# Presentation: 526204

## Corporate Income Taxes:  An Economics Perspective

- Presentation to the President’s Advisory Panel on Federal Tax Reform
- March 8, 2005
- William M. Gentry
- Williams College

**Notes:**
Thank you for this chance to discuss how economists view the corporate income tax – a quite challenging part of the tax system when considering tax reform.

## Overview

- Incidence of the Corporate Tax
- Tax shifting: who bears the burden of the corporate tax?
- Distortions from the Corporate Tax
- Organizational form choices
- Investment decisions
- Financing decisions

**Notes:**
My comments will focus on two areas.  First, I will discuss what economists call “tax incidence” – the process of determining who ultimately bears the cost of a particular tax.  Second, I will outline several of the important ways in which the corporate tax system distorts economic decisions.  I will focus on three specific areas:  the choice of organizational form, the amount and type of investment, and the financing decisions of corporations.

## Views of the Corporate Tax

- A tax on capital used by corporations
- Tax base includes investors’ required return
- Applies to returns to shareholders, but not to returns to creditors
- A tax on pure profits of corporations
- Returns above the ordinary risk-adjusted return

**Notes:**
Before delving into my two broad topics, I want to highlight two views of the corporate income tax.  In one sense, the corporate income tax is a tax on capital used by corporations:  income is measured as the return to the shareholders so income captures the return that the shareholders anticipate by investing in corporations.  One key thing to note is that I am focusing on the equity-financed capital of corporations since interest payments (the return to creditors) are tax deductible.  In another sense, the corporate income tax is a tax on what economists call pure profits of the firms – these are returns that exceed the required returns to investors.  These views are not mutually exclusive.  In practice, the corporate income tax base includes both types of returns:  the ordinary returns and the extraordinary returns.  Furthermore, it is difficult for an income tax to separate these types of returns.

## Tax Incidence

- Allocating tax burden across people
- Critical for evaluating the fairness of taxes
- Insufficient to know who “writes the check”
- Complicated web of responses determines who ultimately bears the burden of the corporate tax

**Notes:**
While calculating tax incidence can be complicated in many instances, these calculations are critical for the policy debate.  Policy analysts create distribution tables that summarize how taxes affect different groups of people, often grouped by income.  Every distribution table that is produced by academics or government agencies must rely on a series of incidence assumptions.  Thus, understanding tax incidence is crucial for understanding the fairness of the tax system.  The most important rule of tax incidence is that who writes the check to the government is not terribly important.  As s a simple example of why who writes the check is insufficient consider a gas tax.  Even if the owner of a gas station writes the check to the government for a gas tax, one would expect that much (if not all) of the gas tax is passed along to the consumers of gasoline.  For the corporate income tax, incidence depends on a complicated web of decisions about output, investment, labor demand, consumer responses, worker responses, and investor responses.

## Avenues for Shifting the Corporate Tax

- Tax on capital used by corporations
- Higher output prices may shift tax to consumers
- Reduction in output affects labor demand
- Substitution away from capital increases labor demand but less capital per worker reduces productivity
- Rate of return on all forms of capital can be reduced by the corporate tax
- Tax on pure profit less likely to be shifted

**Notes:**
From a legal standpoint, it is convenient to imagine that corporations pay the corporate income tax on the behalf of their shareholders so one could claim that the “statutory” incidence is on the shareholders.  However, the economic question is whether the tax can be shifted away from the shareholders.  There are several avenues for tax shifting.  First, to the extent that corporations raise output prices in response to the corporate tax, then the consumers bear the tax and the distribution table would attribute the corporate tax in line with personal consumption.  Second, the behavioral responses to the tax can affect workers in a number of ways:  less corporate output reduces labor demand (though this may be absorbed in part by noncorporate jobs), firms may substitute labor for capital which is good for workers but this substitution also means that workers have less capital to use so they have lower productivity.  These effects on labor are ambiguous but suffice it to say that the distribution table might need to attribute part of the corporate tax to workers.  Third, the shareholders may respond by moving their capital into types of investments that are not subject to the corporate tax.  This shift across types of investment means that the corporate tax may hurt the returns to all forms of saving.  This means that the distribution table would attribute part of the corporate tax based on wealth holding rather than owning shares.  Fortunately, to the economic incidence of a tax on pure profit is more straightforward:  economists do not think this tax can be shifted away from the owners of the corporation.

## Best Estimates of CIT Incidence

- Empirical evidence is relatively scarce
- Agreement that
- CIT is not just a tax on pure profit
- There is shifting of the burden from shareholders to all capital
- Less agreement on
- Amount shifted to workers
- Amount shifted to consumers
- Distribution tables either ignore the CIT or allocate it to all capital owners

**Notes:**
Economic theory can only go so far on the question of tax incidence.  Ultimately, the question in an empirical one.  Sadly, empirical economics has not yet provided a conclusive answer.  Broad agreement among economists that:  (1) the corporate income tax is not just a tax on pure profits (so it falls more broadly than just on shareholders); and (2) the incidence is shifted from the tax’s narrow focus on corporations to all capital.  Less agreement among economists on the amount of the corporate tax that falls on workers or consumers.  Distribution tables produced in Washington either avoid the CIT issue all together or allocate the tax burden based on all capital. 

## Distortions:  Overview

**Organizational Form**
**Investment**
**Financing**
**Debt vs. Equity**
**Dividends**
- Multinational Effects
- Tax Shelters

**Notes:**
I will focus my attention on the organizational form, investment, and financing distortions of the corporate income tax.  I understand that other hearings will devote attention to the complicated issues of multinational corporations and tax shelters.

## Organizational Form

- Corporate tax applies to C-corporations
- Alternative business forms avoid the CIT
- Alternative forms have grown recently
- Is the CIT a tax on being ‘public’?
- Distortion:  if taxes discourage being a C-Corp, then the discouraged firms miss out on the benefits of being public

**Notes:**
One thing to note about the CIT is that it only applies to corporations, specifically being organized as a “C-corporation” under the tax code.  Other forms of business taxation (e.g., property taxes that apply to businesses) do not distinguish different organizational forms.  The world is moving toward the primary characteristic of being subject to the corporate tax is having publicly-traded equity; firms without publicly-traded equity have several other possible organizational forms that avoid the CIT.  As Doug Shackelford reported in his presentation, these alternative organizational forms have grown over time and possible help explain the decline in corporate tax revenues.  It the tax system motivates these organizational form choices, then some firms incur a cost in avoiding the CIT.  This cost is the cost of not having access to public equity markets.  Since firms (and industries) differ in their costs and benefits of public trading, this distortion favors some activities over others.

## Investment

- Taxes can affect investment through:
- Tax Rates
- Tax Rules: e.g., depreciation rules
- Higher taxes & less generous depreciation rules increase the cost of capital
- Level of investment vs. type of investment
- Bottom line:  The tax system can have substantial effects on the amount and type of investment undertaken by corporations

**Notes:**
The effects of the corporate tax system on investment depend on both the tax rate schedule and the rules that govern the definition of taxable income.  In general, higher tax rates and less general depreciation allowances increase the cost of corporate investment.  Differences across types of assets or the ways in which assets can be financed can also create distortions in the type of investment (e.g., equipment vs. structures vs. intangible capital).  Some recent empirical studies (see Jason Cummins, Kevin Hassett, and R. Glenn Hubbard, A Reconsideration of Investment Behavior Using Tax Reforms as Natural Experiments, Brookings Papers on Economic Activity, 1994) suggest that the effects of the tax system can be substantial.  

## Financing:  Debt vs. Equity

- General wisdom:  the double taxation of corporate equity favors debt over equity
- Some offset due to investor-level taxation
- Evidence on taxes and over-leverage
- Relatively modest effects
- Other effects of distinguishing debt vs. equity
- The tax system favors industries or firms that have more access to debt
- A fault line for tax planning and tax sheltering

**Notes:**
The double taxation of corporate equity tends to favor debt financing over equity financing since interest is only taxed at the investor level but corporate earnings are taxed at the corporate level and at the shareholder level (either as dividends or capital gains).  This broad statement needs some fine tuning for the fact that investors are typically taxed more heavily on interest income (the return to holding debt) than on dividends and capital gains (the return to holding equity).  The overall effect of the tax system on corporate financial structure is probably a modest increase in the amount of corporate leverage.  On the high end of estimated effects, Roger Gordon and Young Lee (“Do Taxes Affect Corporate Debt Policy?  Evidence from U.S. Corporate Tax Return Data,” Journal of Public Economics, November 2001) estimate that cutting the corporate tax rate from 35% to 15% would increase the proportion of corporate assets financed by debt by 8 percentage points.  The economic cost of the tax system increasing corporate leverage is that it increases the costs of potential financial distress associated with the increased leverage.  In addition to changing corporate capital structure, the differential taxation of debt and equity can favor investment by firms or industries that have easier access to debt.  Lastly, the distinction between debt and equity creates some opportunities for tax planning and tax sheltering. 

## Financing:  Dividends

- The tax system can also affect firms’ dividend decisions
- Dividends vs. retained earnings
- Dividends vs. share repurchases
- Evidence from 2003 tax cut:  corporate dividends increased after the tax cut
- By distorting dividend policy, taxes can alter which firms have capital

**Notes:**
The overall tax system – corporate and personal income taxes – can also affect firms’ decisions about the level, timing, and form of distributions that it makes to shareholders.  While much of the ‘action’ along this margin comes from differential personal taxation of different types of returns (i.e., dividends and capital gains), some types of corporate-level tax reforms could also affect these incentives.  One common model of dividends suggests that the personal tax rate on dividends discourages dividends; instead, firms will either retain earnings or repurchase shares.  If firms retain earnings to avoid taxes even though they have weaker investment opportunities than other firms, then this distortion impedes the efficiency of capital allocation across firms.  (Other models of taxes and dividends – i.e., the “new view” – suggest that permanent changes in dividend tax rates may have little effect on corporate distributions but temporary changes in tax rates would affect dividend decisions.)  Evidence from the recent tax cut on dividends received by individuals indicates that dividends have increased in response to the taxes (see Raj Chetty and Emmanuel Saez, “Dividend Taxes and Corporate Behavior:  Evidence from the 2003 Dividend Tax Cut,” NBER Working Paper No. 10841, October 2004; and Jennifer L. Blouin, Jana Smith Raedy, and Douglas A. Shackelford, “Did Dividends Increase Immediately after the 2003 Reduction in Tax Rates?” NBER Working Paper No. 10301, February 2004).  Chetty and Saez argue  that their results on the changes caused by the rate reduction are “consistent with an improvement in capital allocation efficiency.”

## Summary of Distortions

- Corporate taxation creates a wide-range of economic distortions
- Organizational form
- Investment:  levels and type
- Financing and capital structure choices

## Conclusions

- Most of the burden of corporate taxation probably falls on the owners of capital
- The economic cost – in terms of distortions – from corporate taxation are wide-ranging and likely to be substantial

**Notes:**
While the incidence of the corporate income tax likely falls on the owners of capital and this burden may increase the progressivity of the overall tax system, any positive benefits of the corporate tax system and the revenue raised from taxing corporations must be weighed against the distortions created by the tax.  Of course, almost all taxes distort behavior to some degree so the fact that the CIT creates some distortions does not immediately make it a prime target for reform.  However, given the wide-ranging nature of the distortions from the corporate income tax and their importance in capital formation and the allocation of capital across uses, the corporate income tax seems like a part of the tax system that is a leading candidate for major tax reform.