Key concepts and methodology

Forward-looking effective tax rates (ETRs) are synthetic tax policy indicators calculated on the basis of a prospective, hypothetical investment project. Unlike backward-looking ETRs, they do not incorporate any information about firms' actual tax payments.

The OECD methodology has been described in detail in the OECD Taxation Working Paper No. 38 (Hanappi, 2018), building on the theoretical model developed by Devereux and Griffith (1999, 2003). Further methodological information is available in the explanatory annex.

The methodology builds on the following key concepts:

• Economic profits are defined as the difference between total revenue and total economic costs, including explicit costs involved in the production of goods and services as well as opportunity costs such as, for example, revenue foregone by using company-owned buildings or self-employment resources. It is calculated as the net present value (NPV) over all cash flows associated with the investment project.
• The cost of capital is defined as the pre-tax rate of return on capital required to generate zero post-tax economic profits. In contrast, the real interest rate is the return on capital earned in the alternative case, for example, if the investment would not be undertaken and the funds would remain in a bank account.
• The tax inclusive effective marginal tax rate (EMTR) measures the extent to which taxation increases the cost of capital; it corresponds to the case of a marginal project that delivers just enough profit to break even but no economic profit over and above this threshold.
• The effective average tax rate (EATR) reflects the average tax contribution a firm makes on an investment project earning above-zero economic profits. It is defined as the difference in the NPV of pre-tax and post-tax economic profits relative to the NPV of pre-tax income net of real economic depreciation.
• Real economic depreciation is a measure of the decrease in the productive value of an asset over time; depreciation patterns of a given asset type can be estimated using asset prices in resale markets.
• Jurisdiction-specific tax codes typically provide capital allowances to reflect the decrease in asset value over time in the calculation of taxable profits. If capital allowances match the decay of the asset's value resulting from it being used in production, then fiscal depreciation equals economic depreciation.
• If capital allowances are more generous, fiscal depreciation is accelerated; where capital allowances are less generous, fiscal depreciation is referred to as decelerated. The NPV of capital allowances, measured as percentage of the initial investment, accounts for timing effects on the value of capital allowances, thus providing comparable information on the generosity of fiscal depreciation across assets and jurisdictions.

As can be seen from the definition of the cost of capital, the tax inclusive EMTR is not defined if the cost of capital approaches zero. In cases where this happens, e.g., due to interactions between high inflation, generous tax incentives or interest deductibility, the respective EMTR is recorded as a missing observation.

Asset categories and tax provisions covered

The calculations build on a comprehensive coverage of jurisdiction-specific tax rules pertaining to four quantitatively relevant asset categories:

Non-residential structures: manufacturing plants, large engineering structures, office or commercial buildings.

Tangible assets: (1) road transport vehicles, (2) air, rail or water transport vehicles, (3) computer hardware, (4) equipment and (5) industrial machinery.

Acquired intangible assets: (1) acquired software.

Inventories.

The following corporate tax provisions have been covered:

• combined central and sub-central corporate income tax rates;
• asset-specific fiscal depreciation rules, including first-year allowances, half-year or mid-month conventions;
• general tax incentives only if available for a broad group of investments undertaken by large domestic or multinational firms;
• inventory valuation methods including first-in-first-out, last-in-first-out and average cost methods;

• allowances for corporate equity.

The composite ETRs reported in this database are constructed in three steps. First, ETRs are calculated separately for each jurisdiction, asset category and source of finance (debt and equity); while the debt-finance case accounts for interest deductibility, jurisdiction-specific limitations to interest deductibility have not been covered in this edition. Second, an unweighted average over the asset categories is taken, separately for both sources of finance. Third, the composite ETRs are obtained as a weighted average between equity- and debt-financed investments, applying a weight of 65% equity and 35% debt finance.

Macroeconomic Scenarios

The two main macroeconomic parameters, inflation and interest rates, interact with the effects of the tax system in various ways and can thus have significant effects on the ETRs.

• Corporate tax is levied on nominal returns, irrespective of the underlying real return. Increases in nominal returns due to inflation, which are not matched by corresponding increases in real returns, therefore increase effective tax rates.
• Capital allowances are determined by the acquisition costs of the asset. While inflation increases nominal returns, capital allowances are deducted over the lifetime of the asset at non-inflated values, thus increasing effective taxation relative to real returns.
• The NPV of capital allowances depends on the discount rate which may be affected by the nominal interest rate. A higher nominal interest rate implies that future deductions and allowances are valued less at present, again leading to an increase in effective taxation.
• Interest payments can be deducted from the tax base at the nominal rate. Thus, increases in inflation or real interest rates increase the nominal interest rate and the corresponding deductions from the corporate tax base, implying lower effective taxation.

The database contains ETR results for two different macroeconomic scenarios. In the first scenario interest and inflation rates are held constant. In the LOW scenario real interest is 3% and inflation is 1%. The second scenario uses country-specific (CS) macroeconomic parameters. The corresponding country-specific real interest and inflation rates are listed in the explanatory annex. While the former approach addresses the question how differences in tax systems compare across jurisdictions holding other factors constant, the latter approach gives better indications on the tax effects on investment incentives in a specific country at a specific point in time.