Answer to Question #87456 in Finance for Vanessa

Question

Investors require a minimum rate of return of 10% on all capital invest- ments, and both equipment and structures depreciate at a rate of 15% per year. Firms are 100% equity financed. In what follows, assume that the opportunity cost of equity finance is not deductible for tax purposes.
In the initial setting, the corporate tax rate is 50% and investment in equipment can be expensed (written off immediately) for tax pur- poses, while investments in structures are written off on a declining balance basis with tax depreciation allowances equal to true economic depreciation.

Determine the equilibrium values of the pre-tax marginal prod- ucts of equipment and structures in this setting. What are the marginal effective tax rates on equipment and structures respec- tively?

Answer 1

The pre-tax marginal products of equipment and structures can't be calculated without additional information.

The marginal effective tax rate on capital income is the expected pretax rate of return minus the expected after-tax rate of return on a new marginal investment, divided by the pretax rate of return. 

So, marginal effective tax rate = (0.1 - 0.05)/0.1 = 0.5.