Corporate Income Taxation

June 27, 2013

Outline

• The logic of corporate taxation• Incidence and efficiency effects of the

corporate income tax: the Harberger Model and beyond

• Integration and other approaches to reform• International tax issues

Why Tax Corporations?

• Benefit taxation– Argument: corporations benefit from government

action, and so should be taxed– But why charge more than marginal cost for these

benefits? Why tax corporate income?• Corrective taxation– Do corporations impose a cost on society?–Maybe some do, but is it corporations, per se? All

corporations? Is the cost related to their income?

Why Tax Corporations?

• Effective collection point– An argument for withholding, but not for tax

specifically on corporate income• To backstop personal tax– Related to withholding argument, but in this case

more like a presumptive tax–We could do without this, but only with a

comprehensive personal income tax

Why Tax Corporations?

• To impose a tax on economic rent– Example: natural resource taxation– Suggests a particular structure of tax – cash-flow

taxation, so that “normal” returns exempt• Because people think someone else bears tax– Can we export taxes via multinationals?

The Harberger Model

• Previous thinking: the corporate tax as a tax on shareholders

• Harberger: imposing a tax on corporate income will induce a movement of capital out of the corporate sector that will spread burden more widely by driving down returns to capital elsewhere.– This response will also be associated with

deadweight loss

The Harberger Model

• Assumptions:– Corporations and noncorporate businesses produce

different commodities, so no direct substitution– Production is competitive, using capital and labor– Corporate “profits” are normal returns to capital– Capital and labor can move freely between sectors

to equalize rates of return and wages– Overall supplies of capital and labor fixed– Corporate income tax amounts to an extra tax on

capital income in the corporate sector

The Harberger Model

• Key finding:– Under plausible (further) restrictions, capital as a

whole will bear 100% of the corporate tax.– That is, after-tax rates of return in both sectors will

fall by enough that labor bears none of the burden; real wages don’t fall even if the price of corporate products rises.

The Harberger Model

• Intuition: the corporate tax has two effects– “Excise tax” effect: corporate products become

more expensive, reducing demand for them and shifting resources to the noncorporate sector.

– “Factor substitution” effect: the corporate sector is discouraged from using capital, and so increases labor intensity of its production.

– The first effect may hurt capital or labor more (it depends on which sector is more capital intensive), but the second hurts capital and helps labor; together, the effects on labor may cancel.

The Harberger Model

• Deadweight loss– Both of the effects (excise and factor substitution)

induce deadweight loss.– But the factor substitution effect makes production

inefficient – we’re off the PPF, because we could produce more with the same amounts of capital and labor.

– In this model, there would be no DWL if all consumption were taxed uniformly, since income is fixed; likewise with a uniform tax on capital.

The Harberger Model

• This model remains very influential.– For example, its incidence result was, until very

recently, incorporated in CBO distribution analyses.

• But it has many limitations, some of which have grown worse over time.

The Harberger Model

• One obvious issue is that many firms can choose whether to be a C corporation.– Between 1980 and 2007 C-corporation share of US

business income fell from 80% to 53%.• Another limitation is variable factor supply.–With saving responsive to the rate of return, part of

the burden may shift to labor, especially over time.• But there are many other issues as well.

Limitations of the Harberger Model

• Dynamics– Adjustment takes time, especially for capital, so

this is a story about the long run.– After-tax rates of return are not immediately equal.

Limitations of the Harberger Model

• Dynamics– Adjustment takes time, especially for capital; so

this is a story about the long run.– After-tax rates of return are not immediately equal.– But assets in both sectors have to yield the same

market return, so difference in after-tax rates of return to capital must be capitalized into share values.

– So, some of the incidence is on shareholders, after all – today’s shareholders.

Limitations of the Harberger Model

• Dynamics• New vs. old capital– The structure of taxation matters; raising (or

lowering) the tax rate affects all capital; changing investment incentives affects only new capital.

– Differential treatment of new and old capital should be capitalized into the value of old capital.

– Imposing a tax only on old capital (via a tax rate plus expensing) should have no impact on investment, but should reduce the value of shares.

An Aside: Effective Tax Rates

• Definition: the tax rate on income from new investment with the same present value as the combination of existing provisions– A tax at rate on income net of economic

depreciation has an effective tax rate of .– Providing more generous depreciation deductions

and/or investment tax credits lowers effective tax rate below .

An Aside: Effective Tax Rates

• Definition: the tax rate on income from new investment with the same present value as the combination of existing provisions– For investment expensing (or any combination of

investment incentives and deductions of the same present value), government covers the same share of investment costs as it receives in investment returns; so the effective tax rate = 0.

– But rents and returns to old capital are still taxed at rate under this cash flow tax.

Limitations of the Harberger Model

• Dynamics• New vs. old capital• Interest deductibility– As good as pass-through treatment, so maybe the

corporate tax is paid only if doing so provides a net benefit (Miller equilibrium)

– To the extent that borrowing has nontax costs and benefits, another tax distortion associated with the corporate tax

Limitations of the Harberger Model

• Dynamics• New vs. old capital• Interest deductibility• Favorable taxation of capital gains– Appears to introduce another distortion,

encouraging firms to retain earnings– But, if inevitable, dividend taxes will be

capitalized and the apparent advantage to retention vanishes – “new view” of dividend taxation

The New View

• Two elements:– Dividend taxes don’t affect the rate of return.– Dividend taxes are capitalized into share values.

• No effect on rate of return (ignore c.g. tax):– Retain earnings: out-of-pocket cost = (1-d)– Reinvest at rate r; distribute (1+r) one year later as

dividends, for net of (1+r)(1-d)– Gross rate of return is (1+r)(1-d)/(1-d) = 1+r, so

net rate of return is r

The New View

• Two elements:– Dividend taxes don’t affect the rate of return.– Dividend taxes are capitalized into share values.

• Dividend tax capitalization:– Value per dollar inside the firm must equal the

value of after-tax dividends, (1-d); otherwise, the firm would distribute more (or less)

The New View

• With c.g. taxes, analysis applies to difference; that is, if effective capital gains tax rate is g, then and the rate of tax on investment is g and (d -g)/(1-g) is capitalized.

• The new view, like interest deductibility, undercuts the argument that there is “double” taxation.

• Note that it applies only to mature firms, with equity investment through retained earnings.

Corporate Tax Reform (Domestic)

• Traditionally (i.e., before so much focus on the activities of multinationals), much attention to approaches to alleviating distortions within a single economy

• Ideal approach: pass-through treatment, like S corporations– But difficult because of need to attribute retained

earnings to shareholders– Could instead tax shareholder capital gains on

accrual (or the equivalent); nothing so far on this

Corporate Tax Reform (Domestic)

• For most existing approaches (and detailed proposals), action relates to the taxation of interest and dividends within existing corporate structure.

Approach Dividend Tax Rate Interest Tax RateClassical c + (1-c)d p

Imputation d p

Split-Rate System d p

Dividend Exclusion c p

CBIT c c

Corporate Tax Reform (Domestic)

• Note that, under the new view, reductions in dividend taxation provide lump-sum windfalls to existing capital, increasing share values with no impact on incentives to invest through retained earnings.– Can limit these windfalls by focusing on dividends

from new equity (Andrews, ALI Reporter’s Study, 1982), but this would add complexity (and lose political support of those denied their windfalls)

International Issues

• Increasingly important, given the rising significance of multinational activity– From 49% of US C corporate assets in 1982 to

82% in 2005• Effects on incidence and efficiency depend on

the structure of corporate taxation.• Within the simplest structure, source-based

taxation, capital flows (like an elastic savings response) shift more of the burden to labor.

Source-Based Taxation

• Indeed, for a small open economy with a source-based tax on capital income, the optimal tax rate is zero.– This holds for any capital income tax, not just a

corporate income tax.–With an elasticity of supply of capital that is

effectively infinite, a tax on capital is shifted to domestic factors, leaving behind deadweight loss.

Source-Based Taxation

• For a larger economy (like the United States), optimal source-based tax rate may not be zero because of capital responsiveness, but there are other factors that make the tax less attractive.– In particular, profits can “move” somewhat

independently of capital.• This introduces another distinction between

provisions affecting tax base and tax rate.– Not just new vs. old capital, but new capital vs.

worldwide profits

Alternative Tax Bases

• But source-based taxation isn’t the only approach; other approaches include– Residence-based taxation– Formulary apportionment– Destination-based taxation–What the United States does

• Also, many margins on which decisions are made, beyond location of profits and assets; for example, where to locate company itself

Source vs. Residence

• Can summarize different approaches to taxation, using three effective tax rates; on– Domestic earnings of resident companies (c)– Domestic earnings of foreign companies (m)– Foreign earnings of resident companies (f)

• Source-based tax: c = m > 0; f = 0• Residence-based tax: c = f > 0; m = 0• Incentive effects are different under the two

taxes.

Source vs. Residence

• Source base:– Capital location distorted c > f – Profit “location” distorted c > f – A different effective value of c could apply to

profits and capital, as just discussed.• Residence base:– Company location distorted– Company ownership of assets distorted– Both because US tax rates don’t apply to

companies resident elsewhere

US base vs. Source and Residence

• Somewhere in between• Like source base, a tax on US earnings of

foreign companies– Also, with tax credits and deferral, foreign-source

income of US companies may face little/no tax• But additional tax on some foreign-source

earnings– Also, additional effects present under neither

source nor residence, notably the “lock-out” effect

International Tax Reform

• Current US discussion mostly involves changes in domestic rate vs. base, as well as whether to move closer to residence or source approach– Toward residence:• Expansion of Subpart F• Minimum tax on foreign-source earnings

– Toward source:• Exemption of active foreign source income of US

resident companies

International Tax Reform

• Which of these approaches is better?• We could address this question using incidence

and efficiency analysis based on behavior at different margins.– Difficult in practice, although there is ongoing

research to estimate empirical magnitudes• But we can also expand our thinking to

consider alternatives to the source and residence approaches.

Formula Apportionment

• As practiced by US states• Three-factor formula: apportion overall

income based on share of sales, assets and payroll

• Eliminates transfer pricing problem, since “location” of income is irrelevant to tax calculation

• But simulates a tax on the factors in the formula (McLure)

Formula Apportionment

• For example, asset-based apportionment is like a tax on assets (or capital income), although without the incentive for profit shifting.

• This has led to a shift among US states toward sales-only apportionment.

Sales-Only Apportionment

• Problems remain, since based on all sales, including to businesses – production distortion

• Also, instead of profit shifting, encourages sales churning – just increase turnover elsewhere with little change in real activity

• Can’t combat these problems by basing apportionment only on final sales; would just lead to zero-profit “resale” companies

• Issue: base and apportionment factor differ

Destination-Based Taxation

• Follows the notion of basing taxation on sales, but actually does so, rather than using sales to apportion worldwide income

• Effectively a subtraction-method value added tax, but with a deduction for wages – a business cash flow tax

• Start with source-based cash flow tax; convert to destination basis by ignoring foreign transactions (could impose border adjustments)

Implementation

• Example: if $100 of revenue from foreign source, ignore revenue– Could also include revenue in tax base but then

rebate tax on exports, but leads to same outcome– Same approach to expenses: ignore instead of

allowing deduction & including imports in base• Is this pro-export? As much or little as a VAT

would be– Depends on whether exchange rates can adjust; if

so, then adjustment will neutralize trade effects

Effects of Destination-Based Approach

• Eliminates transfer pricing problems, since cross-border transactions not in base

• Eliminates incentive to shift capital away, since zero tax based on source

• Eliminates incentive to change residence, since zero tax based on residence

• Taxes rents related to US consumption, but not to US production

Summary

• Incidence and efficiency effects of the corporate tax depend on its structure.

• Incidence: not just shareholders vs. capital vs. labor, but also which generation, and where

• Structure:– Tax rate vs. tax base– Treatment of foreign-source income, foreign

investors, and cross-border transactions