Welfare analysis of the Corporate Tax Policy. Chongung Kim Department of Economics Daegu Haany University Kyungsan, Kyungbuk, Korea

Transcription

1 Welfare analysis of the Corporate Tax Policy Chongung Kim Department of Economics Daegu Haany University Kyungsan, Kyungbuk, Korea Gyan Pradhan* Department of Economics Eastern Kentucky University Richmond, KY Shunming Zhang School of Finance Renmin University of China Beijing, P. R. China, Asia- Pacific Economic Association June 24-25, 2011 *Corresponding author

2 Abstract This paper examines the welfare effects of corporate taxes to find the welfare improving optimal corporate tax rate. For this purpose, we develop a computable general equilibrium (CGE) model. The CGE model is then applied to data from China, Korea and the United States and simulation analysis is conducted. We then analyze the effects of the corporate tax to find the welfare improving optimal corporate tax rate for these countries. We find that the welfare level of each country depends on its economic structure and the welfare improving optimal corporate tax rate doesn't have any particular pattern. In the United States, the optimal corporate tax rates are 24.2 percent for agriculture, 24.2 percent for manufacturing, 26.2 percent for services, and 29.2 percent for construction under the constraints of less than 10 percent tax revenue increase. In China, the changed corporate tax rate for the four sectors, 25 percent rate that went into effect recently gives better welfare. Our analysis suggests that changed corporate tax rate will increase tax revenue by about 60 percent. In Korea, applying corporate tax rates of 16.5 percent to agriculture and small and medium manufacturing firms, and 21.6 percent to large manufacturing firms and services provides the highest welfare to the representative agent under the present economic system and within the 10 percent tax revenue change. Each country has its own unique economic system and each sector in the economy has different productivity and growth rates. Therefore, tax policy to improve welfare should consider these differences between sectors as long as it does not make adverse effects such as a worsening of the income distribution. Topic areas: H25, H32 Key words: Corporate tax, tax change, CGE model, Welfare analysis, Optimal corporate tax rate

3 Welfare analysis of the Corporate Tax Policy 1. Introduction There is some controversy about whether corporations should be taxed at all. Some question why corporate activity should be subject to a separate tax and suggest that the incomes of corporation owners should be taxed via the personal income tax. Others justify a separate tax on corporations for several reasons. First, corporations are separate legal entities, with discrete ownership and control. Second, the corporate tax represents the fee for the benefits that corporations receive from society, including the limited liability of the stockholders. Finally, if corporations are not taxed, they may be inclined to retain income instead of paying it out creating opportunities for personal tax avoidance. (Rosen, 2005) Taxes usually impose an excess burden. That is, their costs exceed the revenues collected. However, because taxes generate excess burdens does not imply that taxes are bad. For instance, taxes can benefit society in terms of enhanced efficiency or fairness. In any event, taxes are necessary for the government to provide essential functions. An optimal or efficient tax raises a given amount of revenue with a minimum excess burden. Since governments wish to improve national welfare, they may try to reduce tax burdens of households and companies in order to encourage production, investment and economic growth. Increasing globalization has made it easier for capital to cross national boundaries. In order to boost economic growth and tax compliance, many countries are moving toward lower corporate taxes. There exist different opinions about whether lower taxes lead to economic growth. Some support a tax reduction policy because of its favorable effect on economic growth. Others are opposed to such policies because of the negligible effects on production and

4 consumption, and the resulting expansion in the government budget deficit. In the United States, corporations are subject to a separate income tax. The corporate tax rate structure is graduated. The lowest bracket is 15 percent and the highest bracket, which begins at $10 million of taxable income, is 35 percent. Most corporate income is taxed at the 35 percent rate. This rate is low by historical standards. Before the Tax Reform Act of 1946, it was 46 percent. The statutory rate, however, does not reflect the effective burden. Before applying the 35 percent tax rate, firms may deduct employee compensation, interest payments and depreciation allowances. These deductions are meant to measure the cost of producing revenue. Dividends, the cost of acquiring equity funds, are not deductible. Dividends and realized capital gains are taxed at the individual level. The calculation of the effective tax rate paid by corporations varies as it is affected by the choice of the discount rate, the expected rate of inflation, the extent of true economic depreciation, and by how the investments are financed. A report by the Government Accountability Office (2008) estimates the average effective corporate tax rate for U.S. corporations at 25.2 percent. Similarly, the International Finance Corporation of the World Bank (2009) estimates that the United States has a lower effective corporate tax rate than that of several countries including Brazil, Canada, China, Germany, India, Italy and Japan. In another study, Gravelle (2004) estimates the effective overall marginal tax rate on corporate capital to be 32 percent. Effective January 2008, the corporate tax rate in China is 25 percent for both domestic and foreign companies. Previously, the tax rate was 33 percent. However, foreign firms paid a tax rate as low as 10 percent if they operated in special economic zones, development zones or industrial parks. Until January 2009, the corporate tax rates in Korea were 11 percent on the first 200

5 million of the tax base and 22 percent for higher incomes. Effective January 2010, the tax rates were reduced to 10 and 22 percent. In addition to the basic tax rate, there is a resident tax surcharge of 10 percent on income tax liability. Many studies have analyzed the welfare effects of tax policies around the world. For example, Summers (1981) examines the welfare effects of tax reform by comparing the equilibrium between before and after tax reform in an overlapping-generations model. Sinn (1981) uses an infinite horizon model to analyze the welfare levels between equilibriums. Auerbach, et al. (1983) study the welfare effects of capital income taxation along a transition path. Jorgenson and Yun (1986) examine the effects of equalizing capital income tax rates between sectors. Judd and Balcer (1987) analyze the welfare effects of a change in the marginal tax rate. Peretto (2007) suggests that reducing taxes on corporate profit financed with increases in taxes on dividend income improves welfare and economic growth. Clausing (2007) finds that the revenue-maximizing corporate tax rate is 33 percent for OECD countries and that this tax rate tends to be lower the smaller and more open the economy. Djankov, et al. (2009) in their cross-sectional study of 85 countries find that corporate taxes have negative effects on aggregate investment, foreign direct investment and entrepreneurial activity. In contrast, there are very few country-specific studies on the subject. Such studies include those by Yun and Kim (1995) and Kim and Hwang (2009) which analyze the effects of fiscal policy in Korea by building appropriate models. Given this dearth of studies for individual countries, it is difficult to draw any reasonable conclusion about the effects of corporate tax policy on countries with different economic systems. The purpose of this study is to examine the effects of a change in corporate taxes on economic welfare. First, we build an appropriate theoretical model to analyze the effects of

6 corporate tax changes on economic welfare. Second, we apply this model to data from China, Korea and the United States and undertake simulation analysis to examine the effects of tax adjustments in each country. Finally, we try to estimate the welfare improving optimal corporate tax rate that will improve economic growth and welfare in these three countries. It is hoped that this study will provide another theoretical basis for the appropriate corporate tax policy and suggest some directions for better tax policy. The rest of the paper is organized as follows. The theoretical model is discussed in the next section. The following section discusses the data used in the study. The welfare effects of the corporate tax are examined next. The final section summarizes and concludes the paper. 2. Basic Model for Welfare Analysis It is possible to use a variety of models to analyze the effects of tax policies. In this paper we build a simple computable general equilibrium (CGE) model comprised of multi (n) sectors. The CGE model is set up in two parts production and consumption. We consider an open, price-taking economy with n sectors. The world prices for each sector's goods are P 0 i for i = 1, 2,, n. Domestic prices are then given by world prices plus (or minus) the effect of ad valorem border measures (either import tariffs or export subsidies). That is: P i = (1 + t i ) P i 0 i = 1, 2,, n (2.1) where P i for i = 1, 2,, n are domestic prices of the n sectors products, and t i for i = 1, 2,, n are tariffs or export subsidies for each sector (t i > 0 indicates import tariffs, and t i < 0 indicates export subsidies for i = 1, 2,, n). For the n sectors we assume a Cobb-Douglas production function of the form: Y i = A i L i ai K i 1-ai i = 1, 2,, n (2.2)

7 where Y i is output, L i is labor input, K i is capital input, A i is a units term (scalar parameter), and ai is the production exponent. For each sector i = 1, 2,, n the markets are assumed to be fully competitive. The wage rate and return to capital are determined by the marginal products of labor and capital: W i = P i Y i / L i = a i P i* A i L i ai-1 K i 1-ai R i = P i Y i / K i = (1-a i )P i* A i L i ai K i ai = a i (P i Y i /L i ) i = 1, 2, n (2.3) = (1-a i )(P i Y i /K i ) i = 1, 2,, n (2.4) The zero profit condition holds: P i Y i = W i L i + R i K i i = 1, 2,, n (2.5) Harberger (1959, 1962) considers the enterprise tax for two production sectors where incorporated production enterprises pay the corporate tax while non-incorporated production enterprises do not pay the corporate tax. In this paper, all sectors are incorporated and the corporate tax rate of each sector is t i > 0 for i = 1, 2,, n. In the equations above, R i is the rate of return of gross-of-tax capital. We denote R i ' as the rate of return of net-of-tax capital. Thus: R i = (1 + t i ) R i ' i = 1, 2,, n (2.6) On the demand side of the model, domestic consumption of output of n sectors reflects utility maximizing behavior by a single representative individual who represents the aggregation of all the members in the economy and has a preference defined over the distinct subsector outputs as well as leisure which for convenience we write as: U = X 1 γ1 X 2 γ2 X n γn γ1 + γ2 + γn = 1 (2.7) The representative consumer receives income from working in four sectors. This income actually accrues from sales of produced goods and subsidies from the government based on taxes. I = P i Y i + V + S + B (2.8) where V is tariff revenue, S is subsidy revenue, and B is net trade balance. Corporate tax

8 revenue (TRn) of n sectors is: TRn = t i R i 'K i (2.9) Under this budget constraint, the representative consumer allocates his income in n kinds of goods and maximizes his utility: Max U = X 1 γ1 X 2 γ2 X n γn (2.10) ST P i X i = I Utility maximization subject to a budget constraint in this case implies: X i = (γ i I)/P i i = 1, 2,, n (2.11) General equilibrium for this model is characterized by the equilibrium of the goods and factor markets under the constraints of labor and capital endowments. Since the movement of capital between sectors is flexible, the rate of return to capital should be equalized across the n production sectors. It follows that the equilibrium conditions of the markets are as follows: X i = Y i + Z i, i = 1, 2,, n L i =L K i =K R 1 ' = R 2 '= R n ' (2.12) The representative consumer decides his consumption of all kinds of products given the budget constraint. For equilibrium, variations of corporate tax rates of each sector will change the allocation of labor and capital between sectors to maximize utility under the budget constraint. Every country has its own economic system and the optimal corporate tax rate will vary based on the existing economic system. To compare the welfare levels based on a change in the corporate tax rate, we use the equivalent variation (EV):

9 EV = E(U 1,P 0 ) - E(U 0,P 0 ) (2.13) Following Shoven and Whalley (1992), the equivalent variation can also be described as: EV = {(U 1 - U 0 )/U 0 }*I 0 (2.14) 3. Data We use data for 2008 to set up the base economies for China, Korea and the United States. For the purpose of analysis, the economies are divided into four sectors but the composition of these four sectors differs somewhat as indicated in Table 1. We use this data to carry out simulations based on different corporate tax policies. Table 1: Economic Sectors Sector America China Korea 1 Agriculture Agriculture Agriculture 2 Manufacturing State-owned firms 3 Services Private firms 4 Construction Foreign firms investment Small and medium manufacturing firms Large manufacturing firms Services Table 2: Tax Rates Sector America China Korea Τ t τ t τ t

10 Table 3: Production Function Data Sector America China Korea A a A a A a Table 4: Utility Function Data Sector America China Korea γ γ γ Welfare Effects of Corporate Tax The base year for simulation is Based on the model and data collected for each country, we can calculate the utility level (U 0 ) in the base year under the condition of the base year's corporate tax rate. The objective of this study is to find alternative corporate tax rates which give the representative individual in each country a higher level of utility than the base case. As alternative cases to compare with the base case, we choose four different cases which have different corporate tax rates for the four sectors. Since the amount of tax revenue generated is a very important factor, we apply a 10 percent higher tax revenue condition to the alternative cases for the United States and Korea. China recently changed its corporate tax rates for different sectors to a unified tax rate of 25

11 percent for all sectors. Therefore, we compare the welfare level of two cases which have different corporate tax rates without the tax revenue constraint. Table 5: America Sector (U 1 -U 0 )/U 0 (TR 1 -TR 0 )/ TR 0 t Base Alt Alt Note: 0 is base case; 1 is alternative case To analyze the United States case, we divide the economy into four sectors: agriculture, manufacturing, services and construction. Under the constraint of less than 10 percent tax revenue increase, the optimal corporate tax rates are 24.2 percent for agriculture, 24.2 percent for manufacturing, 26.2 percent for services, and 29.2 percent construction (Alt 2). Compared with the current corporate tax rates, the optimal corporate tax rates for services and construction are higher. In particular, the optimal corporate tax rate for the construction sector is 4 percent higher than the current rate. Table 6: China Sector (U 1 -U 0 )/U 0 (TR 1 -TR 0 )/ TR 0 t Base Alt Note: 0 is base case; 1 is alternative case To analyze the China case, the four sectors we consider are agriculture, state-owned companies, private companies, and foreign investment companies. The welfare level of changed unified corporate tax rate for the four sectors(25%) in China is higher than that of the previous tax rates which were different from sectors.

12 Table 7: Korea Sector (U 1 -U 0 )/U 0 (TR 1 -TR 0 )/ TR 0 t Base Alt Alt Note: 0 is base case; 1 is alternative case Finally, to analyze the Korea case, we divide the sectors into agriculture, small and medium manufacturing companies, large manufacturing companies, and services.. Under the constraints of less than 10 percent tax revenue increase, the welfare improving corporate tax rates are 16.5 percent for agriculture and small and medium manufacturing companies, and 21.6 percent for the large manufacturing companies and services sector (Alt 2). Compared with the current corporate tax rates, the welfare improving optimal corporate tax rates for the two sectors are lower by less than 1 percent. 5. Conclusion An optimal or efficient tax raises a given amount of revenue with a minimum excess burden. Every government wishes to improve its national product and welfare. To this end, some governments try to reduce tax burdens of households and firms to encourage production and investment. This paper is designed to examine the welfare effects of corporate taxes to find the welfare improving corporate tax rate. For this purpose, an appropriate CGE model is constructed. We apply the CGE model to the case of China, Korea and the United States and conduct simulation analysis. We then analyze the effects of the corporate tax to find the optimal level of corporate tax rates for these countries.

13 Our study indicates that the welfare level of each country depends on its economic structure and the welfare improving optimal corporate tax rate doesn't have any particular pattern. In analyzing the optimal corporate tax rate, we apply within 10 percent higher tax revenue condition to the alternative cases except China. In the United States, the optimal corporate tax rates are 24.2 percent for agriculture, 24.2 percent for manufacturing, 26.2 percent for services, and 29.2 percent for construction under the constraints of less than 10 percent tax revenue increase. In China, the changed corporate tax rate for the four sectors, 25 percent rate that went into effect recently gives better welfare. Our analysis suggests that changed corporate tax rate will increase tax revenue by about 60 percent. In Korea, applying corporate tax rates of 16.5 percent to agriculture and small and medium manufacturing firms, and 21.6 percent to large manufacturing firms and services provides the highest welfare to the representative agent under the present economic system and within the 10 percent tax revenue change. Each country has its own unique economic system and each sector in the economy has different productivity and growth rates. Therefore, tax policy to improve welfare should consider these differences between sectors as long as it does not make adverse effects such as a worsening of the income distribution. To develop our study, we can extend our model to include more sectors and taxes etc. In addition, we can try other simulations to get better policy implications by changing constraints or including more countries.

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