TAXATION OF COMPANIES

1. TAXATION OF COMPANIES Alan J. AuerbachMichael P. Devereux and Helen Simpson

2. Outline • Brief summary of Meade’s recommendations • Relevant developments since 1978 in economies, economic theory and empirical evidence • Growth of cross border flows • Relationship between corporate and personal taxes • Financial innovation • Corporation tax incidence • Alternative proposals for reform of corporation tax

3. 1. MEADE’S PROPOSALS:A Flow-of-Funds Tax • Aim to leave marginal investment tax-free; cost of capital unaffected by tax • under standard models, investment and choice of finance unaffected by tax • Achieves this by allowing all expenses to be deducted from taxable profit when they are incurred; so no attempt to match accounting profit • Choice of three possible tax bases: R, R+F and S

4. Analysis of Flow of Funds Real inflows – Real outflows = R base + Financial inflows – Financial outflows = R+F base = Share outflows – Share inflows = S base

5. Relationship with Personal Tax • Meade considers relationship appropriate with various combinations: • a comprehensive income tax and two forms of expenditure tax; and • a company profits tax, and R base and an S base • Appropriate form of integration varies with combination • But little analysis of integration in a more general setting

6. 2. SUBSEQUENT DEVELOPMENTSA: Growth in Cross Border Flows of Capital and Profit

8. Impact of Taxes on Capital Flows • Direct flows depend on different decisions • discrete choice of where to locate • depends on effective average tax rate • conditional on discrete choice, usual investment decision • depends on effective marginal tax rate • Considerable evidence of significant role of tax – but mainly for average rate

9. Profit Shifting • Another type of internationally-mobile flow • Conditional on the location of plants and capital, profit possibly more mobile than capital • Considerable empirical evidence • Studies analyse relationship between tax rates and: declared profitability, repatriation of dividends, use of debt, patterns of within-firm trade • Generally depends on statutory tax rate

10. Tax Competition • Between governments: • over statutory rate to attract profit • over effective average tax rate to attract firms • over effective marginal tax rate to attract capital • Empirical evidence especially for competition over statutory rates • Policy relevance: OECD and EU initiatives on “harmful” tax competition • Trends in rates?

13. Implications for Tax Design • Effective marginal tax rate of zero is not sufficient for neutrality • In international context especially, statutory rate and effective average tax rate also affect flows of capital and profit • Flows of funds tax could have high statutory rate and effective average tax rate • Competition is exerting downward pressure on statutory rates

14. 2. SUBSEQUENT DEVELOPMENTSB: Relationship Between Corporate and Personal Taxes Two issues: • Does a classical relationship for taxation of dividends imply lower investment? • Do differences between taxation of corporate and personal income distort choice of organisational form?

15. Why Might Effects on Investment be Small? • In a small open economy, shareholders are dispersed around the world • At a given asset price, each investor will trade off higher or lower tax against higher or lower risk • A higher tax on domestic investors will not affect the asset price (and hence not investment) if the wealth of domestic investors is small in world terms • “New view” • Dividend taxes are capitalised into share prices • For investment financed by retained earnings, dividend taxes are like an S-based tax, which is neutral

16. Note: UK offshore islands were re-classified to Rest of World in 1997 Source: ONS, Share Ownership 2004.

17. Differences in Legal Form • Choice to incorporate can depend on the relative overall tax treatment of corporate income v personal income • e.g., in US, strong growth of S-corporations, which have limited liability but are not liable to corporation tax • also in US, small companies can “check the box” to be taxed under the personal income tax • has given rise to “hybrid entities” used for international tax avoidance

19. Implications for Tax Design • Need to distinguish between different types of enterprises: • Existing firms vs. start-ups • Taxation of dividends may have different effects • Firms that can choose organizational form vs. firms that cannot (due to ownership structure, need for capital market access, etc.) • Need to distinguish burdens on investment from those on incorporation – like the distinction governing international location decision

20. 2. SUBSEQUENT DEVELOPMENTSC: Financial Innovation • Substantial increase in the availability of new financial instruments, blurring the distinction between debt and equity • Growth in financial sector • Increasing difficulty of distinguishing real and financial flows

21. US Common Stock & Hybrid Equity Issuance, 2001 – 2005

23. Implications for Tax Design • Increased difficulties under both R and R+F bases • R base: • Need to distinguish between real and financial transactions on the sales side, e.g., GM vs. GMAC • How to tax financial companies, whose returns are excluded from R base? • R+F base: • Need to distinguish debt and equity flows, as under current law

24. 2. SUBSEQUENT DEVELOPMENTSD: Corporate Tax Incidence • Continuing shift away from the view based on the Harberger model • Increased emphasis on open economy • Even in closed economy, several complicating factors

25. Open Economy Incidence • Much less likely for capital to bear the corporate tax • Burden shifted to land, labor and less mobile factors • Bigger distinction (mentioned earlier) between taxes on portfolio investors and taxes on corporations

26. Closed Economy Incidence • Dynamics, financial policy and existence of rents all suggest that some taxes may be borne by shareholders • To the extent that initially shifted to all capital, responsiveness of saving may shift at least partially to labor

27. Implications for Tax Design • Positive marginal tax rates on corporate capital more likely to be borne by shareholders, labor and land than “all capital” • As in tax competition discussion, several relevant characteristics of corporate tax, not just marginal tax rate on new investment

28. 3. REFORMING THE CORPORATE TAX: ALTERNATIVES TO R AND R+F • ACE • Flow of funds approach but with different timing • Deals with tax losses arising from expensing of investment • Pattern of deductions closer to economic depreciation, so smaller impact of tax rate changes • No solution to other problems, such as real/financial distinction

29. 3. REFORMING THE CORPORATE TAX: ALTERNATIVES TO R AND R+F • CBIT • Fixes problem of distinguishing between debt and equity finance • Broader base allows statutory rate to be lower • Worsens real/financial distinction

30. 3. REFORMING THE CORPORATE TAX: ALTERNATIVES TO R AND R+F • Dual Income Tax • Single tax rate on all capital income in principle removes significance of debt/equity distinction • lower rate on capital income compared to labour income helps with greater mobility of capital • But single rate typically only for corporate and personal tax combined, so only applies to domestic residents

31. 3. REFORMING THE CORPORATE TAX: ALTERNATIVES TO R AND R+F • Formula apportionment • Reduces scope for shifting profit between locations • A more stable alternative to source-based taxation? • Isn’t a shift to sales factor essentially a means of imposing a sales tax? • Doesn’t address other issues raised

32. 3. REFORMING THE CORPORATE TAX: ALTERNATIVES TO R AND R+F • Flat/X tax • Progressive tax combining R based business tax with progressive wage tax • Problems if source-based tax similar to those of present system • Can implement as a destination-based tax