BAK TAXATION INDEX: THE METHODS APPLIED · BAK Taxation Index: The methods applied BAKBASEL 5 2 Corporate Taxation Structure of the Devereux and Griffith model The measurement of

BAK TAXATION INDEX: THE METHODS APPLIED

Effective Tax Burden on Companies

and on Highly Qualified Manpower

Editor

BAKBASEL

Authors

Prof. Dr. Christina Elschner, Europa-Universität Viadrina, Frankfurt (Oder), and ZEW

Dr. Jost Heckemeyer, Universität Mannheim and ZEW

Katharina Richter, ZEW

Uwe Scheuering, ZEW

Beatrice Wichmann, Europa-Universität Viadrina, Frankfurt (Oder)

Sponsors of the research project

Swiss Federal Tax Administration, Bern

Tax, Finance and Economics Departments of Appenzell Ausserrhoden, Basel-Stadt, Bern, Glarus, Graubünden,

Luzern, Nidwalden, Obwalden, Schaffhausen, Schwyz, St. Gallen, Thurgau, Uri, Zug and Zürich.

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© 2014 by BAK Basel Economics AG

All rights reserved, including the right in any form of reproduction in whole or in part.

BAK Taxation Index: The methods applied

BAKBASEL 3

Contents

1 Introduction ............................................................................................................................................... 4

2 Corporate Taxation .................................................................................................................................... 5

3 Taxation of Highly Qualified Manpower ...................................................................................................... 9

4 References .............................................................................................................................................. 12

List of Tables

Table 2-1: Important model assumptions .................................................................................................................... 6

Table 3-1: Alternative definitions of highly qualified labour force ........................................................................... 10

Table 3-2: Exchange rates for the calculation of taxes and contribution burdens on the use of highly skilled

workers in the years 2003-2013 ............................................................................................................ 11

List of Figures

Figure 2-1: Structure of a hypothetical investment ............................................................................................... 5


4 BAKBASEL

1 Introduction

The BAK Taxation Index presents indicators for the effective tax burden on companies and on the assignment of highly

skilled manpower. This document describes the methods that are applied for the calculation of the BAK Taxation Index,

and serves as a complement to the main report that presents the current results.

This document is structured as follows.

Section 2 explains the approach used to calculate the effective tax burden on companies. After an introduction into the

fundamental structure of the model underlying the calculations, the important indicators of the effective taxation of

companies are explained one by one. These are the effective average tax rate (EATR), the effective marginal tax rate

(EMTR), and the costs of capital. The EATR represents the headline indicator of the BAK Taxation Index and is most

relevant for the ranking of regions.

Section 3 describes the approach used to calculate the effective tax burden on the employment of highly qualified

manpower. The method and its headline indicator, the effective tax rate on highly skilled manpower, are introduced.

Furthermore, the specific scenarios underlying the calculations as well as the treatment of changing exchange and

inflation rates are explained in detail.


BAKBASEL 5

2 Corporate Taxation

Structure of the Devereux and Griffith model

The measurement of the effective tax burden on companies is based on an approach introduced by Devereux and

Griffith.1 This approach is a so-called forward-looking approach, which calculates the tax burden on a hypothetical

investment project of a company considering the actual tax provisions. It provides a possibility of modelling the most

relevant provisions of tax regimes in a systematic way. Using this approach, cost of capital, an effective marginal tax

rate (EMTR) and also an effective average tax rate (EATR) can be computed.2 The cost of capital and the EMTR are

measures for the effective tax burden attributable to marginal investments whereas the EATR indicates the effective tax

burden on profitable investments. The BAK Taxation Index for company taxation is composed as an EATR at the

corporate level. Figure 2-1 shows the structure of the supposed investment along with its financing.

Figure 2-1: Structure of a hypothetical investment

Source: ZEW

The model assumes a corporation in the manufacturing sector, which invests in five different assets and uses a

particular combination of sources of finance. The types of investment assets considered are industrial buildings,

intangibles (patents) bought from third parties, machinery, financial assets and inventories. The assets are weighted

equally in the calculations, i.e. each type of asset is assigned a weight of 20%. The financing policies of the corporation

take into account three different sources of finance: new equity capital, retained earnings and debt from external

lenders. The sources of finance are weighted according to empirical data already applied by earlier studies (see

European Commission (2002) or the former studies prepared for the International Benchmarking Programme IBP

issued by BAKBASEL). The BAK Taxation Index is calculated assuming a pre-tax real rate of return of 20%. Table 2-1

summarizes the most important model assumptions.

1 See Devereux and Griffith (1999, 2003). The Devereux/Griffith approach is based on the commonly accepted framework developed

by King and Fullerton (1984). For more detailed explanations we refer the interested reader to these papers.

2 See Devereux and Griffith (1999, 2003) and Schreiber, Spengel and Lammersen (2002) for a more detailed explanation of the tax

measures.

Industrial

Buildings Intangibles Machinery Financial

Assets Inventories

Corporation

Shareholder

5 Types of Assets

3 Sources of Finance

Dividend

External

Lender

Interest

Additional

Dividend

Debt Equity

Retained

Earnings

Dividends

in Future

Periods

Qualified

Share Non-Qualified

Share Zero-Rate

Share


6 BAKBASEL

Table 2-1: Important model assumptions

Assumption on … Value

Legal Form Corporation

Industry Manufacturing sector

Assets (weight) Industrial buildings (20%), intangibles (20%), machinery (20%), financial assets

(20%), inventories (20%)

Sources of finance (weight) Retained earnings (55%), new equity (10%), debt (35%)

True economic depreciation Declining balance method

Industrial buildings 3.1%

Intangibles 15.35%

Machinery 17.5%

Real interest rate 5%

Pre-tax real rate of return

(for calculation of EATR) 20%

Inflation rate 2%

Source: ZEW

The model covers the most relevant tax provisions of the national tax systems. The study mainly focuses on the

effective tax burden on the corporate level. With respect to the taxation of corporate profits, the model considers

statutory corporate profit tax rates as well as surcharges and some other special rates for particular types of income

and expenditures. It takes into account the most important features of taxes on capital, especially real estate taxes.

Regarding the definition of the taxable base, the relevant rules concerning depreciation and amortization allowances,

valuation of inventories and interest deductibility in case of debt financing are considered. Additionally, the model

includes some important generally available investment incentives.

Cost of Capital

The cost of capital is a measure for the effective tax burden attributable to marginal investments. Marginal investments

are incremental corporate investments which display a net present value of zero, i.e. they yield a rate of return on the

initially invested capital that is just sufficient in order to compete with an alternative investment. This minimum rate of

return before taxes required by a shareholder is called cost of capital. The alternative investment considered is a

financial asset that yields the market interest rate. Thus, in the absence of taxes, cost of capital equals the real market

interest rate. In the calculations of the BAK Taxation Index, a real market interest rate of 5% is assumed. If taxation

causes the cost of capital to fall below the real market interest rate, it actually favors corporate investment over the

financial investment. Otherwise, if taxation raises the cost of capital above the real market rate, taxation exerts a

negative influence on the optimal level of investment activity. Furthermore, the cost of capital is an indicator for the

competitiveness of a company since it determines the long-term lower limit of potential prices at which the company

can offer its products.

At the company level, profit and capital taxes increase the cost of capital. Only in the case of debt financing the return

on investment is shielded from profit taxation as interest payments are deductible, i.e. they lower the profit tax base.

Favorable depreciation allowances have a decreasing effect on the cost of capital.

At the shareholder level, dividend taxation generally has a low impact on the cost of capital. It has no influence in the

case of the marginal investment being financed by retained earnings because the tax savings due to the non-

distribution of earnings in the period of investment exactly equal the taxes due on future dividends. It has no influence

in the case of a debt financed marginal investment either because the respective return is fully absorbed by debt

servicing. Consequently, dividend taxation only exerts influence on the cost of capital if the marginal source of funds is

new equity. In contrast, the income taxation of interest payments has a much more important impact on the cost of

capital. In case of an equity-financed investment, the cost of capital falls if interest taxation rises. This is due to the

decline of the post-tax rate of return on a financial investment, which represents the shareholder’s alternative to an

investment in the corporation. Nevertheless, in the case of debt financing, the cost of capital remains unaffected. The

personal income tax on capital gains is of particular relevance if retained earnings are used as marginal source of

funds. As long as earnings are retained, they add to the value of the shares. Only when returns are eventually


BAKBASEL 7

distributed, will there be some relief from capital gains taxation. Capital gains taxation thus considerably raises the cost

of capital for an investment financed by retained earnings. Personal non-income taxes, usually designed as net wealth

taxes, only affect the cost of capital if they differ between funds invested as equity and funds lent. If funds invested in

equity were exempt as opposed to lending, the cost of capital of equity financed investments would decrease.

The EMTR

Beside the cost of capital, the EMTR is another measure of the effective tax burden on marginal investments. The

EMTR is defined as the difference in per cent between the cost of capital, denoted by ,p and the post-tax real rate of

return, denoted by :s

The EMTR determines the share of the return on a marginal investment which is cut by taxation. If we focus only on

taxation at the corporate level, the real post-tax rate of return s is equal to the real market interest rate r . In this

case, the EMTR is a strictly monotonously increasing transformation of the cost of capital and contains the same

information. Expressing effective tax burdens on marginal investments in terms of EMTR facilitates the comparison with

other concepts of tax rates like EATR or the statutory profit tax rate. In case of personal taxes, s depends on the tax

position of the shareholder. Because the assumed marginal use of funds of the shareholder is lending, the personal

income taxes on interest influence s . The EMTR is not a monotonously increasing transformation of the cost of capital

due to this additional personal tax wedge. A low EMTR might come along with high cost of capital if interest is taxed

lightly, and vice versa. Therefore, results calculated at the corporate level are presented only in terms of the EMTR in

this report; whereas results considering personal taxation are presented in both terms, cost of capital and EMTR. Annex

The EATR

The EATR reflects the percentage reduction of the net present value of a profitable investment, i.e. an investment that

earns a net present value of more than zero. In other words, the profitable investment generates more than the

minimum required pre-tax rate of return on investment which is necessary to attain the after-tax return claimed by the

investor. To be precise, in this report for the calculation of the EATR a profitable investment with a pre-tax real rate of

return of 20% is assumed. When choosing between two or more mutually exclusive profitable investments, an investor

will favor the alternative with the highest post-tax net present value. Location decisions for subsidiaries of international

corporations are the most relevant examples of this kind of decision. In this case, the EATR is an important indicator for

the attractiveness of a location. Therefore, the BAK Taxation Index, which ranks company taxation internationally, is

composed by the EATR.

The following equation describes a particular relationship between the cost of capital, the EMTR and the EATR:

This relationship illustrates the properties of the EATR and helps to identify the impact of the different tax drivers on the

effective tax burden. The EATR equals the weighted average of the EMTR and the combined statutory corporate income

tax rate, denoted by . The weights are determined by the share of the pre-tax return p that is covered by the cost of

capital p (for the EMTR) and the part above the cost of capital. Consequently, the EATR equals the EMTR if the

assumed rate of return of an additional investment equals the cost of capital. In this case, we consider a marginal

investment. Moreover, the tax burden does not only depend on statutory corporate income tax rate. It is rather

profoundly affected by the definition of the tax base – especially by tax depreciation allowances – and by non-income

taxes. The more the rate of return exceeds the cost of capital, the more the EATR converges against the combined

statutory corporate income tax rate .

As concerns the main drivers of EMTR and EATR, tax rules determining the taxable base have a greater influence on the

EMTR than on the EATR results. This becomes intuitively clear if one keeps in mind that a marginal investment only

earns its cost of capital, i.e. the lowest sufficient rate of return to be worthwhile for the investor. The receipts only

exceed the expenses by little. Thus, the treatment of these expenses for the purpose of taxation – particularly the path

of tax depreciation allowances – is relatively important. The more advantageous, i.e. the faster tax depreciation is as

compared to true economic depreciation, the higher is the present value of future tax savings from depreciation and


8 BAKBASEL

the lower is the EMTR. Moreover, property and capital taxes take up a comparatively large fraction of the return and

thus have a significant influence on the EMTR. In contrast, as the EATR supposes a rather profitable investment, the

weight of depreciation allowances and non-profit taxes is relatively low as opposed to the much increased importance

of profit taxes. We can explain this intuitively: if we consider a profitable investment with the same level of expenses as

a marginal investment, but now accompanied by a higher level of income, the additional income is regularly taxed at

the statutory tax rate without triggering additional allowances. Thus, the treatment of the expenses for tax purposes

becomes less relevant for the determination of the effective tax burden if the level of profitability increases. Since

marginal and profitable investments display the same initial cost but different levels of return, non-income taxes take

away a smaller share of the return of a more profitable investment and also become less relevant. In summary, the

statutory income tax rate becomes the dominant factor in determining the effective tax burden of a highly profitable

investment.


BAKBASEL 9

3 Taxation of Highly Qualified Manpower

Simulation Model

The BAK Taxation Index on highly skilled manpower is measured by means of a simulation model, the ZEW HR Tax

Analyser.3 The model determines how much an employer has to pay to guarantee a fixed disposable income after taxes

and charges for the highly skilled employee. The background of this measurement is that especially highly skilled

employees become more and more mobile. Thus, when they chose their location of work-place, they take into account

where an employee receives the highest income after taxes. The model determines the tax burden on a highly skilled

employee for a given disposable income after taxes. In order to achieve this, a two-step calculation procedure is

performed. At first, the model conducts the tax assessment of a typical qualified employee’s income before taxes (the

employment costs). If the resulting income after taxes falls short of (exceeds) the required disposable income, the

model repeats the assessment for higher (lower) employment costs in a second step. It then iterates until the

employment costs necessary to obtain the predetermined disposable income are found. The effective average tax rate

is then equal to the difference between employment costs and disposable income (the tax wedge) divided by the

employment costs.

mployment costs isposable income

mployment costs

Considered Taxes and Fees

Taxes in this context are all income taxes including surcharges as well as state and municipality taxes, and payroll taxes

paid by the company. Social security contributions are part of the tax burden inasmuch as the employee does not earn

a specific individual benefit by paying them. According to the basic idea of competition, there is little risk of

unemployment for the kind of qualified employees considered in this study. Accordingly, we define contributions to

unemployment insurance and, with a similar reasoning, contributions to accident insurance, as taxes. In contrast, we

consider health insurance contributions not to be taxes since they are deemed to provide a genuine insurance.

Contributions to public pension schemes partly qualify as taxes as well. The first pillar of old-age insurance is usually

organized as a pay as you go system involving redistribution between generations and between high and low earning

workers. In as much as contribution payments do not result in actual fair pension entitlements, they constitute an

implicit tax rather than an insurance. In order to account for this fact, we recognize entitlements earned by the highly

qualified labor as income. The lower the rate of return on pension payments, the higher are the implicit taxes, because

the employer has to pay a correspondingly higher salary until the required total disposable income is achieved.

Definition of Workers, Salary Levels and Salary Composition

In this study, we distinguish between three kinds of compensation: (1) cash compensation, (2) contributions to old-age

provisions and (3) benefits in kind (in the form of a company car). These components are taxable in different periods.

Cash compensation and benefits in kind are taxable income in the year of payment. Contributions to old-age provisions

are either excluded from taxable income and, thus, pension benefits are subject to taxation, or contributions are paid

out of taxed income implying that pensions are non-taxable income during retirement. Our model explicitly deals with

the timing of tax and pension payments by using an inter-temporal approach.

We calculate the tax burden on highly qualified manpower for three income levels with different income packages (see

Table 3-1). The lowest disposable income with EUR 50,000 comprises 75% cash compensation and 25% old-age

provision. The middle and high disposable incomes of EUR 100,000 and EUR 200,000 respectively consist of 75%

cash compensation, 20% old-age provision and 5% benefits in kind. We measure the effective tax rates for a single

employee as well as for a married employee with a non-working spouse and two children. The case of a single employee

with EUR 100,000 disposable income represents the BAK Taxation Index.

3 For more information on the simulation model see Elschner and Schwager (2007).


10 BAKBASEL

Table 3-1: Alternative definitions of highly qualified labor force

Marital Status Size of the

disposable

income

thereof

Cash

compensation

Contributions

to old-age

provisions

Benefits in kind

(company car)

Single, without

children

EUR 50,000 75% 25% -

EUR 100,000 75% 20% 5%

EUR 200,000 75% 20% 5%

Married, two children

(age 6-12),

single-earner household

EUR 50,000 75% 25% -

EUR 100,000 75% 20% 5%

EUR 200,000 75% 20% 5%

Currency and Inflation

The BAK Taxation Index is intended to illustrate the fiscal attractiveness of a region. Over time, changes in the tax

burden of a region due to tax reforms should be recognized. This works in the BAK Taxation Index on companies

without problems, since only a typical, incremental investment is considered. In BAK Taxation Index on the highly skilled

labor force, specific wage sizes (see Table 3-1) have to be assumed, because of the progressive income tax rates and

income thresholds for social security.

In an international comparison, in which countries with different currencies are included, as well as in a comparison

over time, which implies that the development of prices plays a role, the measurement of the taxes and contributions

burdens on the highly skilled workers is particularly challenging. On the one hand, while converting the wage sizes (e.g.

EUR 100,000) into local currencies one has to take into account the over-time fluctuating exchange rates. On the other

hand, the wages themselves must be adjusted for inflation.

Table 3-2: Exchange rates for the calculation of taxes and contribution burdens on the use of highly skilled workers in the years 2003-

2013

Country Currency 2003 2005 2007 2009 2011 2013

based on the average exchange rates for the years

1999-2002 2001-04 2003-06 2005-08 2007-10 2009-12

China CNY 9.950 10.205 9.650 8.892

Czech

Republic

CZK 31.348 30.675 30.395 27.710 25.641 25.330

Denmark DKK 7.429 7.435 7.446 7.454 7.451 7.447

Hong Kong HKD 9.461 10.396 10.880 10.473

Hungary HUF 238.095 243.902 256.410 253.809 267.131 280.393

Norway NOK 7.299 8.230 8.104 8.076 8.205 7.998

Poland PLN 3.990 4.146 4.196 3.804 3.919 4.146

Singapore SGD 2.033 2.051 1.959 1.796

Slovak

Republic

SKK 43.860 38.911 39.370 EUR EUR EUR

Slovenia SIT 232.558 243.902 EUR EUR EUR EUR

Sweden SEK 9.099 8.977 9.200 9.351 9.723 9.468

Switzerland CHF 1.467 1.535 1.546 1.588 1.485 1.320

U.K. GBP 0.643 0.694 0.684 0.712 0.832 0.857

USA USD 1.020 1.308 1.215 1.335 1.400 1.345

Note: The exchange rate is given as 1 EUR = 9.950 CNY etc.

Source: OANDA and Eurostat.


BAKBASEL 11

Currency differences to the euro are accounted for with the help of the average exchange rates of the past four years,

in order to avoid major fluctuations. Exchange rates are adjusted every two years to the update of the international BAK

Taxation Index (see Table 3-2 for an overview).

Rising prices are taken into account since the update of 2013th indexation of disposable income. Thereby, the three

nominal income sizes (EUR 50,000, EUR 100,000, and EUR 200,000) are adjusted for inflation in the euro area. Due

to the two-year update of the international BAK Taxation Index, the inflation of two previous years is considered each

time. This amounted to 2.7% in 2011 compared to the 2.5% in 2012.

The effective taxes and contribution burdens on the use of highly skilled labor are in the update of 2013 calculated with

respect to the disposable income of EUR 210,535, EUR 105,268 and EUR 52,634. Accordingly, in the report it is

spoken of the disposable income according to "prices of the base year 2010."


12 BAKBASEL

4 References

Devereux. M.P. and R. Griffith (1999). The Taxation of Discrete Investment Choices. IFS Working Paper W98/16.

Revision 2.

Devereux. M.P. and R. Griffith (2003). Evaluating tax policy for location decisions. International Tax and Public

Finance. 10. 107-126.

Elschner. C. and R. Schwager (2007). A Simulation Method to Measure the Tax Burden on Highly Skilled Labour.

Finanzarchiv. 63. 563-582.

European Commission (2002). Company Taxation in the Internal Market, Commission Staff Working Paper COM

(2001) 582 final. Brussels.

King. M.A. and D. Fullerton (1984). The Taxation of Income from Capital. University of Chicago Press. Chicago.

Schreiber. U., C. Spengel, and L. Lammersen (2002). Measuring the Impact of Taxation on Investment and

Financing Decisions. Schmalenbachs Business Review 2000. 2-23.

Documents

BAK TAXATION INDEX: THE METHODS APPLIED · BAK Taxation Index: The methods applied BAKBASEL 5 2 Corporate Taxation Structure of the Devereux and Griffith model The measurement of