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.
Postal Address
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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
BAK Taxation Index: The methods applied
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.
BAK Taxation Index: The methods applied
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
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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
BAK Taxation Index: The methods applied
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
BAK Taxation Index: The methods applied
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.
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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).
BAK Taxation Index: The methods applied
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.
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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."
BAK Taxation Index: The methods applied
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.