Corporate Tax Integration: Incidence and Effects 

on Financial Structure 

J. Gregory Ballentine 

Charles E. Mclure, Jr. 

Comment 

Martin J. Bailey 
Corporate Tax Integration: Incidence and Effects 

on Financial Structure 

J. Gregory Ballentine 

Charles E. Mclure, Jr. 

Income derived from corporate equity that is used to pay dividends is taxed more heavily than are corporate interest payments 

or income derived from investment in the noncorporate sector.1 

Similarly, if retentions of corporate earnings result in fong-term 

capital gains, dividends carry an aggregate tax burden greater 

than that on retained earnings.2 The differential taxation of dividends and retained earnings can be expected to influence the dividend payout ratios of corporations. Beyond that, if firms have 

relatively high payout ratios or if combined (personal and corporate tax) rates on capital gains are high, earnings on corporate 

equity will be taxed more heavily than interest on corporate debt. 

If this occurs, we can expect debt-equity ratios to be skewed toward the issuance of more debt. Finally, depending upon several 

conditions-the relative reliance upon debt and equity finance in 

the corporate sector, retention rates, and the combined marginal 

tax rates on corporate debt, distributed earnings, and retentionscapital income originating in the corporate sector can be taxed 

1 

Under present law the marginal rates applied to ordinary income range 

~rom 0 to 70 percent. Thus the combined rate on distributed earnings ranges rom 48 to 84.4 percent. 

ta a The combined rates under the corporate income tax and the capital gains 

X .range from 48 percent to 73.5 percent. If we ignore gains and losses 

att~1butable to other causes, retentions theoretically should be reflected in 

c~p1tal gains. See Bailey (1969) for evidence that this has indeed happened istorically. 

J. GREGORY BALLENTINE is with the Department of Economics at 

Wayne State University and CHARLES E: McLURE, JR. is with the DePartment of Economics and Accounting at Rice University and the National 

Bureau of Economic Research. 

(243) 
244 COMPENDIUM OF TAX RESEARCH 

either more or less heavily than that originating in the noncorporate sector, with consequent effects on resource allocation and' 

output.s of the two sectors. 

In 1962 Harberger presented a general equilibrium model of 

incidence intended to capture the reallocation of capital that occurs in response to the differential taxation of capital in the corporate and noncorporate sectors. In designing the model he assumed that investors are indifferent between investments in the 

corporate ahd noncorporate sectors (though they may require a 

risk premium to reflect relative risks in the two sectors) and thus 

earn the same net return in the two sectors (again allowing for 

risk). Employing this model Harberger found that the corporate 

income tax reduces the total return to capital by approximately 

the amount of the tax, i.e., that capital bears the burden of the 

tax. Particularly noteworthy is Harberger's conclusion that the 

corporate income tax is born by the owners of all capital, not just 

owners of corporate shares. 

Harberger's model makes no distinction between debt and equity 

capital in the corporate sector and barely refers to the pref erential treatment of retained earnings under the capital gains tax. 

Thus, it can at best deal only with the intersectoral reallocation 

of capital; it can give no clues as to how the differential taxation 

of corporate debt, dividends, and retentions affects the financial 

structures of firms or how tax-induced readjustments of financial 

structures can affect the cost of corporate capital--questions that 

are important not only in their own right, but also as intermediate 

problems to be addressed in the process of answering such traditional questions as the incidence and resource-allocation effects of 

taxation. Finally, the traditional Harberger model can shed little 

light on the effects of various schemes for integration of the corporate and personal income taxes. 

This paper adds to the Harberger model a more realistic description of the corporate financial decision. 3 We retain the twosector model developed by Harberger, but allow for two distinct 

types of corporate securities-debt and equity. The return to the 

latter is composed of two components, dividends and retained 

earnings. As in the real world, gross corporate income is subject 

to the corporate income tax, and dividends are subject to the personal tax rate. Retentions are assumed to be taxed at some fraction of the personal rate. Capital in the noncorporate sector is 

11 After this paper was essentially completed, a paper by Feldstein, Green, 

and Sheshinski (1977) that discusses similar issues came to our attention. 

While we employ a static two-sector model, they employ a one-sector growth 

model. 
CORPORATE TAX INTEGRATION 245 

financed solely through the issuance of a financial asset, the income from which is subject to the personal income tax. For simPlicity, we assume that the personal income tax is proportionate 

to income. 

The key theoretical conclusion of this paper is that because investors do not see corporate debt, corporate equity, and investment 

in the noncorporate sector as perfect substitutes, the net rates of 

return on all these uses of capital need be neither equal nor 

affected equally by the corporate tax. Indeed, owners of corporate 

shares bear proportionately less of the long-run burden of the 

corporation income tax than do investors in the noncorporate sector. That is, the burden of the corporation income tax is overshifted to noncorporate investors rather than shared equally by all 

capitalists, as in Harberger's analysis! Investors in corporate 

debt, like corporate shareholders, bear less of the tax burden thaii 

Rarberger suggested. The practical significance of these conclusions is, of course, that the corporation income tax is even less 

Progressive than the Harberger analysis suggests, and the Harberger analysis itself is less progressive than if the tax were 

Inerely borne by shareholders. 5 6 

'This result is suggested by the following quotation from Barzel (1976): 

. !he corporate income tax is fundamentally an ad valorem tax. When such a tax 

Is Imposed or raised it can be evaded in part by switching to corporate financing 

based more on debt and less on equity. The risk borne by equity holders will then increase. The measured rate of return to equity, reflecting this risk, might exceed the 

change in the tax rate, giving the impression of more than 100 percent shifting. 

(p. 1185) 

It seems unlikely that the return to equity would rise by enough to suggest 

tnore than complete shifting. (Our reference to overshifting should be in-

~rpret;ed as being relative to the Harberger result of diffusion to all capitalists.) Moreover, Barzel does not mention the increase in risk premiums paid 

to debtholders induced by the rise in the debt-equity ratio. 

~ Harberger (1962) explicitly recognized the possibility that risk premiums 

nu~ht be affected by differential taxation, but he dismissed the problem as unimportant: 

· · · we must make clear that the "equali:zation" which our theory postulates is 

~qualization net of such risk premiums. So long as the pattern of risk differentials 

Is not itself significantly altered by the presence of the corporation income tax, our 

theoretical results will be applicable without modification. And even if the pattern 

of risk premiums applying to different types of activities and obligations has 

changed substantially as a result of the tax, it is highly likely that the consequent 

modification of our results would be of the second order of importance. (p. 137) 

Our analysis could be interpreted as an attempt to determine whether 

this dismissal was ill-advised. 

e The increase in risk premiums may help to explain Krzyzaniak and 

~usgrave's (1963) extremely high estimate of shifting of the corporate tax . 

. hereas they regressed the profit rate on the tax rate (and other variables), 

It might have been preferable to employ two-stage least squares to determine 

the influence of taxation on the corporate debt-equity ratio and then to regress the profit rate on the tax rate and the debt-equity ratio resulting from 
246 COMPENDIUM OF TAX RESEARCH 

We initially explain our addition of a corporate financial sector 

in the context of Harberger's standard differential equation 

model. But we estimate the effects of the present differential taxation of corporate-source income using a formulation of that 

model that allows us to simulate the exact effects of finite changes 

in taxes. Whereas Shoven ( 1976) has shown that linear approximations based on Harberger's model are reasonably accurate, 

there is no a priori reason to believe that the accuracy of the 

analogous linear approximations of the effects on financial structure and various return to capital are equally acceptable. 

The next section of this paper contains a review of the literature on corporate financial structure and its response to taxation 

that is particularly relevant to' our problem; it also gives a 

description of a model of corporate financial policy in the presence 

of taxes and the risk of bankruptcy (especially the firm's choice 

of an optimal debt-equity ratio) that is consistent with the main 

threads of that literature. A third section describes how the model 

of corporate financial policy can be integrated with the standard 

Harberger model; an important attribute of the model presented 

here is that the parts of the model describing input and output 

choices and those describing financial structure can be separated. 

This separability does not imply that input and output decisions 

are independent of financial decisions; because the firm's financial 

structure determines its cost of capital, input combinations and 

output decisions depend on financial decisions. But the influence 

runs in only one direction. Optimal debt-equity ratios (and dividend-payout ratios) depend upon differentials in taxation but not 

upon levels of inputs or outputs. 

In a fourth section of this paper we discuss the interpretation 

of the analytical results obtained using our augmented Harberger 

model. In a fifth section we employ our model to examine the 

effects of several schemes that have been suggested to eliminate 

the double taxation of dividends, including full integration of the 

corporate and personal income taxes. In order to analyze integration we must add a description of the corporate choice of a dividend-payout ratio. In the final sections of this paper we describe 

the technique used to simulate the effects of the present tax system and integration and present and interpret the results of that 

simulation. 

the first stage (plus other variables). Of course, the speed of adjustment of 

risk premiums needed to make this a reasonable explanation may be unrealistically high. 
CORPORATE TAX INTEGRATION 247 

Financial Policy and Taxes 

A substantial amount of literature is devoted to the proposition 

that under certain conditions the value of a firm is independent 

of that firm's financial structure, i.e., that there is no optimal debtequity ratio. 1 An important corollary of that proposition is that 

the firm will finance its operations entirely from the source of 

funds that bears the lowest rate of taxation, i.e., that firms will be 

financed 100 percent from debt, given present patterns of taxation. 8 A further implication of this line of reasoning is that the 

corporation income tax does not exert the distortionary influences 

described earlier, because it does not affect the marginal cost of 

capital.9 

Crucial to all demonstrations of the so-called Modigliani-Miller 

( 1958) hypothesis of the irrelevance of corporate financial structure is the assumption that bankruptcy is impossible. As Stiglitz 

0972) has shown, if there is a positive probability of bankruptcy, corporate financial structure is not irrelevant for the valuation of the firm, and there is an optimal debt-equity ratio. Of 

more immediate relevance for present purposes, if bankruptcy is 

Possible, as Stiglitz has noted, ". . . the tax advantages of debt 

Would increase the debt-equity ratio from what it would have 

been otherwise, but would not result in the firm going to an 'all 

debt' position" ( Stiglitz, 1973, p. 23) . The corporation income tax 

is not, therefore, irrelevant in a world in which bankruptcy is 

Possible. Scott ( 1976) has attempted to model both the firm's 

choice of an optimal debt-equity ratio and the response of that 

optimal ratio to the differential taxation of debt and equity in a 

World in which bankruptcy is possible. He found that the optimal 

debt-equity ratio is an increasing function of the corporate tax 

rate. 

Our description of the optimal debt-equity ratio is in the spirit 

of the analyses by Stiglitz and Scott. But it abstracts from many 

complexities in order to simplify the analysis and focus attention 

on our key purpose-integrating the corporate financial decision 

into a general equilibrium model of incidence. In particular, Stiglitz and Scott use partial equilibirum analysis to consider the imPlications of taxes and/ or the risk of bankruptcy on the firm's 

optimal debt-equity ratio; but because of the complexity of the 

Problems, they have difficulty obtaining comparative-statics re7 See Modigliani and Miller (1958) for the initial statement of this theorem and Stiglitz (1974) for a restatement under less restrictive conditions. 8 See Stiglitz (1973) for an elegant demonstration of these conclusions. 

'See Stiglitz (1973). 
248 COMPENDIUM OF TAX RESEARCH 

suits, and they make no pretense at general equilibrium analysis. 

By comparison, our description of the risk of bankruptcy is deliberately vague and somewhat ad hoc, and it is based ultimately 

upon the availability of empirical estimates of key parameters. 

J3ut we are able to employ it in a general equilibrium analysis 

from-which we obtain comparative-statics conclusions about the 

incidence and financial effects of taxation. We assume (a) that 

investors are not indifferent to the corporation's debt-equity ratio, 

but demand increasing risk premiums on both debt and equity as 

the debt-equity ratio rises, and (b) that the firm minimizes the 

cost of obtaining the amount of capital it needs by adjusting its 

debt-equity ratio. Shareholders require larger returns as the debtequity ratio rises because the increased fixed charges for interest 

inherent in increased leverage implies an increased coefficient of 

variation of equity earnings. Bondholders require a higher interest rate in the same circumstances because the increased coefficient of variation in earnings implies a greater likelihood of suspension of payments-and,' ultimately, bankruptcy.10 With this 

background we can describe our model of corporate financial behavior.11 

10 Tambini (1969) has stated this well, noting that risk premiums rise 

with the debt-equity ratio: 

The main problems are whether, why, and by how much the marginal cost of 

debt and equity differ from their average costs. These are different stages of the 

same question. The basic point is that a change in financial structure affects the 

riskiness of corporate capital, that is, of debt and of equity, and so it affects their 

required rates of return and their cost to corporations. In particular, an increase 

in debt financing, or leverage, increases the riskiness of the firm (and vice versa 

for a decrease in leverage), and therefore the risk for debt-holders (lender's risk) 

and the risk for stockholders (borrower's risk). The main reason for the change 

in the lender's and borrower's risk is that, given ~he probability distribution of expected income from capital, the payment of fixed charges, like interest, leaves the 

dispersion of the distribution of corporate profits unaffected, but with a smaller 

mean. The ratio of the standard deviation to the mean of profits-the coefficient of 

variation-provides us with one measure of risk. On the assumption that stockholders have an aversion to risk and prefer a more certain to a less certain income 

stream, an increase in debt, by increasing the coefficient of variation of earnings of 

equity-holders, would cause an increase in borrower's risk. Similarly, an increase 

in the coefficient of variation of earnings increases the probability of negative 

profits, of a suspension in interest payments, and therefore of lender's risk. Of more 

weight still is the fact that the increase in the coefficient of variation increases the 

probability of gambler's ruin, i.e., of bankruptcy on the assumption that bankruptcy is a function of the total "loss" accumulated over one or more years. 

A second (possibly alternative) measure of risk for debtholders and stockholders 

is the ratio of debt to the market value of equity, DIE. The meaning of the ratio 

is intuitive for debtholders, as the market value of equity can be viewed as an 

estimate of what is left after having paid all other claimants: it is therefore a 

cushion or a measure of security. Since equity is the present value' of expected 

profits, an increase in the DIE ratio increases the probability of bankruptcy, and 

hence borrower's risk. (p. 196) 
CORPORATE TAX INTEGRATION 249 

The Model 

Corporate capital (K:,;) can be financed from either debt or 

equity. Let E be that portion of the capital stock in the corporate 

sector that is financed by equity and B, the portion financed by 

debt. Thus 

(1) 

The cost of debt capital in the corporate sector (P,,x) is given by 

the following simple expression: 

(2) 

Where i,, is the net of tax return and t,, is the personal tax rate 

applied to interest payments, there being no corporate tax on 

intere.st. 12 13 At this point we do not distinguish between retentions 

and dividends and differences in their taxation. Thus, the analogous expression for the cost of corporate equity. capital (Prx), to 

be elaborated further in a later section, is: 

P ex= ie ( 1 + te), ( 3) 

Where ie is the net of tax return on corporate equities and te is 

the aggregate (corporate and personal) tax rate applicable to the 

return to equity capital. 

Combining equations (1), (2), and (3), we can write the following expression for the cost of a given corporate capital stock: 

(4) 

The net return to corporate equity (ie) and the net interest rate 

on corporate debt (i,,) depend (positively) upon the corporate 

debt-equity ratio (B/E), reflecting the risk of bankruptcy associated with leverage. That is, taking the net return to capital in 

the non corporate sector (in) as a benchmark, we express the 

11 Tideman and Weber (1977) employ a similar description of the corporate financial decision but utilize it to examine the effects of integration 

on saving rather than in~idence. 12 

In describing the financial sector it will be convenient to use i, properly 

bu~scripted, to indicate net returns to various forms of investments and to 

uild up costs of capital from the net returns and relevant taxes. 

h Besides allowing us to avoid extremely messy notation, this convention 

elps to highlight the separation of the real and financial P.arts of the 

lnodel discussed further later. 13 .Both the return to noncorporate capital and interest on debt are presently 

subJect to the personal income tax. Thus, we could set tk11 and tb equal to 

each other and the (constant) marginal personal tax rate tp. We do not do 

so .at this point because maintaining separate notation will allow us better 

to Identify the roles played by various differentials in taxation. 
250 COMPENDIUM OF TAX RESEARCH 

ratios of ie to in and ib to in as increasing functions (f and g) of 

B/E: 14 

(5) 

and 

(6) 

Given this state of affairs, the firm attempts to minimize the cost 

of financing its capital stock by choosing the optimal debt-equity 

ratio. Substituting from equations ( 1), ( 5), and ( 6) into equation 

(4) and differentiating with respect to B (which is equivalent to 

differentiating with respect to B/E, since B+E is constant), we 

obtain the following first-order condition: 

i, c1 +t.> -i.(1 +t,) +.:.( i+ ; ) [ g'; <i+.t,) + f' (l+ t,) J ~o. (7) 

This expression has a ready explanation. A change in the amount 

of capital financed by debt, given the total corporate capital stock, 

raises the cost of capital by an amount equal to the cost of debt 

(the first term), but reduces it by an amount equal to the cost of 

equity (the second term). But the rise in the debt-equity ratio also 

induces a rise in both the returns that must be paid on corporate 

securities. Thus, in total, the cost of capital rises. by the difference 

in the first two terms plus the third term, which indicates how the 

total cost is affected when both debt and equity become more expensive because of investor reluctance to invest with the higher 

debt-equity ratio. 

Figure 1 may assist in understanding our analysis of the firm's 

choice of optimal financial structure. In it we measure the fraction 

of the firm's capital stock that is debt-financed(_!!__) along the 

B+E 

horizontal axis from the left; the fraction financed by equity is 

measured from the right. The curves labeled ib and ie indicate the 

ratios of the returns that must be paid on corporate debt and 

equity at various debt-equity ratios (ratios of B to B + E, to be 

more precise) to in in the absence of taxes. Though we have drawn 

the left-hand intercepts of both ib and ie to exceed unity, indicating 

14 These functions may take on a form such as the following: 

i.!in=C(B!E)"+ V 

and 

(5') 

(6') 

The constants are required because the equations cannot take on a zero 

value when B=O. But whether V and W are greater or less than unity cannot be known. 
CORPORATE TAX INTEGRATION 251 

FIGURE 1.-The choice of an optimal tlebt-equity ratio 

'·* 1

bt -------

i .o _________ __,,....!...---+--------__.1.0 

_!!I._ E 

B+E ... ~ B+E i 

B+E 

a Positive risk premium on both corporate securities at a zero debtequity ratio, this has been done primarily to avoid confusing the 

diagram ; this placement has no other significance. On the other 

hand, it is necessary for an interior solution that the left-hand 

intercept of ie be above the left-hand intercept of i,,. Otherwise, 

the optimal debt-equity ratio would be zero.15 

• 15 Similarly, m . must intercept the right-hand axis below the right-hand 

intercept of mb if 100 percent debt financing is not to be optimal. Of course, 

as 100 percent debt financing is approached ~t can be expected that both risk 

Premiums approach infinity. For our purposes all that is required is that 

m . and m b intersect. 
252 COMPENDIUM OF TAX RESEARCH 

While ie and ib indicate the average cost of corporate equity capital and borrowing, they do not show the corporate sector's marginal costs of the two sources of finance. Thus, to illustrate the 

choice of an optimal debt-equity ratio, we must add me and mb, the 

two curves that are marginal to ie and ib. In the absence of taxes, 

the intersection of these two curves reveals the optimal debt-equity 

combination (~). With that financial structure, the return 

B+E 

to equity is"i• and the interest rate on corporate debt is i*. e b 

In anticipation of the next section, we can note the effect of a 

tax applied only to corporate equities. Such a tax would cause both 

the ie and me curves to shift upward. The intersection of the new 

marginal cost curve ( m' ) and mb occurs farther to the right; e 

that is, the tax increases the optimal debt-equity combination 

( to ~)· Moreover, and of special interest in the analysis of tax 

B+E 

incidence, both ie and ib rise relative to .i10 as shown by their values 

at the new optimal debt-equity ratio, i:t and i:t. It is for this reason 

that we say that holders of corporate securities bear less of the 

oorporation income tax than Harberger suggests ; this contention 

is examined further in a later section. 

Combining the Real and Financial Models 

It can easily be shown that in the standard Harberger model the 

equilibrium values of key variables depend upon the relative costs 

of capital in the corporate and noncorporate sectors. Of special 

interest for our purposes is the following expression for the change 

in the cost of capital in the noncorporate sector resulting from a 

change in the relative costs 'of capital in the two sectors: 

(8) 

where " over a variable indicates percentage change and H is as 

indicated by Ballentine and Eris ( 1975, p. 635, equation 3). 

Given that capital is assumed to earn the same rate of return in 

both sectors, we know that 

A "' A Pkg)=Pk+ (l+tkz), A A A 

Pk,;= Pk+ (1 + tkv), 

and 

(9) 

(10) 

(Sa) 
CORPORATE TAX INTEGRATION 253 

Thus, once we know Pk11 from equation (8), we can use equation 

(10) to solve for Pk, which is vital for incidence analysis. We 

could also determine the changes in such variables as Ka;, La;, X, Y, 

~~and P11 from equations analogous to equation (8), but our attent~on will focus instead on fitting the description of corporate financial policy contained in equations (1) through (7) into equation (8). 

Before turning to the differentiation of the equations describing 

financial policy that is necessary to allow us to combine the model 

of financial policy with the basic Harberger model, it will be useful to demonstrate that this combination will, in fact, be quite 

simple. We begin by writing the cost of capital in the noncorporate 

sector as the net return to investment in that sector augmented by 

the personal tax rate: 

Pk11 =in (1 + tn). (lOa) 

Next we can rewrite equation (4) as 

Pk41=i11(1+t,,)~+ie (l+te)~. (4a) B+E B+E 

Dividing Pk11: by Pk11 and rewriting Bl (B+E) and El (B+E), we 

obtain 

Pka7=~ BIE + ie (l+t0 ) 1 (

4b) 

Pk11 ~ 1+ (BIE) in (l+t,,) 1+ (BIE) 

Since in equations (5) and (6), i11 1in and ielim are functions of 

B/E, equation (4b) states Pk11:IPk11 as a function of BJE and the 

tax rates. But if equation (7), which determines the optimal debtequity ratio, is divided by in, it is clear that BIE is itself an imPlicit function of t,, and t 6 • This means that we can use the financial model equations (5), (6), and (7) to write Pk:r:IPk11 as a 

function of t,, and t 6 • This in turn implies that 

d (Pk11:/P7c11) A A 

p /P =Pu-Pk11 

ka; k11 

~n be written in terms of 1.+t,, and 1.i~e· Finally, Pk11:-Pkt1 can be 

inserted into equation (8) to solve for Pk11• With that solution, all 

the remaining variables can be calculated. 

In order to derive the differential equation relating BIE to to 

and t,,, let us write d (BIE) as follows: 

d(B/E) d(B/E) dt + d(B/E) dt. (11) 

dte e dt.,, b 

To solve for the right-hand side, we divide equation (7) by in, 

obtaining an implicit function of the form 
- - ~~ 

254 COMPENDIUM OF TAX RESEARCH 

F(BIE, t,,, te) =0. (7a) 

By the implicit function theorem we know that 

d(BIE) -oFlote 

dte oF lo (BIE) (12) 

and 

d(BIE) -oFlot,, 

dt,, oF lo (BIE) (13) 

Solving equation (7a) for these partial derivatives, we obtain: 

--="7"-f' 1+- , oF ic ( B) 

ate in E (14) 

_ oF =~-g'.!!_( l+~) ot,, in E E ' (15) 

and 

O(;~E) ( 1+ !) [ 2g' (l+t.) + g"; (1 +t,) + /" (l+t,)J. (16) 

Substituting sequentially from equations (14), (15), and (16) 

into equations (12) and (13), and from there into equation (11), 

and converting to percentage changes, we obtain the following key 

equation: 

B "" ""' E (B-E) = 

c1+t,>[{:--r(1+~) J c1+t,> - c1+t,i[~+(i+~~u'] <1+t,J 

( 1+ !)[ 2(1+t,)g'+ (l+t,) !u"+ (l+t,,)/" J 

(17) 

But we see from equation (7) that the terms premultiplying 

(l+te) and (1.+t,,) in the numerator are equal to each other. 

Equation ( 17) can therefore be written as 

B-E= (l+t,>[ ~~+( l+~)u' J [ (l+t,) - (l+t,) J. (l

7

a) 

J 

where J is the denominator in equation (17). For ease of future 

reference, we can also rewrite this equation as A A A A 

B-E= Q[ (1 +te) - (l+t,,)]. (17b) 

Since the numerator of Q is unambiguously positive, Q will carry 

the sign of its denomnator. But J is simply the first derivative of 

equation (7) with respect to B/E, i.e., the second-order condition 
CORPORATE TAX INTEGRATION 255 

for minimizing the cost of capital with respect t.o the debt-equity 

ratio. Thus J-and Q-must be positive. Equation (17a) tells us 

.that the debt-equity ratio must rise if the tax on equity rises relaive to that on debt and by how much it will rise. 

The next step is to differentiate equation ( 4a) in the logs. The 

result can be written in the following two equivalent forms: 

pkz=8,,[i,,+ (1.+t,,)] +Oe[ie+ (1.+te)] +(811~-()e~)(B-E) . B+E B+E 

(18a) 

() [

" A A A 

= b i,,+ (l+t,,)] +Oe['ie+ (l+te)] 

+ o,,_!__[i" <1 + .t,,> -ie <1 + te> J <B-E>, (lsb > 

B+E i,,(l+te) 

Wh . Bi,, ( 1 + t,,) . ere o,, is , the fraction of the gross return to capital . (B+E)Pk:z; 

in the corporate sector accruing to bondholders, and Be is the share 

accruing to owners of corporate equities. If we now differentiate 

equations ( 5) and ( 6) in the logs, we obtain 

f' B "" A ie-in=f E (B-E) (5a) 

and 

.. .. g' B A A. 

i,,-in=--(B-E) (6a) gE 

'I'hese can be rewritten as follows: I'\ A 

ie = 7Je ( B - E) +in (5b) 

and 

A A 

i,, = 'Y/b ( B - E) +in. ( 6b) 

~n this formulation 'Y/e and 7/b relate the percentage changes in 

1

el ~ and i,,/ in to the percentage change in the debt-equity raitio, 

and are therefore elasticities. 

Substitution from equations ( 5b) and ( 6b) into equation ( 18b) 

~ields the following: 

p " A A A A 

k~=in+ [8,,(l+t,,)Oe(l+te)] + (Ob'Y/b+()e7]e) (B-E) 

+()b~[i,,(1+.t,,) -ie(l+te) J (B-E). (19) 

E + B i,, ( 1 + t,,) 

'I'his equation has a simple explanation, based on the meaning of 

each of its terms. The cost of corporate capital rises, all else equal, 

by the same percentage amount that the net return to noncorporaite 

capital rises (in). But the costs of corporate and noncorporate 

capital differ because of the risk premiums and taxes on the two 
- - - ~ -- - - - - - ---- ----

256 COMPENDIUM OF TAX RESEARCH 

forms of return to corporate capital ; the remaining three terms 

capture these influences. The divergence between Pk "' :c and in is 

widened to the extent that the two taxes on the return to corporate 

capital increase; as indicated in the second term, (1 i tl» and 

(1 f'-te) are weighted by the shares(),> and Oe. 

As indicated in the third term of the equation (19), an increase 

in the debt-equity ratio increases the risk premiums (or ratios of 

ib and ie to in) by 7/b and 7/eJ weighted by debt and equity's share in 

the total gross return to corporate capital. However, an increase in 

the debt-equity ratio also shifts the financial s'tructure of the firm 

toward the least expensive means Gf finance. Since the firm is continually choosing a debt-equity ratio that minimizes its cost of 

capital, these two effects must cancel out (i.e., 0Pk:c/d(B/ E) =0 is 

the cost-minimizing condition). Collecting the third and fourth 

terms of equation ( 19) and using the first-order condition equation (7), it can be shown thart these terms do indeed drop out, leaving simply ;'\ A A 

Pk:c =in+Ob(l+tb) +Oe (l+te). (19a) 

That is, the percentage change in Pk:c is merely in plus the weighted 

average of (l+tb) and (l+te). 

Equation ( 19a) plays the :Same role in our analysis as does 

equation (9) in the standard Harberger model. The implication of 

this is worth emphasfaing. Although the differential taxation of 

debt and equity induces corp{>rations to change their relative reliance on debt finance, the change in the debt-equity ratio does nort 

directly affect the relationship between the return to capital in the 

noncorporate sector and the cost of capital in the corporate sector, 

so long as corporations minimize :the cost of capital.16 This result 

occurs· because the rise in the debt-equity ratio has two off setting 

effects on the cost of corporate capital: the rise in the risk premium is exactly offset by the reduction in the cost of capital resulting from the shifit from the expensive to the inexpensive 

means of finance. 

Interpretation of Results 

Replication of Harberger Analysis 

It may be worthwhile to pause at this point to note that the 

essential features of the results of the original Harberger analysis 

16 Thus, if the taxes on equity and debt were changed in opposite directions by enough to keep"'the total tax burden on corporate capital unchanged 

[i.e., if 8b(1+tb)+e. (l+t. )=0], Pkzlin would be unaffected, despite the induced shift in BI E. 
CORPORATE TAX INTEGRATION 257 

can be replicated in the context of the present model. Suppose that 

~ + tb and 1 + te are raised by the same percentage amount (from 1, 

lf this analysis is to be exactly comparable to Harberger's original 

a?~lysis). In that case equation (19a) becomes identical to equation (9), except for the change in notation, and the Harberger 

solution for Pk becomes applicable for in. Moreover, we can see 

from equation (17b) that this equal percentage change in the 

taxation of corporate debt and equity leaves the debt-equity ratio 

Unchanged. Thus, from equations (5a) and (6a) we know that ic 

and ib experience the same percentage change as in.11 

A more faithful description of the effects of the present tax 

treatment of corporate-source income would, however, involve 

differential taxation of debt and equity; to simplify matters, let us 

analyze briefly the case in which interest on corporate debt is 

taxed at the same rate as the return to investment in the noncorPorate sector but the return to corporate equity is taxed more 

heavily. Since a uniform tax on all return to all capital would reduce the return to all capital by the amount of the tax without 

causing any distortions (as in the standard Harberger model) , we 

need examine only the case in which (1 + tc) pertains only to the 

diff erent'ial taxation of equity . 

. Inspection of equation (19a), together with an appreciation for 

its role with equations (8) and (10), reveals that this differentially heavy tax on equity capital will have exactly the same relative 

effect on in as tkx has on Pk in the standard formulation, except for 

the scale factor Oe, resulting from the fact that only a portion, Oe, 

of the total gross return to _capital in the corporate sector is being 

taxed. Analogous statements can, of course, be made about the 

effects of this tax on the values of all other real variables. In this 

sense we again replicate the results of the Harberger analysis. In 

addition, however, we obtain other results. As indicated in the discussion of figure 1 and the algebra of this section (equations 17 a, 

5a, and 6a), imposition of a tax on corporate equity, by inducing 

firms to increase their debt-equity ratios, increases the risk premium demanded by investors in both corporate debt and corporate 

equity. As a result, the returns to investments in these securities 

decline by less than they would in a riskless world in response to a 

given rate of tax levied on the return to corporate equity .

18 

-----

t 17 lf, in addition, in=ic=ib in the initial situation, then di11=die=dib, and 

he Harberger result would be exactly replicated. We cannot, however, gen-

~i-ally kno~ t~at the first set of equalities holds, and so must be content to 

now that in=i =~· 18 Care must be taken in comparing the results presented here with those 

froni the original Harberger model. The statements in the text make such 
258 COMPENDIUM OF TAX RESEARCH 

The Incidence Concept 

In the original formulation of the Harberger model, the change 

in the real income of capital on the side of sources of income could 

be expressed as 

(20) 

Since by assumption dK is equal to zero, and since capital receives the same rate of return in both sectors, the change in income on the sources side is determined entirely by the change in 

the return to capital, dPk. 

In the present model the interpretation of incidence is somewhat more complex. This is because some of the change in ib and 

ie is simply a compensation for risk-taking and does not reflect a 

change in welfare. Nonetheless, we shall follow Musgrave's classical definition of incidence as the "change in the distribution of 

income available for private use" (Musgrave, 1959, p. 207). 

Under this interpretation, changes in capital income resulting 

from changes in risk premiums would be counted like any other 

changes in income.1 9 20 So far as changes in the functional distribution of income are concerned, this is the measure of incidence we use, i.e., we calculate the change in the total income of 

capitalists. 

While the measure just described is useful in describing changes 

in the functional distribution of income, it tells us little about the 

a comparison for a given tax rate. Applying the scale factor Be makes the 

results of effects on the real sector directly comparable. But a given taxrate change has less impact in our model since it applies only to a portion 

of capital financing. 1 9 Another interpretation is also quite reasonable. In the original formulation of the Har berger model there is no risk premium; nor is there any 

reservation use of capital. From the economy-wide standpoint, all capital 

income is therefore a rent, and any increase (decrease) in that income is a 

dollar-for-dollar benefit (loss) to capitalists. In our model, however, pa.rt 

of the income of those who invest in corporate bonds and equities is a risk 

premium over and above the return available in the noncorporate sector, one 

that must be paid to compensate for the riskiness of those assets. As a 

result, part (or all) of a given increase in capital income may be due to an 

increase in risk premiums. Increases (decreases) in income reflecting higher 

risk premiums are not necessarily dollar-for-dollar gains (losses) to capitalists. For a similar line of reasoning applied to tax-induced changes in work 

effort, see Feldstein (1974). Thus, a second measure of functional incidence 

might be simply the change in in. ~Feldstein, Green, and Sheshinski (1977) recognize this same problem. 

While we choose to ignore welfare changes and concentrate on income changes, 

they assume that the debt-equity ratio is constant, and thus that risk premiums are constant and income changes reflect welfare changes. To avoid 

either our simplification or that used by Feldstein, Green, and Sheshinski 

would require a more complete analysis of risk and risk aversion. 
CORPORATE TAX INTEGRATION 259 

changes in the distribution of income by income classes. For the 

latter we need to know the tax-induced changes in ib, ie, and ~ 

and the ownership of corporate debt, corporate equities, and noncorporate capital in various income classes. In a later section we 

Present some tentative conclusions about the incidence of the 

corporate income tax and the various means to integrate the income tax; we then compare those results with those suggested by 

the standard Harberger analysis. 

Integrating the Income Taxes 

Thus far we have dealt entirely with equity capital and its return in quite general terms, without specifying whether the returns take the form of dividends or capital gains. If all corporate 

Profits were distributed, if dividend payout ratios were insensitive 

to tax policy, or if both dividends and capital gains were taxed 

at the same rates (in present value terms), this specification 

Would be adequate. In reality, however, not all profits are distributed, capital gains are ~xed less heavily than dividends, and 

there is empirical evidence that payout ratios do indeed respond 

to the relative taxation of dividends and capital gains. Thus, in 

order to provide a realistic model of the incidence of the corPoration income tax, and especially in order _:to be able to model 

the effects of integrating the income taxes, we must add to our 

lllodel a description of corporate dividend policy. 

Why corporations pay dividends is a more difficult question than 

Why corporations do not finance their capital needs entirely from 

debt. Given perfect capital markets, retained earnings could be 

converted to cash, and shareholders would be more or less indifferent between dividends and retentions. Retentions would be 

Preferred only because they are taxed more lightly than dividends; but given differential taxation, there would be no reason 

to Pay dividends at all. 

. Of course, capital markets are not perfect (especially for lowincorne individuals), and at least some shareholders are likely to 

Prefer dividends to retentions if tax considerations are ignored. 

~oreover, corporate managers may be expected. t.o prefer financing expansion from retained earnings over paying out dividends 

and then having to go to capital markets with new issues. Augmenting corporate managers' preference is the tax discrimination 

against distribution noted earlier. On balance, then, there is 
260 COMPENDIUM OF TAX RESEARCH 

likely to exist an optimal dividend-payout rate that balances the 

preferences of high- and low-income shareholders and corporate 

managers. This optimal payout rate can be expected on a priori 

grounds to depend upon the relative taxation of retained and distributed earnings. 

Feldstein ( 1970) has estimated the response of British dividend-payout rates to tax-induced changes in the opportunity costs 

of retained earnings. He found that when this opportunity cost 

was raised "from £0.68 per £ to £1.0 per £ (a little less than 50 

percent) by the elimination of a surcharge on corporate distributions, the ratio of corporate income paid as dividends rose by 

somewhat more than 40 percent. (This estimated elasticity of 

about 0.90 has since been reestimated at a;bout 0.50 by King, 

1971.) Similarly, Brittain (1964; 1966) has found that dividendpayout ratios are also affected by the relative t.axation of dividends and capital gains under the personal income tax. 

The following description of the tax effects on the dividendpayout ratio, while somewhat less sa;tisfactory than that of the 

debt-equity choice, seems indicative of the nature of the problem, 

reasonable, and generally consistent with the discussion of theoretical underpinnings and empirical results just presented. 

Assume that corporate income results in a flow of dividends net 

of all personal and corporate taxes of D and a net flow of retained 

earnings of R. 21 The gross amounts of corporate income needed 

to pay these net dividends and provide these retentions are 

D ( 1 +ta) and R ( 1 +tr), respectively, where ta and tr include both 

the corporate income tax and the relevant personal taxes (to be 

discussed further later) . Thus, the per unit cost of equity capital 

is 

. ( D(l+ta) +R(l+t,.) 

ie l+te) = E • (21) 

By comparison, the net return on equity is 

(22) 

21 In this case R must be net of the corporate tax and the present value 

equivalent of the tax eventually to be collected on capital gains resulting 

from retentions. 
CORPORATE TAX INTEGRATION 261 

Assume further that the reduced-form relationship between 

retaining earnings and paying dividends can be described as 

follows: 22 

(R/ D) v(~::J (23) 

Differentiating equation (23) in the logs, we can also write: 

R-D= -~e[(l.+t,.) - (l+tci)], (23a) 

Where e is the reduced-form elasticity of substitution between 

the two kinds of net return to equity capital. Several characteristics of equations (23) and (23a) are worthy of mention. First, 

equation (23) is not based upon cost minimization similar to 

that in our description of the determination of the optimal debtequity ratio. Rather, it is intended to describe the outcome of the 

interaction of the preferences of managers and investors, as determined by tax considerations; that is, it is a reduced-form exPression for the dividend-payout ratio resulting from the ( unknown) optimization by corporate managers and shareholders. 

This being the ca.se, it is somewhat less satisfactory than our 

description of the optimal debt-equity ratio. Second, equation 

(23a) describes only the response of the dividend-payout ratio to 

changes in tax differences. This formulation is generally consistent with the results of Feldstein (1970), who found that 

While the dividend-payout ratio depended upon the tax treatment 

of dividends and retentions, it was independent of the magnitude 

of earnings available for distribution. 

Third, it should be noted that R/D, the logarithmic differential 

of which is R-D, is not uniquely related to the corporate payout 

(or retention) rate, as usually defined. Net dividends D differ 

from gross dividends by the amount of the personal tax. Similarly, 

22 Figure 2 may help to illustrate 

the origin of equation (23). Assume 

t~at there is a given quantity of equity capital and no tax on retained 

earnings. We can then use (l+t.i) to 

stand for (l+t.i)/(l+tr) and D!Ei • 

. <tnultiplying by Eic/R), for DIR. It 

is reasonable to believe that if divid~nds are taxed highly, few dividends 

~Il~ be paid and that the quantity of 

dividends will depend inversely on the 

tax rate applied to dividends. This relationship is shown by the curve D in 

the diagram. The elasticity l:. in 

equation (23a) is analogous to the 

elasticity of curve D. 

FIGURE 2 

D 

D/Eie 
262 COMPENDIUM OF TAX RESEARCH 

R is retentions net of the personal tax on the gains they produce. 

Thus D differs from the percentage change in personal taxes on 

dividends, and similarly for R. Changes in the payout (retention) 

ratio can, of course, be solved utilizing this identity. Even though 

corporations may not actually visualize the choice in these terms, 

we have chosen to employ equation (23) rather than an analogous 

expression in terms of gross dividends and retentions, because 

(a) optimal financial policy should be based on net dividends and 

retentions, and (b) the concepts of gross dividends and retentions 

become fuzzy once we admit the possibility of various schemes for 

integrating the income taxes. This second point can be clarified 

by considering alternative but equivalent methods of providing 

dividend relief. Suppose retained earnings are constant. If relief 

is provided at the shareholder level, gross dividends might appear 

not to be affected, even though net dividends rise. But if relief is 

provided at the firm's level, both gross and net dividends would 

rise. The formulation of equation (23) avoids this ambiguity. 

If we differentiate equations (21) and (22) in the logs to obtain 

(unwritten) equations (21a) and (22a) and substitute from 

equations (22a) and (23a) into equation (21a), we obtain the 

following expression : 

( 1 + tc = Odg ( 1 + td) + Org ( 1 + t,.) 

+OrOdg[~J~c[(l.+t,.)- (1.+td)], (24) l+td 

where 0,. is net retentions as a fraction of net dividends plus net 

retentions [O,.=R/ (R+D)] and Odu is gross dividends as a fraction of gross dividends plus gross retentions, 

Odu=D (1+ td) /[R(l +t,.) + D (l+td) ]. 

If we were interested in changes in the taxation of dividends and 

retentions per se, as well as in the overall taxation of the return 

to equity capital, we would substitute from equation (24) into 

equation (19a). Moreover, equation (24), expanded further, is 

useful in the analysis of integration of the income taxes. 

If retentions and dividends are initially taxed at equal rates 

( td = t,.) , the percentage increase in the tax on the return to equity 

(1 + tc) is simply the weighted average of the percentage increases in the taxes on dividends (1 + td) and retentions (1 it,.). 

If the two returns to equity are taxed differently, there will, however, be adjustments in the dividend-payout ratio that tend to 

augment or off set some of this primary effect. That is, suppose 

that dividends are taxed more heavily than retentions and that 

the tax on dividends is raised. In addition to the direct result 
CORPORATE TAX INTEGRATION 263 

measured by the first term in equation ( 24) , the increase in td, 

causes a shift toward retained earnings-the lower-taxed means 

of finance-which offsets some of the direct effect. Had an increase in the tax on retentions been at issue, the tax-induced shift 

in financial structure would have been toward the more heavily 

taxed source of finance, augmenting the primary effect. Finally, 

if 8du(l~td) were set equal to -OruO+tr), there would still be an 

effect on (1 + te), because of the tax-induced shift in the payout 

rate.23 

In the context of this model, integration of the income taxes involves adjusting either td or both td and tr to make them equal to 

tb and tn, which are, in fact, equal. That is, integration for dividends only would involve setting td equal to the tax rate on ordinary income, without altering the tax on retained earnings. Such 

a policy would, of course, stimulate dividends (equation 23) and 

encourage less reliance on debt finance (equations 17 a and 24) . 

Fun integration for retained earnings as well as dividends would 

have similar (but probably less extreme) effects on the dividendPayout ratio and debt-equity structure of the corporate sector. 

Moreover, both policies would reduce the risk premiums now being 

~aid to owners of corporate securities. These effects are simulated 

in the following two sections. 

Before turning to the simulation exercises, we must further define td and tr. These can be written as 

1 + td = ( 1 + t 0 ) ( 1 + tP) ( 25a) 

and 

1 + tr= ( 1 + t 0 ) ( 1 + ,Btp) , ( 25b) 

Where tc is the corporate tax rate, tP is the personal tax rate, and 

f3 is the fraction of retained earnings that are included in the personal tax base, on a present-value basis. 

N •We must~ote one potentially unsatisfactory characteristic of this model. 

ote that (1 +tr) can be negative, for an increase in (l+td), if 

l+t, 1 l:.,>--·-. 

ttl-tr Br 

;'hat is, if l:. exceeds unity by enough, an increase in the differentially hea.vy 

ax on dividends could cause so much shift toward the low-taxed use of mc?me (retentions) that the average tax ratie on equity would fall rather than 

:ise. While this result would appear to be a logical possibility, it is ignored 

~n What follows since, as noted above, even Feldstein's estimate for l:., of 

.. 9 has been questioned as being too high. It may be asked why, if this result 18 Possible, the firm had not already adopted a lower payout ratio in order 

to minimize its cost of capital. The answer is that shareholders prefer to 

r~eive dividends but are dissuaded from doing so to such an extent by the 

lgher tax on dividends. The switch to retentions could be great enough to 

offset the higher tax on dividends. 
264 COMPENDIUM OF TAX RESEARCH 

The Simulation Model 

In this section we sketch the outlines of the simulation model 

used to derive numerical estimates of the effects of various tax 

policies on financial structure and the returns to different types. 

of capital; the model is exposited in detail elsewhere (Ballentine, 

197S). In the next section, we present estimates of the results of 

(a) eliminating the corporate income tax, (b) integrating the income taxes, and ( c) providing total relief from the double taxation of dividends. Following t~t i§ a diseussion of policy implications. 

Ballentine (197S) shows how one can solve the structural 

equations of the two-sector Harberger model in order to specify a 

function of the following general form : 

(Sb) 

Given equation (Sb) and the value of Pka;/Pky, one can, using a 

''canned" computer program, solve for Pky· In previous two-sector 

incidence models P kxl P ky has been simply the ratio ( 1 + tka;) I 

(1 + tky), where tkx is the (single) tax on capital in sector X and 

tky is the tax on capital in sootor Y. In our model Pkx!Pky is more 

difficult to specify. However, as shown earlier, we can use the 

equations that describe the financial decisions of corporations 

and the equation that defines the cost of capital in the noncorporate sector to solve for Pkxl Pky jn terms of the tax rates. 

In what follows· we sketch that solution. 

We first specify the precise function al form of ~uations ( 5) 

and (6): 

and 

ie -:-=C(B/E) a+ V ~ 

i,, =;==G (B/E) o+ W. ~ 

(5') 

(6') 

In these two equations we require that a and () be no less than 1 

in order to guarantee that the second-order conditioI,l for cost 

minimization be satisfied, that C and G be positive, that V and 

W be positive, and that V> W. The last two conditions ensure that 

if there are no taxes on debt and equity (or if the taxes are 

equal), then the optimal debt-equity ratio will be positive. 
CORPORATE TAX INTEGRATION 265 

As discussed earlier, when equation (7), which determines the 

optimal debt-equity ratio, is divided by in (1 + tb), it can be written 

in the following general form : 

F2 B/E, -- =0. ( l+te) 

l+t11 (7b) 

Thus, B/ E can be determined, given (l+te)/(l+tb). The solutions for B/ E, ielin, from equation (5'), and ib/in, from equation 

(6'), can then be used to solve equation (4b) for the value of 

Pkx!Pk11 for given tax rates, tb and t 6 • All that remains is to specify the effective rate of tax on equity, t", in terms of the tax rates 

on dividends and retained earnings. 

From equations (21) and (22) we derive: 

1 + tc = ( 1 + tr) ( 1-RD ) + ( 1 + td) _!!_. +D R+D (2lb) 

We assumed earlier that RID is a function of (1 +tr) I (1 + td), 

Which implies that D/(R+D) is also a function of (l+tr)/ 

O+td). We assume that the function relating D/(R+D) to the 

tax rates is of the following form. 

D -M( l+tr)p R+D- l+td . (23b) 

As discussed later, we chose this functional form because it is 

similar to an equation estimated by Feldstein ( 1970) . Inserting 

equation (23b) into equation (21b) and finally into equation (4b) 

results in Pkx!Pk11 being stated solely in terms of the tax rates. 

In short, then, the procedure followed to simulate the impaot of 

tax changes is as follows. First, we use equations (23b) and (21b) 

to solve for the effective tax on equity income, tc, based on the 

tax rates t,. and td. Then, we use a computer to solve equation 

(7b) for the optimal debt-equity ratio, given (l+te)/(l+tb). 

Next, using the solution for the optimal debt-equity ratio, we first 

solve for ie/in and ib/in and, then using the value of (1 + te) I 

(1 + t11), solve for the relative costs. of capital, Pkx!Pk11 , using 

equation ( 4b). Fourth, we solve for Pk11 based on the value of 

Pkx!Pk11 using a computer to solve equation (8b). Finally, using 

the computed value for Pk11 we can easily solve for all of the remaining variables of the model. 

Before the results of our simulations are presented it may be 

Well to discuss briefly the nature of the fiscal exercises and their 

relevance for policy analysis. The first issue involves the question of the fiscal change that accompanies the various tax changes 
266 COMPENDIUM OF TAX RESEARCH 

being examined. Specific incidence analcvsis, always a dubious 

choice, is particularly unsatisfactory in a world thart includes 

debt. 24 

Differential incidence, the usual choice, is quite satisfactory if 

our interest goes no further than the proportionate tax system 

being examined here. Although the calculation would be more 

complex, because of the adjustments in financial structure included in our model, we could certainly adjust the personal tax 

rate to compensate for the revenue lost in changing the taxation 

of corporate-source income and could compare the results of alternative changes in the taxation of corporate-source income. But in 

a real sense, the case being examined here-that of a flat-rate personal tax-is only the first stage in a more realistic analysis of 

corporate tax policy, the ultimate objective being to model integration and other corporate tax policies in a world with a progressive personal income tax. Once we allow progressive rates, the 

calculation of endogenous changes in tax revenues becomes extremely complicated, and with it the possibility of differential 

analysis. Since we are not yet prepared to incorporate progressive rates, it may be better to abandon differential incidence analysis than to employ it in the case with a flat-rate personal tax. We 

at least avoid an appearance of concreteness, which would be unrealistic and probably misleading. 

In what follows, therefore, we employ balanced-budget incidence analysis, making the standard assumptions that allow us 

to abstract from the expenditure side. (In our model this requires 

assuming that individuals, the government, and corporations 

divide their expenditures between corporate and noncorporate output in the same way. We must include corporations because the 

expenditures that retained earnings give rise to are controlled by 

corporations.) Because we merely change the corporate income 

tax, leaving the personal income tax unchanged except as changes 

are required as a component of full integration, the revenue effects 

of the three fiscal experiments are quite different. By the same 

token, the revenue effects calculated are of little interest since, as 

just noted, they would be quite different in a world of progressive 

personal rates. Thus, the purpose of our reporting changes in tax 

revenues is primarily to show that our results are comparable to 

Harberger's and not to indicate that they are of interest per se. 

u With bonds of constant purchasing power, specific incidence analysis 

becomes somewhat more attractive methodologically, if not more realistic. 
CORPORATE TAX INTEGRATION 267 

The Simulation Results 

The simulations are based essentially on the data in Harberger 

(1966), as corrected by Shoven (1976) and augmented to include 

a description of the corporate financial sector. That data set and 

its derivation are described in the appendix. At this point we 

describe only the aspects that are necessary for an understanding 

of the fiscal experiments reported in the next sec~ion. 

First, we employ a corporate income tax of 50 percent, a personal tax rate of 31.1 percent, and a rate of tax on retained income of 8 percent. (These are rates expressed in the manner common in the U.S.; in the terminology of the notation used here, 

they are 1.0, 0.4517, and 0.087, respectively.) Second, we provide 

alternative calculations based on varying assumptions about the 

elasticities of factor substitution and substitution in demand. 

Estimates based on alternative values of the parameters of equations ( 5') and ( 6') are presented in the appendix. 

In order to specify more fully the exact experiments being conducted, we note in table 1-the tax rates applied to distributed and 

retained corporate-source income in the present situation and 

under each tax change and the order of magnitudes of the revenue effects involved. Of particular note is the fact that full integration is more costly than dividend relief-a result that is unlikely t.o prevail in the real world. This res~lt occurs because with 

the flat-rate personal tax, that part of integration that applies to 

retentions, like that for dividends, can only reduce tax revenues, 

Whereas we would expect that with progressive rates, we would 

actually recoup enough revenue from high-income shareholders 

to reduce the cost of full integration to less than that of dividend 

relief alone. 

Tables 2, 3, and 4 present the results of our simulation exercises. Columns (b), (c), and (d) in table 2, and columns (a), (b), 

TABLE 1.-Tax rates and revenue changes for existing systems and 

three alternatives 

Effective tax rates Approximate 

Non- Corporate income 

fall in 

revenue corpora ($billion) income Distributed Retained 

Present system 31.1 65.6 54 

No corporate tax 31.1 31.1 8 18-19 

Fun integration 31.1 31.1 31.1 10-12 

Dividend relief 31.1 31.1 54 2-3 
TABLE 2.-8imulated values of key variables under alternative corporate tax regimes, for various parameter values 1 

8.,=8r=84=1.0 8.,=81=0.5; 84=1.0 

Initial No corp. Full Dividend No corp. Full Dividend c 

0 values tax integ. relief tax integ. relief a:: 

Variable (a) (b) (c) (d) (e) (f) (g) "'O 

t:i:.2 

z 

Capital income 44.21 62.64 54.59 46.54 57.71 51.81 45.92 t::::I 

..... i.,, 0.71 0.78 0.74 0.72 0.72 0.71 0.71 c:: 

i. 1.40 1.82 1.64 1.46 1.68 1.56 1.44 a:: 

in 1.00 1.42 1.24 1.06 1.31 1.18 1.04 0 

~ 

BIE 0.818 0.396 0.538 0.740 0.396 0.538 0.740 t-3 

Bl(B+E) 0.450 0.284 0.350 0.425 0.284 0.350 0.425 > 

>< 

B 10.61 8.22 9.50 10.45 7.79 9.14 10.33 ~ 

E 12.97 20.76 17.66 14.12 19.67 16.98 13.95 t:i:.2 

00 

DI (R+D) 0.150 0.150 0.174 0.211 0.150 0.174 0.211 t:i:.2 

> D 2.73 5.66 5.03 4.33 4.95 4.60 4.22 ~ 

c R 15.43 32.02 23.93 16.21 28.03 21.89 15.81 ~ 

R, 16.77 34.81 34.74 17.62 30.47 31.78 17.19 

1 In this table q:i=l.4 and a==l.2. For values of i.,,, i., and i,. under alternative assumptions, seP. tables A.-1 and A-2. 
CORPORATE TAX INTEGRATION 269 

TABLE 3.-Changes in key variables under alternative corporate tax policies, 

for various parameter values 1 

S.,=Sy=Sd=l.0 S.,=Sy=0.5; Sd=l.0 

No corp. Full Dividend No corp. Full Dividend 

tax integ. relief tax integ. relief 

Variable (a) (b) (c) (d) (e) (f) 

~ tax revenues -18.4 -10.4 -2.3 -19.2 -11.7 -2.9 

Li capital income +18.4 +10.4 +2.3 +rn.5 +1.6 +i.1 

% Li ib +9.3 +4.5 +0.1 +o.8 -0.6 -0.6 

% Li i. +29.6 +17.1 +3.9 +19.8 +u.4 +2.5 

% Li in +41.5 +24.3 +5.7 +30.1 +18.1 +i.o 

% Li Bl (B+E) -36.9 -23.3 -5.6 -36.9 -23.3 -5.6 

%LiD +107.3 +s4.2 +58.6 +si.3 +68.5 +54.6 

o/oLiR +101.5 +55.1 +5.1 +sI.6 +41.9 +2.5 

% LiR, +101.6 +59.5 +5.1 +si.1 +89.5 +2.5 

1 Based on table 2 

TABLE 4.-Percentage shares of total net capital income and tax burden 1 

S.,=Sy=Sd=l.0 S.,=Sy=0.5; Sd=l.0 

No corp. Full Dividend No corp. Full Dividend 

tax integ. relief tax integ. relief 

(a) (b) (c) (d) (e) (f) 

Percentage shares of total net capital income 

Corporate bonds 13.0 14.8 16.5 12.9 14.6 16.4 

Corporate equity 52.3 47.7 42.6 50.2 46.5 42.4 

N oncorporate 34.7 37.6 40.8 37.0 38.9 41.2 

Percentage share in tax burden 

Corporate bonds 4.4 4.0 2.7 0.5 -0.7 -3.3 

Corporate equity 49.3 45.6 40.7 45.7 43.8 39.3 

N oncorporate 46.3 50.5 56.6 53.7 56.~ 63.9 

1 Based on table 2. Net income accruing to each type of investment is average of 

income in initial situation and income with the indicated tax policy. Numerator for 

calculating shares in tax burden is the change in respective net rates of return multiplied by the average of amount of capital in initial situation and with the policy in 

question. Denominator is sum of numerators. 

and ( c) in tables 3 and 4 assume that the two elasticities of factor substitution and the elasticity of substitution in demand equal 

unity (i.e.,Sd=Sa;=S11 =-1).Incolumns (e), (f),and (g) in table 

2 and columns (d), (e), and (f) in tables 3 and 4, Sai=Sy=·-.5, 

and Sd= -1. In all tables 6=1.4 and a=l.4; alternative values of 

these parameters are employed in the appendix. Although these 

results seem to be fairly robust for alternative values of key variables and parameters, we must stress that the various inputs into 
270 COMPENDIUM OF TAX RESEARCH 

the simulation model are not intended to be precise estimates of 

the actual values for the U.S. economy. Our numerical simulations 

are therefore probably best considered as roughly suggestive and 

not exact estimates of the pattern of corporate tax incidence in 

the United States. 

Eliminating the Income Tax 

Because we examine the abolition (rather than the imposition) 

of the corporation income tax, table 3 shows government revenues 

declining and the return to capital rising. The change in capital 

income as a proportion of the change in government revenues, 

which can be considered to be capital's share in the direct tax 

burden, is 100 percent for Sx=S11 =So,= -1 and about 70 percent 

for Sl1J=S11=-.5 and Su,=-1. For the standard Harberger model, 

the result in the former case is also 100 percent; in the latter case, 

Shoven (1976) calculates capital's share at about 67 percent. 

Thus, our model suggests about the same overall burden share for 

capitalists (owners of capital) as does the Harberger model. 

It is in our calculations of the distribution of the burden among 

capitalists that we differ from previous work. Whereas the traditional Harberger analysis would find all capitalists gaining equally 

from the elimination of the corporation income tax, we calculate 

that corporate bondholders would gain relatively little. That is, 

ib rises by less-and perhaps substantially less-than 10 percent. 

Corporate shareholders would gain by a much larger fraction ( ie 

rises by 20 to 30 percent, depending on the elasticity assumptions), but investors in the noncorporate sector would gain most 

of all ( ~ rises by about 30 to 40 percent, depending on the elasticity assumptions). This result, stated from the other side, says 

that the corporate income tax is borne mainly by shareholders 

and noncorporate investors and relatively little by corporate bondholders.25 

Table 4 presents an effort to quantify the differences in the ways 

the various returns to capital are affected by elimination of the 

tax. The top part of the table presents, for three tax changes and 

two elasticity assumptions, the fraction of total net capital income accruing to corporate bondholders, holders of corporate 

z As the results reported in the appendix show, under some circumstances 

debtholders may benefit more than shareholders. Thus it may be better to 

concentrate on the difference in the change in the return on corporate securities taken together rather than individually. 
CORPORATE TAX INTEGRATION 271 

shares, and investors in the noncorporate sector.26 The bottom 

Part indicates the share in the tax burden experienced by investors in each type of capital.21 We see that risk premiums on corPorate bonds fall enough with the elimination of the corporate income tax that bondholders gain little (perhaps 4 to 5 percent at 

the most) from the elimina:tion, though they receive some 13 percent of total net capital income. Even corporate shareholders pay 

a share of the corporate income tax ( 46 to 49 percent) that is 

smaller than their share of net capital income (roughly 46 to 54 

I>ercent) . Finally, investors in the noncorporate sector are the 

big gainers from the elimination of the corporate income tax. 

Althoug!" .. they receive only some 35 to 37 percent of net capital 

income, they receive roughly 46 to 54 percent of the benefits of 

eliminating the tax. These results, which are markedly different 

from those of the standard Harberger model, suggest that the 

corporate income tax is somewhat less progressive than ordinarily 

assumed.2s 

Table 5 gives an indication of how much difference the modification presented here makes for the incidence of the corporate 

income tax. In columns (a) and (b) the corporate income tax is 

allocated among income classes in proportion to ownership of corPorate shares and total capital. In column ( c) half the tax is allocated in proportion to ownership of corporate securities and half, 

in proportion to income from noncorporate capital. 29 

While the differences in results in columns (b) and ( c) are not 

enormous, they do suggest that the corporate income tax is somewhat less progressive at the top of the income scale-and more 

regressive at the bottom-than commonly assumed on the basis 

of the Harberger analysis. 

38 Because the fractions depend crucially upon whether they are based on 

shares in net capital income in the initial (cum tax) situation or in the 

situation without tax, we sum the income figures in the cum-tax and no-tax 

situations in calculating the fraction. Simply taking the average of the fractions in the cum-tax and no-tax situations produces essentially the same re- sults. 

~We calculate the numerators by multiplying the average amount of a 

certain type of capital (with and without the tax) by the change in the 

relevant net rate of return. The denominator is the sum of the numerators, 

and is, in general, not equal to the change in the total net capital income. 21 Under the Harberger approach the tax burdens would, of course, be 

allocated in strict proportion to capital income. 

•The capital ownership series are from Projector and Weiss (1966). 

Because separate series are not available for corporate debt and corporate 

equity, the burden on these two forms of capital ownership were lumped 

together. "Noncorporate'' is primarily housing and (agricultural and nonagricultural) businesses and professions. The 50-50 allocation is consistent 

With the average of results in columns (a) and (d) of table 4. 
272 COMPENDIUM OF TAX RESEARCH 

TABLE 5~-Effective tax rates for corporate income tax by income classes, 

using traditional, Harberger, and simulated estimates of incidence 

Income class 

-($1,000) 

0-3 

3-5 

5-7.5 

7.5-10 

10-15 

Above 15 

Traditional 1 

(a) 

5.6 

1.5 

1.7 

2.7 

2.9 

10.6 

Harberger 

estimate' 

(b) 

8.4 

2.4 

2.3 

3.1 

3.1 

8.6 

Source: Table 3 and Projector and Weis~ (19°66). 

Simulation 

estimate 1 

(c) 

9.5 

2.7 

2.5 

3.3 

3.2 

7.8 

1 Corporate tax is attributed to income classes m proportion to ownership of 

corporate shares. 

'Corporate tax is attributed to income classes in proportion to ownership of 

capital. 3 Half the corporate tax is attributed in proportion to income from corporate 

securities, half in proportion to noncorporate capital income. These results are consistent with the average of the results for columns (a) and'-(d) of table 4. 

The incidence of the corporate income tax is, of course, only 

part of the story. In the absence of the tax, only some 30 percent 

of corporate capital would be debt-financed, instead of the current 

45 percent. Stated differently, the ratio B/(B+E) is some 50 

percent higher than in the absence of the tax. Finally, as inspection of equations (23), (25a), and (25b) reveals must be the 

case, elimination of the corporation income tax does not affect 

net dividend-payout ratios. 30 But dividends and retentions (both 

net and gross of personal tax) would rise by 80 to 110 percent, 

depending upon elasticities. This concltfsion must, however, be 

qualified in at least two ways. First, we are ignoring completely 

how revenue would be recouped. Second, that part of our model 

dealing with dividend-payout ratios-and any estimate based 

upon it-is less satisfacto·ry than other parts of the model. Thus, 

this result should not be overemphasized. 

Full Integration 

The incidence results for full integration are essentially the 

same as those for the reduction in the corporation income tax, 

except that the changes are smaller in absolute value. This might 

30 This rather anomalous result can perhaps be clarified by examination of table 1. Under the present syst.em $46 of aft.er-tax retentions can 

be exchanged for $34.4 of aft.e·r-tax dividends. Thus, elimination of the 

corporate tax leaves unaffected the rate at which the two returns to equity 

can be exchanged. 
CORPORATE TAX INTEGRATION 273 

have been expected since the major difference between the two 

cases is the higher effective tax on retained earnings in the case of 

full integration. That higher tax on retentions means that the effecti.ve tax reduction is less in the case of full integration. In addition, noncorporate investors gain relatively more than they might 

have even under elimination of the corporate tax, shareholders 

gain somewhat less, and corporate bondholders actually lose from 

-integration. Of course, the original Harberger model does not deal 

With this case. 

Effects on the debt-equity ratio are also smaller than in the 

case of eliminating the income tax. But, whereas elimination of 

the cor:r )rate income tax does not affect net dividend-payout 

ratios, full integration equalizes the tax treatment of dividends 

and retentions and causes the net dividend-payout ratio to rise. 

Indeed, DI (R+D) rises from about 0.150 to 0.174-. In spite of the 

rise in the dividend-payout ratio, however, net retentions actually 

rise by about 42 percent because of the larger amount of net-oftax equity earnings. 

Dividend Relief 

As a final experiment, we have considered integration for dividends only. That is, we have abolished the corporation income 

tax on dividends while keeping the tax on retentions. Once again, 

the incidence results are basically a dampened version of the results for the abolition of the corporation income tax. But noncorPorate investors are relatively larger gainers, as in the case of 

full integration. Noncorporate capitalists enjoy some 55 to 65 

Percent of the benefits of dividend relief, despite accounting for 

only about 41 percent of net capital. Most of the remaining benefits accrues to owners of corporate equities, and under one set of 

elasticity assumptions, corporate bondholders lose. Moreover, because integration is extended only to dividends, the net dividendPayout ratio rises to about 0.211. Even so, (gross and net) retentions rise slightly because of the increase in equity income net of 

corporate tax. 

Evaluation 

Overall, the results show that full integration, dividend-only 

integration, and abolition of the corporation income tax all lower 

the cost of equity capital for corporations. This tends to raise the 

rate of return to capital in the economy. However, such tax re-
274 COMPENDIUM OF TAX RESEARCH 

ductions also lower the cost of equity capital relative to debt for 

corporations. In response, corporations lower their debt-equity 

ratios. This in turn reduces the risk premium that must be paid 

on corporate debt and equity and thus lowers the observed rat.e 

of return on such assets. This latter effect tends to counteract the 

general rise in the rate of return to capital. Because the offset is 

almost complete for corporate debt, the interest rate on corporate 

debt remains virtually unchanged. It is less complete for corporate 

equity; thus, the equity rate of return rises by almost as much as 

the noncorporate rate of return. The lesson for the incidence of 

the corporate income tax is that owners of noncorporate capital 

bear the greatest relative burden, owners of equity bear the 

next largest burden in relative terms, and owners of debt pay 

very little. 

While our model explicitly focuses on the functional distribution 

of income and on the distribution of capital income by asset type, 

the ultimate concern for incidence analysis is usually the impact 

of tax changes by income group. Prior to Harberger's work, many 

economists argued that the corporation income tax is paid by 

stockholders. Given the distribution of st.ock ownership by income 

class, this meant that the tax was likely to be progressive. Since 

the distribution of ownership of noncorporate capital, mainly 

housing and real estate, is less skewed toward the rich than is the 

distribution of stock ownership, Harberger's result implied that 

the tax is less progressive than previously thought. Our results, 

which indicate that the tax is "overshifted" to the noncorporate 

sector, imply that the tax is even less progressive than Harberger 

suggested and that integration reduces progressivity less than is 

commonly assumed. 

Appendix: The Choice of Parameter Values 

and Some Sensitivity Analysis 

Since it was Harberger's analysis (1962) that developed the 

now familiar result that capital bears all of the corporation income tax (and further, that all capitalists bear it equally), we 

use his data (as corrected by Shoven, 1976) for our estimates. 

These data are: 

x =252.265 

y 44.349 

pklJ) 2.2211 

Lx =199.871 

L 11 17.471 

Pk11 1.4517 

Kx =23.587 

K11 =18.515 

PIJ) =P11=Pk=in=1. 
CORPORATE TAX INTEGRATION 275 

Because our model describes the financial policy of the firm, it 

requires additional data. In particular, we must divide gross corporate profits, PkxKx, into debt payments, retained earnings, and 

dividend paymenU:l. From Schwartz and Aronson (1967) we shall 

take the proportion of the corporate capital stock financed by 

equity to be 55 percent.1 This implies a value of BI E of .818. 

Further, since B+E=Kx=23.589, B=l0.615 and E=l2.974. 

Finally, from Rosenberg (1969), we take debt payments to be 

about 20 percent of the total return to corporate capital. 

Using these figures we can state that 

ib (1+tb)=1.031 

and 

ic(l+te) =3.195. 

Taking the tax on corporate debt to be the same as the tax on 

noncorporate capital (i.e., tb = .4517) implies that ib = .71. For 

the moment let te= 1.282 (this value is explained later) ; this imPlies that ie = 1.4.2 

To complete our basic data, we need only to obtain values for 

R, D, tc, trp, and te. We set tc=l, thus approximating a corporate 

income tax of 50 percent. We set the tax rate on retained earnings at .087, giving an effective tax rate of around 8 percent. (This 

figure is consistent with that obtained by Bailey, 1969.) Fur.ther, 

We take the gross of personal tax dividend-payout ratio to be 

about .25. From this we calculate D = 2.7288, R = 15.434, and 

tc= 1.282. 

We must also specify the parameters of the various functions 

of the model. By assuming the production function to be of the 

CES (constant elasticity of substitution) form, and with the 

knowledge of the initial equilibrium values of outputs and inputs, 

a choice for the value of the elasticity of factor substitution completely specifies all of the parameters of the production function. 

Similarly, if the utility function is homothetic, then a choice for 

the elasticity of substitution in demand is all that is needed to 

1 This is based on Schwartz and Aronson's (1967) calculations for all industries in 1961 and 1928. 2 Note that the values of i.,, and ic are implied by our choices for other 

Values. As a check on the reasonableness of our choices, the ratio of the 

corporate interest rate to the corporate return on equity, both gross of personal taxes, which are implied by our data, can be compared with actual 

Values. Shepherd (1972) has calculated the average return on equity for 

large corporations to be about 11 percent over the period 1960-1969. CorPorate Aaa interest rates during 1962-1969 ranged from 40 percent to 64 

Percent of the equity rate while Baa bonds ranged from 47 percent to 71 

J>ercent. Our data imply a value of 64 percent for this ratio. 
276 COMPENDIUM OF TAX RESEARCH 

specify consumption of X and Y. In our estimates we consider 

alternative values for these elasticities of substitution. 

Obtaining reasonable values for the functions that relate ib/ i,,, 

and ie/ in to BI E is more difficult. From the text, these two functions are written as 

and 

~e =I (BI E) = c (BI E) a+ v 

in 

ib -=g(B/E) =G(B/ E)fJ+ W. 

in 

(5') 

(6') 

We know of no empirical work that estimates relationships identical to these. However, as discussed later, there is some work 

that can be used to suggest values for the elasticities of these 

functions. Fortunately, we need not rely entirely on what little 

econometric work is available. When the values for the tax rates, 

interest rates, and B/E are introduced into equation (7), we obtain a simple linear relationship between g' and f'. That relationship is: 

!' = .5206 - .5203g'. 

We require .that f' and g' be strictly positive, which implies that 

O<f' <.5206 and that O<g' <1.0006. Since it will be convenient 

later to speak of the elasticities of f and g, these values imply that 

the elasticity of ielin with respect to B/E is less than .30 and that 

the elasticity of ib/in is less than 1.15. 

If the functions f and g are linear or nearly linear, we can 

nar,row the range of values for f' and g' even further. The second-order condition for optimal financial policy requires that 

2g'(l+tb) +g"(B/E) (l+tb) +f"(l+te) >0. 

If the value of this express.ion is close to zero, large changes in 

the debt-equity ratio will be required to restore equilibrium if 

some tax change is made. Experimentation has shown that if f 

and g are linear (i.e., if g" = f'' = 0), values of g' below .28 result 

in the optimal debt-equity ratio going to zero when the corporation income tax is zero. 

For the linear case, then, the elasticity of ib/in with respect to 

B/E must not only be less than 1.15, but must also be more than 

0.32, which is the same as g' = 0.28. This implies that, for that 

case, the elasticity of ielin must be less than 0.22. 

Baker (1973) and Hurdle (1974) report linear regressions of 

after-tax corporate profit rates on, among other variables, firm 
CORPORATE TAX INTEGRATION 277 

'leverage. Since both of the.se are cross-section studies, we interpret them for our purposes as assuming that the noncorporate 

rate of return is const.ant. Because these studies measure profit 

rates in dollars per dollar of invested capital while we use wage 

units per physical unit of capital, we must convert their results 

to an elasticity measure. Since Hurdle's ( 1972) rates of return 

Were from the Fortune Directory data, we used the 1956 rate of 

return on corporate capital from that Directory along with our 

Value of B/ E to convert her regression coefficient to an elasticity. 

The result gives the elasticity of iel'in to· B/ E of 0.25, which is 

slightly outside the range our model will accept. (The value of 

0.25 implies an elasticity of 0.20 for ib/ in.) A similar conversion 

for Baker's (1973) result gives a higher elasticity for ib/ in (0.34) 

and a very low estimate for the elasticity of ib/ in (0.14). 

Clearly, the results of both of these studies are inconsistent 

With the other values of our data. However, because of the paucity 

of studie.s of this type, the relatively low explanatory value of 

the regression equations reported, and the relatively small number 

of corporations considered, we are reluctant to place great confidence in the values of the slope estimates obtained. (The studies 

do, however, provide good evidence of a significant positive effect 

of debt-equity ratios on rates of return to equity.) Instead, in 

table A-1 we provide some sensitivity analysis employing a wide 

range of values of the elasticity of ib/ in to B/ E (and thus a corresponding wide range for the elasticity of ie/ in). The results refer to eliminating the corporation income tax. The figures in 

Parentheses are the percentage changes in the relevant rates of 

return. Table A-1 assumes that f and g are linear. The top row 

shows the assumed values of the elasticity of ib/i,i to B/ E. Table 

A-2 assumes that f and g are nonlinear, with ~=a= 1.5. 

Both tables show that our general conclusions are fairly insensitive to the choice of elasticity values. The rise in the noncorI>orate rate of return is particularly insensitive, ranging from 41 

i& 

i. 

i .. 

TABLE A-1.-Rates of return (RR) and percentage changes (% 6.) in rates 

of return resulting from elimination of corporate income tax for linear f 

and g functions 

Elasticity of ib/i,. w.r.t. Bl E 

.35 .58 .92 1.15 

RR %6. RR %6. RR %6. RR %6. 

.74 (4) .69 (3) .60 (-16) .54 (-24) 

1.68 (20) 1.83 (31) 1.94 (38) 2.00 (43) 

1.44 (44) 1.43 (43) 1.43 (43) 1.43 (43) 
278 COMPENDIUM OF TAX RESEARCH 

TABLE A-2.-Rates of return (RR) and percentage changes (% !:J.) in rates 

of return resulting from elimination of corporate income tax for nonlinear 

f and g (cp=a=1.5) 

Elasticity of ib/i,. w.r.t. Bl E 

.12 .28 .58 .92 

RR % !;. RR % !;. RR % !;. RR % !;. 

ib .94 (32) .87 (21) .78 (10) .69 (-3) 

ie 1.68 (20) 1.76 (25) 1.86 (33) 1.94 (38) 

i .. 1.41 (41) 1.41 (41) 1.41 (41) 1.41 (41) 

percent to 44 percent. In only one case, when a=~= 1.5 and the 

elasticity of i,jin is only .12 (i.e., {;lightly below Baker's estimate), 

do we find that ib rises by a greater proportion than ie; otherwise 

ie rises relative to ib. Most importantly, in all cases in rises relative 

to both ie and ib, indicating that imposition of the corporate tax 

imposes the greatest burden on owners of noncorporate capital. 

The figures that conform most closely to the results of Hurdle 

and Baker are the first column of table A-1 and the first and 

second columns of table A-2. However, those results also imply 

large changes in corporate debt-equity ratios. This is at variance 

with a rather large quantity of empirical evidence indicating that 

shifts in corporate debt-equity ratios have been fairly modest as 

corporate taxes rose. As a result, we tend to rely more on the 

results obtained with the elasticity of ib/in around 0.58. Nonetheless, it is worth mentioning again that our basic results are fairly 

insensitive to the choice for the value of that elasticity. 

References 

Bailey, Martin J. "Capital Gains and Income Taxation." In Arnold C. 

Harberger and Martin J. Bailey (Eds.), The Taxation of Income from 

Capital. Washington, D.C.: The Brookings Institution, 1969, pp. 11-

49. 

Baker, Samuel H. "Risk, Leverage and Profitability: An Industry 

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pp. 503-507. 

Ballentine, J. Gregory. "A Simple and Efficient Method of Calculating 

the Impact of Finite Tax Changes in a Two-Sector Model." Southern 

Economic Journal (January 1978). 

Ballentine, J. Gregory, and Ibrahim Eris. "On the General Equilibrium 

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1975),pp.633-644. 

Barzel, Yorarn. "An Alternative Approach to the Analysis of Taxation." 

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CORPORATE TAX INTEGRATION 279 

Britta.in, John A. "The Tax Structure and Corporate Dividend Policy." 

American Economics Review 54 (May 1964), pp. 272-287. 

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Feldstein, Martin S. "Corporate Taxation and Dividend Behavior." 

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1974),pp. 551-573. 

Feldstein, Martin S., Jerry Green, and Eytan Sheshinski. "Corporate 

Financial Policy and Taxation in a Growing Economy" (Discussion 

Paper No. 556. Cambridge, Mass.: Harvard Institute of Economic 

Research, 1977. 

llarberger, Arnold C. "Efficiency Effects of Taxes on Income from Capital." In M. Krzyzaniak (Ed.), Effects of Corporation Income Tax. 

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llarberger, Arnold C. "The Incidence of the Corporation Income Tax." 

Journal of Political Economy 70 (June 1962), pp. 215-240. 

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Review of Economic Studies 38 (July 1971), pp. 377-380. 

Rrzyzaniak, Marian, and Richard A. Musgrave. The Shifting of the 

Corporation Income Tax. Baltimore: Johns Hopkins Press, 1963. 

Modigliani, Franco, and Merton H. Miller. "The Cost of Capital, Corporation Finance, and the Theory of Investment." American Economic 

Review 48 (June 1958), pp. 261-297. 

Musgrave, Richard A. The Theory of Public Finance. New York: McGraw Hill, 1959. 

Projector, Dorothy S., and Gertrude S. Weiss. Survey of Financial 

Characteristics of Consumers. Washington, D.C.: Board of Governors 

of the Federal Reserve System, 1966. 

Schwartz, Eli. "Theory of the Capital Structure of the Firm." Journal 

of Finance 14 (March 1959), pp. 18-39. 

Schwartz, Eli, and J. R. Aronson. '"'Some Surrogate Evidence in Support 

of the Concept of Optimal Financial 'Structure." Journal of Finance 

22 (March 1967), pp. 10-18. 

Scott, James H., Jr. "The Theory of Optimal Capital Structure." Bell 

Journal of Economics 7 (Spring 1975), pp. 33-54. 

Shepherd, W. G. "The Elements of Market Structure." Review of Economics and Statistics 54 (February 1972), pp. 25-37. 

Shoven, John B. "The Incidence and Efficiency Effects of Taxes on Income from Capital." Journal of Political Economy 84 (NovemberDecember 1976), pp. 1261-1283. 

Stiglitz, Joseph E., "On the Irrelevance of Corporate Financial Policy." 

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280 COMPENDIUM OF TAX RESEARCH 

Tambini, Luigi. 4'Financial Policy and the Corporation Income Tax." In 

ArIWld C. Harberger and Martin J. Bailey (Eds.), The Taxation of 

Income from Capital. Washington: The Brookings Institution, 1969, 

pp. 185-222. 

Tideman, T. Nicholas, and Warren E. Weber. "Saving and Investment 

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CORPORATE TAX INTEGRATION 281 

COMMENT 

Martin J. Bailey, University of Maryland 

The Ballentine-McLure paper is a valuable addition to the literature on the incidence and resource-allocation effects of the corporation income tax. It modifies existing theory to allow for the 

effects of this tax on debt-equity ratios and on dividend-payout 

ratios; these effects are large enough to imply notable new conclusions. 

However, I find myself in disagreement with the two authors 

concerning a major point of interpretation of the results. Harherger found, broadly, that the burden of the corporation income 

tax is distributed evenly among all owners of capital through reduced after-tax rates of return. Ballentine and McLure say that 

corporate shareholders bear less of the tax, and other owners of 

capital more, than the Harberger findings show. The reason for 

this new finding is that increased debt financing induced by the 

tax increases the risk of both corporate debt and equity, and, to 

compensate for the extra risk, increases their equilibrium rates of 

return relative to that of other capital. Although the effect of the 

tax on debt financing and on yields (assuming that transactions 

costs negate the Modigliani-Miller theorem) is straightforward, it 

does not follow that the owners of corporate capital bear less of 

the tax. 

In the paper under review the yields on curporate bonds and 

equity rise just enough tO compensate for their extra risk due to 

increased debt financing; their risk-adjusted yields remain equal 

to those on noncorporate capital. The extra yields, merely being 

compensation for added risk, cannot properly be said to represent 

an offset to the burden of the tax, which should be measured 

using risk-adjusted yields. Because the extra risk-taking must be 

compensated, it is a real cost induced by the tax. Hence it is part 

of the excess burden of the tax, analogous to and an enlargement 

of the excess burden due to shifting of capital from the corporate 

sector to the noncorporate sector. 

Because the new, added risk is distributed uniformly over all 

corporate capital (to a first approximation), it represents an 

added economic cost levied against all corporate capital. Therefore, its excess burden is to be measured not by a Dupuit-Harberger triangle but by the entire extra after-tax income required 
282 COMPENDIUM OF TAX RESEARCH 

to compensate owners of corporate capital : the higher average 

corporate after-tax yield times the amount of corporate capital, 

compared with the yield with the tax but without the added debt 

financing. This extra burden should be imputed to owners of 

corporate capital, bringing their share of the total burden into 

line with Harberger's results. 

REPLY 

J. Gregory Ballentine and Charles E. Mclure, Jr. 

Traditionally, incidence analysis has focused upon the change 

in income available for private use (see Musgrave, 1959, p. 207). 

When some private income is derived from risk premiums, 

changes in those risk premi urns will not, in general, reflect 

changes in welfare. This is the issue Professor Bailey raises, one 

we also discussed briefly in our paper. Without a thorough specification of investor behavior, including attitudes toward risk, it 

is not clear how to go about measuring the welfare effects of taxation in our model. One tentative approach which we mentioned 

in footnote 19 of our paper and which seems to be consistent with 

Bailey's comments is to calculate incidence using only changes in 

capitalists' income net of all risk premiums (i.e., changes in inK). 

While we chose to follow the traditional approach in our paper, it 

may be interesting to mention here a result ,that obtains if only 

changes in inK are considered. Capital income taxes generate government revenues at the expense of all capital income, including 

risk premiums. As a result, even in the well-known Cobb-Douglas 

case, which under the traditional incidence approach implies that 

capitalists bear the full tax burden, the fall in capitalists' incomes 

net of risk premiums will be less than the rise in government 

revenues. The shortfall is the amount of revenues generated at 

the expense of risk premiums. Following such an approach it is 

not clear who can be said to bear the burden of that shortfall and, 

hence, under what circumstances capitalists can be said to bear 

the whole burden of the tax.