Corporate tax cuts by the numbers

The federal government is set to reduce corporate income tax (CIT) rates from 18% to 16.5% in January of 2011, and then again to 15% in 2012. The effects of these measures have been characterised in two ways:

• $6b per year in tax revenues. The Liberals use this number when they explain that they are choosing to use $6b/yr to finance social programs instead of corporate tax cuts, and (for reasons discussed below) the Conservatives don't seem to be disputing it.
• 233,000 jobs.  The Conservatives are using this number to describe the costs of reversing the CIT cuts.

Although I wouldn't say that these numbers are meaningless, they should be put in proper context.

$6b: As far as I can tell, the source of this number appears to be this annex to the 2009 budget. In Table A2.2, the numbers for cumulative business tax relief increase by $1.8b in 2011-12, and by another $3.4b in 2012-13. That adds up to $5.2, or about $1.7b for each CIT percentage point. This number isn't far from what the CIT was generating before the recession: around $40b/yr on a CIT rate of 22.12% inclusive of surtax. I'm not sure where the $6b number came from, but since the distance from here to there can be covered by optimism and rounding, I'm not going to get to exercised about it. The Conservatives are happy with this number, as it fits in with their theme of 'tax relief'.

The problem is that these results are obtained by static analysis, where it is assumed that the tax change has no implications for behaviour: the only effect of a CIT change is to alter the numbers on the cheques sent to the Receiver-General. This is an odd assumption to make here, since the main objective of a CIT reduction is to induce a behavioural response, namely, increased investment and income.

One of the services provided by the US Congressional Budget Office is dynamic scoring, which incorporates behavioural responses into estimates for the effects of the budget balance. Our own Parliamentary Budget Office still doesn't have the resources required to do this properly, but it seems to me as though the true effect of the CIT cuts will be much less than $6b.

The only study I've been able to track down that touches on the issue is this 2004 paper from the Department of Finance. It's a calibration exercise, so we should interpret the results as properties of the model and not necessarily of the Canadian economy. Notwithstanding, the suggestion that the effects on the budget balance decline by more than a half as the effects of the CIT cut on investment and output make themselves felt seems plausible.

Here's a graph of federal CIT rates and the revenues they've generated:

Profits are a very volatile series and are also highly cyclical, so there's no reason to expect a tight link between short-term changes in CIT rates and movements in CIT revenues. But if you were making policy based on an assumption that CIT revenues were proportional to CIT tax rates, then you might want to see some sort of downward trend during a thirty-year period in which CIT rates were reduced by half.

(Note that the link between GST rates and GST revenues is remarkably stable: GST revenues were a roughly constant share of GDP before the GST rate cuts.)

It may be the case that the CIT cuts will cost $6b in the very short run, but the longer-term effects will be much less. It is a mistake to think that the effects of a 3 percentage point decrease in the corporate income tax will have  the same effect on the federal budget balance as $6b/yr in new spending.

233,000: Characterising the effects of the CIT in terms of employment is one of those things that seems to make sense to everyone but economists. Nick might call this an exercise in applied orthogonality, namely, the insistence on using one dimension - employment - to evaluate policy:

I think we sometimes get fixated on a certain dimension, and analyse all policy questions in terms of how they look on that dimension, even when they matter on some other dimension that is orthogonal to the first. Involuntary unemployment is a problem. It's a dimension that matters. But reducing involuntary unemployment is not always the same as increasing employment. And some policies are good policies for reasons that have nothing to do with reducing involuntary unemployment, or even increasing employment. I can't think of any reason why the HST should have any effect in either direction on involuntary unemployment.

Short-run macro policy is about jobs. So is the minimum wage. So are unions.

The HST is not about jobs. Nor is free trade. Nor is environmental policy like carbon taxes. Most economic policies aren't about jobs.

To that list I would add corporate taxes.

The number itself comes from some back-of-the-envelope calculations in this study by Jack Mintz and Duanjie Chen:

Canada’s planned reductions in federal and provincial taxes on capital investment over the next several years will reduce this country’s METR to a level that should be competitive with these rapidly growing economies, enhancing Canada’s ability to attract capital investment in a volatile global economy. For instance, the three-point reduction in the federal corporate income tax will reduce the METR from 21.4% to 18.9% by 2013. Based on typical empirical estimates, a 10% reduction in the tax-inclusive cost of capital would increase the demand for capital stock by 7% in the long run. This would imply that the planned federal corporate rate cut would increase Canada’s capital stock by $49 billion and labour demand by 233,000 jobs in the long run.

The empirical estimates referred to are from this Department of Finance study.

Of all the lessons to take from the Mintz-Chen paper, the 233,000 number is almost certainly the least important, and is orthogonal - that word again - to the rest of the article. Indeed, it only makes sense if you assume that the increase in labour demand doesn't affect wages, and is completely described by an increase in employment. If the base is the 17.1m employed in May 2010, then we're talking about an increase of 1.4%.

But that isn't what will happen: the labour supply curve is much steeper than what this sort of analysis would suggest. And if workers take advantage of higher wages by working less, it may even be backward-bending. If employment isn't affected, then the long-run effect of a three percentage-point reduction in the CIT is to increase wages by 1.4%. Hardly earth-shattering, but you wouldn't leave it on the table.

If the CIT cuts go through and are later rescinded, we will not see a recession in which some 233,000 people lose their jobs. Instead, long-run incomes will be about 1.4% lower than they otherwise would have been.

I think rescinding the CIT cut would be a mistake, and that it will cost less than the advertised $6b figure. But it wouldn't be the worst mistake we've seen in the last five years.

Comments

[Stephen Gordon]

The expression 'backward-bending' is a source of amused exasperation among my colleagues. In Canada, the French term is courbe à rebroussement. In France, they say backward-bending with an Inspector Clouseau accent.

[Mike Moffatt]

"Instead, long-run incomes will be about 1.4% lower than they otherwise would have been."

The Federal government collects over $100B from personal income tax each year. As a back-of-the-envelope estimate I would think that a 1.4% increase in wages would increase PIT revenue around 1.8-2.0B per year. You'd need to have some idea of whose wages are going up, what tax brackets are they in, etc. If anyone can provide a more accurate estimate, I'd love to see it.

In the long-run, increased revenue from PIT would alone pay for 1/3 of the CIT cut. Between increased firm profits, HST collections, etc. I would expect to see roughly 50-75% of the 'lost' tax revenue come back in other forms - so in reality we're talking about a 2-3B tax cut, not a 6B one.

RE: Dynamic scoring - is it not possible to do something like that with SPSD/M? (Sorry if my question is naive - I've never used the program)

[Stephen Gordon]

so in reality we're talking about a 2-3B tax cut, not a 6B one

That sounds right to me.

[Just visiting from Macleans]

Very informative and good post. Much more meaningful to me (and others I suspect) than economic studies when evaluating policy trade-offs. Thx.

[Paul Friesen]

It seems to me that cutting corporate taxes is, at least to some extent, a beggar-thy-neighbour policy. If we cut taxes, we attract more investment, but that hurts other countries, who lose that investment. Of course, the total amount of world investment would be expected to rise a bit, but by how much?

How do you think your analysis would change under the assumption that other countries are going to follow our lead and also reduce CIT?

I often think that, in an ideal and perhaps unattainable world, we would have international agreements and rules on minimum tax rates to prevent such a race to the bottom.

[Mike Moffatt]

Paul: I do understand the concern about the race to the bottom, but how much empirical evidence is there for it? A couple of data points:

- At the federal level, corporate tax revenues as a percentage of revenues has been rising over the last 30 years.

- There is tax competition between countries, but you would think that there would be even more tax competition between two provinces in the same country. But we don't see Manitoba dropping corp. tax rates to zero in order to lure companies from Toronto to Winnipeg. No province in Canada has completely eliminated corporate taxation.

[Patrick]

Paul: Stephen has argued (fairly convincingly I think) that firms pass-on a sizable chunk of any income tax increases to workers by reducing wages.

The problem isn't a CIT race to the bottom. The problem is our complete inability to have intelligent public debate about how to pay for and maintain civilization. One side hysterically screams about tax relief and wasteful government and the other throws around hyperbolic nonsense about wealthy corporations. In the meantime granny's diaper isn't being changed and our kids are being educated in moldy trailers with 6 kids per text book. But never fear, the local professional sports franchise is getting a new arena. Makes me want to open a vein.

[Stephen Gordon]

How do you think your analysis would change under the assumption that other countries are going to follow our lead and also reduce CIT?

We'd go back to a closed-economy analysis, where the gains are reduced. Not reversed, not zero: reduced.

[happyjuggler0]

"Race to the bottom" may be good framing for something like environmental standards, but it is bad framing for a policy that is desirable like reducing or eliminating taxes on capital.

Better framing would be "race to the top in productivity" regarding cuts in the CIT.

[Paul Friesen]

Seems to me there is corporate tax competition between provinces. Certainly that was rather the theme when Mr. Flaherty, a couple of years ago, called Ontario the last place in Canada to start a business due to its corporate tax rate.

Certainly the political rhetoric is there. Politicians are always selling tax cuts as a way to attract investment from elsewhere, not so much as a way for the whole world to create investment.

I'm probably not enough of an economist to tackle the question of which effect is more important properly and I certainly don't have the time. But it is hard for me to believe that the attraction effect would not be very important.

I also think that good social services are more important than maximizing growth.

[Mike Moffatt]

"Seems to me there is corporate tax competition between provinces."

That's a bit different than a 'race to the bottom', though.

Questions:

- When you talk about a race to the bottom, what is the 'bottom' tax rate? Is it zero? If not, why not?
- Canadian provinces have had corporate taxes for generations. If we are not currently at the bottom, why has it taken so long to get there?

If the census debate has taught us anything, it's that we should avoid taking rhetoric from politicians at face value.

"I also think that good social services are more important than maximizing growth."

That's presupposing that corporate taxes are the only way to pay for 'good social services'. Consider the Nordic countries, which rely very little on corporate taxation, but have strong social services.

[Just visiting from Macleans]

MM,

Let's assume your and SG numbers are ballparkish correct. Continuing on with the scheduled CIT cuts (devised long before the recession occurred or was even anticipated) immediately loses $6 billion Fed tax. But there is a lag - some number of years before the effects (benefits) are seen which may reduce the annual loss to $2-$3 billion.

Which is better, where we are today, 2010, $55 billion deficit, slow/no recovery in the US?

CIT cuts now; or balance the books sooner - and boost confidence that way faster - for whomever balanced books is more important? All I see from you is a constant CIT cut droning. Stay the course. All the time, anytime.

Profound tweet o' the day: Why is uncertainty considered a sign of intellectual weakness and not of intellectual strength? - SG Oct 7th

[Mike Moffatt]

"CIT cuts now; or balance the books sooner - and boost confidence that way faster - for whomever balanced books is more important? All I see from you is a constant CIT cut droning. Stay the course. All the time, anytime."

I think that's the first time in my life I've ever been accused of wanting the status quo.

"CIT cuts now; or balance the books sooner - and boost confidence that way faster - for whomever balanced books is more important?"

It's a false dichotomy, but let's suppose that 'balancing the books' faster is a really big deal (not sure why, but I'll play along).

The question is, are you better off reversing the CIT cut and taking the hit later on, or are you better off getting the money elsewhere?

Given everything we know - the theoretical studies, the applied studies, history in other countries, etc., we can be pretty certain the answer is 'somewhere else'. Not metaphysically certain, but 'more likely than not'.

"Profound tweet o' the day: Why is uncertainty considered a sign of intellectual weakness and not of intellectual strength? - SG Oct 7th"

That's unnecessary, Jvfm. For one thing, when have you shown any uncertainty that a CIT cut is a bad idea? We've shown all kinds of studies, data, etc., yet you've never shown any hesitation that this is a bad idea, and continue to refuse to let the matter drop.

[Just visiting from Macleans]

That's unnecessary, Jvfm. For one thing, when have you shown any uncertainty that a CIT cut is a bad idea? We've shown all kinds of studies, data, etc., yet you've never shown any hesitation that this is a bad idea, and continue to refuse to let the matter drop.

Oh, I don't know. Continuing to ask questions on CIT cuts when faced with better info on a blog titled Corporate tax cuts by the numbers seems entirely appropriate, if not probable. Especially when some real meat has been put on the bones. In a way this blog goes a long way to answering my query a while ago:

Q: Tax cutting in the last decade. Where does it show up in these graphs, and how would one measure if it was effective? Or can one measure it in these graphs? etc.
http://tinyurl.com/2f7n7el

I do not think at all my proposition is a false dichotomy. Politically. Like any decision tree, you take each branch separately, and cross each decision point as you come to it. First things first. Walk before you run. The process of debate.

[K]

Stephen Gordon: "We'd go back to a closed-economy analysis, where the gains are reduced. Not reversed, not zero: reduced."

How do you know that the gains are not zero or reversed?  Assuming we have three available taxes: CIT, Income and VAT.  In a closed economy what is the most efficient proportion collected from each?  Should the CIT rate be zero? If not, how do we know that we are not below the most efficient closed economy rate?

[Stephen Gordon]

The efficiency arguments don't go away as the CIT gets lower. The constraints are essentially what happens as people try to game the difference between CIT and personal tax rates:

- High earners trying to set up shell corporations in order to take advantage of lower tax rates. I understand the CRA is pretty good at sniffing these cases out, but if lots of people are tempted, this might change.

- Corporate profits can be thought of as a 'withholding tax'. Since capital gains are largely tax-exempt, the increased after-tax profits could be retained by firms in order to drive up its stock price. The temptations for financial and financial mischief would increase.

There may be a point where these and other considerations will outweigh the efficiency gains from lower CIT rates. We don't seem to have reached that point yet, but we might someday. That's a reason for proceeding gradually, and not going to zero (or whatever) all in one go.

[Paul Friesen]

Mike, your questions:
- When you talk about a race to the bottom, what is the 'bottom' tax rate? Is it zero? If not, why not?
- Canadian provinces have had corporate taxes for generations. If we are not currently at the bottom, why has it taken so long to get there?

I don't think that governments have any clearer an idea of optimum tax policy than you or I do. So they can't really optimize it. But they obviously follow each other and tend to move in similar directions. For several decades after WWII, there was a trend in Canada and internationally to raise taxes and improve services. That trend seems to be moving the other way now, as right-wing small government ideas gain ground.

It might turn around again if people get sick of poor services. Or the poor services might get used as an excuse to cut further. I worry that our health care could become so damaged by cost cutting that certain people will be able to use its poor state as an excuse to privatize it.

So I don't know where the "bottom" tax rate is. But my point is that right now, governments and some people who try to influence them are using the idea that reducing taxes can lure investment as a reason for reducing them. It doesn't matter if they believe that or not. They may well have other reasons for wanting low taxes.

[Determinant]

What about the fact that corporate dividends are further taxed in the hands of the shareholders? AIUI Canadians get a preferential rate (linked to the corporate rate), and foreigners get the full income tax treatment.

Surely some of the "cut" will show up in the personal stream in the form of dividends.

The part that is truly lost is the part that isn't paid out as dividends.

[Andrew F]

If there is a tax treaty, foreign investors may get a domestic tax credit to offset any taxes paid in Canada.

[Patrick]

I imagine that most Canadians who own stocks do so primarily inside an RRSP, where the capital gains and dividends are tax exempt.

Paul: Lowering CIT does not imply lousy government service IF we get the money to pay for the services elsewhere. The point is that CIT is not really a very good way to collect taxes. We have other options, like a carbon tax or consumption taxes. Both of which are probably a better choice for reasons explained in detail by many people smarter that me.

[Just visiting from Macleans]

Timing is everything; location, location, location.

[Declan]

Stephen, any chance you can add corporate profits (pre-tax) as a percent of GDP to your chart. It seems like it would help in interpreting the other lines.

Paul is right that we're seeing a race to the bottom in corporate tax rates and that it will come at the expense of social services (sure we could, in theory, make up for the reduction in corporate taxes by raising other tax rates, but we won't so it's a moot point)

[Stephen Gordon]

Corporate taxes as a share of GDP looks basically like the revenues graph, with only a change in the scale - centred around 10% instead of 2%.

sure we could, in theory, make up for the reduction in corporate taxes by raising other tax rates, but we won't so it's a moot point

I suppose if enough people keep saying this, then yes it is moot. Will Brian Mulroney go down in history as the last Prime Minister to raise taxes?

[Jim Rootham]

Until and unless there is a major change in the political landscape: Yes

[Declan]

Thanks for the response Stephen, I guess it's asking a bit much for you to have 3 y-axes on the same graph, although I do think it would be interesting to see profits plotted on that graph.

With respect to Mulroney going down in history, your comment made me wonder if there might be a generation gap with respect to taxes. I'm closing in on turning 40 and as best I can recall my taxes haven't been increased (net, as a % of income) by any government since I was old enough to vote, so you can understand my skepticism (never mind my weariness with people (not you) who rail on about the ever-expanding government and ever-rising taxes). But I guess for an older generation, the concept of a tax increase is more plausible or 'real'.

[Mike Moffatt]

There was a tax increase just *3* weeks ago. Did we all miss that?

http://www.cbc.ca/politics/story/2010/09/30/flaherty-ei-premiums.html

[Mike Moffatt]

Now I know the response will be, 'yeah, but they had an independent panel look at it and the Conservatives still watered down the recommendations'. All of which is true. But if a party in power is looking to implement sensible tax policy reform but is worried about the political hit, perhaps an independent panel is the way to go. The panel recommends a 2% rise in the GST, the party in power waters it down to 1% and away we go. There are always options.

[Just visiting from Macleans]

Adjusting tax structure (tempered raising of taxes or not cutting others) in response to an under-performing Canadian economy seems entirely appropriate to me - well, at least options that should not be ruled out entirely w/o discussion.

[Bob Smith]

Determinant: "What about the fact that corporate dividends are further taxed in the hands of the shareholders? AIUI Canadians get a preferential rate (linked to the corporate rate), and foreigners get the full income tax treatment."

Just to clarify, from the Canadian perspective, dividends paid to foreigners are only subject to withholding tax (at a rate varrying from 5-25% depending on the circumstances and any applicable tax treaties), so from a Canadian perspective, taxing shareholders rather than corporations does entail a revenue loss (this is why income trusts were so populat amongst non-residents - they avoided entity level tax). Similarly, there is an immediate revenue loss on dividends paid to Canadian resident non-taxables (RRSPs, pension plans, etc. - again, this is why income trusts were popular with Canadian non-taxable), although that will be offset to some degree in the future. For taxable Canadian residents, however, as I noted in an ealier post, the effective tax rate on dividends is INCREASING as corporate income tax rates fall, as the federal government (and the provinces) are reducing the dividend tax credit rate to offset the reducings in the corporate income tax in order to maintain integration (roughly) with the personal income tax system (i.e., so that income earned in a corporation is, in aggregate, taxed at roughly the same rate as income earned personally). This is an effective tax increase (and an appropriate one) that no one has picked-up on, that will offset the CIT cuts to some degree.

"The part that is truly lost is the part that isn't paid out as dividends"

Is that really a "loss". Presumably the company does something with that money (either reinvests it - which is presumably the point of the exercise - or it gets appropriated by management and workers through higher wages and benefits - who are then taxed at the full personal income tax rate).

Patrick: It is not correct to say that dividends paid to an RRSP are a loss to the tax system. Income and gains earned in an RRSP are only tax-deffered, not exempt entirely from tax. You pay tax when you take them out in the future. There's a deferral advantage, and there may be some rate-arbitrage advantages (for most people, the effective tax rate on withdrawl from an RRSP is less than it is during their working life), but the government will eventually tax some of that money (and the gains thereon). Moreover, for dividends, because RRSPs cannot claim the dividend tax credits, the effective tax rate on dividends withdrawn from an RRSP may well be higher than it would have been had the dividends been earned directly (generally if you have an income less than $35-40,000 - for example many retirees - dividend income earned directly is effectively tax-free)

[Just visiting from Macleans]

"Read my ellipses. No new ..."

[Jurist]

"It may be the case that the CIT cuts will cost $6b in the very short run, but the longer-term effects will be much less. It is a mistake to think that the effects of a 3 percentage point decrease in the corporate income tax will have the same effect on the federal budget balance as $6b/yr in new spending."

I realize this can be read in a couple of different ways, but on at least one interpretation it's venturing dangerously into CTF-style "all government is evil and wasteful" territory. So can we clarify that government spending too produces returns in terms of tax revenue, economic activity and the value of the service delivered - and that at least some smart people in some circumstances (e.g. studies as to the returns on stimulus spending) see permanent tax cuts as a poor comparative investment?

[Just visiting from Macleans]

Say, I have a couple of questions for Bob Smith,SG or anyone else familiar with what happened in the 90's.

It looks like, from the graph, the Paul Martin austerity budget of '94 had a slight increase in CIT. What was the rational for that? Or was it some program expiring?

Also, in terms of corporate investment in equipment to enhance competitiveness/productivity. Mark Carney in his press conference the other day suggested that in discussions with some Can corporate heads/reps it was well understood by them that investment in equipment was necessary in the short to medium term. With the dollar near parity, and with BOC rate at around 1%, corporations flush with cash or cheap debt financing, CIT rates at 18%, has there ever been a better time to make these types of investments? It strikes me that an additional 1.5% - 3% CIT cut would not necessarily get one past the invest/no invest tipping point (although, every little bit counts).

Any qualitative/quantitative historical context to add?

[Michael Smart]

Stephen, Another great post. But here are some words in defence of the Mintz approach to employment impacts.

If I'm understanding the post, you are arguing that the capital stock will increase in the long run but labour supply will not, so the increased productivity will be capitalized in higher wages, and not boost employment. But remember that the CIT is a tax on the CORPORATE sector, so capital and labour will flow into that sector from the unincorporated sector, boosting the relevant labour elasticity. Second, and more important I think, Canada is an open economy for labour, and 233,000 jobs is only about 2 years of net international immigration at current flow rates. Doesn't it make sense that greater productivity will boost immigration in future, particularly for prime age and skilled workers? In short, if I had to pick an extreme elasticity assumption, I would pick Mintz's not yours.

[Stephen Gordon]

Hmm. I confess that I hadn't thought of immigration flows. But then again, I'd be very surprised to learn they are *that* sensitive to variations in Canadian wages.

[Michael Smart]

If skilled immigrants aren't coming to get access to our capital, then what are they coming for, the weather?

This isn't my area, but there is at least some research on the impacts of short-run, rather than long-run, economic conditions on net migrations. Like this.

[Brian_Dell]

"...if you assume that the increase in labour demand doesn't affect wages"

Strikes me as a reasonable assumption if the economy is not at full employment and the market for labour is competitive.

"If the CIT cuts go through and are later rescinded, we will not see a recession in which some 233,000 people lose their jobs. Instead, long-run incomes will be about 1.4% lower than they otherwise would have been."

Has the idea that wages are downward "sticky" been discredited? It seems to me that if your general thesis is correct, when we go through recessions employment levels should largely hold up while wages fall. The empirical data I've seen suggests that it is the other way around.