Monday, February 1, 2016

What's most wrong with the corporate tax?

The corporate tax is the tax that economists most love to hate. It discourages capital formation, repels profitable investment, and causes untold dead weight loss in the form of tax lawyers' labor. And while the U.S. is generally a low-tax country, its (statutory) corporate tax rate is anomalously the highest in the developed world. Thus, unsurprisingly, corporate tax reform is always on the forefront of tax economists in Washington, DC.

One solution, of course, would be to get rid of the corporate tax entirely (and maybe throw in some anti-abuse rules to prevent corporations from becoming vehicles to accumulate investments tax-free). While the corporate income tax raises far less revenue than the payroll or individual income tax, it still raises about 10% of total federal revenue, and it does so in a highly progressive way, since most of the incidence of the corporate tax falls on capital owners. It would be quite difficult to replace that revenue in as progressive a manner as the corporate tax.

Of course, short of repealing the corporate tax (or cutting the tax rate dramatically), there are many parameters of the corporate tax code that could be reformed --- even in a revenue-neutral way. The biggest challenge is that there are just so many problems caused by the corporate tax, and they all interact with each other in complicated ways. It is hard to fix one problem without exacerbating another. To illustrate, here is a non-exhaustive list of problems and distortions caused by the corporate tax:

  1. Neoclassical effect on capital formation: In the simplest model of investment, corporations invest until the marginal dollar of investment will earn some required rate of return r. The presence of taxes raises that required rate of return (since the owners of the corporation don't receive the entire pre-tax return), and so corporations invest less. One way to fix this is to move toward a consumption-type corporate tax, in which corporations can immediately expense (deduct) all investment, rather than slowly over the course of many years. For a marginal investment, the value of the immediate deduction would precisely offset the present value of the future stream of taxes the corporation would pay on the returns of that investment --- leading to an effective marginal tax rate of zero. But, such a change would reduce tax revenue; to recover that revenue, the statutory rate would need to be increased.
  2. Shifting the location of discrete investment: Of course, not all production occurs via a well-behaved, concave production function; one full factory can probably produce more than 4 times what 1/4 of a factory can. These types of investment projects will typically be profitable (even net of the opportunity cost of capital) at whatever tax rate we're thinking about, so the amount of the investment won't be heavily influenced by the tax rate. Yet, the location decision might be highly responsive to taxes --- in particular, to the average tax rate that applies to the project in question. For highly profitable projects, the average tax rate is reasonably well approximated by the statutory tax rate (unless some lower tax rate applies to the marginal dollar of profit, which is true in the case of manufacturing industries in the United States). So the way to address this issue is to lower the top rate --- perhaps, making up for the revenue loss by broadening the base ways that actually increase the effective marginal tax rate. Already, we can see how the goals of corporate tax reform conflict with each other.
  3. Profit shifting: This is a similar phenomenon to (2), but they should be kept separate in our heads. "Profit-shifting" involves the shifting of profits on paper, but not in any meaningful economic sense, to a lower-tax country. It's actually not immediately obvious that this is a "problem." Suppose that all companies could costlessly shift exactly half their profits (and cannot shift a cent more) to zero-tax Bermuda, such that they actually face a 17.5% U.S. corporate tax rate. While this causes a revenue loss to the U.S., it just functions as a corporate tax cut, and we should evaluate it in the same way that we would an explicit change in rates. In my view, the difference between reality and my absurdly simplified example is that (a) profit shifting is not actually costless and (b) some firms can shift profits more easily than others. Problem (a) creates dead weight loss, equal to the amount of effort spent to shift profits. Problem (b) creates horizontal inequity, and can distort the allocation of resources if profit-shifting causes a change in effective tax rates on the margin for some firms (and not others). The intuition from point (2) still holds: a lower average tax rate on profitable discrete investments --- e.g., patents or other intangible property --- reduces the incentive to profit-shift. Of course, there are lots of other tax parameters that are designed to affect profit-shifting --- most of which are beyond my pay-grade. But changing many of these parameters would affect the average and marginal tax rates facing real investment too --- and it's not obvious that we want to do that.
  4. Miscellaneous other distortions: 
    1. Debt vs. equity: Interest payments by corporations are generally deductible against corporate tax, while dividends are not. (Dividends are taxed at the individual level less heavily than interest payments, but the former effect dominates.) As a result, debt-financed investment is more tax-favored than equity-financed investment. One way to address this would be to eliminate (or reduce) the deductibility of corporate interest expense. But if debt is the marginal source of investment funds for a corporation, this would have the effect of increasing the effective marginal tax rate on investment --- exacerbating problem (1).
    2. Corporate vs. non-corporate: The corporate tax applies only to C corporations, not to S corporations, partnerships (including LLCs that choose to be taxed as such), nor sole proprietorships; the "pass-through" tax regime that applies to these other forms is generally more favorable. This could lead businesses to choose a different entity form. As with profit shifting, this creates dead weight loss if (a) businesses change organizational forms due to tax policy and this has a real cost, or if (b) resources shift to pass-through firms (since pass-through status may be correlated with industry, size, etc.). 
    3. Et cetera: payout policy (dividends versus share repurchases), forms of merger/acquisition (e.g., purchase of stock or assets, with stock or cash). 
In most discussions of corporate tax reform, I fail to see a discussion of which reform goal that reform is most designed to address, and how it would affect the other goals. I also haven't seen a good discussion weighing the importance of each of these elements (though I may not be looking in the right place). Without some sense of what problems we should be trying hardest to solve, it's very hard to come up with a solution that makes sense.

Here's one very nice exception to this: This paper by Peter Sorensen, evaluating the tradeoff between reducing the debt / equity distortion and reducing the marginal cost of capital. 

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