The skinny on METRs
The push for “competitiveness” is often framed around differences in corporate taxation. Our tax rates, it is argued, must be equivalent to or less than those of our competitors so that we can attract the investment we need to increase our standard of living. There is some truth to that in that if our taxes were way out of line this might be a disincentive to investment. But there are many other factors at play when companies make their investment decisions: cost and availability of labour (skilled and unskilled), access to markets, proximity to resources or suppliers, energy costs, availability of infrastructure and other publicly-provided benefits such as public health insurance. And as an overall point, I think the feds are way too obsessed with attracting foreign investment to the detriment of meaningful industrial policies.
Lately, much of the attention has been on differences in marginal effective tax rates (METRs) and how these may affect investment decisions (assuming all other things equal, a big assumption). While it is easy for most people to compare actual tax rates, the METR is a more complex beast and it is problematic to the extent that they are presented for comparison purposes in a way that looks like they are actual tax rates. Looking at the background documentation, it seems to me that most people will quickly get lost in the jargon; they will accept the conclusions largely on the basis of how they view the credibility of the proponent.
So consider this a primer on what METRs are and what their shortcomings may be. Osgoode Hall tax professor Neil Brooks reviews the history of the METR concept (which goes back the late 1970s) in an article for the Canadian Tax Journal:
Although refinements of the [METR] concept are complex, the intuition underlying it is straightforward. The neoclassical model of investment behaviour assumes, among other things, that a firm will seek to maximize its profits over time. This implies that a firm will invest in capital up to the point where its marginal product of capital (the amount of extra output the firm gets from an extra unit of capital) exactly equals the cost of using that capital. The cost of using one unit of capital for one time period, or, as it sometimes referred to, the user cost of capital or the rental rate of capital, is its opportunity costâ€”basically, the interest cost of borrowing to finance the investment and, if the asset declines in value over the period, the investmentâ€™s loss in value due to depreciation. In this model of investment behaviour, taxes affect investment decisions by changing the user cost of capital to the firm. Because the revenue earned by the additional capital in the firm is taxed, the user cost is generally increased by taxes and thus investments are reduced. In the phrase â€œthe marginal effective rate of tax,â€ the term â€œmarginalâ€ refers to the fact that the concept is a measure not of the total or average taxes paid by the firm but of the taxes paid on the firmâ€™s marginal investment, expressed as a percentage of the investmentâ€™s pre-tax rate of return. The term â€œeffectiveâ€ refers to the fact that the concept takes into account not only the statutory rate of tax but also all of the major design features of the tax base that might affect the taxes to be paid, such as the availability of investment tax credits or accelerated capital cost allowances. The concept thus offers an easy-to-understand measure of the incentive (or disincentive) that the tax system provides to undertake a particular project.
He then cautions:
The concept of marginal effective tax rates, for all its usefulness in measuring the possible incentive or disincentive that the tax system might have on a firmâ€™s investment decisions, does not measure the firmâ€™s actual response to these incentives. And while the concept is based on the neoclassical model of investment behaviour, according to which profit-maximizing firms are assumed to respond to changes in the user cost of capital, there are other theories of investment behaviour. Consequently, the debate over the likely effect of tax changes on investment behaviour can only be resolved by examining the empirical evidence. Many economists have tried to measure the effect of taxes on business investment. Unfortunately, they have reached conflicting conclusions.
A more thorough critique of the METR comes from UNB economist Joe Ruggeri. In a paper published by the Caledon Institute, Canada’s Fiscal Advantage, he and co-author Jennifer McMullin point out a number of concerns about the concept:
Four major features of METRs should be emphasized. First, they are calculated on the assumption that â€œmarkets are perfectly competitive, and that firms behave as profit maximizers â€“ which is to say that capital is fully mobile and firms chase the same goalâ€ [Chen 2000: 10]. Second, they are marginal, not average rates, because they apply to investment decisions at the margin. They measure â€œthe impact of tax on the income generated by an incremental dollar of capital investmentâ€ [Chen 2000: 4]. Third, they are effective rates in the sense that they â€œtake into account all tax provisions â€“ not just statutory rates but also allowances and other provisions such as carry-over rules, inventory accounting methods, thin capitalization rules, and so onâ€ [Chen 2000: 3]. Finally, they are calculated as the wedge between the pre-tax and post-tax rate of return on capital expressed as a ratio to the pre-tax return. For example, if the pre-tax rate of return is 10 percent and the posttax rate of return is 6 percent, the associated METR is 40 percent.
In interpreting estimated METRs across different countries, it is important to remember that those estimates are based on the assumption that all other factors are the same in each country. For example, no account is taken of non-tax factors that may affect the risks associated with a given investment. Locating a given investment in Country A which has a stable political system, low crime rate, highly educated population, and well-developed transportation and communication systems will generate a less risky flow of revenue than in Country B which has lower standards of the above factors. Even if marginal costs are equal, risk-adjusted marginal revenue will be higher in Country A. If the lower risk is produced by publicly-funded institutions and programs, Country A may generate a higher after-tax rate of return even if it has a higher measured METR. Some government-funded programs not incorporated in the tax system, such as the availability of inexpensive serviced land and the provision of loans and loan guarantees, may have a double effect on the METR by altering both the absolute size of the wedge and the pre-tax rate of return.
An attempt at incorporating the spending side as well as taxation has recently been made by Mintz ; his analysis extended the coverage of taxes on business to include corporate capital taxes and sales taxes on capital equipment and included benefits such as R&D credits and public spending on health care and education. In his estimation, however, Mintz assumes that taxes on the labour input are borne entirely by employers â€“ an assumption contrary to the results of most theoretical and empirical studies [Dahlby 1992].
Since the estimation of METRs requires the use of complex models, comparative estimates for a variety of countries are not readily available. Moreover, even when different studies for the same countries are available, the results are not always comparable or consistent. For example, Chen and Mintz  estimated a METR of 16.8 percent for large manufacturing corporations in the US in 2002, while Devereux, Griffith and Klemme  estimated a METR of 24 percent for the same sector in 2001. The most recent METR estimates for Canada and the US are found in Chen and Mintz  and … shows higher METR values for Canada in all sectors. These results led Chen and Mintz to conclude that â€œCanada looks less competitive than the United States, despite the advantage of having a lower statutory corporate income-tax rateâ€.
This conclusion may be misleading, especially when placed within the context of labour productivity and capital accumulation, because it includes investment in inventories; inventories bear a much lower burden of taxation in the United States. One may argue that, for the purpose of raising productivity and living standards, the focus should be on fixed investment excluding inventories. Although inventories are part of the overall process that ultimately determines the rate of return on capital, they are directly part of the production decision and are affected by short-term developments that do not influence the investment decision. Let us consider, as an example, the manufacturing sector. Combining the information on METR values … based on Chen and Mintz , with the composition of capital by type found in Chen [2000: Table 1], one can show that the METR values are lower in Canada when inventories are excluded from the calculations or the METR for inventories in Canada is set to be equal to that in the US. When we exclude inventories, the conclusion about Canadaâ€™s non-competitive corporate tax system in terms of METR no longer holds in the case of manufacturing.
The concept of the METR on capital is well founded in standard microeconomic theory as it is based on profit maximization in perfectly competitive markets. The investment decisions of firms, however, do not always involve marginal adjustments especially in the case of large corporations. Quite often they involve â€œlumpy investmentsâ€ in the form of large and expensive projects that are expected to generate a flow of revenue over a long period of time. In those cases, the impact of taxation is measured by calculating the amount of tax that will be paid on the profits earned by the firm over the lifetime of the project (an average rather than a marginal rate concept) where taxes are treated as one of a number of factors influencing the location and investment decision. Estimates of these effective corporate income tax rates for different cities in 11 countries have been developed by KPMG .
Other issues in using perfect competition in a neoclassical model include that such models by and large ignore economies of scale, which will affect estimations on the cost side. And on the revenue side, marginal revenue is essentially the demand curve. Thus the level of demand, or anticipated demand at the time of the investment, is likely to play a bigger role than given in the discourse on METRs. Empirically, it seems to me that there is a much stronger relationship between demand and investment than supply side factors such as the tax rate (see a literature survey for the IMF by Phillip Gerson). To suggest that lowering Canadian corporate taxes will induce more investment is likely to be a mirage, and recent history suggests that this is indeed the case.