Corporate Taxes: Economic Effects and Optimal Design

1. Corporate Taxes:Economic Effects and Optimal Design Roger Gordon UCSD

2. Aim of workshop • Provide an overview of past research on the role and economic effects of corporate taxes • Start with a stylized description of the personal tax • Given this personal tax law, initial analysis of the role for a corporate tax • Discussion of corporate behavior in response to the remaining tax distortions • Reexamination of the optimal design of the corporate tax

3. Stylized description of the personal tax • Take as given an existing personal income tax • Progressive rate structure • Tax rate on labor income denoted by m, with rate varying by tax bracket • Tax rate on real interest denoted by n • Tax rate on dividends at rate d • Capital gains taxed at an effective rate g. • Will presume that n > d > g

4. Taxation of non-corporate business income • Underlying aim to tax resulting labor income at rate m and capital income at rate n. • Assume that income net of depreciation deductions taxed at rate m. • Generosity of depreciation deductions chosen so that effective tax rate on capital income equals n.

5. Choice of depreciation schedule • Required rate of return satisfies: (1 - m) f ‘ = [r (1 – n) + d] (1 – mz) where z is the present value of depreciation deductions. • Avoid distortions to form of savings if f ‘ = r + d • Can choose z so that f ‘ = r + d. • If n = 0, then set z = 1, implying “expensing”. • Otherwise, the choice depends on n/m, which can vary by investor.

6. What if had no corporate tax? • Incorporate firm and don’t pay dividends, tax rate falls from m to g • Incorporate bank account • Sell shares when want to withdraw funds • Converts interest income into capital gains • Borrow to invest in bank account – riskless arbitrage • Shift from being an employee to being an incorporated independent contractor, selling shares when need funds

7. How can these evasion opportunities be avoided? Why not just attribute corporate income to shareholders, to be taxed under the personal income tax in the same way as non-corporate income? (“partnership” treatment)

8. Is a “partnership” treatment feasible? • Key attribute of a corporation is the ease of trading shares. • With minimal transactions costs of trade in shares, shares can be held for an arbitrarily short time period • Yet taxable income of firm calculated at best once per quarter. • For partnerships, transactions costs of trade in shares high, and trades are infrequent

9. Existing personal taxes on corporate income Personal taxation of income from corporations then focuses on forms of income that can be monitored, regardless of holding period: dividends and realized capital gains. With gain from deferral, corporate income then treated more favorably than non-corporate income. Further advantage if reduced capital gains tax rate, e.g. to ease lock-in effects.

10. Note on effective tax rate on capital gains • Statutory rate of g* on realized gains • Tax therefore deferred (without charge) until sell shares, lowering the discounted present value of the tax • Option to sell losses quickly but to delay selling gains lowers effective rate further • In U.S., accrued gains not sold before death were tax free (until this year) • Crude presumption that effective rate g≈.25g*

11. Role of the corporate tax Role of the corporate tax is then to impose a supplementary tax on retained earnings to compensate for the low personal tax rate on this income. Any corporate revenue that is already fully taxable under the personal tax, e.g. wage payments, interest, rents, royalties, and (to some degree) dividends, should then not be part of the corporate tax base.

12. Implied structure for the corporate tax Tax base and tax rate should be designed so that corporate income is treated the same as equivalent income from non-corporate firms. Non-corporate income can include both labor and capital income to the partners, and the same is true for corporate income What are “equivalent” taxes for entrepreneurial income and capital income accruing within a corporation?

13. Equivalent tax on labor income • If labor income paid out as wages, taxable under the personal tax, it is taxed at some rate m • If earnings accrues instead within a corporation, it is taxed each year at the corporate rate t, while the accruing capital gains face personal taxes when realized, with an effective tax rate g. • Avoid distorting where income is reported if: m = t + g(1- t )  t*

14. Equivalent tax on capital income • Let personal tax rate on income from savings be n . Non-corporate investment faces an effective rate of n if suitably adjust depreciation provisions, given statutory rate m. • With same depreciation schedules, t* = m also results in effective tax rate n on income from corporate investments.

15. What are the resulting problems? • Difficulties in setting t such that m = t* : • Variation in m across taxpayers due to a progressive personal tax schedule • Variation in g due as well to choice of when to sell • Variation in t due to treatment of business losses • To degree m ≠ t*, distortions are created: • Incentive to shift income to lower tax rate, and deductions to higher tax rate

16. Outline of rest of lecture • Opportunities for income shifting • Organizational form • Debt vs. equity finance • Forms of compensation of employees • Other decisions that are distorted • Dividends • Corporate investment • Risk-taking • Reassessment of optimal design of corporate tax • Taxation of multinationals

17. Organizational form:corporate vs. non-corporate • Pre-tax profits of P yield after-tax profits of • If non-corporate: P (1 – m ) • If corporate: P (1 – t* ) if profits P if losses • If P > 0, choose the lower tax rate • If P < 0, strong tax incentive to be non-corporate. (In U.S., special rules for small firms to weaken this distortion.)

18. Organizational form:Other forecasts • Lifecycle of firm: Start non-corporate as long as tax losses likely, then incorporate when m > t*. • Tax arbitrage at any date if m > t*: Own firms of both types, and use transfer pricing to shift losses to non-corporate firm and profits to corporate firm.

19. Non-tax considerations • In past, needed to change legal form in order to change tax status • Non-tax effects of corporate form • Limited liability • Public trading of shares • In U.S., non-tax factors have weakened over time, with introduction of subchapter S corporations and limited-liability companies, and check-the-box provisions. • Large size of corporate sector suggests that non-tax factors remain important.

20. Evidence • Clear changes in organizational forms following the 1986 Tax Reform Act, when t* - m changed sign. • Jump in sub-chapter S corporations • Shift of tax losses from partnerships to corporations • Implications for t : • Keep t* ≈ max(m) • Large distortions particularly when P < 0. • “Safe harbor leasing” one attempted solution. • Corporate mergers between firms with profits and losses is another response

21. Debt vs. equity finance • Assume nr = mi, where i is the nominal rate • An extra dollar of corporate debt saves taxes each year of (t* - m) i, given deductions for firm but personal taxes on interest income for investors

22. But what is the value of m?? • Tax rate of investor who is indifferent between bonds and stocks, with pension funds and those in lower brackets buying bonds and those in higher brackets buying stocks. • Given risky return to equity, all investors forecasted to hold both debt and equity. Security pricing then yields an effective m that is a weighted average across investors, weighting by assets, and the inverse of risk aversion.

23. Forecasts vs. data • Modigliani and Miller argued that non-tax factors leave firm indifferent to form of finance, as long as there are no real costs from bankruptcy • If t* > m, firm should then be all debt financed. • But D/K ≈ .25 in U.S.

24. Initial presumptions about non-tax factors • Bankruptcy-cost model • Real costs of bankruptcy • Real costs of arising from conflicts of interest between debt and equity, given the risk of future bankruptcy • Contrary to bankruptcy-cost model, though, • Observable costs during bankruptcy very small • Profitable large firms often have little debt • Firms with tax losses, and small firms in a lower corporate tax bracket, borrow much more heavily • Large use of debt prior to introduction of income taxes

25. Lemons Model Alternative “lemons” model due to Myers and Majluf (1983) Outside investors less well informed about true risk of bankruptcy Firms with a higher risk of default then find debt finance more attractive Due to lemons problem, market interest rate is high, and good firms decline to borrow Equity finance generates worse lemons problems, so is dominated by debt finance

26. Implications of “lemons” model Forecasts more consistent with evidence Profitable firms reluctant to borrow, while firms doing badly borrow more heavily “Lemons” problems yet worse with equity than with debt finance, helping to explain lack of equity issues by smaller firms Also helps explain why cash-flow matters for investment Lemons problems limit debt issues even if bankruptcy costs small

27. Implications of “lemons” model for tax policy Taxes can potentially ease lemons problems Efficiency gains from encouraging good firms to borrow while discouraging bad firms from borrowing. Corresponds with tax law if good firms have t* > m, while bad firms have t* < m Can ease liquidity constraint by lowering corporate tax rate on small firms

28. Empirical evidence • Evidence: Lee and Gordon (2001,2007) • Look at changes in use of debt over time as tax schedules change. • Find quite large effects of i (t* - m) on use of debt. • These responses though can arise under either model, making the efficiency implications unclear.

29. Forms of compensation • Wage payments generate tax deductions for firms and taxable income for individual • Other forms of compensation can generate corporate rather than personal income • Self employed can leave earnings within the firm. • Employees can be paid with equity in the firm that is undervalued for tax purposes. • Choice should depend on t* - m • When t* > m, wage payments preferred • When t* < m, equity compensation preferred, generating tax avoidance

30. Resulting distortions • Size of resulting distortion • Depends on t* - m for each individual • Distortions particularly large for firms with tax losses, e.g. start-up firms • Evidence: Gordon-Slemrod (2001) find that the reported corporate average profit rate (pre interest deductions) is very sensitive to relative tax rates ( t* - m), particularly for those with m > t*.

31. Other distortions • Corporate investment • Dividend payout rates • Risk taking

32. Corporate vs. non-corporate investment Corporations invest until No distortion to allocation of savings (f’ = r + d) if t* = m.

33. Range of distortions to investment • Corporate tax rate varies across firms depending on their size and whether they have tax losses. • Non-corporate tax rate varies across individual tax brackets. • Implies distortions to allocation of capital across types of firms

34. Range of distortions to investment • Investment incentives change if shift between corporate and non-corporate form over the life of the investment. • Gain from use of debt finance varies by type of capital and by firm. • Churning: sell capital so that it can be re-depreciated by new firm. A gain if g < zt*

35. Dividend payout rates • Under personal tax, dividends normally face a higher tax rate than capital gains. • But in most countries, corporate tax payments are unaffected by dividend payouts.

36. Dividend puzzle • Alternative forms of payout of a dollar: • Dividends yield (1 – d) • Retentions yield (1 – g) • Dividends then dominated by retentions, generating the dividend puzzle: Why dividends??

37. Alternative explanations:“New View” • “New view” of Auerbach, Bradford, King • Dividend tax capitalized into the value of the firm. A dollar retention then generates capital gains of some amount q (Tobin’s q). Dividends become attractive whenever (1 – d) > q (1 – g) • Investment undistorted by tax among dividend paying firm: cost and return to investment both taxed at d

38. Counterfactual implications • With cheap shares, better to buy firms owning desired capital than to invest in new capital • Avoid discount with repurchase of shares, with acquisitions of other firms, or conversion to non-corporate form. Repurchases now virtually as large as dividend payments. • Dividends go up when dividend tax is cut, contrary to model • Share prices go up in response to a dividend announcement, contrary to model

39. Alternative explanations:Signaling • Dividends signal that the firm can afford to pay out funds. The more free cash flow, the more dividends it can manage to pay out. • There is an optimal cost of a signal, obtained through signaling with the right combination of dividends and repurchases. • Helps explain why share prices go up in response to a dividend, and why dividends go up in response to a cut in tax rate.

40. Counterfactual implications • Dividends and repurchases should move together, and should respond in opposite directions to a change in d • Share prices should be unaffected by the dividend tax rate, yet observed to fall.

41. Alternative Explanations:Agency Costs • Agency problems • Managers are empire builders, and want to invest more than shareholders do. • Shareholders, by restricting the cash flow available to managers through dividend payments, can restrict the funds available for over-investment.

42. Fewer counterfactual forecasts • Repurchases forecast to be volatile if shareholders choose dividend without knowing true profits • Tax reduces share values • Dividend announcement increases share prices if Board has additional information

43. Implications for tax policy • New view: Tax simply reduces value of equity without affecting investment in firms paying dividends. • Signaling: Tax simply changes the mix of dividends and repurchases with no other real effects • Agency costs: Tax does distort amount of free-cash flow. But agency costs generate other efficiency consequences for tax policy.

44. Risk Taking • The tax law affects entrepreneurial risk taking through several channels • Tax treatment of business vs. wage income • Tax treatment of profits vs. losses • Reallocation of risk from the entrepreneur to taxpayers

45. Tax rate applied to profits vs. losses • If tax rate the same, then expected profits unaffected. • But if tax rate on losses exceeds tax rate on profits, then risk taking encouraged. • Occurs when m > t*, and non-corporate if losses • Opposite happens under a progressive corporate tax schedule

46. Reallocation of risk • With a common tax rate on profits vs. losses, the government bears t* % of the risk and receives t* % of the risk premium. • The marginal cost to the entrepreneur of bearing risk • Remains unchanged if the risky tax revenue is ultimately reallocated efficiently across investors • If risk allocated more efficiently, then cost of risk-bearing falls. Could arise with “lemons” problems.

47. Empirical evidence • Cullen and Gordon (2009) find sizeable effects of the tax law on non-corporate risk taking, arising through all three channels. • Tax law then affects growth, and affects efficiency through its implications for externalities from entrepreneurial activity.

48. Implications for design of corporate tax: Perfect markets • Personal tax reforms interact with corporate tax • Cut in m should lead to a cut in t* • Elimination of taxes on dividends, interest, and capital gains should lead to expensing, but increases the appropriate corporate tax rate • If in addition all equity held in pension plans, including equity in one’s business, then no need for a corporate tax • If shift to a personal tax on an imputed risk-free return to savings, nr K with remaining income taxed as labor income, as with a dual income tax, then again no need for a corporate tax.

49. But market imperfections pervasive in this literature • Debt/equity ratios best explained assuming lemons problems, also implying a form of credit rationing • Dividends suggest agency problems • Externalities from risk taking • Choice of inventory accounting rules best explained by concern with book profits • Corporate tax provisions can then help ease the resulting misallocations.

50. Taxation of multinationals • So far, we’ve assumed a closed economy • Income-shifting pressures become much greater when taxing cross-border activity. • How should the tax system be designed? • Still want to design law so that m = t* on all income accruing to domestic residents, to avoid distortions to location of investment or forms of compensation.