Up or down? Capital income taxation in the United States and the United Kingdom

Empirical evidence suggests that the E¤ective Marginal Tax Rate (EMTR) on income from capital has increased considerably in both the United States and the United Kingdom over the period 1982-2005. This evidence contradicts the corporate tax literature which predicts that the EMTR should instead fall over time as a result of increasing international capital mobility and higher tax competition between governments. This paper argues that this inconsistency is entirely due to the fact that EMTRs on income from capital are currently computed from versions of the neoclassical investment model which do not take into account …nancial constraints on dividend policy faced by …rms investing in both the United States and the United Kingdom. The paper incorporates …nancial constraints on dividend policy into the analytical framework for the computation of the EMTR and employs the new model to re-calculate time series of the EMTRs in both countries. The new empirical results show that, in contrast to the existing evidence, the EMTR on investment …nanced by either retained earnings or new equity has indeed declined over time in both countries, while the EMTR on debt-…nanced investment has remained relatively stable. Keywords: Capital income taxation; dividend policy; e¤ective marginal tax rates; …nancial constraints. JEL classi…cation: H3. Acknowledgments: I would like to thank Alexander Klemm for sharing his earlier data set; Ernesto Longobardi, Patrick Minford, Paolo Panteghini, Assaf Razin and Partho Shome for useful comments; participants at the CESifo Conference on Corporate Taxes and Corporate Governance (Munich, November 2010); and seminar participants Cardi¤ Business School, Brescia Economics Department and HM Revenue and Customs.