Corporate Tax Reform: Issues for Congress
Corporate Tax Reform:
Issues for Congress
Updated July 24, 2008
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Thomas L. Hungerford
Specialist in Public Finance
Government and Finance Division
Corporate Tax Reform: Issues for Congress
H.R. 3970, introduced by Chairman Charles B. Rangel of the House Committee
on Ways and Means, includes corporate tax revisions, trading a lower rate for a
broader tax base as part of the revenue neutral reform package. Some participants
at a recent Treasury conference, and some discussions by economists in opinion
pieces, suggest there is an urgent need to lower the corporate tax rate, but not
necessarily to broaden the tax base.
Arguments for lowering the corporate tax rate include the traditional concerns
about economic distortions arising from the corporate tax and newer concerns arising
from the increasingly global nature of the economy. Some claims have been made
that lowering the corporate tax rate would raise revenue because of the behavioral
responses, an effect that is linked to an open economy. Although the corporate tax
has generally been viewed as contributing to a more progressive tax system because
the burden falls on capital income and thus on higher income individuals, claims
have also been made that the burden falls not on owners of capital, but on labor
income — an effect also linked to an open economy.
The analysis in this report suggests that many of the concerns expressed about
the corporate tax are not supported by empirical data. Claims that behavioral
responses could cause revenues to rise if rates were cut do not hold up on either a
theoretical basis or an empirical basis. Studies that purport to show a revenue
maximizing corporate tax rate of 30% (a rate lower than the current statutory tax rate)
contain econometric errors that lead to biased and inconsistent results; when those
problems are corrected the results disappear. Cross-country studies to provide direct
evidence showing that the burden of the corporate tax actually falls on labor yield
unreasonable results and prove to suffer from econometric flaws that also lead to a
disappearance of the results when corrected, in those cases where data were obtained
and the results replicated. Similarly, claims that high U.S. tax rates will create
problems for the United States in a global economy suffer from a misrepresentation
of the U.S. tax rate compared to other countries and are less important when capital
is imperfectly mobile, as it appears to be.
While these new arguments appear to rely on questionable methods, the
traditional concerns about the corporate tax appear valid. While an argument may
be made that the tax is still needed as a backstop to individual tax collections, it does
result in some economic distortions. These economic distortions, however, have
declined substantially over time as corporate rates and shares of output have fallen.
Moreover, it is difficult to lower the corporate tax without creating a way of
sheltering individual income given the low rates of tax on dividends and capital
A number of revenue-neutral changes are available that could reduce these
distortions, allow for a lower corporate statutory tax rate, and lead to a more efficient
corporate tax system. These changes include base broadening, reducing the benefits
of debt finance through inflation indexing, and reducing the tax at the firm level
offset by an increase at the individual level. This report will not be updated.
The Corporate Tax as a Revenue Source................................3
Magnitude and Historical Pattern.................................3
The Role of the Corporate Tax in Backstopping the Individual Tax.......5
Behavioral Responses and Revenue Maximizing Tax Rate.................6
Brill and Hassett Study........................................11
Cross Country Investment Estimates: The Djankov Study.................14
The Harberger and Randolph Studies.............................17
The Hassett and Mathur Study...................................19
Other Cross Country Wage Studies...............................23
Economic Efficiency Issues.........................................26
Allocation of Capital Within the Domestic Economy.................27
International Capital Flows.....................................32
Potential Revisions in the Corporate Tax..............................33
Eliminating Corporate Tax Preferences............................33
Interest Deduction Inflation Correction............................36
Reducing Tax at the Firm Level and Increasing Individual Level Taxes..36
Appendix A. Revenue Maximizing Tax Rates in an Open Economy........38
Appendix B. Data and Estimation Methods............................40
Appendix C: Modeling Problems of the Desai, Foley, and Hines Study.......43
List of Tables
Table 1. Tax Rates For Alternative Forms of Organization Under
Alternative Rate Structures, Individual at 35% Rate...................6
Table 2. Revenue Maximizing Tax Rates and Share of Variance
Explained in the Clausing Study..................................8
Table 3. Coefficient Estimates: Dependent Variable is Corporate
Revenues as a Percentage of GDP (Brill and Hassett Model)...........12
Table 4. Coefficient Estimates: Dependent Variable is Corporate
Revenues as a Percentage of GDP (Clausing Model).................13
Table 5. Coefficient Estimates: Key Independent Variable is
Constructed Effective Tax Rate (Djankov, Ganser, McLiesh,
Ramalho, and Shleifer Model)...................................16
Table 6. Coefficient Estimates: Dependent Variable is the Logarithm
of the 5-Year Average of Wage Rates.............................21
Table 7. Coefficient Estimates: Dependent Variable is Annual
Logarithm of Real PPP-Adjusted Wage Rates......................23
Table 8. Differential Tax Rates across Asset Types......................29
Table 9. Effective Tax Rates by Sector and Type of Finance...............30
Table 10. Corporate Tax Preferences and Projected Revenue Costs,
Table 11. Corporate Revenue Raisers in H.R. 3970......................35
Table B1. Standard Deviation of Corporate Tax Rate Variables in the
Three Data Sets..............................................42
Corporate Tax Reform: Issues for Congress
On October 25, 2007, Ways and Means Committee Chairman Charles B. Rangel
introduced H.R. 3970, a tax reform plan that included revisions in the corporate tax
to lower the rate and broaden the base. This proposal would cut the corporate tax
rate and, in a roughly revenue-neutral sub-section of the proposal, broaden the tax
Interest in corporate rate cuts and other corporate revisions has been developing
for some time. In November 2005, President George W. Bush’s Advisory Panel on
Tax Reform reported on a variety of proposals for major reform of the tax system,
including those for corporate and business income taxes.1 Hearings were held on
these proposals in 2006, but no further action occurred. On July 16, 2007, The Wall
Street Journal published an opinion article by Treasury Secretary Henry M. Paulson
addressing concerns that the U.S. corporate tax rate is high relative to other countries
and announcing a conference to be held July 26 that would examine the U.S. business2
tax system and its effects on the economy.
On July 23, the Treasury Department released a background paper (hereafter,
the Treasury Study) that addressed several issues associated with the corporate tax:
(1) special tax provisions that narrow the corporate tax base; (2) the efficiency effects
of the tax (distortions in the size and allocation of investment); (3) the size of the
unincorporated sector; and (4) a comparison of corporate taxes in the United States
with other countries.3 The paper, however, did not discuss important justifications
for a corporate tax, such as its role in the progressivity of federal taxes assuming the
burden of the tax falls on capital, and the need for a corporate tax to avoid the use of
the corporate form as a tax shelter by high income individuals.
While the Treasury Study focused largely on efficiency issues and international
comparisons, on the day of the conference, R. Glenn Hubbard, President Bush’s first
chairman of the Council of Economic Advisors, also published an opinion article in
The Wall Street Journal referring to the conference.4 His article echoed some
arguments that have been made in recent months that are based partly, or largely, on
empirical studies of differences across countries. He addressed the distributional
1 Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, November 2005,
which can be found at [http://www.taxreformpanel.gov/].
2 Henry M. Paulson, Jr., “Our Broken Corporate Tax Code,” The Wall Street Journal, July
3 United States Department of the Treasury, “Treasury Tax Conference on Business
Taxation and Global Competitiveness: Background Paper,” July 30, 2007, at
[http://www.ustreas.gov/ press/releases/hp500.htm] .
4 R. Glenn Hubbard, “The Corporate Tax Myth,” The Wall Street Journal, July 26, 2007.
issue, but referred to some evidence that the burden of the corporate tax falls on
labor. In addition to theoretical arguments, he cited an empirical paper by Kevin
Hassett and Aparna Mathur of the American Enterprise Institute.5 His article also
discussed empirical evidence suggesting that the U.S. might raise revenue by cutting
corporate tax rates because of large behavioral responses.6 Hubbard concludes by
suggesting that cutting the corporate tax rate would reduce a tax that is largely, or
even fully, borne by labor and that behavioral responses would offset much of the
static revenue cost.
During the conference, discussions included whether business representatives
would trade tax preferences for lower rates, whether reform should take the form of
lower rates or write-offs of investments, and methods of avoiding the corporate tax
by income shifting in a global economy. Some participants complained that the
corporate tax is outdated, too complex, distorts decisions, and undermines the ability
of firms to complete in a global economy. Echoing some issues raised in Hubbard’s
article, Kevin Hassett indicated that the corporate tax was not an effective way to
raise revenues and suggested that lowering the rate would raise revenues.7
Prior to the 2007 conference, Congress held hearings in 2006 on the Advisory
Panel’s proposals, with a general hearing followed by one concentrating on business
tax issues. In the 110th Congress, attention to capital income taxes has been targeted
to narrower issues such as the tax gap and offshore tax havens.8 At the time of the
Treasury conference, Chairman Charles B. Rangel of the House Ways and Means
Committee released a statement inviting the Bush Administration to discuss such
issues as tax reform, especially the Alternative Minimum Tax (AMT), addressing
tax havens, and increasing equity and fairness in the tax structure.9
H.R. 3970 includes some of the base broadeners included in the Treasury Study
and others that were not. The rate reduction, from 35% to 30.5% was not as large as
5 Kevin A. Hassett and Aparna Mathur, Taxes and Wages, American Enterprise Institute,
working paper, March 6, 2006, presented at a conference of the American Enterprise
Institute on May 2, 2006.
6 Hubbard’s article cites Michael Devereux, and apparently refers to a paper also presented
at the American Enterprise Institute Symposium.
7 This summary and other references to the issues discussed at the conference are based on
two detailed media accounts of the conference; although the conference was televised, there
is no transcript at this time. The articles are Heidi Glenn, “Business Leaders would Give
Up Tax Breaks for Lower Rates,” Tax Notes, July 30, 2007, pp. 324-327, and Joanne M.
Weiner, “U.S. Corporate Tax Reform: All Talk, No Action,” Tax Notes, August 27, 2007,
8 Hearings were held by the Senate Finance Committee on August 3, 2006, with a follow-up
focused on business tax issues on September 20, 2006. The committee also held hearings
on May 3, 2007 on tax havens.
9 Statement released by the Honorable Charles B. Rangel, Chairman, Ways and Means
Committee, July 26, 2007.
that discussed in the Treasury Study, 27%. Base broadeners in H.R. 3970 have
already been criticized by some business groups.10
The corporate tax debate continues to be in the news. In May 2008, N. Gregory
Mankiw published an article suggesting that most of the burden of the tax falls on
labor, and cites research suggesting the corporate tax is borne by labor and that
revenue losses may be fully or largely offset by behavioral responses.11
This report provides an overview of corporate tax issues and discusses potential
reforms in the context of these issues, with particular attention to some of the recent
research concerning large behavioral responses and their implications for revenue and
distribution. The first section reviews the size and history of the corporate income
tax, and discusses an important issue that has been given little attention by those who
propose deep cuts in the corporate tax: its role in preventing the use of the corporate
form as a tax shelter by wealthy business owners. This section also discusses the
potential effect of behavioral responses on corporate tax revenues. The second
section examines the role of the corporate tax in contributing to a progressive tax
system and discusses claims that the burden falls on workers. The third section
reviews arguments relating to efficiency and revenue yield, and traditional criticisms
of the corporate tax as one that causes important behavioral distortions. One aspect
of this discussion is the question of how the tax might be viewed differently in a
more global economy. The final section examines options for reform.
The Corporate Tax as a Revenue Source
The corporate tax is the third largest source of federal revenue, but its
importance as a revenue source has diminished considerably over time.
Magnitude and Historical Pattern
Despite concerns expressed about the size of the corporate tax rate, current
corporate taxes are extremely low by historical standards, whether measured as a
share of output or a based on the effective tax rate on income.12 In 1953, the
10 See Jeffrey H. Birnbaum, “Democrat Overhall of Taxes: Rangel Would Annul AMT,
Shift Burden,” Washington Post, October 26, 2007, p. D1.
11 N. Gregory Mankiw, “The Problem with the Corporate Tax,” New York Times, June 2,
2008. For empirical evidence on incidence he cites an empirical study by Wiji
Aralampalam, Michael P. Devereux, and Giorgia Maffini, The Direct Incidence of
Corporate Income Tax on Wages, Oxford University Center for Business Taxation, May,
2008. For empirical evidence on the feedback effects on revenue, he cites Alex Brill and
Kevin Hassett, Revenue Maximizing Corporate Income Taxes, AEI working paper # 137,
American Enterprise Institute, July 31, 2007.
12 The data discussed in this paragraph are taken from Jane G. Gravelle, “The Corporate
Tax: Where Has it Been and Where is it Going?,” National Tax Journal, vol. 57 (December
budget/historical.shtml] and The Budget and Economic Outlook, Fiscal years 2008-2017
corporate tax accounted for 5.6% of GDP and 30% of federal tax revenues. In recent
years the tax has fluctuated round 2% of GDP and 10% of revenues, reaching a low
of 1.2% of GDP in 2003, and standing at 2.7% in 2006. The tax is projected to
continue to raise revenues of around 2% of GDP. Today, it is the third largest federal
revenue source, lagging behind the individual income tax, which is about 8% of GDP
and the payroll tax, which is about 6.5%. It is much more significant, however, than
excise taxes, which are slightly over 0.5%, and estate and gift taxes at 0.2%. (Note
that the income tax share is expected to grow and will exceed 10% if the 2001-2003
tax cuts are not made permanent; estate and gift tax revenues will also rise slightly.)
Much of the historical decline arises from legislated reductions in the corporate
effective tax rate on the return to new investment, which has fallen from 63% of
corporate profits in 2003 to about 30% today. These changes include a reduction in
the top statutory rate from 52% to 35% and much more liberal depreciation rules.
The total tax burden on corporate source income has declined even more due to lower
rates on dividends and capital gains at the shareholder level and the increased fraction
of stocks held in tax exempt form.
While a large fraction of the decline in corporate tax revenues is associated with
these changes in rates and depreciation, other causes may be more liberal rules that
allow firms to obtain benefits of corporate status (such as limited liability) while still
being taxed as unincorporated businesses and tax evasion, particularly through
international tax shelters. The Treasury Report documents the significant rise in the
share of total business net income received by unincorporated businesses since 1980,
from 21% of total net income to 50%. While the share of proprietorships (which
have no limited liability) has declined slightly, from 17% to 14%, the share of
Subchapter S firms (firms that are incorporated but are allowed to elect taxation as
an unincorporated business) rose from 1% to 15%. These changes followed a
dramatic increase in the number of shareholders allowed for the election (the limit
of 10 was raised to 35 in 1982, to 75 in 1996, and to 100 in 2004). Partnerships
(including limited liability corporations and limited liability partnerships) increased
from 3% to 21%, with most of the increase occurring after 1990. This growth
reflects in part the growth of limited liability corporations established under state law
(the first state adopted such a provision in 1982), which qualify as unincorporated
business for corporate tax purposes. While Subchapter S firms are constrained by the
shareholder limit, partnerships are not.
Although it has declined considerably in importance, the corporate tax remains
a major source of federal revenue, and a significant change in individual income
taxes would be required to offset a substantial reduction in corporate taxes. Current
pressures to find revenue sources to pay for relief from the AMT make an overall
corporate tax cut difficult to envision. For that reason, the Bush Administration has
proposed trading off rate reductions, or possibly broad investment subsidies that
reduce the effective burden on new investment, for base broadening, through
reduction of corporate tax preferences.
[ h t t p : / / www.cbo.gov/ f t pdoc.cf m?i ndex=7731&t ype=0] .
The Role of the Corporate Tax in Backstopping
the Individual Tax
Measuring corporate tax revenue falls short of describing the full role of the
corporate tax in contributing to federal revenues because the corporate tax protects
the collection of individual income taxes. As long as taxes on individual income are
imposed, a significant corporate income tax is likely to be necessary to forestall the
use of the corporation as a tax shelter. Without a corporate tax, high income
individuals could channel funds into corporations, and, with a large part of earnings
retained, obtain lower tax rates than if they operated in partnership or proprietorship
form or in a way that allowed them to be taxed as such. As suggested by the growth
in unincorporated business forms above, wealthy business owners may be quick to
take advantage of tax rate differentials, which currently tend to favor unincorporated
businesses. (Since 1986, when individual tax rates were lowered dramatically, the
corporate tax rate has been high relative to the individual tax rate). The Treasury
Study indicated that 61% of the income of unincorporated businesses was associated
with taxpayers in the top income tax bracket.
Although the top tax rate on corporations is equal to the top individual rate
(35%), the corporate tax is graduated. Consequently, for high income taxpayers, there
is an advantage to shifting part of one’s income into a corporation because corporate
tax rates are graduated (15% on the first $50,000 and 25% on the next $25,000) and
are lower than the top marginal tax. This opportunity, however, is restricted by: (1)
limiting to one the number of corporations income can be shifted to; (2) the amount
on which rates are graduated; and (3) disallowing graduated rates for personal service
corporations. There are over 600,000 corporations with earnings less than $50,000,
according to Internal Revenue Service statistics, suggesting some shifting occurs. In
recognition of the potential use of the corporation as a shelter, tax law has in the past
contained a tax on accumulated earnings. As long as dividends were taxed as
ordinary income and the accumulated earnings tax was strict enough, it was difficult
to use the corporate form to shelter a great deal of income.
This tax shelter constraint on lowering the corporate rate is arguably more
binding today because of the lower rates on dividends and capital gains enacted as
part of the Administration’s corporate relief package in 2003. Table 1 calculates the
effective tax rate for operating through a corporation, versus an unincorporated
business, for an individual in the 35% tax bracket. If dividends are taxed at 15% and
the corporate rate is lowered to 27% as suggested in the Treasury conference, the tax
rate in the corporate form would be less than the tax rate on unincorporated
businesses. In fact, with a 15% rate on dividends, corporations that distributed less
than 73% of their income would present a tax shelter opportunity with a 27% tax rate.
This outcome would occur even without the benefit of graduated rates and could
potentially benefit labor income as well as individual capital income. Moreover,
although there are rules restricting accumulated earnings, it is common for
corporations to reinvest a significant fraction of their earnings. This unlimited
sheltering option would not exist as long as the corporate tax were as high as the
individual tax, and its scope would be limited if dividends and capital gains were
taxed at higher rates.
Some reforms might address these shelter issues directly, including raising tax
rates on dividends and capital gains at the individual level while lowering the rate at
the firm level, eliminating the graduated rate structure, and more formal methods of
integrating the individual and corporate income taxes.
Table 1. Tax Rates For Alternative Forms of Organization Under
Alternative Rate Structures, Individual at 35% Rate
100% of50% ofNo Income
Income Income Di stributed
Di s t r i but e d Di stributed
Dividends Taxed at 15% Rate
Corporate Tax Rate of 35%454035
Corporate Tax Rate of 27%383227
Dividends Taxed at Ordinary Rates
Corporate Tax Rate of 35%58 4635
Corporate Tax Rate of 27%463627
Source: CRS analysis.
Behavioral Responses and Revenue
Maximizing Tax Rate
Although it has long been recognized that there are behavioral responses to the
corporate tax (even aside from the tax sheltering issues indicated above), and that
these responses have important implications for the efficiency of the economy and
the burden of the tax, the issue of a revenue maximizing tax rate, popularly
associated with the “Laffer” curve, has rarely entered into the discussion. A Laffer
curve graphs revenue against the tax rate, and is based on the notion that revenue is
zero at a zero tax rate and zero at a 100% tax rate (at least with respect to some13
taxes). In a Laffer curve, the revenue first rises with the tax rate and then falls, and
at the point it reverses direction is the revenue-maximizing tax rate.
A Laffer curve for the corporate tax has been proposed or alluded to recently in
several articles in the popular press. One is the article by Glenn Hubbard, cited
above. In National Review, Kevin Hassett discusses the Laffer curve and presents
a chart that he indicates is an illustration that appears to show a negative relationship
13 Excise taxes can be set at more than 100% and still yield revenue. Taxes on real capital
income in excess of 100% can also yield revenues because inflation is an implicit tax on the
holding of cash.
between corporate revenues as a share of GDP and the tax rate.14 Only 13 countries
are shown on this graph, however, and the negative relationship is clearly strongly
affected by an outlier, Ireland, which is a well known tax haven; most economists
would not find this illustration persuasive proof. Another discussion of this issue
appeared in an editorial in The Wall Street Journal, which also presented a chart with
a number of OECD countries on it.15 In this chart, the editors simply drew a curve,
which passed through a couple of points. There was no statistical fitting to the data
and no informative value to such an analysis; moreover the two points through which
the freehand curve was drawn were questionable: one was the United Arab Emirates
with no tax, which is neither a typical country nor in the OECD, and the other was
Norway, whose corporate tax revenue tends to be high because of oil. The bulk of the
data showed no obvious trend.16
The Hubbard and Hassett articles do, however, cite some more sophisticated
research. Hassett referred to a paper by Kimberly Clausing,17 and Hubbard referred
to a paper by Michael Devereux.18 In addition, Alex Brill and Kevin Hassett also
prepared a statistical analysis examining the change in the relationship over time.19
A cross country study was also prepared by Mintz.20. Clausing, who is referred to in
the Hassett article, is quoted as claiming that the United States is likely to the right
of the revenue maximizing point on the Laffer curve, but this statement, presumably
from an earlier draft, is not found in her published article. That article finds a
revenue maximizing tax rate of 33%, in her simple specification, but as she added
variables and accounted for other features the revenue maximizing tax rate seemed
to rise, as indicated in Table 2. Large countries and countries that are less open, such
14 Kevin A. Hassett, “Art Laffer, Righter Than Ever,” National Review, February 13, 2006.
15 “We’re Number One, Alas,” The Wall Street Journal, July 13, 2007, p. A12.
16 For insight into how this graph was viewed by economists, see Brad DeLong, an
economist at Stanford and author of a website, Brad DeLong’s Daily Journal, who titled his
entry “Most Dishonest Wall Street Journal Editorial Ever.” There was some perception,
which was incorrect, that this graph was prepared by Kevin Hassett because he was
mentioned as a source, but that was not the case; he provided some of the data (personal
communication with Kevin Hassett). Based on data provided by one of the correspondents
in that debate, a simple regression of corporate share on tax and tax squared showed no
significant coefficients for tax variables, indicating no relationship:
[http://delong.typepad.com/sdj /2007/07/most-dishonest-.html ].
17 Kimberly A. Clausing, “Corporate Tax Revenues in OECD Countries,” International Tax
and Public Finance, vol. 14 (April 2007), pp. 115-133.
18 Michael P. Devereux, Developments in the Taxation of Corporate Profit in the OECD
Since 1965: Rates, Bases and Revenues, May 2006 presented at a conference of the Alliance
for Competitive Taxation and the American Enterprise Institute, June 2, 2006.
19 Alex Brill and Kevin Hassett, Revenue Maximizing Corporate Income Taxes, AEI
working paper # 137, American Enterprise Institute, July 31, 2007.
20 Jack M. Mintz, 2007 Tax Competitiveness Report: A Call for comprehensive Tax Reform,
C.D. Howe Institute, No. 254, September 2007.
as the United States, have a revenue maximizing tax rate of 57% — much larger than
the combined federal and state rate for U.S. firms of 39%.21
Table 2. Revenue Maximizing Tax Rates and Share of Variance
Explained in the Clausing Study
(2) Additional Variables 390.43
(3) Additional Variables420.46
(4) Additional Variables410.23
(5) Additional Variables370.21
(8) Openness and size570.28
Source: Kimberly Clausing (2007).
Note: The R-Squared is a statistical term that measures the share of the variance in the dependent
variable explained by the independent variables.
Michael Devereux’s paper indicates that, while he finds a revenue maximizing
rate of 33% under the same specification as Clausing, he finds only weak evidence
of a relationship between tax rates and corporate tax revenues as a percentage of
GDP. Many of his specifications do not yield statistically significant effects. Brill
and Hassett find a rate of around 30%, which has been falling over time. Mintz finds
a rate of 28%, but his data span only a few years (2001-2005).22
In the remainder of this section, we first discuss theoretical expectations of this
relationship and then examine these empirical studies. Both the theoretical and
empirical assessments suggest that the results of these analyses are questionable.
The issue of a Laffer curve has not been a part of the debate because the notion
of a revenue maximizing tax rate other than at very high tax rates is inconsistent with
most of the models of the corporate tax. Traditionally, the main behavioral response
associated with the corporate tax was the substitution of noncorporate capital for
corporate capital within an economy where the amount of capital was fixed.
Imposing a corporate tax (in excess of the noncorporate tax) caused capital to earn
21 The 33% tax rate is from the simplest regression; the other regressions, which include
other variables, or control for country size and/or openness, lead to higher revenue
22 Hence, most of the variation is across countries, which, as discussed below, is a
potentially serious problem.
a lower return in the corporate sector and to flow out of that sector and into the
noncorporate sector, thereby lowering the return in the noncorporate sector and
raising the return, before taxes, in the corporate sector. The higher pre-tax return on
capital also caused prices to go up in the corporate sector and fall in the noncorporate
sector, causing a shift towards non-corporate sector total production. The corporate
profits tax base, therefore, had two opposing forces: the amount of capital was falling
but the profit rate was rising. The taxable base could, therefore, either increase as tax
rates increased, or it could decrease. The direction depended on the substitutability
of capital and labor in the corporate sector. The central tendency of most models
(with unitary elasticities) suggested, however, that the tax base was relatively
invariant to tax rates, and revenues would always rise with the tax rate.
Consequently, under any reasonable set of assumptions there would either be no
revenue maximizing tax rate or an extremely high one.23
If behavioral responses caused the total capital in the U.S. economy to contract,
the outcome could be different. One such model, the open economy model, appears
to be a motivation for the belief in a relatively low revenue maximizing tax rate.
Brill and Hassett discuss elasticity estimates of foreign capital flows to after tax
returns in the range of 1.5 to 3 (they also cite a recent study with an elasticity of 3.3)
in their paper that finds a revenue maximizing tax rate of around 30%. They
conclude that “[t]hese high elasticities are consistent with the view that reductions
in corporate rates could lure a significant enough amount of economic activity to a
locality to create a Laffer curve in the corporate tax space.”24
As shown in the Appendix A, however, one cannot achieve this tax rate even
with infinite elasticities. In the most extreme case, where: (1) the country is too small
to affect worldwide prices and rates of return; (2) capital is perfectly mobile; and (3)
products in international trade are perfectly substitutable, the revenue maximizing tax
rate would be the ratio of the labor share of income to the factor substitution
elasticity. Assuming fairly common values for a model without depreciation of 75%
for labor’s share of income and a factor substitution elasticity of 1, the tax rate would
be 75% — far above the rates of around 30% reported by Brill and Hassett. This rate
could rise as these conditions are relaxed. If the U.S. is assumed to have 30% of
world resources, the rate rises to 81%; if imperfect substitutability between
investments across countries and between foreign and domestic products is allowed,
it would rise further.
Although it is possible to have a revenue maximizing tax rate that does not
asymptotically approach 100% it is probably not possible to find a rate that
maximizes revenues as a percentage of GDP, because GDP falls as well as tax
revenues. In this case, we are back to the same circumstances as in the reallocation
23 An invariant tax base would occur when both production and utility were of the Cobb
Douglas form, that is unitary factor substitution elasticities and unitary product substitution
elasticities. At 100% tax rate a corner solution would be presumably be reached where the
corporate sector would entirely disappear, but only at that extreme rate would such an effect
24 Brill and Hassett, Revenue Maximizing Corporate Income Taxes, p. 6.
of capital in the closed economy: with unitary elasticities, the corporate share of
income is constant relative to GDP, and with other elasticities it can rise or fall.
A related circumstance where capital can contract would be in a model where
savings responds so powerfully that the savings supply is infinitely elastic, that is,
when a tax is imposed, the capital stock must contract so much, and the pre-tax rate
of return rises so much that the after-tax return comes back to its original value. This
extreme savings response model yields the same revenue maximizing tax rate as the
extreme open economy, 75%, and probably no revenue maximizing tax rate for
revenues as a percent of GDP. Moreover, the slowness with which the capital stock
adjusts (most models allow 150 years for full adjustments) means that the revenue
would be affected by tax rates in the past.
The result of this discussion makes it clear that revenue maximizing tax rates
cannot arise from physical reallocations or contractions of capital. Nor are they likely
to arise from a substitution between debt and equity, since the debt share has changed
very little despite significant changes in the relative tax burden, and estimates of
elasticities that do exist are small.
A remaining source of a different outcome is profit shifting. This could involve
firms maintaining the same activity and shifting the form of operation to
unincorporated businesses. This could be a possibility (although the point of revenue
maximization would be much too low because much of the tax has not disappeared,
but rather has shifted). But, at least in the United States, this shift is probably less the
result of high corporate tax rates and more the result of increasingly loose restrictions
on operating with limited liability outside the corporate form, actions that have not
been taken by other countries.25 The other profit shifting issue is the shifting of
profits (rather than activity) to foreign countries. Such effects are possible, but it
would seem unlikely that tax avoidance could be of this magnitude, given that only
as is characteristic of most tax havens, might have little enough domestic capital that
they could afford the loss from lowering the rate in order to attract more capital, such
an outcome is much less likely for the United States.
As noted above, several recent studies have examined the relationship between
corporate tax rates and corporate tax revenues as a percentage of gross domestic
product (GDP). We obtained the data used for two of these studies to replicate and
extend the analyses. Both studies and our analysis estimate the effect of the top
25 The Treasury Study provides data on the growth over time in unincorporated business
forms and suggests that the large share of this income in the United States relative to other
countries is due to the ability to avoid the corporate tax and still retain limited liability in
the United States. The growth in Subchapter S income (partnerships that can elect to be
taxed as corporations) corresponds to increasing limits on the number of permissible
shareholders, and the growth in partnership income to the growth in the number of states
allowing limited liability companies that do not fall under the corporate tax. Proprietorship
income shares have changed very little. In any case, this growth occurred during a period
when the corporate tax was constant or falling.
corporate tax rate (and its square) on corporate tax revenues as a percentage of GDP.
Panel data for 29 OECD countries is used for the analysis.
Brill and Hassett Study
In their study, Brill and Hassett use panel data for the OECD countries from 1981 to
2003.26 They use regression analysis (OLS) to estimate the effects. Brill and Hassett
find that the corporate tax rate has at first a positive effect on corporate tax revenues
as a percentage of GDP and then a decreasing effect — the effect looks like an
inverted U, the shape of the classic Laffer curve. All of their coefficient estimates
are statistically significant. However, they do not account for problems often
encountered with the use of panel data, and their coefficient estimates would appear
to be biased and inconsistent.27
The estimation results from our re-analysis of the Brill and Hassett study are
reported in Table 3. The regression includes a tax rate and a tax rate squared to
allow for a curve. Panel A of the table displays the results for central government
corporate tax data (in the case of the U.S., this is federal government tax data). The
coefficient estimates for the full time period (1980 to 2003) and the four subperiods
defined by Brill and Hassett are reported. In all cases, the coefficient estimates are
fairly small and none are statistically significant at conventional confidence levels.
Panel B of the table displays the results for total government (that is, governments
at all levels) corporate tax data. Again, the coefficient estimates are fairly small and
none are statistically significant. Once appropriate estimation methods are used to
correct problems arising with panel data, there appears to be no statistically
significant relation between corporate tax rates and corporate tax revenues as a
percentage of GDP.
26 See Alex Brill and Kevin A. Hassett, Revenue-Maximizing Corporate Income Taxes: The
Laffer Curve in OECD Countries. We obtained our data from the same sources as Brill and
27 The terms “biased” and “inconsistent” are technical statistical terms. See Appendix B
for a description and the consequences of these problems, and the statistical definitions for
biased and inconsistent.
Table 3. Coefficient Estimates: Dependent Variable is
Corporate Revenues as a Percentage of GDP
(Brill and Hassett Model)
1980-1986 1987-1992 1993-1997 1998-2003 1980-2003
A. Central government corporate tax revenues; federal corporate tax rate
squared (0.109) (0.100) (0.129) (0.178) (0.053)
Prob>F 0.008 0.303 0.719 0.809 0.603
B. Total government corporate tax revenues; total corporate tax rate
squared (0.214) (0.091) (0.109) (0.123) (0.047)
Prob>F 0.112 0.811 0.602 0.481 0.612
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other
variables include time dummy variables.
Clausing uses panel data for the OECD countries from 1979 to 2002 to study the
effect of corporate tax rates on corporate tax revenue as a percentage of GDP.28 She
includes more explanatory variables than did Brill and Hassett, but her overall
research findings and conclusions are essentially the same as theirs — there is a
Laffer curve relationship between corporate tax rates and corporate tax revenue as a
percentage of GDP. However, her estimation methods would lead to biased and
inconsistent coefficient estimates.29
28 See Kimberly A. Clausing, “Corporate Tax Revenues in OECD Countries.” The authors
thank Kimberly Clausing for providing her data.
29 Clausing included two variables in her analysis indicating the type of corporate tax system
that do not vary over time for a country. The coefficients of these variables are not
identified when using the fixed effect estimation method, which is probably why she
estimated the coefficients using OLS. While she obtained coefficient estimates for these
two variables, the estimates are biased and inconsistent.
The estimation results for five different specifications are reported in Table 4.
The five specifications differ by what explanatory variables are included in the
analysis. In all five specifications, the coefficient estimates of the corporate tax rate
(and its square) are smaller than those estimated by Clausing and have the opposite
signs. Most of the coefficient estimates are not statistically significant at
conventional confidence levels, but two are statistically significant at the 10% level
only. (In these cases where the coefficients are significant on the tax squared term
they still do not produce the Laffer curve shape but rather suggest rising revenue with
a rising tax rate). Overall, these results suggest that the corporate tax rate has little
effect on corporate tax revenues as a percentage of GDP. Consequently, there is little
evidence to support the existence of a corporate tax Laffer curve.
Table 4. Coefficient Estimates: Dependent Variable is
Corporate Revenues as a Percentage of GDP (Clausing Model)
squared (0.047) (0.147) (0.061) (0.048) (0.061)
Per capita GDP
Per capita GDPXX
Prob>F 0.251 0.473 0.236 0.354 0.298
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other
variables include the indicated variables and time dummy variables. *significant at 10% level.
Cross Country Investment Estimates:
The Djankov Study
Cross country empirical studies, as noted above, have recently been employed
to address the Laffer curve issue and, as will be discussed subsequently, the incidence
of the corporate tax on wages. In addition to these direct estimates, there are
numerous empirical studies that examine underlying relationships, such as the effect
of the user cost of capital (which incorporates the tax rate along with other variables)
on investment. Most of these studies have found modest effects on domestic
investment and have employed times series estimates within the United States.30
One recent study on investment, Djankov et al.,31 is similar to the other studies
in that it employs a cross country data base and an independent variable reflecting the
tax rate to directly estimate estimate the effect of the corporate tax rate on
investment, emtrepreneurship and other variables. The study found no effect on
investment for statutory tax rates, but very large effects for constructed first year and
five year cash flow tax rates. This study, unlike the others discussed in this paper,
is a single cross section, so there is no way to introduce fixed country effects.
Several difficulties arise in the Djankov analysis. First, the cash flow tax rate
variable they construct is hypothetical one (for a hypothetical firm) which is not
representative of the capital stock or the firm size in a country (or in all countries).
The denominator is income measured before labor income taxes paid by the firm
(such as social security taxes in the United states) and economic depreciation. The
first is very problematic because the capital income tax rate increases as the labor
income tax rate falls, which is a relationship that seems to have no obvious economic
justification. It also measures taxes on a cash flow basis for the first year (or the first
five years in an alternative scenario), rather than over the life of the investment.
An examination of scatter-plots of their data suggest that the results are highly
affected by outliers, particularly Bolivia (which has a very high tax rate and a very
low investment rate) and Mongolia, a low tax country where investment has been
flowing in recently due to mining.
The tax rate for Bolivia is about twice the typical tax rate and is inconsistent
with the corporate rate in Bolivia. According to the authors, the tax rate reflects an
alternative transactions tax. However, a transactions tax is not a tax on corporate
30 For reviews see Robert Chirinko, “Investment Tax Credits,” in The Encyclopedia of
Taxation and Tax Policy, ed. by Joseph J. Cordes, Robert D. Ebel and Jane G. Gravelle,
Washington, D.C., the Urban Institute. 2005, pp. 226-229 and Kevin A. Hassett and R.
Glenn Hubbard, “Tax Policy and Business Investment”, Handbook of Public Economics,
New York, Elsiever, 2002, pp. 1293-1343.
31 Simeon Djankov, Tim Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer,
“The Effect of Corporate Taxes on Investment and Entreprenuership,” National Bureau of
Economic Research, Canbridge, MA, Working Paper 13756, January 2008.
income but falls on all income in the economy. Assuming that about a quarter of
income is capital incomes, the tax should be reduced by 75%.
As with the Laffer-curve estimates, the results of this study, at least for the
United States, are not plausible. According to their estimates, a 10 percentage point
drop in corporate tax increased investment by 2.2 percentage points. According to
an open economy model developed by Gravelle and Smetters,32 however, U.S.
capital would increase a maximum of 0.7 percentage points with the elimination of
corporate tax; with more reasonable elasticities, it would increase by 0.3 percentage
points. (This study was directed at the question of tax incidence and will be
discussed in more detail in the section below which addresses distributional issues
and the burden on labor). Moreover, these effects may understate the investment
effects because they do not take into account debt. Thus, their results suggest an
investment increase that is at least 11 times too large and that could be 25 or more
times too large.
While the issue of fixed effects would cause this study to remain problematic
in any case, this section explores the effects of the tax rate changes and of
specifications that include multiple control variables.
The Djankov et al. sample consists of 2004 tax and economic data for 85
countries. They examine the effect of the corporate tax rate on (1) aggregate
investment, (2) foreign direct investment, and (3) two measures of entrepreneurial
activity. The main results of their study and our reanalysis are reported in Table 5.
The first row of the table displays the coefficient estimate of the effective corporate
tax rate variable taken from the Djankov et al. study. Their basic specification
includes only the tax rate as an independent variable. The second row of the table
reports the range of estimates when a single additional independent variable is added
— the authors add 10 variables, one at a time. In all but one instance, the estimates
are statistically significant at the 1% or 5% confidence level, and at the 10% level in
the remaining case.
We reanalyzed their data after correcting an error in their tax rate for Bolivia,
and cumulatively added selected independent variables that Djankov et al. included
in their analysis; we also included a region-of-the-world variable for each country.
The first row of the bottom panel in Table 5 presents the coefficient estimates for the
basic model with only a single independent variable: the effective corporate tax rate.
For each dependent variable, the coefficient estimate of the tax rate variable is
smaller than Djankov et al.’s estimate, which illustrates the importance of Bolivia to
their results. Furthermore, the estimated effect of the tax rate on aggregate
investment is not statistically significant. The final row of Table 5 reports the
coefficient estimate of the tax rate when the full set of independent variables is
included in the analysis. The estimated effect of the tax rate on aggregate investment
32 Jane G. Gravelle and Kent A. Smetters, “Does the Open Economy Assumption Really
Mean That Labor Bears the Burden of a Capital Income Tax?” Advances in Economic
Policy and Analysis, vol. 6, No. 1, 2006.
is much smaller than Djankov et al.’s estimate and not statistically significant. The
estimated effect of the corporate tax rate on foreign direct investment and
entrepreneurial activity is somewhat smaller than the effects estimated by Djankov
et al., but the estimates are statistically significant.
Table 5. Coefficient Estimates: Key Independent Variable is
Constructed Effective Tax Rate (Djankov, Ganser, McLiesh,
Ramalho, and Shleifer Model)
F oreign Business Average
Investment100 PeopleEntry Rate
Estimate (0.074) (0.045) (0.063) (0.057)
Range of-0.165 to --0.189 to --0.090 to --0.110 to -
Estimate 0.236 0.233 0.196 0.141
Coefficient Estimates of Tax Rate Variable with Corrected Data
Re gi on -0.046 -0.191*** -0.115* -0.126**
Indicators (0.071) (0.045) (0.058) (0.056)
GDP (0.070) (0.045) (0.050) (0.055)
(0.076) (0.048) (0.055) (0.057)
Source: Author’s analysis.
Notes: Standard errors in parenthesis.
* significant at 10% level.
** significant at 5% level;
*** significant at 1% level;
A second issue that was a focus of the Hubbard article, but was not in the
Treasury Report was the distributional effects of the corporate income tax. If the
corporate tax falls on owners of the corporation, or on capital in general, it
contributes to a progressive tax system, since higher income individuals have more
income from capital than from labor. Based on tax data, for taxpayers with incomes
up to $100,000, over 90% of income is labor income, while for those over
$1,000,000, less than a third is labor income.33 The traditional analysis of the
corporate income tax indicates that the burden generally spread to all capital, but
does not fall on labor income. Most government and private agencies that routinely34
do distributional analysis allocate the corporate tax to capital income.
Hubbard refers to three studies in his article: one a working paper by economist
Arnold Harberger,35 one a working paper by William Randolph of the Congressional36
Budget Office, and one a recent empirical cross-country study using data similar to
the studies discussed above, by Hassett and Mathur.37 Three other empirical studies38
that use cross country data have also been released recently, by Felix, by Desai,
Hines and Foley,39 and by Arulampalam, Devereux, and Maffiini.40 Mankiw refers
to the Randolph and Arulampalam, Devereux, and Maffinni studies.
The Harberger and Randolph Studies
The first two studies explicitly focus on the effects of an open economy. It is
a standard finding that for a small open single-good economy with perfect capital
33 See CRS Report RL33285, Tax Reform and Distributional Issues, by Jane G. Gravelle.
34 This is the allocation used by the Congressional Budget Office, the Treasury Department,
and the Urban-Brookings Tax Policy Center.
35 It is not clear which of Harberger’s papers is being referred to, but it is presumably the
more recent one: Arnold C. Harberger, Corporate Tax Incidence: What is Known,
Unknown, and Unknowable, University of California, 2006. This paper was presented at
a conference at Rice University in 2006, and will be published with other papers.
36 The paper in question is not an official CBO paper but rather a working paper by William
Randolph. William C. Randolph, International Burdens of the Corporate Tax, CBO
working paper 2006-09, August 2006.
37 Kevin A. Hassett and Aparna Mathur, Taxes and Wages, American Enterprise Institute,
working paper, April 2008.
38 Rachel Alison Felix, Passing the Burden: Corporate Tax Incidence in Open Economies,
November 2006. This paper was a dissertation essay, University of Michigan.
39 Mihir A. Desai, C. Fritz Foley, and James R. Hines, Jr., Labor and Capital shares of the
corporate Tax Burden: International Evidence. Prepared for the International Tax forum
and Urban-Brookings TAx Policy Center conference on Who Pays the Corporate Tax in an
Open Economy, December 18, 2007.
40 Wiji Aralampalam, Michael P. Devereux, and Giorgia Maffini, The Direct Incidence of
Corporate Income Tax on Wages, Oxford University Center for Business Taxation, May,
mobility and perfect product substitution, the burden of any source based capital
income tax falls on labor (whereas for residence based taxes, that is taxes that apply
to domestic owners of capital regardless of where they are domiciled, the burden
would fall on capital). The corporate tax has some aspects of a source based tax and
some of a residence based tax.
Both the Harberger and the Randolph studies are based on this simple model of
perfect substitution, altered to account for the United States as a large county (which
lowers the elasticities) and to account for multiple sectors. Randolph’s study does
not so much predict the burden of the tax as explore incidence in certain types of
models; he acknowledges that less capital mobility causes the burden to shift from
labor to capital. Harberger’s model has four sectors, corporate and non-corporate
tradeable sectors and corporate and non-corporate nontradeable sectors. He assumes
that the corporate tradeable sector is more capital intensive that the average industry,
which leads to a burden of greater than 100% of the tax falling on capital. Despite
the vision of the manufacturing sector as highly capital intensive, it actually is not:
housing services, which are 100% capital, accounts for over a third of the capital
stock in the country, and many other industries, such as utilities and agriculture are
also more capital intensive than manufacturing. Using the same assumptions about
mobility, but with a less capital intensive manufacturing sector, Randolph finds 70%
of the corporate tax burden falls on labor.
To permit other than perfect substitutability, a much more complex computable
general equilibrium model would be required, which neither Harberger nor Randolph
has provided. Such a model has been developed by Gravelle and Smetters41 who
find, with reasonable elasticities, that capital still bears most of the burden, about
While the Gravelle and Smetters model is a very complex, it still abstracts from
some important features of the corporate tax. There are two other factors that would
further push the corporate tax burden towards capital. First, the current corporate tax
has elements of a residence based tax, and the burden of a residence based tax falls
on capital. Second, the current corporate tax actually subsidizes debt finance at the
firm level, and if debt is much more substitutable than equity, total capital would be
less likely to be exported: indeed, raising the corporate tax could cause capital to flow
Finally, note that as long as countries tend to choose tax rates similar to each
other, which appears to be the case, the world becomes like the original closed
economy, a model stressed by Harberger, with the burden falling on capital.
According to the Treasury Study, the U.S. combined state and federal corporate
statutory rate is 39%, the G-7 average is 36% and the OECD average is 31%.
Effective tax rates, which should govern the movement of capital, are even closer
together, and in some cases are lower for the U.S. than for other countries.
41 Jane G. Gravelle and Kent A. Smetters, “Does the Open Economy Assumption Really
Mean That Labor Bears the Burden of a Capital Income Tax?” Advances in Economic
Policy and Analysis, vol. 6, No. 1, 2006.
An argument is often made that the burden of any capital income tax tends to
fall on labor because it reduces savings, an effect that would also occur in a closed
economy. While one model predicts that the entire burden of a capital income tax
eventually falls on labor, this model requires some extreme assumptions about human
behavior such as perfect information, an infinite planning horizon, perfect liquidity,
and asexual reproduction. Models allowing for finite lives (such as the life-cycle
models) find results that vary, but if the revenue loss is made up by higher taxes on
labor, there is little or no effect. Some economists believe that these models are
inappropriate, as they assume too much information and skill on the part of
individuals; they suggest that individuals use rules of thumb, such as fixed savings
rates or targets, instead. These rules of thumb suggest that a cut in capital income
taxes either has no effect on saving or reduces savings. These economists also point
out that most empirical evidence does not point to an increase in savings; historically,
savings rates do not appear to respond to reduced tax rates.42
The Hassett and Mathur Study
While the theoretical models do not provide much support for the corporate tax
burden falling on labor, Hubbard also refers to an empirical study by Hassett and
Mathur that uses the corporate tax rate to explain differences in manufacturing
wages. They find a statistically significant result that indicates a 1% increase in the
corporate tax causes manufacturing wages to fall by 0.8% to 1%. These results are
impossible, however, to reconcile with the magnitudes in the economy. Through
competition, wage changes in manufacturing should be reflected in wages throughout
the economy, implying that a 1% rise in corporate revenues would cause an 0.8% to
while labor income is about two thirds. These results imply that a dollar increase in
the corporate tax would decrease wages by $22 to $26 dollars, an effect that no model
could ever come close to predicting.43
The lack of theoretical reasonableness of the results may be explained by
statistical issues. The Hassett and Mathur study used data from 72 developed and
42 These issues surrounding savings are discussed in greater detail in CRS Report RL32517,
Distributional Effects of Taxes on Corporate Profits, Investment Income and Estates, by
Jane G. Gravelle; CRS Report RL33545, The Advisory Panel’s Tax Reform Proposals, by
Jane G. Gravelle; and CRS Report RL33482, Savings Incentives: What May Work, What
May Not, by Thomas L. Hungerford. The recognition that replacement of capital income
taxes by wage taxes in a life cycle model could have little effect on savings or contract them
can be found in numerous simulation studies, for example, Alan Auerbach and Laurence
Kotlikoff, Dynamic Fiscal Policy (Cambridge, MA: Cambridge University Press, 1987).
43 Two other studies using cross country data have examined the incidence of the tax on
labor income. Passing the Burden: Corporate Tax Incidence in Open Economies, by Rachel
Alison Felix, November 2006, finds smaller effects than Hassett and Mathur, but ones that
are still too large to be predicted by a theoretical model. This study has problems similar
to those that are discussed subsequently and, in addition, do not control for country fixed
developing countries for the 1981 to 2003 period.44 For their analysis, their
dependent variable is the logarithm of the five-year average of the average
manufacturing wage. They justify their use of the five-year average wage by (1)
noting that due to capital adjustment costs, the economic effects of corporate tax rate
changes show up over longer time periods, and (2) arguing that this may control for
possible measurement error induced by the business cycle.45 The wage rates for all
countries were converted to U.S. dollars using annual exchange rates. Hassett and
Mathur include the price level of consumption as an explanatory variable to capture
cost of living differences across countries. The main explanatory variable of interest
is the logarithm of the top corporate tax rate. Hassett and Mathur also use the
average effective and marginal effective corporate tax rates (in logarithms) as
explanatory variables in some specifications.
We repeated the Hassett and Mathur basic estimation exercise; the results are
reported in the first row of Table 6.46 The coefficient estimate reported in the first
column (-0.759) suggests that a 10% increase in the top corporate tax rate will lead
to an 7.6% decrease in the average manufacturing wage rate. This estimate is
statistically significant at the 5% level.47 The results are not as strong (the estimates
are closer to zero) when using alternative measures of the corporate tax rate (see the
next two columns of Table 6).
The exchange rate between two currencies reflects the relative supply and
demand for those two currencies, and is affected by financial markets and
government policies. Exchange rates may not be good indicators of the relative
buying power of wage rates in two countries. Purchasing Power Parities (PPPs),
however, are specifically designed to equalize the internal purchasing power of the
currencies. Workers in Australia, for example, are concerned with what their wages
will purchase in Australia, and not how many dollars their wages will buy. Using
PPPs is a more appropriate way to convert national currencies to a common currency
44 Hassett and Mathur, Taxes and Wages. We are grateful to Kevin Hassett and Aparna
Mathur for providing their data. Several of the countries only have data for shorter periods.
45 Their independent or explanatory variables take their value from the beginning of the five-
year period over which wages are averaged. It should also be noted that Hassett and Mathur
calculate the five-year average with nominal wages (that is, they are not corrected for
46 See Appendix B for a description of the estimation method. Visual inspection of the
Hassett and Mathur data uncovered some errors with their 5-year averages of wage rates —
some averages were based on 6 years of data and others were based on less than 5 years of
data. We corrected the errors so that each 5-year period for each country contains 5 years
of data. Some of the averages are based on less than 5 years of data because of missing
values in the wage series; most of the missing valued are in the 2001 to 2005 period.
47 The specific test of statistical significance of the coefficient estimates is the t-test. This
is a test of whether or not the estimate is equal to zero (the null hypothesis is the estimate
is equal to zero). The significance level indicates the risk of rejecting the null hypothesis
when it is, in fact, true. A significance level of 5% indicates that the null hypothesis will
be inadvertently rejected only 5% of the time. Significance levels commonly used in
empirical social science work are the 1%, 5%, and 10% levels.
The second row of Table 6 reports the coefficient estimates when the wage rates
are converted to U.S. dollars using the consumption PPPs. Consumption PPPs are
more appropriate for converting wages than using general PPPs (over GDP) because
they omit national expenditures for government and investment goods. Again,
nominal wages are the dependent variable. The coefficient estimates are closer to
zero than the estimates reported in the first row, but the coefficient estimate reported
in the first column (-0.728) is statistically significant at the 5% level. The estimates
for the alternative measures of the corporate tax rate are not statistically significant
at the conventional confidence levels.
Table 6. Coefficient Estimates: Dependent Variable is the
Logarithm of the 5-Year Average of Wage Rates
How WageCorporate Tax Rate Variable
Converted to U.S.Effective
DollarsTop Tax RateEffective AverageMarginal
PPP — Constant-0.488*-0.294-0.218
Dollars (0.298) (0.318) (0.215)
Observations with 5-year Averages based on 5 Years of Data
PPP — Constant-0.064-0.230-0.180
Dollars (0.350) (0.351) (0.231)
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model. Other variables include time
dummies, log personal tax rate, log real value-added, log consumer price variable (except for real
PPP). ** significant at 5% level; *significant at 10% level.
The most appropriate measure of wages is the inflation-adjusted consumption
PPP-adjusted wage rate. Wages in each country were converted to U.S. dollars using
the consumption PPP and then converted to constant (inflation-adjusted) dollars
using the CPI-U before calculating the 5-year average. The final row of Table 6
displays the coefficient estimates for the model using this measure as the dependent
variable. The estimates are closer to zero than in the other two cases. The coefficient
estimate in the first column (-0.488) is statistically significant at the 10% level but
not at the 5% level. The other two estimates in columns two and three are not
statistically significant at the conventional confidence levels. While there is still
some evidence of corporate tax rates having a negative influence on wage rates in
manufacturing, the effect is smaller and less robust than reported in the Hassett and
Hassett and Mathur averaged wages over 5-year periods. They justify using 5-
year averages by arguing that it helps to control for possible measurement error
induced by the business cycle. But, because of missing values in the wage data, 66
observations have the average wage based on less than 5 years of data (60
observations use only 2 consecutive years of data for the calculation of the average,
which would likely not affect any measurement error). The bottom panel of Table
6 reports the estimation results when these 66 observations are excluded from the
analysis (leaving 153 observations). In all cases, the coefficient estimates for all
measures of the corporate tax rate are not statistically significant.
Averaging the wage data over five years and using the beginning of period value
for the explanatory variables, however, eliminates much of the variation in wages and
tax rates, thus throwing away much of the information needed to estimate the
economic effects. The statistical analysis is repeated using annual data and including
various lagged values of the corporate tax rate as explanatory variables.48 The results
are reported in Table 7. The first column of the table displays the coefficient
estimates for the current value of the corporate tax rate (labeled t in the first column)
and the values for the previous five years (t-1 to t-5), which allows for longer term
effects of tax rates on wages. In each case, the coefficient estimates are negative but
very close to zero; none are statistically significant at the conventional confidence
levels. Furthermore, all the tax rate variables in column (1) are not jointly
statistically significant. The next six columns report the results when the corporate
tax rate values (current and lagged) are entered individually. In every case, the
coefficient estimates are close to zero and are not statistically significant at
conventional confidence levels. In using annual data, we can find no evidence that
changes in the top corporate tax rate affects wage rates in manufacturing.49
48 Including the lagged values of the corporate tax rate allows the tax rates for the previous
five years to individually have an impact on wages. All tax rates are entered into the model
49 We obtain the same estimation results when the exchange rate is used to convert wage
rates to U.S. dollars — the method used by Hassett and Mathur.
Table 7. Coefficient Estimates: Dependent Variable is Annual
Logarithm of Real PPP-Adjusted Wage Rates
t -0.031(0.208) 0.010(0.140)
t-1 -0.217(0.188) -0.219(0.143)
t-2 -0.076(0.166) -0.074(0.144)
t-3 -0.040(0.159) 0.021(0.145)
t-4 -0.113(0.156) -0.070(0.146)
t-5 -0.154(0.155) -0.165(0.147)
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other
variables include time dummies, log personal tax rate, log real value-added. ***significant at 1% level;
** significant at 5% level; *significant at 10% level.
Other Cross Country Wage Studies
Three other recent studies using cross country data have examined the incidence
of the tax on labor income. Felix,50 in a study that controls for education, finds much
smaller effects than Hassett and Mathur, but ones that are still too large to be
predicted by a theoretical model (about $4 dollars for each dollar of corporate tax
revenue). This study has problems similar to those that for Hassett and Mathur and,
in addition, does not control for country fixed effects, and thus reflect cross country
variation. The sample is unusual as well, with 19 countries covered for varying
years. Out of the total of 65 observations (countries and years), about a quarter of the
sample is drawn from Italy and Mexico and seven of the 19 countries had only one
or two years of data.
A second study, by Desai, Foley and Hines51 uses observations on foreign owned
affiliates of U.S. firms across countries and in different time periods. This study uses
data on multinational subsidiaries of U.S. firms to estimate the allocation of the tax
burden between labor and capital using a seeming unrelated regression for capital
50 Rachael Alison Felix, Paaing the Burden: Corporate Tax Incidence in Open Economies,
November 2006. This paper was a dissertation essay at the University of Michigan.
51 Mehir A. Desai, C. Fritz Foley, and James R. Hines, Jr., “Labor and Capital Shares of the
Corporate Tax Burden: International Evidence,” Prepared for the International Tax Policy
Forum and Urban-Brookings Tax Policy Center conference on Who Pays he Corporate Tax
in an Open Economy?, December 18, 2007.
income (which they measure by the interest rate) and labor income. In their model,
labor and capital burdens are restricted to the total of taxes, and they impose a cross-
equation restriction on the estimated burdens. They find the share of the burden
falling on labor income to fall between about 45% and 75% of the total, a number
that is not inconsistent with theoretical expectations.
This approach, however, has the fundamental theoretical problem that wages at
an individual firm should not reflect tax burdens at an individual firm. In deriving
a model that assumes it does, they assume that the price level of their goods is fixed
and base their results only on their sample of firms (which is comprised solely of
multinational corporate sector firms). This approach creates both econometric
problems in their analysis and also means that their results cannot be construed as
reflecting actual burdens in any of their economies, as discussed in more detail in
They have also represented equity returns through the interest rate, under the
assumptions that investors equate (net of risk) debt and equity returns. If these assets
are generally substitutable, the increase in corporate tax should cause portfolios to
shift toward debt and drive the interest rate up (while driving the equity return down).
Moreover, the tax burdens on debt and equity differ at the individual level and those
differences depend, among other things, on any special tax rates for dividends and
capital gains, the deferral advantage of capital gains and the inflation rate.
Aside from these theoretical problems, an important issue with their study is that
it appears that their results are forced by the cross equation restriction. Bill
Randolph, a discussant at a recent conference, found that if the restriction is
eliminated there are no statistically significant results from their study.52 In an
example he presented, the estimates of the wage effect was 48% of the burden, with
a standard error of 18% in the original study; in a regression without the restriction
the share was 19% with a standard error of 100%.53 Randolph considered a number
of other specifications, including excluding the largest countries, but found no
statistically significant results. He also suggested that only manufacturing
subsidiaries be considered since other subsidiaries may be involved in tax sheltering
operations. In the case where he considered only manufacturing subsidiaries, the sign
reversed (indicating labor benefitted from the tax) but it was not statistically
A third study, by Arulampalam, Devereux, and Maffini, uses firm level data (for
about 55,000 firms) from several European countries (primarily France, Italy, Spain
and Germany) over a relatively short time frame of 1996-2003.54 It controls for firm-
specific effects. About a quarter of the observations are for only 4 years and about
52 His remarks were made at a seminar at the American Enterprise Institute, March 17, 2008.
53 The coefficient must be close to twice the standard error to be statistically significant; thus
the result from the unrestricted regression showed no relationship between taxes and wages.
54 Arulampalam, Wiji, Michael P. Devereux, and Georgia Maffinin, The Direct Incidence
of Corporate Income Tax on Wages, Oxford University Centre for Business Taxation, May
run. The same authors had a earlier version of their study with a smaller sample.55
Although the authors control for firm level fixed effects, they do not control for
The premise of this study is quite different from the premise of the other
empirical studies or the theoretical literature on the incidence of the corporate income
tax. The authors present a bargaining model, where capital and labor split the excess
profit (profit over a normal required return). Thus, the theoretical motivation is not
driven by shifts in capital in response to changes in return, but by other factors that
do not have implications for capital income distortions.
The study reports, for the preferred specification, that labor bears 96% of an
increase in tax in the short run, and 92% in the long run. (These numbers were
considerably different in an earlier version of the study, which found that labor bore
54% in the short run and 176% in the long run, at least for the specification that the
There are several reservations about this study, with the estimation results, the
plausibility of the findings, and the underlying theory and execution. Perhaps the
most serious of these reservations is in translating from the motivating theory to the
actual estimation process. The theory addresses a bargaining division of excess
profits (including the taxes on those excess profits) between labor and capital as a
steady state long-run relationship. But the actual empirical implementation examines
the change in wages as a function of the change in output and taxes. It does not allow
for normal profit or taxes on normal profit, or for possible changes in options. It is
thus an estimate of the short run incidence of a tax change that could fall on both
normal return and excess profits, not the long-run sharing of the tax on rents.
Traditionally, economists have assumed that the burden of the corporate tax falls on
owners of the firm in the short run since capital cannot be easily shifted.
Even though it is technically possible to derive a long-run elasticity if the
regression includes lagged dependent variables,56 these short-term data are unlikely
to be useful. As a long-run specification, the estimating relationship is deeply flawed
because the factors that determine the incidence of the tax on normal returns, which
are held fixed in the model, can also change. For this part of the tax, the burden on
labor arises from general equilibrium effects in the economy and the effects on wages
in a particular firm bears no relationship to the tax burden of that firm.
To the extent that the study is measuring the short-run effects, the results, as
reported, are not plausible. To expect that labor would bear all of the short-run
55 Arulampalam, Wiji, Michael P. Devereux, and Georgia Maffinin, The Incidence of
Corporate Income Tax on Wages, Oxford University Centre for Business Taxation, April
56 One can trace an infinite series of tax changes through a lagged dependent variable. For
example, if there is an effect of the tax rate in this year and an effect of the wage rate last
year, then the wage rate last year is a function of the tax rate last year and the wage rate two
years before, which is in turn a function of tax and wage rates. By continuous substitution
the taxes can be traced back infinitely long and converge on a long run effect.
burden of a corporate tax in a bargaining model would seem unreasonable. There are
implicit or explicit multi-year contracts that likely make short-run adjustments of this
nature difficult. In the more intermediate term, if all firms are considered, labor is
free to move from the firms with high taxes per worker to those with lower taxes.
At the same time, it is not clear that the results do imply such a large share is
born by labor. The regression is estimated in logarithms, for reasons that are not
apparent — such as specification is not consistent with the model presented and
implies a burden that rises as the wage rises relative to taxes. A change in wages due
to a change in taxes equals the estimated coefficient, multiplied by the rate of wages
per worker to taxes per worker times the change in taxes. The authors report the
value calculated at the median. If one took such a formula literally, it would imply
that burdens for more labor-intensive firms would be more than 100% of the change,
an implausible outcome for bargaining. The normal way to report results of this
nature is to measure them at the mean. In this case, the short run incidence would fall
from 96% to around 52%, based on data reported in the study.
There are also some important reservations about the econometric methods.
Panel data with short time periods (where persistence effects can be serious) and the
need to control for firm specific effects face some significant econometric problems.
The authors use a number of different specifications, with widely varying results,
which suggest that the results are not robust.57 There are several other aspects of the
econometrics that are not transparent.58
Overall, it is not clear what relationship or phenomenon the study is measuring.
We are interested ideally in how an exogenous tax change affects incomes. Yet for
some of the countries that constitute a large share of the data, there were no changes
in tax rates. In others tax rate changes were virtually all declines, with most of those
declines occurring during the growth period of the late 1990s, when productivity and
output was rising. It is possible that the results are capturing that phenomenon.
Economic Efficiency Issues
The traditional criticism of the corporate tax, as spelled out in the Treasury
Study, is that the tax causes distortions, and that these distortions are exacerbated by
corporate tax preferences that prevent, for a given level of tax revenue, a lower tax
rate. The issues discussed in this section include allocation of capital within the
domestic economy, savings effects, and international capital flows.
57 The tests used by the authors to determine their preferred specification are not without
problems. See David Roodman, “How to Do xtabond2: An Introduction to “Difference” and
“System” GMM in Stata,” Center for Global Development, Working Paper 103, December
58 For example, no reason is presented for using a dynamic specification or the specific
number of lagged variables, and the number of instruments was not reported.
Allocation of Capital Within the Domestic Economy
Traditionally, the efficiency concern about the corporate tax is related to the
misallocation of resources between corporate and noncorporate production (including
owner-occupied housing). Over time, efficiency issues have also encompassed
differential taxation of the returns to assets of different physical types, and financial
distortions, which affect the debt-equity ratio, payout choice, and decision to realize
Some efficiency costs, including those that alter the mix of a firm’s physical
assets, arise not so much from the existence of a corporate tax but from its design.
Table 8 captures the effects of the two most significant generally available
provisions that affect tax burdens on different assets: depreciation rules and the
recently enacted production activities deduction, which in effect allows a lower tax
rate on certain domestic activities that are deemed production (manufacturing,
construction, etc.). The tax rates in this table account only for the corporate tax (that
is, they do not include the benefits of deducting interest or the tax at the individual
level on interest, dividends, and capital gains). They are also forward looking and
marginal: they estimate the share of the return on a prospective investment that is
paid in tax. If income were correctly measured and taxed that share would be the
statutory rate; most assets face lower tax rates.
The variations within a column illustrate the distortions firms face in choosing
the mix of capital within a firm. Overall the variations not only distort the mix of
capital within a firm, but also the allocation of capital across different industries. In
general, the most favored major industry is oil and gas extraction where a large
fraction of investment is deducted when incurred. Other things equal, firms eligible
for the production activities deduction and firms that have a larger share of their
capital stock in equipment than average will be favored.
In the aggregate, the tax rate on equipment is estimated at about 25%, a full 10
percentage points below the statutory tax rate, while structures (covering the last
seven rows of Table 8) are subject to a 30% rate. Inventories are subject to a 37%59
rate and the overall rate on reproducible capital is 29%.
The Treasury Study reports aggregated asset specific data, which provide a
similar result, indicating that equipment is favored. Their measures include the total
tax burden, including the benefit of deducting interest, and individual level taxes.
They estimate a tax rate of 25% on equipment, 34% on structures, and 33% on land
These estimates are somewhat overstated because they do not include intangible
investments, such as research and advertising. Some research and experimentation
expenditures are expensed (leading to a zero tax rate on those expenditures) and
eligible for a credit as well (leading to a negative rate, but only intangible
59 These estimates are reported in CRS Report RL33545, The Advisory Panel’s Tax Reform
Proposals, by Jane G. Gravelle.
expenditures, however, are eligible). Spending on advertising is expensed and
subject to a zero rate even though some advertising has future benefits.
Table 9 reports the types of distortions that are an artifact of the corporate tax
as a separate tax. These estimates, unlike those in Table 8, take into account all
levels of taxes. One of the complications of estimating these tax rates is whether the
estimates should consider the significant (over 50%) fraction of individual passive
income that is held in tax exempt form through pensions, IRAs, life insurance
annuities and non-profits. In some ways, these sources can be viewed largely as not
affecting marginal investment (for example, overall savings) because they are capped
or not controlled directly by the investors and in other ways they affect choices (such
as debt or equity of pension funds). For this reason, in addition to the estimates
presented by Treasury, two sets of CRS estimates are provided which assume either
no tax exempt investment or half is tax exempt.
Within the corporate sector, in addition to asset differences, there is a larger
differential with respect to debt versus equity finance. The aggregate tax burden on
debt is slightly negative, while equity is taxed at close to 40%. If economic income
were measured correctly, interest would be subject to the individual income tax rate,
which is typically slightly above 20%. Debt is subsidized at the firm level, however,
because nominal interest is deducted (including the inflation premium) while
corporate profits before this deduction are effectively taxed at a rate below the
statutory rate on real income. The result is that at the firm level, equity is subject to
a tax rate of around 30% while debt is subsidized at about the same level (a negative
32% tax rate). At the individual level, the tax on interest for taxable recipients is
higher than the statutory rate because nominal interest is taxed, which pushes the
overall tax rate towards a small but negative rate.
Table 8. Differential Tax Rates across Asset Types
AssetNo ProductionDeductionWith ProductionDeduction
Office/Computing Equipment 3128
T r ucks /Buses/T railers 29 26
Service Industry Equipment2825
General Industrial Equipment2523
Electric Transmission Equipment3330
Other Electrical Equipment2421
Furniture and Fixtures2320
Special Industrial Equipment2119
Engines and Turbines3633
Ships and Boats1715
Mining Structures 76
Public Utility Structures2724
Commercial Structures343 1
Source: Congressional Research Service, from CRS Report RL33545, The Advisory Panel’s Tax
Reform Proposals, by Jane G. Gravelle.
Table 9. Effective Tax Rates by Sector and Type of Finance
CRS Estimates,CRS Estimates,
SectorTreasuryEstimatesNo Tax ExemptHalf of Investment
Source: Treasury Report; CRS Report RL33545, The Advisory Panel’s Tax Reform Proposals, by
Jane G. Gravelle.
Evidence on the size of this distortion is limited, but since there appears to be
limited substitution between debt and equity, it is probably less than 5% of corporate60
tax revenue. Some simple measures, however, could significantly reduce this
distortion (such as indexing interest payments for inflation). Lower corporate tax
rates would also reduce this distortion.
The distortion that has probably received the most attention by those studying
the corporate tax is the misallocation of capital between the corporate and
noncorporate sectors. One source of the distortion arising from the corporate tax
system is the taxation of corporate business at around 30%, while unincorporated
business is taxed at only 20%. The higher corporate tax also contributes to a larger
wedge between corporate production and owner-occupied housing, which is
generally taxed at a negligible rate. The magnitude of the estimated distortion
produced by having a separate corporate tax varies depending on the model used and61
ranges from less than 10% of corporate tax revenue to about a third. Since the
deadweight loss varies with the square of the tax rate, the recent decline in the
differential due to lower tax rates on dividends and capital gains suggests the
60 See Jane G. Gravelle, The Economic Effects of Taxing Capital Income (Cambridge: MIT
Press, 1994), pp. 82-83, suggesting a distortion of about 0.17% of total consumption. With
consumption (including government spending) about 83% of output, and the corporate tax
2.7%, this amounts to about 5% of corporate revenue. This amount has fallen slightly due
to lower rates on capital gains and dividends.
61 See the review in Gravelle, The Economic Effects of Taxing Capital Income, pp. 77-82.
distortion relative to revenue would be smaller — probably no more than 4% to 7%
A distortion not captured in Table 9 is the one that affects corporate payouts.
Given that appreciation in stock values is not taxed until realized, there is a benefit
to retaining earnings. There is a dispute about what determines payout ratios, and
what the consequences of the tax are, but, in general, the welfare cost is small. There
is also some distortion due to the lock-in effect for capital gains realizations.63
Considering all of these distortions together, they are probably in the range of
10% to 15% of corporate tax revenues, a magnitude that could be considered as a
significant component of the burden of the tax. However, given the revenue needs
of the government, there would also be distortions, perhaps smaller, associated with
alternative taxes. Ways to reduce these distortions may, however, be worth
Much of the Treasury Study’s discussion emphasized effects on savings
although this is not normally the focus of efficiency concerns about the corporate
income tax. This distortion is not unique to corporate income taxes, but occurs with
all capital income taxes. There are many difficulties with analyzing this issue. The
first is that, as noted above in the discussion about the potential effect of savings on
the wage rate, the economic distortion depends on the behavioral response of savings
to tax changes, and what tax replaces them. Some economists have a strong view
that taxes on the rate of return are always distorting, but these views are based on
dynamic infinite-horizon models that may not be very realistic. With life-cycle
models, the distortions depend on what revenue substitute is provided; substituting
taxes on wages for taxes on capital, the most likely substitute in the U.S. tax system,64
could potentially increase distortions, depending on the responses in the models.
62 The distortion is proportional to the square of the wedge between pretax returns, which
is , where is the corporate tax rate and the unincorporated.ttttcc()()11−−−tct
The corporate tax fell from about 44% in the mid-1980s to 32% today, while the
noncorporate tax fell from 22% to 20% and the rate on owner occupied housing remained
about the same (roughly zero). Holding the after-tax return constant, the wedge between
corporate and noncorporate capital fell by over a half, and the square of the wedge by 80%.
A calculation for owner-occupied housing suggests that the wedge fell by 40% and the
deadweight loss by two thirds. For the largest deadweight loss estimates, virtually all of the
distortion was due to the corporate non-corporate differential, so that the current deadweight
loss would be only 20% as large, while for the others, both assets played an important role.
63 Estimates of 0.04% to 0.11% of consumption translate into 1% to 4% of corporate
revenues, see Gravelle, The Economic Effects of Taxing Capital Income, p. 89. With the
reduction in tax rates of almost 50%, and the welfare cost proportional to the square of the
tax wedge, the welfare cost would be about 30% of its former value or less than 1%. There
is also a welfare cost from the realizations response of about 1%, but recent evidence has
shown this response to be small, about the same size as the pay-out distortion.
64 See Jane G. Gravelle, “Income Consumption and Wage Taxation in a Life Cycle Model:
In models of bounded rationality, where savings are based on rules of thumb such as
fixed shares of income or fixed targets, there is no response, or only an income effect,
which would not produce a distorting effect.
International Capital Flows
Tax rules can affect the efficiency of allocation of capital around the world, and,
if the U.S. rate is different from other countries, it can cause misallocations of capital.
Despite claims that the U. S. tax rate is much higher than other countries, its rate of
according to data in the Treasury Study. Since the production activities deduction
acts in the same way as a statutory tax rate reduction, the actual U.S. rate is not 39%,
but rather about 37%, virtually the same as the G-7 average.65 The G-7 rate would
be higher if weighted by GDP. The U.S. rate is below the 38% rate in Germany and
40% rate in Japan, the two largest of the G-7 other than the U.S. In addition, it is at
the same rate as Italy, just above the 36% rate of Canada, and slightly above the 30%
rate of Great Britain. The 19 OECD countries had an average of 31%, but this
average would be higher if weighted by country size because larger countries have
higher rates (if Ireland, with a 13% tax rate were eliminated, the average would be
33%). Although these rates put the United States rate close to those of other large
developed countries, the report also indicates that several countries, in particular
Germany, are planning to cut their corporate tax rates.
The Treasury Study also reports effective marginal tax rates on equipment
investment (which accounts for tax preferences such as depreciation): the effective
tax rate for the United States at 24%, was the same as the G-7 average, and just 4
percentage points above the 19 OECD country average. For debt finance, the U.S.
had a higher negative rate, -46% (and thus more beneficial tax treatment) than the G-
7 average at -39%, and the average for 19 OECD countries of -32%. If the measure
is simply the average tax rate (corporate tax dividend by corporate surplus), which
accounts for various corporate preferences, the U.S. average rate is 17%, which is
below the OECD average of 22%.
These data do not indicate the U.S. is a high tax country with respect to
investment, and would probably not become so even if some reductions occur in the
future in other countries. The main source of international distortion, therefore, is
probably the increased investment that occurs in low tax and tax haven countries
because the United States and other developed countries do not tax that income at all
or tax it on a deferred basis. This inefficiency is not due to the corporate effective
tax rate, but rather is due to the provision of a tax benefit for investment abroad.66
Separating Efficiency from Redistribution,” American Economic Review, vol. 81, no. 4
(September 1991), pp. 985-995.
65 This reduction of two percentage points was based on the estimates for the production
activities deduction relative to corporate revenues presented in the paper.
66 The issues of efficiency in international taxation are discussed in much more detail in
Even when tax rates diverge, the efficiency costs may not be significant because
the evidence suggests, as noted in previous sections, limited mobility of capital as a
result of varying tax rates.
Potential Revisions in the Corporate Tax
There are a variety of potential revisions that could be made to the corporate tax
to permit lowering the rate. The revisions discussed here include (1) broadening the
corporate tax base and using the revenues to reduce the rate or to provide investment
incentives, (2) correcting interest deductions and income for inflation, and (3)
increasing the individual level tax to permit a lower tax at the firm level.
Eliminating Corporate Tax Preferences
One type of revision that would probably be supported by most economic
analysts, is to eliminate corporate preferences in exchange for a lower statutory
corporate tax rate. The Treasury Study estimates that eliminating corporate
preferences would allow the tax rate to be lowered to 27%. Table 10 shows the
preferences the Treasury Study lists and the FY2008-2017 revenue costs.
The largest preference in the list is expensing and accelerated depreciation ($410
billion) and the second largest is the production activities deduction ($210 billion);
both provisions are captured in effective tax rates cited above. Other significant
provisions (worth over $100 billion each in these years) include the exclusion of
interest on state and local bonds, the research and experimentation tax credit, and the
deferral of income from foreign sources, which is probably responsible for much of
the international distortions.67
Interestingly, their list does not include graduated rates for small corporations,
which costs slightly over $4 billion per year, and would, allowing for growth, raise
over $50 billion in revenue over the period if were eliminated. Since owners of small
corporations are typically as wealthy (or more wealthy) than owners of large ones,
there appears to be little economic justification for not including these rates.
CRS Report RL34115, Reform of U.S. International Taxes: Alternatives, by David L.
Brumbaugh and Jane G. Gravelle.
67 The purpose of most of the provisions is self explanatory; note, however, the property
sales source rule (also known as the title passage rule) is effectively an export subsidy.
Percentage depletion benefits independent oil and gas producers and mineral and coal
producers and allows a deduction of costs based on a percentage of receipts rather than the
Table 10. Corporate Tax Preferences and Projected Revenue
PreferenceRevenue Cost ($ Billions)
Expensing and accelerated depreciation410
Deduction for U.S. production activities210
Exclusion of interest on state and local debt135
Research and experimentation (R&E) credit132
Deferral of income of controlled foreign corporations120
Low income housing credit55
Exclusion of interest on life insurance savings30
Inventory property sales source rule29
Deductibility of charitable contributions28
Special Employee Stock Ownership Plan (ESOP) rules23
Exemption of credit union income19
New technology credit8
Special Blue Cross/Blue Shield Deduction8
Excess of percentage over cost depletion7
Other corporate preferences.27
Source: Treasury Study.
A full discussion of the economic merits of these provisions is beyond the scope
of this paper, but are discussed in the Senate Budget Committee Print, Tax68
Expenditure Compendium; most would be regarded as provisions that lead to
economic distortions. One possible exception is the Research and Experimentation
(R&E) credit, since social returns to research and development appear higher than
private returns, but many economists believe that the credit is probably poorly
targeted and possibly abused. Arguments could also be made that the tax exempt
bond benefit is shifted to state and local governments (which can charge lower
interest rates) and that these assets and revenue loss would be shifted to individuals.
Arguments could also be made that the benefits of the charitable contribution
68 See U.S. Congress, Senate Committee on the Budget, Tax Expenditures, committee print,
109th Cong., 2nd sess., December 2006, S. Prt. 109-072 (Washington: GPO, 2006). The
document is posted at [http://frwebgate.access.gpo.gov/cgi-bin/useftp.cgi?IPaddress=
deduction and the low income housing credit ultimately accrue to charities and lower
income tenants, at least in part. Many other provisions have some support, and may,
therefore, be difficult to repeal.
H.R. 3970 would lower the tax rate to 30.5% (at a 10 year cost in FY2008-
FY2017 of $363.8 billion), as well as a permanent extension of provisions allowing
expensing for small business (at a cost of $20.5 billion). As shown in Table 11,
eliminating the production activities deduction is the proposal’s largest base
broadener. It also includes a provision that is somewhat more limited than
eliminating deferral: disallowing expenses associated with foreign source income that
is tax-deferred. The proposal also includes two other international provisions, one
eliminating a provision adopted in 2004 that included worldwide (rather than
domestic) interest in allocation rules for the foreign tax credit limit and one
restricting the availability of lower withholding tax rates on income invested in the
United States under treaty rules. Another major revenue raiser is a restriction in
inventory accounting rules. The only depreciation base broadener in the proposal is
one to extend the depreciation period for acquired intangibles. As is often the case
in tax legislative proposals, revenue raisers are not always in the tax expenditure list.
Table 11. Corporate Revenue Raisers in H.R. 3970
Provision10-Year RevenueGain ($billions)
Production Activities Deduction114.932
Allocation of Expenses for Deferred Income106.385
Repeal of Worldwide Allocation of Interest 26.204
Limitation Eligibility for Reduced Treaty Withholding 6.397
Repeal Last-In First-Out Inventory Accounting106.506
Repeal Lower of Cost or Market Inventory Method 7.146
Special Rule for Service Providers 0.225
20-Year Amortization of Intangibles 20.967
Economic Substance Doctrine 3.787
Reduction in Dividends Received Deduction 4.596
Ordinary Tax on S Corporation Stock Options in an ESOP 0.606
Terminate Domestic International Sales Corporation Benefit 0.881
Tax Debt Securities as a Tax Free Spin Off 0.235
Source: Joint Committee on Taxation.
The Treasury Study also discussed the possibility of using this base broadening
to provide an investment incentive, such as a partial expensing. Such a provision
would have a larger effect on lowering the tax rate on new investment than is the case
for a rate reduction. It is difficult, however, to design investment subsidies in a
fashion that is both neutral across types of assets and generates an even revenue loss
pattern over time. Historically, investment subsidies have been restricted to
equipment. The provision used most frequently in the past is the investment tax
credit which, if allowed at a flat rate, favors short-lived assets. Partial expensing is
neutral across investments if allowed for all types but its revenue loss is very large
in the short run. Accelerated depreciation can be designed to be neutral, but it also
has an uneven revenue loss pattern and cannot be applied to non-depreciable assets,
such as inventories. A benefit of lowering the statutory rate is that it reduces the
incentive to shift profits abroad to tax havens, although that incentive would probably
be considerably lessened in any case if deferral of taxation of foreign source income
The ending of deferral might be a controversial provision, and indeed some
pressure has been exerted to move in the other direction, toward a territorial tax.69
There are, however, some more limited approaches. For example, the President’s
advisory panel proposed to exempt dividends of active businesses but disallow costs
such as interest to the extent income is exempt. And, as proposed in H.R. 3970, one
could also defer interest deductions associated with deferred income without making
any other changes, or direct restrictive rules to tax havens.
Interest Deduction Inflation Correction
If the inflation premium were disallowed for interest deductions, assuming that
about half of interest is inflation, the savings would eventually be $30 billion per year
at the corporate level, which would be offset by about a $10 billion loss at the
individual level. This could allow a 2.5 percentage point reduction in the corporate
tax rate. The important aspect of this change is that it would virtually eliminate the
distortion between debt and equity, which is responsible for a significant portion of
the overall distortion in the corporate tax, while maintaining the overall corporate tax
Reducing Tax at the Firm Level and
Increasing Individual Level Taxes
Given the value of lowering the corporate tax rate to reduce the shifting of
income into tax havens and concerns over the U.S. position among other countries,
one change that would allow this reduction is to raise the tax at the individual level
and use the revenues to lower the corporate tax rate. Since individual taxes tend to
69 A territorial tax system is one where the tax is imposed only in the country where business
activity occurs and not in the country of ownership. While the present international tax
system results in distortions, it is not clear how moving to a territorial tax would reduce
these distortions, and even less clear how it would improve tax compliance and profit
shifting. For a more detailed discussion see CRS Report RL34115, Reform of U.S.
International Taxes: Alternatives, by David L. Brumbaugh and Jane G. Gravelle
be collected regardless of where income is earned, these taxes are neutral with respect
to international allocation. This approach also allows more scope for lowering
corporate tax rates without creating sheltering opportunities for high income
individuals. If the 2003 tax changes that lowered rates on dividends and capital gains
to 15% were rolled back, the federal corporate tax rate could be reduced to 31%.70
Taxing capital gains at full rates, as was enacted in 1986 and remained largely in
place until 1997 would allow two or three more percentage points in reduction. One
could go even further, by taxing corporate capital gains on an accrual basis, which
would yield dramatically more revenue. This type of change would also eliminate
distortions arising from payout policies and realizations response. Even lower
corporate rates could be achieved by taxing non-profits enough to offset their savings
from the lower corporate rates — a change that would leave them unaffected, but
would simply shift the source of tax collection. These latter proposals would
arguably be broad enough to move much of the way towards an integration of the
corporate and individual income taxes.
Is there an urgent need to lower the corporate tax rate, as some recent
discussions and analyses have suggested? On the whole, many of the new concerns
expressed about the tax appear not to stand up under empirical examination. The
claims that behavioral responses could cause revenues to rise if rates were cut does
not hold up on both a theoretical basis and an empirical basis. Studies that purport
to show a revenue maximizing tax rate of 30% contain econometric errors that
produce biased and inconsistent results; when those problems are corrected the
results disappear. Cross-country studies to provide direct evidence showing that the
burden of the corporate tax actually falls on labor yield unreasonable results and
prove to suffer from econometric flaws that also lead to a disappearance of the results
when corrected. Similarly, claims that high U.S. tax rates will create problems for
the United States in a global economy suffer from a mis-representation of the U.S.
tax rate compared to other countries and are less important when capital is
imperfectly mobile, as it appears to be.
While these new arguments appear to rely on questionable data, the traditional
concerns about the corporate tax appear valid. While many economists believe that
the tax is still needed as a backstop to individual tax collections, it does result in
some economic distortions. These economic distortions, however, have declined
substantially over time as corporate rates and shares of output have fallen. There are
a number of revenue-neutral changes that could reduce these distortions, allow for
a lower corporate statutory tax rate, and lead to a more efficient corporate tax system.
70 Details of these proposals are provided in CRS Report RL34115, Reform of U.S.
International Taxes: Alternatives, by David L. Brumbaugh and Jane G. Gravelle.
Appendix A. Revenue Maximizing Tax Rates
in an Open Economy
For an exploration of corporate tax revenue, consider a very simplified example
where there is a U.S. corporate sector and the rest of the world with no tax. The
lowest revenue maximizing rate would apply in a case where there is a small country
which is a price-taker (that is, worldwide price and rate of return after tax are fixed
because there is perfect capital mobility and perfect product substitutability). To
determine the revenue maximizing tax rate, begin with the equation for corporate tax
where , the corporate capital stock, and , the after-tax rate of return, areKR
potentially functions of the tax rate, . Revenue is maximized when the totalt
differential of equation (A1) with respect to taxes is equal to zero, which is:
⎛ ⎞dK dR
(A2)()10−+⎝⎜ ⎠⎟ +=ttR tK RK
Assuming the rest of the world can be treated as a aggregate and has a zero
capital income tax rate, Gravelle and Smetters71 show that, in a case of a small
country with perfect substitutability, does not change andR
K t−σ ()1
where is the labor share of income and is the factor substitution elasticity.µσ
Substituting equation (A3) into equation (A2) we obtain the revenue
maximizing rate of . To use some common values, if is 0.75 and is 1,µσµσ
the revenue maximizing rate is 75%.
Since the United States is a large country, the rates would be even higher,
because the tax can affect the world wide interest rate. The Gravelle and Smetters
paper provide effects for and for a given country share, which can also beRK
substituted into equation (A2). As a result, the revenue-maximizing tax rate is
where is the output share. For example, if the Unitedµµγσγ(()+−1γ
States has approximately 30% of the total output, the tax rate would be 81%. The
rates would rise further if capital were not perfectly mobile or products not perfectly
71 Jane G. Gravelle and Kent A. Smetters, “Does the Open Economy Assumption Really
Mean That Labor Bears the Burden of a Capital Income Tax?” Advances in Economic
Policy and Analysis, vol. 6, No. 1, 2006.
substitutable, since these factors would allow to fall further. At the extreme, itR
would return to a closed economy solution. Gravelle and Smetters present evidence
to suggest that the outcome is more similar to a closed economy than a small open
This same outcome, a 75% rate, would also apply for the most extreme case of
growth models, the Ramsey model, where the supply of savings is perfectly elastic.
Note that in both of these extreme cases, the after tax return is fixed and the total
burden falls on wage income, so that labor income would fall. One could also
calculate a corporate tax rate than maximizes revenue while taking into account the
effect on wages and keeping the wage rate constant. Again, relying on the model in
Gravelle and Smetters and maximizing,
(A4)REV tWLl= +
Where is the tax rate wages, we obtain a revenue maximizing corporate tax ratetl
of . With an approximate 20% tax rate on labortttll=−−(()()µσµ1
income, the revenue maximizing corporate tax rate is 70%. Note however, that this
is not the rate that would be found in the cross-section analysis.
Appendix B. Data and Estimation Methods
We obtained the data used in the Hassett and Mathur study and the Clausing72
study. The data used to replicate the Brill and Hassett study were obtained from the
original sources cited in the study.73 We were able to replicate the results reported
for all studies.
The data we use are for several countries for a period of several years, and are
known as panel data. The model of the relationship between the corporate tax rate
(the independent variable) and the various dependent variables takes a linear form:
(B1)YXit it it=+ +α β ε
where is the dependent variable, is the independent variable (the corporateYitXit
tax rate in our case), and are the regression parameters to be estimated, andαβεit
is a random error term.74 The subscripts, i and t, indicate that information for a
particular observation comes from country i for year t (for example, information for
Australia for 1992). The random error term, , is a random variable and capturesεit
omitted and unobservable factors or variables that affect the dependent variable. The
error term will be discussed in further detail below.
If the following conditions are met:
!the expected value (mean) of the random error term, , is zero;εit
!the variance of the random error term is constant for all
!the random error term for one observation is uncorrelated with the
error term for another observation; and
!the random error terms are uncorrelated with the explanatory
then the ordinary least squares (OLS) estimators will yield the best linear unbiased
estimators of the parameters ( and ). The parameter shows the trueαββ
relationship between the dependent variable and the independent variable, and is the
72 We thank the authors for providing their data to us. The studies are Kevin A. Hassett and
Aparna Mathur, Taxes and Wages, American Enterprise Institute, working paper, 2006; and
Kimberly A. Clausing, “Corporate Tax Revenues in OECD Countries,” International Tax
and Public Finance, vol. 14 (2007), pp. 115-133.
73 Alex Brill and Kevin A. Hassett, Revenue-Maximizing Corporate Income Taxes: The
Laffer Curve in OECD Countries, AEI working paper #137, American Enterprise Institute,
July 31, 2007.
74 For ease of exposition only one independent variable is written in the equation.
Generally, several independent variables are included in the linear model. This
simplification does not change the following discussion of our model and estimation
parameter of interest to us. Denote the estimate of as. Since is an estimate,β$β$β
it is a random variable drawn from a probability or sampling distribution with an
expected value (mean) and variance. This estimator will have the following desirable
!unbiased: the expected value of is ;$ββ
!efficient: the variance of is smaller than the variance of all other$β
unbiased estimators; and
!consistent: the probability distribution of collapses on as the$ββ
number of observations gets arbitrarily large.
Estimation problems often arise with panel data because one or more of the
conditions listed above are not met. The result is the OLS estimator will be biased
and inconsistent. Problems arise with panel data, as is demonstrated when equation
(B1) is rewritten as:
(B2)YXit it i t it=+ + + +α β ν φ η .
The term is an effect (unobserved heterogeneity) specific to a particular countryνi
capturing differences among countries in (1) the measurement of economic data, (2)
economic institutions, (3) laws and regulations applying to business, and (4) attitudes
toward business, among other things. The term is a time specific effect capturingφt
such things as the international business cycle. Since the corporate tax rate is a
reflection of the attitudes toward business in a country, and will be correlated.Xitνi
Ignoring the country-specific unobserved heterogeneity means that the OLS estimate
of is biased and inconsistent because the error term in equation (B1) is correlatedβ
with the explanatory variable — one of the conditions listed above is violated.
Another problem often encountered with data that has a time dimension is the error
terms are correlated from one year to the next year (called autocorrelation).
Statistical tests indicate that these problems exist with the data we obtained.
Consequently, we estimate the parameters of the model using the fixed effect
estimation procedure allowing for an AR(1) error structure.75
Neither Brill and Hassett nor Clausing offer any justification in their studies for
using OLS rather than the fixed effects method to estimate the parameters of their
model. A well-known drawback of the fixed effects method is variables that vary
across countries, but not across time within a country, cannot be included in the
estimation (that is, the parameters associated with these variables are not identified).
75 See Christopher F. Baum, An Introduction to Modern Econometrics Using Stata (College
Station, TX: Stata Press, 2006) for a description of this technique. Our overall results and
conclusions are not changed when using the random effects estimation procedure allowing
for an AR(1) error structure.
Devereux (2006) claims “changes in the statutory [corporate tax] rate within a
country are comparatively rare. In practice, as found by Clausing (2006), there is not
enough variation within country to identify an effect of the statutory rate, conditional
on country fixed effects.”76
To check the correctness of this statement and the justification for using OLS,
we directly examine the variation of the corporate tax rate across countries and over
time. Table B1 displays the results for the data from the three studies we reanalyzed.
The first row displays the relevant explanatory corporate tax rate variable used in the
study. The second row reports of mean of the variable. The third row reports the
standard deviation (a measure of variation of a variable) of the corporate tax rate
variable. The last two rows decompose the standard deviation into the between
country component and the within country component. If there is no variation in the
variable over time within countries, then the within component of the standard
deviation will be zero. Consequently, the effect of that variable on the dependent
variable is not identified conditional on fixed effects (that is, it cannot be estimated
using the fixed effects procedure). As can be seen from the table, there is almost as
much variation within countries (the within component) as there is between countries
(the between component).
Table B1. Standard Deviation of Corporate Tax Rate Variables
in the Three Data Sets
Brill and HassettClausing DataHassett and
VariableCorporate tax rateCorporate tax rateLogarithm ofcorporate tax rate
Mean 0.362 0.354 -1.106
Between 0.065 0.078 0.307
Within 0.064 0.063 0.248
Source: Authors’ analysis of data.
In addition, we find that all OECD countries changed their corporate tax rate at
least once between 1979 and 2002. Four countries (Ireland, Norway, Spain, and
Switzerland) changed their corporate tax rate only once during this period. In
contrast, Luxembourg changed their corporate rate 12 times over this period. On
average, OECD countries changed their corporate tax rates once every five years.
Therefore, we can find no evidence to support the argument that the effect of the
corporate tax rate on corporate tax revenues is not identified conditional on fixed
76 Michael P. Devereux, Developments in the Taxation of Corporate Profit in the OECD
Since 1965: Rates, Bases and Revenues, University of Warwick, working paper, May 2006,
Appendix C: Modeling Problems of the Desai,
Foley, and Hines Study
This appendix explains in further detail the modeling problems associated with
the Desai, Foley, and Hines study (hereafter DFH) study, which include the failure
to recognize price variability. This means that their cross-equation restriction is not
justified (and that restriction is what gives rise to their results). The DFH study also
fails to correctly interpret their results given that other sectors exist in the economy.
The DFH model effectively begins with an equation that forms a basic part of
any general equilibrium model, namely that a percentage change in price is a
weighted average of the percentage in costs for small changes. In the case of an
imposition of a tax, that is:
where p is price, r is rate of return, w is the wage rate, is the tax rate and is theτα
share of capital income. The hat notation refers to a percentage change except in the
case of the tax variable, where the hat means the change in tax rate divided by one
minus the tax rate. Beginning with a no tax world, that variable is simply . Thisdτ
relationship can be derived from a profit maximization problem. DFH derive such
an equation to motivate their seemingly unrelated regression model. They then
assume that p, the price of the good, does not change, which produces an equation
of the form:
Since is an exogenous variable this equation indicates that the change in the taxτ
would be shared by interest rates and wages, and this is the basis for the two
seemingly unrelated regressions where the dependent variables are r and w, and the
coefficients are constrained so that the burden will add up to one.
The argument for keeping the price fixed is that such a good would have its
price fixed due to trade: e.g. all commodities have to sell at the same price. There are
two difficulties with this assumption. First, if consumers in different countries have
different preferences for goods based, in part, on country of origin (i.e. they do not
consider French wine and German wine to be perfect substitutes) these prices will not
be fixed. Indeed, this phenomenon is widely recognized, and the price responses are
referred to as Armington elasticities — and they have been estimated empirically.
Second, their observations are the weighted average of firms in each country but the
firms themselves produce heterogeneous products, and all of these product prices
cannot stay fixed because they have different capital intensities and because the
products will vary from one country to another. Indeed, the trading of heterogeneous
products means that fixed prices cannot be assumed because, in such a model,
countries could not produce, consume and trade numerous products with differential
taxation because such a world economy would be characterized by corner solutions
(i.e. no internal equilibrium).
This problem means that there is another variable, price, that is affecting the
results and presumably is correlated with the error term (that is, the price would tend
to be higher when the tax rate is higher, making the regression suspect and that the
coefficient restriction is not appropriate.
Even if these problems did not exist, there is an additional problem with the
interpretation of their findings, namely that they did not adjust for other sectors in the
economy, including non-traded sectors and sectors not subject to the corporate tax.
Incidence results must be adjusted for the fact that the tax is only a partial one.
To illustrate in the simplest fashion, suppose the remaining sector of the
economy is a non-corporate non-traded sector of the economy whose price is denoted
by a capital P:
This commodity has no taxes and if we estimate the effects on r and w, those can be
used to determine the change in P.
What we ultimately want to determine is the fraction of the tax, rKc(wheredτ
Kc is the capital in the corporate traded sector) that falls on labor, that is what share
of Ldw, where L is total labor in the economy, is of rKc. dτ
To derive the real change in wages, we want the change in nominal wage
divided by the change in total price level in the economy, or, if the corporate sector
is responsible for (1-) of output in the economy the percentage change in real wageθ
(which we denote with a capital W) can be expressed as follows:
If s is the share of the burden falling on labor income, from equation (1),
sd− α τ
and . $()rsd=−−1τ$w=−
And, by substitution of these values into (3) and in turn into (4), and allowing the
initial price level to be normalized at 1, we obtain the equation for incidence in the
economy, noting that equals rKc/wLc:αα/()1−
(5) Ldw L L s s s rK dcc=− − − − − −(/ )( ( ) ( )( )/ )θ β θ α β α τ111
The first term, total labor divided by labor in the tax sector reflects the increased
burden from the spread of the nominal fall in wages to the other sector, while the
negative terms inside the next parenthesis reflects the rise in real wages due to the fall
in the price of the untaxed sector. Whether the burden rises or falls depends on a
variety of factors. As the capital intensity of the untaxed sector rises the burden falls;
at the extreme when becomes 1, the first term collapses to 1 and the second termβ
is less than s, so the total burden on labor is less in the economy than it is in the
estimation. This possibility is more important than it might initially appear, because
one of the most important uses of capital not subject to the corporate income tax is
in housing in the United States.