Taxing Corporations Sijbren Cnossen CPB Netherlands Bureau for Economic Policy Analysis Erasmus University Rotterdam (Fiscaal-Economisch Instituut, 11 June 2010)

Outline 1.Introduction 2.Alternative forms of CT 3.How are corporations taxed in the European Union? 4.Choosing the most appropriate form of CT

1a. Introduction: why tax corporations? Traditionally the following arguments have been made for imposing a CT:  to tax foreign investment (source entitlement principle)  to tax capital gains (which are difficult to tax at the shareholder’s level)  to tax pure profits (which can be taxed without causing distortions)  Backstop to individual income tax (PT)  Because other countries have CT (treasury transfer argument)  Willie Sutton! ¶Arguments bypass incidence issue and do not address the question whether or not capital should be taxed

1b. Introduction: A broader view of the issues Traditional arguments bypass, e.g. the treatment of interest, the inadequacy of the benefit-received argument, and the existence of firm-specific rents So a broader view of the issues seems called for and we should ask ourselves the following questions:  What is the base of the CT?  Where should the base be taxed?  What is the appropriate relationship between the CT and the PT?

What should be taxed, where and how?  What is the base of the CT? - accounting vs. economic profits - return on equity and return on debt - corporate source income vs. business cash-flow  Where should the base be taxed? - source or residence principle? - separate accounting or formulary apportionment?  What is relationship between CT and PT? - distributed vs. retained profits - corporate source income vs. other capital income

2. Alternative forms of CT CTs can be usefully distinguished depending on whether or not the normal return (‘hurdle rate of return’) is included in the base  Income-based CTs do include the normal return on equity in the base  Cash-flow based CTs confine the base to above-normal or pure profits

Income-based CTs: classical system Double-taxation (distributed and retained profits)  Distortions - in business organization - in financial structure (debt/equity ratio) - in dividend policy (pay-out ratio) - through variations in effective tax rates between assets, industries, risk-taking, timing, etc.  Challenges in the finance literature (Modigliani- Miller) and the public finance literature (new view), but conclusion still stands that distortions are real although perhaps not as large as sometimes thought

Income-based CTs: integration systems  Full integration (conduit view)  Partial integration (dividend relief) - imputation - split-rate - dividend-deduction ¶ Systems can be made equivalent for domestic shareholders - ad hoc approach: lower PT or partial exemption

Income-based CTs: schedular systems  Dual income tax (DIT): capital income taxed separately from labor income  Comprehensive business income tax (CBIT): no deduction for interest, but exemption at recipient level (= DIT with final interest withholding tax)  Wealth tax approach (double taxation)

2b.Cash-flow based CTs  Concept: tax on flow of funds is equivalent in present value terms to tax on annual pure profits levied over the lifetime of the investment (full expensing and no deduction for interest)  Examples - allowance for corporate equity (ACE) (=CBIT with immediate expensing) - Hall-Rabushka type of flat tax (business cash-flow component of VAT) * C = Y – S = W + [R – I] ¶Extension to consumption tax?

Issues in cash-flow taxation  Economic effect uncertain  Distributional effects controversial  High tax on profitable firms  Simplicity gains difficult to quantify  Transitional effects problematical  Political obstacles large  FTC available?  Still requires harmonization

3.How are corporations taxed in the EU?  Classical system: Ireland  Shareholder level relief - imputation system: Malta, UK - schedular PT lower than top rate PT (16 member states) - exemption, partial or full (6 member states)  Corporate level relief - deduction for “notional interest” (Belgium) - profits distribution tax (Estonia)

Common features of CTs in EU  Capital and labor income are taxed separately  Capital income is taxed at lower rates  Distributions taxed higher than retained profits  Most interest income escapes tax; interest on inbound capital is not taxed  Generous tax incentives in new accession states (accelerated depreciation + exemption of interest)

4.Choosing the most appropriate form of CT Considerations  Tax normal return  Low rate which is favorable to highly mobile international capital, but still taxes firm-specific and especially location-specific rents  Uniform rate which reduces distortions, tax arbitrage and international tax avoidance  Permits separate capital income tax rate, which is not held captive by the higher labor income tax rate  Allows use of treasury-transfer argument, maintains backstop function for the PT, and avoids pitfalls of cash-flow tax  Permits different CT rates between member states ¶Implies low uniform-rate CT, i.e. DIT

Workings of the DIT Characteristics  All capital income taxed at CT rate, which is also the lowest labor income tax rate  Costs of earning income only deductible against the basic rate  No basic allowance for capital income  Offset of negative capital income against labor income  Imputation system or PT-exemption for distributed profits  Capital gains tax but write-up of base of shares  No withholding on interest on inbound capital  Splitting system for profits of proprietorships and closely-held companies

DIT: first step towards CT harmonization Bottom up, reversible approach (soft law approach)  Introduction of DITs, but separate rates on capital income between member states  Agreement on withholding taxes on interest and royalties (CBIT)  Approximation of capital income tax rates  Common base and formulary apportionment?  Adoption of European CT?

Conclusions  Reforms of CTs in member states should precede CT coordination between member states  Coordination important if CT compliance costs are to be reduced (and capital income is to be taxed)  Importance of subsidiarity: bottom-up, gradual and initially reversible process