Corporate Taxes:
Economic Effects and
Optimal Design
Roger Gordon
UCSD
Aim of workshop

Provide an overview of past research on the role
and economic effects of corporate taxes
 Start
with a stylized description of the personal tax
 Given this personal tax law, initial analysis of the role
for a corporate tax
 Discussion of corporate behavior in response to the
remaining tax distortions
 Reexamination of the optimal design of the corporate
tax
Stylized description of the personal
tax

Take as given an existing personal income tax
 Progressive
rate structure
 Tax rate on labor income denoted by m, with rate
varying by tax bracket
 Tax rate on real interest denoted by n
 Tax rate on dividends at rate d
 Capital gains taxed at an effective rate g.
 Will presume that n > d > g
Taxation of non-corporate business
income
Underlying aim to tax resulting labor
income at rate m and capital income at
rate n.
 Assume that income net of depreciation
deductions taxed at rate m.
 Generosity of depreciation deductions
chosen so that effective tax rate on capital
income equals n.

Choice of depreciation schedule



Required rate of return satisfies:
(1 - m) f ‘ = [r (1 – n) + d] (1 – m z)
where z is the present value of depreciation
deductions.
Avoid distortions to form of savings if f ‘ = r + d
Can choose z so that f ‘ = r + d.
n = 0, then set z = 1, implying “expensing”.
 Otherwise, the choice depends on n/m, which can
vary by investor.
 If
What if had no corporate tax?


Incorporate firm and don’t pay dividends, tax
rate falls from m to g
Incorporate bank account
 Sell
shares when want to withdraw funds
 Converts interest income into capital gains
 Borrow to invest in bank account – riskless arbitrage

Shift from being an employee to being an
incorporated independent contractor, selling
shares when need funds
How can these evasion
opportunities be avoided?

Why not just attribute corporate income to
shareholders, to be taxed under the
personal income tax in the same way as
non-corporate income? (“partnership”
treatment)
Is a “partnership” treatment
feasible?

Key attribute of a corporation is the ease of
trading shares.
 With
minimal transactions costs of trade in
shares, shares can be held for an arbitrarily short
time period
 Yet taxable income of firm calculated at best once
per quarter.

For partnerships, transactions costs of trade
in shares high, and trades are infrequent
Existing personal taxes
on corporate income



Personal taxation of income from
corporations then focuses on forms of income
that can be monitored, regardless of holding
period: dividends and realized capital gains.
With gain from deferral, corporate income
then treated more favorably than noncorporate income.
Further advantage if reduced capital gains
tax rate, e.g. to ease lock-in effects.
Note on effective tax rate on capital
gains





Statutory rate of g* on realized gains
Tax therefore deferred (without charge) until sell
shares, lowering the discounted present value of
the tax
Option to sell losses quickly but to delay selling
gains lowers effective rate further
In U.S., accrued gains not sold before death
were tax free (until this year)
Crude presumption that effective rate g ≈.25g*
Role of the corporate tax


Role of the corporate tax is then to impose a
supplementary tax on retained earnings to
compensate for the low personal tax rate on
this income.
Any corporate revenue that is already fully
taxable under the personal tax, e.g. wage
payments, interest, rents, royalties, and (to
some degree) dividends, should then not be
part of the corporate tax base.
Implied structure for the
corporate tax



Tax base and tax rate should be designed so
that corporate income is treated the same as
equivalent income from non-corporate firms.
Non-corporate income can include both labor
and capital income to the partners, and the
same is true for corporate income
What are “equivalent” taxes for
entrepreneurial income and capital income
accruing within a corporation?
Equivalent tax on
labor income



If labor income paid out as wages, taxable under
the personal tax, it is taxed at some rate m
If earnings accrues instead within a corporation,
it is taxed each year at the corporate rate t, while
the accruing capital gains face personal taxes
when realized, with an effective tax rate g.
Avoid distorting where income is reported if:
m = t + g(1- t )  t*
Equivalent tax on capital income


Let personal tax rate on income from
savings be n . Non-corporate investment
faces an effective rate of n if suitably
adjust depreciation provisions, given
statutory rate m.
With same depreciation schedules, t* = m
also results in effective tax rate n on
income from corporate investments.
What are the resulting problems?

Difficulties in setting t such that m = t* :
 Variation
in m across taxpayers due to a
progressive personal tax schedule
 Variation in g due as well to choice of when to sell
 Variation in t due to treatment of business losses

To degree m ≠ t*, distortions are created:
 Incentive
to shift income to lower tax rate, and
deductions to higher tax rate
Outline of rest of lecture

Opportunities for income shifting




Other decisions that are distorted





Organizational form
Debt vs. equity finance
Forms of compensation of employees
Dividends
Corporate investment
Risk-taking
Reassessment of optimal design of corporate tax
Taxation of multinationals
Organizational form:
corporate vs. non-corporate

Pre-tax profits of P yield after-tax profits of
non-corporate: P (1 – m )
 If corporate:
P (1 – t* ) if profits
P
if losses
 If
If P > 0, choose the lower tax rate
 If P < 0, strong tax incentive to be noncorporate. (In U.S., special rules for small
firms to weaken this distortion.)

Organizational form:
Other forecasts
Lifecycle of firm: Start non-corporate as
long as tax losses likely, then incorporate
when m > t*.
 Tax arbitrage at any date if m > t*: Own
firms of both types, and use transfer
pricing to shift losses to non-corporate firm
and profits to corporate firm.

Non-tax considerations


In past, needed to change legal form in order to change
tax status
Non-tax effects of corporate form




Limited liability
Public trading of shares
In U.S., non-tax factors have weakened over time, with
introduction of subchapter S corporations and limitedliability companies, and check-the-box provisions.
Large size of corporate sector suggests that non-tax
factors remain important.
Evidence

Clear changes in organizational forms following
the 1986 Tax Reform Act, when t* - m changed
sign.
 Jump in sub-chapter S corporations
 Shift of tax losses from partnerships

to corporations
Implications for t :
 Keep t* ≈ max(m)
 Large distortions particularly
when P < 0.
“Safe harbor leasing” one attempted solution.
 Corporate mergers between firms with profits and
losses is another response

Debt vs. equity finance
Assume nr = mi, where i is the nominal
rate
 An extra dollar of corporate debt saves
taxes each year of (t* - m) i, given
deductions for firm but personal taxes on
interest income for investors

But what is the value of m??


Tax rate of investor who is indifferent between
bonds and stocks, with pension funds and those
in lower brackets buying bonds and those in
higher brackets buying stocks.
Given risky return to equity, all investors
forecasted to hold both debt and equity.
Security pricing then yields an effective m that is
a weighted average across investors, weighting
by assets, and the inverse of risk aversion.
Forecasts vs. data
Modigliani and Miller argued that non-tax
factors leave firm indifferent to form of
finance, as long as there are no real costs
from bankruptcy
 If t* > m, firm should then be all debt
financed.
 But D/K ≈ .25 in U.S.

Initial presumptions about non-tax
factors

Bankruptcy-cost model
 Real
 Real
costs of bankruptcy
costs of arising from conflicts of interest between
debt and equity, given the risk of future bankruptcy

Contrary to bankruptcy-cost model, though,
 Observable costs during bankruptcy very small
 Profitable large firms often have little debt
 Firms with tax losses, and small firms in a lower
corporate tax bracket, borrow much more heavily
 Large use of debt prior to introduction of income taxes
Lemons Model

Alternative “lemons” model due to Myers and
Majluf (1983)
 Outside
investors less well informed about true risk of
bankruptcy
 Firms with a higher risk of default then find debt
finance more attractive
 Due to lemons problem, market interest rate is high,
and good firms decline to borrow
 Equity finance generates worse lemons problems, so
is dominated by debt finance
Implications of “lemons” model

Forecasts more consistent with evidence
 Profitable
firms reluctant to borrow, while firms doing
badly borrow more heavily
 “Lemons” problems yet worse with equity than with
debt finance, helping to explain lack of equity issues
by smaller firms
 Also helps explain why cash-flow matters for
investment
 Lemons problems limit debt issues even if bankruptcy
costs small
Implications of “lemons” model
for tax policy

Taxes can potentially ease lemons problems
 Efficiency
gains from encouraging good firms to
borrow while discouraging bad firms from borrowing.
 Corresponds with tax law if good firms have t* > m,
while bad firms have t* < m

Can ease liquidity constraint by lowering
corporate tax rate on small firms
Empirical evidence

Evidence: Lee and Gordon (2001,2007)
 Look
at changes in use of debt over time as
tax schedules change.
 Find quite large effects of i (t* - m) on use of
debt.
 These responses though can arise under
either model, making the efficiency
implications unclear.
Forms of compensation


Wage payments generate tax deductions for firms
and taxable income for individual
Other forms of compensation can generate
corporate rather than personal income
 Self
employed can leave earnings within the firm.
 Employees can be paid with equity in the firm that is
undervalued for tax purposes.

Choice should depend on t* - m
 When
t* > m, wage payments preferred
 When t* < m, equity compensation preferred,
generating tax avoidance
Resulting distortions

Size of resulting distortion



Depends on t* - m for each individual
Distortions particularly large for firms with tax losses,
e.g. start-up firms
Evidence: Gordon-Slemrod (2001) find that the
reported corporate average profit rate (pre
interest deductions) is very sensitive to relative
tax rates ( t* - m), particularly for those with
m > t*.
Other distortions
Corporate investment
 Dividend payout rates
 Risk taking

Corporate vs. non-corporate
investment

Corporations invest until
f '

*
(r (1  n)  d )(1  t z )
1 t
*
No distortion to allocation of savings
(f’ = r + d) if t* = m.
Range of distortions to investment
Corporate tax rate varies across firms
depending on their size and whether they
have tax losses.
 Non-corporate tax rate varies across
individual tax brackets.
 Implies distortions to allocation of capital
across types of firms

Range of distortions to investment
Investment incentives change if shift
between corporate and non-corporate
form over the life of the investment.
 Gain from use of debt finance varies by
type of capital and by firm.
 Churning: sell capital so that it can be redepreciated by new firm. A gain if g < zt*

Dividend payout rates
Under personal tax, dividends normally
face a higher tax rate than capital gains.
 But in most countries, corporate tax
payments are unaffected by dividend
payouts.

Dividend puzzle

Alternative forms of payout of a dollar:
yield (1 – d)
 Retentions yield (1 – g)
 Dividends

Dividends then dominated by retentions,
generating the dividend puzzle:
Why dividends??
Alternative explanations:
“New View”

“New view” of Auerbach, Bradford, King
 Dividend
tax capitalized into the value of the
firm. A dollar retention then generates capital
gains of some amount q (Tobin’s q).
Dividends become attractive whenever (1 – d)
> q (1 – g)
 Investment undistorted by tax among dividend
paying firm: cost and return to investment
both taxed at d
Counterfactual implications




With cheap shares, better to buy firms owning
desired capital than to invest in new capital
Avoid discount with repurchase of shares, with
acquisitions of other firms, or conversion to noncorporate form. Repurchases now virtually as
large as dividend payments.
Dividends go up when dividend tax is cut,
contrary to model
Share prices go up in response to a dividend
announcement, contrary to model
Alternative explanations:
Signaling



Dividends signal that the firm can afford to pay
out funds. The more free cash flow, the more
dividends it can manage to pay out.
There is an optimal cost of a signal, obtained
through signaling with the right combination of
dividends and repurchases.
Helps explain why share prices go up in
response to a dividend, and why dividends go
up in response to a cut in tax rate.
Counterfactual implications
Dividends and repurchases should move
together, and should respond in opposite
directions to a change in d
 Share prices should be unaffected by the
dividend tax rate, yet observed to fall.

Alternative Explanations:
Agency Costs

Agency problems
 Managers
are empire builders, and want to
invest more than shareholders do.
 Shareholders, by restricting the cash flow
available to managers through dividend
payments, can restrict the funds available for
over-investment.
Fewer counterfactual forecasts
Repurchases forecast to be volatile if
shareholders choose dividend without
knowing true profits
 Tax reduces share values
 Dividend announcement increases share
prices if Board has additional information

Implications for tax policy



New view: Tax simply reduces value of equity
without affecting investment in firms paying
dividends.
Signaling: Tax simply changes the mix of
dividends and repurchases with no other real
effects
Agency costs: Tax does distort amount of freecash flow. But agency costs generate other
efficiency consequences for tax policy.
Risk Taking

The tax law affects entrepreneurial risk
taking through several channels
 Tax
treatment of business vs. wage income
 Tax treatment of profits vs. losses
 Reallocation of risk from the entrepreneur to
taxpayers
Tax rate applied to profits vs. losses
If tax rate the same, then expected profits
unaffected.
 But if tax rate on losses exceeds tax rate
on profits, then risk taking encouraged.

 Occurs
when m > t*, and non-corporate if
losses
 Opposite happens under a progressive
corporate tax schedule
Reallocation of risk


With a common tax rate on profits vs. losses, the
government bears t* % of the risk and receives
t* % of the risk premium.
The marginal cost to the entrepreneur of bearing
risk
 Remains
unchanged if the risky tax revenue is
ultimately reallocated efficiently across investors
 If risk allocated more efficiently, then cost of riskbearing falls. Could arise with “lemons” problems.
Empirical evidence
Cullen and Gordon (2009) find sizeable
effects of the tax law on non-corporate risk
taking, arising through all three channels.
 Tax law then affects growth, and affects
efficiency through its implications for
externalities from entrepreneurial activity.

Implications for design of
corporate tax: Perfect markets

Personal tax reforms interact with corporate
tax
 Cut in m should lead to a cut in t*
 Elimination of taxes on dividends,
interest, and
capital gains should lead to expensing, but
increases the appropriate corporate tax rate
 If in addition all equity held in pension plans,
including equity in one’s business, then no need
for a corporate tax
 If shift to a personal tax on an imputed risk-free
return to savings, n r K with remaining income
taxed as labor income, as with a dual income tax,
then again no need for a corporate tax.
But market imperfections
pervasive in this literature





Debt/equity ratios best explained assuming
lemons problems, also implying a form of credit
rationing
Dividends suggest agency problems
Externalities from risk taking
Choice of inventory accounting rules best
explained by concern with book profits
Corporate tax provisions can then help ease the
resulting misallocations.
Taxation of multinationals
So far, we’ve assumed a closed economy
 Income-shifting pressures become much
greater when taxing cross-border activity.
 How should the tax system be designed?

 Still
want to design law so that m = t* on all
income accruing to domestic residents, to
avoid distortions to location of investment or
forms of compensation.
Taxation of inbound investment



Inbound investment does not gain from low
domestic capital gains tax rate.
Suggests a zero tax rate to gain fully from
trade in capital.
With elastic supply of capital, incidence of tax
falls on labor, yet discourages K/L as well as
labor supply, so is dominated by a tax on
labor income.
Taxation of inbound investment

Why then does inbound investment face the
same corporate tax rate as domestic firms?
 Domestic
firms can acquire a foreign identity.
 Domestic employees of these firms face distortions
to forms of compensation.
 Expensing eliminates tax on foreign parent while
still maintaining tax on retained compensation of
employees
Taxation of outbound investment

For domestic savings invested abroad, need to
impose an effective tax rate on the resulting
income at rate n to avoid distortions to form of
savings.
 Tax
income from portfolio investments at accrual
 Tax corporate income at rate t* to the extent there are
domestic shareholders, regardless of “nationality” of
firm, to assure same tax treatment of domestic and
foreign-source profits. Same would be true for domestic
operations when there are foreign owners.
Current tax treatment of
multinationals

By OECD rules, choice of
 Taxation
(normally at repatriation) with a credit for
taxes paid abroad.
 Territorial treatment, exempting foreign-source
income.

With effective tax rate varying by location of
reported income, firms face strong pressure to
reallocate income to tax havens, and to defer
repatriation. Strong empirical evidence
supporting these forecasts.
What about foreign-source
entrepreneurial income?

Corporate tax rate on foreign-source earnings
should equal m in present value.
 One
way to accomplish this is to impose a tax at rate
m on all repatriations, with a deduction for all funds
sent abroad. (Same logic as with pensions.)
 This is close to the tax treatment in the U.S. and
Japan, where foreign-source earnings are fully taxed
at repatriation.

Is entrepreneurial income less important in
territorial countries?
Inference about sources of
corporate income


Note that existing U.S. tax provisions for
multinationals “make sense” only if corporate
income primarily entrepreneurial income.
Consistent with evidence in various studies:
 Gordon
and Slemrod (1988) and Gentry and
Hubbard (1997) both find that the normal return to
capital has been a minor part of the U.S.
corporate tax base.
Summary



Corporate tax serves as a backstop to the
personal tax, preventing tax avoidance through
converting ordinary income into capital gains on
corporate equity.
Its design should be closely linked to the design
of the personal income tax.
Many distortions created in the process, though
these may to some degree address various
market imperfections.