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.

If n = 0, then set z = 1, implying “expensing”. Otherwise, the choice depends on n/m, which can

vary by investor.

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 non-corporate 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 Organizational form Debt vs. equity finance Forms of compensation of employees

Other decisions that are distorted 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 If non-corporate: P (1 – m ) If corporate: P (1 – t* ) if profits P if losses

If P > 0, choose the lower tax rate If P < 0, strong tax incentive to be non-

corporate. (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 limited-liability 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 costs of bankruptcy Real 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

No distortion to allocation of savings (f’ = r + d) if t* = m.

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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 re-depreciated 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:Dividends yield (1 – d)Retentions yield (1 – g)

Dividends then dominated by retentions, generating the dividend puzzle:

Why dividends??

Alternative explanations:“New View”

“New view” of Auerbach, Bradford, KingDividend 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 non-corporate 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 problemsManagers 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 free-cash flow. But agency costs generate other efficiency consequences for tax policy.

Risk Taking

The tax law affects entrepreneurial risk taking through several channelsTax treatment of business vs. wage incomeTax treatment of profits vs. lossesReallocation 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

lossesOpposite 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 risk-

bearing 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.