The Effect Of Corporate Income Tax

Published Date: 02 Nov 2017

Chantalle LaFontant

Introduction

Uncertainty continues to dominate the global economy. For those charged with stimulating the economic growth for the nation mounting evidence supports using a reduction in corporate income tax rates to increase foreign direct investment (FDI) inflows. Such a reduction promises to grow a country’s economy, and indirectly the tax base (Tyson). The purpose of this report is to provide tax policymakers with a brief overview of generally why a corporate income tax rate reduction is recommended. In the first part of this paper a brief overview of global economic conditions is given and why increasing FDI inflows is a priority. Then a generalized case for why rate [1] reductions should be pursued is presented. In this first part of the paper an overview of how this reform confirms to general principles of sound tax reform is detailed. In the second part, an overview of how this reduction could affect different country groups is presented with the aim of helping policy makers how to apply general principles to the particular needs and circumstances of their home country.

Overview of the Current Global Economy

The United Nations Conference on Trade and Development (UNCTAD) announced in January 2013 that much of the gains in global foreign direct investment (FDI) inflows since the Great Recession were lost in 2012 (UNCTAD 2013). Since many economy planners have placed increasing importance on FDI inflows as important component of growth, considering how global factors affect FDI inflows is thus increasingly important, especially for emerging economies (Arbatli, 2011). FDI inflows commonly follow the direction of most other economic indicators. Macroeconomic indicators remained positive in 2012, but declined from rates seen in the previous year. Global growth rates for gross domestic product (GDP) fell from 2.7 to 2.3 percent from 2011 to 2012, trade fell from 5.8 to 3.2 percent and employment fell from 1.5 to 1.3 percent (see Table 1 in Appendix). [2] Global FDI inflows, however, declined by 18%, declining from 1.60 trillion (USD) in 2011 to 1.31 trillion (USD) in 2012 (UNCTAD 2013). For a number of reasons, chief among them the continuing financial and budgetary difficulties in Europe and the United States, FDI inflows have declined much more greatly than other macroeconomic indicators would suggest. In summary, using the words of Christine Lagarde, Managing Director of the International Monetary Fund (IMF), the recovery of the global in 2013 most likely will be "fragile and timid" (Monk 2013). For many countries this means competing more intensely for the remaining FDI inflows available.

Most countries have chosen to increase their global competitiveness by lowering their corporate income tax rates. The global total tax rate as the percent of commercial profits have continued to decline. Year by year since 2005 this figure has decreased, starting with a high of 53.6% in 2005 to 44.7% in 2012, a nearly 17 percent total decline (see Figure 1). From having a negligible impact in 1970, worldwide 13 billion (USD), FDI inflows have increased by 120 fold by 2000 to 1,492 billion (USD). FDI inflows accounted for almost 50 out of every 100 (USD) of GDP in 2000, compared to less than 1 (USD) in 1970 (Jones and Wren, 2006, p. 7). Countries with highest corporate income tax rates have lower FDI inflows (Bénassy-Quéré, Fontagné, and Lahrèche-Révil, 2005). Knowing that tax rates have an effect on FDI flows, countries have responded by decreasing their tax rate. Policymakers now also have to contend with an increasingly global competitive environment over FDI flows and likely stagnant economic conditions for the foreseeable future. This creates increasing fiscal pressures on tax revenues as governments face increasing welfare needs in the form of swelling unemployment insurance expenditures and other social welfare programs. As a result deficit spending has increased (World Bank Indicators, 2013), meaning, especially in developed countries, growing populace sentiment that favors corporations paying more taxes, less (Taylor, 2012).

The Benefits of Increased FDI Inflows

There are a number of reasons why countries compete to increase FDI inflows. First, FDI increases the capital available for investment. Presupposing that FDI does not crowd out local investment, which evidence indicates is usually not the case, given that financial markets are well developed (see Alfaro, Chanda, Kalemli-Ozcan, and Sayek, 2010; Azman-Saini, Law, and Ahmad, 2010), increasing inflows grows a country’s economy. When financial markets are not well developed, some still see FDI as beneficial since it likely there does not exist the capacity to meet the capital requirements for large investment activities. TNCs via FDI inflows can bring this needed capital to these financially underdeveloped markets (OECD, 2002). Some even think that FDI inflows helps to develop local capital markets, since the foreign injection of capital creates opportunities for new local business activity, wealth generation, and thereby the eventual formation of a more well-formed local capital market (Easson, 1999, p. 9).

Second, FDI inflows can increase employment and introduce new skills and technology into the country (Blomström, Kokko, and Mucchielli, 2003). The impacts of these declines differ dramatically for different countries. For developed countries, FDI inflows have decreased to levels seen nearly ten years ago. According to Harrison (1994), FDI inflows tend to improve performance and promote higher levels of productivity for the host country. Technology transfers occur between those directly associated with the firms. There is also evidence that FDI inflows encourage domestic firms to enter into export markets. Additionally, for those employed by foreign firms are paid at a higher rate. Finally, FDI inflows often create spillover effects (Easson, p. 11).

The range of spillover effects can be numerous. Beyond direct employment by foreign firms, often local partnerships are formed increasing employment indirect as a result of FDI inflows. FDI inflows promotes higher rates of general innovation, and allocative and productive efficiency, and (Cheung and Lin, 2004; Javorcik, 2004; Zhang et al., 2010). The manufacturing done in the host country also creates addition export opportunities, thereby creating another opportunity for revenue generation for the host country. Foreign firms also usually increase the country infrastructure – new roads are built, electricity generation and distribution increases (i.e. new power lines), new sewer lines and more are built (Easson, p. 11; UNCTAD, 1992). At some point it may even be possible for domestic interest to replace FDI (Markusen and Venables, 1999). However, some criticize the depth of these spillover effects. Profit repatriation is often cited as chief among these concerns. At the same time, others can argue that countries with environments to induce FDI withdrawal or lack of reinvestment by TNCs are unlikely to economically viable in any case (Bénassy‐Quéré, Coupet, and Mayer, 2007).

Adequacy of Corporate Income Tax

The challenge for policy makers, however, is figuring out if a tax rate reduction will spur enough new investment to make up for the rate reduction. In general, the adequacy of corporate income tax revenue is low. It is neither stable nor inelastic. A pattern of predictable growth is not found with income taxes (Keightley and Sherlock, 2012). Since the corporation tax is based on profits, when the economy contracts so does the amount of business and thus the tax revenue generated from this source. This tax is also highly elastic. In times of economic growth, corporate tax revenue totals grows with the economy. This also means that when there is an economic downturn, tax revenue from this source also declines. Ideally, over the course of the business cycle revenue from this tax will cover the public services provided to those paying the tax. Income taxes at the national level, at least for more developed countries, are not a significant part of the tax base. In the U.S. corporate income taxes make up about 7 percent of the total tax base and in the OECD on average about 10 percent (Williams, 2011).

For transition and developing countries, the contribution of corporate income tax revenue to the total tax base is harder to determine. FDI also does not contribute much tax revenue for developing countries (Goodspeed, 2006). These countries tend to rely on FDI inflows very heavily as a source of economic development. As a result, these countries offer a lower statutory tax rate on corporate income (see Figure 4). Additionally, they offer a number of other tax incentives to attract TNC direct investment into their country, ranging from tax holiday, investment allowances, and more (see Table 2). These forms of tax expenditures, thereby, reduce the contribution of corporations to the tax base. These incentives also make it harder to decipher what is the true impact of statutory tax rates on corporate income, especially when deciphering its effect on FDI inflows. For example, although the United States is often cited as having one of the higher corporate income tax rates in the world, in 1994 the effective tax rate was about 25% despite having a statutory tax rate of 38% on corporate income. Although in that year there was no investment tax allowance in the United States, the effective taxed reduced by more than a third by allowing corporation to benefit from a generous depreciation schedule on buildings (4.4%) and machinery (18.6%), inflation rate assumptions, and interest deductions. A similar difference between the effective and statutory corporate income tax rates was also observed in Spain (Morisset and Pirnia, 2000, pp. 12-13). 

Transparency and Efficiency

As demonstrated by the difference between statutory and effective tax rates, transparency is also an issue. For example, the number of deductions and other tax expenditures found in the United States tax system favor those corporations who have the expertise and ability to distort behaviors that take advantage rules to reduce their effective tax rates. Because statutory rates differ widely from country to country, change regularly, and there are a wide variety of tax incentives involved that lower effective rate greatly from statutory rates, as whole corporate income taxes are "complex" (PWC, 2012, p. 2). A lack of transparency then also promotes a culture of tax avoidance among firms. According to international tax theory, the main objective to ensure that international income is taxed once (Desai and James, 2003; Figueroa, 2005). That does not mean that the international tax rate on mobile capital has to be same. However, when it is then, then that income ought to be only taxed once. For example, when the taxation in total from jurisdiction 1 and 2 totals the tax rate found in jurisdiction 3, then jurisdiction 3 should impose any addition tax. If so that would be an example of double taxation. The goal is avoid double taxation. For FDI that means that "investing abroad should not provide means of avoiding tax, but nor should it be penalized by excessive taxation" (Easson, 1999, p. 30). The realities of international tax coordination, however, fall far short from this standard (Razin and Yuen, 1999). The lack of transparency in the international tax system exacerbates this problem.

At the same time, governments face political and economic constraints that limit their ability to set tax rates at optimal competitive levels, as dictated by international public finance theory (Franzese and Hays, 2007). Countries with severe budget constraints and political will strongly opposed to corporate tax rate reductions will likely not reduce tax rates to gain a competitive advantage. Plümper, Troeger and Winner (2009) find this is generally true for homogenous countries facing severe budget constraints and political will against corporate tax rate reductions. They conclude that tax competition fosters tax diversity rather than tax convergence in tax policies and no race to the bottom (p. 21). In the words of Paul H. O’Neil, former Secretary of the U.S. Treasury:

For a long time we’ve maintained what I think is clearly a fiction – the idea that somehow corporations and businesses pay taxes. The clear economic truth is that businesses and corporations don’t pay taxes, they just collect them for the government… (Marlow, 2001)

His words express the sentiment held by most economists that firms are merely collecting the taxes that ultimately will fall onto employee, consumers and investors. The result is that the standard of living is lower. Some estimate the lifetime earnings gained by the elimination of the corporate income tax in the United States would be $10,000. The result is that in tax systems where personal income and consumption also exists alongside the existence of a corporate income tax, then there is a double tax. For those in tax systems where there exist taxes on pensions, real estate, mutual funds and stocks, the corporate income also dis-incentivizes investment (Marlow, 2001). Despite the inefficiency of this tax, political will and intransigency makes the elimination of the corporate income tax very unlikely for virtually all nations.

Nonetheless, globally the trend is to reduce the statutory tax rates on corporate income. According to Price Waterhouse Cooper (2012), during the last seven years 51 percent of the 183 economies included in their study have lowered their statutory tax rates, with 14% having reduced the rates more than once. Rate reduction were less in the Latin America and Caribbean region and the Middle East, which is not too surprising since FDI already tend to flow more heavily to these regions. Rate reduction occurred most often in Eastern Europe and Central Asia (p. 9), areas dominated by transition economies. And so, while statutory rates worldwide are declining, it is unlikely that statutory rates will trend to or near zero. However, it is clear that countries find the benefits associated with decreases in the corporate income tax rate to outweigh the costs of forgone tax revenue. It is also clear that that tax competition causes countries to continually lower their tax rates. Countries must compete or they risk being unable to attract FDI inflows at any level. This makes the international tax system inefficient. Firms seek arbitrage opportunities and difference in tax rates creates instances of double-taxations.

Lack of transparency is part of the problem. Developing countries rely on tax holidays, the creation of free enterprise zones, and other methods to induce greater FDI inflows and produce effective tax rates much lower than the statutory tax rates on corporate incomes. Developed countries rely more so on firm-advantageous depreciation schemes, interest deductions, and inflation assumption. The net effect produces inefficiencies. Because the international tax system lacks transparency and convergence in tax rates for reasons already explained, countries compete to attract FDI inflows. Especially in today’s fragile global economic environment, countries face extra pressure to attract new FDI inflows into their countries.

Collectability

Policy makers also have to contend with collection challenges. Tax avoidance is a particular problem when it comes to collecting taxes on corporate income. Incentives used to induce greater FDI inflows can also be avoid paying taxes. TNCs can also move profits from high to low tax-rate areas; thus, violating a principle of a sound international tax system. TNCS also defer income, either by continually re-investing it or through transfer pricing. Continual re-investment can theoretically delay the tax indefinitely, since income is only tax once repatriated in the home country. Estimates for profit shifting range from $10 to $60 billion per year (Gravelle, 2009). For some, this profit shifting is reason enough to move away from an international system and turn towards a territorial tax system, which would limit tax collection to only business transactions that occur within a country’s borders (Dittmer, 2012).

Policy makers also have to contend with tax havens that offer TNCs (and individuals) to escape or drastically reduce tax liabilities (Palan, Murphy, and Chavagneux, 2013). These tax havens erode the tax bases of higher tax rate countries. However, lending support to the desirability of a lower corporate income tax rate, this erosion does not make high income countries worse off. Moreover, although the existence of tax haven do not benefit nations with higher tax rates, evidence does exist that tax haven countries seem to have stronger governance mechanisms than comparable countries without tax havens. Although tax havens may create this this benefit by happenstance, the net effect is that tax havens reduces the tax base for many countries, making tax collection fall below what they would be without their existence. This challenge to collectability, however, may not be all bad. They do not make high-tax rate countries worse off and correlate with higher levels of governance in tax have countries (Dharmapala, 2008).

Thus, on the basis of collectability, corporate income tax reform is needed. Profit shifting, tax havens, and the seemingly inconsequential effect of tax avoidance for higher tax-rate countries lends itself to argument that the corporate income tax rate needs lowering and that the potential increases in FDI inflow are well worth the costs that a rate reduction may bring.

Competition for FDI Inflows – Equity Implications

In a world of increasingly mobile capital traditional theory dictates that the corporate income tax rate should fall to zero as government compete to attract firms and add to their tax bases (Mutti, 2003). Wilson and Wildasin (2004) define this tax competition "as noncooperative tax setting by independent governments, under which each government’s policy choices influence the allocation of a mobile tax base among ‘‘regions’’ represented by these governments" (p. 1067). Although governments may compete also over worker and consumers, FDI inflow competition concerns itself with competition over firm and capital location. This definition of tax competition used by Wilson and Wildasin eliminates the needs to consider issues of vertical tax competition, whereby sub-national units within the nation may compete with the national government over FDI inflows in this case. The impact of horizontal tax competition between countries is thus the focus of this paper as it pertains to tax competition.

Further, corporate income tax rate reduction should start at first with decreasing the statutory rates. Doing so promotes greater vertical firm equity. Firms unable to take advantage of complex loopholes incur less cost for their inability to do so. It makes sure that domestic firms are not unduly disadvantaged, as could occur through other tax instruments that would specifically target foreign firms. A rate reduction narrows vertical firm inequities, but it does not eliminate it. Firm vertical equity would occur only when the corporate income tax system would not disadvantage firms unable to take advantage of complex tax expenditure schemes (OECD, 2007; Auerbach, 2002). Another important consideration for policymakers is how to classify TNCs headquartered in a country. There is an argument that home countries in many ways have to compete for their business just like other potential host countries to keep substantial business activities within its confines (Hao and Lahiri, 2012). Headquarter status often requires minimal home country activities. The implication is that corporate income tax policy creates a lack of vertical firm equity also for this reason. TNCs dominate and tax systems may cater to their needs in order to maintain or attract their business. TNC equity, thus, might also arise, since home countries may favor domestic TNC over foreign equivalents when constructing corporate income tax structures.

Overall, corporate income tax systems are riddled with inequities, especially when considered from the perspective of the firm. Because the focus is on tax competition between countries for attracting FDI inflows, by definition, only horizontal equity concerns at the country level. From either perspective (firm or nation), the current system does not create equity. This is another reason why the system needs reform and why decreasing the statutory rate is a good place to start.

The Relationship Between Corporate Income Tax Rates and FDI Inflows

Empirical evidence confirms theory that the corporate income tax rate does affect firm location decisions. While there are a number of factors that affect firm location decisions, Bellak, and Leibrecht (2009) find that corporate income tax rate by way of the bilateral effective average tax rate (beatr) is about as equally important as other costs that affect location decisions in their study of Central and East European countries. They calculate a semi-elasticity of FDI of about -4.3 for the tax. This contrasts with lower tax-rate elasticities calculated by de Mooji and Ederveen (2003). In their meta-analysis study de Mooij and Ederveen had the semi-elasticity of FDI to tax rates range from –22.7 to +13.2, averaging either –3.3 or –4.0, subject to whether non-significant estimates are or not counted. Desaid and Hines (2001) find that the elasticity of FDI to tax rates spans from –0.6 to –2.8, depending the estimation method used. Although elasticity estimates are higher when effective tax rates are used, in any case, the ultimate conclusion is the same – corporate income tax rates do affect FDI inflows.

The empirical evidence about taxation’s effect on FDI has shifted. When James Markusen (1995) surveyed TNCs nearly twenty years ago he found "little support for the idea that risk diversification or tax avoidance are important motives for direct foreign investment" (p. 171). Easson (1999) supports Markusen (1995) earlier contention that once a firm chooses to invest abroad, all other factors being equal, tax consideration plays an important role. A number of researchers in more recent years have come to conclusions that taxations weigh more heavily as determinant of FDI allocation (Haufler and Stӧwhause 2003). For the policy maker, however, the most important fact is that: "During the second half of the 1980s, global foreign direct investment flows grew faster than domestic output, twice as fast as domestic investment, two-and-a-half times as fast as technology payments" (UNCTAD, 1992, p. 1).

In light of the after effects of the global-wide Great Recession increasing FDI flows is attractive way to spur economic recovery. At the same time, FDI flows are heavily influenced by the global economic conditions. The drivers of FDI inflows are TNCs. Ramamurti (2011) finds that emerging market TNCs are both significant enough and capable of a sustained contribution to FDI flows. The 2012 UNCTAD World Investment Report supports this conclusion. Although in 2011 FDI have increased by 16 percent to $1,524 billion from 2010’s $1,309 billion, growth in developed countries was due largely to cross-border merger and acquisitions. In developing and transition countries, FDI was due mainly to greenfield investments (p. 3). The FDI stocks from emerging TNCs have increased by six times from 1990 to 2001 and by three times from 2000 and 2008 to about $2.6 trillion. This is good news for policy makers and explains in part why greenfield investments were able to continue in the aftermath of the Great Recession (Ramamurti, 2011). Developed countries likely would benefit the most from FDI inflows in the form of M&A. Foreign firms invested and provided the needed finance for struggling business in developed countries, whereas in the developing world greenfield investments created the jobs and infrastructure that these countries need the most.

Calderón, Loayza, and Serven (2004) produced evidence that an FDI inflows in the form of M&A leads to increased greenfield investments. For both developed and developing countries this is good news. This implication is important, especially for developing countries, and seems supported by FDI trends in recent years. After the initial M&A bloom fades, FDI continues in the form of greenfield investments. In the mid-1980s for developing countries FDI as M&A was around 10 percent. By the early part of the 2000 this figure had increased to a third (pp. 15-16). For policy makers the main implication of this finding is that FDI inflows from new TNCs most often takes place in the form of cross-border M&A. For developing countries this occurred mostly in the form privatization of public utilities and other businesses during the 1990s. Increased cross-border M&A were also seen in transitional (formerly centrally planned) countries during that time. Now too there is there is the existence of emergent TNCs, new multinational corporation from countries like China and South Korea. FDI inflows from such countries often have proved advantageous for countries who are recipients of their FDI inflows since these firms are characterized as having "a deep understanding of local customers; a capacity for ultra low-cost value chain operations; know-how for operating in economies with weak institutions; and late-mover advantage in mid-tech industries" (Ramamurti, 2011).

Although not the only factor that explains firm decision about FDI, regions dominated by lower tax rates also seem to be those that attract more FDI inflows. Developing countries on average have a lower tax rate in comparison to developed (see Figure 4). More importantly, developing countries offer greater opportunities. These economies offer lower workforce and regulation costs. In addition, evidence exists that FDI inflows follows the path of foreign aid flows, which many go to developing countries (Anyanwu, 2012). However, in the end, regional trends are more important than global trends when effectuating corporate income tax reforms that will spur great FDI inflows (Bellak, and Leibrecht 2009). Careful consideration ought to occur about with whom is the country competing and what will be the effect of new FDI inflows into the region.

Conclusion

Although capital markets may grow and become stronger as a result of FDI inflows, FDI often takes the form of either merger and acquisitions or greenfield investments. Policymakers must decide what kind of FDI inflow that they wish to encourage. However, to do so requires more than just reducing the corporate income tax rate. That is why free enterprise zones proliferate in developing countries (Hadari, 1990; Tanzi, V., & Zee, 2000). Tax expenditures will continue to play an important role in attracting FDI inflows. There also exists the ‘double taxation’ bind that causes many governments to use tax expenditures in the form of deductions, exemptions and more. Finally, some caution that competitiveness sometimes is not the proper rationale for tax reform. This is a point that the Keightley and Sherlock (2012) made when writing on corporate income tax reform for the Congressional Research Service. They point out that economic growth is not a zero-sum game. Rather the economic growth of a neighbor might also create spillover effects (p. 22).

However, if the policymaker’s goal is to attract increasing levels of FDI inflows, then reductions in the nation’s corporate tax rate is recommended. Not only is it likely that it will attract greater levels of FDI inflows, in the end the reduction will benefit domestic firms and individuals. By exactly how much should policymakers reduce the corporate income tax rate, and what other changes in the corporate income tax system should accompany these tax reforms, requires detailed analysis beyond the scope of this report. This paper’s goal is provide policymakers with greater understanding for why to reduce the corporate income tax rate. Whether developed or developing, in general theoretical and empirical evidence supports further reductions in this tax rate. By measures of adequacy, equity, efficiency, collectability and transparency, world-wide the corporate income tax system needs reforms. Starting with a reduction of the statutory rate is a good first step. Many countries, as reported by Price Waterhouse Cooper (2012), seem to have already adopted this stance.

Appendix I

Table 1:

Growth Rates of Global GDP, GFCF, Trade, Employment and FDI, 2008-2014

Variable

2008

2009

2010

2011

2012a

2013b

2014b

GDP

1.4

-2.1

4

2.7

2.3

2.4

3.1

Trade

3

-10.4

12.6

5.8

3.2

4.5

5.8

GFCF

2.3

-5.6

5.3

4.8

4.6

5.3

6

Employment

1.1

0.4

1.4

1.5

1.3

1.3

1.3

FDI

-9.5

-33

14.1

16.2

-18.2

7.7

17.1

FDI (in trillions USD)

1.81

1.21

1.38

1.6

1.31

1.4

1.6

Source: UNCTAD Global Investment Trends Monitor (No. 11, January 23, 2013)

a Estimate, b Projection, GFCF=Gross Fixed Capital Formation

Table 2: Types of Incentives Used by Region

Incentive Type

Africa (23)

Asia (17)

Latin America & Caribbean (120

Central & Eastern Europe (25)

Western Europe (20)

Other Countries (6)

Total (103)

Tax holidays

16

13

8

19

7

4

67

Accelerated depreciation depreciation

depreciation

12

8

6

6

10

5

47

Investment allowances

allowances

4

5

9

3

5

26

Import duty Exemption exemption

exemption

15

13

11

13

7

4

63

Duty drawback

10

8

10

12

6

3

49

Source; Morisset, J., & Pirnia, N. (2000). 

Figure 1: Total Tax Rate (% of Commercial Profits)

Source: World Bank Indicators, 2013

Figure 2: FDI Infows, 1995-2011

By Global Total, Devleoped, Developing and Transitional Economies

Source: UNCTAD World Investment Report 2012, p. 3

Figure 3: Long-Run Trends in Total Tax Revenue

Source Acosta-Ormaechea and Yoo (2012).

Figure 4: Trends in Tax Revenue by Revenue Source

Source Acosta-Ormaechea and Yoo (2012).