The Economics of Corporate and Business Taxation

The role and consequences of corporate taxation (and of business taxation more generally) are central to current tax policy debates around the world, and are major topics of interest to firms and to scholars in a variety of fields. An extensive debate has developed in the US over the last few years over various proposals to reform its current system of business taxation. My paper ‘The Economics of Corporate and Business Tax Reform’ provides a framework for analyzing these reform proposals by describing the lessons from economic research and analysis for business tax reform. In view of the importance of the international aspects of business taxation, the paper addresses both international and domestic reforms within a unified perspective.

The paper begins by identifying ten potential inefficiencies created by the current corporate tax regime. These include distortions to the amount and location of investment by firms, to the use of external debt, to payout and repatriation decisions, to the organizational form chosen by firms, to the ownership of assets and the market for corporate control, and to patterns of global portfolio investment. Particularly relevant to international tax reform are distortions to dividends paid by foreign affiliates of US-based multinationals to their parents (termed the ‘lockout effect’), and deadweight costs created by the expenditure of resources by firms on tax planning. My paper aims to clarify the efficiency consequences of these distortions and to briefly describe the empirical evidence regarding their magnitude.

In addition, the paper presents a simple model that seeks to clarify the nature of the deadweight costs of tax planning in the specific setting of multinational firms engaging in the shifting of income across different jurisdictions (ie ‘base erosion and profit shifting’, as this activity has come to be widely known). The model derives the conditions under which the observed responsiveness of firms’ reported income to tax rates can be used to infer the deadweight cost of tax planning. If firms’ tax planning costs are pure resource costs, then the deadweight cost can be inferred directly from the observed responsiveness. If tax planning costs are instead transfers to tax planning professionals, then the deadweight cost depends on the relationship between tax planning costs and tax planners’ socially valuable output in their next-best occupation; in general, the deadweight cost cannot be directly inferred from the observed responsiveness.

The paper then discusses three classes of reform proposals. The first (which enjoys widespread support among commentators and is thus arguably a ‘consensus’ approach) involves the US substantially lowering its corporate tax rate, while instituting a territorial tax regime (that exempts dividends paid by foreign affiliates to their US parents). This is combined in some versions with a one-time levy on the foreign cash holdings of US multinational firms and with a minimum tax on the foreign income of these firms. The second is a formula apportionment system (which would allocate the worldwide income of multinational firms to particular countries based on a formula, such as the volume of sales within each country). The third category includes a destination-based cash flow tax (DBCFT), which would transform the tax base from income to cash flows and impose tax only on cash flows related to domestic activity.

The paper evaluates each of these proposals in the light of the framework introduced earlier. It concludes that the relatively modest ‘consensus’ reforms currently under discussion would address only a few of the efficiency margins. A formula apportionment system would solve some of the cross-border problems associated with the current international tax regime, but it may give rise to entirely new types of distortions. In contrast, more fundamental reforms such as a DBCFT would eliminate all or most of the inefficiencies of corporate taxation. Thus, a DBCFT is a very attractive reform proposal from the perspective of the efficiency-based framework articulated in this paper. However, most of its virtues are shared by a destination-based value-added tax (VAT; a tax to which the DBCFT is very much akin). The US is extremely unusual in not yet having introduced a VAT. Implementing a DBCFT would raise new issues of administration and law, whereas the implementation of a VAT could draw on the extensive body of law and experience developed by about 150 countries over several decades.

Dhammika Dharmapala is the Julius Kreeger Professor of Law at the University of Chicago.