Changes in Tax Neutrality of Effective Tax Rates in the Czech Republic in 2010–2018

Abstract

he presented paper builds on previous research in this area (Holečková, 2013) and aims to examine the tax neutrality in the Czech Republic (i.e., the extent to which the given tax leaves corporate decisions as to investments or sources of financing unchanged). A tax system that seeks to raise revenue without distortive effects is considered a neutral tax system. This aspect is of great importance as it defines one of the aims of modern tax systems and points towards one specific criterion by which they may be assessed. Our approach adopts effective tax rates on different types of capital assets and sources of financing and based on the calculation of the tax wedges it assesses the degree to which taxation affects the incentive to undertake investments in the Czech Republic. The precise methodology used to calculate effective tax rates on marginal investments is based on the approach developed by King and Fullerton (1984), whose methodology became the most widely accepted method adopted to calculate effective tax rates (tax wedges). The method appeals to both academics and practitioners to this day (e.g., Florio, 2007). The tax wedge will vary according to the type of asset: machinery, buildings, inventory (because of different capital allowance rates relative to the assumed true economic depreciation rates) and the type of financing sources: new equity, debt and retained earnings (since the tax treatment of debt, dividends and retained earnings differs). Effective tax rates take into account not only the statutory corporate tax rate, but also other aspects of the tax system which determine the amount of taxes paid and profitability of investment, including personal taxes. The paper finds out that, based on the calculations for 2018, businesses need to ensure the rate of return higher by 1.33 percentage points for the retained earnings (and by 1.80 percentage points for new equity, respectively) compared to the final post-tax rate of return which investors actually get. The adopted analysis suggests that Czech tax system tends to favour investments in machinery on the expense of buildings and, particularly, inventories. With this respect, our results correspond to outcomes of other, similar country-specific studies, such as, for example, de Almeida–Paes (2013). The tax system also lacks neutrality when considering alternative sources of finance, i.e., the debt finance tends to be favoured over equity and retained earnings.