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Features of the US tax system and law are employed to illustrate the complexities that arise in practical discussions of tax policy: the tax treatment is considered of income from assets held by households, non-corporate businesses and corporations under US tax law, and for assets held in each sector an appropriate cost of capital and rate of return is defined. The chapter begins with the household sector, where the taxation of income from capital takes its simplest form. The taxation of income from non-corporate business is then considered — this is treated as fully distributed to its owners (individual income tax). Next, an analysis is made of the taxation of corporate income, which requires the integration of provisions of individual and corporate income tax laws. The last two sections of the chapter discuss tax reform and alternative approaches.

A quantitative and detailed description is presented of the US tax system and law, which begins by providing estimates of the rates of capital income taxation at both corporate and individual levels for the period 1947–86; property tax rates are also presented for household, non-corporate and corporate sectors. It is noted that the adoption of these tax preferences in the USA dramatically altered the incentives to invest in different types of assets and radically changed the distribution of the tax burden. Provisions are then discussed for capital cost recovery, including capital consumption allowances and the investment tax credit; next, a description is given of features of the financial structure of corporate and non-corporate businesses and households that affect the taxation of income from capital. Finally, the impact is considered of the Tax Reform Act of 1986 on the US tax system, especially in relation to the tax (financial) structure for income from capital; alternative approaches are considered. The data presented can be used to implement either the traditional or the new view of the corporate cost of capital.

This introductory chapter shows how the concept of cost of capital arises in the management of capital as a factor of production. The concept is introduced of an effective tax rate within a highly simplified system for taxation of income from capital. A tax wedge is defined as the difference between the remuneration of capital before taxes, which corresponds to the marginal product of capital, and the compensation after taxes available to holders of financial claims on the firm. The effective tax rate is the ratio of this tax wedge to the marginal product. The chapter is organized as follows: it first outlines the contents of the following chapters, and then goes on to present simple economic analyses of cost of capital, capital as a factor of production, rates of return and capital income taxation.

Alternative policy provisions are compared for capital income taxation and the social rates of return in terms of marginal effective tax rates, since, by measuring these for different assets, it is possible to quantify the sources of distortions in decisions involving the allocation of capital among different uses. Marginal effective tax rates for the USA are presented for capital income over the period 1947–86 for corporate and non-corporate businesses, and households. Differences in the effective tax rates under the 1986 Tax Reform Act (and the pre-existing 1985 Tax Law) are then considered, looking again at the same three categories, and also giving data on social wedges (differences in social rates of return) between the short- and long-lived assets. The last section of the chapter looks at alternative approaches.

This final chapter provides an evaluation of the cost of capital approach to tax policy analysis. This approach has amply proved its usefulness as a guide to tax reform. While the US tax policy changes of the early 1980s introduced additional barriers to efficient allocation of capital, the Tax Reform Act of 1986 reduced these barriers substantially. Important discrepancies remain, however, between effective tax rates on income from household and business assets (both corporate and non-corporate). Further reduction in these discrepancies presents an important opportunity for increasing the efficiency of capital allocation.