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Marginal Tax Rate (MTR)

Marginal Tax Rate (MTR). Definition: present value of current plus deferred income taxes (both implicit and explicit) to be paid per dollar of additional taxable income (where taxable income is grossed up to include implicit taxes) Why is the marginal tax rate important?

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Marginal Tax Rate (MTR)

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  1. Marginal Tax Rate (MTR) • Definition: present value of current plus deferred income taxes (both implicit and explicit) to be paid per dollar of additional taxable income (where taxable income is grossed up to include implicit taxes) • Why is the marginal tax rate important? • Why is the marginal tax rate difficult to determine?

  2. Why MTR is Important • After-tax returns to investment alternatives depend on MTR • For tax clienteles, choice of investments depends of relation between marginal explicit tax rate (METR) and marginal implicit tax rate • High METR taxpayers prefer tax-favored investments, while low METR taxpayers prefer tax-disfavored investments

  3. Issues in Determining MTR and METR • Need to include present value of deferred taxes to be paid in the future • Will depend on future marginal tax rates, which may depend on (uncertain) future earnings • Should also include foreign, state and local taxes (which may be deductible for federal income tax purposes) • For individuals, phase outs of certain deductions increase MTR

  4. Impact of State and Local Taxes on METR – Example • Assume a firm is subject to a federal explicit tax rate of 34 percent, a state tax rate of 8 percent, and a local tax rate of 1 percent • What is the firm’s net state and local tax cost after considering the federal deduction? • What is the firm’s total METR?

  5. Impact of Deferred Taxes on METR – Example • Suppose a firm has a $2,000,000 NOL carry forward into 2003, and expects to generate $400,000 of annual taxable income in 2003 and beyond. The firm’s expected statutory tax rate in the future is 40% and its after-tax discount rate is 6% • What is its expected METR? • What if expectations are wrong, and annual taxable income in 2003 and beyond is $700,000? What is the actual METR?

  6. Costs of Misestimating the METR • Since investment decisions are based on expected METR, taxpayers could end up invested in the wrong assets for longer term investments • Lower realized returns • Transaction costs to switch investments • Some protections • Adaptabilty • Reversibility • Insurance

  7. Some Alternative Measures of Tax Burden • Average tax rate • Definition: present value of current and deferred income taxes (both explicit and implicit) divided by the present value of taxable income (grossed up to include implicit taxes) • Effective tax rate • Two popular definitions • Sum of current and deferred tax expense under GAAP divided by net income before taxes • Current tax expense divided by net income before taxes

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