TAXATION OF COMPANIES

Alan J. AuerbachMichael P. Devereux

and Helen Simpson

Outline

1. Brief summary of Meade’s recommendations

2. Relevant developments since 1978 in economies, economic theory and empirical evidence

A. Growth of cross border flows

B. Relationship between corporate and personal taxes

C. Financial innovation

D. Corporation tax incidence

3. Alternative proposals for reform of corporation tax

1. MEADE’S PROPOSALS:A Flow-of-Funds Tax

• Aim to leave marginal investment tax-free; cost of capital unaffected by tax– under standard models, investment and choice of finance

unaffected by tax

• Achieves this by allowing all expenses to be deducted from taxable profit when they are incurred; so no attempt to match accounting profit

• Choice of three possible tax bases: R, R+F and S

Analysis of Flow of Funds

Type Inflows Outflows

Real Sale of produce, service, fixed assets

Purchase of materials, wages, fixed assets

Financial Increase in borrowing, interest received

Repayment of borrowing, interest paid

Shares Increase in own shares issued, dividends received

Repurchase of shares, dividend payments

Real inflows – Real outflows = R base

+ Financial inflows – Financial outflows = R+F base

= Share outflows – Share inflows = S base

Relationship with Personal Tax

• Meade considers relationship appropriate with various combinations:– a comprehensive income tax and two forms of

expenditure tax; and– a company profits tax, and R base and an S base

• Appropriate form of integration varies with combination

• But little analysis of integration in a more general setting

2. SUBSEQUENT DEVELOPMENTS

A: Growth in Cross Border Flows of Capital and Profit

Outward FDI: US and UK

0

50

100

150

200

250

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

Year

2000

$bn

UK US

Impact of Taxes on Capital Flows

• Direct flows depend on different decisions– discrete choice of where to locate

• depends on effective average tax rate

– conditional on discrete choice, usual investment decision

• depends on effective marginal tax rate

• Considerable evidence of significant role of tax – but mainly for average rate

Profit Shifting

• Another type of internationally-mobile flow– Conditional on the location of plants and capital,

profit possibly more mobile than capital

• Considerable empirical evidence– Studies analyse relationship between tax rates and:

declared profitability, repatriation of dividends, use of debt, patterns of within-firm trade

– Generally depends on statutory tax rate

Tax Competition

• Between governments:– over statutory rate to attract profit– over effective average tax rate to attract firms– over effective marginal tax rate to attract capital

• Empirical evidence especially for competition over statutory rates

• Policy relevance: OECD and EU initiatives on “harmful” tax competition

• Trends in rates?

OECD Average Statutory Corporation Tax Rates

20%

25%

30%

35%

40%

45%

50%

55%19

8219

83

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

median unweighted mean GDP weighted mean

OECD average present discounted value of depreciation allowances

72%

74%

76%

78%

80%

82%

1982 1986 1990 1994 1998 2002

Assumed inflation rate (3.5%) Actual inflation rate

Implications for Tax Design

• Effective marginal tax rate of zero is not sufficient for neutrality

• In international context especially, statutory rate and effective average tax rate also affect flows of capital and profit

• Flows of funds tax could have high statutory rate and effective average tax rate

• Competition is exerting downward pressure on statutory rates

2. SUBSEQUENT DEVELOPMENTS

B: Relationship Between Corporate and Personal Taxes

Two issues:1. Does a classical relationship for taxation of

dividends imply lower investment?2. Do differences between taxation of corporate

and personal income distort choice of organisational form?

Why Might Effects on Investment be Small?

• In a small open economy, shareholders are dispersed around the world– At a given asset price, each investor will trade off higher or

lower tax against higher or lower risk

– A higher tax on domestic investors will not affect the asset price (and hence not investment) if the wealth of domestic investors is small in world terms

• “New view” – Dividend taxes are capitalised into share prices

– For investment financed by retained earnings, dividend taxes are like an S-based tax, which is neutral

Ownership of UK Listed Shares by Rest of the World

0

5

10

15

20

25

30

35

1963 1975 1989 1991 1993 1997 1999 2001 2003

Year

% R

est o

f W

orld

Sha

reho

lder

s

Note: UK offshore islands were re-classified to Rest of World in 1997

Source: ONS, Share Ownership 2004.

Differences in Legal Form

• Choice to incorporate can depend on the relative overall tax treatment of corporate income v personal income– e.g., in US, strong growth of S-corporations, which

have limited liability but are not liable to corporation tax

– also in US, small companies can “check the box” to be taxed under the personal income tax• has given rise to “hybrid entities” used for

international tax avoidance

S Corporation Share of Nonfinancial Corporate Income

0

0.1

0.2

0.3

0.4

0.5

1980 1984 1988 1992 1996 2000

Year

S C

orpo

rati

on S

hare

Implications for Tax Design

• Need to distinguish between different types of enterprises:– Existing firms vs. start-ups

• Taxation of dividends may have different effects

– Firms that can choose organizational form vs. firms that cannot (due to ownership structure, need for capital market access, etc.)

• Need to distinguish burdens on investment from those on incorporation – like the distinction governing international location decision

2. SUBSEQUENT DEVELOPMENTS

C: Financial Innovation

• Substantial increase in the availability of new financial instruments, blurring the distinction between debt and equity

• Growth in financial sector• Increasing difficulty of distinguishing real

and financial flows

US Common Stock & Hybrid Equity Issuance, 2001 – 2005

$0

$50

$100

$150

$200

$250

$300

2001 2002 2003 2004 2005

Tot

al V

olum

e ($

bil

lion

s)

Common Stock Optional Convertibles Mandatory ConvertiblesTrust Preferred DRD Eligible Preferred

Taxes on Financial Corporations as a Share of All Corporate Taxes, 1983-2003

0.00

0.05

0.10

0.15

0.20

0.25

0.30

0.35

1983 1987 1991 1995 1999 2003

Year

Fra

ctio

n of

Cor

pora

te T

ax

Rev

enue

s

UK

US

Implications for Tax Design

• Increased difficulties under both R and R+F bases– R base:

• Need to distinguish between real and financial transactions on the sales side, e.g., GM vs. GMAC

• How to tax financial companies, whose returns are excluded from R base?

– R+F base:• Need to distinguish debt and equity flows, as under

current law

2. SUBSEQUENT DEVELOPMENTS

D: Corporate Tax Incidence

• Continuing shift away from the view based on the Harberger model

– Increased emphasis on open economy– Even in closed economy, several complicating

factors

Open Economy Incidence

• Much less likely for capital to bear the corporate tax– Burden shifted to land, labor and less mobile

factors

• Bigger distinction (mentioned earlier) between taxes on portfolio investors and taxes on corporations

Closed Economy Incidence

• Dynamics, financial policy and existence of rents all suggest that some taxes may be borne by shareholders

• To the extent that initially shifted to all capital, responsiveness of saving may shift at least partially to labor

Implications for Tax Design

• Positive marginal tax rates on corporate capital more likely to be borne by shareholders, labor and land than “all capital”

• As in tax competition discussion, several relevant characteristics of corporate tax, not just marginal tax rate on new investment

3. REFORMING THE CORPORATE TAX:

ALTERNATIVES TO R AND R+F

• ACE– Flow of funds approach but with different timing– Deals with tax losses arising from expensing of

investment– Pattern of deductions closer to economic

depreciation, so smaller impact of tax rate changes– No solution to other problems, such as

real/financial distinction

3. REFORMING THE CORPORATE TAX:

ALTERNATIVES TO R AND R+F

• CBIT– Fixes problem of distinguishing between debt and

equity finance– Broader base allows statutory rate to be lower– Worsens real/financial distinction

3. REFORMING THE CORPORATE TAX:

ALTERNATIVES TO R AND R+F

• Dual Income Tax– Single tax rate on all capital income in principle

removes significance of debt/equity distinction– lower rate on capital income compared to labour

income helps with greater mobility of capital– But single rate typically only for corporate and

personal tax combined, so only applies to domestic residents

3. REFORMING THE CORPORATE TAX:

ALTERNATIVES TO R AND R+F

• Formula apportionment– Reduces scope for shifting profit between

locations– A more stable alternative to source-based taxation?– Isn’t a shift to sales factor essentially a means of

imposing a sales tax?– Doesn’t address other issues raised

3. REFORMING THE CORPORATE TAX:

ALTERNATIVES TO R AND R+F

• Flat/X tax– Progressive tax combining R based business tax

with progressive wage tax– Problems if source-based tax similar to those of

present system– Can implement as a destination-based tax