Observable Depreciation Deductions and the Effective Marginal Tax Burden on Investment

Summary Forward-looking measures like the well-known effective marginal tax rate developed by King and Fullerton (1984) rely strongly on standardized assumptions on the effective use of depreciation deductions. This paper derives a method of assessing these assumptions empirically and of quantifying the bias resulting from simplifying assumptions. Using a balanced panel of German firms we calculate the path of depreciation deductions that should be observed if the assumptions on depreciation allowances were correct. These hypothetical deductions are compared to the observable ones in the data. We find that observable deductions slightly exceed the hypothetical ones. Moreover, we find a considerable degree of heterogeneity in the actual use of depreciation deductions across firms. On the basis of these results we calculate an adjusted effective marginal tax rate. It turns out that even small estimation biases in determining the tax deductions have a large impact on the effective tax rates for marginal investment projects. We conclude that forward-looking measures can and should be assessed empirically and that future research should emphasize the heterogenous impact of tax-related disincentives on business investment.