CBO’s Model for Estimating the Effect That Federal Taxes Have on Capital Income From New Investment: Working Paper 2022-01

By Paul Burnham and Dorian Carloni.

The Congressional Budget Office has developed a model to estimate the effect that federal taxes have on capital income from new investment; it uses that model to help estimate how changes in tax law would affect the economy. The model follows a well-established analytical framework that involves calculating the difference between the before-tax rate of return required to justify an investment and the after-tax rate of return demanded by savers (that is, individuals purchasing the equity and debt issued by businesses). The calculation of the before-tax rate of return is based on the Hall-Jorgensen formula for the user cost of capital and incorporates marginal tax rates on profits, deductions for interest and cost recovery, and investment tax credits. The formula for after-tax rates of return accounts for the taxation of interest, dividends, and capital gains at the individual level, as well as for the opportunity to shelter such income from taxation in retirement accounts. Calculations in the model are performed at a level of disaggregation that reflects differences in tax treatment among different industries, types of assets, legal forms of organization, and sources of financing. The disaggregated measures are weighted to more aggregated levels on the basis of asset values in such a way that the results reflect both the differences in tax treatment and differences in the distribution of assets among the various groups. An alternative approach to aggregation that isolates the differences in tax treatment is presented in an appendix.