the statutory tax
rate, despite depreciation allowances that are more generous than economic
depreciation. As we shall see, the taxation of purely nominal capital gains
is another important factor causing high effective tax rates.
C. ExplicLt Indexation
We calculate effective tax rates for three examples of explicitly
indexed tax systems. First, we index only depreciation allowances. Next, we
index both depreciation allowances and the base for capital gains. Finally,
we add the indexation of deductions for interest payments on debt. This last
case represents a fully indexed tax system. For all these cases we index
carryover losses.
- 19 -
For the case where only depreciation is indexed, the effective tax
rate continues to rise as inflation increases with all equity financing (see
Table 3). However, this rise in effective tax rates, to 52.5 percent and to
57.4 percent for inflation rates of 10 percent and 50 percent, respectively,
is less severe than those for the nonindexed cases. These results demonstrate
the benefit of maintaining the real value of depreciation allowances, but also
supports our earlier conclusion that another factor is also responsible for
the large distortions arising from inflation.
With all equity financing, the addition of capital gains indexation
leads to stable effective tax rates that are equal to the base case result for
zero inflation and close to the statutory rate (see Table 3). This clearly
indicates that the taxation of purely nominal gains is the other culprit
behind the high effective tax rates in the previous cases with inflation.
This point is confirmed, by comparing the cash flows of these two
indexation policies. Table 5 contains the cash flow for the case when only
depreciation is indexed and inflation equals 10 percent. The depreciation
allowances (line 24) roughly equal the replacement investment (line 3,
excluding year 0), which is equal to economic depreciation in each period.
But notice in line 14, in year 10, the sale year, taxable capital gains equal
207.489 units. These gains are mostly nominal because the base for capital
gains is not indexed.
Table 6 contains the cash flow for the case when both depreciation
and capital gains are indexed. The only difference between this cash flow and
- 20 -
the one in Table 5 is taxable capital gains. Here, capital gains are reduced
to 59.371 units, greatly reducing the firm's tax liability.
Indexing depreciation and capital gains and not indexing interest
payments produces an effective tax rate well below the statutory rate when
there is debt financing and inflation. Here, METR calculates effective tax
rates of 33.8 percent and 25.2 percent for inflation rates of 10 percent and
50 percent, respectively (see Table 4). With inflation, nominal interest
payments exceed real interest expenses, driving taxable income below real
economic income. Nominal interest payments include the implicit amortization
of real principal caused by inflation. In effect, the taxpayer is now allowed
to deduct payments on principal from taxable income.
This was the situation in Mexico after the 1982 tax reform of the
corporation income tax. The generous interest deductions led to a large
increase in debt financing and a real erosion of revenue from the tax. In
1987, Mexico conducted a second tax refo:rm to correct this problem. With the
addition of indexing interest deductions, the tax system is essentially fully
indexed. Effective tax rates stabilize and approximate the statutory tax rate
(see Table 4).
D. Reduced Capital Gains Taxes
Another common feature in business tax systems is a reduced tax rate
on capital gains. Like accelerated depreciation, this may be a makeshift way
to offset the distortions caused by inflation. It could also be meant as an
incentive to encourage a particular investment behavior. For example, many
- 21 -
countries offer reduced capital gains taxes for long term investments. Here
we look at results for a 50 percent reduction in the capital gains tax rate
and a 100 percent exemption from capital gains taxation.
The results clearly indicate that a reduced capital gains tax is a
substantial benefit for the investor. The effective tax rates for these cases
show a marked decrease from the base case results (see Tables 3 and 4). This
further supports our earlier conclusion about the taxation of purely nominal
gains and effective tax rates. But like the cases featuring accelerated
depreciation, the results for the reduced capital gains cases are still
sensitive to changes in the inflation rate.
As a final note on the effects of inflation on depreciation and
capital gains, METR produces explicit evidence on the relative importance of
these effects. With a 100 percent exemption from capital gains taxes and all
equity financing, the effective tax rates are 48.3 percent and 58.5 percent
for inflation rates of 10 percent and 50 percent, respectively (see Table 3).
These compare to effective tax rates of 52.5 percent and 57.4 percent for the
case with indexed depreciation. At the 10 percent inflation rate, the
taxation of nominal gains is more distortionary than unindexed depreciation
allowances, but at the higher 50 percent inflation rate, the unindexed
depreciation allowances are slightly more distortionary.
E. Investment Incentives
Developing countries frequently use investment incentives for a
number of reasons: to attract foreign investors, to increase the
- 22 -
manufacturing of exports, to encourage investment in modern technology, and so
on. METR is useful for quantifying the benefit of typical investment
incentives. Here, we use METR to produce results for a 20 percent investment
deduction, a 20 percent investment tax credit and a five year tax holiday,
each applied to the base case.15/ Though we restrict ourselves to these
cases, METR is equipped to analyze a wide array of investment incentives (see
Section 3).
The results indicate that the investment incentives lower the
effective tax rate from the results for the base case, though none of the
incentives insulate the effective tax rate from inflation. As we would
expect, the investment tax credit is a more generous incentive than the
investment deduction, but the strength of each depends upon some
administrative points. The five year t:ax holiday proves to be a generous
incentive, though, the effective tax rate increases when the project is
partially financed with debt. A look at the cash flow generated by METR helps
to solve this puzzle.
Investment deductions are sometimes administered as a clear benefit,
separate from the capitalizing of the investment expenditure. In this case,
the deduction is subtracted from the tax base and the entire project is then
depreciated. Further, the base for the capital gains tax is not adjusted in
15/ By a 20 percent investment deduction, we mean that 20 percent ofinvestment spending becomes a deductible expense during the current year.The 20 percent investment tax credit means that 20 percent of investmentspending is subtracted directly from current tax liabilities. If theinvestor is able to reap the full benefit of these incentives in thecurrent year, then an investment deduction is equivalent to an investmenttax credit at the rate ic = t x id, where t = the tax rate and id = rateof the investment deduction.
- 23 -
this case. The results for the 20 percent investment deduction show that this
can be a generous incentive. With all equity financing, effective tax rates
decreased roughly 10 percentage points at each inflation rate, when the
deduction is added to the base case (see Table 3).
The benefit of the investment deduction is moderated, when the bases
for depreciation and capital gains are adjusted for the deduction. This
adjustment reduces the base for depreciation and raises the base for capital
gains by the amount of the deduction. In this case, the 20 percent investment
deduction is equivalent to expensing 20 percent of the investment, while the
remainder is depreciated by the straight-line method. This case is similar to
the accelerated depreciation case when an initial allowance is granted and the
base for annual allowances is adjusted. Rather than providing an extra
benefit, allowances are merely shifted toward the beginning of the asset's
useful life.
The results are similar for the investment tax credit, though a tax
credit is a more generous incentive than a deduction. Here, with all equity
financing, effective tax rates decreased roughly 20 percentage points when the
20 percent investment tax credit is added to the base case (see Table 3).
Again, this benefit is moderated when the bases for depreciation and capital
gains are adjusted.
Table 3 also shows that a five year tax holiday greatly reduces
effective tax rates from the base case. Table 4 indicates that the same is
true with 50 percent debt financing. But we observe a curious phenomenon, if
we compare these results across the tables. With debt financing, the tax
- 24 _
holiday is relatively less generous. The cash flow result suggests that the
tax holiday eliminates the main benefit of nominal interest deductions.
Interest deductions are greatest during the initial periods of the project,
but these deductions are no longerll75'relevvith the tax holiday
simultaneously in effect (see Table 7).
This result illustrates one of METR's greatest assets. The result
is not very intuitive, but by studying, the cash flow generated by METR, the
user can gain some understanding of ccnflicting elements in tax policy.
F. Debt Financing
The use of debt financing generally lowers the effective tax rate of
the examples in our study. As we stated in the discussion about interest
indexation, the deduction of unindexed interest payments can become a generous
allowance for tax purposes. This feature is mostly responsible for the lower
effective tax rates that prevail in Table 4 under the inflationary settings.
But there are a couple of subtleties that may curb the benefit of debt
financing.
Debt financing reduces the amount that must be raised directly from
the investors. This amount, the sale of equity in the model, is the base for
the rate of return calculation. Thus a given benefit or cost which is not
affected by debt is amplified in the rate of return calculation when debt
financing reduces the investors' initial outlay. For example, in the zero
inflation case, the effective tax rate for the ordinary declining balance
depreciation example is 45.8 percent wi.th all equity financing. This is a
- 25 -
case where taxable income slightly overestimates economic income. Using debt
financing amplifies this disadvantage, leading to a higher effective tax rate,
46.3 percent, for this case in Table 4.
We can experiment with METR to get a more vivid example. With all
equity financing, the base case produced an effective tax rate of 56.0 percent
with 10 percent inflation (see Table 3). Running METR for this case with 50
percent debt financing, but indexing interest deductions to isolate the pure
impact of debt financing, produces an effective tax rate of 61.4 percent.
Again, the effect of overestimating economic income is amplified with debt
financing.
Several examples show the positive effect of debt financing when the
tax base underestimates economic income. With zero inflation, all of the
accelerated depreciation examples have lower effective tax rates with debt
financing compared to the same results with all equity financing. The
accelerated depreciation lowers taxable income below economic income and debt
financing increases this benefit relative to the owners' investment.
The case of a five year tax holiday discussed above illustrates
another subtlety of debt financing. The timing of deductible interest
payments influences the calculation of effective tax rates. At the beginning
of the project, interest deductions are at their greatest level. At the same
time, taxable income may be low or negative or some investment incentive may
be in effect. This coincidence tends to diminish the benefit of the interest
deductions, especially if the project incurs losses and the firm is not fully
compensated for those losses.
- 26 -
G. The Sensitivity of Effective Tax Rates to Inflation
The high effective tax rates for the nonindexed cases, made us
curious about the sensitivity of effective tax rates to inflation. For every
case that did not explicitly index for inflation, the effective tax rate
increases as inflation increases, regardless as to whether the project is
financed entirely with equity or with 53 percent equity - 50 percent debt. We
can use METR to isolate the impact of inflation on the effective tax rate.
Figure 3 plots the effective tax rates for the base case with all
equity and 50 percent equity - 50 percent debt financing as annual inflation
runs from zero to 100 percent. To produce the data for this figure, we
calculate effective tax rates, while varying inflation and holding all other
parameters constant. Figure 3 shows that effective tax rates rise more
sharply at low and moderate rates of inflation, approaching some asymptote as
inflation increases.16/ At the low rates of inflation, the effective tax rate
is more sensitive to changes in the inflation rate.
This example, as does the above example isolating the pure effect of
debt financing, points out how METR can isolate an element of the tax system
or the economic environment and illustrate the sensitivity of results with
16/ This makes sense. As inflation increases, the real value of nonindexedcomponents of the tax base asymptotically approaches a fixed limit. Realdepreciation allowances fall to zero, real capital gains approach thereal sale price of the assets and real interest deductions equal realinterest plus the original principal.
- 27 -
respect to that element. In this case, the impact of inflation has some
strong policy implications.
H. Policy Implications
This study suggests that the policymaker should consider explicit
indexation of the tax system, even at moderate rates of inflation. Further,
the indexation should be complete, as METR and the Mexican experience
indicate.17/ The basic principle is simply that indexation allows a tax
system to maintain a good approximation of real economic income, yielding
stable effective tax rates.
Although it may appear that the policymaker could design a
nonindexed system with reduced capital gains taxation, accelerated
depreciation, investment incentives, or a limit on deductible interest there
are a number of potential pitfalls to such a scheme. In particular, the
effective tax rates for a nonindexed business income tax system are still
sensitive to changes in the rate of inflation. Given that inflation is seldom
stable, such nonindexed systems will constantly have to be adjusted to
maintain stable effective tax rates. The policymaker should also be aware
that biases in a nonindexed tax system tend to get exaggerated by changes in
the inflation rate, leading to changes in the choices of investments and
financing.
17/ Simplicity is also a worthy goal of a tax system. Harberger shows thatthis goal need not be sacrificed when indexing business income taxes.See Harberger (1982), "Notes on the Indexation of Income Taxes." Foranother method of indexation, see Fiscal Policy and Tax Reform in Turkey,Report No. 6374-TU, World Bank (July 7, 1987).
- 28 -
If the policymaker is still averse to indexing the tax system, he
should be aware of the strong impact on effective tax rates from taxing
nominal capital gains and the deduction of nominal interest payments. In this
case, a reduced capital gains tax and a limit on interest deductions are
appropriate.
We should add a word of caution to these recommendations. These
policy implications are somewhat tentative and would benefit from further
testing of effective tax rates. Because the results in this study point to a
strong influence from the treatment of capital gains, it would be wiseto
study effective tax rates for other projects that have smaller capital gains
relative to annual income.18/ To obtain the most realistic effective tax
rates, one should check the data on the size of actual capital gains relative
to the annual income of firms and choose a project for METR that has similar
magnitudes.
18/ Professor Harberger pointed this out to us.
- 29 -
SECTION 3: THE MODEL
This section describes the model in detail. It serves as a general
reference and as preparation for the learning-by-doing exercise in Section 4.
We hope to convey a thorough understanding of how METR works by presenting
numerous examples that reflect actual tax policies found throughout the
developing world. These examples also point out some methodological
differences in business income tax policy across countries.
METR allows the user to accurately simulate most tax policies that
he will encounter. In the few cases where METR does not explicitly
accommodate a particular situation, a little creativity can usually yield a
close approximation. A thorough understanding of METR's parameters will
assist the user in such endeavors. With the background offered here, the
reader should be able to apply METR to a most any situation.
Like the overview in Section 1, we discuss the parameters first and
the cash flow second. For clarity, we make frequent references to Tables 1
and 2a-c located there. We strongly suggest that the reader check these
references to become thoroughly familiar with METR's features.
A. Setting Parameters
To operate METR, the user must specify the project and the tax
policy. Our tactic is to address each group of parameters individually,
discussing their overall purpose and capabilities and then describe how to set
- 30 -
the parameters. Following this discussion, we offer some general operating
tips on setting parameters.
The Physical Investment
To specify the physical investment, the user must set the shares of
each asset in the total investment, choose whether worn-out assets are
replaced to keep the original investment intact, and set the economic
depreciation rates of the assets. For example, the project in Table 1
consists of four physical assets: land, buildings, machinery and equipment,
and vehicles. The last three assets depreciate over time. The worn-out
assets are replaced each year, thus keeping the original investment intact.
The project can contain up to four depreciable assets and one
nondepreciable one. The user sets the percentage share of each depreciable
asset in the investment. METR automatically assigns the remaining share of
the investment to the nondepreciable asset. The shares of the three
depreciable assets in our study are equal to 40 percent for buildings, 40
percent for machinery and equipment, and 10 percent for vehicles. The
remaining 10 percent goes into the nondepreciable asset, land. In the base
case, the available parameter for a fourth depreciable asset is left equal to
zero.
The user can generate results for a single asset, as well. Simply
set the asset's share equal to 100 percent and the shares of the other assets
- 31 -
equal to zero.191 In their study, King and Fullerton (1984) calculate
effective tax rates for individual assets. To get an effective tax rate for a
project, they then take the weighted average of the effective tax rate for
each asset. For mathematical reasons and convenience, we prefer METR's
ability to analyze a combination of assets.20/
The option for replacement investment allows the user to specify
whether worn-out assets are replaced at the ewd of each period. If the user
chooses not to replace worn-out assets, the productivity of the investment
decays at the same rate as the decay of the physical assets. Because METR
holds relative prices fixed over time, real annual income and the real sale
price of the investment also diminish at this rate (see Figure 4). With
replacement investment, the physical plant remains intact, keeping
productivity constant. In this case, both annual income and the sale price of
the investment maintain their real values (see Figure 4). In our study, we
set METR for replacement investment by setting this parameter equal to 1. A
zero entry would mean that there is no replacement investment.
To complete the physical specifications of the project, we have to
set the real economic depreciation rate for each of the depreciable assets.
These parameters are located in the right-hand column of the depreciation
section (see Table 1). With relative prices held fixed, real economic
depreciation equals physical depreciation, which METR assumes is exponential.
19/ If the single asset is land, then set the shares of the depreciableassets equal to zero and METR will automatically set land's share to 100percent.
20/ See Pellechio, February 1987. The internal rate of return calculation isnonlinear. Thus these two methods yield different results.
- 32 -
Our study uses the physical depreciation rates from Hulten and Wykoff (1981).
For buildings, machinery and equipment, and vehicles, these rates are 3.6
percent, 12.25 percent and 30 percent, respectively. Again, the user is free
to adjust these as he sees fit.
Operation
.The project's operation parameters serve two main purposes. They
complete the information METR needs to determine real revenues and they
perform the managerial decision on the distribution of after tax profits.
This latter feature allows the user to analyze tax policy for corporations and
their shareholders as well as tax policy for unincorporated firms.
Given the specification of the physical investment, three factors
determine real revenues: the real before tax rate of return, wage and
material expenses and the operating period. METR calculates annual income by
adjusting revenues so that the income net of expenses yields the specified
rate of return. In Table 1, the real before tax rate of return is set equal
to 20 percent and, for simplicity, wage and material expenses are set equal to
zero.
METR assumes that the project is operated for a period of time and
is then sold. The "Operating Period" parameter determines the sale year. The
firm sells the project for the value of the assets at the end of the year
specified here. The operating period for the project in our study is ten
years (see Table 1). In general, METR can produce a cash flow for a project
that runs for up to thirty years.
- 33 -
The remaining operational decision is how to distribute the profits,
after taxes and expenses have been paid. METR allows the user to specify the
share of annual profits that are retained by the firm. The remainder of these
profits are distributed to investors as dividends. Similarly, in the sale
year, METR allows the user to specify how the sale proceeds are distributed.
By specifying the distribution of profits, the user can include the tax
treatment of dividends, retained earnings,,[l37peaadnal capital gains in the
analysis. Also, the retained earnings feature can be used to analyze the
impact of the firm's accumulation of funds on effective tax rates. See the
discussion on the treatment of dividends, retained earnings and investors for
a complete description of METR's capabilities in this area.
In Table 1, we distribute all the profits in the current period by
setting the retained earnings parameter equal to zero. Also, the proceeds
from selling the project are entirely used to purchase equity by setting that
parameter equal to 100 percent. One interpretation for these settings is that
the project is operated directly by the investors and not by an incorporated
firm issuing shares (for example, a partnership or proprietorship).
Financing
The project is financed either directly by investors, through the
sale of equity, or by borrowing, through the issuing of debt. If the project
uses debt financing, the user must specify the term of the loan and the
interest rate on debt, though the model normally calculates a default interest
rate. The following two options for debt servicing are also available: a
- 34 -
constant debt-equity ratio over the project's life and an initial period when
only interest is paid.
Setting the financing parameters is fairly straightforward. The
user first selects the share of the original investment financed with debt.
Next, he can choose to keep the debt-equity ratio constant by entering a 1 for
that parameter. The user can also choose to pay only interest for a period of
time before paying off the principal of the loan. To do this, set the "Years
Interest Only" parameter equal to the desired number of years during which the
firm only pays interest. The default setting, zero, for both these parameters
implies that the loan is paid off following a normal amortization schedule.
The loan term parameter determines the number of years in the
amortization schedule. In their work, the authors usually set this parameter
equal to the operating period. If the user is studying an individual asset,
the natural loan term is the depreciable life of the asset.
The interest rate parameter is slightly less transparent. METR sets
the interest rate equal to the before tax rate of return for the project.
Using this interest rate keeps the before tax rate of return constant for any
debt ratio. The user can specify any other rate he wishes, but he should save
the default formula for later use.21/ If the user does use an interest rate
that differs from the targeted before tax rate of return, the realized before
tax rate of return will differ from the target. Nevertheless, METR will still
calculate a valid effective tax rate for the project.
21/ The default formula is (i=(l+BTROR)(l+Inflation)-l), where BTROR is thereal before tax rate of return specified above.
- 35 -
Inflation
METR uses the inflation rate parameter to calculate cash flows in
current units and to convert current units into constant units. METR assumes
that the annual inflation rate remains constant over the entire life of the
project. Any other pattern for inflation would require some reprogramming of
the model. In Table 1, the annual inflation rate is 10 percent.
At this point, the project is completely specified. The remaining
parameters specify the tax system. Basically, METR's features allow the user
to set the tax rate and define the tax base for a series of taxes that are
typically imposed on businesses and investors. The following discussion
clarifies these tasks so that the user can read actual tax code and accurately
simulate it with METR.
Taxes on Income
The income tax is the central feature of the model. The group of
parameters at the top of column II allow the user to set the income tax rate
and activate other taxes related to income. The parameters that define the
income tax base are distributed throughout METR's other parameter groups and
will be discussed in the appropriate places.
Fundamentally, the business income tax base is revenue less
expenses. METR allows for the inclusion of annual income, capital gains and
interest earned on retained earnings in taxable income. Possible deductions
- 36 -
include wages, cost of materials, depreciation, interest paid on debt,
payments on principal, dividends, additions to retained earnings, carried over
losses, import and property taxes, and investment deductions.
METR can simulate three basic types of taxes on income: the income
tax, a surtax and a minimum tax. Again, for each tax, the user sets the tax
rate and defines the tax base.
Setting the income tax rate is usually straightforward. In most
cases, the user simply enters the statutory rate. But sometimes this task
requires a little more thought. For example, there may be a number of income
brackets or categories, each with a different tax rate, and the user must
decide which rate is most appropriate. In Morocco, the agricultural sector is
taxed at a rate well below the manufacturing sector. A cross sectional study
would use a representative income tax rate for each sector. It is also common
to find a progressive rate structure for business income taxes. Again the
user must choose the appropriate rate(s), depending on his investigation. For
example, a marginal effective tax study on the corporate income tax would
probably use the tax rate on the highest income bracket.
Furthermore, some countries may impose additional taxes on income.
Mala'ysia levies a 5 percent development tax on taxable income.22/ In this
case, the income tax rate should equal the statutory rate plus the development
22/ This and many subsequent references to business taxation in developingcountries come from the International Bureau of Fiscal Documentation(IBFD): Amsterdam, the Netherlands. Specific IBFD publications are:WTaxes and Investment in Asia and the Pacific"; 'Taxation in LatinAmerica"; 'The Taxation of Companies in Europe^; and "African TaxSystems'.
- 37 -
tax rate. The user should be aware that some countries refer to these
additional taxes as surtaxes in their tax code. But this is different from
METR's definition of a surtax. The user must read the tax law and determine
the tax base. If the base is taxable income, add the so called "surtax rate"
to the statutory income tax rate.
METR defines a surtax as a tax on the calculated income tax
liability (not an additional tax on the income tax base). A reference to
Table 2a clarifies this point. Table 2a contains the derivation of the before
and after tax cash flows for the base case in our study. Line 34 contains the
income tax due in each period. If there were a surtax, it would be equal to
the surtax rate times line 34. This tax liability would appear in line 35.
To activate the surtax, set the surtax rate and specify the number
of years during which the tax is in effect. For example, entering .1 and 5 in
"Surtax Rate" and "Surtax Years" parameters, respectively, activates a 10
percent surtax for the first five years of operation. If the surtax is
permanent enter 30 into the "Surtax Years" parameter. For the study in
Section 2, none of the tax systems imposed a surtax, so we set these
parameters equal to zero (see Table 1).
Some countries impose a minimum tax obligation. Usually this
obligation is a percentage of gross revenue. If income taxes are less than
this amount, then the minimum tax is applied to make up the difference. To
set this tax, the user specifies the minimum tax as a percent of gross revenue
in the "Min Tax (Z of Rev)" parameter.
- 38 -
Another form of imposing a minimum tax obligation is to place a
lower bound on taxable income. The Colombian corporate income tax system
requires that taxable income is at least as great as the larger of 2 percent
of revenue or 8 percent of the value of the firm's assets. METR allows for
both minimum bounds on taxable income. The user need only ssecify the
appropriate percentage for the "Min Tax Inc (Z rev)" parameter or for
"MinTaxInc (Z assets)" or both and METR will solve for the larger minimum
taxable income. Again, for the study in Section 2, none of the cases impose a
minimum tax or a minimum taxable income, so these parameters equal zero in
Table 1.
Standard Deductions
The standard deductions include wages paid and the cost of
materials. These deductions are virtually universal in that every income tax
system that the authors have seen allow for their deduction from the income
tax base. We have included some general parameters for depreciation in this
group for convenience, though they are less standard. These latter parameters
will be discussed in the depreciation and indexation sections, below.
In general, the user enters a 1 in the appropriate parameter to
activate that feature. For example, to deduct the firm's wage bill, enter a 1
in the "Deduct Wages?" parameter. Entering a zero implies that wages are not
deductible. Similarly, entering 1 in the "Deduct Materials?" parameter
deducts the cost of materials from the income tax base. Of course, the user
is free to experiment with these features.
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Depreciation
Like other expenses, firms are generally allowed to deduct expenses
related to investment spending. But because of the durability of physical
assets, the true expenses related to investment are generally not incurred at
the time of the investment expenditure itself. Rather, assets suffer from
economic depreciation and accounting methods are generally used to calculate
depreciation deductions from taxable income associated with this true expense.
This discussion describes METR's capabilities for calculating depreciation
allowances. It also describes immediate expensing for investment spending,
though technically, this is not a depreciation method.
Depreciation allowances typically fall into three categories:
initial allowances granted in the first year of the depreciation schedule,
annual allowances granted each year, and balancing allowances or adjustments
made when the assets are sold or discarded. The user activates depreciation
allowances by setting the "Deduct Depreciation?" parameter, located in column
II, equal to 1. The user then specifies the depreciation allowances for each
depreciable asset individually, because depreciation rates and, sometimes,
methods differ across assets. The depreciation parameters are located below
the project and tax parameters (see Table 1). Tax systems may also index
depreciation allowances for inflation (see the discussion on indexation). The
discussion here focuses on initial and annual depreciation allowances. We
discuss the balancing adjustment with the treatment of capital gains below.
There are two basic methods for calculating annual depreciation
allowances: the straight-line method and the declining balance method.
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Straight-line deducts from taxable income an equal portion of the asset's
original cost put into the basis for depreciation, each period over the
depreciable life of the asset. For example, consider an asset with a
depreciable life of ten years. With straight-line depreciation, the firm
deducts one-tenth of the original cost of the asset, each year. The declining
balance method, on the other hand, subtracts depreciation allowances
previously granted from the basis for current depreciation. Hence the basis
for an asset and the resulting depreciation allowances decline over time.
With the declining balance method, the depreciable life of the asset is not
fixed and the firm can take depreciation allowances for as long as the asset
is in service.23/
The "Depr Meth?n parameter lets the user choose the method for
calculating annual depreciation allowances. The user sets this parameter
equal to zero for the straight-line method or one for the declining balance
method. The user must also specify the depreciation rate and the depreciable
life with the "Depr Rate" and the "Depr Life" parameters, respectively. For
the straight-line method, the depreciation rate is typically equal to 1
divided by the depreciable life of the asset. For the declining balance
method, the user specifies the depreciation rate for the asset given in the
tax law. Because the depreciable life is open ended, for this case, set the
"Depr Life" parameter equal to 30, the maximum time horizon for the model.
The base case for our study, represented in Table 1, uses the
ordinary straight-line method. The "Depr Meth?' parameter is set equal to
23/ Declining balance depreciation is equivalent to exponential decay indiscrete time.
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zero and the "Depr Rate" and "Depr Life" parameters are typical for the three
assets. For the declining balance case in the study, the 'Depr Meth?" and the
"Depr Life" parameters are set equal to 1 and 30, respectively, for each
asset. The depreciation rates are the same as in the base case.
Because declining balance depreciation continues indefinitely, some
tax systems allow the firm to switch over to the straight-line method to
complete the depreciation process. For example, in both the United States and
the Philippines, firms can initially depreciate investments with the declining
balance method at twice the normal rate and then switch over to straight-line
when it becomes beneficial to the firm. This method, called double declining
balance with switchover, shifts depreciation allowances toward the beginning
of the asset's depreciable life (that is, accelerated depreciation).
To set METR for declining balance with switchover, the user must
enter 1 for "Depr Meth?" and the appropriate rate for "Depr Rate". So far,
these steps are similar to the steps for ordinary declining balance, but now,
instead of entering 30 for "Depr Life", enter the allowable, finite
depreciable life. Finally, to activate the switchover mechanism, enter 1 in
the "Switchovr" parameter. METR automatically calculates the optimal time to
switch over to straight-line.
Initial allowances are typically a percentage of the original cost
of the asset. They are granted, along with annual depreciation, in the first
year of the asset's depreciable life, that is, the period that the asset is
actually put into production. METR assumes that there is a one period lag
between the time an investment is made and when it becomes productive. The
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user specifies the amount of the initial allowance by entering the appropriate
rate in the 'Initial Allow" parameter.
The user must also specify the years during which the initial
allowance is in effect. Most often, initial allowances are a permanent
feature of the tax system, but occasionally they may serve as a temporary
investment incentive. The user can specify the eligible years by entering the
beginning period in the "Initial Yr" parameter and the final period in the
'Final Yr" parameter. For the case where the initial allowance is a permanent
feature, set these parameters equal to zero and 30, respectively.24/ Thus,
replacement investments, as well as the original investment, are eligible for
this allowance.
A subtle, yet significant, point that the tax analyst must be aware
of is that some tax systems grant an initial allowance and then subtract it
from the original cost of the asset when determining the basis for annual
depreciation allowances. With this adjustment, the tax system limits total
depreciation allowances to the original cost (real or nominal) of the asset
and the initial allowance serves as a method for accelerated depreciation.
The user can capture this element of the tax code by entering 1 in the "Adj
Base?" parameter. Setting this parameter equal to zero means that the basis
for annual depreciation is not adjusted, implying that the initial allowance
is granted in addition to the full annual depreciation.
24/ See the discussion on Investment Deductions for more details on the"Initial Yr" and 'Final Yr" parameters.
- 43 -
Thus far, we have described some standard depreciation methods. The
depreciation portion of most tax systems consists of these methods and hence,
METR can readily simulate them. But some countries offer somewhat irregular
methods for calculating depreciation allowances. METR can usually simulate
such irregularities, but it may require some creativity on the part of the
user. The following three examples, found in China, Colombia and Mexico,
suggest a few tips for handling these situations.
China uses a straight-line method for depreciation, but the firm is
only allowed to depreciate up to 90 percent of the original cost of the asset.
To satisfy this restriction, we multiplied the standard depreciation rates by
.9, while leaving the depreciable lives unchanged. Another way to satisfy
this requirement would be to multiply the depreciable lives by .9, while
keeping the depreciation rates at their full values. The latter method is
slightly more generous to the firm, but it can run into problems, if the
resulting depreciable life is not a whole number. In general, when there is a
discrepancy in the relationship between depreciation rates and depreciable
lives in straight-line depreciation, this quick fix can yield good results.
Following the 1986 tax reform in Colombia, all assets are
depreciated over three years, 40 percent in each the first two years and 20
percent in the last year. In its general form, METR cannot duplicate this
depreciation method exactly, but with the declining balance with switchover
method the user can make a good approximation. Specify a 40 percent annual
depreciation rate and a three year depreciable life and activate the
switchover mechanism. The result is a 40 percent allowance in the first year
and a 30 percent allowance in each of the last two years (that is, 50 percent
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of the remaining basis over the last two years). Again, a little creativity
can lead to a reasonable approximation in an extreme case.25/
Mexico offers another example of a case that may initially seem very
difficult to simulate, but again, METR and the creative user can meet the
challenge. After the most recent corporate income tax reform, Mexican firms
can write off expenses related to investment in one of two ways. First, they
can use an indexed straight-line method for depreciation. METR's straight-
line method and indexation feature easily and accurately simulate this
technique. Second, instead of depreciating the asset, firms can immediately
deduct the cost of the investment. But rather than setting the deduction
equal to the actual cost of the investment, the deduction is equal to the
present value of the nonindexed depreciation allowances that would have been
granted under an ordinary straight-line method.26/ The discount rate for this
calculation is 7.5 percent, a proxy for the real rate of interest.
To simulate the second method, the user can expense (i.e.,
immediately deduct) the investment by employing the investment deduction
parameters located at the bottom of the parameter section (see Table 1). For
251 The user who is experienced with Lotus 123 can make a minor programmingchange to simulate the Colombian depreciation method exactly.
26/ This technique is quite similar to the Jorgenson-Auerbach method. Theirmethod is based on the present value of allowances calculated with thedeclining balance method. The value of the investment deduction in thiscase is d/(d+r) times the amount of the investment, where d is thedepreciation rate and r is the discount rate.
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each depreciable asset, enter the share that is deductible.27/ Set the
'Initial Yr" and "Final Yr" parameters equal to zero and 30, respectively, to
make this a permanent feature of the tax system. Also, for each asset, set
the "Adj Basis?" parameter equal to 1, so that capital gains will be
calculated correctly. And finally, to avoid deducting depreciation allowances
in addition to the expensing, set the "Deduct Depreciation?" parameter, in
column II, above, equal to zero. The user is now ready to conduct any
simulations accurately, either with or without replacement investment.
The case for Mexico is one example of the immediate expensing of
investment spending. With the "Investment Deductions:" parameters, the user
can simulate both full and partial expensing for the project as a whole or for
selected assets. Simply set the investment deduction equal to the share of
the investment being expensed, the eligible years for the expensing, and the
"Adj Basis?" parameter equal to 1. For example, to fully expense investment
spending on buildings, enter 100 percent, zero, 30, and 1 in these parameters,
respectively. To expense only half the investment cost and depreciate the
rest, enter 50 percent in the investment deduction parameter.
For typical expensing arrangements, the user can set the "Deduct
Depreciation?" parameter equal to 1. In fact, this is necessary for partial
expensing cases, where only a portion of the asset is expensed and the
27/ The Mexican tax authorities publish these shares for each asset. AsSweder Van Wijnbergen pointed out, these shares can also be derivedanalytically. Van Wijnbergen's formula for the investment deduction is
(1/n)[1-1/(l+r)n]/r,where r is the discount rate and n is the depreciable life of the asset.This formula differs from the Jorgenson-Auerbach formula because it isbased on depreciation allowances calculated with the straight-linemethod.
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remainder is depreciated. Setting the "Adj Basis?" parameter equal to 1,
removes the expensed portion of the investment from the depreciation process.
The Mexico example required that we deactivate the depreciation process,
because the calculated investment deduction does not equal 100 percent, though
it is treated as full expensing and no further depreciation allowances are
granted.
At this point, the user should be able to experiment with the
depreciation process. To become more familiar with the process, check the
depreciation calculations (see Table 2c) to make sure that the intended method
is successfully simulated.
Indexation
Indexing attempts to maintain the real value of various elements of
the tax system during periods of inflation. Very few countries employ a fully
indexed tax system for inflation, that is, a system that is completely
insulated from the effects of inflation. Often there exist ad hoc techniques
that replace explicit indexation or limitations that may allow for only
partial indexation. METR's indexation features are flexible enough to
simulate numerous indexation methods found throughout the world. This
flexibility is achieved by requiring the user to separately activate the
indexation mechanism for each component of the tax system and by allowing him
to specify the corresponding rate of indexation.
For the business income tax, METR allows for the indexation of
depreciation allowances, interest deductions, interest earned, the carryover
- 47 -
of losses and unused tax credits, and capital gains. The option to index
capital gains at the personal level is also available. To fully index the
system, activate all of the indexing mechanisms by entering a 1 in the 'Index
... ?n parameters. In addition to this, enter a 1 in the "Adj Inv for Lag'
parameter for depreciation. Also, set the rate of indexation equal to the
inflation rate, for each mechanism, to fully adjust each variable.28/
Below the surface, when the indexation mechanisms are activated,
METR is scaling up the basis for depreciation, the adjusted basis or
investment costs used in calculating capital gains or the balancing
adjustment, and the losses and unused credits carried over by their respective
indexation rates. The indexing mechanisms for interest paid and interest
earned remove the inflation component of the nominal interest rate, so that
only the real interest component is deducted or taxed. For personal capital
gains, the indexing mechanism scales up the amount of investors' outlays by
the indexation rate.
A subtle point arises in the indexation of depreciation allowances.
There is a one period lag between the time an investment is made and when it
gets added to the basis for depreciation. A fully indexed system scales up
the cost of the investment during this lag, but some countries may wait until
the asset is added to the depreciation basis before indexing begins. This
element of the tax code can be significant even at moderate rates of
inflation. To index the investment cost during this lag, enter 1 in the
"Adjust Inv for Lag" parameter located with the "Standard Deductions:"
28/ METR sets the default rate of indexation equal to the inflation rate.
- 48 -
parameters in column II. Set this parameter equal to zero, if the tax code
does not allow an adjustment.
Though the setting of the indexation parameters are generally
straightforward, some countries place limits on the amount of indexation that
may require some creative parameter setting on the part of the user for an
accurate simulation with METR. For example, until recently, in Turkey, the
tax code limited the indexation of depreciation allowances, while in
Guatemala, interest deductions are limited.
Turkey allowed for only partial indexing of depreciation by setting
the indexation rate to the annual inflation rate less 10 percent. For
inflation greater than 10 percent, simply subtract 10 percent from the
inflation rate to derive the correct indexation rate. But if inflation is
less than 10 percent, the indexation rate should be zero and not a negative
number. To satisfy these conditions, the user could set the indexation rate
for depreciation equal to a simple Lotus 123 formula.29/ (Currently, Turkey
allows the full indexation of depreciation allowances. We present the former
method only for illustrative purposes.)
In Guatemala, interest deductions are limited to 16 percent of
outstanding debt. Implicitly, 16 percent is used as a proxy for the real
interest rate. If the interest rate is greater than 16 percent, we want to
subtract the difference from deductible interest. That is, set the indexation
rate equal to the interest rate less 16 percent. But in the case of a low
29/ This formula is @MAX(C32-.1,O), where cell c32 is the inflation rate.
- 49 -
interest rate, we do not want the indexation rate to become negative and
deduct more interest than was actually paid. Once again, set the rate of
indexation equal a simple Lotus 123 formula to simulate this policy.30/
Treatment of Debt
METR allows the user to tailor deductions related to debt financing
to his specific needs. Deductions for both interest paid and payments on
principal are available. Further, interest deductions can be indexed for
inflation (see the discussion on indexation).
In most countries with market economies and private capital markets,
interest paid on debt is deductible from taxable income. To activate this
feature, enter a 1 for the "Deduct Interst Paid?" parameter in column II.
There are some countries that do not allow deductions for interest paid on
private debt. For example, Hungary enforces this policy. To accommodate such
a policy, set the "Deduct Interst Paid?" parameter equal to zero.
Occasionally a tax system allows for the deduction of payments on
the principal component of debt servicing. For example, China allows firms to
deduct payments on principal from the income tax base. In Hungary, firms can
deduct the payment of principal on loans from the State Development Institute.
Set the 'Deduct Pmts on Prin?" parameter equal to 1, to activate this feature.
In most countries, payments on principal are not deductible expenses and this
parameter should be set equal to zero.
30/ This formula is §MAX(C30-.16,O), where cell C30 is interest rate on debt.
- 50 -
Treatment of Capital Gains
As we discovered in Section 2, the treatment of capital gains can
have a major impact on the effective tax rate. Further, capital gains
treatment varies widely across countries. In many cases, capital gains are
treated as ordinary income for tax purposes, while in other cases they are
taxed separately. Even when they are treated as ordinary income, they are
often subject to a reduced tax rate. Also, the definition of capital gains
varies across countries. And in some countries, the base for capital gains
may be indexed for inflation. Again, METR is flexible enough to handle most
situations.
Treating capital gains as ordinary income mainly implies that the
can use capital losses to offset income from other sources. This is 300'firm
important, because depreciation of the physical assets can lead to substantial
losses under certain methods for calculating the capital gains base. To
capture this element of a tax system, set the "Capital Loss Offset" parameter
equal to 1.
Treating capital gains as ordinary income also implies that the base
may be calculated in a number of ways. The main options are the sale price of
the assets, the sale price less the original cost and the sale price less the
adjusted basis of the assets.31/ These are options, 1, 2 and 3, respectively,
are located at the bottom of the second column in Table 1. Options 2 and 3
31/ The adjusted basis of the assets is the original cost of the assets lessdepreciation allowances already taken. This is a standard accountingdefinition. Other terms which might be used for this are written downvalue or book value of the assets.
- 51 -
are the most common. Option 2, sale price less original cost, leads to
potentially large capital losses, if there is low inflation or indexation,
because economic depreciation drives the sale price down relative to original
costs. The user enters the option number in the "Cap Gains Option" parameter
to choose the appropriate calculation.
Typically capital gains are taxed at the same rate as ordinary
income, if they are treated as such. To set METR for this situation, enter
the same tax rate for capital gains as for ordinary income. The capital gains
tax rate may also differ from the tax rate for ordinary income. For example,
sometimes the tax rate on capital gains falls, if the owner holds the assets
for a given period of time. For this case, set the capital gains tax rate to
this reduced value. The study in Section 2 has an example where capital gains
are taxed at half the ordinary rate. If the capital gains tax rate is reduced
and capital losses can still offset other income, METR proportionately reduces
offsetting losses as well.
Often, when capital gains are taxed at a different rate than
ordinary income, the tax is separated from the income tax. In this case,
capital losses cannot be used to offset other taxable income. Setting the
'Capital Loss Offset" parameter equal to zero accomplishes this separation.
Treating capital gains separately typically affects the choice of
the tax base. Most of these systems define capital gains or losses as the
difference between the sale price and the original cost of the assets. This
is capital gains option 2.
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The separate treatment of capital gains usually implies the
application of a balancing adjustment at the time the assets are sold. The
balancing adjustment is an addition to or deduction from ordinary taxable
income for any discrepancy between depreciation allowances granted and the
actual economic depreciation that took place. The difference between the sale
price and the adjusted basis of the assets reflects this discrepancy. For
example, if the sale price is below the adjusted basis, then the assets
actually depreciated more than the depreciation allowances suggest. In this
case the balancing adjustment is an allowance deducted from ordinary income to
make up this difference. If the sale price is above the assets' adjusted
value, then the balancing adjustment is an addition to taxable income,
correcting for too many depreciation allowances granted over the life of the
project. This addition is usually limited to the total allowances granted.
To set the balancing adjustment, use option 4 in the "Balancing Adj Option"
parameter.
Under either treatment of capital gains, the bases for capital gains
and the balancing adjustment can be indexed. As the study in Section 2 shows,
the taxation of purely nominal gains can substantially distort effective tax
rates. The user sets the indexing feature for capital gains in the usual way.
Treatment of Losses and Unused Credits
There are two basic ways to treat losses and unused credits, full
loss offset and carryover. The first method allows the firm to deduct losses
incurred on the project and redeem all tax credits in the current period. In
effect, the government reimburses the firm for the losses times the tax rate,
- 53 -
plus the credits. Carryover requires that losses incurred in one period can
only be deducted from future taxable income. Similarly, unused credits must
be carried over until the firm acquires tax liabilities. The appropriate
method to use depends on the user's interests and on the business income tax
legislation.
When is it appropriate to use full loss offset? If the project
under study is part of the operations of a bigger firm with taxable income
from other sources, then the firm can usually use losses and credits from the
project to reduce its overall tax liability. In this case, the user should
set METR for the full loss offset option to best simulate the true effective
tax rate of the project.
To set METR for full loss offset, enter a 1 in the "Full Loss
Offset" parameter (see Table 1). This automatically overrides the carryover
provisions for both losses and credits and it is not necessary to enter zeros
in the carryover parameters.
The carryover provisions for losses are similar to the provisions
for unused credits. We will discuss carryover in the context of losses, but
the discussion is applicable to unused credits.
If the project is isolated and there are no special provisions
compensating the firm in the current period for losses incurred, then the user
should specify the carryover treatment. METR optimally carries losses forward
by using up the earliest losses first. This minimizes the expiration of
unused losses. To set METR for loss carryover, make sure that the full loss
54 -
offset parameter equals 0 and the carryover loss parameter equals 1. The user
must then set the parameters to specify the share of losses that can be
carried over, indexation and the expiration of unused deductions.
If all the losses incurred can be carried over, the "Shr of Losses"
parameter should be set equal to 100 percent. In both Jordan and Ecuador,
only half the losses incurred are eligible for the carryover provisions. For
these countries, set this parameter equal to 50 percent.
The user sets the indexation parameters in the usual way. Note that
an interesting rate of indexation would be the interest rate. This setting
would maintain the present value of losses as they get carried over.
The remaining carryover parameters determine the expiration of
deductions for losses. The "Eligible Years" parameter allows the user to
specify whether carryover provisions are a permanent or temporary feature of
the tax system. In most countries they are permanent, so the user should set
this parameter equal to 30. If they are temporary, enter the appropriate
number of eligible years. For example, in the Philippines, a registered firm
can carryover losses incurred only in the first ten years of operation. In
this case, the user should enter 10 in this parameter.
The number of years a firm can carry losses forward varies across
countries. Enter this limit in the "Forward Years" parameter. The example in
Table 1 has a five year limit, which is quite common. If losses have not been
used up after this limit, the unused deductions expire. If losses can be
carried forward indefinitely, enter 30 in this parameter.
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The "Exempt Years" parameter refers to the treatment of losses
during a tax holiday. In some countries, losses incurred during a tax holiday
can be saved until the holiday is completed and then they begin the normal
carryover procedure. In other countries, losses get used up during a tax
holiday, thus yielding no compensation for the firm. If the former case
prevails, set this parameter equal to the number of years in the tax holiday.
For the latter case, set this parameter equal to zero.
The treatment of credits has an additional feature, the redemption
of credits option. In some countries, credits are redeemable for cash
payments from the government. If the full loss offset option is not
appropriate, yet firms are immediately reimbursed for tax credits, set the
"Credits Redeemable?" parameter equal to 1 to simulate this policy.
Treatment of Dividends
The treatment of dividends can be important when studying taxes on
corporate income. Many countries subject corporate income to a double
taxation by taxing it at the corporate level and then subjecting dividends to
a second tax, such as personal income taxes or taxes on dividends remitted
abroad. METR allows for these taxes in its calculation of effective tax
rates. METR also conforms to various methods used to avoid the double
taxation of corporate income.
To include taxes on dividends in the effective tax rate calculation,
simply enter the relevant tax rate in the 'Divd Tax/Cred (+1-)" parameter.
- 56 -
Entries here should reflect only final taxes. In particular, withholdings
taxes are generally not final taxes.32/ Typically, they are only a means of
payment for later taxes, such as personal income taxes. In this case, the
relevant tax rate is the personal income tax rate and not the withholdings tax
rate (also see discussion on the treatment of investors).
Many countries avoid the double taxation of corporate income, at
least in principle, by either taxing income only at the corporate level or
only at the personal level. In Hong Kong, corporate income is taxed at a
modest 15 percent rate and then dividends are exempt from further taxation.
On the other hand, in Greeee, dividends are deductible from the corporate
income tax base so that income is mostly taxed at the personal level. In
several other countries, various methods are used to credit taxes already paid
at the corporate level toward shareholders' tax liabilities on dividend
income. In this way, corporate taxes are more like withholdings on personal
income taxes. The following paragraphs describe METR's ability to include
these various techniques in the analysis.
In Greece, dividends are deductible from taxable income. For
example, if taxable income is one million drachmas and proposed dividends are
600,000 drachmas, the tax base for the corporate income tax is 400,000
drachmas. To activate this feature, enter 1 in the 'Deduct Dividends?"
parameter. As usual, enter zero to switch it off.
32/ There are exceptions to this. Withholdings taxes on dividends remittedabroad may never be credited to the investor's tax liabilities. Thisdepends on the tax arrangements between the host country and theinvestor's home country.
- 57 -
To simulate the actual policy, METR does not allow this deduction to
create losses for the firm. That is, this deduction is restricted to the
extent that there is sufficient taxable income to cover it. If the proposed
dividends above were, say, 1.2 million drachmas, taxable income would only
fall to zero and not become negative.
To avoid circularity in the programming, METR uses a proxy, rather
than actual dividends, for this deduction. There is a mechanism in the model
to correct for differences between proposed dividends used for the deduction
and actual dividends paid out. If the user wishes to obtain exact results
instead, he can easily substitute actual dividends in the programming and
perform iterations when calculating the effective tax rate. It takes about
five iterations to complete the calculation for a ten year project.
A direct credit on dividends is sometimes used to avoid double
taxation. Chile grants a 10 percent credit on dividends that is roughly equal
to the taxes paid at the corporate level. The corporate income tax rate is
also equal to 10 percent, but taxable income may differ from distributed
profits, so the credit may be more or less than the amount of corporate taxes
paid.
To activate this feature, set the tax on dividends equal to the
negative of the credit rate. In the case of Chile, this would be -.1. If the
user is also analyzing other taxes on dividends, then the appropriate entry
here would be the tax rate less .1.
- 58 -
The dividend credit method roughly converts the corporation income
tax into a withholdings tax, but it is not exact. Another method that can be
exact credits shareholders for the amount of taxes already paid at the
corporate level. For example, in Guatemala, if 100 percent of profits are
distributed to shareholders, then the entire amount of corporate taxes paid
are credited toward the shareholders' tax liabilities. Mexico had proposed a
similar system, but there, only 72.4 percent of the tax paid would have been
credited.33/ (In Mexico, this policy was discarded, before it ever came into
effect.)
To activate this feature, enter the share of taxes paid eligible for
the credit in the "Corp Inc Tax Credit' parameter. For Guatemala, the user
should enter 1, while for the Mexico example, he should enter .724.
Even with the 100 percent credit, this credit fails to convert the
corporate income tax into an exact withholdings tax, if some profits are
retained by the firm. The share of taxes eligible for this credit is
proportional to the share of profits distributed as dividends. If only 75
percent of profits are distributed (that is, the retained earnings parameter
in the Operations section is set equal to .25), then only 75 percent of the
corporate income taxes paid are eligible for this credit.
The final method used to avoid the double taxation of corporate
income is also based on the principle of using the corporate income tax as a
withholdings tax. Here, the firm is liable for the corporate income tax as
33/ Recently, Mexico switched to a system similar to the Greek system, wheredividends are deducted from taxable income.
- 59 -
well as a normal withholdings tax on dividends. That is, the withholdings tax
is then credited to shareholders' tax liabilities. But now, corporate income
taxes already paid are credited to the firm's withholdings tax obligations.
Essentially this credits the shareholders for taxes already paid at the
corporate level, but limits this credit to the amount of withholdings tax due
(the withholdings tax rate times total dividends). This system is used in
Ecuador, Malaysia and Singapore.34/
To activate this feature, enter the share of the corporate income
tax that can be used to offset the withholdings tax liability in the "Corp Tax
Offset" parameter. For Ecuador and Singapore, 100 percent of the corporate
tax is eligible, so the user would enter 1 for this parameter. In Malaysia,
there is a 5 percent additional tax on corporate income that is not eligible
for this offset feature. To exclude that portion, set the offset parameter
equal to 40/45 (the regular corporate income tax rate is 40 percent). The
user must also specify the limit of the offset by setting the 'Limit (Z of
Divd)' parameter. Usually this limit is equal to the withholdings tax rate.
Corporate income taxes paid in excess of this limit are carried over for
future offsets.
Treatment of Retained Earnings
Firms retain earnings for a number of reasons. There may be tax
incentives inducing the firm to set up special funds, such as a fund to cover
34/ If the CIT already paid is greater than the withholdings taxes due, thefirm can carry the excess forward to offset future withholdings taxliabilities.
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future expected losses, or it may be required by law that the firm invest in a
particular fund. Or, the firm may just want to hold some liquid assets. METR
allows the user to include the accumulation of retained earnings in the
calculation of effective tax rates. The features METR offers are the
deduction of retained earnings from taxable income, taxes or credits on
retained earnings, and the earning and taxation of interest income on
accumulated retained earnings.
To deduct retained earnings from taxable income, set the "Deduct
RE?n parameter equal to 1. With this option, additions to a tax deductible
fund are subtracted from the income tax base. Similarly, withdrawals from the
fund are added to the tax base. Entering zero for this parameter eliminates
this tax inducement for accumulating the fund.
Some countries place a tax on retained earnings. In Brazil, the
Federal government levies a 25 percent tax on retained earnings. To capture
this tax, set the "RE Tax/Cred (+/-)" parameter equal to .25. The user can
also specify a tax credit on retained earnings with this parameter. For
example, to grant a 10 percent tax credit for contributions to a special fund,
set the tax rate on retained earnings equal to negative 10 percent.
METR allows funds retained by the firm to earn interest. The user
can specify the rate of interest earned on these funds and whether the
interest earned is taxable and indexed for inflation. The "Interest Rate on
RE" parameter and the "Tax Interest Earned?" parameters, located in column
III, serve these purposes.
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METR automatically calculates a default value for the "Interest Rate
on RE' parameter.35/ The user can override this by entering another rate.
For example, until April 1987, a corporation in India was obligated by law to
invest in the Industrial Development Bank of India. This investment could
yield a low rate of return and virtually become a tax on the firm. To capture
this effect, the user allocates a share of profits that goes into this fund
with the retained earnings option and sets the interest rate on retained
earnings to the low yield. In this way, METR allows the user to determine the
impact of mandated funds on the effective tax rate.
Import Taxes
The user can include duties on imported capital factors of
production. This feature was inspired by the frequent use of exemptions of
these duties as investment incentives in developing countries.
For each asset, the user specifies the share of the asset that is
imported and the appropriate tax rate. If the user is analyzing an exemption,
specify the exemption rate and the number of years the exemption is in effect.
These parameters are located in column IV of the parameter settings, next to
the results (see Table 1). The user must also specify whether these taxes are
deductible from taxable income.
35/ This is the same formula for the "Int Rate on Debt" parameter.
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Other Taxes
Cash Flow Tax. The base of the cash flow tax is equal to all
inflows of cash less all outflows. Inflows include revenue, the sale of
assets and the borrowing of funds. Outflows include wage and material
expenses, investment spending and debt servicing, both interest paid and
payments on principal. With this tax, the government effectively becomes a
partner in the investment.
In METR, the base for this tax is the before tax cash flow (line 10
in Table 2a). To activate this tax, enter the cash flow tax rate in the "Cash
Flow Tax" parameter.
Excess Profits Tax. Some countries impose an excess profits tax.
These countries define a normal profit as some percentage of the value of the
firm's assets as measured by the adjusted basis. Profits in excess of this
amount face an additional tax. To set METR for this tax, enter the tax rate
in the "Excess Profits Tax" parameter and normal rate of profit in the
"NormProf (Z AdjBas)" parameter.
Property/Wealth Tax. The property/wealth tax is levied on the
adjusted (written-down) value of the firm's physical assets. It is a simple
matter to program the model to include accumulated retained earnings held by
the firm to convert this into a wealth tax. (One could also subtract
outstanding debt from the base to get a net wealth tax.) To activate this
tax, enter the tax rate in the "Property/Wealth Tax" parameter. The user must
also specify whether this tax is deductible from taxable income.
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Treatment of Investors
These parameters allow the tax treatment of investors to be included
in the calculation of effective tax rates. This treatment may prove useful in
analyzing direct investments by foreigners or in analyzing the combined effect
of the corporate and personal income taxes. In particular, these parameters
allow the user to analyze additional taxes on dividends and capital gains
beyond those imposed directly on the firm.
To place a tax on dividends, simply enter the tax rate in the "Pers.
Tax on Divds" parameter. For taxes on the transfer of equity, use the
parameters for the personal capital gains tax. Enter the tax rate in the
"Pers. CG Tax Rate" parameter. METR calculates the personal capital gains as
the difference between the sale price of assets less the investors' outlays.
The user must specify whether the base is indexed and whether capital losses
can be used to offset the investors' other tax liabilities.
If we think of the project as being the sole project of a
corporation, then the sale of the assets may imply a simple transfer of
equity. This may be the case for corporate takeovers. In this case, the
personal capital gains tax may be more relevant than the capital gains tax at
the corporate level.
Note the parameter "Z Sale Year Proceeds Used to Purchase Equity" in
the Operations section of column I. This, along with accumulated retained
earnings determine the sale price of the investors' equity.
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Investment Incentives
Besides the tax exemptions on import taxes, METR is programmed for
the analysis of three types of explicit investment incentives: investment
deductions, investment tax credits and tax holidays. The parameters for
specifying these incentives are located along the bottom of the parameter page
(see Table 1).
Investment Deductions and Tax Credits. An investment deduction
allows the firm to deduct a share of the cost of an investment from taxable
income, while a tax credit is directly deductible from the firm's tax
liabilities. The parameters for investment deductions and credits are
identical (see Table 1).
The user specifies investment deductions (credits) for the entire
project and/or for specific assets by entering the appropriate percentage
deductions (credits) in the first column of the incentive's parameters. This
is usually a straightforward procedure, but sometimes the user might have to
be a little creative. For example, Turkey offers an investment credit on
imported machinery and equipment.36/ A simple way to calculate this benefit
without any special programming is to multiply the percent credit times the
share of machinery and equipment that is imported and enter the result into
the credit parameter.
36/ This credit is included in taxable income, yielding a net credit of(l-t) times the specified percentage credit, where t equals the taxrate.
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Often, these incentives are available for only a fixed period of
time. For example, an investment deduction may be offered through the fifth
year of a firm's operation. To set METR for this example, enter 0 and 5 in
the adjacent "Initial Yr" and 'Final Yr" parameters, respectively. If the
incentive is a permanent feature, enter 0 and 30 for these parameters. Or if
the incentive is available only for replacement investment, enter 1 and 30
(only replacement investment takes place in year one and beyond; the original
investment occurs in year zero).
To complete the specification of the investment deduction (credit),
the user must indicate whether to adjust the bases for depreciation and
capital gains for the incentive. Entering zero in the "Adj Basis?" parameter
implies there is no adjustment to these bases and the incentive is truly an
added benefit for the investor. Entering a 1 here reduces the base for
depreciation by the amount of the incentive and, correspondingly, the capital
gains base is increased by this amount for capital gains options 2 and 3.
These adjustments are important for simulating the expensing of investment
costs (see Depreciation).
Tax Holidays on Business Income Taxes. The tax holiday on business
income taxes works much the same way as the exemption for import taxes. The
user sets the exemption rate and the duration of the holiday. For business
income taxes, the user can specify a two-stage tax holiday. For example, METR
can accommodate a 100 percent exemption from taxes during the first five years
of operation, followed by a 50 percent exemption over the next five years.
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This is a fairly common investment incentive, particularly for favored
investments in several East Asian countries.
To set METR for this incentive, enter the length of the tax holiday
at the first exemption rate in the 'Exempt Per. 1 (Yrs)' parameter in the
lower, right-hand corner of the parameter page (see Table 1) and the exemption
rate in the parameter just below it. If there is a two-stage tax holiday,
enter the length of the second period and the new exemption rate in the
"Exempt Per. 2 (Yrs)n parameter and in the parameter immediately below it,
respectively. If the tax holiday is a simple one-stage exemption, set the
second period parameters equal to zero.
General Tips on Setting Parameters
With its numerous parameters, METR is a versatile tool. But this
bbnefit may also lead to confusion. The key to meaningful applications of the
model is for the user to have a clear picture of the exercise he wants to
perform. For example, the user can apply METR to taxes on a corporation or
taxes on a noncorporate firm.37/ If he chooses the former case, the user must
make the managerial decision on how to distribute profits. Also, he may want
to include taxes on dividends, retained earnings and personal capital gains in
the calculations. For the latter case, these additional taxes are mostly
irrelevant.
37/ By noncorporate, we are referring to firms which do not use dividends todistribute profits, such as self-employed businesses or partnerships.
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Similarly, the user must decide whether the proiect is one of many
projects operated by the firm or if it is an isolated project. This is
important for the treatment of losses and the calculation of capital gains.
For example, typically, full loss offset is relevant for the first case, while
carryover is relevant for the isolated project. Also, consider the case of a
corporation that consists of a single project. The sale of that project may
be best represented as a sale of the firm's equity, like a corporate takeover,
and thus may only be subject to capital gains taxation at the personal level
and not at tuie corporate level.
Table 8 suggests appropriate settings of several parameters that are
effected by these choices. Of course, the user can alter the parameters as he
sees fit, but to make his results more meaningful, he should be aware of the
situation he is simulating.
B. The Cash Flow
The cash flow is generated by following basic accounting principles
and straightforward applications of the tax code. As such, the cash flow is
conceptually simple, though occasionally some special programming is necessary
for a realistic simulation. This discussion points out some of the special
programming. It may be helpful to the experienced Lotus 123 programmer who is
trying to figure out the cell formulas.
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The Before and After Tax Cash Flows
Table 2a presents the before and after tax cash flows for the base
case in our study. In calculating taxable income, most of the formulas simply
refer to the supporting or depreciation calculations, below, and check the
parameter settings to see if the particular addition or subtraction is
appropriate.
For clarity, it is worth noting that the deductions for retained
earnings and dividends are actually approximations with a correcting factor.
Because the actual decision for the distribution of profits occurs after
taxes, using actual dividends and retained earnings to calculate the tax base
leads to circularity in the programming. METR uses the before tax cash flow
as a proxy for after tax profits and then corrects the current year for over
or underestimates made the previous year. The user can adjust this proxy to,
say, half of the before tax cash flow or can substitute actual profits and do
iterative calculations to derive the effective tax rate.
The treatment of losses and unused credits plays a central role in
calculating the tax base and the after tax cash flow. When the user sets METR
for carryover, the after tax cash flow can never be greater than the before
tax cash flow. The tax base cannot fall below the minimum taxable income and
tax credits can only be redeemed if there is a sufficient tax liability to
offset or if the user specifically sets METR to make credits redeemable. With
full loss offset taxable income can be negative and all credits are redeemed
in the current period, so that the after tax cash flow could conceivably be
greater than the before tax cash flow. With this option, effective tax rates
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could actually become negative (subsidies, rather than taxes), while the
minimum effective tax rate under the strict carryover option is zero.
Supporting Calculations
Table 2b contains the supporting calculations for the cash flows.
Again, many of the calculations are self-explanatory, so the discussion here
only briefly describes the general function of some of the calculations.
Lines 57 to 61 keep track of accumulated retained earnings,
adjusting them for yearly additions, taxes and credits. The additions include
interest earned on previously accumulated funds.
Lines 63 to 67 contain calculations that yield the final, real cash
flows that the results are based upon. The inflation factor converts the
nominal before and after tax cash flows (lines 10 and 56, above) into real
cash flows and the cash flow dummy variable truncates the cash flows according
to the operating period. The final, real cash flows are reported in lines 66
and 67. The sale year dummy is used in calculations related to the sale of
the project.
Lines 71 to 75 calculate the sale price of the individual assets and
line 76 sums them up to get the sale price for the entire project. The sale
price formula equals the original cost of the asset, plus replacement
investment, less economic depreciation, and is adjusted for inflation.
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Along with the sale price, lines 78 to 84 are used in calculating
the capital gains in line 85. METR's capital gains options cover most cases,
but occasionally a country uses an irregular method for calculating capital
gains. For example, in Jordan, only the sale of land and buildings are taxed
for capital gains. The base is option 2, sale price less the original cost,
and it is adjusted for inflation. Though the user can approximate the taxable
gain by playing with the capital gains tax rate, he can get an exact result by
making a minor programming change. In line 78, 'Orig & Repl Inv Cost' only
include the investments in land and buildings. Similarly, in line 82,
"SalePrice-Orig & Repl Inv Cost", only include the sale price of land and
buildings, lines 71 and 72.
Lines 89 through line 105 keep track of the various carryover
features in the model. Line 89 monitors the corporate income taxes that are
carried over for the offset feature found in Malaysia, Singapore and Ecuador.
Lines 91 to 95 monitor the carryover of losses so that the expiration of
unused losses is kept to a minimum. Similarly, lines 97 to 101 and lines 103
to 105 optimally monitors the carryover of tax credits.
Line 107 calculates the minimum taxable income. Usually this limit
is zero, but some countries enforce a minimum equal to a percent of revenues
or a percent of assets.
Depreciation Calculations
These calculations are illustrated in Table 2c. As noted
previously, the depreciation allowances are calculated separately for each
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asset. The programming for each calculation is identical. This brief
description focuses on the first asset in Table 2c, buildings, but is relevant
for any depreciable asset.
The calculation begins with the cost of the investment made each
period (line 113). Next, if there is an investment deduction or tax credit
and the adjust basis option is chosen, METR subtracts the amount of the
incentive from the investment cost (line 114) to derive the basis for
depreciation. The initial allowance is calculated in line 115. If the adjust
basis option is used for the initial allowance, then it is also subtracted
from the investment cost in deriving the basis for annual depreciation.
The next step is to calculate the basis for annual depreciation
allowances. After making the necessary adjustments, METR reports the addition
to the basis for annual depreciation in line 116. Line 116 is added to the
basis for declining balance depreciation (line[1600'or for straight-line (line
120), depending on the method specified by the user. In calculating the
current basis for the declining balance method, METR also subtracts the
previous year's allowance (from line 118) and any of the basis that switches
over to straight-line (line 119). For the straight-line method, METR adds the
basis that switches over and subtracts the basis that expires (line 122) to
get the current basis for depreciation.
The annual allowance is simply the basis multiplied by the
appropriate depreciation rate. METR reports annual depreciation allowances in
lines 118 and 121 for the declining balance and straight-line methods,
respectively. The total depreciation for each year is the sum of the initial
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and the annual allowances (line 123). The total depreciation for each asset
is added together and is reported as a deduction in the derivation of taxable
income (see Table 2a).
The adjusted basis used in capital gains option 3 and balancing
adjustment option 4 is reported in line 125. It is equal to the investment
cost less adjustments for investment deductions and tax credits (if
specified), less total depreciation allowances, less other adjustments (line
124). For tax purposes, this represents the current value of the asset.
Finally, the appropriate bases are indexed according to the
indexation rate, if their respective indexation mechanisms are specified.
As noted earlier, with creative use of the parameters, the user can
at least approximate most depreciation methods. If the user wishes to pursue
exact results for obscure cases, he can alter the programming in this section
of the model.
C. Miscellaneous
A few calculations and Lotus 123 macros are located below the
parameter settings. These calculations derive the investment income for the
first year the project generates revenue and determine the indexation factors
for the various indexation mechanisms. The macros are useful for printing the
parameter page and the cash flows and for running iterations of the model.
The discussion in Section 4 describes how to use them.
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SECTION 4: REPRODUCING THE STUDY
This section provides step by step instructions for reproducing the
results presented in Section 2. It serves as a tutorial, giving the user a
chance to gain some "hands on" experience with the model. For the best
results, the user should operate METR as he works through this section.
We begin by learning to move around the METR spreadsheet. Then we
reproduce the results in Tables 3 and 4, case by case, first for the "real
world" cases and then for the theoretical cases. We wrap up the discussion
with some tips on operating the macros.
A. Surveying the Model
Retrieve METR from the diskette.38/ As noted in Section 1, METR is
divided into two parts, the parameter settings and results (range Al..T56) and
the cash flow (range AAl..BG168). There are also some miscellaneous
calculations and print macros located below the parameter settings.
The example stored on the diskette is the base case in Section 2
with 10 percent inflation and all equity financing. This is also the example
presented in Tables 1 and 2a-c. The cursor is initially located in cell Al,
the upper left-hand corner of the parameter settings. Check the parameter
settings on your screen with Table 1.
38/ Appendix 2 contains a few elementary Lotus 123 skills needed to operateMETR. These skills are easily mastered within a few minutes.
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Survey the parameter settings using the (page up), {page down) and
{tab) keys. First, press (page down) and check where you are with Table 1.
The cursor should be in cell A21. Again press {page down). You should see
the depreciation and investment deduction parameters on the screen. Continue
to check your location with Table 1, until you become familiar with the layout
of the parameters.
Return to cell Al by pressing the (home) key. Press {tab), to move
the cursor one screen to the right. Press (tab) a second time to get the
results to appear on the screen. This sequence, (home) (tab) (tab), is useful
for quickly locating the results from anywhere in the spreadsheet.
To assist in moving around METR, we have named various cells. By
pressing the function key (F5} and these range names, the user can quickly go
to his desired location. See Table 9 for a list of these locations. Continue
to survey the parameter settings, checking your location with Table 1.
To see the cash flow, go to cell AA1. That is, press the function
key (F5) and enter AA1 (or CF). The cursor is located in the upper left-hand
corner of the cash flow. Check this with Table 2a.
Press the (page down) key to move down the cash flow. Again check
your position with Table 2a. Continue moving down the cash flow. Now check
your position with Tables 2b and 2c. The cash flow ends at line 168.
Return to cell AA1, using the Goto key, {F5). Now, use the (tab)
key to move across the cash flow. METR produces a cash flow for 30 years.
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To complete the tour of METR, note that a few miscellaneous
calculations and macros are located below the parameter settings. Go to cell
Al by pressing the {home} key. Press the (page down} key three times to
reveal some of these formulas. Again, using the {page down} and {tab) keys,
the user can survey this portion of the model.
Return to cell Al.
Reproducing Tables 3 and 4. This exercise is aimed at familiarizing
the user with setting parameters and running the model. In reproducing Tables
3 and 4, we will not touch the majority of parameters available.
Nevertheless, between this exercise and Section 3, the user should feel quite
competent in operating the model. Of course, his competence will grow with
experience.
B. The Base Case
We have just surveyed the parameter settings for the base case.
This particular example is set for all equity financing and 10 percent annual
inflation. Table 3 contains the results for all equity financing and
inflation rates of zero, 10 percent and 50 percent. Table 4 contains these
results for 50 percent debt - 50 percent equity financing.
Let's begin by reproducing the base case for zero inflation.
Starting from cell Al, move down by pressing the {page down} key. You should
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be located in cell A21. Using the arrow keys, go to cell C32. The current
value of C32 is .1. Change this to zero by pressing 0 {enter).
Now let's run the model and check our results. Press {home) (tab)
(tab}. The results for 10 percent inflation should appear on the screen. To
run the model for our new parameter setting, press the function key {F9).
METR is calculating. With an AT machine, the calculation should take between
10 and 15 seconds. An XT machine may require about 45 seconds.
When the calculation is complete, the new results should appear and
the CALC message at the bottom of the screen should disappear. The effective
tax rate for this case should equal 44.1 percent, the same result as in Table
3. Check your result. If it is not correct, survey the parameter settings to
make sure they are the same as in Table 1 or retrieve METR from the diskette
and repeat the exercise.
To get results for 50 percent debt - 50 percent equity financing, we
have to change the debt financing parameter. Press {home) and then {page
down) to get this parameter on the screen. Using the arrow keys, move to cell
C24. Enter .5.
Again, return to the results by pressing (home) {tab) {tab). Press
{F9), to run the model. The effective tax rate should be equal to 43.6
percent, as in Table 4. Check your result.
We are now ready to run through the remaining calculations. The
steps are similar to those in these base case calculations. Set the inflation
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rate (cell C32) to either zero, 10 percent or 50 percent and the share of debt
financing (cell C24) equal to zero or 50 percent so that you can check your
results with the results in Tables 3 and 4.
C. Nonindexed Depreciation
The next example is for ordinary declining balance depreciation.
Move the cursor to display the depreciation section of the parameter settings
(A40..K47). The depreciation parameters must be set for each asset. Activate
the declining balance method by entering 1 for depreciation method (G42 to
G44). The example in the study uses the same depreciation rates as the base
case, but because the asset is depreciated over an indefinite period of time,
the depreciable life must be set equal to 30 (I42 to I44).
We are now ready to calculate the effective tax rate for the
ordinary declining balance example. Press {F9} to run the model and check
your result with the appropriate ordinary declining balance case in Table 3 or
4. If you are having problems, check your parameter settings with Table 1,
adjusting the depreciation parameters for declining balance.
The next example is a form of accelerated depreciation, double
declining balance with switchover to straight-line. This method allows for
twice the normal rate of declining balance depreciation, but has a switchover
to straight-line so that full depreciation is allowed within a fixed period of
time. To set METR for this, double the depreciation rates located in cells
H42, H43 and H44, to .1, .2 and .4, respectively. Next, change the
depreciable lives back to their finite values used in the base case. Enter
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20, 10 and 5 into cells I42, I43 and I44. Finally, enter a 1 into the
switchover parameters, cells J42, J43, and J44, to activate the switchover
mechanism.
Press (F9} and check your result.
The next two cases use a 20 percent initial allowance along with the
straight-line method for their annual depreciation. To set the parameters for
the first one, reset depreciation for the straight-line method. Set G42 to
G44 equal to 0. Set H42, H43 and H44 equal to .05, .1 and .2, respectively.
And set J42 to J44 equal to 0. Next, to specify the initial allowance, enter
.2 in C42 to C44. Because we specified the initial allowance as a permanent
element of the tax policy, the eligible years are 0 to 30. Leave D42 to D44
equal to 0 and enter 30 in E42 to E44. This way, initial allowances can be
taken for spending on replacement investment as well as the original
investment.
Press {F9} and check your result. Again, if you have any problems,
check your parameter settings with those in Table 1. Other than the initial
allowance parameters, everything should look like the base case.
The second case featuring the initial allowance reduces the basis
for annual depreciation by the amount of the initial allowance granted. To
perform this with METR, enter a 1 in the "Adj Base?" parameters located in
cells F42 to F44. Press {F9} and check your result.
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The interested reader can check the actual depreciation calculations
located in the range AA113..BG168 of the cash flow. The user may gain some
further insight into the depreciation methods by checking the allowances
calculated with the various parameter settings.
D. Explicit Indexation
The examples in Tables 3 and 4 incrementally add indexing elements
to the base case. To reproduce these cases, reset the parameters for the base
case (that is, reset the initial allowance parameters equal to zero). Then,
case by case, activate indexation, for depreciation, for capital gains and
finally for deductible interest payments.
Activate indexation for depreciation by setting G15 and G16 equal to
1. The default indexation rate is the inflation rate, so G17 already refers
to C32. Also, index the carryover provisions by setting cells K7 and K15
equal to 1. Press {F9} and check your result.
To index capital gains, enter 1 in G29. Again, the default setting
for the indexation rate is appropriately set equal to the inflation rate, cell
C32. Press {F9) and check your result.
To index interest paid, enter 1 in G22. Like depreciation, the
default rate for indexing interest is the inflation rate. G23 refers to C32,
which is appropriate for the study. Press {F9} to run the model.
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E. Reduced Capital Gains Taxes
The reduced capital gains cases in Tables 3 and 4 are equivalent to
the base case with a lower capital gains tax rate. In the first of these
cases, the capital gains tax rate is 22.5 percent, half the tax rate on
ordinary income, and in the second case, capital gains are exempt from
taxation.
To set the parameters for these cases, return to the base case.
From the previous example, this means deactivating the indexation mechanisms.
Note that it is not necessary to zero out the indexation rates, simply enter
zero in the index option parameters. That is, enter zero in cells G15, G16,
G22, G29, K7, and K15. Now, move the cursor to the "Cap Gains Tax Rate"
parameter (cell G27) and enter 22.5 percent (that is, .225).
Press {F9} and check your result.
For the next case, simply enter zero in cell G27. Press {F9} and
check. Alternatively, for this latter case, you could enter zero in the 'Cap
Gains Option' parameter to exempt capital gains from taxation.
F. Investment Incentives
The study in Section 2 include results for only a few standard
investment incentives: a 20 percent investment deduction, a 20 percent
investment tax credit and a five year tax holiday on business income taxes.
These incentives are applied to the base case tax system. Once again, first
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set the parameters for the base case. From the previous case, set the capital
gains tax rate equal to .45 (cell G27) and make sure option 3 is chosen for
the capital gains base (cell G28).
The investment deduction is granted for the entire project and is
treated as a permanent feature in the tax code. To simulate this, set cell
C51 equal to .2 and cells DSl and E51 equal to zero and 30, respectively.
Press {F9}. Check your result with the investment deduction and no adjustment
case.
To include the adjustment for depreciation and capital gains, enter
1 in cell F51. This case is now equivalent to partially expensing (20
percent) the investment and depreciating the remainder. Press {F9} and check
your result.
The procedure for setting up the investment tax credit is identical
to the procedure for investment deductions. Set J51, K51 and L51 equal to .2,
zero and 30, respectively. Before calculating the effective tax rate, switch
off the investment deduction (set C43, D43, E43, and F43 equal to zero).
Press {F9) and check.
Like the investment deduction, to adjust the depreciation and
capital gains basesOO'fothe tax credit, enter a 1 in M51. Press {F9}.
Investment deductions and credits can also be specified for
individual assets. Lines 52 through 56 of the parameter settings allow for
this and are used the same way as described above. Also, by specifying the
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desired period, METR can calculate effective tax rates for temporary
incentives.
The tax holiday in the study is a one-stage, 100 percent exemption
over five years. To set up the model for this incentive, first remove the
investment tax credit (enter zero in J51, K51, L51, and M51). Then, moving to
the tax holiday parameters in the lower, right-hand corner of the parameter
settings, set the tax exempt years and exemption rate for period 1. Enter 5
in Q51 and 1 in Q52. Press (F9).
Set the tax holiday parameters (Q51 and Q52) equal to zero to return
to the base case.
G. Other Cases
To reproduce the case where we isolated the pure effect of debt
financing for the base case with 10 percent inflation, index interest payments
for inflation (set G22=1). The all equity case yields the result in Table 3.
Enter .5 in C24, to set financing for half debt, half equity. Press {F9}.
The result should equal 61.4 percent.
For the sensitivity analysis on the responsiveness of effective tax
rates to changes in inflation, we again start with the base case. To generate
the data for Figure 3, enter inflation rates ranging from zero to 100 percent
in C32. We used increments of 5 percent.
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H. Theoretical Results
The Samuelson and cash flow results are straightforward applications
of METR. The model can also be used to get results for a combination of the
Samuelson and Musgrave neutrality cases.
For the Samuelson result, the user must fully index the system and
set depreciation equal to economic depreciation. Also, to ensure that all
costs and benefits are completely realized at their proper present value, we
use the full loss offset option. Starting from the base case, enter 1 in the
indexation features, G15, G16, G22, and G29. Because we use full loss offset
in this case, we do not have to index carryover of losses and unused credits.
Activate the full loss offset feature by entering a 1 in cell K4.
To set the depreciation allowances equal to economic depreciation
(exponential decay in discrete time), enter 1 in G42 to G44 to specify the
declining balance method of depreciation. Set the depreciation rates in H42
to H44 equal to the economic depreciation rates in K42 to K44 and enter 30 for
the depreciable lives in I42 to I44. Press {F9). The result should equal the
statutory tax rate, 45 percent. Feel free to vary inflation, the share
financed by debt, and the make up of the project to test if the effective tax
rate remains invariant.
To produce the cash flow results, simply enter zero in the "Income
Tax Rate' parameter (cell G4) to deactivate the income tax and enter the tax
rate, 45 percent, in the 'Cash Flow Tax" parameter (cell 027). Press {F9}.
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The effective tax rate should equal zero. Again, feel free to check for the
invariance of the result.
For all equity financing, the result combining Samuelson neutrality
with Musgrave neutrality is produced by partially expensing the project.
Reset the model for the Samuelson result. Then set the investment deduction
parameters as follows: C51 equal to the expensed portion of the project (50
percent), D51 and E51 equal to zero and 30, respectively, and F51 equal to 1.
The "Adj Basis?" parameter must be activated to avoid additional depreciation
on the expensed portion of the project. Again, for all equity financing, the
effective tax rate should remain invariant, the Harberger result.
A quick and dirty way can also be used to generate the Harberger
result. Reset the parameters for the Samuelson case. Then enter .225 (equal
to one-half the statutory tax rate) for the income tax rate (cell G4) and .225
for the cash flow tax rate (cell 027). This technique produces the invariant
effective tax rate for debt financing, as well.
This completes the learning-by-doing exercise. We hope that it has
given the user some confidence in his ability to operate METR.
I. Operating the Macros
There are five macros that are useful for printing the parameter
page and cash flows, and a sixth macro that can be used to run iterations of
the model to yield a targeted after tax rate of return. This last macro
assists the user in producing results for an equilibrium setting.
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To run a macro, press the {Alt} key simultaneously with the letter
corresponding to the desired macro. For example, pressing {Alt} and P prints
the parameter settings and the entire cash flow. Pressing {Alt} and Q prints
the parameters and the first two pages of the cash flow. {Alt} R prints the
parameters and the first page of the cash flow, while {Alt} S prints only the
parameter settings. (Alti T prints the entire model, like (Alt P}, but it
separates the print ranges vertically, so that a letter width printer can
adequately do the job.
Currently, the macros print the cash flows for ten years. To change
this, you have to change the print ranges for the cash flow. These ranges are
PAGE1, PAGE2 and PAGE3 for macros P, Q, R, and S. The cash flow ranges in
macro T are CFA and CFB. Appendix 2 explains the Lotus keystrokes that
perform this task.
The iteration macro calculates the investment income that yields the
targeted after tax rate of return. The principle is simple. If the after tax
rate of return is too low, the macro increases the investment income. If it
is too high, it lowers it.
This macro operates interactively. That is, the user must make some
data entries along the way. To start the macro, simultaneously press {Alt}
and I. The results section will appear on the screen, along with some
parameters that assist the targeting operation. The cursor will go to the
cell that contains the target for the after tax rate of return and the macro
will stop. The letters CMD will appear in a box at the bottom of the screen.
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This indicates that the program is waiting for the user to make an entry.
Specify the desired after tax rate of return and press enter. (Pressing the
{Enter) key allows the macro to continue.)
The cursor will then move to the cell that contains the starting
value for the investment income. Enter your best guess for the first year's
investment income. If the initial guess is fairly good, the macro will
continue until METR hits the targeted after tax rate of return.39/ For a bad
guess, it's faster to manually change the START value. The macro moves the
cursor to the START value and stops, so the user can make the necessary
changg. Then, press {Enter} for another try. Continue this procedure until
the macro hits the target.40/
If for some reason you need to stop the macro before reaching the
target, press the {Ctrl) and {Break} keys simultaneously. To continue working
with the model, it would then be best to retrieve a copy that was saved prior
to this mishap. Also, since the iterative technique takes time, it is a good
idea to keep track of the final values of the investment income for future
use.
39/ Because the programming for the Lotus internal rate of return functionEIRR, an error (ERR) may appear for a guess that is way off the mark.Don't panic. Just enter another START value and let the macro continue.
40/ The Lotus 123 function that calculates the internal rate of return for acash flow, EIRR, fairly often produces errors (ERR). Usually, adjustingthe first argument of the EIRR function to a value close to the expectedoutcome solves this problem.
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CONCLUSION
We believe that METR is already a very useful tool, but we also
believe that there is room for improvement. As is evident in Section 2, METR
has the ability to pinpoint the individual factors that influence effective
tax rates. In general, METR has a good track record of assisting tax
analysts. It is versatile and it has proven to be insightful for studying the
complex issue of business income taxation. The richness of METR comes from
its fundamental simplicity. METR is merely an application of basic accounting
and taxation principles to a hypothetical project.
Though we have much confidence in METR's current ability to assist
the user, we should note that the model is still going through an evolutionary
process. We would like to take this opportunity to discuss a couple of
possible improvements to the model. We should also mention some caveats, to
avoid misinterpreting the results from the model.
The first improvement relates to the current state of the
hypothetical project. There are two points that are noteworthy: make
replacement investment more realistic by making it "lumpier" and make the cash
flow more realistic by including a "start-up" period for the project.
With regards to replacement investment, the model currently invests
in new assets every year, replacing a little bit of worn-out buildings, a
little more of machinery and equipment, and a little more of vehicles. It
would be more plausible if these investments did not take place every year,
but rather once every number of years, depending on the asset. For example,
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replace vehicles once every three or four years and replace machinery once
every seven or eight years or whatever seems realistic. One could also allow
for maintenance spending, a key element of most projects, in such a framework.
The other feature that would add realism to METR is to allow a
"start-up" period, where the project operates at less than full capacity. For
example, suppose that it takes two or three years before reve..eO are at their
maximum real value. METR could be programmed so that revenues reach this
point in annual increments. This feature could be important, especially when
analyzing investment incentives that are often granted during the initial
years of operation.
By targeting the before tax and not the after tax rate of return,
METR is neglecting the general equilibrium of the economy. Several people
have criticized this point. Investors are interested in the bottom line, what
they get after taxes. If the prevailing after tax rate of return is a given
amount, then the project should yield that amount for investors to consider it
a viable project.
One problem with targeting the after tax rate of return is that
effective tax rate comparisons are no longer for a given project. Before tax
revenues, and hence the productivity of the investment, must adjust to yield a
fixed after tax rate of return as other parameters change.
The user should also be aware that the project in the model is not
an optimizing one. For example, when we evaluated an investment incentive in
Section 2, we held the project fixed. Thus, the firm may not have taken full
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advantage of the incentive. In previous studies using METR, the project has
typically been held fixed, though the user is free to experiment with this.
Another avenue toward improving the model may be to develop an explicit
production function that allows the firm to adjust to a changing environment
so that profits are maximized.
In general, the user should remember that METR simply analyzes one
case at a time. By varying the cases, the user can get a more complete
picture of the effects of a tax system.
This leads to an important implication on how not to use the model.
There may be a tendency to want to correct distortions created by the tax
system with makeshift solutions; for example, offer an investment deduction to
correct for inflation. Though using METR may suggest that one can design a
system yielding any desired effective tax rate, in reality firms may adjust
their behavior so that the effective tax rate in reality differs from that
calculated from the model.
A final caveat is related to Lotus 123. The internal rate of return
calculation is not very stable in Lotus 123, especially for cash flows that
yield multiple roots. It might be worthwhile to calculate the effective tax
rates based on present value calculations.
For the future, the authors believe that with some work, METR can
become an even more versatile tool. Further, the authors envision other
productive uses for METR. In particular, with a minor change in perspective,
from that of taxation to that of the investors' after tax return, METR can
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serve as a powerful tool for project evaluation. METR can readily calculate
after tax returns under a number of possible scenarios, allowing the investor
to determine an expected return on the project. It could also be used for
social evaluations of projects.
Another possibility is to expand the model to a general equilibrium
framework for cost of capital calculations. This would involve using METR to
calculate the present value of the effects of tax policy on cash flows. Also,
revisions must be made to accommodate the effect of various elasticities on
incidence, most notably, the supply elasticities of factors of production,
substitution elasticities in production, and demand elasticity for output.
In closing, METR's strength and versatility come from its simple
approach: define a project and apply the tax policy to derive a before and an
after tax cash flow. This approach allows METR to produce insightful results
in its current form and is the foundation for future developments of the
model.
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BIBLIOGRAPHY
Harberger, Arnold C. 1978. "Tax Neutrality in Investment Incentives,' inHenry J. Aaron and Michael J. Boskin, eds., The Economics ofTaxation. Washington, DC: The Brookings Institute.
Hulten, Charles R. and Frank C. Wycoff. 1981. 'The Measurement of EconomicDepreciation' in C. R. Hulten, ed. Depreciation, Inflation, and theTaxation of Income from Capital. Washington, DC: The UrbanInstitute.
International Bureau of Fiscal Documentation: Amsterdam, the Netherlands.
King, Mervyn A. and Don Fullerton. 1984. The Taxation of Income fromCapital. A Comparative Study of the United States, the UnitedKingdom, Sweden, and West Germany. Chicago: The University ofChicago Press.
Musgrave, R. A. 1959. The Theory of Public Finance. New York: McGraw-Hill.
* Pellechio, Anthony J. February 1987. A Model for Analysis of Taxation ofCapital Investment in Developing Countries. DRD Discussion PaperNo. DRD263. Washington, DC: The World Bank.
* Pellechio, Anthony J., Gerardo P. Sicat and David Dunn. March 1987a.Taxation of Investment in East Asian Countries. DRD DiscussionPaper No. DRD261. Washington, DC: The World Bank.
* _________ . March 1987b. Effective Tax Rates under Varying Tax Incentives.DRD Discussion Paper No. DRD262. Washington, DC: The World Bank.
Samuelson, Paul A. 1964. "Tax Deductibility of Economic Depreciation toInsure Invariant Valuation," Journal of Political Economy, 72(December 1964): 604-606.
* World Bank. July 7, 1987. Fiscal Policy and Tax Reform in Turkey, ReportNo. 6374-TU.
* . March 21, 1988. "Investment Incentives in Ghana: The Effectsof Company Tax Provisions".
* _________ . November 30, 1989. Mexico: Industrial Policy and Regulation.Report No. 8165-ME.
* _________ . December 15, 1989. Bangladesh: An Agenda for Tax Reform (InThree Volumes], Report No. 7196-BD.
. 1989. Malaysia: Matching Risks and Rewards in a MixedEconomy.
* . January 1990. "Hungary: Policies for Improving InvestmentDeficiency".
* Denotes internal report of the World Bank. The reader may inquire aboutobtaining a copy of such a report by contacting the author or relevantdepartment at the World Bank, 1818 H Street, NW, Washington, DC 20433.
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APPENDIX 1: OTHER STUDIES THAT CAN BENEFIT BY USING METR
1. Comparisons of tax systems of different countries (or different proposals
within the same country), including the comparison of returns to direct
foreign investment.
* For each country, set the parameters for the appropriate tax policy.
Choose a project or individual assets and calculate the effective
tax rates in each country. For studying direct foreign investment,
pick a home country for an investor (such as the United States,
Japan, ... ) and, using the tax laws and treaties on remittances
abroad, compare the effective tax rates for a group of host
countries.
2. Comparisons across sectors. Corporate vs. noncorporate or manufacturing
vs. agricultural vs. mining vs. ...
e Things that may typically vary across sectors include: the relevant
tax rate, the level of debt that is typical in each sector, and the
composition of the physical assets in the investment. Simply vary
the appropriate parameters to conduct a study.
3. Comparisons among investments in different assets (for example, land vs.
buildings vs. M&E vs. vehicles...) or short term projects vs. long term
projects.
* Vary the appropriate parameters.
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4. Studying sensitivity to virtually any factor (such as inflation, level of
debt financing, distribution of profits, interest rates, operating period ... )
Vary the appropriate parameters.
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APPENDIX 2: SOME USEFUL LOTUS INSTRUCTIONS FOR OPERATING METR
Starting Lotus 123
While in DOS, use the change directory command (cd\) to get into the
directory containing Lotus 123. For example, if this directory is called
LOTUS, type cd\LOTUS and enter. Once in this directory, enter 123, to operate
Lotus 123.
Retrieving METR
METR is on a floppy disk. To retrieve it, put the disk in the A:
drive. From Lotus 123, press the / (slash) key and a menu will appear. Press
F for file and R for retrieve and Lotus will prompt you for the name of the
file that you wish to retrieve. Press the {Esc} key until the space after the
prompt is blank, typically once or twice, type a:METR and enter.
It may take a minute or two for METR to get loaded into Lotus. When
it appears on the screen, the cursor will be in the cell where it was located
when the model was last saved.
Saving METR
Before saving the model, or any file for that matter, to help orient
oneself, it is a good idea to move the cursor to cell Al (press fHome}). The
keystrokes for saving a file are: / F S. At that point, follow the Lotus
prompts.
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Moving Around the Spreadsheet
The arrow keys move the cursor in the direction indicated one cell
at a time. The {Page Up) and (Page Down) keys move the cursor up and down a
page (that is, the height of the screen). The (Tab} key moves the cursor one
page (screen) to the right. (Tab) and (Shift) together move the cursor one
page to the left. (F51 is the "go to" key. To move immediately to a
particular cell, press {F5) and enter the cell address or range name (see
Table 9 for range names). Also, pressing (Home) returns the cursor to cell
Al.
Running the Model
Press {F9} to make METR calculate the results. To view the results
quickly, press {Home) {Tab) (Tab) or {F5) R {Enter).
Printing the Parameters and Cash Flows
Section 4 describes the technique for running the print macros. But
sometimes the range for the cash flow that is printed is not appropriate. For
example, the default setting will print a cash flow for 10 years, but the user
may want a cash flow for 15 years. Or, the width of the printer may require a
narrower range of only 7 or 8 years.
The ranges for the cash flow in macros P, Q, R, and S are PAGE1,
PAGE2 and PAGE3 for the before and after tax cash flows (Table 2a), the
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supporting calculations (Table 2b) and the depreciation calculations (Table
2c), respectively. To change these ranges, use the range name create option,
keystrokes / R N C. The range names will appear at the top of the screen.
Use the arrow keys to position the cursor at the appropriate range name and
press (Enterl. The user can now make the specified range wider or narrower by
using the left and right arrow keys. Press the {Enterl key when the new range
is appropriate. The macros can now be operated as before.
The technique is the same for changing the ranges in macro T.
Making Graphs
Plotting the data is often a useful technique for understanding and
communicating information generated by METR. The graphics option (/ G) in
Lotus is very friendly and easy to use. Here, we present a brief example
using Lotus graphics. The user should feel free to experiment further with
this option.
This example creates a bar chart to compare the before and after tax
cash flows for the base case. Press / G. First, let's reset the graphics
settings, so we can start with a clean slate, press R G. Then specify the
type of graph, a bar chart, by pressing T B. Next, specify the data for the
chart. Press X for the variable on the X-axis (horizontal axis). To put time
on the X-axis, at the prompt set the range equal to AC1..AMl. Set the A
variable equal to the before tax cash flow by pressing A and entering
ACIO..AM10 at the prompt. Similarly, set the B variable equal to the after
tax cash flow by pressing B and entering AC56..AM56. (To create this same
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graph for the real before and after tax cash flows, set A and B equal to
AC61..AM61 and AC62..AM62, respectively.)
The graph is virtually completed at this point. Press V to view the
graph. The user only needs to give the graph titles, specify the legends and
perform any other desired formatting features. To leave the viewing mode,
press {Enter). To save the graph, press N U and at the prompt, give the graph
a name. Then, press S to save the named graph. To exit the graphics menu,
enter Q. Finally, to print the graph later, be sure to save the worksheet as
well (F F S).
Table 1: The parameter settings and results for the base case.(Inflation - 10 percent)
1 I I3UIIODL 19-FLM902 I II III IV V3 NICN INIEIINT: DM OR Il(: IIT R 0f LOSSES & MEDITS: WlORT WE: TAILSS:4 Orinal Invesntt 100.00 Incow Ta Rate 45.0% full LOsS Offset 0 Yes 1 Deduct from Inc Tax? 1 Yes=l Rates of Return (ROR)5 kurtax Rate 0.0t arrrQver Losses 1 Yes1l Buildings Nosinal Bef ores-Ta OR 32.0t6 10.0% S tax Years 0 Shrl Eiqible for CM 100.0% % luported 0.0% Rea I fore-Ta RR 20.0%7 ldInges 40.0%1 n Ta % of rev) 0.0% Intex CML? 0 YerI Import Tax Rate 0.0% NoInal After-Ta RO 19.7%I IIU 40.0% 11n Ta c (I rev) 0.0% Rats of Indexatlon 10.0% EKe.pt on Rate 0.0o Real After-Tx ROR 8I %9 Vhiclu 10.0N I.nhsIn (I assets) 0.0% Eligible Years 30 EKcpt .on Period 0
10 0.0% Forurd eren 5 liE11 55UUDA D15CIIU 5: Etempt Years 0 % portd 0.0% Effective Ta Rabts 56.0%12 Ibplace Orig Inmt? 1 Yesl Deduct 100.? 1 bP1 nr Tax Rate 0.0%13 Deduct NaItriuls IYesl Credits Rdebile? 0 Yesl EreiptonRats 0.0%14 M3ATION: Deduct Dpreclatlon? 1 Yesl Cbrry-Over Credits? 1 euPl Perlt onPsrid 015 lal Bere hs IR 20.0% Ind Dereciation? 0 Yesi Idsx COC? 0 Yes V cs16 ms i % of Opnc 0.0% AdjuBt Inv for lAg 0Yesl Rate of Indexation 10.0% % I rted 0.0%171Nte m % of 0 .0% Rate of Indextion 10.0% Eligible Years 30 Iport Tax Rate 0.0118 Operat1nq Per.ed 10 (=Inf 1 Rats, lf Fully Indexed) Forard Yeurs 30 Exept on Rate 0.0%19 I o Atr I 0IIc 0.0% ExemptIon Period 020 isale Year Proceeds 100.0% !DIIST Co DEBT MAIIQ F DIVIDMlI:21 Used to P brchase Equity Mect Intert Paid? 1 lessI 1 duct Dividnds? 0 Ye61 % Imported 0.0%22 Index Interest Psid? 0 Yes=l vd Tax/Crsd (+/-1 0.0% Ir,ort Tax Rate 0.0N23 FIIIC: Rate of Irexation 10.0% Corp Inc Tax Cred t 0.0N eption Rat 0.0%24 Debt (t of Orig Inv) 0.0% Deduct Psts on Prin? 0 Yess1 Corp Inc Ta Offset 0.0% Execption Period 025 Contant D/E? 0 Yes=1 Likit (% of Mvdi 0.0%26 Years Interet Only 0 OfII CAPITAL GAINS: MER UM :27 Loan Term 10 Cap Gans Ta Rate 45.0% T!DIT Of REAIRED FEI G8: Casb Flow TO 0.0%28 Aunt Borrowd 0.00 Cap Ga ins 4tlen 3 Deduct RE? 0 Yeszl Exnmss Profits Ta 0.0%2910can Pavnt 0.00 Index CG hse? 0 Yssl RE Tax/Cred (+/-) 0.0% BornProf (% Assets) 0.0%30 Int. Rate om Debt 32.N Rats of Indexation 10.0% Interest Rate on RE 32.N0 Property/ilealth Tax 0.0%31 Cpital Loes Offset? 1 !s'l Tax Interest Earned? 1 Yepl Deduct Trm IncTax? 1 Yesul32 NLAION RATE: 10.0% Ba1ing Bt 4djcp 0 Index Int. Earned7 0 Yee133 Options for CaPGa i Sal Adj: Rate of Indexation l0.0 UASIIIIIT CV IEVD1VRS:3362 SPOr f a CostexaItdeoBu? 0 es34 ~ ~ ~ ~ ~ D lo Sts T n DG(o l Adl) Pners. hsomn DlvdOs: D. 03 5 1: Sale ce of assets SP Pers. M Tax Rate 0.0%36 2: 9P-Orzignal Costs (OC Irds i3tss? 0 Yerl37 3: SP OC ad for depr al ous(Adjhs) Rate of Indexation 10.0%38 4: in (SP, )-Adjhs Capital Loss Offset? 1 Yesxl3940 PRECIAIQ:41 Initial Allw Initial Yr Final Yr AdjBse? Depr leth? Depr Rate Depr Life Svitchovr Rate of EcDepr42 Buildings 0.00 0 0 0 0 5.0N 20 0 3.60%43 NUE 0.00 0 0 0 0 10.00 10 0 12.25t44 Vehicle 0.00% 0 0 0 0 20.00% 5 0 30.00%45 0.00% 0 0 0 0 0.00% 0 0 0,00%46 Str Lm-a047 Decl Bal-14849 gvms M.s50 Investunt Dedatlmns: Initial Yr Finl Yr Adj Bues? Investuent Ta Credits: Initial Yr Final Yr AdjBase? Tx hl1iday:51 Proect 0.00 0 Proec 0 0 0 OYes=l Exespt Per. 1 (Yrs) 52 La 0.00% 0 0 0 Land 0.00 0 0 0 ExemPtion Rate 0.0%53 Bid 0.00N 0 0 0 Bld 0.00% 0 0 0 Empt Per. 2 (Yrs) 054 NII 0.00 0 0 0 lIE 0.00% 0 0 0 Rainptlon Rat 0.0%55 Vh 0.00 0 0 0 Veb 0.0ON 0 0 056 0.00% 0 0 0 0.00% 0 0 0 c
Table 2a: Before and after tax cash flows for the base case.(Inflation - 10 percent) - 99
1 CASlHLAS YER 0 1 2 3 4 5 6 7 8 9 1023 -Investt bpeittues 100.000 10.274 11.301 12.432 13.675 15.042 16.546 18.201 20.021 22.023 24.2264 +Investnt Incom 0.000 32.274 35.501 39.052 42.957 47.252 51.978 57.175 62.893 69.182 76.1005 -ages 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0006 -Materials 0.000 0.000 0O00 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0007 -Interest Paid om Debt 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000I -Paynents on Principal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0009 +1et In frm Sale of Assets 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 259.374
10 41u3-T CASH .1i -100.000 22.000 24.200 26.620 29.282 32.210 35.431 38.974 42.872 47.159 311.2491112 +InvesD nt Iec 0.000 32.274 35.501 39.052 42.957 47.252 51.978 57.175 62.893 69.182 76.10013 +Table Interest on RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00014 ftaxable Capital Gain 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 134.23215 +Balancing Adjustent 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00016 -Deduction forlag 0.000 0.000 0.000 0.000 0.000 O.D00 0.000 0.000 0.000 0.000 0.00017 -Deduction for Materials 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00018 -Deductible Interest 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 O.OOD 0.000 0.00019 -Deductible Pnts on Principal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00020 -Investnt Dedction 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00021 -Asset-Specific Inv. Ded. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00022 -Deduction for ktiated RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00023 -Deductible Taxes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00024 -Depreciation Allnes 0.000 8.000 9.278 10.684 12.231 13.932 13.804 15.202 16.741 18.433 20.2942526 =dinary Taxable ITnae 0.000 24.274 26.223 28.367 30.726 33.320 38.174 41.973 46.152 50.749 190.0382728 -Restricted Dedctimos 0.000 0.0 0.000 0.000 0.000 0.000 0.000 0.000 0,000 0.000 0.00029 (Rut. Dedutible Dividends)30 AM'n to ML (+)/Used COL (-) 0.000 0.000 . 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00031 Crry-er lasses (CML) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00032 ktsal Taxble Ine 0.000 24.274 26.223 28.367 30.726 33.320 38.174 41.973 46.152 50.749 190.0383334 Ine TaRate I Taxable Inc. 0.000 10.923 11.800 12.765 13.827 14.994 17.178 18.888 20.769 22.837 85.51735 Surtau + liniu Ta 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00036 Cash Flo Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00037 es Profits Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00038 koperty/health Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00039 IWort Tes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00040 ML Taxes Before Divid.ds 0.000 10.923 11.800 12.765 13.827 14.994 17.178 18.888 20.769 22.837 85.5174142 ITnvthmt Ta Creidit 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00043 Asset-Specific Irv. Ta Cred. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00044 L W iM lable Tax Credits 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0004546 Csh Fnv Before Distr. -100.000 11.077 12.400 13.855 15.455 17.216 18.253 20.086 22.103 24.322 225.73247U +Pmt s of B*ty (Wl H) -100.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 225.7324 4Distr. of kcudated B 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00050 tDividends plus axble Crd 0.000 11.077 12.400 13.855 15.455 17.216 18.253 20.086 22.103 24.322 0.00051-Ta mn Dividend at p Loal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 O.0D0 0.000 0.000 0.00052 +Credits for Ta m Dividmds 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00053 -fesonal Capital aiu Tax 0.000 0.000 0.000 00 0.000 0.000 0.000 0.000 0.000 0.000 0.00054 -Pers al Ta on DivideAs 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0005556 AUf- ClAM 1A -100.000 11.077 12.400 13.855 15.455 17.216 13.253 20.086 22.103 24.322 225.732
Table 2b: Supporting calculations for the base case. - 100 -
(Inflation - 10 percent)
57 Retainre Earnin's:58 hition to B.E Iross of Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00059 Tax on letained Earnings 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00060 Credits for Taxes om RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00061 Accuulated Retaineh lamnings 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0006263 Inflation Factor 1.000 1.100 1.210 1.331 1.464 1.611 1.772 1.949 2.144 2.358 2.59464 Cash Flo Iy 0.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.00065 Sale Year OMy 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 1.00066 Real Before-Ta Casb Flow -100.000 20.000 20.000 20.D00 20.000 20.000 20.000 20.000 20.000 20.000 120.00067 leal After-Ta Casb Flow -100.000 10.070 10.248 10.409 10.556 10.690 10.303 10.307 10.311 10.315 87.0296869 Loan Balance 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0007071 Land Price 10.000 11.000 12.100 13.310 14.641 16.105 17.716 19.487 21.436 23.579 25.93772 Buildings 40.000 44.000 48.400 53.240 58.564 64.420 70.862 77.949 85.744 94.318 103.75073 K&E 40.000 44.000 48.400 53.240 58.564 64.420 70.862 77.949 85.744 94.318 103.75074 Veic1es 10.000 11.000 12.100 13.310 14.641 16.105 17.716 19.487 21.436 23.579 25.93775 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00076 Sale Price 100.000 110.000 121.000 133.100 146.410 161.051 177.156 194.872 214.359 235.795 259.3747778 Orig & Repl INv Cost 100.000 110.274 121.575 134.007 147.682 162.724 179.270 197.471 217.492 239.516 263.74179 Adj. Basis for CG (land) 10.000 10.000 10.000 10.000 10.000 10.000 10.000 10.000 10.000 10.000 10.000o0 Adj. Basis for CG (Total Inv.) 100.000 102.274 104.297 106.045 107.488 108.598 111.341 114.340 117.621 121.211 125.143
8182 SalePrice-Orig & Repl Inv Cost 2.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 -4.36783 SP-(OC-DArklolms) = SP-AdjBas 3.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 134.23284 lin(SP,OC)-AdjBas 4.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 134.23285 Capital Gains 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 134.2328687 Pers C Tax Base (excl RE) -100.000 -100.000 -100.000 -100.000 -100.000 -100.000 -100.000 -100.000 -100.000 -100.000 125.7328889 Corp Tax Offset Carry-over 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0009091 Oed COL 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00092 Crrent Aition to COL 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00093 Wiring Carry-over Loss 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00094 So of Uk COL net of lip OL 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00095 OL Adjtsent 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0009697 Ta Liabilites 0.000 10.923 11.800 12.765 13.827 14.994 17.178 18.888 20.769 22.837 85.51798 Positive 08 Iruent 0.000 0.000 0.000 0.000 0.0 0.000 0.000 0.000 0.000 0.000 0.00099 lrpiring credits 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0
100 So of Pos Taxes net of XpC 0.000 10.923 22.724 35.489 49.316 64.310 81.488 100.376 121.145 143.982 229.499101 CO Adjusbtt 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000102103 Total kvailable Tax Credits-A 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000104 Total Available ax Credits-B 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000105 otal Available Tax Crdaits- 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000106107 Iinina Taxble Inc 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000108109110111112
Table 2c: Depreciation calculations for the base case.(Inflation - 10 percent) -- 101 -
113 Deprciation Calmulations:114 Buildiigs 40.000 1.584 1.742 1.917 2.108 2.319 2.551 2.806 3.087 3.395 3.735115 Mj to Bases for Inv DedaCres 0.000 0.000 0.00 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000116 Initial l1lance 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000117 AM. to Basis for Anal Depr 0.000 40.0OD 1.584 1.742 1.917 2.108 2.319 2.551 2.806 3.087 3.395118 Decl. al. Adj. Basis 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000119 Decl. Bal. Dep. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000120 Svitdhover Adjustent 20.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 C.OOO121 Str. Line Basis 0.000 40.000 41.584 43.326 45.243 47.351 49.670 52.222 55.028 58.114 61.510122 Str. Line Dep. 0.000 2.000 2.079 2.166 2.262 2.368 2.484 2.611 2.751 2.906 3.075123 tbired Str. Line Basis 0.000 0.000 0.000 0.D 0.000 0.000 0.D0O 0.000 0.000 0.D00 0.000124 TOL DV. 0.000 2.000 2.079 2.166 2.262 2.368 2.484 2.611 2.751 2.906 3.075125 Other Mj to Base for CapGain 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000126 Adj. Value (after dep. allow.) 40.000 39.584 39.247 38.998 38.844 38.795 38.863 39.058 39.393 39.883 40.542127128 EKE 40.000 5.390 5.929 6.522 7.174 7.891 8.681 9.549 10.504 11.554 12.709129 Adj to Bases for Imv Ded&Creds 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000130 Initial M1lance 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000131 AM. to Basis for ual Depr 0.000 40.000 5.390 5.929 6.522 7.174 7.891 8.681 9.549 10.504 11.554132 Decl. Bal. Mj. Basis 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000133 Decl. Bal. Dep. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000134 Sitcdover Adjusbent 10.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000135 Str. Line Basis 0.000 40.000 45.390 51.319 57.841 65.015 72.906 81.587 91.136 101.639 113.193136 Str. Line Dep. 0.000 4.000 4.539 5.132 5.784 6.501 7.291 8.159 9.114 10.164 11.319137 Bpired Str. Line Basis 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000138 20UL DIP. 0.000 4.000 4.539 5.132 5.784 6.501 7.291 8.159 9.114 10.164 11.319139 Other Adj to Base for CapGain 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 O.WO 0.000 0.000140 Adj. Value (after dep. allav.) 40.000 41.390 42.780 44.170 45.560 46.950 48.340 49.730 51.120 52.510 53.900141142 Vehicles 10.000 3.300 3.630 3.993 4.392 4.832 5.315 5.846 6.431 7.074 7.781143 dj to Bases for Im Ded&Creds 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000144 Initial Allwance 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000145 Ad. to Basis for Amual Depr 0.000 10.000 3.300 3.630 3.993 4.392 4.832 5.315 5.846 6.431 7.07446 Decl. Bal. Adj. Basis 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000
147 Decl. Sal. Dep. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000148 Switchover Adjustet 5.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000149 Str. Line Basis 0.000 10.000 13.300 16.930 20.923 25.315 20.147 22.162 24.378 26.815 29.497150 Str. Line Dep. 0.000 2.000 2.660 3.386 4.185 5.063 4.029 4.432 4.876 5.363 5.899151 lpired Str. Line Basis 0.000 0.000 0.000 0.000 0.000 0.000 10.000 3.300 3.630 3.993 4.392152 TML DIP. 0.000 2.000 2.660 3.386 4.185 5.063 4.029 4.432 4.876 5.363 5.899153 Oter Adj to Base for CapGain 0.000 0.000 0.000 0.000 0..0 0.000 0.000 0.000 0.M0 0.00 0.000154 Adj. Value (after dep. allw.) 10.000 11.300 12.270 12.877 13.085 12.853 14.138 15.552 17.108 18.818 20.700155156 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000157 Adj to Bases for Inv DedsCred 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000158 Initial All1ance 0.000 0.000 0.000 0.000 0.000 o.000 0.000 0.000 0.000 0.000 0.000159 iM. to Basis for Anmal Der 0.000 0.000 0.000 0.000 0.0 0.000 0.0 D.0 0.000 0.000 0.000160 Decl. 8al. Adj. Basis 0.000 0.0o0 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0o0 0.0oo161 Decl. Sal. Dep. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000162 Sitdr Adjus et 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000163 Sta. Line Basis 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000164 Str. Line Dep. 0.000 0.00 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000165 lpired Str. Line Basis 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000166 TL DIP. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 O.0O o.000 0.000 0.000167 Otber Adj to Base for CapGain 0.000 0.000 0.000 .0 0.O0 O0. 0.000 O.00O 0.O00 O.000 0.000168 Adj. Value (after dep. allo.) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.oo
- 102 -
Table 3: Effective tax rates for various tax systems.20 percent real before tax rate of return.All equity financing.
INFLATION: 0% 10% 50%CASES:
Theoretical:Samuelson Neutral 45.0X 45.0% 45.0%Musgrave Neutral (Cash Flow) 0.0% 0.0% 0.0%Harberger Neutral 29.1% 29.1% 29.1%
Non-inxdexed Depreciation:Ordinary Depreciation;Straight-line (Base Case) 44.1% 56.0% 72.3%Declining Balance 45.8% 57.8% 73.1%
Accelerated Depreciation;2 Decl Bal w/ Switchover 40.5% 51.7% 68.3%20% Initial Allow w/ SL 38.5X 49.3% 66.1%
a -/ Adjusted Basis 40.7% 51.6% 67.6%
Explicit Indexation:Indexed Depreciation 44.1% 52.5% 57.4%& Indexed Capital Gains 44.1% 44.1% 44.1%& Indexed Interest Deduct 44.1% 44.1% 44.1%
Reduced Capital Gains Tax:50% Reduction 42.6% 52.0% 64.9%100% Exemption 41.1% 48.3% 58.5%
Tax Incentives:20% Investment Deduction 32.4% 44.8% 62.7%
* v/ Adjusted Basis 39.7X 50.3% 65.4%20% Investment Tax Credit 18.7% 31.9% 51.8%
* v/ Adjusted Basis 25.7% 37.0% 54.3%5-year Tax Holiday 13.9% 21.3% 29.8%
- 103 -
Table 4: Effective tax rates for various tax systems.20 percent real before tax rate of return.50 percent debt / 50 percent equity financing.
INFLATION: 01 10X 50X
CASES:
Theoretical:Samuelson Neutral 45.0X 45.0X 45.0X
Nusgrave Neutral (Cash Flow) 0.0X 0.0X 0.0X
Harberger Neutral 29.1X 29.1X 29.1X
Non-indexed Depreciation:Ordinary Depreciation;Straight-line (Base Case) 43.61 51.3X 60.6X
Declining Balance 46.31 54.0X 61.8X
Accelerated Depreciation;2 Decl Bal w/ Switchover 37.4X 44.11 56.1:
201 Initial Allow w/ SL 34.2X 41.31 54.81
a w/ Adjusted Basis 38.0X 44.8X 56.4:
Explicit Indexation:Indexed Depreciation 43.61 45.6: 40.2X
- Indexed Capital Gains 43.61 33.81 25.2X
& Indexed Interest Deduct 43.6: 43.7X 43.9:
Reduced Capital Cains Tax:501 Reduction 41.1X 45.5X 52.0X
1001 Exemption 38.81 40.3: 44.5X
Tax Incentives:201 Investment Deduction 24.5: 35.21 51.6:
a w/ Adjusted Basis 36.6: 43.2: 54.5X
20X Investment Tax Credit 7.5X 21.2: 42.41a w/ Adjusted Basis 16.5: 27.5X 44.9X
5-year Tax Holiday 17.4: 27.6: 37.1X
Table 5: Nonindexed taxable capital gains. - 104 -
(Inflation = 10 percent)
I CAM FLaS BYAR 0 1 2 3 4 5 6 7 8 9 1023 -Investment pE-nditures 100.000 10.274 11.301 12.432 13.675 15.042 16.546 18.201 20.021 22.023 24.2264 +Invesbnt Incoe 0.000 32.274 35.501 39.052 42.957 47.252 51.978 57.175 62.893 69.182 76.1005 es 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0006 -aterials 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0007 -Interest Paid on Debt 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0008 -Payments on Principal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0009 +1et Rev frs Sale of Assets 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 259.374
10 BE -TX CASM l -100.000 22.000 24.200 26.620 29.282 32.210 35.431 38.974 42.872 47.159 311.2491112 +Investent Iire 0.000 32.274 35.501 39.052 42.957 47.252 51.978 57.175 62.893 69.182 76.10013 +Taxable Interest on RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00014 +Taxable Capital Gain 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 207.48915 +Balancing djustent 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00016 -Deduction for Wages 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00017 -Deduction for Xaterials 0.000 0.000 0.000 0.ooo 0.000 0.000 0.000 0.000 0.000 0.000 0.00018 -Deductible Interest 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00019 -Deductible Punts on Principal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00020 -Investment Deduction 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00021 -Asset-Specific Inv. Ded. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00022 -Dedwtion for Estiuated RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00023 -Deductible Txes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00024 -Depreciation Alloances 0.000 8.800 11.086 13.741 16.817 20.370 20.922 24.110 27.725 31.823 36.4632526 =rdinary Txable Incme 0.000 23.474 24.415 25.310 26.140 26.883 31.055 33.066 35.168 37.359 247.1272728 -Restricted Deductions 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00029 (lt. Dedutible Dividends)30 Ad'n to ML (+)/Used COL (-) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00031 Carry-over Loss (COL) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00032 bia1 Taxable Ince 0.000 23.474 24.415 25.310 26.140 26.883 31.055 33.066 35.168 37.359 247.1273334 Incme Tax-Rate X Taxable Inc. 0.000 10.563 10.987 11.390 11.763 12.097 13.975 14.880 15.825 16.812 111.20735 Surtax + Iinium Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00036 Casb Flow Ta 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00037 Ecss Profits Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00038 Property/kealth Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00039 Imort Taxes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00040 MTLI Taes Before Dividends 0.000 10.563 10.987 11.390 11.763 12.097 13.975 14.880 15.825 16.812 111.2074142 Investent ax Credit 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00043 Asset-Specific Inv. Tax Cred. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00044 T TL Available Tax Credits 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0004546 let Cash Flow Before Distr. -100.000 11.437 13.213 15.230 17.519 20.113 21.456 24.095 27.046 30.347 200.0424748 +Putm of uity (escl R) -100.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 200.04249 +Distr. of Aa:unlated 11 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 O.OOD50 +Dividends plus Taxable Creds 0.000 11.437 13.213 15.230 17.519 20.113 21.456 24.095 27.046 30.347 0.00051 -Tax O Dividend at Corp Level 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00052 +Credits for Tax on Dividends 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00053 -Personal Capital Gains Ta 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00054 -Personal Tau o Dividens 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0,0005556 AFTR-TAX CASH FlM -100.000 11.437 13.213 15.230 17.519 20.113 21.456 24.095 27.046 30.347 200.042
Table 6: Indexed taxable capital gains. - 105 -(Inflation - 10 percent)
1CASE Ka YFR 0 1 2 3 4 5 6 7 8 9 102 -3 -Investment Expenditures 100.000 10.274 11.301 12.432 13.675 15.042 16.546 18.201 20.021 22.023 24.2264 +Investent imco 0.000 32.274 35.501 39.052 42.957 47.252 51.97B 57.175 62.893 69.182 76.1005 -bges 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0006 -hterials 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0007 -Interest Paid on Debt 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0008 -Payments on Principal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0009 tlet Rev frm Sale of Assets 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 259.374
10 4BKFE- CAUSE -100.000 22.000 24.200 26.620 29.282 32.210 35.431 38.974 42.872 47.159 311.2491112 +Investuent Iole 0.000 32.274 35.501 39.052 42.957 47.252 51.978 57.175 62.893 69.182 76.10013 +Taxable Interest on RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00014 +Taxable Capital Gain 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 515 +Balancing Adjustent 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00016 -Deduction for lages 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00017 -Deduction for laterials 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00018 -Dedwctible Interest 0.000 0.000 0.000 0.000 0.000 0.000 0.00 0.000 0.000 0.000 0.00019 -Deictible Pnts on Principal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00020 -Investunt Dedction 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00021 -Asset-Specific Inv. Ded. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00022 -Dedoction for stinted RE 0.000 0.000 0.000 0.000 0.000 0.000 0.D00 0.000 0.000 0.000 0.00023 -Deductible Taxes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00024 -Dereciation Allnaes 0.000 8.800 11.086 13.741 16.817 20.370 20.922 24.110 27.725 31.823 36.4632526 0rdinary Taxable Incoe 0.000 23.474 24.415 25.310 26.140 26.883 31.055 33.066 35.168 37.359 99.0082728 -Restricted Deductions 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00029 fist. Deductible Dividends)30 Add'n to CDL (+)/Used COL (-) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00031 Carry-Oyer Lsses (COL) 0.000 0.000 0.000 0.000 0.000 0.000 o.00 0.000 0.000 0.000 0.00032 ctual Taxable Ince 0.000 23.474 24.415 25.310 26.140 26.883 31.055 33.066 35.168 37.359 99.0083334 Incoe Tax4ate I Taxable Inc. 0.000 10.563 10.987 11.390 11.763 12.097 13.975 14.880 15.825 16.812 44.55435 Sr'tax + luim Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00036 Cash Flo Ta 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00037 Excess Profits Tax 0.000 0.0 0.000 0.000 0.000 0.000 0.000 0.000 0.00 0.000 o 0.00038 Prety/1ea1th Tau 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00039 Import Taxes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00040 ToAL MTaes Before Dividends 0.000 10.563 10.987 11.390 11.763 12.097 13.975 14.880 15.825 16.812 44.5544142 Invesoent Tax Cedit 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00043 Asset-Specific Inv. Tau Cred. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00044 TOL Available Tax Credits 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0004546 let Cash Flow Before Distr. -100.000 1.437 13.213 15.230 17.519 20.113 21.456 24.095 27.046 30.347 266.6954748 Purhases of quity (exc 1) -100.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 266.69549 +Distr. of Acaulated 8. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00050 Vivideins plus TWable Cres 0.000 11.437 13.213 15.230 17.519 20.113 21.456 24.095 27.046 30.347 0.00051 -Tax on Dividend at Crp levl 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00052 +Credits for Tax m Dividends 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00053 -Persoa l Capital Gaii Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00054 -Pa l Ta on Dividends 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0005556 AFU-T CaSM FI. -100.000 11.437 13.213 15.230 17.519 20.113 21.456 24.095 27.046 30.347 266.695
Table 7: Before and after tax cash flows for the 5 year tax holiday with debt. - 106 -(Inflation - 10 percent)
I C ASH FLYEAR a 1 2 3 4 5 6 7 8 9 la23 -Investment xpenditures 100.000 10.274 11.301 12.432 13.675 15.042 16.546 18.201 20.021 22.023 24.2264 +Investment Inoe 0.000 32.274 35.501 39.052 42.957 47.252 51.978 57.175 62.893 69.182 76.1005 -Wages 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0006 --aterials 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0007 -Interest Paid on Debt 0.000 16.000 15.660 15.211 14,619 13.837 12.805 11.442 9.644 7.270 4.136-Payments on Principal -50.000 1.062 1.402 1.851 2.444 3.226 4.258 5.620 7.419 9.792 12.926
9 +let Rev frco Sale of Assets 0.000 0.000 0.000 0.000 0,000 0.000 0.000 0.000 0.000 0.000 259.37410 1EBUM- CSE FLa -50.000 4.938 7.138 9.558 12.220 15.148 18.369 21.912 25.809 30.097 294.18711 12 +-Investent Income 0.000 32.274 35.501 39.052 42.957 47.252 51.978 57.175 62.893 69.182 76.10013 +Taxable Interest on RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00014 +Taxable Capital Gain 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 134.23215 +Balancing Mjustent 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00016 -Dedufction for 5ages 0.000 0.000 0.000 0.000 0.000 0.000 0.0 0.000 0.000 0.000 0.00017 -Deduction for laterials 0.000 0.000 0.000 0.000 0,000 0.000 0.000 0.000 0.000 0.000 0.00018 -Dedctible Interest 0.000 16.000 15,660 15.211 14.619 13.837 12.805 11.442 9.644 7.270 4.13619 -Deductible Pints on Principal 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00020 -Investment Deduction 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00021-Asset-Specific Inv. Ded. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00022 -Deduction for 3stijated RE 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00023 -Deductible Taxes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00024 -Depreciation All1ances 0.000 8.000 9.278 10.684 12.231 13.932 13.804 15.202 16.741 18.433 20.2942526 =Qrdinary Taxable Income 0.000 8.274 10.563 13.156 16.107 19.483 25.369 30.531 36.509 43.479 185.9012728 -Restricted Deductions 0.000 0,000 0,000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00029 (Est. Deductible Dividends)30 At'n to COL (+)/Used COL (-) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00031 Carry-Over Losses (COL) 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00032 Acbal Txable Income 0.000 10. 0.000 0.000 0.000 0.000 25.369 30.531 36.509 43.479 185.9013334 Incme TaxRate I Taxable Inc. 0.000 0.000 0.000 0.000 0.000 0.000 11.416 13.739 16.429 19.566 83.65635 Surtax + linim Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00036 Cash Flow Ta 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0,00037 ess Profits Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00038 Proper/Wealth Tax 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00039 Import Taes 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00040 AL ETes Before Dividends 0.000 0.000 0.000 0.000 0.000 0.000 11.416 13.739 16.429 19.566 83.6564142 Investuent Tax Credit 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00043 Asset-Specific Inv. Tax Cred. 0.000 0.000 0.000 0.000 0.000 0.000 0.000 O.DOO 0.000 0.000 0.00044 ML Available Ta Credits 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00045 46 let Cash Flo Before Distr. -50.000 4.938 7.138 9.558 12.220 15.148 6.953 8.173 9.381 10.531 210.5314748 Purcases of luity (escI E) -50.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 210,53149 fDistr. of Acumlated RE 0.000 0.000 0.000 0.000 0.000 0,000 0.000 0.000 0.000 0.000 0.00050 +Dividends plus Taxable Creds 0.000 4.938 7.138 9.558 12.220 15.148 6.953 8.173 9.381 10.531 0.00051 -T on Dividend at orp Level 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0,00052 4Credits for Tas o Dividends 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00053 -Personal Capital Gains Tax 0.000 0.000 0O0 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.00054 -Personal Ta n Dividends 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.0005556 AER- CASE FIU -50.000 4.938 7.138 9.558 12.220 15.148 6.953 8.173 9.381 10.531 210.531
- 107 -
Table 8: GUIDELINES FOR PARAMETER SETTINGS
Type of firmNoncorporate Corporate
Isolated Project
1. All profits are distributed./a 1. Choose the share of profits thatare distributed.
2. No further taxes on profits./b 2. May include taxes or credits ondividends.
3. Capital gains are taxed at the 3. May choose to tax capital gainsbusiness level. at the business level or
personal level or both./c
4. Carryover losses and unused 4. Carryover losses and unusedcredits. credits.
Project is part of a Larger Firm
1. All profits are distributed./a 1. Choose the share of profits thatare distributed.
2. No further taxes on profits./b 2. May include taxes or credits ondividends.
3. Capital gains are taxed at the 3. Capital gains are taxed at thebusiness level. business level./d
4. Full loss offset. 4. Full loss offset.
/a To analyze the setting up of special funds, the user may choose to retainsome profits.
/b If there are relevant taxes on distributed profits, for example, taxes onprofits remitted abroad, the user may choose to use the treatment ofdividends parameters.
/c In this case, selling the project is equivalent to transferring ownershipof the entire corporation. The user may choose how to best simulate thistransaction with the purchase equity parameter.
/d Now, only a portion of the corporation is sold. The user may choose topurchase some outstanding shares or distribute the receipts from thesale.
- 108 -
Table 9: Some useful range names.
For moving around METR:
CF AAI .. AM168 Top of cash flowCG E26 Capital gains parametersCO I3 Carry-over parametersDEBT E20 Debt parametersDEPR B40 Depreciation parametersDVD I20 Dividend parametersFIN B23 Financing parametersID B49 Investment deduction parametersINT M3 Import tax parametersINFL B32 Inflation parameterITC H50 Investment tax credit parametersOP B14 Operation parametersOT M26 Other tax parametersR Q1 ResultsRE I27 Retained earnings parametersRN A158 Range namesTARGET C15 BTROR TargetTAX E3 Income tax parametersTH 050 Tax holiday parameters
For printing:
CF AAl ..AM168 Cash flow rangesCFA AAl .. AJ168CFB AJI ..AM168PAGEO Al .. T56 Parameters and resultsPAGEOA Al ..K56PAGEOB Il ..T56PAGEI AA1 ..AM56 Cash flowsPAGE2 AA57 ..AM112 Supporting calculationsPAGE3 AA113 ..AM168 Depreciation calculations
Macros:
\I A130 Iteration macro\J A131 & subroutine
\P A104 Print macros\Q AIIO\R A115\S A119\T A122
- 109 -
Figure 1: THE EFFECTIVE TAX RATE CALCULATION
The Capital Market
Rate of S(ATROR)Return
BTROR -
ATROR
D(ATROR) D(BTROR)
I Investment
The Effective Tax Rate - (BTROR - ATROR) x 100YooBTROR
where ATROR = After Tax Rate of Return andBTROR = Before Tax Rate of Return.
- 110 -
Figure la: THE EFFECTIVE TAX RATE CALCULATION WITHADDITIONAL TAXES ON DISTRIBUTED PROFITS /a
The Capital Market
Rate of S(ATROR')Return
N~~~~~
BTRORN~~~
ATROR
ATROR' _
"\D(BTROR)
D(ATROR)D(ATROR')
I Investment
ETR = (BTROR - ATROR) x looz,BTROR
ETR' = (BTROR - ATROR') x 10OZ, whereBTROR
ETR = The Effective Tax Rate at the business level,ETR' = The Effective Tax Rate including taxes on distributed
profits,BTROR = The Before Tax Rate of Return,ATROR = The After Tax Rate of Return including only taxes at
the business level, andATROR' = The After Tax Rate of Return including taxes on
distributed profits.
/a Taxes on distributed profits include personal income taxes on dividendsor taxes on profits remitted abroad.
-. 111 -
Figure 2a: The effect of inflation on nonindexed straight-line depreciation.
15-
4-4
: ~5-
0~~~
1 2 3 4 5 6 7 8 9 10
Year
Zero lOX 50X EconomicInflation Inflation 0Inflation i Depreciation
- 112 -
Figure 2b: The real value of accelerated depreciation with lOX inflation.
25
20-0
44 150
10
1 2 3 4 5 6 7 8 9 10Year
2DB v/ 20X Initial 0 20X Initial A EconomicSvitchover Allowance Allowance Depreciationto SL Depr w/ SL Depr W/ SL Depr
& Adj Bases
- 113 -
Figure 2c: The real value of accelerated depreciation with 50% inflation.
20-
15 20
*1,4
000.
0
Year
2D8 v/ 20X InitialI 20X Initial Economic°Svitchover + Allowance 0 Allovance Depreciationto SL Depr v/ SL Depr w/ SL Depr
& Adj Bases
- 114 -
Figure 3: The effect of inflation on the effective tax rate for the base case.
80%-
75% -
70%
co 65% -
60% -
'4 55% -
50%-
45%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%Inflation
0 All Equity Financing + 50X Debt / 50% Equity Financing
- 115 -
Figure 4: Real revenues for projects with & without replacement investment.
150-
100 -
co
50
l 2 3 4 5 6 7 8 9 10Year
aWithout Replacement + With ReplacementInvestment Investment
Note: Revenues in year 10 include the sale of the project.
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Recent World Bank Discussion Papers (continued)
No. 48 Contract Plans and Public Enterprise Pe!formance. John Nelis [Also available in French (48F)]
No. 49 Improving Nutrition in India: Policies and Programs and Their Impact. K. Subbarao
No. 50 Lessons of Financial Liberalization in Asia: A Comparative Study. Yoon-Je Cho and Deena Khatkhate
No. 51 Vocational Education and Training: A Review of World Bank Investment. John Middleton and Terry Demsky
No 52 The Market-Based Menu Approach in Action: The 1988 Brazil Financing Package. Ruben Lamdany
No. 53 Pathways to Change: Improving the Quality of Education in Developing Countries. Adriaan Verspoor
No. 54 Education Managersfor Business and Govemment. Samuel Paul, Jacob Levitsky, and John C. Ickis
No. 55 Subsidies and Countervailing Measures: Critical Issuesfor the Uruguay Round. Bela Balassa, editor
No. 56 Managing Public Expenditure: An Evolving World Bank Perspective. Robert M. Lacey
No. 57 The Management of Common Property Natural Resources. Daniel W. Bromley and Michael M. Cernea
No. 58 Making the Poor Creditworthy: A Case Study of the Integrated Rural Development Program in India. Robert Pulley
No. 59 Improving Family Planning, Health, and Nutrition Outreach in India: Experiencefrom Some World Bank-Assisted Programs.Richard Heaver
No. 60 Fighting Malnutrition: Evaluation of Brazilian Food and Nutrition Programs. Philip Musgrove
No. 61 Staying in the Loop: Intemational Alliancesfor Sharing Technology. Ashoka Mody
No. 62 Do Caribbean Exporters Pay Higher Freight Costs? Alexander J. Yeats
No. 63 Developing Economies in Transition. Volume I: General Topics. F. Desmond McCarthy, editor
No. 64 Developing Economies in Transition. Volume II: Country Studies. F. Desmond McCarthy, editor
No. 65 Developing Economies in Transition. Volume III: Country Studies. F. Desmond McCarthy, editor
No. 66 Illustrative Effects of Voluntary Debt and Debt Service Reduction Operations. Ruben Lamdany andJohn M. Underwood
No. 67 Deregulation of Shipping: What Is to Be Learnedfrom Chile. Esra Bennathan with Luis Escobar and George Panagakos
No. 68 Public Sector Pay and Employment Reform: A Review of World Bank Experience. Barbara Nunberg
No. 69 A Multilevel Model of School Effectiveness in a Developing Country. Marlaine E. Lockheed and Nicholas T. Longford
No. 70 User Groups as Producers in Participatory Afforestation Strategies. Michael M. Cemea
No. 71 How Adjustment Programs Can Help the Poor: The World Bank's Experience. Helena Ribe, Soniya Carvalho, RobertLiebenthal, Peter Nicholas, and Elaine Zuckerman
No. 72 Export Catalysts in Low-Income Countries: A Review of Eleven Success Stories. Yung Whee Rhee and Therese Belot
No. 73 Information Systems and Basic Statistics in Sub-Saharan Africa: A Review and Strategyfor Improvement. Ramesh Chander
No. 74 Costs and Benefits of Rent Control in Kumasi, Ghana. Stephen Malpezzi, A. Graharn Tipple, and Kenneth G. Willis
No. 75 Ecuador's Amazon Region: Development Issues and Options. James F. Hicks, Hennan E. Daly, Shelton H. Davis, andMaria de Lourdes de Freitas [Also available in Spanish (75S)]
No. 76 Debt Equity Conversion Analysis: A Case Study of the Philippine Program. John D. Shilling, Anthony Toft, andWoonki Sung
No. 77 Higher Education in Latin America: Issues of Efficiency and Equity. Donald R. Winkler
No. 78 The Greenhouse Effect: Implicationsfor Economic Development. Erik Arrhenius and Thomas W. Waltz
The World Bank
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