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 Rate
Classical
c + (1-c)d
p
Imputation
d
p
Split-Rate System
d
p
Dividend Exclusion c
p
c
c
CBIT
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