Friday, January 21, 2011

Friday Morning Corporate Tax Reading

As the discussion over corporate tax slashing heats up, there's plenty worth reading on . Let's start with Andrew Jackson's observations on what actually drives investment, and how small a role corporate income tax rates play in the picture:
Ultimately, an investment will be made if expected returns exceed a hurdle rate of return. Canada does not have to be the lowest tax jurisdiction in North America or the world to sustain a set of good corporate investment opportunities so long as corporations can find other things they value - accessible natural resources; cheap power; good infrastructure; skilled workers; low benefit costs due to public health care etc. etc. (Many of these things have, of course, to be financed through taxes.)

Further, at any given time, especially in periods of strong economic growth, some corporations will be earning profits which exceed average and previously expected rates of return. If they anticipate continued high rates of return, an increase in effective rates of tax will not decrease investment so long as profitability remains above the threshold level. And any tax cut would make no difference to the investment decision but would simply result in lost government revenue.

This is the case today in much of the energy and minerals sector. An increase in the effective rate of corporate income tax would not slow investment, and any cut in the corporate tax rate will simply divert high resource rents from citizens to corporate shareholders (and half of the assets are foreign owned.)

Similarly, profitability has in recent years generally been much higher in the financial sector, and there is little reason to believe that bank and insurance profits are a major driver of business investment in the real economy. Higher taxation of excess corporate profits in these sectors could raise additional revenues at little cost in terms of lower real investment.
And Erin follows up by describing how that theory will play out in practice:
With Jim Flaherty’s target corporate tax rate of 25%, investments would need a pre-tax return of only 13.3% (13.3*(1 - 0.25) = 10). So, recent corporate tax cuts should prompt the corporation to make some tranche of new investments with pre-tax rates of return between 13.3% and 15.6%.

But as Andrew notes, investments with pre-tax returns above 15.6% would have happened anyway. On all of those investments, corporate taxes were a perfectly efficient and costless source of public revenue. Corporate tax cuts were a pure giveaway that did nothing to improve incentives.

Also as noted by Andrew, pre-tax rates of return are not constant. If there is insufficient demand for a corporation’s output, the potential return on new investments will be close to zero. Public spending financed by corporate taxes can get potential investments over the hurdle by increasing demand and/or by providing needed inputs like infrastructure.
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To a substantial extent, corporate taxes just skim off excess profits from investments that are already over the hurdle. Rather than simply defending corporate taxes as a necessary source of revenue, there is a case to be made that they are a particularly efficient means of raising revenue.

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