How much new revenue will be generated by an increase in federal corporate taxes?

It's budget season, and there's a federal deficit to worry about. The government wants to cut spending, and the opposition parties want to increase taxes on high earners as well as corporate income taxes (CIT) instead. (No-one wants to increase the GST.)

In a recent Economy Lab post, I went through the arithmetic of calculating the extra tax revenues you might get from increasing taxes on high earners (spoiler: not much). In this post, I'm going to look at how much extra revenue the federal government could expect to receive from a higher CIT rate.

According to Cansim Table 380-0007, the federal government received $32.917b in corporate income tax revenue on a CIT rate of 16.5% in 2011 - the new rate of 15% went into effect on January 1, 2012. This implies a corporate income tax base of 32.917/0.165 = $200b, and that's what I'm going to use as a point of reference in what follows.

If you assume that there's no behavioural response, then each percentage point added to the federal CIT will generate roughly $2b in new revenues. So you'd conclude that the January 1, 2012 reduction in the CIT rate from 16.5% to 15% would reduce revenues by about $3b, and increasing the federal rate from 16.5% back to (say) 24% would increase CIT revenues by some $15b - almost one per cent of GDP.

This is the the sort of answer 'static analysis' gives. In a world in which multinationals file 57,000-page tax returns, one can only marvel at the faith in human nature among those who would make policy based on the belief that the only behavioural change on the part of corporations to an increase in CIT rates will be to put larger numbers on the cheques they send to the Receiver-General.

Here's why no-one should think that the link between increasing corporate tax rates and increasing corporate tax revenues is simply a matter of higher tax rates => higher tax revenues. Data are from the OECD:

A linear regression through these data would give you a negative relationship between CIT rates and CIT revenues: an increase in CIT rates actually reduces CIT revenues as a share of GDP. Of course, this result is almost entirely driven by the outlier that is Norway. But even if you discard Norway, you'd have a hard time extracting a significantly positive relationship between CIT rates and CIT revenues. As far as the Canadian experience goes, the steady reduction in CIT rates hasn't had much effect on revenues.

The key concept in this literature is the tax base elasticity: the parameter describing how the CIT base responds to variations in the CIT rate. I've come across two recent and relevant studies that use Canadian data to estimate CIT base elasticities. One is by Jack Mintz and Michael Smart (Journal of Public Economics version here, working paper version here), and the other is by Bev Dahlby and Ergete Ferede (International Tax and Public Finance version here, older version here). Both find strong evidence that CIT bases are highly sensitive to changes in tax rates.

But I'm somewhat reluctant to use these estimates for the task at hand. What concerns me is that much of the data variation that drives these two sets of estimates is variations across provinces, and indeed the story seems to be that tax shifting across provinces is easier than tax shifting in and out of Canada. (Provincial governments who think that a higher CIT is an effective way of increasing revenues should prepare themselves for disappointment.)

I'm inclined to give more weight to the results from this study, which uses country-level data from the OECD. The elasticities they obtain - around -0.7 for the tax rate - are substantially smaller than the ones obtained using Canadian data, so if anythings, using their numbers is going to err on the side of being too optimistic are far as revenue generation goes.

These models all have dynamics in which the effect of changes in the tax rate on the tax base increases over time. I've ignored them, mainly because the exercise is to estimate the effects of a tax change on the budget balance for FY 2012-13. But they probably do go some way in explaining the lack of any visible link between tax rates and tax revenues in the scatter plot above.

Another thing to consider is that the relevant CIT rate is the combined federal-provincial rate. An increase in the federal rate will reduce the size of a common federal-provincial tax base. Even if provincial PIT rates don't change, they will be applied on a smaller tax base and revenues will fall. Provincial CIT revenues in 2011 were $22.034b, which works out to an average provincial CIT rate of 11.04%.

The policy experiment is to change the combined CIT rate, see what effect it has on the tax base, apply the (new) federal rate and the (old) provincial rates and compare the result to the base case. I've also done the exercise for the Mintz-Smart specification, using a net-of-tax elasticity of 2.5 - the low end of their range, and not far from what Dalhby-Ferede find.

	Change in federal revenues			Change in provincial revenues
	Static analysis	Dynamic scoring: Riedl and Rocha-Akis	Dynamic scoring: Mintz and Smart	Static analysis	Dynamic scoring: Riedl and Rocha-Akis	Dynamic scoring: Mintz and Smart
15.0%	-$3b	-$1.80b	-$1.42b	0	+$0.88b	+$1.15b
15.5%	-$2b	-$1.18b	-$0.92b	0	+$0.58b	+$0.76b
16.0%	-$1b	-$0.59b	-$0.45b	0	+$0.28b	+$0.38b
16.5%	0	0	0	0	0	0
17.0%	+$1b	+$0.57b	+$0.41b	0	-$0.28b	-$0.38b
17.5%	+$2b	+$1.13b	+$0.80b	0	-$0.54b	-$0.76b
18.0%	+$3b	+$1.68b	+$1.16b	0	-$0.80b	-$1.13b
18.5%	+$4b	+$2.22b	+$1.49b	0	-$1.06b	-$1.49b
19.0%	+$5b	+$2.75b	+$1.80b	0	-$1.30b	-$1.86b
19.5%	+$6b	+$3.27b	+$2.08b	0	-$1.54b	-$2.21b
20.0%	+$7b	+$3.78b	+$2.33b	0	-$1.77b	-$2.57b
20.5%	+$8b	+$4.28b	+$2.56b	0	-$2.00b	-$2.92b
21.0%	+$9b	+$4.77b	+$2.77b	0	-$2.22b	-$3.27b
21.5%	+$10b	+$5.25b	+$2.95b	0	-$2.43b	-$3.61b
22.0%	+$11b	+$5.72b	+$3.11b	0	-$2.64b	-$3.95b
22.5%	+$12b	+$6.19b	+$3.24b	0	-$2.84b	-$4.29b
23.0%	+$13b	+$6.64b	+$3.35b	0	-$3.04b	-$4.62b
23.5%	+$14b	+$7.09b	+$3.44b	0	-$3.22b	-$4.95b
24.0%	+$15b	+$7.54b	+$3.51b	0	-$3.42b	-$5.27b

 

People who are using static analysis to make their revenue projections are overestimating the revenue gains from increasing corporate taxes by a factor of at least two in the short run, and by even more in the longer term.

 

Comments

[Frances Woolley]

Great post. Good to see the discussion getting away from power tools, feminism, Lego, hydro power, linguistics, Hawkwind and diet coke and towards some serious economic analysis.

[Stephen Gordon]

Thanks. I like to do these sorts of exercises, and it's something that blogging has made possible. This isn't something a journalist could figure out on her own, and it's hard to see how an academic could turn this into a 750-word op-ed. Nor would an academic see any point in trying to stretch it out into a research paper.

[Andrew F]

Thanks, Stephen. The people who would disagree with your analysis for political reasons would do well to read it and try to understand. The discussion during the last federal election was distressing.

What do you think of Ontario's decision to pause its corporate income tax cut plan? Based on this analysis, it would seem to be a purely political play rather than a genuine attempt to contain the provincial deficit.

Given that the corporate tax base is so sensitive to rates, especially within Canada, does some kind of detente between the provinces make sense, to avoid a race to the bottom, or is a race to 0% something we should have as a goal?

[Frances Woolley]

Andrew F - one thing to bear in mind is that there's a big difference between equalization-receiving provinces and those not receiving equalization. For an equalization receiving province, any increase in the corporate tax base is offset by decreased equalization payments, so there's little incentive to cut rates.

[steve]

So we should decrease the rate to zero for maximum revenue? What is the time factor here? Does the revenue change later in time?

Steve

[steve]

Oops, never mind the zero part. Misread the columns.

Steve

[Determinant]

"Another thing to consider is that the relevant CIT rate is the combined federal-provincial rate. An increase in the federal rate will reduce the size of a common federal-provincial tax base. Even if provincial PIT rates don't change, they will be applied on a smaller tax base and revenues will fall. Provincial CIT revenues in 2011 were $22.034b, which works out to an average provincial CIT rate of 11.04%."

This is conceptually and legally false.

Federal and Provincial corporate taxes are levied on the same base; neither are deductions for one another. It is the same with personal income taxes, Federal and provincial taxes are levied on the same base, no deductions for taxes paid to the other level, Quebec's "Abatement" notwithstanding as it is actually a fiscal transfer done on tax returns instead of government books.

Legally, fiscally and practically federal and provincial corporate taxes are levied simultaneously and do not affect each others base.

The analysis is false because it contains the fallacy of begging the question for the answer.

[Mick.Marrs]

So from what i read, a smart gov. could increase the cit rate to an amount that quiets the left wing while having a small impact on actual revenue since corporations have a greater incentives to hide their profits and pump up their expenses.
Proves the point that everything in business an politics is optics

[K]

Mick.Marrs, the "left wing" wouldn't be so angry if these tax cuts weren't coupled with useless spending on military equipment and (soon) more prisons.

[Andrew F]

Determinant, perhaps you should read the post again.

"Federal and Provincial corporate taxes are levied on the same base; neither are deductions for one another."

Stephen says the same thing with different words in the passage you quoted. The change in the base is not because one tax is a deduction for the other, but because the base changes in size in response to the change in tax rate.

[Stephen Gordon]

Yes, that's right.

[Bob Smith]

Great post Stephen, this sort of post should be mandatory reading for politicians of all political stripes before they mouth off about corporate taxes.

The interaction of the federal rate and the provincial tax base (and vice-versa, I suppose) makes for an interesting political dynamic and likely explains what's happening provincially. If you are, say, Dalton McGuinty, Jean Charest or Christy Clark, you should adamently oppose any increases in federal corporate taxes since you'll bear, depending on your preferred model, some or all (and then some) of the cost of increased federal corporate tax revenue. If I were the future leader of the federal NDP or liberals, that
s something I might want to take into account given the ambitions of those provinces to make gains in those three provinces.

On the other hand, assuming the same analysis worth in reverse (i.e., an increase in the provincial tax rate undercuts federal revenues), a McGuinty, Charest or Clark might not have any problems with increasing provincial taxes, since a good chunk of the lost revenue will be borne by the residents of other provinces (through reduced federal revenues). And guess what we're seeing in both Ontario and BC? Corporate tax freezes/increases. Very interesting.

[Bob Smith]

I suppose the other point is that, while Stephen's analysis focuses on the impact of changes in the corporate income tax rate on corporate income tax revenues, that understates the true revenue impact of those changes, because it doesn't take into account the personal/non-resdient tax side of the equation. To the extent that such income is pushed out to shareholders, it'll be taxed in their hands (eventually, in the case of RRSP/RRIFs/Pension Plans).

Moreover, because our tax system tries to integrate the corporate tax system with the personal tax system through the dividend tax credit regime, a reduction in the corporate tax rate is counteracted with an increase in the effective tax rate on dividends (and vice-versa). As a result, over the last few years we've seen steady increases in the effective tax rate on dividends (a few years ago dividends were taxed at a lower rate than capital gains, now they're taxed at significantly higher rate). Need to say, governments don't boast about how much they've increased taxes on shareholders (since shareholders, unlike corporations, vote).

I haven't seen any good estimates of this effect, but given the current "cost" of the federal dividend tax credit regime (roughly $3 billion a year), it's probably not unreasonable to think that a 50+% increase in the federal corporate tax rate (from 15% to 24%) might cost the fisc. a billion or two in foregone personal income tax (to say nothing of lost non-resident withholding tax income and lower revenue on the collapse of RRSPs/RRIFs). In any event, it's probably likely to be a material amount.

Has anyone else seen any research on this?

[Stephen Gordon]

I was going to make a similar point, but forgot to. To the extent that corporate tax increases are passed on in the form of reduced wages, then there would also be an offsetting loss in personal income tax revenues.

[Jacques René Giguère]

@Bob Smith: shareholders vote, but most of them ,even the high-income ones, have barely any idea how the tax system really works. But top managers understand that if CIT is cut but dividends are not increased, corporations and the C-suite guys have more money to play with,at the expense of the dispersed shareholders... And if corporations don't vote, they lobby.Way more powerful.

@Stephen Gordon 10.35: The adjustment of wages to CIT changes is very slow. During the adjustment period the Fed don't lose on PIT on wages while immediately gaining back on the PIT paid by shareholders. And the contributors in the C-suite are happy.

[Determinant]

"Stephen says the same thing with different words in the passage you quoted. The change in the base is not because one tax is a deduction for the other, but because the base changes in size in response to the change in tax rate."

Correlation does not equal causation and the OP is definitely a case of this. Between regular cost of business deductions and Capital Cost Allowances, corporate costs and investments are not taxed. So one purpose of corporate income tax is to prevent unlimited deferral of income in addition to revenue generation.

There is no link between high corporate tax rates and growth per se, for instance in the post-war period until 1960 the bulk of tax revenues actually came from the corporate stream and tax rates were at 40%+, yet this did not impede growth. It is remembered as a Golden Age for many.

Stephen is implicitly assuming that a corporation is an investment vehicle, a sort of utility maximizer and that the increased revenue from growth will be reflected in wages. It can be, but it isn't that way in reality. Many other considerations come into play. Part of the problem is that the "employment multiplier" of economic growth has diminished, so increased growth and profits do not equal higher employment and wages as they did formerly. If higher profits don't result in higher wages then corporate revenues have a higher growth potential than wages. This means that the tax burden should shift onto the corporate stream, away from the personal stream. A brief consideration of the balance of power in economic relationships shows this is plausible.

Stephen's elasticity is met by the Left's Employment Multiplier. That is the conceptual heart of Lefty arguments for higher CIT.

Stephen's argument contains an implicit acceptance of corporate power that the Left tries to address head-on.

[Andrew F]

"Stephen's elasticity is met by the Left's Employment Multiplier. That is the conceptual heart of Lefty arguments for higher CIT.

Stephen's argument contains an implicit acceptance of corporate power that the Left tries to address head-on. "

But what use is increasing the tax rate on corporations if there is little revenue gain? All the rhetoric from the last campaign implies that significant revenue gains from corporate taxation increases would be a free lunch in terms of new social spending. Does the left deny the effect the tax wedge has on investment?

Why is defering taxation of investment income until it is consumed an evil? It seems to me that RRSPs would be the same kind of evil.

[Determinant]

My argument was echoed and frankly much better made by Jim Stanford on CBC Newschannel this afternoon.

Elasticity is not a linear property but a spectrum, one which has a transitory response (those who will flee to another tax jurisdiction easily) and a steady state response (those who are stuck in Canada, i.e. the big banks).

Unlimited deferment is a problem when it gets too large. RRSP's and pensions benefit from it for a specific policy reason to provide for income for beneficiaries when the cease to work and earn income. Corporations benefit from deductions for normal course of business expenses such as wages and capital cost allowances for investments. So investments are not taxed per se. It is residual profit which is not invested which is used to pay CIT, money that hasn't gone to work.

The tax system has long accepted taxation on accrual instead of on cash receipt. On the personal side life insurance policies are taxed this way; insurers make sure they avoid tilting their insurance policies too far to investment gains. If they tilt to far they are subject to taxation on accrual.

CIT is a revenue generation measure so uninvested profits need to be subjected to taxation instead of unlimited deferment which means they may never be taxed at all. There has to be some revenue to tax and it can't be defined away or given unlimited discretion to avoid taxation. That defeats the purpose of taxation. Corporations have indefinite longevity so when they die (go bankrupt or are dissolved) there is little to tax.

Like most things some people view the benefit from additional social spending to be greater than the burden of additional taxation, even for corporations. Personally I put pharmacare in this category. That's politics.

Since corporate personhood confers several definite legal advantage such as limited liability, separate legal personality and indefinite longevity it is reasonable to tax it separately too. Corporations are not purely reflections of or flow-though structures for their owners, thus they need to be taxed as separate entities too.

[Stephen Gordon]

Determinant, I have no idea what you're trying to say, or how it has anything to do with the OP.

[Determinant]

I'm disagree with your entire Corporate Income Tax Argument in pretty much every way. I have long disagreed with your views but tonight I'm feeling pretty loquacious.

[Nick Rowe]

Two of the things Determinant might be trying to say are:

1. Elasticity might vary as we change the rate rate and move along the supply and demand curves.

2. The long run and short run elasticities might be different.

Both correct, though the effect could go either way, depending on the length of the range and run assumed in the estimates of the elasticity.

He's lost me on the other bits.

[Andrew F]

For a corporation to never distribute profits to shareholders to be taxed in their hands there would need to be losses that consume all the profits, in which case there was no profit in toto on the investment. I don't see why there is a problem with deferring taxation on investment. Profitable investment benefits society, it is the consumption we don't want to become too concentrated on equity grounds.

[Frances Woolley]

Andrew F "I don't see why there is a problem with deferring taxation on investment."

It creates a locked-in effect. Suppose I've made $1000 on my investment in OldSchool Inc. I expect OldSchool to generate a 4% rate of return next year. NewSchool Inc is generating a 5% rate of return. An efficient allocation of capital requires that I take my money from OldSchool and put it into NewSchool, because NewSchool get a bette return on it.

If investment income is taxed upon accrual, then I'll transfer my funds from OldSchool to NewSchool.

If, however, taxation of investment income is deferred until it is realized, then I'll stick with OldSchool, as with OldSchool I'm getting 4% on my *pretax* $1000 profits, however with NewSchool I'm getting 5% on my *aftertax* profits, i.e. something like 5% of $600.

[Andrew F]

Most/many wealthy individuals keep most of their financial assets in a holding company, which would eliminate that effect. Same goes for anyone investing through an RRSP, pension, etc.

[Bob Smith]

JacquesL "But top managers understand that if CIT is cut but dividends are not increased, corporations and the C-suite guys have more money to play with,at the expense of the dispersed shareholders."

Maybe they do, but think about it, to the extent that that money is expropriated by management in the form of higher salaries, bonuses, and other taxable benefits (cars, memberships, etc.) it gets taxed at their marginal tax rate (depending on the province 39-50%) - i.e, a significantly higher rate than shareholders would pay on dividends. Management expropriation may be bad for shareholders, but it's great for the fisc.

[Bob Smith]

Corporations benefit from deductions for normal course of business expenses such as wages and capital cost allowances for investments. So investments are not taxed per se. It is residual profit which is not invested which is used to pay CIT, money that hasn't gone to work.

Whoa, whoa, whoa there cowboy, that just isn't right. First of all, wages, rent and other "expenses" aren't investments in any meaningful sense of the world, they're day-to-day costs of doing business (moreover, not all of them are deductible, the left fulminates against stock options, but stock options are actually quite tax inefficient, since corporations can't deduct the benefit received by employees as an expense). Second, capital cost allowances are only available for some forms of capital investment (machinery, computers, buildings, in very limited form, certain goodwill) and the statutory depreciation rates may or may not reflect real economic cost. Third, a lot of investments doesn't get tax recognition (land, shares, investments in corporations, etc.).

[Jacques René Giguère]

@Bob Smith: a CEO who pays taxes should change accountant... ;-)

[Bob Smith]

Determinant: "CIT is a revenue generation measure so uninvested profits need to be subjected to taxation instead of unlimited deferment which means they may never be taxed at all. There has to be some revenue to tax and it can't be defined away or given unlimited discretion to avoid taxation. That defeats the purpose of taxation. Corporations have indefinite longevity so when they die (go bankrupt or are dissolved) there is little to tax."

That's part of the purpose for the CIT, although you don't need the CIT to achieve that objective. For example, our tax system has a refundable tax regime intended to prevent the use of holding companies to defer the recognition of income on inter-company dividends (which are generally not taxed in Canada). Similarly, our taxation of small busines corporations includes a separate regime for active business inccome (taxed at very low rates) and passive investment income (taxed at very high rates) to prevent tax deferral. If the purpose of the CIT was as you describe, we could readily achieve that goal by having a 0% rate on active business income and a 46% rate on passive investment income (with a component that was refundable when dividends are paid).

Somehow, I don't see Jim Stanford lobbying for THAT change.

[Ryan]

Prof. Gordon, I like this post a lot. It is entirely consistent with what Arthur Laffer has been saying for the past 10 years or so. He hasn't said as much about his storied "Laffer Curve," but has put a lot of effort into highlighting the fact that tax rates don't seem to impact tax collection, no matter what the rate is.

Given that fact, it makes the most sense to set the tax rates as low as politically palatable (or lower). Ignoring these results and favoring higher taxes anyway is just kind of nasty and vengeful IMHO. Less market distortion is better than more.

But as I'm learning to accept, sometimes people favor policies because they want to entertain notions such as "social justice" even when they realize full well that no such justice is accomplished through the policy in question. Sort of like a child who insists on believing in Santa Claus long after he/she realizes that it's a fantasy.

[Bob Smith]

"CIT is a revenue generation measure so uninvested profits need to be subjected to taxation instead of unlimited deferment which means they may never be taxed at all."

Not really. Corporations may be infinitely lived, but their shareholders are not. If the income of a corporation were not distributed to shareholders, but simply reinvested to defer taxation, that deferred income would be reflected in the higher value of its shares, and therefore higher accrued capital gains for shareaholders. When shareholders die (as, so far at least, they always do), they're deemed to have disposed of those shares, so that income would be taxed. (True, in our current system it would only be taxed at half the rate of ordinary income, but our current system is designed that way, in part, to reflect the existence of corporate level income tax. Do away with the CIT, and the case for taxing capital gains at a higher rate becomes a lot stronger - although you'd still want to make allowances for inflation.)

Determinant: "Since corporate personhood confers several definite legal advantage such as limited liability, separate legal personality and indefinite longevity it is reasonable to tax it separately too."

That doesn't follow. What does legal personhood (of a rather limited variety in the case of corporations), limited liability, or indefinite longevity have to do with taxation? After all, partnerships enjoy indifinite longevity and (in some cases) limited liability, but we don't (with a limited exception - SIFT partnerships) tax them, we tax their partners. Trusts enjoy, effectively, indefinite longevity (they have a finite existence, but it can be a good long time) and can have limited liability for benficiaries (but not for trustees) and have legal personality (in the form of the trustee) and yet we permit them to pass income through to their benefiaries to avoid tax at the trust level (so that, for example, most mutual fund trusts in Canada pay no income tax - in fact, if you look at their trust indentures, most of them are required to arrange their affairs so as not to pay tax).

[Bob Smith]

@Bob Smith: a CEO who pays taxes should change accountant... ;-)

A CEO of a public company whose salary is disclosed in the company's annual report and put on the internet will probably want to make sure he pays some taxes. CRA auditors like to use Google.

[Jacques René Giguère]

@Bob Smith: of course Mitt Romney will pay 14% , but not 35. It's like a New Yorker having its mugger's wallet...
http://www.wikihow.com/Make-a-Mugger's-Wallet

Back to serious theory...

[Patrick]

Hmmm. Either I end-up in spam or typepad was hungry last night. Oh well. I'll try again.

57K pages, eh? That's really interesting. And I've seen first hand the lengths to which large firms will go to avoid paying taxes (and wages). I wonder if it's really optimal to figure out ever last tax dodge possible, when those dodges have increasing costs for decreasing returns. Sometimes it looks like like management thinks that every dollar saved with a tax dodge is free; no cost, no opportunity cost. Some kind of hyperbolic discounting? Perverse incentives? Dunno. But it's weird.

My pet theory is that management simply likes playing tax dodge ball with gov'ts. The rules are clear, just hire some lawyers and accountants and it's game on. Actually running the business is way harder, and more uncertain so they naturally go with the easy option. And shareholders are either too diverse a group to coordinate countermeasures or they too irrationally hate taxes so much that they prefer to stick it to gov'ts over the other options.

[Bob Smith]

of course Mitt Romney will pay 14% , but not 35. It's like a New Yorker having its mugger's wallet.

It's a bit odd to blame Mitt Romney for paying the taxes imposed by law - he couldn't pay more taxes if he wanted to. Mitt Romney doesn't pay a 14% tax rate by virtue of clever accounting games, he pays that rate by virtue of being an owner (partner) of Bain Capital so entitled to the favourable tax rate available to investment income. Most CEO's are employees, rather than investors (which may be part of the problem), so can't access to lower tax rate applicable to investment income.

[Bob Smith]

"57K pages, eh? That's really interesting. And I've seen first hand the lengths to which large firms will go to avoid paying taxes (and wages). I wonder if it's really optimal to figure out ever last tax dodge possible, when those dodges have increasing costs for decreasing returns."

Patrick, I wouldn't atribute a 57k page tax return to tax dodges, that's all tax compliance, that's almost certainly what it takes for GE to comply with its statutory obligations under the internal revenue code It doesn't surprise me in the least that a multinational corporation (especially a large one, with dozens or hundreds of subsidiaries around the world, like GE) would have such a massive return. Even a relatively mundane corporate tax return for a Canadian corporation with a few dozen employees and domestic operations can easy run into 100 pages, and frankly our tax legislation and compliance obligations are far less onerous than those of our US cousins (by way of example, our Tax Act is one phone book, the IRC is three, of more or less inpenetrable gibberish). Toss in a few hundred subsidiaries, located in 50-60 countries, schedules for reporting non-arm's length intercompany transactions, reporting of activities of foreign subsidiaries, depreciation claims, supporting schedules, to say nothing of the various statutory requirement to convert income for accounting purposes into tax income. This is the reason that large Canadian companies generally have full-time CRA auditing teams.

"Tax dodges" generally don't have any implications for a tax return (no one files a T-1080 Tax Dodges Schedule).

[Jacques René Giguère]

@Bob Smith: I don't blame Mitt for paying only his legally required 14%. Why ruin such a good deal? I wouldn't. The point is that Mitt and his ilk (gang?) can lobby to have whatever he does classified as 14%-taxable unlike his secretary. That's the point of the Buffet's rule.

[Patrick]

Bob: Really? No T-1080!? WTF!? My dream has always been to one day qualify to fill out the T-1080. I'm crushed. You lawyers are such downers.

I think I should have started a new paragraph after the first sentence.

The point I was getting at is that firms obviously put a huge amount of resources into both tax compliance and tax avoidance. They can hardly change the compliance side (at least in the short run). What I'm wondering is: keeping policy constant, are the obviously massive resources devoted to tax avoidance really optimal? I work for a very large firm and based on what I see, I doubt it. But maybe I just work for stupid people. Or maybe it's just the nature of large firms; centrally planned nightmares.

[Jacques René Giguère]

@ Patrick: given Peter's Principle, you don't work for idiots. Only people who have been promoted one time too much ( or in the C-suite, 5 or 6 times...)

[Patrick]

Jacques: if we accepts Peter's Principle as generally true, then given that I've never been promoted ... Ouch! More evidence I'm just never going to get to fill in that T-1080.

OT: something I witnessed first hand: a firm decides to cut labour costs by moving production from a high wage country to China. They fire all the high wage staff. Bonuses and high fives all around for the execs. Problem is that they were so anxious to cut wages that they fired everyone who knew how production worked before the Chinese facility could actually produce any widgets. So now they have lower labour costs, but they can't make anything. Biz skool rulz.

[Bob Smith]

@Bob Smith: I don't blame Mitt for paying only his legally required 14%. Why ruin such a good deal? I wouldn't. The point is that Mitt and his ilk (gang?) can lobby to have whatever he does classified as 14%-taxable unlike his secretary. That's the point of the Buffet's rule.

Except what he does is collect dividends and capital gains, same as any other investor, obviously he just collects a lot more of them. The differential treatment of that kind of income is a common feature of most developed tax systems and is founded on solid theoretical grounds, rather than gratuitous lobbying. Moreover, in both cases, the lower tax rate reflects, to a degree, the fact that the underlying income has already been taxed at the corporate level (unlike the secretary's income, since her income is likely deductible from her employer's income). And so much for the lobbying efforts of Mitt & co, the US is scheduled to tax dividends as ordinary income starting next year (impose, effectively, a 60% tax on corporate income distributed to high income earners), making it a decided oddball in the world of tax policy (most countries either tax dividends at a preferred rate or provide some sort of credit or imputation for corporation level tax).

The Buffet rule may be good politics, but it's lousy policy.

Of course, if you want to tax investment income received by gazillionaires at the full tax rate, and you wanted to do so in a principled manner, you could abolish the CIT (or, in the case of dividends, allow corporations to deduct dividends in computing their income) so that dividend income is taxed as ordinary income (like interest). Mind you, that wouldn't change the ultimate tax liability (or collect any additional revenue for the government) but it would ensure that Gazillionaires pay tax at a rate of 50% (or whatever the top rate is). Mind you, it would only be an illusion. Gazillionaires would "pay" more tax, but only because the income was taxed once in their hands rather than twice in their hands and the hands of a corporation. In practice, many private US corporations are structured as limited liability corporations that are disregarded for US tax purposes, allowing them to flow-through their income (and the tax liability thefore) to their ultimate shareholders achieving precisely this result.

[Bob Smith]

What I'm wondering is: keeping policy constant, are the obviously massive resources devoted to tax avoidance really optimal?

For whom? Socially? No. Privately, maybe. For tax lawyers, yes! Although a quick dip through the tax cases shows no shortage of cases where taxpayers pursued strategies that had no hope of succeeding and spend considerable funds fighting them in the tax court(think of the numerous "art flip" or "charitable donation" schemes that have been shut down over the years, or the loonie schemes advanced by "de-taxers"), those tend to be relatively unsopisticated (at least from a tax perspective) taxpayers. And typically they don't bother getting proper tax advice on the grounds that (a) it's expensive and (b) the lawyers/accountant will probably shoot them down.

More sophisticated tax avoidance strategies tend to involve people who are better at assessing both the costs involved, the possible upside and the risks. Even if the strategy ultimately fails, typically, there was a reasonable basis for it a priori. This is particularly true in the public company context where, for obvious reasons, tax positions are scrutinized by auditors who have at least some incentive to give aggressive positions a hard time (and, moreover, public companies don't like taking particularly aggressive position, since they don't like the reputational risk that comes with assessments from the CRA). I can't speak for your company, but generally I'm impressed by the tax and business savvy of large company tax directors or their equivalents, i.e., they generally don't let the tax tail wag the business dog. I'm sure there are exceptions, though.

[Phil Koop]

"If, however, taxation of investment income is deferred until it is realized, then I'll stick with OldSchool, as with OldSchool I'm getting 4% on my *pretax* $1000 profits, however with NewSchool I'm getting 5% on my *aftertax* profits, i.e. something like 5% of $600."

Whether that helps you or hurts you depends on the size of your unrealized gains, the rate of taxation, and the time horizon of your investment.

Call your cost base C, your unrealized gain today on OldSchool G, your investment horizon from today T, and your tax rate Rt, except that it will be easier to define K = (1-Rt). If you stick with OldSchool, your after-tax position at T will be:

1) C + K C (exp(0.4T)-1) + K G exp(0.4T)

If you switch to NewSchool, it will be:

2) C + K C (exp(0.5T)-1) + KG + K K G (exp(0.5T)-1)

When is 1) bigger than 2)? The cost account of 2) dominates that of 1), so it is necessary (though not sufficient) to concentrate on the gains accounts. That is, we have a lower bound on NewSchool involving G:

K G exp(0.04T) > K G + K^2 G (exp(0.05T)-1)
G exp(0.04T) > G (1 + K exp(0.05T) - K)
exp(0.04) > 1 + K exp(0.05T) - K

If you are a Canadian paying the top marginal rate, and investment gains are in the form of capital gains, then K is about 0.75. When T=12, then the inequality above will be falsified. Remember, though, that it represents a bound that holds only when C=0; the larger C, the shorter the breakeven T.

[Phil Koop]

Oops: lost the "T" from that last exp(0.4T). Sorry.

[K]

K: "Mick.Marrs, the "left wing" wouldn't be so angry if these tax cuts weren't coupled with useless spending on military equipment and (soon) more prisons."

Hey! I'm "K" around here. Seriously, I've commented here for two years under that name. Find another one!

Regards,
K

[Patrick]

" large company tax directors or their equivalents"

Being reminded that such a thing exists is deeply depressing.

[Determinant]

@bob smith:

Your post at 9:21 would be true if we taxed dividends on accrual in the hands of shareholders instead of when distributed on a cash basis. But we tax on a cash basis for personal returns so we need to have a corporate income tax to get at the profits that a corporation has.

People HATE being taxed on accrual because it means paying for something they haven't yet received in the form of a cheque.

Corporations are legally separate from their shareholders so it doesn't matter when an individual dies, it's not a taxable event from the point of view of the corporation and if there are undistributed profits those profits will remain untaxed.

As an extreme example Warren Buffett famously resisted having Berkshire Hathaway distribute a dividend for decades. Without a corporate income tax the US Government would have been deprived of that enourmous revenue for all that time. As Buffett likes to boast in his annual reports, Berkshire and its subsidiaries now fund an entire day's operation of the US Government, including military activity, though their CIT payments.

[Bob Smith]

Determinant,

I'm sorry, but you're wrong. If corporations simply let profits accrue without distributing them, the value of those accrued profits will be reflected in the share price of the corporation (it's not going anywhere). On the death of a shareholder, there is a deemed disposition of all assets (subjet to fairly limited rollover provisions, to allow you to transfer assets to your spouse on a tax-free basis). That the corporation is a separate legal entity is irrelevant, the accrued income is reflected in the value of the shares held by the taxpayer, that's where its taxed. There'd be no tax at the corporation level, and there's a timing game, but so what, all the income will ultimately be taxed in the hands of shareholders. You can't defer tax indefinitely, CIT or no.

Take Berkshire Hathaway, your example, in the absence of a CIT in the US, a portion of its undistributed profits would be taxed (at a rate higher than the current rate) every time the shares are traded on the NYSE (53K times a day for the Class A shares, roughly 3% of the float, 4.5M times a day for the class B shares - I'm surprised the volume is that high). And of course, in the absence of distributions, those shares would be traded more frequently as people liquidate their holdings to finance their lives (surprisingly, no matter how much people hate paying taxes, people, particularly wealthy people, like spending money).

We could readily set up a tax system without a CIT, but with the same effective tax rates on income earned through corporations, that would collect the exact same amount of revenue as the current system. The proof is that we do so on a daily basis with trusts and parntnerships (and, in the US, with limited liability corporations and s-corporations).

[Determinant]

"I'm sorry, but you're wrong. If corporations simply let profits accrue without distributing them, the value of those accrued profits will be reflected in the share price of the corporation (it's not going anywhere)."

No. True in theory, sometimes true in reality but not true enough to finance a government. The market is not THAT efficient.

Do you want to track down every shareholder of the Big Banks and make them file a personal return or collect the tax from the bank itself? The bank has the cash. This sort of efficiency argument was why we instituted payroll tax deductions at source.

Governments can't tolerate massive 5-50 year deferral of taxes on that scale. Our choice has been not to tolerate it.

[Bob Smith]

Determinant,

Any shareholder of the bank that realizes a gain or receives dividend already has to file a return, so i don't see the alleged efficiency gain from taxing corporations. Indeed, think about, how could a two level tax system ever have lower compliance costs than a single level tax system.

As for the alleged inability of governments to manage the tax deferral, if such a system were implemented, provided that people traded securities or died at a more or less steady rate over time, there's no reason to think that there would be government cash flow issues.

Mind you, i should be careful about encouraging such a development, since the CIT is a boon for tax lawyers (which some might see as a further argument against it).

[Andrew F]

This seems to boil down to whether you believe untaxed profits are a Bad Thing. If you felt that way, you should also oppose RRSPs, TFSAs, etc. I think taxing the profit when it is used for consumption is sensible, and having that tax be progressive. I find arguments for taxing profits (aka investment returns) fairly uncompelling.

[Patrick]

RRSPs and TFSAs have contribution limits. I think it's not unreasonable to worry about hoarding in a no-CIT world.

No-CIT is simply not happening. Perhaps a more fruitful avenue to explore would be tax code simplification, broadening the base, and keeping rates down. I've filed corporate tax returns, and even when it was a one man teeny tiny corporation that basically owned nothing it was an impenetrable morass of a forms and jargon. Thank God 2008 bankrupted all my customers and freed me from the clutches of the accountants! In any case, cost of compliance for larger firms must be astronomical. There must be a better way.

[Bob Smith]

Patrick,

Agreed, we're stuck with the system we have, although it's still helpful to think about alternatives just to give us a counterfactual for assessing our own tax system.

In terms of compliance, notwithstanding my pecuniary interest to the contrary, I'm all for tax code simplification, but simplificity comes with other costs. At the end of the day, there are three desirable attributes of a tax system (i) simplicity (ii) efficiency and (iii) fairness. Unfortunately, you can't have all three of them atonce. You can have a tax system that's simple and efficient, say a flat tax, but it won't be fair. You can have a tax system that's simple and fair, but it won't be efficient. Or you can have a system that's efficient and fair, but it won't be simple.

In practice, we have a trade off between all three. If you run a business, your tax return is complex in part because you can claim deductions that an employee can't claim. Then again, that's neccesary for efficiency reasons since many of those expenses should rightly be deducted from your revenue to properly reflect your income. For employees (most of us), a lot of those deductions aren't available (even though, in some cases, they should be, at least from a principled perspective - for example, interest on my student loan is every bit a cost of earning my employment income as is interest on a line of credit for a small business, but you can deduct the later, but not the former), but the efficiency loss is probably pretty small, and there is the offsetting advantage of simplicity (if you run even a small business, you're well advised to hire an accountant, if you're an employee, you can probably do your tax return in half an hour).

Some of the more complex provisions of the Tax Act, for example, dealing with disability tax credits, are desirable for fairness reasons (both to ensure assistance to those who need it, while preventing those who don't need it from being able to claim such credits), but they come at considerable cost to simplicity. Similarly, others are intended to protect fairness by preventing people from exploiting inconsistencies in the tax act (I can think of at least two that are indecypherable to even senior members of the tax bar).

All of which is to say is that simplification has its limits. Moreover, it's hard to do. Apparently a few years ago the Australians who tried to rewrite their tax code in plain English. A nice idea in its own way, but they got half way through it before they realized that while technical jargon has its limits, it at least has well defined meanings, whereas "plain English" was too vague for a legal document (the example I heard was people deducting the cost of their chauffeur as an "automobile expense", which was defined as something along the lines of "expenses relating to automobiles"). I gather they gave up half-way through. In any event, we won't be getting simplification any time soon, I heard a rumour recently that finance will be releasing 900 pages of technical amendments to the Tax Act one of these days, to take care of a decade's worth of housekeeping - the Tax Lawyer and Accountant Stimulus Bill of 2012.

[Andrew F]

"I think it's not unreasonable to worry about hoarding in a no-CIT world."

What does hoarding mean, though? Reinvesting retained earnings? If there is 'too much' hoarding, surely the returns on marginal investments will fall below the discount rate of some investors, and the corp would pay dividends to be consumed. Or, if the corp keeps investing regardless of how poor returns become, the average return will eventually fall to the point where investors sell and trigger a capital gain. Either way, hoarding is bounded by investors' willingness to defer consumption.