The Calculation of Marginal Effective Tax Rates

Transcription

1 The Calculation o Marginal Eective Tax Rates by Kenneth J. McKenzie University o Calgary Mario Mansour Department o Finance Ariane Brûlé Secretariat o the Technical Committee on Business Taxation May 1998 WORKING PAPER Prepared or the Technical Committee on Business Taxation Working papers are circulated to make analytic work prepared or the Technical Committee on Business Taxation available. They have received only limited evaluation; views expressed are those o the authors and do not necessarily relect the views o the Technical Committee, or the Department o Finance.

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3 The Calculation o Marginal Eective Tax Rates by Kenneth J. McKenzie University o Calgary Mario Mansour Department o Finance Ariane Brûlé Secretariat o the Technical Committee on Business Taxation May 1998 WORKING PAPER Prepared or the Technical Committee on Business Taxation Comments on the working papers are invited and may be sent to: Paul Berg-Dick, Director Business Income Tax Division Department o Finance Ottawa, Ont. K1A 0G5 Fax: (613) [email protected]

4 Kenneth J. McKenzie Department o Economics University o Calgary 2500 University Drive N.W. Calgary, Alberta N6A 3K7 Fax: (403) [email protected] Mario Mansour Business Income Tax Division Department o Finance 140 O Connor Street Ottawa, Ontatio K1A 0G5 Fax: (613) [email protected] Ariane Brûlé Personal Income Tax Division Department o Finance 140 O Connor Street Ottawa, Ontatio K1A 0G5 Fax: (613) [email protected] For additional copies o this document please contact: Distribution Centre Department o Finance 300 Laurier Avenue West Ottawa K1A 0G5 Telephone: (613) Facsimile: (613) Also available through the Internet at Cette publication est également disponible en rançais.

5 Abstract The objective o this working paper is to describe the methodology used to undertake the marginal eective tax rate (METR) calculations contained in the inal report issued by the Technical Committee on Business Taxation. The data underlying the computations are also described and presented, as are various illustrative calculations that supplement the cases covered by the eective tax rates presented in the Technical Committee s report. The model used to calculate the METRs updates, and expands on, earlier Canadian work. The main extensions to the model are: or METRs on tangible capital, incorporation o ederal and provincial capital taxes, and provincial sales taxes on capital inputs, in addition to ederal and provincial corporate income taxes; METRs on research and development (R&D), labour, and total production cost; METRs or non-tax-paying irms; and inally, METRs on tangible and intangible capital using industry-speciic debt-asset ratios. These additions allow or an analysis o METRs on a broader range o production inputs and accounting or a larger variety o ederal and provincial taxes. This has become more relevant or the study o the impact o taxation, given the increase in the relative importance o taxes that are not sensitive to proits (i.e. payroll and capital taxes). The METRs or the current Canadian corporate tax system vary across irm size, asset type and industries. Generally, small irms ace lower METRs than large irms, regardless o the type o investment they make. Investments in machinery, R&D, and exploration and development (E&D) are subject to lower METRs than investment in structures, land and inventories, and METRs on labour are appreciably lower than METRs on capital (except R&D). Finally, a comparison o METRs across industries shows that, in general, service industries are treated less avourably than manuacturing and resource industries. Also provided, to allow international comparisons, is a calculation o METRs on tangible capital in the G-7 countries and Mexico. Canadian METRs on tangible capital are generally lower than those in Germany, Italy and Japan, but higher than those in the rest o the G-7 countries and Mexico. However, investment in manuacturing equipment is treated more avourably in Canada than in most o the other G-7 countries, including the United States, and investment in R&D is treated more avourably in Canada than in the United States. Finally, a simulation o the Technical Committee s policy package shows that the Committee s recommendations would result in little change in the overall level o METRs, but that the variation in METRs would be reduced substantially, especially those across industries.

6 Table o Contents 1. Introduction Methodology Motivation Methodology Results The Base Case Alternative Scenarios International Comparisons Simulating the Technical Committee s Policy Package Concluding Thoughts...50 Appendix A Structure o the METR Model Appendix B Estimated Eective Payroll Tax Rates or Canada Appendix C Estimated Eective Payroll Tax Rates or the United States Reerences...108

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8 Acknowledgments We would like to thank Duanjie Chen, who provided invaluable assistance in the early stages o development o the METR model, particularly on the international and non-renewable resource aspects, and Jack Jung, who provided assistance and advice relating to the calculation o the capital stock weights. Special thanks to John Sargent, Jack Mintz and Paul Berg-Dick or valuable eedback throughout the project.

9 The Calculation o Marginal Eective Tax Rates 1 1. Introduction The purpose o this working paper is to describe the methodology used to undertake the marginal eective tax rate (METR) calculations contained in the report issued by the Technical Committee on Business Taxation. The data underlying the computations will also be described and presented, as will various illustrative calculations, extending somewhat the eective tax rates presented in the Technical Committee s main report. As a part o the documents laying the groundwork or the 1987 tax reorm, various calculations o the marginal eective tax rate on capital or dierent types o assets employed in various sectors were presented. 1 A technical paper explaining the methodology used to compute those eective tax rates, as well as an extensive description o the underlying data, was released by the Department o Finance shortly thereater. 2 The current exercise represents a substantial update and revision o the Department s eective tax rate model. The model has been revised along several dimensions. First, various tax changes that have occurred over the past 10 years have been incorporated into the model. This has involved not only updating tax parameters such as statutory corporate tax rates, capital cost allowance (CCA) rates, investment tax credits rates (ITCs), etc., but also incorporating new taxes into the model, such as the large corporations tax (LCT) at the ederal level and various capital taxes at the provincial level. Second, the 1987 tax reorm documents reported METRs on capital or ully tax-paying corporations only; the current version allows or the incorporation o non-tax-paying irms. Third, much o the underlying data have been revised and updated. Economic parameters such as interest and inlation rates have changed, but so too has the structure o the Canadian economy. For example, the service sector has grown, and small (or tax purposes) corporations have increased in prominence. As such, the capital and industry weights used to aggregate the METRs on capital have been substantially updated. Fourth, several methodological innovations have been incorporated into the model. In 1987 the analysis was devoted exclusively to METRs on various types o tangible capital structures, machinery, land and inventories as well as exploration and development (E&D) in the resource sector. The current version also calculates METRs associated with other inputs in the production process, such as research and development (R&D) and labour. The eective tax rates on the dierent inputs used in production are then aggregated together into a METR on production costs, ollowing a methodology developed by McKenzie, Mintz and Schar (1997). As described in more detail in Section 2, the METR on costs measures the contribution o various taxes levied on inputs to the marginal cost o production. As such, it provides a convenient measure o the extent to which the tax system impinges upon the cost o doing business. Finally, the model has been expanded to allow or the calculation o METRs or purposes o international comparisons. Marginal eective tax rates on tangible capital or the manuacturing and services sector in the G-7 countries, as well as Mexico, are computed. For the United States, METRs on the other inputs as well as production costs are calculated or numerous industrial sectors. 1 Canada, Department o Finance (1987). 2 Jung (1989).

10 2 WORKING PAPER Finally, while the METR calculations contained in this document are state o the art, the methodology does have its limitations. Many aspects o the tax system do not lend themselves to the approach, as they cannot be modelled analytically. Moreover, the estimates can be sensitive to the data and assumptions regarding key parameters. While we do perorm some sensitivity analysis, there is clearly scope or more. Thus, one additional purpose o this document is to give the interested technical reader some eel or the limitations o the estimates. The remainder o the document is organized as ollows. The ollowing section provides an overview o the methodology. Section 3 presents and discusses various METR calculations, under dierent assumptions regarding the tax system and the economic environment. Section 4 presents METRs or the G-7 countries plus Mexico. Section 5 presents the METRs or the Technical Committee s policy package. Finally, section 6 concludes. Three data and technical appendixes are also included. Appendix A outlines the data and structure o the METR model. Appendix B provides the data and methodology used to calculate marginal eective payroll tax rates in Canada, while Appendix C does the same thing or the United States. 2. Methodology In this section, an overview o the basic methodology underlying the calculation o METRs is presented. The section begins with a brie discussion o the motivation behind the approach to the calculation o METRs taken in this study. We then move on to the methodological overview. For the most part, the basic concepts underlying the methodology are quite simple and have been documented elsewhere 3 ; the discussion is thereore largely intuitive. 2.1 Motivation While businesses are subject to various types o taxes, analysts have traditionally ocussed on the corporate income tax (CIT). Since the CIT can be thought o as a tax on the return to capital, the tendency to ocus on it is perhaps understandable in light o prevailing concerns regarding the impact o taxes on capital accumulation and investment. 4 However, other business inputs, most notably labour, are subject to various taxes as well, such as ederal payroll taxes to und Employment Insurance (EI) and the Canada Pension Plan and Quebec Pension Plan (CPP/QPP), and provincial payroll taxes to inance health and education. Moreover, while the implementation o the Goods and Services Tax (GST) largely eliminated the taxation o business inputs that occurred under the ederal manuacturing sales tax, provincial retail sales taxes still result in the taxation o some business inputs. 3 See McKenzie, Mintz and Schar (1997) and reerences therein. 4 Bird (1996) discusses various ways o viewing the CIT, and provides some justiication or its existence. See also Mintz (1995). It is also important to note that while the CIT can be thought o as a tax on the return to capital, the ultimate burden, or economic incidence, o the tax need not all on the owners o capital (shareholders). Depending upon the economic environment, and on the technological characteristics o the corporate sector, the burden o the CIT may be borne by (some combination o) the owners o capital, consumers o goods produced by corporations, other actors o production (e.g. labour, land), or even oreign treasuries in the case o non-resident multinational irms subject to the CIT. For a discussion o some o the issues in this regard, see Whalley (1997).

11 The Calculation o Marginal Eective Tax Rates 3 When analysing the incentive eects o taxation, it is important to consider the impact o taxes on marginal, or incremental, economic decisions (i.e. the decision to employ one more unit o capital, hire one more worker, or produce one more unit o output). In this spirit, we thus ocus on the calculation o marginal eective tax rates. The METR is deined as the amount o tax arising rom the decision o a irm to undertake one more unit o an economic activity. In the case o capital, the activity is the employment o an incremental unit o capital, in the case o labour, it is an incremental worker; and in the case o production, it is an incremental unit o output. Because we measure the taxes arising rom an incremental unit o economic activity, a positive METR associated with that activity indicates that it is discouraged by the tax system, a negative METR indicates that the activity is encouraged by the tax system, while a zero METR indicates that the tax system is neutral with respect to the activity. In the case o a neutral tax system, the activity generates no tax revenue at the margin, but inramarginal units o the activity may generate tax revenue. Taxes imposed on capital (like the CIT) can aect both the level and composition o investment in an economy by distorting the return to an incremental unit o capital. The METR on capital is a summary measure o the size o this distortion. There is a growing body o empirical research that suggests that corporate taxes levied on capital can dampen investment, although there is some disagreement over the magnitude o the impact. 5 Moreover, taxes on capital may aect not only the level o investment, but its composition as well: dierences in METRs across types o capital can give rise to inter-asset distortions; dierences in METRs on capital employed in dierent sectors can give rise to inter-industry distortions; and dierences in METRs on capital employed in dierent jurisdictions can give rise to inter-jurisdictional distortions. Thus, taxes can lead to distortions in the allocation o capital over time, across assets, among sectors, and among jurisdictions. The distortions in the allocation o capital caused by the tax system are important or two reasons. First, the distortions can lead to a reduction in the level o goods and services produced in the economy. This gives rise to what are reerred to as the eiciency costs o capital taxation. Second, although both the theoretical and empirical literature is somewhat less developed on this issue, there is some evidence that there exists a positive correlation between investment and economic growth in cross-country comparisons. 6 Thus, taxes on capital may also aect the rate o growth in the economy through their impact on investment. 7 These linkages between taxes on 5 Auerbach and Hassett (1992), Cummins and Hasset (1992, 1994), Cummins, Hasset and Hubbard (1996), and Chirinko, Fazzari and Meyer (1996) ind signiicant CIT eects on investment, with the elasticity o investment with respect to the tax adjusted cost o capital (discussed below) between.25 and 1. McKenzie and Thompson (1997) also ind that dierences in the tax-adjusted cost o capital between Canada and the United States help to explain dierences in investment rates between the two countries in a statistically signiicant way. 6 See Levine and Renelt (1992). 7 There is some question in the literature as to whether or not changes in investment caused by the tax system are permanent or transitory. In either event, a temporary change in growth may still last or a substantial period o time. As discussed above, even i changes in growth are transitory, they still lead to a permanent changes in the level o economic output (GDP). Also, De Long and Summers (1991) argue that it is not so much the level o savings and investment that matters or economic growth, but rather whether that investment is allocated "appropriately." Thus, inter-asset, inter-industry and inter-jurisdictional distortions may also be important or economic growth.

12 4 WORKING PAPER capital and both the level and growth o economic activity provide much o the motivation or the traditional ocus on measuring METRs on capital. Yet taxes on other business inputs, such as payroll taxes levied on labour, can also have important economic eects. The eect o such taxes on wages and employment are theoretically ambiguous, and the empirical evidence is somewhat mixed. 8 Nonetheless, there is some evidence that taxes imposed on labour, such as payroll taxes, dampen employment, at least in the short run. Moreover, some representations o endogenous growth theory, which ocus on the role that technology and human capital play in contributing to economic growth, suggest that taxes on labour can stile growth by lowering the incentives o individuals to invest in human capital. Aside rom the traditional supply and demand responses to taxes levied on actor inputs such as capital and labour, i input METRs dier across actors, irms will, to the extent that it is technologically possible, alter the mix o inputs used in production. Moreover, taxes levied on business inputs, such as labour and capital, can aect the cost o providing the goods and services that help to produce. Policy analysts oten voice concern with the implications o taxation or competitiveness; 9 yet the meaning o the term is not always well deined. A natural way to think about competitiveness is as the cost o doing business. Taking this view, the extent to which the tax system aects a irm s, or an industry s, or a country s cost o doing business, is a key determinant o competitiveness. More precisely, we are interested in measuring the extent to which the business tax regime might impinge upon the marginal cost o producing an incremental unit o output. The METR on costs does just this it measures the extent to which taxes levied on irm inputs, such as capital and labour, contribute to the cost o producing one more unit o output. It thus aggregates the various METRs on irm inputs into a summary measure o the extent to which the business tax regime adds to the cost o doing business. Measuring the extent to which the business tax regime impinges upon marginal costs is a natural way to think about the implications o taxation or competitiveness. For example, in their examination o border-tax adjustments on imported goods, Poterba and Rotemberg (1995) speciically identiy the preservation o the competitive position o domestic producers vis-à-vis oreign producers, which they deine as the relative marginal costs o domestic and oreign producers, as the objective pursued by governments. The marginal cost o production is a key determinant o the level and composition o goods and services produced in an economy. Businesses maximize proits by producing output up to the point that marginal revenues (the revenue accruing to the irm due to the production o one more unit o output) are just equal to marginal costs. An increase in marginal costs will cause production to decrease, a decrease will cause output to expand. To the extent that government policies aect the marginal cost o production, through the tax system or otherwise, they can thereore aect the level o goods and services produced in an economy. O particular concern is 8 See Dahlby (1992), Di Matteo and Shannon (1995), and Wilton and Prescott (1993). 9 See, or example, Porter (1993).

13 The Calculation o Marginal Eective Tax Rates 5 the extent to which the business tax regime may result in an uneven playing ield by generating tax-induced dierences in marginal costs across producers within a market, across producers rom dierent jurisdictions, and across industries. To close this subsection, it is important to reiterate the distinction between the two basic types o METRs that will be employed in the subsequent analysis. The irst is the METR on inputs, which includes tangible capital such as buildings, equipment, land and inventories, intangible capital such as E&D and R&D, and labour. These METRs measure the taxes collected on an incremental unit o the input employed by a irm. The second is the METR on costs, which measures the contribution o the taxes levied on the various inputs to the cost o producing an incremental unit o output. As discussed above, both sets o eective tax rate measures are motivated by dierent, though not necessarily mutually exclusive, considerations: the input METRs provide an indication o the extent to which the tax system impinges upon the incentive to employ these inputs, while the cost METRs, which are a unction o the input METRs, measure the impact o the tax system on competitiveness, or the cost o doing business. 2.2 Methodology With the above motivation in hand, we now proceed by presenting an explanation o the basic idea behind the methodology. We begin with a discussion o the METR on costs, which is grounded in the undamentals o elementary price theory. We then move on to a discussion o the METRs on the individual inputs labour, tangible capital and then intangible capital METR on Costs To begin, presume that both input and output markets are perectly competitive. The assumption o perect competition is or expositional purposes only, as the analysis also applies to non-competitive markets (with minor modiications). Consider the output market or some good or service. Figure 1 illustrates the equilibrium in the absence o any taxes. The equilibrium occurs at the intersection o the market supply and demand curves, denoted S(p;W 0 ) and D(p) respectively, where p is the output price, and W 0 is a vector o input prices, or user costs. The equilibrium price in this case is p 0 and the quantity is q 0. Ignore, or the moment, the rest o the diagram. The approach incorporates the vertical linkages between input and output markets. The output market is connected to the input markets by the act that the aggregate supply curve is the (horizontal) sum o the marginal cost curves or the individual suppliers. The marginal cost o providing an additional unit o output thus relects the user cost o the various inputs, which in turn relects the supply and demand conditions in the input markets. This is emphasized by writing aggregate supply as a unction o the vector o input prices W 0. The connection between the input and output markets provides the key to the measure o the METR on production costs. 10 We do not provide a ormal derivation here, as it has been done elsewhere. In particular, the discussion related to the METR on costs closely ollows McKenzie, Mintz and Schar (1997), while the discussion related to the METR on capital ollows Chen and McKenzie (1997) and McKenzie and Mintz (1992).

14 6 WORKING PAPER The various taxes applied to irm inputs aect the marginal cost o providing the product by changing the user costs. For example, i the tax system causes the user cost o, say, labour to rise, the marginal cost o providing an additional unit o output will rise as well, and the industry supply curve will shit up. Reerring again to Figure 1, the ater-tax aggregate supply curve is designated S(p;W ), where W denotes the vector o gross-o-tax user costs. The ater-tax equilibrium price and quantity are p and q respectively. Figure 1 S ( p;w ) p = MC ( q ;W ) S( p;w 0 ) 0 p MC ( q ;W 0 ) D( p ) 0 q q The gross-o-tax marginal cost o production at the ater-tax equilibrium is MC(q ;W ), which is expressed as a unction o the gross-o-tax user costs, W. Associated with this gross-o-tax 0 marginal cost is a net-o-tax marginal cost, deined as MC( q ;W ). The METR on costs is then the tax rate T, which, i hypothetically applied to production costs directly, would yield the same gross-o-tax marginal cost that results under the existing tax regime. Thus, T solves the equation 0 (1 + T )MC( q ;W ) = MC( q ;W ), which gives: T = MC (q ;W ) MC (q ;W 0 ) - 1 (1) As deined in equation (1), the METR on the cost o production gives the rate o tax on marginal costs implied by the various taxes levied on business inputs. It can be viewed as aggregating these various taxes together into a simple eective excise tax rate. In terms o Figure 1, the tax 0 wedge, MC( q ;W ) MC( q ;W ), is expressed as a percentage o the net-o-tax marginal cost, 0 MC( q ;W ).

15 The Calculation o Marginal Eective Tax Rates 7 An important issue concerns the incidence o the taxes levied on irm inputs, or the extent to which those taxes are relected in higher user costs, and thereore in marginal production costs. This is important because, under some conditions, taxes levied on inputs may not aect user costs at all, and will thereore not eed through to marginal costs. In general, the extent to which taxes will be relected in the user cost o the inputs depends upon the supply and demand conditions in the input markets. Consider the introduction o a tax at the METR o t i on input i, where w i = w i(1 + ti ) is the user cost o input i (the ith element o the vector W ), and w i is the equilibrium supply price. Assuming that the input market is competitive, equilibrium is determined by: Di ( w i (1+ ti )) = S i ( wi ) (2) where D i (.) is the demand unction or input i and S i (.) is the supply unction. The demand unction or input i is expressed with respect to the gross-o-tax price o the input, and the supply unction is expressed with respect to the net-o-tax price. For simplicity, prices o other inputs are suppressed. Dierentiating both sides o (2) with respect to the tax rate t i, and evaluating the derivative at zero, gives, ater some algebraic manipulation: w i t i S ηi = wi S D ηi + ηi (3) D S where ηi is the elasticity o demand or input i and ηi is the elasticity o supply. Equation (2) implicitly determines the equilibrium user cost o input i as a unction o the tax rate t, w w i( ti ). A irst-order Taylor series approximation o this implicit unction yields: i i = Using equations (3) and (4) gives: o w i w i = wi + ti (4) ti 0 w = w i (1 + ti β ), i i where S η i β i = S D ηi + ηi (5) and 0 wi is the ith element in the vector W 0. The parameter 0 < β i < 1 is a tax-shiting actor. When β i = 1 the tax is ully shited orward to the demander o the input, and the user cost changes by the ull amount o the tax, as would be the case when the input supply unction is perectly elastic, or demand is perectly inelastic.

16 8 WORKING PAPER When β i = 0, none o the tax is shited orward to the user, and the user cost is unaected by the tax or subsidy, as would be the case when supply is perectly inelastic, or demand is perectly elastic. In the intermediate case, the user cost increases by some raction o the tax Functional Form or Cost Function To calculate the eective tax rate on marginal cost, as in equation (1) above, the marginal cost unction must be parameterized. In general, marginal costs will depend upon the level o output, productivity parameters, input shares, actor prices, and the degree o substitutability between actors. In this section, we illustrate the methodology by employing the commonly used linearly homogeneous Constant Elasticity o Substitution (CES) production unction, which has the orm: q = H i 0 x, ai = i i a i 1 ρ i 1 (6) where q is output, x i is the quantity o input i employed, H, a i, i and ρ are production parameters, and the elasticity o substitution is σ=ρ/(ρ-1). The gross-o-tax marginal cost unction that arises rom the CES production unction is: 1 MC( q ; W ) = H a i b ρ i ( iw i ) 1 b (7) where b=ρ/(ρ-1). 0 MC( q ;W ) is determined by evaluating (7) at W 0 rather than W. Recalling rom our earlier 0 discussion that w i = wi ( 1 + ti β i ), equations (7) and (1) give an eective tax rate on marginal cost or a CES production unction o: T = 1 b 0 b b ρ a ( w ) i 1 b i i i A (1 + ti β i ) 1, where Ai =, A = b i i ρ 0 b i ai ( wi i ) i (8) and A i is the actor share or input i. It is possible to show rom equation (8) that as the elasticity o substitution increases, the eective tax rate on marginal costs decreases. This is because as the degree o substitutability between inputs rises, the irm is better able to respond to changes in relative actor prices by changing the input mix. As such, a tax-induced increase in the relative price o an input has a lower impact on marginal costs, the higher the elasticity o substitution.

17 The Calculation o Marginal Eective Tax Rates 9 Two commonly used special cases o the CES production unction are the Cobb-Douglas (CD) and the Leontie, or ixed proportions (FP), production unctions. The elasticity o substitution or the CD case is unity, in which case equation (8) reduces (in the limit) to: T = i Ai (1 + ti β i ) 1 (9) For the FP case, the elasticity o scale is zero, and the eective tax rate on marginal costs becomes: T = n A i( 1 + ti β i ) 1 (10) i=1 It is interesting to note that the eective tax rate on marginal costs or the FP case relects a simple arithmetic-weighted average o the user costs o the inputs (with net o tax prices normalized to unity), while the rate or the CD case relects the geometric-weighted average. The arithmetic average or the FP production unction relects the act that under this technology, irms are not able to respond to tax-induced changes in user costs by substituting away rom (relatively) highly taxed actors. Factors are employed in ixed proportions, and the eective excise tax rate on marginal costs is simply the arithmetic-weighted average o the METRs on the inputs. In the case o a CD production unction, with the elasticity o substitution equal to unity, there is some scope or substituting between actors, and the eective tax rate on marginal costs relects the geometric-weighted average o the tax rates on the inputs, which is lower than the arithmetic average. The empirical calculations o the METR on cost reported later in the paper are based on the CD parameterization o the cost unction. Although they are not reported here, calculations based on the FP parameterization yield similar results; the eective tax rates are slightly higher because no input substitution is possible METRs on Inputs In order to calculate the METR on costs, we must determine the METRs on the various inputs (the t i s). Moreover, as discussed in Section 2.1, the marginal eective tax rates on irm inputs are o independent interest. To make the measurement task manageable, a certain amount o aggregation is required. In the empirical analysis which ollows in Section 3, we include our types o tangible capital (structures, machinery, land and inventories), two types o intangible capital (E&D and R&D), and labour Labour To calculate the METR on labour, we incorporate the various payroll taxes or other levies or social security, employment insurance, etc. Since taxes on labour are oten applied at variable rates, depending upon income, and may also vary by individual characteristics, the dierence between average and marginal rates can be quite important. A key consideration is the meaning o the marginal unit o labour. The approach we use here is to presume that the employment o a

18 10 WORKING PAPER marginal unit o labour involves hiring an additional worker with typical characteristics. We use employment data to construct a proile o a hybrid marginal worker in each sector being studied, and then calculate the eective tax rate on labour or this hybrid worker. The data used to do this, and the computations themselves, are discussed in detail in Appendix B. The incidence o payroll taxes levied on labour is an important consideration. As discussed above, this depends upon the demand and supply elasticities or labour. There is not a broad consensus among economists regarding the incidence o payroll taxes. The literature does seem to suggest that in the long run, the supply o labour is relatively inelastic, which suggests that in the long term, labour bears the bulk (though not all) o the burden o payroll taxes. 11 However, labour demand is relatively elastic in the short run, which suggests that in the short term, the burden o payroll taxes may well all on producers, at least to some extent. Moreover, payroll taxes may not be shited at all onto workers at the minimum wage. The approach that we take here is to assume or the base case calculations that the economic incidence o payroll taxes coincides with the statutory incidence. Thus, both employers and employees are assumed to bear the share o payroll taxes that they are legally required to pay. This coincides roughly to an assumption that the tax incidence o payroll taxes is split equally between employers and employees; we also consider the implications o alternative shiting assumptions. Another issue that arises in the case o payroll taxes is the question o the extent to which they should be viewed as taxes at all. In many cases, payroll taxes inance certain programs rom which employers and employees directly beneit. The most obvious example is workers compensation, which can be thought o as insurance or on-the-job accidents paid or workers by their employers. Although in some provinces workers compensation payments are not actuarially air, or the most part they are a reasonably good approximation. Thus, in our base case we do not include workers compensation payments made by employers with other payroll taxes. At the other end o the spectrum, since provincial payroll taxes go into general revenues, we treat them as taxes. CPP/QPP taxes and EI premiums are more problematic. This is particularly true or EI premiums, as there are substantial variations in the net EI contributions (contributions less beneits) arising rom EI across sectors. Sectors that are systematically net beneiciaries o EI (with beneits exceeding contributions) can be thought o as receiving a labour subsidy, as they are able to pay lower wages because o the income support oered to their employees by the EI system. Our approach is to consider various scenarios regarding the eective CPP/QPP and EI rates. In the base case, payroll taxes are expressed on a net-o-beneits basis, as the rates are adjusted to relect their direct beneit component. In the case o EI, the adjustments are based upon the net inlows or outlows o EI contributions and beneits. We also make adjustments to relect the recent changes to the CPP/QPP system, which will increase payroll tax rates over the next ive years in order to achieve a sustainable system by These adjustments are described in detail in Appendix B. 11 See Dahlby (1992).

19 The Calculation o Marginal Eective Tax Rates Tangible Capital Tangible capital inputs such as structures, machinery, land and inventories present other problems. The diiculty here is that these inputs give rise to a low o output over time, which requires that we impute a per-period cost o holding capital, and calculate the METR applied to this imputed cost. As is the case with the other inputs, some aggregation is required. For physical assets, the approach adopted here is similar to that taken in the user cost o capital literature, which examines the impact o corporate income taxes on physical investment. 12 To begin, it is again useul to consider an economy without any taxes at all. Firms invest in projects that generate a rate o return in excess o a hurdle rate required by inancial markets. This hurdle rate relects the real (inlation adjusted), net-o-depreciation rate o return that investors (debt and equity holders) could earn in the next-best alternative investment opportunity with similar characteristics. I we presume that the proportion o investment inanced by debt is β, the expected rate o inlation is π, the nominal interest rate on debt is i, and the nominal required rate o return on equity is ρ, then the real hurdle rate o return is a weighted average o the required rate o return on debt and equity, or R = βi + (1 β ) ρ π. 13 I we assume that investment is continuously divisible, and that the marginal revenue product o capital (the increment to revenue arising rom investing in one more unit o capital) eventually declines as the amount o capital employed increases, value-maximizing irms will invest in capital up to the point where the rate o return on the last unit o capital employed is equal to the real opportunity cost o the unds tied up in that capital, R, plus the loss in the value o the capital due to economic depreciation, δ. I we denote the relative price o a unit o capital with respect to output by q K, the expression q K ( R + δ ) is reerred to as the cost o capital. Denoting the marginal revenue product o capital by MRP K, the equilibrium condition is MRPK = qk ( R + δ ), where capital is accumulated up to the point that the marginal unit breaks even in the sense that it earns just enough to cover the cost o capital. 14 This condition implicitly determines the demand or capital by irms as a unction o the rate o return on capital net-o-depreciation, R. We are now in a position to see how taxes on capital can aect capital accumulation. Investors are concerned with the rate o return on their capital, net o both corporate and personal taxes. Consider irst the imposition o personal taxes on interest income and on the return to equity. Denoting by m the personal tax rate imposed on nominal interest income, and by c the eective tax rate on equity, the weighted average net-o-personal tax real hurdle rate o return becomes R n = βi( 1 m ) + (1 β ) ρ( 1 c ) π. In capital market equilibrium, in the absence o risk and capital market imperections other than taxes, the ater-tax rate o return on equity must equal 12 See King and Fullerton (1984), and Boadway, Bruce and Mintz (1984). 13 In the absence o taxation, or other capital market imperections, and risk, i=ρ. For expositional ease, we abstract rom risk in the discussion. However, the analysis and calculations are consistent with the presence o what is commonly reerred to as income risk. Income risk involves uncertainty regarding uture revenues or operating costs. I we express rates o return net o risk, the METR calculations are identical to those presented here. For a discussion o the implications o other types o risk see McKenzie (1994). 14 We are implicitly treating capital as the numeraire.

20 12 WORKING PAPER the ater-tax rate o return on debt; thus i(1 m ) = ρ (1 c ), which implies that ρ = i( 1 m ) /(1 c ), in which case R n = i( 1 m) π. The imposition o corporate taxes aects investment by altering the cost o capital. There are several ways in which this can occur, depending upon the details o the tax system. Here we present a somewhat simpliied representation, which ignores some o the details o the CIT in Canada. Modiications required to take some o these considerations into account are discussed below. As discussed above, irms will accumulate capital up to the point where the rate o return generated by the last unit o capital is just equal to the cost o capital. To yield R n ater personal taxes, the marginal investment must earn R = βi + (1 β ) ρ π ater corporate taxes (and net o g depreciation). Denote by R K the gross-o-corporate tax, net-o-depreciation rate o return on a g marginal unit o capital required to yield R ater corporate taxes thus R K = MRPK / qk δ. g R K will relect various provisions o the corporate tax system. For example, the deductibility o nominal debt interest expenses or corporate income tax purposes lowers the nominal cost o debt inance to i(1-u), where u is the combined ederal-provincial statutory corporate income tax rate, including the ederal surtax. 15 Nominal interest deductibility thus lowers the cost o capital to the irm by reducing the average opportunity cost o inance to R = β i( 1 u ) + (1 β ) ρ. 16 The cost o capital is also lowered by the reduction in the eective purchase price o capital, due to the presence o tax depreciation allowances and investment tax credits (ITCs). A company that is provided with an ITC at the rate φ and annual depreciation allowances that generate a reduction in taxes o ua in present value terms, A being the present value o the tax depreciation allowances on one dollar o capital, 17 aces an eective purchase price o capital that is lowered by the amount φ+ua per dollar. Taking all o this into account, the ater-tax cost o capital or a irm is qk ( R + δ π )(1 φ ua ). Recognizing that the incremental revenue generated by an additional unit o capital is taxed at the statutory tax rate, leaving MRP K (1 u ) ater tax, the irm's value maximization condition becomes MRP (1 u ) = q ( R + δ π )(1 φ ua ), or MRPK = qk ( R + δ π )(1 φ ua ) /( 1 u ), whereby the marginal revenue product o capital is equal to the gross-o-depreciation, tax-adjusted user cost o capital. Using this equilibrium g condition, and recalling the deinition o R above, the gross-o-corporate-tax, net-o-depreciation rate o return on a marginal unit o capital is: K K R g K = ( R 1 -φ - ua + δ - π ) 1 - u - δ (11) 15 Thus, u = u (1+ s ) + u p where u is the ederal CIT rate, s is the ederal surtax rate and u p is the provincial CIT rate. 16 Note that the required rate o return to equity, ρ, is not deductible or tax purposes. 17 In the absence o various provisions such as the hal-year rule (which is included in subsequent calculations but t t ignored here or simplicity), A is the ininite sum A = (1 φ ) [ α(1 α ) /(1+ R ) ] = (1 φ ) α /( R + α ), where α is the declining balance Capital Cost Allowance (CCA) rate. This relects the reduction in the tax deprecation base by the ITC. t= 0

21 The Calculation o Marginal Eective Tax Rates 13 As indicated above, some aspects o the business tax system in Canada that are relevant to g physical capital are omitted rom the ormulation o R K given in equation (11). Three o these will be discussed here. Provisions that relate speciically to the resource sector are discussed in Subsection below. First, as discussed above, although the GST largely eliminated the taxation o business inputs, including capital, at the ederal level, various provincial retail sales taxes still result in some sales taxes being levied on some types o capital. This is particularly relevant or machinery and equipment; the problem is less acute or structures and land. Second, the ederal government levies a tax on the capital o large corporations with assets in excess o $10 million (the Large Corporations Tax). The ederal surtax is creditable against the LCT. This means that the LCT impacts only on large corporations with an LCT liability in excess o the surtax this is why the LCT is sometimes reerred to as a minimum tax on large corporations. Third, some provinces impose capital taxes on the capital o large corporations as well. Taking these actors into account, the gross rate o return on a marginal unit o capital becomes: R g K = (1+t s )( R 1- φ - ua+( + δ -π ) t +t P(1 - u))/( R 1- u L + α ) - δ (12) The term t s is the eective sales tax rate on machinery and equipment; it serves to increase the cost o a unit o capital by ( 1 + ts ). This term is relevant or machinery and equipment only, as it is presumed that buildings bear no sales taxes. The term t L is the LCT rate, 18 and t P is the provincial capital tax rate. Thus, ( t L + t P ) /( R + α ) is the present value o the ederal and provincial capital taxes that arise due to the purchase o an incremental unit o capital; t P is multiplied by (1-u) to relect the act that provincial capital taxes are deductible or CIT purposes. The expressions to this point have ocussed on investments in machinery and equipment and buildings. The equations may be modiied to develop similar expressions or investments in land and inventories. Land is similar to investments in machinery or buildings, except that we presume that there is no physical depreciation, so δ is set to zero. Moreover, there are no capital cost allowance deductions, no sales taxes and no investment tax credits, thereore A=φ=t s =0, leaving, g 1+( t L +t P(1 - u))/ R RL = ( R - π ) (13) 1- u For investment in inventories, the relevant eature o the tax system is the act that inventory purchases are ully deducted or tax purposes when used, sold or otherwise disposed o. However, the deduction is based on the irst-in, irst-out (FIFO) method o inventory accounting. This means that a deduction or the original cost o the inventory item is made at the time o disposition, and there is no accounting or any increase in that cost due to inlation. As such, 18 It is presumed in equation (12) that the irm pays the LCT [i.e. the surtax is zero]. The METRs calculations relect a weighted average o irms that pay the LCT and those that do not; see Appendix A or more detail.

22 14 WORKING PAPER an inlation tax is imposed on inventory holdings. 19 I we presume that inventories somehow increase the productivity o the irm, then we can use an approach similar to that used or physical capital. The ater-tax marginal revenue product rom investing an incremental unit in inventories is, as above, MRP I ( 1 u ). The opportunity cost o inventories consists o the orgone return on the capital invested in the inventories and the various tax costs. The ater-tax cost o a marginal unit o inventory capital is thus q ( R π + uπ + ( t + t (1 u )). As above, proit maximization requires MRPI (1 u ) = qi ( R π + uπ + ( t L + t P( 1 u )), or, in rate o return orm: I L P R g I = R -π + u π + ( t 1- u L + t p (1 - u)) (14) The Non-Renewable Resource Sector The discussion above ocusses exclusively on tangible capital employed in the non-resource sector. The non-renewable resource sector mining and oil and gas deserves separate treatment, because o its special characteristics and the special eatures o the tax system applied to it. Most important in this regard are the tax treatment o E&D and the incorporation o special resource levies imposed on the resource sector by the provinces. With respect to the latter, the treatment o provincial resource levies, speciically mining taxes imposed upon businesses involved in mining and royalties imposed upon oil and gas companies, is an important consideration. A somewhat contentious issue concerns whether these levies should be treated as a tax or a cost in the calculation o METRs. While rom the perspective o the irms employed in the extraction o non-renewable resources this distinction is largely meaningless at a simple level they are concerned with the cost o employing inputs and producing output, not with how or why a cost arises the matter can be important to policy makers. The approach taken in this study is to treat provincial resource levies as a cost; however, we also present calculations where they are treated as a tax or comparative purposes. Even in the case where resource levies are treated as a cost, mining tax and royalty rates still aect the METRs because o the way that such levies interact with the corporate income tax system. Particularly important in this regard is the act that such levies are not deductible or ederal corporate income tax purposes, rather, a ederal resource allowance is granted instead (more on this below). The Oil and Gas Sector Oil and gas royalty systems are quite complex. For our purposes, it is convenient to simpliy the regime by assuming that a simple average royalty rate applies. In act, royalty rates vary by production, year o discovery, and the price o oil or gas. As indicated above, royalties are not deductible or ederal CIT purposes, but are or provincial purposes. 20 In lieu o the deduction o 19 For more on taxation and the cost o holding inventories, see Boadway, Bruce and Mintz (1982). 20 With over 90% o oil and gas production occurring in Alberta, we model the Alberta system only.

23 The Calculation o Marginal Eective Tax Rates 15 royalties, at the ederal level, a resource allowance equal to 25 percent o revenues net o operating costs and CCA deductions is granted. Notably, the resource allowance base is not reduced by interest expenses or Canadian Exploration Expenses (CEE). The implications o this will be discussed below. For the oil and gas sector, the ater-cit and ater-royalty marginal revenue product or input i is MRPi ( 1 g u (1 + s )(1 σ ) u p (1 g)), where σ is the ederal resource allowance rate and g is the eective royalty rate; this can be written as MRPi ( 1 g)(1 u (1 σ )(1 + s )(1 g) u p ). The ater-tax marginal revenue product relects the act that royalties are deductible or provincial CIT purposes, but not or ederal CIT purposes, where a resource allowance is granted instead. For physical assets in the oil and gas sector (structures and machinery), the ater-tax cost o capital is qk(1+ ts )(R + δ π )(1 φ (u (1 σ ) + up )A+(tL + t p(1 u))/(r + α)), which incorporates the LCT and provincial capital taxes and any sales taxes levied on physical capital, and relects the deductibility o CCA deductions rom the resource allowance base. As above, the optimality condition involves the employment o capital up to the point where the ater-tax marginal revenue product o capital is equal to its ater-tax marginal cost, or MRP K ( 1 g) ( 1 u (1 σ )(1 + s ) /(1 g) u ) = q (1 + t )( R + δ π )(1 φ ( u (1 σ ) + u ) A + p K S ( t L + t p (1 u)) /( R + α)). As beore, this condition can be expressed in rate o return terms by deining the gross-o-tax and royalty rate o return on a marginal unit o capital as g R K = MRPK / qk δ. Expressed in this way, oil and gas royalties are treated as a tax, and we have: p R g K = (1 + t s )( R + δ -π )(1-φ - ( u (1 -σ ) + u (1- g)(1- u (1- σ )(1 + s p ) A + ( t L + t p(1- )/(1- g) - u p ) u))/( R + α )) - δ (15) I royalties are treated as a cost rather than a tax, we deine the gross-o-tax, net-o-royalty rate o g return as R = MRP (1 g ) δ, giving: K K R g K = (1 + t s )( R p + δ -π )(1-φ - ( u (1 -σ ) + u p ) A + ( t L + t (1- u (1- σ )(1 + s )/(1- g) - u p ) (1- u))/(r + α )) - δ (16) Equations (15) and (16) dier rom one another in that the ormer (where royalties are treated as a tax or measurement purposes) multiplies the denominator by (1-g), while the latter (where royalties are treated as a cost) does not. However, in the latter case, royalties still aect the gross-o-tax, net-o-royalty rate o return, so long as the resource allowance rate (σ) does not equal the royalty rate (g). The ormulas or the gross-o-tax marginal rates o return on investments in inventories and land in the oil and gas sector are straightorward to adjust in a similar way, so they are not reported here.

24 16 WORKING PAPER As discussed above, not only do non-renewable resource irms ace a dierent tax regime than other sectors, they also invest in dierent types o capital. O particular interest in this regard is E&D. The ormulas or E&D ollow the basic methodology presented above, with the exception that E&D is portrayed as a point-input, point-output process (see Boadway, Bruce, McKenzie and Mintz (1987)). This means that E&D expenditures produce output in the year they are incurred. While a low-input, low-output type process might be more realistic whereby E&D expenditures take place over time and generate a low o output into the uture this modelling approach has not been attempted beore, and poses various technical problems. Canadian Exploration Expenses in the oil and gas sector are expensed or CIT purposes. Moreover, unlike CCA deductions, they do not reduce the resource allowance base. This means that CEE are deducted at a higher rate than the resulting revenues are taxed, which tends to lower the METR. Provincial capital taxes and the LCT also do not apply to CEE. The marginal cost o a unit o exploration is 1 u u p, which relects the act that CEE are written o immediately or tax purposes and do not reduce the resource allowance base. Treating royalties as a tax, the ater-tax marginal revenues are MRPCEE ( 1 g)(1 u (1 σ )(1 + s ) /(1 g) u p ), which relects the act that exploration expenditures are deductible or provincial income tax purposes (in Alberta), but not or ederal tax purposes. When royalties are treated as a tax, the gross-o-tax rate o return on CEE is simply: R g CEE = (1 g)(1 u 1 u u p (1 σ )(1 + s )/(1 g) u p ) (17) When royalties are treated as a cost, the expression becomes: R g CEE = 1 u 1 u u p ( 1 σ )(1 + s )/(1 g) u p (18) A similar expression exists or Canadian Development Expenses (CDE), except that it is adjusted to take account o the act that these expenditures are written o over time rather than deducted immediately. The Mining Sector The mining sector aces the same issues discussed with respect to oil and gas. However, there are some important dierences that make the treatment o mining more diicult. These dierences involve the treatment o provincial mining taxes, which are more complicated to incorporate into the modelling ramework than oil and gas royalties. While royalties are represented as a simple levy on gross oil and gas revenues, most provincial mining tax systems grant various deductions and allowances or capital expenses and E&D. Moreover, these regimes vary substantially across the provinces. To simpliy matters, the METR model incorporates the provincial mining tax regimes o B.C., Ontario and Quebec only; these provinces account or over 70 percent o mining investment in Canada. The mining tax regimes in these provinces are quite complicated,

25 The Calculation o Marginal Eective Tax Rates 17 thereore, we limit our discussion here to a simpliied system. For a more extensive discussion, see Boadway and McKenzie (1989), and Boadway, McKenzie and Mintz (1990). The simpliied mining tax system presented here allows physical capital to be written o over time, generating a deduction o A m in present value terms. The mining tax rate is denoted u m. For simplicity, we ignore various processing and other allowances oered under provincial mining tax regimes, although they are incorporated into the calculations presented later. 21 For physical assets in the mining sector (structures and machinery), the ater-tax cost o capital is qk ( 1 + ts )( R + δ π )(1 φ ( u (1 σ ) + u p )A um Am + ( t L + t p(1 u )) /( R + α )), which incorporates the LCT at the ederal level, provincial capital taxes and sales taxes on machinery, and which relects the deductibility o CCA rom the resource allowance base. Following the by now amiliar approach, the optimality condition involves the employment o capital up to the point where the ater-tax marginal revenue product o capital is equal to its ater-tax marginal cost, that is MRPK (1 u (1 σ )(1 + s ) u p um(1 u p )) = qk (1 + ts )( R + δ π ) (1 φ ( u (1 σ ) + u p )A um Am + ( t L + t p( 1 u )) /( R + α )). As beore, this condition can be expressed in rate o return terms by deining the gross-o-tax and gross-o-royalty rate o g return on a marginal unit o capital as R K = MRPk / qk δ. Expressed in this way, mining taxes are treated as a tax, and we have: R g K = ( R + δ π )(1 φ 1 ( u u ( 1 σ ) + u p ( 1 σ )(1 + s )A ) u u m A p m u + ( t m (1 L + u t p p ) (1 u )) /( R + α )) δ (19) I mining taxes are treated as a cost rather than a tax, we deine the gross-o-tax, net-o-miningtaxes rate o return as R = MRP (1 u ) /( 1 u A ) δ. Ater rearranging, this g yields: K k m m m R g K ( R = δ π )(1 φ (u (1 σ )A + + u ( A u p 1 u (1 σ )(1+ s ) /(1 m A m ))/(1 u u m m ) A m u ) + (t p t l + p (1 u ))/(R α )) δ + (20) Exploration and development expenditures are typically written o immediately or mining tax purposes. Following the same approach as or oil and gas, when mining taxes are treated as a tax, the gross-o-tax rate o return on E&D is simply: R g ED = 1 u 1 u u p u (1 σ )(1 + s ) u p m u m (1 u p ) (21) 21 Most provincial mining tax systems grant processing allowances, which provide additional write-os or processing assets up to a maximum expressed as a share o taxable income. For our purposes, we assume that the maximum restrictions o the processing allowances are binding.

26 18 WORKING PAPER When mining taxes are treated as a cost, the expression becomes: R g ED = 1 u 1 u u p (1 σ )(1 + s )/(1 g) u p (22) Non-Renewable Resources in the United States For the U.S. non-renewable resource sector, the tax regimes in Nevada and Texas were used or the mining and oil and gas respectively. As in Canada, the taxation o the resource sector in the U.S. is quite complicated and contains numerous special provisions. Here we briely discuss some o these provisions and their treatment within the METR model. The ederal government in the United States imposes a 2 percent production royalty on the net value o minerals extracted rom ederal lands; this royalty is deductible or the ederal corporate income tax. The treatment o exploration expenses in the U.S. is quite complicated. Firms have two choices with respect to the recovery o the costs associated with exploration expenses: percent o exploration costs may be expensed in the year incurred, with the remainder recovered in a straight-line ashion over 60 months; i this treatment is chosen, the expenses must be subsequently recaptured ater achieving production; or 2. exploration costs may be capitalized and recovered through a depletion allowance. For purposes o calculating METRs or the U.S. non-renewable resource sector, we presumed that the second method is used. This was done primarily or simplicity, as there are substantial analytical diiculties in modelling the U.S. recapture provisions. There are two methods or determining the depletion allowance in the United States. The irst, cost depletion, involves dividing the depletable cost o the property by the estimated recoverable reserve to arrive at a unit cost. The unit cost is then multiplied by current unit sales, to arrive at cost depletion or the taxable year. The second, percentage depletion, involves multiplying gross income rom the property by a speciied depletion allowance rate, which varies depending upon the mineral product. The percentage depletion deduction is limited to 50 percent o the net income o the property. Taxpayers may continue to claim percentage depletion even ater the ull depletable capital investment in the property has been recovered by prior depletion claims. For our calculations, we presume the use o percentage depletion. Moreover, we assume that the 50 percent limit on the depletion allowance is binding. For modelling purposes, this amounts to reducing the corporate income tax rate by 50 percent. With regard to development expenditures, irms also have two options. They may capitalize 100 percent o the expenses and amortize them on a unit o sales basis; or, they may deduct up to 70 percent o the expenses immediately, and amortize the remaining 30 percent over a 60-month period. I the latter option is chosen, there is no recapture required or the development expenditures. We presumed that development expenditures were recovered using the second approach. Post-development costs in the United States can be ully expensed, and no recapture is required.

27 The Calculation o Marginal Eective Tax Rates 19 Tax provisions speciic to the mining sector in Nevada include the ollowing. Nevada imposes no corporate income tax at the state level. However, a progressive minerals extraction tax is imposed on net proceeds. The rate ranges rom 2 percent to 5 percent, depending on the ratio o net proceeds to gross proceeds. A sales tax o 6.5 percent is applied to the purchase o machinery and equipment, and a tax on the transer o property is levied at a rate o 0.13 percent. With regard to the treatment o oil and gas in Texas, there is also no corporate income tax at the state level. A severance tax is imposed on gross production at a rate o 4.6 percent, which is deductible or ederal corporate income tax purposes. The aggregate royalty is percent, which consists o both ederal and state royalties on gross revenue. A sales tax o 6.25 percent is applied to the purchase o machinery and equipment. There is no tax on the transer o property in Texas. With these assumptions in hand, it is straightorward to modiy the METR ormulas described above to undertake similar calculations or the mining and oil and gas sectors in the United States Research and Development Expenditures on R&D receive special treatment under the corporate income tax. Expenditures on both labour and machinery and equipment related to scientiic research are written o immediately. Moreover, the ederal government grants these expenditures a tax credit (the scientiic research and experimental development tax credit). The treatment o R&D varies substantially across the provinces. To simpliy matters, only the R&D regime in Ontario was incorporated into the analysis. To calculate METRs or R&D, we distinguish between labour inputs into the R&D process and capital inputs. Labour inputs are treated much like E&D in the resource sector, except, o course, that the tax treatment is dierent. The ater-tax cost o a unit o labour employed in R&D is ( 1 φ )(1 u u p (1 + ω)), where φ is the SR&ED tax credit rate and ω is the Ontario superallowance rate. The ater-tax marginal revenue rom labour R&D is MRPRDL(1 u u p ). R&D labour will be employed up to the point where the ater-tax marginal cost is equal to the g ater-tax marginal revenue. Deining R = MRP : L RDL R g L ( 1 φ)(1 u u p (1 + ω)) = 1 u (1 + s ) u p (23) For capital equipment expenditures on R&D, we ollow the same procedure as above to obtain: R g K = ( R + δ π )(1 φ)(1 u u p (1 + ω 1 u (1 + s ) u p )) (24) Note that expenditures on equipment used in R&D are deducted immediately, which means that the present value o the deductions on a one dollar expenditure is one dollar (thus, A=1).

28 20 WORKING PAPER Input METRs We are now in a position to determine the marginal eective tax rates on the capital inputs used in the METR on cost expressions (the t i s). As discussed above, or capital inputs to yield R n ater personal taxes, a marginal investment must earn R = βi + (1 β ) ρ π ater corporate taxes (and net-o-depreciation). The METR on input i is deined as the tax rate which, i applied to the net-o-corporate-tax rate o return R, yields the gross-o-tax rate o return g or ( 1 + t )R =, or i R i R, g i t i g Ri R = (25) R Using this expression, and the various ormulas or R g discussed above, METRs may be calculated on each o the capital inputs. 22 For labour, E&D and labour type R&D, which are modelled on a point-input, point-output basis, the R in the expression may be viewed as being normalized to unity METRs or the G-7 Countries and Mexico With regard to the calculation o METRs or the G-7 countries plus Mexico, the ormulas or Canada were modiied to account or speciic eatures o the tax systems in each o the countries. 23 Some o the key tax parameters incorporated into the model are shown in Table A.13 (Appendix A). It should be noted that or all o the countries, except the United States, a great deal o aggregation was required, as we lacked disaggregated data or these countries. For the United States, more disaggregated inormation was available, and thus a disaggregated METR model much like that developed or Canada was used Results Beore we present the results, it is important to briely discuss the eatures o the ederal and provincial tax systems that are included in the METR model. The interested reader should reer to Appendixes A, B and C or more detail. At the ederal level, the present value o depreciation deductions arising rom the decliningbalance depreciation o physical assets under the capital cost allowance (CCA) system relects dierences in CCA rates across asset types, straight-line treatment or some assets, and the hal-year rule. The statutory tax rates relect dierences in the proportion o income subject to the lower manuacturing and processing rate across sectors, as well as the lower rate aced by 22 This diers slightly with some o the METR literature, which expresses METRs relative to the gross-o-tax rate o return rather than the net-o-tax rate o return. The approach adopted here is consistent with the METR on cost orientation o the study. See McKenzie, Mintz and Schar (1997). 23 Reer to McKenzie and Chen (1997) or detailed modiications to the METR ormulas that take into account some o the special eatures o the country tax systems. 24 For more on the calculation o METRs or the U.S., see McKenzie and Mintz (1992) and reerences therein.

29 The Calculation o Marginal Eective Tax Rates 21 small Canadian-controlled private corporations (CCPCs). The model also incorporates special tax credits or investments in qualiying regions and activities, the deductibility o interest expenses or tax purposes, and the FIFO treatment o inventories. Similar provisions at the provincial level are also relected in the model, although we do not incorporate some o the special investment allowances and tax holidays that are available in some provinces. For the non-renewable resource sectors o oil and gas and mining, most o the eatures o provincial mining tax and royalty regimes are incorporated in the model, although some simpliying assumptions had to be made or analytical tractability. The LCT at the ederal level, as well as taxes levied on capital by some provinces, are incorporated into the model. We do not include local property taxes in the model because o the very wide variation in both the eective property tax rate across localities and the lack o a consistent data set. For taxes on labour, as discussed above and in Appendix B, payroll taxes associated with the CPP and EI programs at the ederal level, as well as provincial payroll taxes are incorporated into the analysis. In this section, we report the Canadian METRs on production inputs and METRs on cost, or the base case and or selected alternative scenarios. The results are presented or 12 industries, three irm groups (large, small, and combined large and small), and the seven production inputs discussed in Section 2: our tangible inputs (structures, machinery, land and inventories), two intangible inputs (E&D and R&D), and labour. 25 The tables in this section show the METRs or each o the seven production inputs individually (expressed with respect to net-o-tax returns), as well as several aggregations. For example, the METRs on tangible capital are aggregated together, as are the METRs on tangible and intangible capital. The overall METR on costs, including tangible and intangible capital as well as labour, is reported in the inal column o each table. In order to keep the discussion simple, the emphasis will be on two types o comparisons. First, or a given scenario, the METRs show three types o distortions caused by the tax system: distortions across irm sizes, which come mainly rom a preerential treatment o small companies relative to large companies; distortions across production inputs, which come mainly rom diering CCA rates relative to economic depreciation rates, investment tax credit rates, and statutory tax rates on tangible and intangible inputs versus labour; and distortions across industries, which come rom a combination o all these tax actors, coupled with dierences in input shares and irm sizes. The second type o comparisons is between scenarios. These comparisons show the direction and magnitude o change in the METRs as well as the change in the distortions mentioned above. 25 We do not report METR results separately or the capital and current components o R&D because more than 90% o scientiic research and experimental development (SR&ED) expenditures are current in nature (e.g. salaries and beneits or research sta). It is assumed here that all SR&ED expenditures constitute an intangible input, although the METR on R&D is calculated as a weighted average o METRs on capital and current SR&ED expenditures.

30 22 WORKING PAPER The Base Case Table 3.1-A shows the METRs or the base case, which are reported in the Technical Committee s main report. 26 The base case assumptions are consistent with the Canadian corporate tax system in 1997 (see Appendixes A and B). As discussed above, payroll tax rates are reported on a net-o-beneit basis, under the assumption that the economic incidence o payroll taxes is congruent with the statutory incidence; the rates also incorporate CPP and EI rates that are consistent with the sustainable system envisioned in 2003 (see Appendix B). Although the calculations speak largely or themselves, and are discussed in the Technical Committee s report, we note the ollowing: small irms are treated more avourably than large irms; METRs on tangible capital are appreciably higher than those on intangible capital and labour; and service industries are treated less avourably than non-service industries such as agriculture and orestry, non-renewable resources and construction. The METRs on large irms are appreciably higher than those on small irms or all o the inputs individually and or marginal cost. For example, the METR on investments in structures and inventories by large irms is three times as high as that on investments by small irms. This is due to the much lower tax rates aced by small CCPCs. This also helps explain why the gap between total METRs on investment in machinery or large and small irms is less important CCA deductions are more valuable or large irms because they are subject to higher tax rates. Note also that the METR on labour or large irms is slightly higher than that or small irms, due to exemptions rom payroll taxes granted to small irms in some provinces (see Appendix B). The second type o distortion caused by the tax system is across the various production inputs. In Table 3.1-A (Large and Small Firms), note that tangible capital is taxed much more heavily than intangible capital and labour. In the case o R&D, the system provides a subsidy through the SR&ED tax credit and generous write-os or current and some capital expenditures. E&D in the resource sector also aces very low METRs because o ast write-os or these expenditures. Also o note is the low METR on machinery in the manuacturing industry (or both the large and small-irms groups). This arises because o the relatively ast write-o rate or equipment used in manuacturing. Finally, note that the distortions across the various inputs vary between large and small irms. For example, the METR on investment in inventories by large irms is appreciably higher than the METR on machinery (60.2 percent versus 24.4 percent); or small irms, inventories and machinery ace similar METRs (19.8 percent versus 21.8 percent). The dierential METRs on individual inputs across large and small irms largely relects the dierences in statutory tax rates. 26 The igures in this table are based on input cost excluding taxes. Table 3.1-B shows METRs on capital, expressed with respect to gross-o-tax returns. The comparative analysis that ollows is not aected by how METRs are expressed (see methodology in Section 2 or more detail).

31 The Calculation o Marginal Eective Tax Rates 23 The third type o distortion caused by the tax system is across industries. The Large and Small Firms section o Table 3.1-A shows that overall, METRs or agriculture, orestry, non-renewable resources, construction and retail trade are lower than those or the other industries. Looking at METRs on cost by industry or large and small irms separately, the picture is about the same, which suggests that size is not an important actor, except perhaps or manuacturing and services in the small-irms group. Table 3.1-C considers urther the variation in METRs on capital by reporting three weighted dispersion measures: inter-asset, inter-industry and overall dispersion, by irm size. 27 As expected, the overall dispersion is the highest, since it relects inter-industry, inter-asset and inter-size variations in METRs. 28 The asset dispersion is higher than the industry dispersion or both the large- and small-irms groups, which suggests that inter-asset distortions caused by the tax system are larger than inter-industry distortions. Further analysis showed that on average, R&D METRs account or about 40 percent o the inter-asset dispersion, and 30 percent o the overall dispersion; rom Table 3.1-A, recall that the METRs on R&D are negative and high. 3.2 Alternative Scenarios In this subsection, various alternative scenarios are considered. The purpose o these scenarios is to examine the sensitivity o the METRs to various economic and tax parameters. In each scenario, only one actor is modiied, the others remain equal to the base case. The remainder o this subsection outlines these scenarios and reports the METR results Industry-Speciic Debt-Asset Ratios In the base case, the capital structure o all irms was ixed at 40 percent debt-inancing and 60 percent equity-inancing. Given that interest is deductible or tax purposes while dividends are paid out o ater-tax income, we would expect the METRs to decrease as the debt-asset ratio 27 The dispersion measures are based on Jog and Mintz (1989). The overall dispersion is calculated as 2 1 / / 2 [ wij ( tij t ) ], the industry dispersion is [ w j [ wij( tij t j ) ]], and the asset dispersion is i j 2 1 / 2 wi [ wij( tij ti ) ]] i j j i [, where i is the industry index, j is the asset index, t is the METR, t is the average METR, and the w s are the normalized weights. In this table, the dispersion measures are based on METRs expressed with respect to gross-o-tax returns; in Section 5 (Table 5.2-B and 5.2-C), we report dispersion in METRs on capital and labour, based on METRs expressed with respect to input costs ater taxes. The aggregation level used in the calculation o the dispersions is the same one used to report METR results in this section, that is 12 industries and seven inputs (structures, machinery, land, inventories, E&D, R&D and labour). Note that labour was excluded rom the results in Table 3.1-C and 5.2-A, but it was included in Table 5.2-B and 5.2-C. The dispersion measures reported in Table 3.1-A and 5.2-A were also calculated using the lowest aggregation level available (i.e. 35 industries, seven structure types, 20 machinery types, two E&D types and R&D); the results are similar or the overall and asset dispersion, but tend to be lower or the industry dispersion. 28 Note that the dispersion measures in the column Large and Small Firms are based on METRs or large and small irms taken separately, rather than on average METRs. The number o observations used in calculating these measures is thereore twice that used in the calculation o the dispersion measures reported in the Large Firms and Small Firms columns.

32 24 WORKING PAPER increases. Table 3.2-A reports METRs with industry-speciic debt-asset ratios, and Table 3.2-B reports the change in METRs (in percentage points) between this scenario and the base case. 29 Table 3.2-B shows that, compared to the base case, METRs increase or industries with debt-asset ratios lower than 0.4, and decrease or those whose debt-asset ratios are higher. Note also that the change in METRs is more important or large irms than or small irms; this is due to the act that large irms are subject to higher statutory tax rates, which yield higher tax values or interest deductions Non-Tax-Paying Firms The base case, as well as all other scenarios considered in this section, assume that irms are in a tax-paying position. In this scenario, we calculate METRs or non-tax-paying irms. The methodology used is based upon Mintz (1988). Non-capital losses in a given year can be carried orward seven years or back three years, to reduce taxable income in those years. Such losses are thereore valuable to the company, only i it can use them against uture (seven years) or past (three years) proits; otherwise they are expired losses. Non-capital losses impact the METRs through the statutory corporate income tax rate; $1 o loss in a given year can be seen as reducing the statutory income tax rate by a loss utilization actor equal to 1 /(1+ ρ ) T,where ρ is the cost o equity inancing and T is the number o years that elapse beore the $1 loss expires. The methodology used to calculate the loss utilization actor or each sector is discussed in Appendix A. Tables 3.3-A and 3.4-A report the METRs or non-tax-paying irms and combined tax-paying and non-tax-paying irms respectively; Tables 3.3-B and 3.4-B report the dierence (in percentage points) between Table 3.3-A and the base case and Table 3.4-A and the base case respectively. Note that METRs or non-tax-paying irms are lower than those or tax-paying irms. From the ormula or the loss utilization rate in Appendix A, it is easy to see that the higher this rate, the lower the METR Resource Levies Treated as a Tax Tables 3.5-A and 3.5-B report METRs or the resource sector treating resource levies as a tax, and the dierence between this scenario and the base case respectively. 30 Not surprisingly, the METRs increase when resource levies are treated as a tax. Note in particular the substantial 29 The industry-speciic debt-asset ratios are derived rom Jog (1997); see Appendix A or more detail. For the purpose o this simulation, it is assumed that small irms have the same debt-asset ratio as large irms in a given industry. This assumption would tend to underestimate the METRs or small irms, since we would expect them to have lower debt-asset ratios. 30 The most important levies are mining taxes and oil and gas royalties. Recall that the mining sector is represented by British Columbia, Ontario and Quebec, and the oil and gas sector is represented by Alberta.

33 The Calculation o Marginal Eective Tax Rates 25 increase in METRs, especially or structures and machinery in the mining industry; the input structures in this industry includes investments in new mines and major expansion o existing mines, which are ully expensed or ederal income tax purposes Alternative Assumptions Regarding Payroll Taxes In this last subsection, we analyse the impact o alternative assumptions regarding the burden o payroll taxes on METRs. Three scenarios were considered: (a) METRs on labour relect 1997 CPP/QPP and EI rates, gross-o-beneits; 31 (b) METRs on labour are those in scenario (a), but they include workers compensation, (i.e. workers compensation is treated as a tax on labour rather than a orm o insurance provided by employers); (c) irms bear only two thirds o their statutory share o payroll taxes, one third is shited to the employee. 32 The METRs or these three scenarios are reported in Tables 3.6-A, 3.6-B and 3.6-C respectively. Note the dierence between the METRs on labour expressed gross-o-beneits o unded programs versus those expressed net-o-beneits, 8.0 percent versus 2.7 percent on average. The METRs on labour in scenario (b), which treats workers compensation payments as a tax, yields the highest METRs; compared to the base case, the increase is especially important or agriculture, orestry and construction. In scenario (c), there is a reduction in METRs on labour, and consequently METRs on cost, as one third o the burden o labour taxes is assumed to be shited to the employee through lower wages and beneits. 31 Recall that in the base case, labour METRs are expressed net o estimated beneits o unded programs. CPP/QPP and EI rates are those expected to be eective when current changes are completely phased in shortly ater Labour METRs in this scenario are those o the base case.

34 26 WORKING PAPER TABLE 3.1-A METRs on Inputs: The Base Case Tangible Inputs Total Intangible Inputs Total Labour Total Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: In all the tables reported in Section 3, except Table 3.1-B, METRs are expressed with respect to input costs excluding taxes. Columns labelled Total relect rom let to right: total METRs on tangible inputs, total METRs on tangible and intangible inputs and METRs on costs.

35 The Calculation o Marginal Eective Tax Rates 27 TABLE 3.1-B METRs on Capital: The Base Case Tangible Inputs Total Intangible Total Inputs Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: METRs are expressed with respect to gross-o-tax return on investments.

36 28 WORKING PAPER TABLE 3.1-C Dispersion in METRs on Capital Large Firms Small Firms All Firms (percent) Overall Dispersion Industry Dispersion Asset Dispersion Note: The dispersion measures are based on METRs on tangible and intangible capital expressed with respect to gross-o-tax returns (see Table 3.1-B). The aggregation level used is 12 industries and six assets (structures, machinery, land, inventories, E&D and R&D). See Appendix A or more detail on the aggregation structure o the METR model.

37 The Calculation o Marginal Eective Tax Rates 29 TABLE 3.2-A METRs on Inputs: Industry-Speciic Debt-Asset Ratios Tangible Inputs Total Intangible Total Labour Total Inputs Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: Industry-speciic debt-asset ratios are shown in Table A.12 (Appendix A).

38 30 WORKING PAPER TABLE 3.2-B Change in METRs on Inputs: Industry-Speciic Debt-Asset Ratios vs. The Base Case (in percentage points) Tangible Inputs Total Intangible Total Labour Total Inputs Structures Machinery Land Inventories E&D R&D Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

39 The Calculation o Marginal Eective Tax Rates 31 TABLE 3.3-A METRs on Inputs: Non-Tax-Paying Firms Tangible Inputs Total Intangible Inputs Total Labour Total Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: See Appendix A or a discussion on the calculation o METRs on non-tax-paying irms, and in particular Table A.11, which reports loss utilization rates and proportions o tax-paying irms, by industry.

40 32 WORKING PAPER TABLE 3.3-B Change in METRs on Inputs: Non-Tax-Paying Firms vs. The Base Case (in percentage points) Tangible Inputs Total Intangible Inputs Structures Machinery Land Inventories E&D R&D Total Labour Total Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: See Table A.11 (Appendix A) or the proportions o tax-paying irms, by industry.

41 The Calculation o Marginal Eective Tax Rates 33 TABLE 3.4-A METRs on Inputs: Combined Tax-Paying and Non-Tax-Paying Firms Tangible Inputs Total Intangible Inputs Total Labour Total Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

42 34 WORKING PAPER TABLE 3.4-B Change in METRs on Inputs: Combined Tax Paying and Non-Tax-Paying Firms vs. The Base Case (in percentage points) Tangible Inputs Total Intangible Inputs Structures Machinery Land Inventories E&D R&D Total Labour Total Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

43 The Calculation o Marginal Eective Tax Rates 35 TABLE 3.5-A METRs on Inputs: Resource Levies Treated as a Tax Tangible Inputs Total Intangible Inputs Structures Machinery Land Inventories E&D R&D (percent) Total Labour Total Mining Oil and Gas TABLE 3.5-B Change in METRs on Inputs: Resource Levies Treated as a Tax vs. The Base Case (in percentage points) Tangible Inputs Total Intangible Inputs Structures Machinery Land Inventories E&D R&D Total Labour Total Mining Oil and Gas

44 36 WORKING PAPER TABLE 3.6-A METRs on Inputs: Labour METRs are Gross-o-Beneits, 1997 Tangible Inputs Total Intangible Total Labour Total Inputs Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

45 The Calculation o Marginal Eective Tax Rates 37 TABLE 3.6-B METRs on Inputs: Labour METRs are Gross-o-Beneits and Workers Compensation Contributions are Treated as a Tax Tangible Inputs Total Intangible Inputs Total Labour Total Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

46 38 WORKING PAPER TABLE 3.6-C METRs on Inputs: Labour METRs are Net o Beneits and Firms Bear Two Thirds o Payroll Taxes Tangible Inputs Total Intangible Inputs Total Labour Total Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

47 The Calculation o Marginal Eective Tax Rates International Comparisons In order to provide a point o reerence, METRs were also calculated or the G-7 countries and Mexico. While the METR model or Canada is very detailed, the level o detail is much lower or the other countries due to lack o data. In particular, the level o aggregation across industries and asset types is much higher in the METR calculations or the other countries. An exception to this is the United States, or which METRs or a broad range o assets and industries were calculated. 33 Nonetheless, the international comparisons provide a useul benchmark. The underlying methodology or the international comparisons is identical to that discussed above. An important point to emphasize is that the same input shares used to compute Canadian METRs were employed in the calculation o international METRs, because o the diiculty o obtaining input shares data on a disaggregated basis or the other countries. However, it serves a useul purpose since METRs may be considered more directly comparable to the Canadian METRs in the sense that the dierences arise solely due to variations in the tax system, and not to variations in the industrial structure across economies. The approach adopted closely ollows a recent paper by Chen and McKenzie (1997). The irst set o comparisons is between Canadian and U.S. METRs. Table 4.1 and Table 4.2 show U.S. METRs or a level o details equal to the Canadian one (see tables in Section 3). Table 4.1 is comparable to Table 3.1-A; this is the base case in both countries. 34 Table 4.2 is comparable to Table 3.6-A; this is the scenario where labour METRs in both countries are calculated gross-o-beneits and the 1997 statutory rates apply. A comparison o the Canadian and U.S. base cases reveals the ollowing patterns: As with the Canadian system, the U.S. tax system treats intangible inputs and labour more avourably than tangible inputs. METRs on costs in Canada are higher than those in the United States, except or orestry; this exception is mainly due to a lower Canadian METR on labour and, to a lesser extent, a higher tax subsidy or R&D. On average, the Canadian system imposes higher METRs on tangible inputs and labour than the U.S. system (except or labour in the orestry industry). The Canadian system provides a higher tax subsidy or R&D than the U.S. system. 33 The structure o the U.S. calculations is as ollows: one irm size (large); 12 industries and seven production inputs (the same as those listed in the tables in Section 3); structures were urther disaggregated into 14 categories and machinery into 20 categories. 34 Recall that the Canadian base case applies CPP/QPP and EI rates that will prevail ater 2000 when current proposed changes are ully phased in.

48 40 WORKING PAPER The Canadian METR on machinery employed in the manuacturing industry is lower than that in the United States (9.4 percent versus 13.8 percent); this is mainly due to a lower statutory tax rates on M&P income and higher tax depreciation rates on M&P machinery in Canada. In the United States, METRs on cost or the transportation and communications industries are appreciably lower than average METRs on cost; in Canada, the METR on cost or transportation is close to the average, and that or communications is appreciably higher than the average. Finally, note that the distortion between U.S. service and non-service industries is less important than that in Canada. Looking at Tables 3.6-A and 4.2, note that only the METRs on labour change (they are gross-o-beneits). Note that Canadian METRs on labour are lower than the U.S. METRs, although marginally so or most industries. However, U.S. METRs on cost remain lower than those in Canada, because METRs on tangible inputs in the United States are lower. The METR calculations on tangible capital or the G-7 countries and Mexico are presented in Table 4.3. Note that only two industries were considered here: manuacturing and services. The ollowing patterns are worth noting: The average Canadian METRs on tangible inputs are lower than those o Germany, Italy and Japan, but higher than those o the United States, the United Kingdom and Mexico, especially in service industries. With respect to inter-asset distortions, the Canadian system imposes higher METRs on inventories than all G-7 countries and Mexico. However, METRs on machinery in manuacturing industries are below most G-7 countries and Mexico; this relects the combined eect o lower statutory tax rates on M&P income and higher tax depreciation rates or M&P machinery and equipment in Canada relative to the other countries. The inter-industry variations in Canadian METRs are relatively more important than those in the United States, the United Kingdom, Japan and Mexico, and similar to those in Germany, France and Italy.

49 The Calculation o Marginal Eective Tax Rates 41 TABLE 4.1 U.S. METRs on Inputs: The Base Case Tangible Inputs Total Intangible Inputs Total Labour Total Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: The columns labelled Total relect rom let to right: total METRs on tangible inputs, total METRs on tangible and intangible inputs, and METRs on costs. METRs are expressed with respect to input costs ater taxes. TABLE 4.2 U.S. METRs on Inputs: Labour METRs Are Gross-o-Beneits Tangible Inputs Total Intangible Inputs Total Labour Total Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: The columns labelled Total relect rom let to right: total METRs on tangible inputs, total METRs on tangible and intangible inputs, and METRs on costs. METRs are expressed with respect to input costs ater taxes.

50 42 WORKING PAPER TABLE 4.3 International Comparisons o METRs on Tangible Inputs: The G-7 Countries and Mexico Large Firms Tangible Inputs Structures Machinery Land Inventories Total (percent) Manuacturing Canada United States United Kingdom Germany France Italy Japan Mexico Services Canada United States United Kingdom Germany France Italy Japan Mexico Manuacturing and Services Canada United States United Kingdom Germany France Italy Japan Mexico Notes: METRs are expressed with respect to gross-o-tax returns. Services are narrowly deined; they correspond to Other Services" in the tables reported in Section 3. The METR results or Canada are similar when services are broadly deined (i.e. when they include construction, transportation, communications, public utilities, wholesale trade, retail trade, and other services); the exception is the Canadian METR on machinery, which equals 32% instead o the 35.7% reported in this table. This is mainly due to lower METRs on machinery in the wholesale and retail trade industries.

51 The Calculation o Marginal Eective Tax Rates Simulating the Technical Committee s Policy Package In this last section, we present METR results or the current system adjusted to relect most o the Committee s recommendations. The purpose o this exercise is to compare the METRs o the Committee s policy package with the base case METRs in Table 3.1-A, and see what changes would occur in the variations in marginal eective tax rates i the government were to implement the Committee s recommendations. Beore we present the results, it is useul to briely list the Committee s recommendations that were relected in the simulation; or a ull summary o the recommendations, the reader should reer to Chapter 1 o the Committee s main report, and to Chapters 4 to 11 or detailed discussions. The Committee s proposed changes to statutory corporate tax rates were all relected in the simulation: the top ederal income tax rate o percent and the manuacturing and processing rate o percent (both including the 4 percent surtax) would be lowered to 20 percent; the small business rate would be increased rom percent to 14 percent, but there would be an employment tax credit that would reduce that rate by up to 3 percentage points, resulting in an average small business rate o about 12.5 percent. Osetting the rate reduction, the Committee s proposed base-broadening measures, which were relected in the simulation, are: changes to CCA rates; changes to the SR&ED tax credit; changes to the taxation o mining and oil and gas industries; elimination o the Atlantic Canada Investment Tax Credit; and elimination o the deductibility o provincial capital taxes. In addition, two adjustments were made to relect the Committee s suggestion to the provinces that they reduce their corporate income and capital tax rates by an average amount that would roughly oset the provincial revenue gain rom the above base-broadening measures. First, average provincial statutory income tax rates were assumed to be reduced by one percentage point. Second, average provincial capital tax rates were assumed to be reduced rom percent to percent. 35 Although most o the Committee s recommendations were relected in the simulation, some were not taken into account, or two main reasons: (1) the recommendation would have no impact on the Canadian METRs on domestic investment (e.g. changes to the taxation o inbound and outbound investment); or, (2) the recommendation could not be handled within the theoretical ramework that we have considered (e.g. eiciency gains in compliance with and enorcement o the corporate tax system). 35 Recall that in the METR model, the tax systems o the provinces and territories are represented by average statutory income and capital tax rates or three types o income (income taxed at the small business rate o 12%, income taxed at the M&P rate o 21%, and income taxed at the 28% ederal tax rate) and two irm sizes (large and small. See Appendix A or more detail.

52 44 WORKING PAPER Table 5.1-A reports the METRs o the Committee s policy package, and Table 5.1-B reports the dierence (in percentage points) between these METRs and those o the base case (Table 3.1-A). 36 In order to evaluate the overall impact o the Committee s package on the distortions caused by the tax system, we report dispersion measures in Tables 5.2-A, 5.2-B and 5.2-C. The numbers in Table 5.2-A measure the dispersion in METRs on capital (structures, machinery, land, inventories, E&D and R&D), expressed with respect to gross-o-tax returns. The numbers in Table 5.2-B measure the dispersion in METRs on capital and labour, expressed with respect to input costs ater taxes. Finally, the numbers in Table 5.2-C measure the industry dispersion in METRs on capital and labour separately. 37 Compared to the base case, Tables 5.2-A, 5.2-B and 5.2-C all show a decrease in the dispersion in METRs under the Committee s policy package. The main patterns that these tables show are as ollows: The decrease in the industry dispersion in METRs is much more important than the decrease in the asset/input dispersions. For example, Table 5.2-A shows that the industry dispersion in METRs or large irms decreases rom 6.7 percent to 3.9 percent (a 42 percent reduction), while the asset dispersion decreases rom 14.3 percent to 11.7 percent (an 18 percent reduction). The decrease in the dispersion measures or large irms is generally more appreciable than that or small irms. For example, Table 5.2-A shows that the overall dispersion or large irms decreases by 25 percent (rom 16.6 percent to 12.5 percent), while the overall dispersion or small irms decreases by 6 percent (rom 9.6 percent to 9.0 percent). Similar comparative results can be obtained rom Tables 5.2-B and 5.2-C. Finally, rom Table 5.1-B, we note the ollowing patterns in the METRs o the Technical Committee s policy package compared with those o the current system: Overall, the impact o the Committee s policy package on the METRs on cost is almost neutral: METRs on cost would increase by 0.2 percentage points or large irms and 0.1 or small irms. The average METR on capital would decrease by 0.2 percentage points or large irms and 0.4 points or small irms; the average METR on labour would increase, however, by 0.2 percentage points or large and small irms. (This relects the proposed introduction o partial experience rating o employer EI premium, which is designed to be revenue neutral relative to the base case or the EI system as a whole, but which results in a marginal increase in average premiums or the industries covered in the METR analysis.) 36 Table 5.1-C reports METRs on capital (tangible and intangible), expressed with respect to gross-o-tax returns. 37 Recall that in Tables 5.2-B and 5.2-C, the METRs on capital were obtained by aggregating the METRs on structures, machinery, land, inventories, E&D and R&D.

53 The Calculation o Marginal Eective Tax Rates 45 The reduction in the METRs would be appreciable or certain types o capital assets. For large irms, note a reduction o 8.6 percentage points on inventories, 5.2 on land and 2.5 on structures; or small irms, the reductions would be less important: 1.8 points on inventories, 0.9 on land and 0.7 on structures. These reductions are mainly due to recommended changes to statutory income tax rates and CCA rates. There would be an increase in the METRs on machinery or both large and small irms (10.1 and 2.3 percentage points respectively), and an increase in METRs on R&D (5.1 points or large irms and 1.8 points or small irms). The irst is mainly due to recommended changes to CCA rates or M&P equipment (rom 30 percent to 25 percent). The latter is mainly due to recommended changes to CCA and ITC rates or R&D capital expenditures. (The Committee recommends that ull expensing or such expenditures be replaced by a 35 percent declining balance rate, and that the ITC rate be lowered rom 35 percent to 27 percent or small irms and rom 20 percent to 15 percent or large irms.) There would be a decrease in the METRs on cost or service industries and construction, especially in the large-irms group. However, the METRs or mining, oil and gas, manuacturing, agriculture and orestry would increase. For mining and oil and gas, the increase is mainly due to recommended changes to CCA rates or Canadian Development Expenses (rom 30 percent to 25 percent) and or major expansions o existing mines (rom ull expensing to 35 percent declining balance), as well as to changes to the base or the calculation o the ederal resource allowance. For manuacturing, agriculture and orestry, the slight increase is mainly due to the recommended change to the CCA rate or M&P equipment (rom 30 percent to 25 percent). In summary, a comparison o the METRs under the Committee s recommended policy changes with the METRs o the current corporate tax system shows that there is almost no change in the overall METR on cost or both large and small irms. However, there is an appreciable decrease in the dispersion in METRs, especially inter-industry dispersions.

54 46 WORKING PAPER TABLE 5.1-A METRs on Inputs: The Technical Committee s Policy Package Tangible Inputs Total Intangible Total Labour Total Inputs Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

55 The Calculation o Marginal Eective Tax Rates 47 TABLE 5.1-B Change in METRs on Inputs: The Technical Committee s Policy Package versus The Base Case (in percentage points) Tangible Inputs Total Intangible Inputs Structures Machinery Land Inventories E&D R&D Total Labour Total Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries

56 48 WORKING PAPER TABLE 5.1-C METRs on Capital: The Technical Committee s Policy Package Tangible Capital Total Intangible Total Capital Structures Machinery Land Inventories E&D R&D (percent) Large Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Large and Small Firms Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Note: METRs are expressed with respect to gross-o-tax returns.

57 The Calculation o Marginal Eective Tax Rates 49 TABLE 5.2-A Dispersion in METRs on Capital: The Base Case versus the Technical Committee s Policy Package Large Firms Small Firms Large and Small Firms (percent) The Base Case Overall Dispersion Industry Dispersion Asset Dispersion The Technical Committee s Package Overall Dispersion Industry Dispersion Asset Dispersion Note: The dispersion measures are based on METRs on tangible and intangible capital expressed with respect to gross-o-tax returns; labour METRs are not taken into account in this table. The aggregation level used is 12 industries and six assets (structures, machinery, land, inventories, E&D and R&D). TABLE 5.2-B Dispersion in METRs on Capital and Labour: The Base Case versus the Technical Committee s Policy Package Large Firms Small Firms Large and Small Firms (percent) The Base Case Overall Dispersion Industry Dispersion Input Dispersion The Technical Committee s Package Overall Dispersion Industry Dispersion Input Dispersion Note: The dispersion measures are based on aggregate capital and labour METRs calculated with respect to input costs ater taxes. The aggregation level is 12 industries and two inputs (capital and labour); capital METRs by industry were obtained by aggregating the METRs on structures, machinery, land, inventories, E&D and R&D. TABLE 5.2-C Industry Dispersion in METRs on Capital and Labour: The Base Case versus the Technical Committee s Policy Package Large Firms Small Firms Large and Small Firms (percent) The Base Case Capital Dispersion Labour Dispersion Capital and Labour Dispersion The Technical Committee s Package Capital Dispersion Labour Dispersion Capital and Labour Dispersion Note: The dispersion measures are based on aggregate capital and labour METRs calculated with respect to input costs ater taxes. The aggregation level is 12 industries and two inputs (capital and labour); capital METRs by industry were obtained by aggregating the METRs on structures, machinery, land, inventories, E&D and R&D.

58 50 WORKING PAPER Concluding Thoughts The purpose o this document is to describe the methodology and present the data underlying the calculation o marginal eective tax rates (METRs) contained in the report issued by the Technical Committee on Business Taxation on April 6, The document serves three purposes. First, it documents the methodological innovations that distinguish the calculations rom previous METR calculations released as a part o the 1987 White Paper on corporate tax reorm, and described in the subsequent Department o Finance working paper. Second, it reports various alternative METR scenarios that were not contained in the Committee s report. Third, it presents in detail the data underlying the METR model. These data are important not only or an understanding o the calculations contained in the report, but also should prove very useul in their own right.

59 The Calculation o Marginal Eective Tax Rates 51 Appendix A Structure o the METR Model This appendix describes the basic structure o the METR model and the data used to undertake the main calculations. Aggregation Structure and Calculation o Input Shares At the most disaggregated level, METRs are calculated or 35 industries, two irm sizes: large and small, 1 and seven production inputs: structures, machinery, land, inventories, exploration and development (E&D), 2 research and development (R&D), and labour. In addition, E&D is divided into Canadian Exploration Expenses (CEE) and Canadian Development Expenses (CDE); and, structures and machinery are divided into 27 Capital Cost Allowance (CCA) classes (seven structure classes and 20 machinery classes see Table A.1). The 35 industries are shown in Table A.2, along with the corresponding 1980 Standard Industrial Classiication (SIC) code and division names. The deinitions o large and small irms approximate the tax deinition. A small irm is a Canadian-controlled private corporation (CCPC) with total assets less than $15 million; all other irms are large. 3 For example, a oreign-controlled corporation with assets less than $15 million is counted in the large irms group because it is not eligible or the small business deduction (i.e. it aces either the 28 percent ederal corporate income tax rate or the 21 percent manuacturing and processing rate). The input share matrix was constructed using our data sources: Statistics Canada input-output (I-O) tables and corporate statistics, and Revenue Canada T2 and T661 databases. 4 The construction o this matrix involved three steps: 1. calculation o the labour weights; 2. calculation o R&D weights; and 3. calculation o structures, machinery, land, inventories and E&D weights. 1 Small irms in the mining and oil and gas sectors and large irms in the agriculture, ishing and trapping sector are ignored because they account or a very small proportion o production inputs. 2 Only irms in the mining and oil and gas sectors undertake E&D activities. 3 Although the weights are based on this assumption, the METR calculation assumes that all small irms ace the small business tax rate at the margin. 4 Statistics Canada, The Input-Output Structure o the Canadian Economy, Catalogue , 1988 to Statistics Canada, Financial and Taxation Statistics or Enterprises; Catalogue , The T2 database contains tax and accounting inormation on a sample o about 15,000 corporations; a weighted version representing the entire Canadian corporate sector is also available (about 975,000 corporations or 1994, the last year available). The T661 database contains tax data relating to the calculation o the SR&ED tax credit. Unlike the T2, the T661 is not a sample database; it is the population o corporations that claim the SR&ED tax credit.

60 52 WORKING PAPER The labour weights were derived as ollows: w L i = SW i SW + SLI + SLI i i + OS (1 d i i i ) where i is the industry index (i=1, 2,..., 35), SW is salaries and wages o incorporated businesses, 5 SLI is supplementary labour income, OS is operating surplus, and d is the depreciation charge portion o the operating surplus. The operating surplus variable rom Statistics Canada I-O tables is reported gross o depreciation, interest and income taxes. The depreciation expense is not reported separately in these tables; d was calculated using data rom Statistics Canada s corporate statistics publication: d i = Π i D i + D + IN i i where D is the depreciation expense, Π is proit beore income tax, and IN is the interest expense. The expression Π+D+IN approximates the operating surplus variable in the I-O tables, that is the term OS in the ormula or w L. 6 The second step in the construction o the input share matrix is the calculation o the R&D shares, which was derived as ollows: w R i Ri = Y (1 p )(1 d i i i ) where R is SR&ED current and capital expenditures, 7 Y is gross revenues, p is the primary input portion o all production inputs, and d is the depreciation portion o the operating surplus (deined above). 8 5 Excludes salaries and wages eligible or the SR&ED tax credit, since this is accounted or in the calculation o the R&D share. 6 For SW, SLI, OS and p (in the ormula or w R ), we used average igures; d was derived using average igures or The I-O tables do not report values or SW, SLI, OS and p or large and small irms separately; we used the distribution o average gross revenues by industry and irm size rom the T2 database to split these values between large and small irms or each industry (see Table A.3); however, it was assumed that the same d vector applies to large and small irms. 7 Current expenditures represent more than 90% o total SR&ED expenditures; it is mainly because o this that the model treats R&D expenditures as an intangible. 8 The R&D shares obtained using this method were slightly higher than what is observed at the irm level in some industries, especially agriculture and orestry, as well as compared to the ratio o R&D to GDP. An adjustment was made to these shares, so that or each industry, the ratio o the R&D share to the total share o tangible capital is equal to the ratio o SR&ED expenditures to tangible capital expenditures.

61 The Calculation o Marginal Eective Tax Rates 53 The expression Y i (1-p i ) approximates the gross operating surplus variable in the I-O tables. It was used because the R&D shares were derived rom Revenue Canada s T661 database on SR&ED, which does not report operating surplus igures that are consistent with those in the I-O tables. For the variables R and Y, the 1993 T661 database was used; the parameter p was derived rom the I-O tables using average igures or The labour and R&D shares were calculated as percentages o the total input share or each o the 35 industries, which is equal to one. The shares o the other production inputs were calculated residually as: j j ki L R wi = (1 wi wi ) j ki j Where j represents the inputs: structures, machinery, land, inventories and E&D, and K is the weight o input j in industry i. The k s were derived rom the T2 database as ollows: k j i = j,i BV j i j i BV where BV is the net book value o the stock o input j. The weights or structures and machinery were urther disaggregated by CCA class using the distribution o CCA additions. Since the use o CCA additions may bias the weight or some CCA classes, a three-year average o CCA additions was used in order to minimize the impact o the bias. 9 Table A.4 shows the capital stock weight matrix or structures, machinery, land, inventories and E&D, and Table A.5 shows normalized production input shares or these production inputs plus R&D and labour. The weights in Table A.4 are used to aggregate METRs on capital within broad types o capital (i.e. expressed with respect to gross-o-tax return on capital); the shares in Table A.5 are used to aggregate METRs on inputs (i.e. expressed with respect to net-o-tax returns on production inputs); the aggregation o METRs on inputs yields METRs on cost, as discussed in Section 2. 9 The book values o the dierent inputs are rom the 1993 T2 database; average additions to CCA pools are rom T The distribution o CCA additions was used because stock values or CCA classes are not available; however, note that the bias caused by using the lows o CCA additions would occur only when we aggregate METRs or dierent CCA subgroups within structures or machinery.

62 54 WORKING PAPER Income Tax Rates Combined ederal-provincial statutory income tax rates were calculated or 35 industries and two irm sizes. The large and small average statutory ederal tax rates are as ollows: u L = qu L S + ( 1 q ) u u = u S M where q is the proportion o taxable income eligible or the M&P deduction, and u L, u M and are the ederal corporate tax rate on regular income (28 percent), the tax rate on M&P income (21 percent) and the tax rate on small business income (12 percent) respectively. For large irms, dierences in the average tax rates across industries are attributable to q; or small irms, there are no dierences in the tax rates across industries since, at the margin, small irms are subject to the small business rate. Table A.6.1 shows values or q and combined ederal-provincial average statutory tax rates by industry or large and small irms. The provincial average statutory tax rates were calculated in a similar ashion, with the exception that one provincial three-rate structure (i.e. regular income, M&P and small business rates) was used rather than 12 dierent rate structures (i.e. 10 provinces and two territories). The average provincial rate structure was generated by weighting the individual provincial rates by the distribution o taxable income across provinces. 10 For example, the small business rate was calculated as: u = cu p S Where v represents the province; c is the share o province v o taxable income, and u is province v s statutory corporate income tax rate on small business (see Table A.6.2). Combined ederal-provincial rates were obtained by adding the ederal and provincial rates. The ederal surtax o 4 percent, as well as various provincial surtaxes, are also included. Capital Tax Rates At the ederal level, the LCT is imposed at a rate o percent on corporations with taxable capital in excess o $10 million. In the METR model, this tax applies to the large corporations group; at the margin, small corporations are not aected by the LCT. The METR calculations relect a weighted average o irms that pay LCT and those that do not. The latter proportion was estimated at 20 percent. 11 v v S u S 10 The provincial allocation o corporate taxable income is rom the 1994 T2 database. Note that the same distribution was used or all industries to avoid the impact o provincial speciic rates on industry comparisons. 11 This estimate was calculated using the 1994 T2 database; the 80% was assumed to apply across all industries.

63 The Calculation o Marginal Eective Tax Rates 55 Seven provinces impose general capital taxes similar to the ederal LCT at dierent rates, varying rom 0.25 percent in Nova Scotia to 0.64 percent in Quebec. One average provincial capital tax rate was used in the model. It was calculated by weighting the provincial rates by the provincial distribution o taxable income (See Table A.7). Investment Tax Credit Rates Most investment tax credits (ITCs) were phased out in the 1987 tax reorm. In the current corporate tax system, there is only one ITC remaining (other than the SR&ED ITC): the Atlantic Canada Investment Tax Credit, which applies at a rate o 10 percent on eligible capital expenditures made in speciied regions o the Atlantic provinces, including oshore oil and gas activities. Since ITC rates apply to speciied capital expenditures rather than to all additions to CCA pools, statutory ITC rates could not be used. Eective ITC rates were calculated or each industry and CCA class by dividing the ITC claim by the cost o additions to CCA pools. Table A.8 reports average eective ITC rates or structures and machinery. Economic Depreciation Rates The economic depreciation rates are the same as those used in Jung (1987), with the ollowing exceptions: most o the dierences in the rates between industries at the 35 level were ignored, that is one rate was used in most cases or all industries that belong to the same division as indicated in Table A.1; and the dierences between large and small irms were ignored. Table A.9 reports the economic depreciation rates by CCA class as well as weighted averages across CCA classes and across industries. Provincial Sales Taxes on Capital Input Eective provincial sales taxes on capital inputs apply to machinery only. They were calculated as the ratios o provincial sales taxes paid to capital expenditures. Given that the data were not available or large and small irms, only one rate was calculated and used or both groups o irm (see Table A.10). Non-Tax-Paying Firms and Loss Utilization Rates Non-capital losses in a given year can be carried orward seven years, or back three years, to reduce taxable income in those years. Such losses are thereore valuable to the company only i it can use them against uture (seven years) or past (three years) proits; otherwise they are expired losses. Non-capital losses impact the METRs through the statutory corporate income tax rate; $1 o loss in a given year can be seen as reducing the statutory income tax rate by a actor equal to: 1 ( 1 + ρ ) T

64 56 WORKING PAPER where ρ is the cost o equity inancing and T is the number o years that elapse beore the $1 loss expires. The parameter T was approximated by 2/U, where U is the loss utilization rate, estimated as L/(OL+UCCA+UDEP); L is the amount o non-capital-losses claimed, OL is the opening balance o non-capital-losses in a given period, UCCA is the pool o unused CCA deductions and UDEP is the pool o unused depletion deductions. Both UCCA and UDEP were estimated as the dierence between what a irm could claim in depreciation and depletion in a given year and what it actually claimed. 12 The combined METRs or tax-paying and non-tax-paying irms were then calculated as θ METRtax paying + ( 1 θ ) METRnon tax paying, where θ is the proportion o tax-paying irms. Table A.11 shows estimated values or θ and T or large and small irms. 13 Capital Structure, Cost o Finance, and Inlation Two assumptions on the capital structure o irms were considered. In the irst, irms inance 40 percent o their assets by debt and 60 percent by equity; this assumption was used in the base case. In the second, debt-asset ratios vary by sector, as reported in Table A.12. The industry-speciic debt-asset ratios were derived rom Jog (1997). 14 For each o the 35 industries in the METR model, we calculated the average debt-asset ratios o similar industries considered in Jog (1997); or those industries that were not represented in Jog (1997), we assumed that the overall average applies. Finally, it was assumed that return on debt inancing is 8 percent, return on equity inancing is 6.7 percent, 15 the risk-ree return on capital is 8 percent, and inlation is 2 percent. 12 The calculation was based on average igures rom the T2 weighted sample ile, The methodology or calculating T ollows Mintz (1988). 13 The proportion o non-tax-paying irms was calculated based on ederal income tax only; the LCT was excluded rom the calculation, as well as the tax on the capital o large inancial institutions, which are not accounted or in the model. It is important to dierentiate between non-tax-paying irms and proitable but non-tax-paying irms ; it is the ormer that are reported here. There are many reasons why a irm may not pay taxes in a given year, including inter-corporate dividends, losses, and tax credits such as the SR&ED tax credit. 14 The author uses two approaches to calculate debt-asset ratios: the market value approach and the book value approach; the ratios that we consider here are based on the ormer approach. 15 This rate is equal to i(1-m)/(1-c), where i is the interest rate, m is the personal tax rate on interest income and c is the personal tax rate on capital gains (see Section 2 or more detail).

65 The Calculation o Marginal Eective Tax Rates 57 TABLE A.1 Capital Cost Allowance (CCA): Classes and Rates CCA Class CCA Rate (%) Principal Assets Structures 1 (2,5,20,31,32) 4 Buildings, bridges, canals, dams, roads, railway tracks, electrical generating equipment 3 5 Breakwaters (other than wooden), trestles, docks, windmills, wharves 6 10 Wooden breakwaters, greenhouses, ences, railway locomotives and tanks Leaseholds 26 5 Catalysts, deuterium-enriched water Timber resources 41a 100 Mining assets or new mines or major expansion o existing mines Machinery 4 6 Tramway or trolley buses 7 25 Vessels, canoes, rowboats, scows 8 (11,19) 20 A broad range o assets (mainly machinery) not included in other classes 9 25 Aircrat 10 (30) 30 Automotive equipment 12 (18) 100 Dies, jigs, kitchen utensils and other tools that cost less than $ Patents, ranchises, licences Assets or cutting and removing timber Trucks, taxis, leased automobiles Telephone and telegraph systems Water pollution control equipment (ends in 1998) Air pollution control equipment (ends in 1998) Energy-eicient equipment 35 7 Railway cars 36 7 Deemed depreciable property Income Tax Act 13(5.2)(c) Amusement parks 38 (22) 30 Earth moving equipment acquired ater b 25 Mining assets acquired ater 1987 or new mines or major expansions o existing mines Fibre optic cables 43 (21,29,39,40) 30 Manuacturing and processing equipment Note: Classes in parentheses reer to old classes that no longer exist or that are being phased out; the new CCA rates apply to such classes or purposes o the METR calculation. The Principal Assets column is not meant to be exhaustive; the interested reader should reer to the Income Tax Act or more details.

66 58 WORKING PAPER TABLE A.2 Industrial Structure Industry Name SIC Code (1980) Division Name Agriculture Agriculture, Forestry and Fishing Fishing and Trapping Agriculture, Forestry and Fishing Forestry Agriculture, Forestry and Fishing Mining , , Mining Oil and Gas , Oil and Gas Food Manuacturing Beverages Manuacturing Tobacco Manuacturing Rubber Manuacturing Plastic Manuacturing Leather Manuacturing Textile Manuacturing Clothing Manuacturing Wood Manuacturing Furniture Manuacturing Paper Manuacturing Print and Publishing Manuacturing Primary Metal Manuacturing Metal Fabrication Manuacturing Machinery Manuacturing Transportation Equipment Manuacturing Electrical Manuacturing Mineral Manuacturing Petroleum Manuacturing Chemical Manuacturing Miscellaneous Manuacturing Manuacturing Construction Construction Transportation Transportation and Storage Storage Transportation and Storage Communications Communication Electrical Power, Gas and Water Public Utilities Wholesale Trade Wholesale Trade Retail Trade Retail Trade Services to Business Management Other Services Government, Personal and Misc. Services Other Services

67 The Calculation o Marginal Eective Tax Rates 59 TABLE A.3 Distribution o Gross Revenues Large Firms (percent) Small Firms Agriculture Fishing and Trapping Average Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Average Manuacturing Construction Transportation Storage Average Transportation and Storage Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services Average Other Services All Industries

68 60 WORKING PAPER TABLE A.4.1 Capital Stock Weights Large Firms Structures CCA Classes Total Structures Machinery Land Inventories E&D CL1 CL3 CL6 CL13 CL26 CL33 CL41a Agriculture 1.9E E E E E E E E E E E E+00 Fishing and Trapping 1.5E E E E E E E E E E E E+00 Subtotal 2.1E E E E E E E E E E E E+00 Forestry 8.7E E E E E E E E E E E E+00 Mining 3.2E E E E E E E E E E E E E-03 Oil and Gas 3.7E E E E E E E E E E E E E-03 Food 1.8E E E E E E E E E E E E+00 Beverages 5.2E E E E E E E E E E E E+00 Tobacco 2.5E E E E E E E E E E E E+00 Rubber 2.6E E E E E E E E E E E E+00 Plastic 6.2E E E E E E E E E E E E+00 Leather 8.7E E E E E E E E E E E E+00 Textile 3.7E E E E E E E E E E E E+00 Clothing 2.3E E E E E E E E E E E E+00 Wood 1.0E E E E E E E E E E E E+00 Furniture 1.2E E E E E E E E E E E E+00 Paper 3.3E E E E E E E E E E E E+00 Print and Publishing 6.0E E E E E E E E E E E E+00 Primary Metal 1.5E E E E E E E E E E E E+00 Metal Fabrication 8.7E E E E E E E E E E E E+00 Machinery 1.1E E E E E E E E E E E E+00 Transportation Equipment 3.8E E E E E E E E E E E E+00 Electrical 1.3E E E E E E E E E E E E+00 Mineral 7.6E E E E E E E E E E E E+00 Petroleum 4.6E E E E E E E E E E E E+00 Chemical 2.4E E E E E E E E E E E E+00 Miscellaneous Manuacturing 4.6E E E E E E E E E E E E+00 Subtotal 2.2E E E E E E E E E E E E+00 Construction 2.5E E E E E E E E E E E E+00 Transportation 2.7E E E E E E E E E E E E+00 Storage 1.2E E E E E E E E E E E E+00 Subtotal 2.8E E E E E E E E E E E E+00 Communications 7.1E E E E E E E E E E E E+00 Electrical Power, Gas and Water 7.5E E E E E E E E E E E E+00 Wholesale Trade 4.7E E E E E E E E E E E E+00 Retail Trade 3.8E E E E E E E E E E E E+00 Services to Business Management 1.1E E E E E E E E E E E E+00 Government, Personal and Misc. 2.0E E E E E E E E E E E E+00 Services Subtotal 1.3E E E E E E E E E E E E+00 Total 6.4E E E E E E E E E E E E E-03

69 The Calculation o Marginal Eective Tax Rates 61 TABLE A.4.1 Capital Stock Weights Large Firms (continued) Machinery CCA Classes CL4 CL7 CL8 CL9 CL10 CL12 CL14 CL15 CL16 CL17 CL24 CL27 CL34 Agriculture 9.7E E E E E E E E E E E E E+00 Fishing and Trapping 0.0E E E E E E E E E E E E E+00 Subtotal 9.7E E E E E E E E E E E E E+00 Forestry 0.0E E E E E E E E E E E E E+00 Mining 1.1E E E E E E E E E E E E E+00 Oil and Gas 0.0E E E E E E E E E E E E E-05 Food 2.7E E E E E E E E E E E E E-05 Beverages 1.1E E E E E E E E E E E E E-08 Tobacco 0.0E E E E E E E E E E E E E+00 Rubber 0.0E E E E E E E E E E E E E+00 Plastic 0.0E E E E E E E E E E E E E+00 Leather 0.0E E E E E E E E E E E E E+00 Textile 0.0E E E E E E E E E E E E E-05 Clothing 0.0E E E E E E E E E E E E E+00 Wood 0.0E E E E E E E E E E E E E-05 Furniture 0.0E E E E E E E E E E E E E+00 Paper 0.0E E E E E E E E E E E E E-04 Print and Publishing 0.0E E E E E E E E E E E E E+00 Primary Metal 0.0E E E E E E E E E E E E E-07 Metal Fabrication 0.0E E E E E E E E E E E E E-06 Machinery 0.0E E E E E E E E E E E E E+00 Transportation Equipment 0.0E E E E E E E E E E E E E+00 Electrical 0.0E E E E E E E E E E E E E-08 Mineral 0.0E E E E E E E E E E E E E+00 Petroleum 0.0E E E E E E E E E E E E E+00 Chemical 4.2E E E E E E E E E E E E E-07 Miscellaneous Manuacturing 0.0E E E E E E E E E E E E E+00 Subtotal 4.2E E E E E E E E E E E E E-04 Construction 8.9E E E E E E E E E E E E E-05 Transportation 0.0E E E E E E E E E E E E E-05 Storage 0.0E E E E E E E E E E E E E+00 Subtotal 0.0E E E E E E E E E E E E E-05 Communications 2.0E E E E E E E E E E E E E+00 Electrical Power, Gas and Water 2.8E E E E E E E E E E E E E-05 Wholesale Trade 1.3E E E E E E E E E E E E E-07 Retail Trade 6.1E E E E E E E E E E E E E-06 Services to Business Management 9.1E E E E E E E E E E E E E-05 Government, Personal and Misc. Services 1.9E E E E E E E E E E E E E+00 Subtotal 2.8E E E E E E E E E E E E E-05 Total 8.1E E E E E E E E E E E E E-04

70 62 WORKING PAPER TABLE A.4.1 Capital Stock Weights Large Firms (continued) E&D CL35 CL36 CL37 CL38 CL41b CL42 CL43 CEE CDE Agriculture 0.0E E E E E E E-05 Fishing and Trapping 0.0E E E E E E E-06 Subtotal 0.0E E E E E E E-05 Forestry 0.0E E E E E E E-05 Mining 2.3E E E E E E E E E-03 Oil and Gas 2.9E E E E E E E E E+00 Food 0.0E E E E E E E-03 Beverages 0.0E E E E E E E-03 Tobacco 0.0E E E E E E E-04 Rubber 0.0E E E E E E E-04 Plastic 0.0E E E E E E E-03 Leather 0.0E E E E E E E-05 Textile 2.5E E E E E E E-03 Clothing 0.0E E E E E E E-04 Wood 1.4E E E E E E E-03 Furniture 0.0E E E E E E E-04 Paper 5.9E E E E E E E-03 Print and Publishing 0.0E E E E E E E-03 Primary Metal 1.0E E E E E E E-03 Metal Fabrication 3.2E E E E E E E-03 Machinery 0.0E E E E E E E-03 Transportation Equipment 1.3E E E E E E E-02 Electrical 3.7E E E E E E E-03 Mineral 0.0E E E E E E E-03 Petroleum 0.0E E E E E E E-04 Chemical 5.0E E E E E E E-03 Miscellaneous Manuacturing 1.9E E E E E E E-04 Subtotal 1.5E E E E E E E-02 Construction 0.0E E E E E E E-04 Transportation 6.9E E E E E E E-04 Storage 6.8E E E E E E E-05 Subtotal 6.9E E E E E E E-04 Communications 0.0E E E E E E E-05 Electrical Power, Gas and Water 0.0E E E E E E E-05 Wholesale Trade 0.0E E E E E E E-03 Retail Trade 0.0E E E E E E E-04 Services to Business Management 5.1E E E E E E E-04 Government, Personal and Misc. Services 3.0E E E E E E E-04 Subtotal 5.4E E E E E E E-04 Total 1.4E E E E E E E E E-03

71 The Calculation o Marginal Eective Tax Rates 63 TABLE A.4.2 Capital Stock Weights Small Firms Structures CCA Classes Total Structures Machinery Land Inventories E&D CL1 CL3 CL6 CL13 CL26 CL33 CL41a Agriculture 2.5E E E E E E E E E E E E+00 Fishing and Trapping 6.2E E E E E E E E E E E E+00 Subtotal 2.5E E E E E E E E E E E E+00 Forestry 2.9E E E E E E E E E E E E+00 Mining Oil and Gas Food 4.1E E E E E E E E E E E E+00 Beverages 1.9E E E E E E E E E E E E+00 Tobacco 2.5E E E E E E E E E E E E+00 Rubber 9.4E E E E E E E E E E E E+00 Plastic 2.1E E E E E E E E E E E E+00 Leather 1.8E E E E E E E E E E E E+00 Textile 9.3E E E E E E E E E E E E+00 Clothing 2.2E E E E E E E E E E E E+00 Wood 3.8E E E E E E E E E E E E+00 Furniture 1.2E E E E E E E E E E E E+00 Paper 6.8E E E E E E E E E E E E+00 Print and Publishing 2.1E E E E E E E E E E E E+00 Primary Metal 6.5E E E E E E E E E E E E+00 Metal Fabrication 8.3E E E E E E E E E E E E+00 Machinery 2.5E E E E E E E E E E E E+00 Transportation Equipment 1.9E E E E E E E E E E E E+00 Electrical 1.6E E E E E E E E E E E E+00 Mineral 1.9E E E E E E E E E E E E+00 Petroleum 1.1E E E E E E E E E E E E+00 Chemical 1.7E E E E E E E E E E E E+00 Miscellaneous Manuacturing 1.9E E E E E E E E E E E E+00 Subtotal 3.8E E E E E E E E E E E E+00 Construction 3.7E E E E E E E E E E E E+00 Transportation 1.0E E E E E E E E E E E E+00 Storage 1.2E E E E E E E E E E E E+00 Subtotal 1.1E E E E E E E E E E E E+00 Communications 6.7E E E E E E E E E E E E+00 Electrical Power, Gas and Water 4.8E E E E E E E E E E E E+00 Wholesale Trade 4.3E E E E E E E E E E E E+00 Retail Trade 5.7E E E E E E E E E E E E+00 Services to Business Management 1.1E E E E E E E E E E E E+00 Government, Personal and Misc. 4.0E E E E E E E E E E E E+00 Services Subtotal 1.5E E E E E E E E E E E E+00 Total 3.6E E E E E E E E E E E E E+00

72 64 WORKING PAPER TABLE A.4.2 Capital Stock Weights Small Firms (continued) Machinery CCA Classes CL4 CL7 CL8 CL9 CL10 CL12 CL14 CL15 CL16 CL17 CL24 CL27 CL34 Agriculture 1.6E E E E E E E E E E E E E-06 Fishing and Trapping 0.0E E E E E E E E E E E E E+00 Subtotal 1.6E E E E E E E E E E E E E-06 Forestry 0.0E E E E E E E E E E E E E-08 Mining Oil and Gas Food 0.0E E E E E E E E E E E E E+00 Beverages 0.0E E E E E E E E E E E E E+00 Tobacco 0.0E E E E E E E E E E E E E+00 Rubber 0.0E E E E E E E E E E E E E+00 Plastic 0.0E E E E E E E E E E E E E+00 Leather 0.0E E E E E E E E E E E E E+00 Textile 0.0E E E E E E E E E E E E E+00 Clothing 0.0E E E E E E E E E E E E E+00 Wood 0.0E E E E E E E E E E E E E+00 Furniture 2.6E E E E E E E E E E E E E+00 Paper 0.0E E E E E E E E E E E E E+00 Print and Publishing 0.0E E E E E E E E E E E E E+00 Primary Metal 0.0E E E E E E E E E E E E E+00 Metal Fabrication 0.0E E E E E E E E E E E E E+00 Machinery 0.0E E E E E E E E E E E E E+00 Transportation Equipment 0.0E E E E E E E E E E E E E+00 Electrical 0.0E E E E E E E E E E E E E+00 Mineral 0.0E E E E E E E E E E E E E+00 Petroleum 0.0E E E E E E E E E E E E E+00 Chemical 5.4E E E E E E E E E E E E E+00 Miscellaneous Manuacturing 0.0E E E E E E E E E E E E E+00 Subtotal 3.2E E E E E E E E E E E E E+00 Construction 0.0E E E E E E E E E E E E E+00 Transportation 2.8E E E E E E E E E E E E E+00 Storage 0.0E E E E E E E E E E E E E+00 Subtotal 2.8E E E E E E E E E E E E E+00 Communications 0.0E E E E E E E E E E E E E+00 Electrical Power, Gas and Water 0.0E E E E E E E E E E E E E-04 Wholesale Trade 3.9E E E E E E E E E E E E E+00 Retail Trade 1.1E E E E E E E E E E E E E+00 Services to Business Management 5.0E E E E E E E E E E E E E-06 Government, Personal and Misc. Services 2.2E E E E E E E E E E E E E+00 Subtotal 2.7E E E E E E E E E E E E E-06 Total 1.4E E E E E E E E E E E E E-04

73 The Calculation o Marginal Eective Tax Rates 65 TABLE A.4.2 Capital Stock Weights Small Firms (continued) E&D CL35 CL36 CL37 CL38 CL41b CL42 CL43 CEE CDE Agriculture 0.0E E E E E E E-05 Fishing and Trapping 0.0E E E E E E E-05 Subtotal 0.0E E E E E E E-05 Forestry 1.3E E E E E E E-05 Mining Oil and Gas Food 0.0E E E E E E E-04 Beverages 0.0E E E E E E E-05 Tobacco 0.0E E E E E E E+00 Rubber 0.0E E E E E E E-06 Plastic 0.0E E E E E E E-04 Leather 0.0E E E E E E E-05 Textile 0.0E E E E E E E-04 Clothing 0.0E E E E E E E-04 Wood 0.0E E E E E E E-04 Furniture 0.0E E E E E E E-04 Paper 0.0E E E E E E E-04 Print and Publishing 0.0E E E E E E E-03 Primary Metal 0.0E E E E E E E-04 Metal Fabrication 0.0E E E E E E E-03 Machinery 0.0E E E E E E E-04 Transportation Equipment 0.0E E E E E E E-04 Electrical 0.0E E E E E E E-04 Mineral 0.0E E E E E E E-04 Petroleum 0.0E E E E E E E-05 Chemical 0.0E E E E E E E-04 Miscellaneous Manuacturing 0.0E E E E E E E-04 Subtotal 0.0E E E E E E E-03 Construction 0.0E E E E E E E-04 Transportation 0.0E E E E E E E-06 Storage 0.0E E E E E E E-06 Subtotal 0.0E E E E E E E-06 Communications 0.0E E E E E E E-06 Electrical Power, Gas and Water 0.0E E E E E E E-08 Wholesale Trade 0.0E E E E E E E-03 Retail Trade 0.0E E E E E E E-04 Services to Business Management 0.0E E E E E E E-04 Government, Personal and Misc. Services 0.0E E E E E E E-04 Subtotal 0.0E E E E E E E-03 Total 1.3E E E E E E E E E+00

74 66 WORKING PAPER TABLE A.4.3 Capital Stock Weights Large and Small Firms Structures CCA Classes Total Structures Machinery Land Inventories E&D CL1 CL3 CL6 CL13 CL26 CL33 CL41a Agriculture 2.6E E E E E E E E E E E E+00 Fishing and Trapping 7.6E E E E E E E E E E E E+00 Subtotal 2.7E E E E E E E E E E E E+00 Forestry 3.8E E E E E E E E E E E E+00 Mining 3.2E E E E E E E E E E E E E-03 Oil and Gas 3.7E E E E E E E E E E E E E-03 Food 2.3E E E E E E E E E E E E+00 Beverages 5.4E E E E E E E E E E E E+00 Tobacco 2.5E E E E E E E E E E E E+00 Rubber 2.7E E E E E E E E E E E E+00 Plastic 8.3E E E E E E E E E E E E+00 Leather 1.0E E E E E E E E E E E E+00 Textile 4.6E E E E E E E E E E E E+00 Clothing 4.6E E E E E E E E E E E E+00 Wood 1.4E E E E E E E E E E E E+00 Furniture 2.4E E E E E E E E E E E E+00 Paper 3.4E E E E E E E E E E E E+00 Print and Publishing 8.1E E E E E E E E E E E E+00 Primary Metal 1.6E E E E E E E E E E E E+00 Metal Fabrication 1.7E E E E E E E E E E E E+00 Machinery 1.4E E E E E E E E E E E E+00 Transportation Equipment 4.0E E E E E E E E E E E E+00 Electrical 1.4E E E E E E E E E E E E+00 Mineral 9.5E E E E E E E E E E E E+00 Petroleum 4.7E E E E E E E E E E E E+00 Chemical 2.6E E E E E E E E E E E E+00 Miscellaneous Manuacturing 6.5E E E E E E E E E E E E+00 Subtotal 2.6E E E E E E E E E E E E+00 Construction 6.2E E E E E E E E E E E E+00 Transportation 3.7E E E E E E E E E E E E+00 Storage 2.5E E E E E E E E E E E E+00 Subtotal 3.9E E E E E E E E E E E E+00 Communications 7.2E E E E E E E E E E E E+00 Electrical Power, Gas and Water 8.0E E E E E E E E E E E E+00 Wholesale Trade 9.0E E E E E E E E E E E E+00 Retail Trade 9.5E E E E E E E E E E E E+00 Services to Business Management 2.2E E E E E E E E E E E E+00 Government, Personal and Misc. 6.0E E E E E E E E E E E E+00 Services Subtotal 2.8E E E E E E E E E E E E+00 Total 1.0E E E E E E E E E E E E E-03

75 The Calculation o Marginal Eective Tax Rates 67 TABLE A.4.3 Capital Stock Weights Large and Small Firms (continued) Machinery CCA Classes CL4 CL7 CL8 CL9 CL10 CL12 CL14 CL15 CL16 CL17 CL24 CL27 CL34 Agriculture 1.1E E E E E E E E E E E E E-06 Fishing and Trapping 0.0E E E E E E E E E E E E E+00 Subtotal 1.1E E E E E E E E E E E E E-06 Forestry 0.0E E E E E E E E E E E E E-08 Mining 1.1E E E E E E E E E E E E E+00 Oil and Gas 0.0E E E E E E E E E E E E E-05 Food 2.7E E E E E E E E E E E E E-05 Beverages 1.1E E E E E E E E E E E E E-08 Tobacco 0.0E E E E E E E E E E E E E+00 Rubber 0.0E E E E E E E E E E E E E+00 Plastic 0.0E E E E E E E E E E E E E+00 Leather 0.0E E E E E E E E E E E E E+00 Textile 0.0E E E E E E E E E E E E E-05 Clothing 0.0E E E E E E E E E E E E E+00 Wood 0.0E E E E E E E E E E E E E-05 Furniture 2.6E E E E E E E E E E E E E+00 Paper 0.0E E E E E E E E E E E E E-04 Print and Publishing 0.0E E E E E E E E E E E E E+00 Primary Metal 0.0E E E E E E E E E E E E E-07 Metal Fabrication 0.0E E E E E E E E E E E E E-06 Machinery 0.0E E E E E E E E E E E E E+00 Transportation Equipment 0.0E E E E E E E E E E E E E+00 Electrical 0.0E E E E E E E E E E E E E-08 Mineral 0.0E E E E E E E E E E E E E+00 Petroleum 0.0E E E E E E E E E E E E E+00 Chemical 4.2E E E E E E E E E E E E E-07 Miscellaneous Manuacturing 0.0E E E E E E E E E E E E E+00 Subtotal 4.5E E E E E E E E E E E E E-04 Construction 8.9E E E E E E E E E E E E E-05 Transportation 2.8E E E E E E E E E E E E E-05 Storage 0.0E E E E E E E E E E E E E+00 Subtotal 2.8E E E E E E E E E E E E E-05 Communications 2.0E E E E E E E E E E E E E+00 Electrical Power, Gas and Water 2.8E E E E E E E E E E E E E-04 Wholesale Trade 5.2E E E E E E E E E E E E E-07 Retail Trade 1.1E E E E E E E E E E E E E-06 Services to Business Management 5.1E E E E E E E E E E E E E-05 Government, Personal and Misc. Services 2.2E E E E E E E E E E E E E+00 Subtotal 2.7E E E E E E E E E E E E E-05 Total 1.5E E E E E E E E E E E E E-04

76 68 WORKING PAPER TABLE A.4.3 Capital Stock Weights Large and Small Firms (continued) E&D CL35 CL36 CL37 CL38 CL41b CL42 CL43 CEE CDE Agriculture 0.0E E E E E E E-05 Fishing and Trapping 0.0E E E E E E E-05 Subtotal 0.0E E E E E E E-05 Forestry 1.3E E E E E E E-04 Mining 2.3E E E E E E E E E-03 Oil and Gas 2.9E E E E E E E E E+00 Food 0.0E E E E E E E-03 Beverages 0.0E E E E E E E-03 Tobacco 0.0E E E E E E E-04 Rubber 0.0E E E E E E E-04 Plastic 0.0E E E E E E E-03 Leather 0.0E E E E E E E-05 Textile 2.5E E E E E E E-03 Clothing 0.0E E E E E E E-04 Wood 1.4E E E E E E E-03 Furniture 0.0E E E E E E E-04 Paper 5.9E E E E E E E-03 Print and Publishing 0.0E E E E E E E-03 Primary Metal 1.0E E E E E E E-03 Metal Fabrication 3.2E E E E E E E-03 Machinery 0.0E E E E E E E-03 Transportation Equipment 1.3E E E E E E E-02 Electrical 3.7E E E E E E E-03 Mineral 0.0E E E E E E E-03 Petroleum 0.0E E E E E E E-04 Chemical 5.0E E E E E E E-03 Miscellaneous Manuacturing 1.9E E E E E E E-03 Subtotal 1.5E E E E E E E-02 Construction 0.0E E E E E E E-04 Transportation 6.9E E E E E E E-04 Storage 6.8E E E E E E E-05 Subtotal 6.9E E E E E E E-04 Communications 0.0E E E E E E E-05 Electrical Power, Gas and Water 0.0E E E E E E E-05 Wholesale Trade 0.0E E E E E E E-03 Retail Trade 0.0E E E E E E E-04 Services to Business Management 5.1E E E E E E E-03 Government, Personal and Misc. Services 3.0E E E E E E E-04 Subtotal 5.4E E E E E E E-03 Total 1.4E E E E E E E E E-03

77 The Calculation o Marginal Eective Tax Rates 69 TABLE A.5.1 Production Input Shares Large Firms Total Structures Machinery Land Inventories E&D R&D Labour (percent) Agriculture Fishing and Trapping Subtotal Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Subtotal Construction Transportation Storage Subtotal Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services Subtotal Total

78 70 WORKING PAPER TABLE A.5.2 Production Input Shares Small Firms Total Structures Machinery Land Inventories E&D R&D Labour (percent) Agriculture Fishing and Trapping Subtotal Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Subtotal Construction Transportation Storage Subtotal Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services Subtotal Total

79 The Calculation o Marginal Eective Tax Rates 71 TABLE A.5.3 Production Input Shares Large and Small Firms Total Structures Machinery Land Inventories E&D R&D Labour (percent) Agriculture Fishing and Trapping Subtotal Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Subtotal Construction Transportation Storage Subtotal Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services Subtotal Total

80 72 WORKING PAPER TABLE A.6.1 Average Statutory Tax Rates by Industry, 1997 Large Firms Small Firms M&P Share Federal Tax Rate Provincial Tax Rate Combined M&P Share Rate (percent) Federal Tax Rate Provincial Tax Rate Combined Rate Agriculture Fishing and Trapping Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Construction Transportation Storage Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc

81 The Calculation o Marginal Eective Tax Rates 73 TABLE A.6.2 Statutory Federal and Provincial Income Tax Rates, 1997 Taxable Income Share (1) Large Firms Small Firms Regular M&P Regular M&P (percent) Federal British Columbia Alberta Saskatchewan Manitoba Ontario Quebec New Brunswick Nova Scotia Prince Edward Island Newoundland Yukon Northwest Territories Provincial Average Combined Federal-Provincial (1) Revenue Canada; T2 Database, TABLE A.7 Statutory Federal and Provincial Capital Tax Rates, 1997 (percent) Federal British Columbia Alberta n/a Saskatchewan Manitoba Ontario Quebec New Brunswick Nova Scotia Prince Edward Island n/a Newoundland n/a Yukon n/a Northwest Territories n/a Provincial Average 0.345

82 74 WORKING PAPER TABLE A.8 Eective Investment Tax Credit Rates Large Firms Small Firms Large and Small Firms Structures Machinery Total Structures Machinery Total Structures Machinery Total (percent) Agriculture Fishing and Trapping Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Construction Transportation Storage Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services All Industries

83 The Calculation o Marginal Eective Tax Rates 75 TABLE A.9 Economic Depreciation Rates Weighted Average Structures CCA Classes Machinery CCA Classes All Assets Structures Machinery CDE CL1 CL3 CL6 CL13 CL26 CL33 CL41a CL4 CL7 CL8 CL9 (percent) Agriculture Fishing and Trapping Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Construction Transportation Storage Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services All Industries Note: For E&D, economic depreciation applies to CDE only; CEE is ully expensed.

84 76 WORKING PAPER TABLE A.9 Economic Depreciation Rates (continued) CL10 CL12 CL14 CL15 CL16 CL17 CL24 CL27 CL34 CL35 CL36 CL37 CL38 CL41b CL42 CL43 (percent) Agriculture Fishing and Trapping Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Construction Transportation Storage Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services All Industries

85 The Calculation o Marginal Eective Tax Rates 77 TABLE A.10 Eective Provincial Sales Tax Rates on Machinery (percent) Agriculture 1.6 Fishing and Trapping 3.3 Forestry 3.3 Mining 1.3 Oil and Gas 1.3 Food 2.3 Beverages 2.3 Tobacco 0.0 Rubber 1.1 Plastic 1.1 Leather 2.0 Textile 0.7 Clothing 2.2 Wood 3.3 Furniture 1.8 Paper 2.6 Print and Publishing 2.3 Primary Metal 1.7 Metal Fabrication 1.9 Machinery 2.1 Transportation Equipment 1.8 Electrical 2.4 Mineral 2.5 Petroleum 1.8 Chemical 2.0 Miscellaneous Manuacturing 1.8 Construction 5.4 Transportation 2.5 Storage 2.5 Communications 4.8 Electrical Power, Gas and Water 3.4 Wholesale Trade 4.4 Retail Trade 4.4 Services to Business Management 4.3 Government, Personal and Misc. Services 4.3

86 78 WORKING PAPER TABLE A.11 Loss Utilization Rates and Proportion o Tax-Paying Firms Loss Utilization Rates Proportion o Tax-Paying Firms Large Firms Small Firms Large Firms Small Firms (percent) Agriculture Fishing and Trapping Forestry Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Construction Transportation Storage Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services All Industries

87 The Calculation o Marginal Eective Tax Rates 79 TABLE A.12 Industry Speciic Debt-Asset Ratios (percent) Agriculture 36.8 Fishing and Trapping 28.0 Forestry 26.0 Mining 26.0 Oil and Gas 26.0 Food 28.0 Beverages 35.0 Tobacco 35.0 Rubber 35.0 Plastic 35.0 Leather 35.0 Textile 35.0 Clothing 35.0 Wood 44.0 Furniture 44.0 Paper 44.0 Print and Publishing 39.0 Primary Metal 30.0 Metal Fabrication 30.0 Machinery 35.0 Transportation Equipment 34.0 Electrical 35.0 Mineral 35.0 Petroleum 33.0 Chemical 33.0 Miscellaneous Manuacturing 35.0 Construction 39.0 Transportation 48.0 Storage 48.0 Communications 50.0 Electrical Power, Gas and Water 56.0 Wholesale Trade 35.0 Retail Trade 32.0 Services to Business Management 39.0 Government, Personal and Misc. Services 39.0

88 80 WORKING PAPER TABLE A.13 Main Features o the Corporate Tax Systems in the G-7 Countries and Mexico, 1995 Canada United States United Kingdom Germany France Italy Japan Mexico (percent) Income Tax Rate National / Local to 12 No 5-25 No (a) No Tax Depreciation Rate Manuacturing Structures 5 DB 6 DB 4 SL 4 SL 5 SL 3 SL 4 SL 5 SL Machinery 39 DB 32 DB 25 DB 15 SL 15 SL 13 SL 10 SL 10 SL Services Structures 5 DB 7 DB 4 SL 4 SL 5 SL 3 SL 4 SL 5 SL Machinery 29 DB 34 DB 25 DB 15 SL 15 SL 13 SL 10 SL 10 SL Business Tax No No No No No No No Capital Tax (average: 0.57) No No No No No No 1.8 as minimum tax Property Transer Tax No No 1 No Inventory Accounting FIFO FIFO/LIFO FIFO LIFO LIFO LIFO FIFO/LIFO LIFO Tax Indexation No No No No No No No Yes Sources: Department o Finance METR Model, and Chen and McKenzie (1997). Notes: There are dierent types o income taxes that apply at the local level in Japan; see Chen and McKenzie (1997) or a brie description. The average capital tax or Canada is composed o the LCT (0.225% ) and the weighted average provincial capital tax (0.345%).

89 The Calculation o Marginal Eective Tax Rates 81 Appendix B Estimated Eective Payroll Tax Rates or Canada This appendix describes the data and the methodology used to compute the eective payroll tax rates or Canada used in the METR model. As discussed in the text, in the base case, it is assumed that the economic incidence o payroll taxes coincides with the legal incidence, although other incidence assumptions were also considered. The METR methodology requires the calculation o the marginal tax rate on labour inputs, which we interpret as the tax associated with expansion o employment o a irm or industry. In principle, there are several ways in which this might be done. One approach would be to simply take total payroll taxes by sector and divide them by total wages and salaries paid in the sector, to obtain an average payroll tax rate; but ully comparable data on payroll taxes and payroll are not readily available. Another approach would be to calculate the (wage and salary) income or an average worker in each industry, and apply the statutory payroll tax provisions to the average worker. But this approach would not take into account dierences in the distribution o wages and salaries among industries. These dierences, when coupled with the income ceilings and loors associated with most payroll taxes, can aect the tax rate. 1 Thus, a third approach was ollowed, which allowed or more variability in eective payroll tax rates across sectors. This approach involved the calculation o average earnings or income groups within each sector. The statutory provisions o the various payroll taxes were then applied to each o these groups, and a weighted average taken to determine the overall eective payroll tax rate or a typical hybrid employee in each industry. To compute eective payroll tax rates or Canada, inormation is required or each o the 10 provinces, as there are substantial dierences in payroll tax regimes across the provinces. Data on the distribution o hourly wages 2 by industry or (Table B.1) provided a starting point. Unortunately, these wage distribution data were or Canada as a whole rather than or individual provinces. While we combined these Canada-wide wage distribution data with provincial data on average weekly hours by industry, the resulting calculations o annual wages by industry or each province obviously only allow in part or province-speciic actors. The hourly wage distribution consists o ive wage groups (the wage brackets were converted to 1996 dollars using a ixed-weight index o average hourly earnings). Since the ith group includes hourly wages over $22.06 with no upper limit, an average wage had to be computed or 1 For example, the $39,000 ceiling on wages subject to contribution or purposes o Employment Insurance, together with the statutory employer contribution rate in 1997, mean that an employer contributes at an eective rate o 4.06% o wages or an employee earning $30,000 per year but at a rate o 3.17% o wages or an employee earning $50,000 a year. 2 Statistics Canada (1996b), Table 11.

90 82 WORKING PAPER this class. This hourly wage was calculated as a residual using inormation on the distribution o employees among the ive wage categories and on the overall average hourly wage. 3 Column (1) o Table B.2 shows the values calculated or the 1996 overall average hourly wage by industry, and column (2), the average hourly wage in the ith wage group (>$22.06). Data by province on average weekly hours worked or employees paid by the hour and or salaried employees, or 33 industries, 4 were converted to average annual hours worked by typical employees using the assumption that typical employees are paid or 52 weeks per year. Using the hourly wage distribution and assuming the same average annual hours or each wage group within an industry, average annual wages were then determined or the purpose o computing the taxes paid by an employer or a typical employee by industry. For each province, this gives average annual wages or ive wage groups, or 33 industries. The calculated average annual wages or employees in each o the ive wage groups by industry or Ontario are shown in Table B.3 as an example. The 1997 statutory tax rates (see Table B.4) were then used to calculate the eective payroll tax rates or each o the ive wage groups o the 33 industries, in each province. (The table also shows certain tax rates or to be discussed below.) Basically, to compute eective payroll tax rates, we applied the statutory rates to the average salary level in each group, and then calculated the weighted average tax rate. Taxes Paid 1. Canada Pension Plan: CPPj, k = ( MIN( AAWj, k,$35,800) $3,500) 2.925% where CPP j,k represents CPP taxes o wage group j in industry k, AAW j,k is the average annual wage, $3,500 is the minimum earning subject to contribution, $35,800 is the maximum earning subject to contribution, and percent is the tax rate in Employment Insurance: EIj, k = MIN( AAWj, k,$39,000) 4.06% where EI j,k represents the Employment Insurance taxes in wage group j in industry k, and 4.06 percent is the tax rate in Statistics Canada (1996b), Table These observations are rom Statistics Canada (1996a) Employment, Earnings and Hours, 1995.

91 The Calculation o Marginal Eective Tax Rates Provincial Payroll Taxes: Four provinces impose a tax or health and education: Newoundland, Quebec, Ontario and Manitoba. The thresholds under which the small irms are exempt rom paying this tax are $100,000 in Newoundland; $400,000 in Ontario; and $750,000 in Manitoba. There are no exemptions in Quebec. To determine the proportion o small irm payrolls under and over the thresholds by industry, we used Canada-wide data rom the T2 database or small irms, as indicated below. 5 Percentage o Small Firms Payroll Canada < $100,000 < $400,000 < $750,000 (percent) Forestry Mining Oil and Gas Manuacturing Construction Transportation and Storage Communications Public Utilities Wholesale Trade Retail Trade Other Services Total Taxes and Eective Payroll Tax Rates: Total payroll taxes or each annual wage group within an industry and province were determined by summing up the dierent taxes paid: CPP/QPP, EI and, where relevant, provincial payroll taxes. The eective tax rates or each industry subsector were then calculated as weighted averages (using shares o employees). This approach generates eective payroll tax rates or 11 industries (orestry; mining; oil and gas; manuacturing; 6 construction; transportation and storage; 7 communications; public utilities; wholesale trade; retail trade; and other services 8 ) or each province, or small and large irms separately. Since no data were available or agriculture, ishing and trapping, we used the calculated values or orestry as an approximation. The industry-speciic eective payroll tax rates or each o the 10 provinces were then combined, 5 See Appendix A or a description o small versus large irms. 6 Manuacturing subsectors were combined using a weight matrix based on the number o employees. The observations on the number o employees are rom Statistics Canada, Catalogue No A weight o 50% or each subsector was used. 8 Includes services to business management and government, personal and miscellaneous services. Other services subsectors were combined using a weight matrix based on the number o employees (Statistics Canada, ).

92 84 WORKING PAPER using the industrial distribution among provinces shown in Table B.5, to obtain eective payroll tax rates or Canada by industry, or small and large irms. All o these calculations were completed or small and large irms separately, since, as mentioned above, small irms that are under a provincial-speciic threshold are exempt rom paying payroll taxes except in Quebec, where all irms must pay these taxes. The eective payroll tax rates by industry or small irms were combined with the eective payroll tax rates by industry or large irms, to generate eective payroll tax rates by industry or Canada. 9 The resulting 1997 eective payroll tax rates by industry or Canada are shown in Table B.6. These rates can be thought o as gross rates, given the 1997 payroll tax regime in Canada. Two urther adjustments were made to these rates to produce the base case payroll tax estimates used in the METR calculations in the Technical Committee's report. The irst involves an adjustment or changes to payroll tax rates associated with expected changes in CPP/QPP and EI contribution rates; the second involves an adjustment or beneits. As well, alternative estimates o eective payroll tax rates were prepared, which include estimates o employer contributions or workers compensation. Adjustment or Anticipated Changes in CPP/QPP and EI Contribution Rates The CPP/QPP and EI contribution rates or 1997 might be regarded as not representative o the contribution rates or these programs that will prevail in the medium term. In the case o the CPP, legislation was passed in 1997 that provides or a sequence o rate increases rom 1998 to 2003, with the rate structure reached by 2003 intended to be one that can be maintained while leaving the CPP on a sustainable inancial basis. In the case o EI, while there is no announced schedule o uture rate changes, the act that the EI account is running a surplus on an annual basis at current contribution rates leads to a presumption that the sustainable average rate is appreciably lower than the current rate, and there is a general expectation that EI contribution rates will be reduced over the next several years. In order that the base case will be representative o the rate structure expected to prevail over the next ew years, we have used CPP and EI contribution rate structures that are estimated to prevail when currently anticipated adjustments to rate structures or these programs have been completed (and have labelled these the rates ). As shown in Table B.4, or the CPP/QPP, we used the rate structure that is scheduled to apply in 2003 (employer contribution rate o 4.95 percent, compared with the 1997 rate o percent). For EI, we used an employer contribution rate o $3.08 per $100 o contributory earnings an estimate o the rate structure that would yield balance in EI annual contributions and beneits on an average basis. This corresponds to an employee contribution rate o $2.20, and compares with employer contribution rates o $4.06 or 1997 and $3.78 or (On the basis o most recent inormation, the estimate that we have used or the rate structure that would yield balance in the EI account may be on the high side. See Canada, Human Resources Development (1997).) 9 Using the distribution o gross revenues (see Table A.3 o Appendix A).

93 The Calculation o Marginal Eective Tax Rates 85 The approach used to calculate the corresponding Eective Payroll Tax Rates shown in Table B.6 parallels the approach described above or the calculation o the eective rates or 1997, except that we have used CPP/QPP and EI statutory contribution rates assumed or Adjustment or Beneits As noted in Section o this paper, in the base case, we use estimates o eective payroll tax rates net o directly associated beneits (where workers compensation, CPP/QPP and EI are viewed as having directly associated beneits, while general provincial payroll taxes are viewed as pure taxes or which no associated beneit needs to be netted against the contribution rate). For workers compensation, we assume that beneits match contribution rates by industry, resulting in a zero net contribution rate. For CPP/QPP, our estimate o the net contribution rate relects the view that, by 2003, the rate will somewhat exceed the expected value o beneits or the average employee (due to the need to cover the actuarial deiciency o the plan accumulated by lack o ull unding to date). We assumed an eective contribution rate, net o beneits, o 1.5 percent or 2003 and ollowing years. This would correspond to the employer share (50 percent) o an excess o the 2003 combined employer-employee actual contribution rate over the ull cost rate o 3 percentage points. The Chie Actuary s Report o September estimated the combined ull cost rate to be 6.1 percent, compared with the combined employer-employee actual rate schedule or 2003 o 9.9 percent. This implies that our assumed rate might be viewed as modestly underestimating the net o beneits rate (the employers share o the dierence between the 2003 rate and this latest oicial estimate o the ull cost rate would be 1.8 percent, rather than our assumed 1.5 percent). We urther assume that, in the case o the CPP/QPP, the relationship between beneits and contributions does not vary systematically or employees in dierent industries. Thus we apply a common 1.5 percent net rate, subject to the loor and ceiling on insurable earnings discussed above, to all industries. For EI, we wish to allow in an approximate way or the systematic dierence by industry in the relationship between contribution rates and beneits (see discussion in Chapter 8 o the Report o the Technical Committee on Business Taxation). Our estimates are based on detailed EI beneit and contribution data by industry developed or by Corak and Pyper (1995). Table B.7 shows the Corak-Pyper data or total EI beneits by industry expressed as ratios to approximately matched data on labour income by industry (column (a)). Data rom the same source on total (employer and employee) contributions by industry are also expressed as ratios to labour income, and then adjusted by a common proportionality actor so that total contributions (rom all industries including the public sector, not just those industries shown in the table) equal total beneits (column (b)). (Adjusted) contribution rates net o beneits (column (c)) are then 10 Canada, Oice o the Superintendent o Financial Institutions (1997), page 13.

94 86 WORKING PAPER multiplied by 1.4/2.4 to give an estimate (column (d)) o eective employer contribution rates, net o beneits, in a balanced system corresponding approximately to the current EI structure. These EI employer contribution rates net o beneits by industry are shown in the last column o Table B.7, and in the EI net o beneits line o Table B.8. They are used in calculating the overall eective payroll tax rates, net o beneits, shown in Table B.9. Finally, we provide estimates o eective EI employer contribution rates, net o beneits, by industry under the partial experience rating employer contribution rate structure put orward as an illustration by the Technical Committee (see Report, Table 8.3). These eective EI employer rates are shown in the Technical Committee Illustrative Proposal EI net o beneits line o Table B.8. They in turn are used in calculating the overall Eective Payroll Tax Rates, Net o Beneits, Including Technical Committee EI Employer Rate Illustrative Proposal section o Table B.9. Workers Compensation All o the calculations to this point have, in eect, ignored workers compensation, ollowing the premise that workers compensation is, to a irst approximation, an actuarially air beneit tax. Contribution rate data on workers compensation are inherently complex, since each province has its own rate system, dierent rates are generally set or each o a multitude o narrow industry categories (which themselves are not common across provinces), and there can be urther rate variations or irms within an industry category. Calculating weighted average eective rates is urther complicated by diiculties in obtaining payroll data consistent with the narrow industry categories used in setting workers compensation contribution rates. To provide an approximate indicator o variation in eective workers compensation contribution rates across the set o broad industry categories used in the METR analysis, we attempted to compute rates or various industries in Ontario. Table B.10 shows the weighted average workers compensation rates or 34 industries based on the rates or 3-digit industries in Ontario. 11 Inormation is also available on average eective workers compensation rates by province or 1995 (DiMatteo and Shannon (1995)). I it is assumed that industry contribution rates relative to the provincial average in other provinces are similar to the Ontario pattern, rates by industry or Canada as a whole can then be calculated. Table B.11 shows the resulting calculated average tax rates or 1997 workers compensation. 11 Association o Workers Compensation Boards o Canada (1996).

95 The Calculation o Marginal Eective Tax Rates 87 The total eective payroll tax rates or the case where workers compensation is included, and no allowance is made or beneits associated with any o the payroll taxes, are shown in Table B.12. These overall eective payroll tax rate estimates may be compared with the 1997 rates in Table B.6. Both are notional or 1997, and neither are net o directly associated beneits. The B.12 estimates include workers compensation rates, whereas the B.6 estimates do not.

96 88 WORKING PAPER TABLE B.1 Wage Distribution, (Hourly Wages in 1996 dollars) W ÃÇ $9.56 < W $13.04 $13.04 < W $16.81 (percent) $16.81 < W $22.06 W > $22.06 Total Forestry Mining Oil and Gas Manuacturing Food Beverages Tobacco Rubber Plastic Leather Textile Clothing Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral Petroleum Chemical Miscellaneous Manuacturing Construction Transportation and Storage Transportation Storage Communications Public Utilities Wholesale Trade Retail Trade Other Services Services to Business Management Government, Personal and Misc. Services Note: Some totals do not add up to 100% since these numbers are estimates. Source: Statistics Canada (1996b).

97 The Calculation o Marginal Eective Tax Rates 89 TABLE B.2 Average Hourly Wage Rates o Full Time Equivalent Jobs by Industry Group, 1996 (1996 dollars) Average Hourly Wage (1) Average Hourly Wage in Fith Wage Group (2) Forestry Oil and Gas Mining Food and Beverages Tobacco Rubber and Plastics Leather Textile Knitting Mills Clothing Wood Furniture and Fixtures Paper and Allied Products Print and Publishing Primary Metal Metal Fabricating Machinery Transportation Equipment Electrical Non-metallic Petroleum Chemical Miscellaneous Manuacturing Construction Transportation Storage Communications Public Utilities Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services Wage Group Average Hourly Wage Hourly Wage à < Hourly Wage à < Hourly Wage à < Hourly Wage à Hourly Wage > Notes: The numbers in columns (1) and (2) are calculated by the authors; or column (1), the wages were adjusted using a ixed-weighted index rom average hourly earnings, Statistics Canada The high wage in the clothing industry is less than $22.06 since the average hourly wage in that industry is low.

98 90 WORKING PAPER TABLE B.3 Calculated Average Annual Wage o Employee by Wage Rate Group and Industry, Ontario, 1996 (1996 dollars) Average Hourly Wage Rate = $9.56 = $11.31 = $14.93 = $19.44 > $22.06 Forestry 20, , , , , Mining 20, , , , , Oil and Gas 19, , , , , Food 18, , , , , Beverages Tobacco Rubber Plastic 19, , , , , Leather Textile Clothing 18, , , , , Wood 18, , , , , Furniture 20, , , , , Paper and Allied Products 20, , , , , Print and Publishing 17, , , , , Primary Metal 21, , , , , Metal Fabrication 19, , , , , Machinery 20, , , , , Transportation Equipment 20, , , , , Electrical 19, , , , , Mineral Petroleum Chemical 18, , , , , Miscellaneous Manuacturing 19, , , , , Construction 18, , , , , Transportation 19, , , , , Storage 19, , , , , Communications 18, , , , , Public Utilities 19, , , , , Wholesale Trade 18, , , , , Retail Trade 13, , , , , Services to Business Management 17, , , , , Government, Personal and Misc. Services 13, , , , , Note: Authors calculations as described in text.

99 The Calculation o Marginal Eective Tax Rates 91 TABLE B and Statutory Payroll Tax Rates, Excluding Workers Compensation Large and Small Firms Maximum Earnings Subject to Contribution Contribution Rate (%) Min ($) Max ($) ($) CPP 1997 Rates ,500 35, Rates ,500 35,400 1, EI 1997 Rates ,000 1, Rates ,000 1, Workers Compensation 1997 Rates Rates NF PE NS NB QC ON MB SK AB BC Payroll Tax Provincial Threshold ($) 100,000 n/a n/a n/a 0 400, ,000 n/a n/a n/a Rate on Payroll Above Threshold (%) 2.00 n/a n/a n/a n/a n/a n/a TABLE B.5 Industrial Distribution Among Provinces, 1995 FOR MIN OG MAN CON TS COM PU WT RT OS (percent) Newoundland Prince Edward Island Nova Scotia New Brunswick Quebec Ontario Manitoba Saskatchewan Alberta British Columbia Total Notes: FOR = Forestry, MIN = Mining, OG = Oil and Gas, MAN = Manuacturing, CON = Construction, TS = Transportation and Storage, COM = Communications, PU = Public Utilities, WT = Wholesale Trade, RT = Retail Trade, OS = Other Services. Calculated using the number o employees rom Statistics Canada s catalogue No Some o the totals do not add up to 100% since observations were not available or some industries in some provinces.

100 92 WORKING PAPER TABLE B and Eective Payroll Tax Rates, Excluding Workers Compensation Large Firms Small Firms Large and Small Firms (percent) 1997 Eective Payroll Tax Rates Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation and Storage Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Eective Payroll Tax Rates Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation and Storage Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Source: Authors calculations. TABLE B.7 Eective EI Tax Rates, Net o Beneits Based on 1989 Data with Contributions Adjusted to Balance Beneits Total Beneits / Labour Income Total Adjusted Contributions / Labour Income Adjusted Contributions Net o Beneits / Labour Income Employer s Share: Contributions Net o Beneits (1.4/2.4)*(c) (a) (b) (c) (d) (percent) Forestry Mining Oil and Gas Manuacturing Construction Transportation Communications Public Utilities Wholesale Trade Retail Trade Commercial All Industries Note: Data on beneits, premiums and payrolls are rom Corak and Pyper (1995).

101 The Calculation o Marginal Eective Tax Rates 93 TABLE B Payroll Tax Rates, Net o Beneits and with Technical Committee Alternative EI Proposal Net o Beneits Maximum Earnings Subject to Contribution Contribution Rate (%) Min ($) Max ($) ($) CPP ,500 35, Workers Compensation NF PE NS NB QC ON MB SK AB BC Payroll Tax Provincial Threshold ($) 100,000 n/a n/a n/a 0 400, ,000 n/a n/a n/a Rate on Payroll Above Threshold (%) 2.00 n/a n/a n/a n/a n/a n/a EI Experience-rated Maximum Insurable Earnings $39,000 FOR MIN OG MAN CON TS COM PU WT RT OS (percent) EI Eective Employer Contribution Rate, Net o Beneits Partial Experience Rating (Technical Committee Illustrative Proposal) Note: FOR = Forestry, MIN = Mining, OG = Oil and Gas, MAN = Manuacturing, CON = Construction, TS = Transportation and Storage, COM = Communications, PU = Public Utilities, WT = Wholesale Trade, RT = Retail Trade, OS = Other Services.

102 94 WORKING PAPER TABLE B Eective Payroll Tax Rates Large Firms Small Firms Large and Small Firms (percent) Net o Beneits Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation and Storage Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Net o Beneits, Including Technical Committee EI Employer Rate Illustrative Proposal Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation and Storage Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Source: Authors calculations.

103 The Calculation o Marginal Eective Tax Rates 95 TABLE B.10 Calculation o Workers Compensation Rates or Ontario, 1997 SIC Industry Rate Weight o Subindustries Weight o Aggregate Industries SIC Industry Rate Weight o Sub-industries Weight o Aggregate Industries ($) (%) (%) ($) (%) (%) 11 Livestock arms Primary steel Field crop arms Steel pipe and tubes Fruit, other vegetable arms Iron oundries Services incidental to arming Non-errous metal smelters/reineries Total Agriculture Aluminium roll cast and extrude Total Primary Metal Total Fishing and Trapping Power boiler Total Forestry Fabric Ornamental Metal mines Stamp press coat metal products Stone quarries Wire and wire products Sand and gravel pits Hardware tool and cutlery Services incidental to mining Heating equipment Total Mining Machine shop Other metal abrication Oil and Gas Total Metal Fabrication Meat and poultry products Agricultural equipment Fruit and vegetable Other machinery and equipment Dairy products Total Machinery Bakery products Sugar and sugar conectionery Aircrat and aircrat parts Other ood products Motor vehicles Total Food Truck and bus body and trailers Motor vehicle parts and accessories Beverages Railroad rolling stock Shipbuilding and repairs Rubber Products Boat building and repairs Total Transportation Equipment Plastic Products Appliances, lighting, etc Leather and Allied Products Major appliances Electronic equipment Primary textile Oice stores and business machines Textile products Electric industrial equipment Total Textile Total Electrical Total Clothing Concrete products Ready-mix concrete Wooden box, pallet, coin Glass and glass products Sash door and other millwork Total Mineral Total Wood Petroleum Household urniture Oice urniture Industrial chemicals Other urniture and ixture Plastic and synthetic resin Total Furniture Pharmaceutical and medicine Paint and varnish Paper box and bags Soap and cleaning compounds Other converted paper products Toilet preparations Total Paper Other chemical products Total Chemical Commercial printing Platemaking and bindery Other Manuacturing Industries Publishing industries Total Printing and Publishing Residential buildings and development Non-residential buildings Highway and heavy construction Trade contracting Total Construction

104 96 WORKING PAPER TABLE B.10 Calculation o Workers Compensation Rates or Ontario, 1997 (continued) Weight o SIC Industry Rate Weight o Subindustries Aggregate Industries ($) (%) (%) 451 Air transport Services incidental to air trans Railway transport Water transport Services incidental to wat. trans Truck transport Public passenger transit system Total Transportation Grain elevator Other storage and warehousing Total Storage Other telecommunications Postal and courier service Total Communications Electric power systems Gas-distribution systems Total Public Utilities Farm products Petroleum products Food wholesale Household urniture Metal and metal products Hardware, air conditioning, etc Lumber and building materials Farm equipment and supplies Construction machines Industrial machines Electronics Other products Total Wholesale Trade Food Liquor, wine and beer Prescription drugs Clothing Automobile dealers Auto parts and accessories General merchandising Total Retail Trade Advertising services Architecture and engineering Other business services Total Business Services Non-institutional health services Hotels, motels and tourism Food services Sports and recreation clubs Laundries and cleaners Membership organizations Services to buildings/dwellings Total Government and Personal Services All Industries Sources: Data or control rates are rom Association o Workers Compensation Boards o Canada (1996). Weights o subsectors are based on average payrolls, Corak and Pyper (1995).

105 The Calculation o Marginal Eective Tax Rates 97 TABLE B and Statutory Payroll Tax Rates, Excluding Workers Compensation Large and Small Firms Maximum Earnings Subject to Contribution Contribution Rate (%) Min ($) Max ($) ($) CPP ,500 35, EI ,000 1, FOR MIN OG MAN CON TS COM PU WT RT OS Workers Compensation Rates (%) NF PE NS NB QC ON MB SK AB BC Maximum Taxable Earnings ($) Rates All Industries (%) Payroll Tax Provincial Threshold ($) Rate on Payroll Above Threshold (%) 45,500 35,100 38,600 42,600 48,500 55,600 48,610 48,000 44,000 54, ,000 n/a n/a n/a 0 400, ,000 n/a n/a n/a 2.00 n/a n/a n/a n/a n/a n/a Note: FOR = Forestry, MIN = Mining, OG = Oil and Gas, MAN = Manuacturing, CON = Construction, TS = Transportation and Storage, COM = Communications, PU = Public Utilities, WT = Wholesale Trade, RT = Retail Trade, OS = Other Services. TABLE B Eective Payroll Tax Rates, Including Workers Compensation Employer Contributions Large Firms Small Firms Large and Small Firms (percent) Agriculture, Fishing and Trapping Forestry Mining Oil and Gas Manuacturing Construction Transportation and Storage Communications Public Utilities Wholesale Trade Retail Trade Other Services All Industries Source: Authors calculations.

106 98 WORKING PAPER Appendix C Estimated Eective Payroll Tax Rates or the United States Our objective was to calculate eective payroll tax rates or the United States that were reasonably comparable with those calculated or Canada. The basic approach paralleled the approach or Canada outlined in Appendix B. The ocus o Appendix C is thus on aspects where, because o dierences in tax systems or problems with availability o data, some dierences were required in the approach ollowed. In general, we were attempting to calculate the eective payroll tax rates that would be aced i the U.S. payroll tax regime were to be applied to Canadian industries, rather than to calculate the best estimates o the eective tax rates actually applicable in the United States given the somewhat dierent mix o workers by wage levels that may prevail in U.S. industries. As will be noted below, however, we did make use o U.S. data or some aspects o industry mix. To calculate the average annual wage in order to compute the taxes paid by an employer or a typical employee, we used the same hourly wage distribution as or the Canadian calculations o eective payroll tax rates (Table B.1), converted to U.S. dollars at the 1996 average annual exchange rate, US$1=C$ We did, however, combine these hourly wage rates with U.S. data on average weekly hours worked by industry or nine states, accounting or more than 50 percent o GDP: Caliornia, New York, Texas, Illinois, Florida, Pennsylvania, Ohio, New Jersey and Michigan. Multiplying weekly hours by 52 gives the annual results shown in Table C.1. 1 Using these observations, we then computed average annual wages o production workers or each industry, one or each wage group. We then calculated gross eective payroll tax rates or each o the ive wage groups in each industry using the 1996 U.S. ederal statutory tax rates 2 and ceilings or Old Age, Survivors and Disability Insurance (OASDI), health insurance (HI) and ederal unemployment insurance shown in Table C.2. For the purpose o calculating eective payroll tax rates, we combined the narrow industry classes as ollows to obtain estimates or the broader classes based in the METR analysis: Manuacturing: Includes ood, beverages, tobacco products, rubber, plastics, leather industries, textile industries, wood industries, urniture and ixtures, paper and allied products, print and publishing, primary metal, metal abricating, machinery, transportation equipment, electrical products, chemical products, and miscellaneous manuacturing. To combine the dierent manuacturing categories, we used the weight matrix shown in Table C.3. 1 Data on weekly hours were not available or the ollowing industries used in the Canadian calculations: orestry, clothing, mineral products, petroleum, storage, government, personal and miscellaneous services. 2 CCH Incorporated U.S. Master Tax Guide, paragraph 45.

107 The Calculation o Marginal Eective Tax Rates 99 Transportation and Storage: Includes only observations on transportation, since no observations are available or storage. Services: Includes only services to business management, since no observations are available on government, personal and miscellaneous services. These calculations resulted in estimates o eective ederal payroll tax rates or 10 industries (mining; oil and gas; manuacturing; construction; transportation and storage; communications; public utilities; wholesale trade; retail trade; and services), or nine states. Estimates o industry-speciic national average eective ederal payroll tax rates were then calculated using the industrial distribution among states shown in Table C.4. To determine the values o eective total (ederal and state) payroll tax rates, we also needed estimates o the eective state unemployment insurance tax rates, which vary substantially by industry due to the use o experience rating at the state level. (State-level UI employer contributions are generally substantially larger than the ederal UI employer contributions.) We were unable to locate comprehensive data that would allow direct estimation o such rates. We thus made use o a airly recent study by Anderson and Meyer (1993), which provided estimates o relative average state UI contribution rates on covered wages by industry, and relative covered wage levels by industry, to obtain values or relative UI contributions paid per employee. (The Anderson-Meyer estimates use a somewhat dierent industry classiication structure than we have used or estimating the remaining components o eective tax rates; their analysis is based on data or eight states.) These estimates o relative UI contributions per employee were applied to an estimate o average employer UI contributions across all industries (or 1994), and then coupled with data on employees, and on total wages and salaries, by industry to obtain estimates o the eective tax rate by industry. Table C.5 shows the key steps in these calculations. The resulting estimated eective state UI employer contribution rates by industry (inal column) are repeated in the lower panel o Table C.2 (with the estimate or agriculture in Table C.5 used as the estimated rate or orestry). Estimated ederal, state and total eective payroll tax rates by industry are shown in Table C.6. In addition to calculating gross eective payroll tax rates, we calculated employer payroll tax rates net o beneits, or comparison with the Canadian base case.

108 100 WORKING PAPER Net o beneits: The rates used in making the calculations or this case are shown in Table C.7. A value o 0 percent was used or OASDI, health insurance and ederal UI tax rates, on the assumption that directly related beneits are approximately equal to contributions. 3 Eective state unemployment insurance tax rates net o beneits were calculated as shown in Table C.8. As with state UI employer contribution rates discussed above, in the absence o more comprehensive and current data, rough estimates were developed based on estimates o UI beneits relative to employer contribution by industry in Anderson and Meyer (1993). These were combined with more current data on wages and employment by industry to obtain the rough estimates o eective state UI contribution rates net o beneits as shown in Table C.8. Estimated total eective payroll tax rates net o beneits by industry or the United States, together with eective tax rates net o beneits or the major individual payroll taxes, are shown in Table C.9. 3 While we lumped all U.S. ederal social insurance payroll taxes together and assumed ully osetting beneits (directly related to contributions), arguably, it would have been more comparable with the approach ollowed in calculating the Canadian net-o-beneit payroll tax rates to have separated out the U.S. ederal health insurance component and treated it as having no directly associated osetting beneit. This component unds the U.S. medicare programs, where beneit eligibility, and the expected value o beneits at the individual employee, employer or industry levels, have no direct relation to the level o contributions. I the health insurance component had been viewed as having no directly associated osetting beneit, the overall estimated U.S. payroll tax rates net o beneit would have been approximately 1.5 percentage points higher or all industries.

109 The Calculation o Marginal Eective Tax Rates 101 TABLE C.1 U.S. Average Annual Hours Worked by Industry, 1996 Average Annual Hours Worked Forestry n/a Mining Oil and Gas Food Beverages Tobacco Rubber Plastic Leather Textile Clothing n/a Wood Furniture Paper Print and Publishing Primary Metal Metal Fabrication Machinery Transportation Equipment Electrical Mineral n/a Petroleum n/a Chemical Miscellaneous Manuacturing Construction Transportation Storage n/a Communications Electrical Power, Gas and Water Wholesale Trade Retail Trade Services to Business Management Government, Personal and Misc. Services n/a Note: Data on average annual hours worked are rom National Employment, Hours, and Earnings, Bureau o Labor Statistics, 1995.

110 102 WORKING PAPER TABLE C.2 U.S. Payroll Tax Rates, 1996 Rate (%) Wage Base Ceiling in U.S. $ Federal OASDI ,400 HI UIC ,000 Eective State UI Tax Rates (a) (%) States Forestry 0.95 Mining 0.68 Oil and Gas 0.68 Manuacturing 0.97 Construction 0.96 Transportation and Storage 0.77 Communications 0.77 Public Utilities 0.77 Wholesale Trade 0.75 Retail Trade 1.05 Other Services 0.78 Note: Federal rates and wage base ceiling are rom 1997 Social Security Beneits (a) Authors calculations (see Table C.5 and text). TABLE C.3 Distribution o U.S. Manuacturing Subsectors, 1995 (percent) Food 9.39 Beverages 1.09 Tobacco Products 0.26 Rubber 3.05 Plastics 3.05 Leather 0.66 Textile 4.16 Clothing 0.00 Wood 4.77 Furniture and Fixtures 3.18 Paper and Allied Products 4.32 Printing and Publishing 9.63 Primary Metal 4.43 Metal Fabricating 8.98 Machinery Transportation Equipment Electrical Products Non-metallic Products 0.00 Petroleum and Coal 0.00 Chemical and Chemical Products 6.46 Miscellaneous Manuacturing 2.43 All Manuacturing Industries Notes: A weight o 0 can imply that there are no observations. Data on the number o employees used to calculate this distribution are rom 116th Edition Statistical Abstract o the United States 1996, The National Data Book, Table 654.

111 The Calculation o Marginal Eective Tax Rates 103 TABLE C.4 Industrial Distribution Among States, 1995 FOR MIN OG CON MAN TS COM PU WT RT OS (percent) Caliornia New York Texas Illinois Florida Pennsylvania Ohio New Jersey Michigan Total Notes: FOR = Forestry, MIN = Mining, OG = Oil and Gas, MAN = Manuacturing, CON = Construction, TS = Transportation and Storage, COM = Communications, PU = Public Utilities, WT = Wholesale Trade, RT = Retail Trade, OS = Other Services. State shares by industry are based on data or annual average employment rom United States Department o Labour (1996).

112 104 WORKING PAPER TABLE C.5 Eective State UI Employer Tax Rates by Industry Relative Tax Rate (t i / t) Based on Anderson and Meyer (1993) (a) Relative Taxable Wages Relative Total UI Taxes Paid (w i / w) (t i / t) (w i / w) (1) (2) (3) Agriculture Construction FIRE Manuacturing Mining Retail Trade Services Transportation and Communications Wholesale Trade Total Employer Contributions to State UI, Excluding Railroad and Federal Employees (U.S. $) (4) 1994 Data rom the Survey o Current Business Full-time Equivalent Employees in Private Industries (5) Average Employer Contributions by Employee (U.S. $) (4)/(5) All United States 23,300,000,000 90,441, (6) Employer Contribution per Employee (3) (6) (7) Wages and Salaries (U.S.$ millions) (8) Number o Full-time Employees (9) Average Wage per Employee (8)/(9) (10) Eective UI Tax Rates or Employers (7)/(10) (11) (%) Agriculture ,819 1,631,000 18, Construction ,483 4,988,000 29, FIRE 272 n/a n/a n/a n/a Manuacturing ,219 18,014,000 34, Mining , ,000 44, Retail Trade ,334 17,307,000 18, Services ,838 29,520,000 27, Transportation and Communications ,291 5,782,000 36, Wholesale Trade ,985 5,972,000 36, Notes: t i is the tax rate o industry i, and t is the average tax rate or all industries. w i is total taxable wages in industry i, and w is the average total taxable wages or all industries. (a) Anderson and Meyer (1993). In their inal data set, the years are available or Georgia, or Missouri, or Washington, or Idaho, and or Louisiana, New Mexico, Pennsylvania, and South Carolina.

113 The Calculation o Marginal Eective Tax Rates 105 TABLE C.6 Estimated U.S. Eective Payroll Tax Rates by Industry FOR MIN OG CON MAN TS COM PU WT RT OS ALL (percent) Eective OASDI Rate Eective Health Insurance Rate Eective Federal UI Rate Eective Federal Payroll Tax Rate Eective State UI Rate Combined Eective Federal/State Payroll Tax Rate Notes: FOR = Forestry, MIN = Mining, OG = Oil and Gas, MAN = Manuacturing, CON = Construction, TS = Transportation and Storage, COM = Communications, PU = Public Utilities, WT = Wholesale Trade, RT = Retail Trade, OS = Other Services, ALL = All Industries. For orestry, we generated eective OASDI, HI and ederal UI tax rates using an index comparing this industry with mining. We also used the same eective adjusted UI tax rate calculated or agriculture. TABLE C.7 U.S. Payroll Tax Rates Net o UI Beneits, by Industry Rate (%) Wage Base in U.S. $ Federal OASDI ,400 HI UIC ,000 Eective State UI Tax Rates (a) (%) Forestry 0.12 Mining Oil and Gas Manuacturing Construction Transportation and Storage 0.39 Communications 0.39 Public Utilities 0.39 Wholesale Trade 0.28 Retail Trade 0.54 Other Services 0.39 (a) Authors calculations (see Table C.8 and text).

114 106 WORKING PAPER TABLE C.8 State Eective UI Tax Rates Net o Beneits, by Industry Data rom Anderson and Meyer (a) Total Relative UI Beneit / Tax Taxes Paid Ratio (t i / t) (w i / w) 1994 Data rom Survey o Current Business (b) Number o FT Employees Wages and Salaries (millions o U.S. $) Average Employer s Contribution per Employee (All Industries) (1) (2) (3) (4) (5) Agriculture ,819 1,631, Construction ,483 4,988, FIRE n/a n/a Manuacturing ,219 18,014, Mining , , Retail Trade ,334 17,307, Services ,838 29,520, Transportation and ,291 5,782, Communications Wholesale Trade ,985 5,972, Average Wage per Employee Employer s Contribution per Employee Calculation Results (c) Beneits per Employee State UI Eective Premium Rates State UI Eective Beneit Rates Eective State UI Tax Rates Net o Beneits (3)/(4) (1) (5) (2) (7) (7)/(6) (8)/(6) (9)-(10) (6) (7) (8) (9) (10) (11) (%) (%) (%) Agriculture 18, Construction 29, FIRE n/a n/a n/a n/a Manuacturing 34, Mining 44, Retail Trade 18, Services 27, Transportation and 36, Communications Wholesale Trade 36, Note: Average Employer s Contribution per Employee are rom Table C.5. Sources: (a) Anderson and Meyer (1993). (b) United States Department o Commerce (1996). (c) Authors calculations.

115 The Calculation o Marginal Eective Tax Rates 107 TABLE C.9 Estimated U.S. Eective Payroll Tax Rates Net o UI Beneits, by Industry FOR MIN OG CON MAN TS COM PU WT RT OS ALL (percent) Eective OASDI Rate Eective Health Insurance Rate Eective Federal UI Rate Eective Federal Payroll Tax Rates Eective State UI Tax Rate, Net o Beneits Combined Eective Federal/State Payroll Tax Rate Notes: FOR = Forestry, MIN = Mining, OG = Oil and Gas, MAN = Manuacturing, CON = Construction, TS = Transportation and Storage, COM = Communications, PU = Public Utilities, WT = Wholesale Trade, RT = Retail Trade, OS = Other Services, ALL = All Industries. For orestry, we used the eective adjusted UI tax rate estimated or agriculture.

116

117 108 WORKING PAPER Reerences Anderson, Patricia and Bruce D. Meyer The Unemployment Insurance Payroll Tax and Inter-industry and Inter-irm Subsidies. In Tax Policy and the Economy. Edited by James Poterba. Vol. 7, pp Association o Workers Compensation Boards o Canada Workers Compensation Industry Classiications, Assessment Rates, and Experience Rating Programs in Canada pages. Auerbach, A. and K. Hassett Tax Policy and Business Fixed Investment in the United States. Journal o Public Economics, 47, Bird, R Why Tax Corporations? Working Paper 96-2, Technical Committee on Business Taxation. Ottawa: Department o Finance. Boadway, R., N. Bruce and J. Mintz Corporate Taxation and the Cost o Holding Inventories. Canadian Journal o Economics, 15, Boadway, R., N. Bruce and J. Mintz Taxation, Inlation and the Eective Marginal Tax Rate on Capital in Canada. Canadian Journal o Economics, 17, Boadway, R.W., N. Bruce, K.J. McKenzie and J. Mintz Marginal Eective Tax Rates or Capital in the Canadian Mining Industry. Canadian Journal o Economics, 20(1), Boadway, R.W. and K.J. McKenzie The Treatment o Resource Industries in the 1987 Federal Tax Reorm. In The Economic Impacts o Tax Reorm. Edited by J. Mintz and J. Whalley. Canadian Tax Paper No. 84. Toronto, Ontario: Canadian Tax Foundation, Boadway, R.W., K.J. McKenzie and J.M. Mintz Federal and Provincial Taxation o the Canadian Mining Industry: Impact and Implications or Reorm. Kingston, Ontario: Centre or Resource Studies, Queen's University. Canada. Department o Finance The White Paper on Tax Reorm. Ottawa. Canada. Human Resources Development Chie Actuary s Report on Employment Insurance, Premium Rates in Ottawa. Canada. Oice o the Superintendent o Financial Institutions Canada Pension Plan Sixteenth Actuarial Report, September Ottawa. CCH Tax Law Editors U.S. Master Tax Guide, 79th Edition. Standard Federal Tax Reports, Chicago. Chen, D. and K.J. McKenzie The Impact o Taxation on Capital Markets: An International Comparison o Eective Tax Rates on Capital. In Financing Growth in Canada. Edited by P. Halpern. University o Calgary Press.

118 The Calculation o Marginal Eective Tax Rates 109 Chirinko, R., S. Fazzari and A. Meyer What Do Micro Data Reveal About the User Cost Elasticity? New Evidence on the Responsiveness o Business Capital Formation. Emory University Working Paper. Cook, T. and K. Tre Finances o the Nation Canadian Tax Foundation, 4:1-13. Corak, M. and W. Pyper Worker s, Firms and Unemployment Insurance. Statistics Canada, Catalogue No Cummins, J.G., K.A. Hassett Reconsideration o Investment Behaviour Using Tax Reorms as Natural Experiments. Brookings Papers on Economic Activity, Cummins, J.G. and K.A. Hassett The Eects o Taxation on Investment: New Evidence rom Firm Level Panel Data. National Tax Journal, 45, Cummins, J.G., K.A. Hassett and G.R. Hubbard Tax Reorms and Investment: A Cross-Country Comparison. Journal o Public Economics, 62, 1-2: Dahlby, B Taxation and Social Insurance. In Taxation to 2000 and Beyond. Edited by R. Bird and J.M. Mintz. Canadian Tax Paper No. 93. Toronto, Ontario: Canadian Tax Foundation. De Long, J. and L. Summers Equipment Investment and Economic Growth. Quarterly Journal o Economics, Di Matteo, L. and M. Shannon Payroll Taxation in Canada: An Overview. Canadian Business Economics, Summer, Jog, Vijay M Investing in Canada: Estimation o the Sectoral Cost o Capital in Canada and Case Studies or International Comparisons. In Financing Growth in Canada. Edited by P. Halpern. University o Calgary Press, Jog, V. and J. Mintz Corporate Tax Reorm and Its Impact: An Evaluation o The Phase 1 Proposal. In The Economic Impacts o Tax Reorm. Edited by J. Mintz and J. Whalley. Canadian Tax Paper No. 84. Toronto, Ontario: Canadian Tax Foundation, Jorgenson, D. and R. Landau Tax Reorm and the Cost o Capital: An International Comparison. Washington, D.C: Brookings Institution. Jung, J The Calculation o Marginal Eective Corporate Tax Rates in The 1987 White Paper on Tax Reorm. Working Paper No. 89-6, Department o Finance. Ottawa. King, M. and D. Fullerton The Taxation o Income rom Capital: A Comparative Study o the United States, United Kingdom, Sweden and West Germany. University o Chicago Press. Levine, R. and D. Renelt A Sensitivity Analysis o Cross-Country Growth Regression. American Economic Review, 82(4),

119 110 WORKING PAPER McKenzie, K.J The Implication o Risk and Irreversibility or the Measurement o Marginal Eective Tax Rates. Canadian Journal o Economics, August. McKenzie, K.J. and J.M. Mintz Tax Eects on the Cost o Capital: A Canada- United States Comparison. In Canada-U.S. Tax Comparisons. Edited by J. Whalley and J. Shoven. NBER Research Volume. University o Chicago Press, McKenzie, K.J., J.M. Mintz and K.A. Schar Measuring Eective Tax Rates in the Presence o Multiple Inputs: A production based approach. International Tax and Public Finance, 4, McKenzie, K.J. and A.J. Thompson The Cost o Capital in Canada and the U.S. Working Paper No. 97-1, Technical Committee on Business Taxation. Ottawa: Department o Finance. Mintz, J The Corporation Tax: A Survey. Fiscal Studies, 16(U), Mintz, J.M An Empirical Estimate o Corporate Tax Reundability and Eective Tax Rates. Quarterly Journal o Economics, 412, Porter, M Changing Patterns o International Competition. In Readings in International Business: A Decision Approach. Edited by R. Aliberand and R. Click. Cambridge and London: MIT Press, Poterba, J. and J. Rotemberg Environmental Taxes on Intermediate and Final Goods When Both Can Be Imported. International Tax and Public Finance, 2(2), Statistics Canada. 1996a. Employment, Earnings and Hours, Catalogue No , January to December Statistics Canada. 1996b. Background Data on Employment, Special data compilation prepared or the Technical Committee on Business Taxation. Ottawa. United States Bureau o the Census Statistical Abstract o the United States: 1996, 116th Edition. Washington, DC. United States Department o Commerce Survey o Current Business, January/February Vol. 76, No. 1/2. United States Department o Labor Employment and Wages Annual Averages, Bulletin 2483, Washington, DC.

120 The Calculation o Marginal Eective Tax Rates 111 Whalley, J The Incidence o the Corporate Tax Revisited. Working Paper 97-7, Technical Committee on Business Taxation. Ottawa: Department o Finance. Wilton, D. and D. Prescott The Eects o Tax Increases on Wage and Labour Costs. Discussion Paper 93-29, Government and Competitiveness Series, School o Policy Studies, Queen's University. Kingston, Ontario.

121 112 WORKING PAPER Technical Committee on Business Taxation The Technical Committee was established by the Minister o Finance, at the time o the March 1996 ederal budget, to consider ways o: improving the business tax system to promote job creation and economic growth, simpliying the taxation o businesses to acilitate compliance and administration, and enhancing airness to ensure that all businesses share the cost o providing government services. The report o the Technical Committee was released in April 1998, with public consultations to ollow the release o the report. The Technical Committee was composed o a panel with legal, accounting and economic expertise in the tax ield. The members are: Mr. Robert Brown Price Waterhouse Toronto, Ontario Mr. James Cowan Stewart McKelvey Stirling Scales Haliax, Nova Scotia Mr. Wilrid Leebvre Ogilvy Renault Montreal, Quebec Proessor Nancy Olewiler Department o Economics Simon Fraser University Burnaby, British Columbia Mr. Stephen Richardson Tory Tory Deslauriers & Binnington Toronto, Ontario Proessor Bev Dahlby Department o Economics University o Alberta Edmonton, Alberta Mr. Allan Lanthier Ernst & Young Montreal, Quebec Proessor Jack Mintz, Chair Joseph L. Rotman School o Management University o Toronto Cliord Clark Visiting Economist ( ) Department o Finance Ottawa, Ontario Mr. Norm Promislow Buchwald Asper Gallagher Hentele Winnipeg, Manitoba The Technical Committee commissioned a number o studies rom outside experts to provide analysis o many o the issues being considered as part o its mandate. These studies were released as working papers to make the analysis available or inormation and comment. The papers received only limited evaluation; views expressed are those o the authors and do not necessarily relect the views o the Technical Committee. A list o research studies ollows. They may be requested rom: Distribution Centre Department o Finance 300 Laurier Avenue West Ottawa, Ontario K1A 0G5 Telephone: (613) Facsimile: (613) They are also available on the Internet at

122 The Calculation o Marginal Eective Tax Rates 113 Technical Committee on Business Taxation Research Studies WORKING PAPER 96-1 Comparison and Assessment o the Tax Treatment o Foreign-Source Income in Canada, Australia, France, Germany and the United States Brian Arnold (Goodman Phillips & Vineberg) Jinyan Li and Daniel Sandler (University o Western Ontario) WORKING PAPER 96-2 Why Tax Corporations? Richard M. Bird (University o Toronto) WORKING PAPER 96-3 Tax Policy and Job Creation: Speciic Employment Incentive Programs Ben Cherniavsky (Technical Committee Research Analyst) WORKING PAPER 96-4 The Eects o Taxation on U.S. Multinationals and Their Canadian Ailiates Jason G. Cummins (New York University) WORKING PAPER 96-5 The Integration o Corporate and Personal Taxes in Europe: The Role o Minimum Taxes on Dividend Payments Michael P. Devereux (Keele University) WORKING PAPER 96-6 International Implications o U.S. Business Tax Reorm Andrew B. Lyon (University o Maryland) WORKING PAPER 96-7 The Economic Eects o Dividend Taxation Ken J. McKenzie (University o Calgary) Aileen J. Thompson (Carleton University) WORKING PAPER 96-8 Capital Tax Issues Peter E. McQuillan and E. Cal Cochrane (KPMG, Toronto) WORKING PAPER 96-9 Compliance Issues: Small Business and the Corporate Income Tax System Plamondon and Associates Inc. (Ottawa) WORKING PAPER Study on Transer Pricing Robert Turner, C.A. (Ernst & Young, Toronto) WORKING PAPER The Interaction o Federal and Provincial Taxes on Businesses Marianne Vigneault (Bishop s University) Robin Boadway (Queen s University) WORKING PAPER Taxation o Inbound Investment W.G. Williamson and R.A. Garland (Arthur Andersen, Toronto)

123 114 WORKING PAPER Technical Committee on Business Taxation Research Studies (Cont d) WORKING PAPER 97-1 The Sensitivity o the Corporate Income Tax to the Statutory Rate Peter Dungan, Steve Murphy, Thomas A. Wilson (University o Toronto) WORKING PAPER 97-2 The Income Tax Compliance Burden in Canadian Big Business Brian Erard (Carleton University) WORKING PAPER 97-3 Taxes, the Cost o Capital, and Investment: A Comparison o Canada and the United States Kenneth J. McKenzie (University o Calgary) Aileen J. Thompson (Carleton University) WORKING PAPER 97-4 Tax Policy and the Dynamic Demand or Domestic and Foreign Capital by Multinational Corporations Rosanne Altshuler (Rutgers University) Jason G. Cummins (New York University) WORKING PAPER 97-5 Tax-exempts and Corporate Capital Structure Thomas A. Wilson and Steve Murphy (University o Toronto) WORKING PAPER 97-6 A Critical Review o the Empirical Research on Canadian Tax Compliance Brian Erard (Carleton University) WORKING PAPER 97-7 The Incidence o the Corporate Tax Revisited John Whalley (Universities o Western Ontario and Warwick, and NBER) WORKING PAPER 97-8 Eiciency Considerations in Business Tax Reorm John Whalley (Universities o Western Ontario and Warwick, and NBER) WORKING PAPER 97-9 Tax-exempt Organizations and the Financing o Taxable Businesses Thomas E. McDonnell (The McDonnell Consulting Corporation, Toronto) WORKING PAPER Tax-exempts and Corporate Capital Structure: An Analysis o Eiciency and Revenue Implications James Pesando, Michael Smart and Thomas A. Wilson (University o Toronto)

124 The Calculation o Marginal Eective Tax Rates 115 Technical Committee on Business Taxation Research Studies (Cont d) WORKING PAPER Business Taxation o SMEs in Canada Kenneth Hendricks, Raphael Amit, and Diana Whistler (University o British Columbia) WORKING PAPER The Income Tax Compliance Burden on Small and Medium-sized Canadian Businesses Brian Erard (Carleton University) WORKING PAPER Eects o the Treatment o Tax Losses on the Eiciency o Markets and the Incidence o Mergers Michel Poitevin (Université de Montréal) WORKING PAPER Tax Reorms, Debt Shiting and Tax Revenues: Multinational Corporations in Canada Vijay Jog (Carleton University) and Jianmin Tang (Technical Committee Secretariat) WORKING PAPER The Calculation o Marginal Eective Tax Rates Kenneth J. McKenzie (University o Calgary), Mario Mansour (Department o Finance) and Ariane Brûlé (Technical Committee Secretariat) WORKING PAPER Analysis o National Pollutant Release Inventory Data on Toxic Emissions by Industry Nancy Olewiler and Kelli Dawson (Simon Fraser University) WORKING PAPER The Evolution o Business Taxes in Canada: Data and Estimates John H. Sargent, Claude Bilodeau, Jeanine Hage and Mindy Sichel (Technical Committee Secretariat)