Why Lowering Corporate Taxes Is a Political Promise that Does Not Deliver

With the 2016 US presidential elections, the long and ongoing debate on corporate tax rates was intensified in the media as Donald Trump made the issue central to his campaign. He proposed halving the American rate, offering a new value added-type structure, and allowing foreign profit repatriation incentives if they are paid as dividends to shareholders. These are standard policies countries have employed in varying degrees in the recent past that define modern inter-state tax competition. The problem is that these policies affect nations differently based on the maturity of their economies and their trade openness, exposure and dependence. The degree to which the variations of these three factors are implemented defines a nation’s “tax elasticity”. The tax elasticity is a function of incentives that lower corporate tax burdens. Lower corporate tax burdens are achieved via complex exemption incentive packages that are designed to make a nation more attractive to global businesses in the hope of attracting and retaining capital.

But do they? Economists discuss the difference between “investment” – monetary value of financial flows that include financial instruments and “greenfield investment” – the financing of construction and/or repurposing of production facilities and taxation. National accounting analysts keep discussing tax avoidance as a function of tax elasticity. As international finance diversifies and productivity increases, is lowering the corporate tax rate the “golden egg” that stimulates economic growth? Politicians seem to believe so and base their financial strategies and campaigns on this belief.

The study of Anguelov (2017) casts doubt on this standard policy path by showing that during the decade when globalisation and international finance accelerated at unprecedented rates and most nations engaged in some form of inter-state tax competition chasing foreign direct investment (FDI), those nations that competed most aggressively significantly lowered their GDP growth rates. The results come from a panel analysis of 60 nations with controls for FDI flows, trade openness, level of development and national wealth. The findings suggest that between 1999 and 2009 lowering the marginal corporate tax rate did indeed increase FDI inflows, but that increase had no impact on GDP. On the contrary, the decrease of the tax rate itself decreased GDP growth rates.

There are two main reasons why this trend can be happening over time. One is the impact of FDI on “capital formation”, the generally accepted term for newly created wealth. FDI may not lead to capital formation because today a significant portion of that FDI may be in financial instruments. Financial instruments are increasingly deployed for debt-reducing, tax-deductible write-offs. This finding relates to the changing nature and fluidity of FDI. Most of it now is not in operational assets, but financial instruments, including debt – so increasing aggregate FDI can actually lead to a loss of tax revenue, if debt is treated as a tax deductible liability. The economic community has responded to this change by coining the term “greenfield” FDI vs. “financial” FDI.

The other reason is more indirect. The political decision to lower corporate taxes usually comes on the heels of industrial policies that have failed to produce a needed economic stimulus. It signals a “tipping point” on the willingness of local governments to negotiate further and offer more business-friendly incentives. Those incentives that include taxes also include general re-negotiation of recurrent business costs, such as water, sewerage and electric rates. The problem is that these are also public revenue streams as most utilities are government owned and subsidized. Decreasing their revenue via forgone collection opportunities further erodes public financial streams.

The combination of tax and recurrent cost incentives form the backbone of any industrial recruitment policy. The problem is that industrial recruitment policies as a universal prescription impact developed and developing nations differently. An even more serious problem is that recurrent costs equalise in a downward spiral. Competing via industrial recruitment by lowering those costs is a never-ending cycle of constant re-negotiation of incentive packages to not only attract new investors, but to also keep those already “on the ground” from leaving.

In the sample of countries, the developed nations had higher tax rates that either remained mostly steady or decreased insignificantly, whereas the developing nations had both relatively lower rates and decreased them by statistically significant amounts. This is an important finding because it shows the difference in corporate tax dependence between poor and rich nations.

In fairly wealthy countries, an insignificant percentage of the federal budget comes from corporate taxes. This fact is a function of complicated research and development credits, job creating credits, and national accounting functions that allow operational debt to be tax deductible. In other words, firms can write off debt accrued from expansion in production operations against their corporate profits. This system has gradually grown to such levels that, in the United States for example, less than 9% of the federal budget comes from corporate taxes. The difference is made up of reliance on individual income, payroll and excise taxes. This “trade-off” has increased in the past half century in a downward spiral where in the 1950s around 30% of the American federal budget came from corporate taxes.

It is possible in rich countries to have policies that generate this shift in public financial revenue streams when the income of the average citizen is fairly high and growing. However, this policy is not a good option for developing nations with annual gross national incomes per capita of below $12,235 (according to World Bank classifications), because shifting tax burdens from corporate to individual income is extremely regressive. It disproportionately negatively impacts individual discretionally spending brackets in the wage-earning population while the benefits disproportionately accrue to shareholders in the forms of increased dividends.

Developing nations compete most aggressively for FDI. They depend on foreign finance and technology for climbing the industrialisation ladder and part of their attractiveness are lower production costs, including labour. It is not possible to levy payroll, income and excise taxes significant enough to sustain healthy federal budgets in nations where people earn a few dollars a day.

For these reasons the debate on lowering corporate taxes seems silly. In the developed world, write-off mechanisms have rendered corporate taxes insignificant as a source of federal revenue. Most corporations do not pay marginal taxes on corporate profits; they benefit from a system where the effective tax rate is often 0. If the official (or statutory) tax rate is 39.1% in an economy where the effective tax rate can be 0, as is the case with General Electric in the United States[1], lowering the statutory rate will not magically make General Electric pay more than it legally does under an effective tax rate that can be lowered to 0. According to the US Government Accountability Office over 50% of American corporations pay no taxes under the current system. Without changing the system of tax exemption incentives, simply lowering the rate may build political capital, but not economic growth.

In the developing world, lowering marginal corporate taxes can have more severe consequences because federal revenue is more dependent on corporate income. As developing nations need a steady increase in public funds for infrastructure investment and institution building, cutting the main stream of such funds can lead to dangerous tax erosion. The results of this study may capture some of that dynamic in the context of the larger and more complex reality of tax avoidance and capital flight. The econometric analysis offers ideas of general proxies for studying the impact of changing corporate tax rates on economic growth and can be used to help future research create finer models with more targeted controls for factor endowments, industrial make-up and export dependence.

This article is based on: Anguelov, N 2017, ‘Lowering the marginal corporate tax rate: Why the debate?’, Economic Affairs, vol. 37, no. 2, pp. 213-228.

 

[1] Although General Electric has become the punching bag in the media for paying no taxes, it is not the only one. See: https://www.nytimes.com/2017/03/09/business/economy/corporate-tax-report.html?_r=0