Corporate Income Taxes: An Economics Perspective

Corporate Income Taxes: An Economics Perspective Presentation to the President’s Advisory Panel on Federal Tax Reform March 8, 2005 William M. Gentry Williams College

Overview • Incidence of the Corporate Tax • Tax shifting: who bears the burden of the corporate tax? • Distortions from the Corporate Tax • Organizational form choices • Investment decisions • Financing decisions

Views of the Corporate Tax • A tax on capital used by corporations • Tax base includes investors’ required return • Applies to returns to shareholders, but not to returns to creditors • A tax on pure profits of corporations • Returns above the ordinary risk-adjusted return

Tax Incidence • Allocating tax burden across people • Critical for evaluating the fairness of taxes • Insufficient to know who “writes the check” • Complicated web of responses determines who ultimately bears the burden of the corporate tax

Avenues for Shifting the Corporate Tax • Tax on capital used by corporations • Higher output prices may shift tax to consumers • Reduction in output affects labor demand • Substitution away from capital increases labor demand but less capital per worker reduces productivity • Rate of return on all forms of capital can be reduced by the corporate tax • Tax on pure profit less likely to be shifted

Best Estimates of CIT Incidence • Empirical evidence is relatively scarce • Agreement that • CIT is not just a tax on pure profit • There is shifting of the burden from shareholders to all capital • Less agreement on • Amount shifted to workers • Amount shifted to consumers • Distribution tables either ignore the CIT or allocate it to all capital owners

Distortions: Overview • Organizational Form • Investment • Financing • Debt vs. Equity • Dividends • Multinational Effects • Tax Shelters

Organizational Form • Corporate tax applies to C-corporations • Alternative business forms avoid the CIT • Alternative forms have grown recently • Is the CIT a tax on being ‘public’? • Distortion: if taxes discourage being a C-Corp, then the discouraged firms miss out on the benefits of being public

Investment • Taxes can affect investment through: • Tax Rates • Tax Rules: e.g., depreciation rules • Higher taxes & less generous depreciation rules increase the cost of capital • Level of investment vs. type of investment • Bottom line: The tax system can have substantial effects on the amount and type of investment undertaken by corporations

Financing: Debt vs. Equity • General wisdom: the double taxation of corporate equity favors debt over equity • Some offset due to investor-level taxation • Evidence on taxes and over-leverage • Relatively modest effects • Other effects of distinguishing debt vs. equity • The tax system favors industries or firms that have more access to debt • A fault line for tax planning and tax sheltering

Financing: Dividends • The tax system can also affect firms’ dividend decisions • Dividends vs. retained earnings • Dividends vs. share repurchases • Evidence from 2003 tax cut: corporate dividends increased after the tax cut • By distorting dividend policy, taxes can alter which firms have capital

Summary of Distortions • Corporate taxation creates a wide-range of economic distortions • Organizational form • Investment: levels and type • Financing and capital structure choices

Conclusions • Most of the burden of corporate taxation probably falls on the owners of capital • The economic cost – in terms of distortions – from corporate taxation are wide-ranging and likely to be substantial

Corporate Income Taxes: An Economics Perspective