The role of corporate taxes in an open economy.

• Author: Gordon, Roger H.

The economic effects of corporate taxes, and their role in the tax structure, has been a major focus of research in public finance for many years. Until recently, however, almost all of this work has assumed that the economy is closed. Thus, the conventional view would be that the personal tax law treats savings invested in corporate equity more favorably than income from most other assets, because taxes on accruing capital gains are deferred and gains still unrealized at death are exempt from tax. The corporate tax then helps to offset this distortion to the allocation of savings by adding a supplementary tax on corporate equity. To the extent that the effective tax rate on corporate equity exceeds the rate applied to other forms of savings, capital will shift from the corporate to the noncorporate sector,(1) and corporations will have an incentive to use debt finance in order to reduce their taxable income.(2) The presumption since Harberger,(3) however, has been that the main effect of the corporate tax is to raise the effective tax rate on savings, and that the burden of the tax falls primarily on capital owners.

During the last few years, much of my research has studied how past conclusions about the role of corporate taxes change once we take into account the fact that economies are open. While taxes on savings and investment are equivalent in a closed economy, they are completely different in a small open economy. If a small open economy uses a corporate income tax, the burden of the tax must fall on immobile factors, presumably workers and landowners. The corporate tax has no effect on the net return earned on savings, since capital owners always have the option to invest elsewhere, so they can easily escape the tax. I show that taxes on labor income and land dominate corporate taxes in a small open economy, even from the perspective of workers and landowners: under either type of tax, immobile factors bear the burden of the tax, but with labor and land taxes there are no distortions discouraging capital imports.(4)

In spite of this theory, however, essentially all developed countries have significant corporate taxes and have had them for many years. What explains this sharp contrast between theory and practice?

In a paper with Hal Varian,(5) I examine optimal taxes in large open economies. Large countries certainly would want to take advantage of their market power in world capital markets. Capital-importing countries can impose a corporate tax to discourage capital imports, while offsetting this tax for domestic residents by subsidizing domestic savings. In contrast, large capital-exporting countries would want to reduce their capital exports, so they would want to subsidize domestic investment and tax domestic savings. But this forecast, that only large capital-importing countries would impose positive corporate tax rates, is certainly not consistent with the evidence.

Feldstein and Horioka report that net capital flows across countries are surprisingly small;(6) others show that even gross capital flows are dramatically smaller than would be forecast by existing models of optimal portfolio choice.(7) In a paper with A. Lans Bovenberg,(8) I explore possible explanations for both sets of observations, and their implications for tax policy. We find that the only explanation for both observations is asymmetric...