TAXATION OF COMPANIES Alan J. Auerbach Michael P. Devereux and Helen Simpson

Outline 1.Brief summary of Meades 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. MEADES 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 TypeInflowsOutflows RealSale of produce, service, fixed assets Purchase of materials, wages, fixed assets FinancialIncrease in borrowing, interest received Repayment of borrowing, interest paid SharesIncrease 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

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?

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

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

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

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? –Isnt a shift to sales factor essentially a means of imposing a sales tax? –Doesnt 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