are among America's greatest resources. These individuals try to change
the status quo because they expect to use resources to create higher
value than those resources are currently producing. This takes
investments, and investments are risky. The return to these investments
is the economic growth that they create, which is profit. Yet the
government often taxes these profits twice, once at the business level
and then again when the profits are distributed to individuals.
double taxation not only dampens the incentive to invest, but also
obscures who actually bears the burden of these taxes. Corporations are
often personified and demonized, but a corporation is a legal entity,
not an actual person. Because a corporation is made up of a group of
individuals but is not actually an individual, corporate taxes are
really taxes on the stakeholders in the corporation. In a U.S. Treasury
report, William Gentry points out that empirical studies show that
employees and consumers really bear the cost of corporate and
results show that repealing the corporate income tax alone, which
would cost approximately $300 billion in annual tax revenue, would produce by 2012:
- 2 million more jobs than the baseline scenario;
- $280 billion more in real (inflation-adjusted) gross domestic product (GDP);
- $4,000 more in real disposable income for a family of four; and
- $707 billion more in household net wealth—the base of economic strength and stability.
Losing Our Competitive Edge
a global economy, investments will flow to the areas where they can
earn the highest returns. Many factors—such as labor supply, resource
availability, and legal structure—influence the return on investments.
In particular, taxing returns on investment discourages investment,
holding all else constant.
According to a recent Organisation
for Economic Co-operation and Development (OECD) working paper, of the
three taxes (income, corporate, and consumption), corporate taxes are
most harmful to economic growth.
Other countries are aware of this and have steadily reduced their
corporate tax rates. The U.S. has been the exception. Chart 1 shows how
most other countries in the global economy have undercut U.S.
competitiveness in corporate tax rates.
Congress repealed the corporate income tax, investments would flow into
the country. Multinational and international companies would be
encouraged to operate in the United States, bringing jobs and new
technology to meet today's economic challenges. Owners of
corporations—those who earn the profits—would have more resources to
invest in things that create value for others.
corporate tax would also encourage owners to hire and train people and
to invest in their workforces because a more competitive tax structure
would give corporations a greater incentive to domicile in the U.S.
Further, higher levels of investment would require new skills of
employees. As these investments paid off, economic growth would occur.
Implementing the President's Stated Goals
the corporate income tax would accomplish President Barack Obama's
stated goals of increasing investment and ushering in an era of
responsibility and economic growth, all at a lower cost than the recently passed stimulus bill.
First, the President's call for investment seems to demonstrate that he knows that investment drives economic growth.
Finding solutions to economic challenges requires investment, and in
the United States, that is precisely what businesses do. Businesses
throughout the country have an "on the ground" view of these challenges
and knowledge of the available resources. Businesses have already
mobilized individuals that specialize in providing these solutions to
consumers, and businesses are making investments. Removing a barrier to
business would be a quicker and more effective way to foster economic
growth than spending billions to assess "worthy" investment projects
and wasting time trying to bid resources away from private citizens.
Second, the President has said that he believes in personal responsibility.
Individuals who make investments are personally responsible for the
outcome. In fact, their viability depends on it. On the other hand, a
politician's viability is not directly tied to an investment outcome.
When the government makes an investment decision, no one has ownership
of any specific project. Instead, taxpayers are the owners and must
spend more of their valuable time and resources monitoring their
agents, the politicians. Having the government make investment
decisions weakens individual responsibility. Removing a barrier to
encourage more individuals to take ownership of their investments
would be more stimulative than creating an additional layer of
Third, the President has said that economic
growth depends not only on individuals doing their part, but also on
government doing its part.
Numerous studies, notably at the International Monetary Fund and World
Bank, have found that sound fiscal policy based on low taxes,
transparent collections, manageable debt-to-GDP ratios, and consistent
justice systems are significant factors in economic development and
Focusing the government on governing and providing a fiscally stable
environment while allowing individual entrepreneurs to invest in
valuable new ideas is the best recipe for sustained economic growth.
bottom line is that the stimulus bill and the President's proposed
federal budget borrow billions of dollars, raising the nation's
debt-to-GDP ratio to precariously high levels. We have little
experiential understanding of how much risk these levels of debt will
inject into the U.S. economy, which was built by a nation of
entrepreneurs over the past few centuries.
Simulation Shows Effectiveness of the Policy
at The Heritage Foundation simulated the effect of repealing the
corporate income tax using the Global Insight (GI) short-term
macroeconomic model of the U.S. economy and the Tax Policy Advisers (TPA) overlapping-generations dynamic general equilibrium model.
The GI structural model gives quantitative results on many detailed
macroeconomic variables, while the TPA model gives direction on the
underlying behavioral effects in the economy.
The GI model
indicates that annual GDP growth would average 0.6 percentage point
higher over the next four years. This is not as high as the average 10
percent increase in investment because the higher productivity from the
investments allows individuals to enjoy an improved quality of life
from the labor–leisure trade-off.
That is, people can sustain their standard of living with less labor
time. This quality-of-life benefit is not captured in the GDP measure.
models show that housing investment and the housing capital stock would
decrease. The distortionary effect of housing deductions in the tax
code along with double taxes on profits has led to a
higher-than-efficient investment in housing relative to investments in
output-producing capital. The economic efficiency gained from this
reallocation away from housing and toward productive new capital can
be seen in higher GDP. If this reallocation had been less efficient,
GDP would have fallen relative to the baseline. Eliminating the
distortions of the corporate income tax allows the economy to
recapture this deadweight loss, thereby increasing GDP.
higher stock of productive capital makes labor more productive and
wages increase. Wages and salaries in the private sector are 3 percent
($177 billion) higher in 2012 than the baseline. This corresponds to
about $4,000 more in disposable income for a family of four in 2012.
Higher disposable income allows families to spend more and to save and
invest more. The net worth of households (assets minus liabilities) is
$717 billion higher in 2012. This result further strengthens the
economic fundamentals that lead to a higher living standard for those
in the economy.
Over the next four years, net foreign investment
(U.S. investment abroad minus foreign investment in the U.S.) decreases
by an average nominal amount of $61 billion indicating greater foreign
investment in the U.S. A meta-analysis of elasticity estimates finds
that a 1 percent decrease in the average effective corporate tax rate
increases foreign direct investment by 3.3 percent.
Consistent with the meta-analysis, the simulation using the GI
structural model shows that both exports and imports increase over the
next four years, but imports increase much more. The relative higher
change in imports versus exports implies a higher trade deficit and
thus a higher capital account surplus. The increased demand for U.S.
dollars increases the value of the U.S. dollar further, demonstrating
this policy's contribution to strengthening the fundamentals of the
The increased investment both domestically and
from abroad creates more jobs, while reducing the unemployment rate. By
2012, this policy produces approximately 2 million more jobs than the
baseline scenario, and the unemployment rate averages 0.6 percentage
point lower over the next four years. (For detailed results from the GI
model, see Appendix C.)
Economic Trade-offs and Considerations
short-term potential losers from the repeal of the corporate income tax
would involve industries built on providing corporate income tax
services, businesses that have made decisions based partly on a tax
benefit, and politicians who use business tax credits as bargaining
chips. These groups may be more vocal and cohesive than the silent
majority that does not "see" all the investment that is being forgone
due to this double taxation. Thus, this policy change requires
effective leadership that seeks ways to compensate temporary losers as
the economy transitions to greater efficiencies in which investment
decisions are based on fundamental resource considerations rather than
on avoiding taxes.
Some might think that eliminating the
corporate income tax would encourage en-masse conversions to the
C-corporation designation from other types of corporate structures. In
fact, repealing the corporate income tax would just remove a layer of
tax on individuals, thus leveling the tax playing field among different
designations. The owners of any type of organizational form would still
be taxed through dividends, capital gains, or higher salary, depending
on how closely the ownership is held. Therefore, legal structures would
be based on considerations of liability exposure and efficient
concern is that owners would have more of an incentive to earn profits
than to pay higher salaries to their workers. With a corporate income
tax, salaries and wages reduce profit and therefore reduce the tax
liability. However, this fear is misplaced. As mentioned above,
employees bear much of the tax burden through lower wages. Taxing
something will reduce the supply of that item or activity. Taxing
businesses reduces business operations, which means that businesses
pay less in wages to employees or hire fewer employees. Conversely,
eliminating the corporate income tax would encourage more businesses to
form, which would increase competition for labor and apply upward
pressure on wages, as the simulation results show.
A final issue
is that owner-operated corporations could pay the owner the profits in
the form of dividends instead of as a salary if the tax on dividends
is less than the tax on wages. For example, if a business incorporated
as a C corporation earns a profit of $100,000 before paying the
manager's salary and the owner is also the manager and the only
shareholder, then the owner could pay himself a salary of $100,000 and
earn zero profit or take no salary and pay himself the profit as a
$100,000 dividend. Assuming that the tax on dividends is 20 percent and
the average effective tax on the $100,000 salary is 28 percent, the
business owner would be wise to forego the salary and instead take a
dividend of $100,000. Ideally, this possibility would be addressed by bringing marginal labor and capital taxes more in line at a low rate.
taxes for businesses would convert those tax savings into
growth-creating savings and investment in the economy. Businesses have
already mobilized individuals and other resources that are working
together for productive purposes. These savings would provide the
capital that entrepreneurs need to invest in their ideas for
Regrettably, because these benefits
are broad and corporate tax repeal opens many direct and indirect
positive feedback channels, the effects are difficult to trace directly
and are dismissed as having no effect on the "average" household. It is
easy to be lulled into the rhetoric that our system privatizes gains
but socializes losses. In fact, the gains are also socialized, but they
are too often taken for granted.
The modern conveniences of the
American standard of living required business investments in the past.
The jobs that people hold today were created through past successful
investments by entrepreneurs. Conversely, most people do not realize
that they perhaps lost job opportunities because the U.S. corporate tax
is higher than the corporate tax rates of almost all other developed
the corporate income tax is a relatively low-cost way to implement the
President's stated goals. At a time when U.S. employees are seeing jobs
leave the country, a tax plan that increases the competitiveness of the
U.S. business environment and encourages saving and investment by
individuals would allow entrepreneurs to implement their ideas for
dealing with the challenges of the 21st century. It would also
encourage job-creating businesses to locate in the U.S. It is
important that this country's leaders signal that the United States is
still the land of opportunity.
Karen A. Campbell, Ph.D., is Policy Analyst in Macroeconomics in the Center for Data Analysis at The Heritage Foundation.
at The Heritage Foundation used the Global Insight short-term
macroeconomic model to simulate the effects of a repeal of the
corporate income tax. The simulation was implemented as follows:
The statutory rate on corporate profits was reduced from 35 percent to zero percent.
OECD research estimated that reducing the corporate tax rate by 5
percentage points would increase productivity growth by 0.4 percentage
point. This implies an elasticity of total factor productivity to the
corporate tax rate of 0.08.
Using this elasticity, repealing the
U.S. corporate income tax (a 100 percent reduction) would increase
productivity growth by 8 percent per year or 2 percent per quarter.
The quarterly change in the TFPTREND variable is thus increased by 2 percent starting in the first quarter of 2009.
the corporate tax really taxes individual stakeholders, employees,
shareholders, and consumers, repealing the tax rate causes micro-level
behavior adjustments for the individuals who bear the tax. Evidence
suggests that the employees bear most of the burden.
simulation of the macroeconomy using the Tax Policy Advisers
overlapping-generations model reveals the direction of the micro-level
adjustments. This model predicts a decrease in labor supply as
individuals, now with higher wages, choose relatively more leisure.
The TPA model is a general equilibrium model; therefore, the implied
labor supply is the full employment or potential of the economy, which
implies a higher natural rate of unemployment.
For this reason,
the natural rate of unemployment variable was increased in the
structural model. This variable was adjusted by the natural rate of
unemployment-to-TFP-trend ratio. Applying this baseline ratio to the
higher TFP trend increased the natural rate of unemployment, ranging
from 0.0002 percentage point to 0.01 percentage point as increased
productivity growth accelerates the wealth effect, allowing
individuals to choose more leisure and less labor.
increased productivity should lower prices and expected inflation, the
structural model interprets price reductions as decreases in demand,
which lowers investment and production. For this reason, the price and
expected inflation variables as well as the consumer confidence
variable are held constant. If the model had correctly incorporated the
lower prices resulting from increased supply, the increased consumption
would cause reported real GDP to be higher. Thus, the results in this
paper can be interpreted as a conservative, lower bound on the effects
of the corporate tax repeal.
two models helps to validate the results and provides greater insight
into the likely effects, both in the long term and along the transition
path. The TPA model found that non-housing investment would be higher,
and the structural model quantifies this as an average of 5 percent
higher. This leads to a higher level of capital stock. The TPA model
predicts a higher interest rate as the unleashing of investment demand
outweighs the increased supply of savings.
A check of the Global
Insight structural model's quantitative results against the qualitative
results predicted by the TPA model, which is based on micro-level
foundations, validates the reported effects.
The TPA model
predicts a decrease in residential investment and an increase in
non-residential investment as the bias is removed from these two types
of capital investment. The structural model also produced these results.
TPA model predicts an increase in wages due to the increased
productivity and tightening of the labor market as individuals are
happy to choose more leisure. The structural model quantifies an
increase in wages as well.
The TPA model predicts a long-term
increase in the equilibrium interest rate as the increased demand for
investment outweighs the increased supply of savings. The structural
model predicts an initial decrease in interest rates as the cost of
capital is lower due to reducing the tax liability. However, as this
lower cost of capital encourages greater investment and shifts the
demand for investment outward as new businesses are incorporated,
interest rates in this model also increase.
This movement in the
rental cost of capital demonstrates the positive feedback effects that
this policy unleashes. First, the tax repeal lowers the cost of
capital. This leads to increased investment, which increases labor
productivity. Higher productivity increases the wages paid to labor
and increases the relative cost of labor so that more capital is
demanded, which bids up the rents paid to capital. This process
continues as new capital again increases the productivity of workers.
literature has found inconclusive results with respect to the effects
of the corporate tax rate on stock market returns. David Cutler
finds that there are winners and losers depending on a firm's degree of
leverage. Corporations that have a high level of debt earn lower
before-tax profits, but their after-tax profits are similar to those
earned by firms that are less leveraged because of the former's ability
to reduce their tax liability by the amount of interest paid on the
debt. Thus, repealing the corporate income tax would cause highly
leveraged firms to have lower profits relative to their less leveraged
peers. This would reduce the relative value of their stock or,
conversely, increase the relative value of their peers' stock.
structural model shows these mixed results. The S&P 500 initially
increases but then decreases. However, the yield on the S&P 500 is
consistently higher over the entire forecast horizon due to the higher
earnings of corporations in general because of reduced tax expenses.
example, studies show that employees pay about 60 percent of the
corporate income tax in lower wages. Some of this occurs through less
investment and higher business costs. Less capital and fewer technology
investments cause worker productivity to be lower, and this lowers
wages. Higher consumer prices caused by higher business costs lead to
less demand for a business's product and therefore less demand for
workers in that business. William M. Gentry, "A Review of the Evidence
on the Incidence of the Corporate Income Tax," U.S. Department of the
Treasury, Office of Tax Analysis Paper No. 101, December 2007, at http://www.treas.gov/offices/tax-
policy/library/ota101.pdf (September 11, 2008).
Johansson, Christopher Heady, Jens Arnold, Bert Brys, and Laura Vartia,
"Tax and Economic Growth," Organisation for Economic Co-operation and
Development, Economics Department Working Paper No. 620, July 11, 2008, at http://www.olis.oecd.org/olis/2008doc.nsf/LinkTo/NT00003502/
$FILE/JT03248896.PDF (September 5, 2008).
OECD working paper found that total factor productivity (TFP) is 0.4
percentage point higher after 10 years from only a 5 percent reduction
in the corporate income tax rate. Jens Arnold and Cyrille Schwellnus,
"Do Corporate Taxes Reduce Productivity and Investment at the Firm
Level? Cross-Country Evidence from the Amadeus Dataset," Centre
d'Etudes Prospectives et d'Informations Internationales Working Paper No. 2008–19, September 2008, at http://www.cepii.fr/anglaisgraph/workpap/pdf/2008/wp2008-19.pdf (March 4, 2009).
U.S. Office of Management and Budget, A New Era of Responsibility: Renewing America's Promise (Washington, D.C.: U.S. Government Printing Office, 2009).
For example, see Luiz R. De Mello, Jr., "Can Fiscal Decentralization Strengthen Social Capital?" Public Finance Review,
Vol. 32, No. 1 (January 2004), pp. 4–35, and Anwar Shah and Jeffrey
Huther, "Applying a Simple Measure of Good Governance to the Debate on
Fiscal Decentralization," World Bank Policy Research Working Paper No. 1894, November 1999, at http://papers.ssrn
.com/sol3/papers.cfm?abstract_id=620584 (February 9, 2009).
information about the details and operation of the Global Insight U.S.
macroeconomic model, see The Heritage Foundation, "Description of the
Global Insight Short-Term US Macroeconomic Model," at http://www.herita
(March 4, 2009). The methodologies, assumptions, conclusions, and
opinions in this report are entirely the work of Heritage Foundation
analysts. They have not been endorsed by and do not necessarily reflect
the views of the owners of the GI model. The GI model is used by
leading government agencies and Fortune 500 companies to
provide indications to policymakers of the probable effects of economic
events and public policy changes on hundreds of major economic
a description of the TPA model, see John W. Diamond and George R.
Zodrow, "Description of the Tax Policy Advisers' Model," The Heritage
Foundation, March 15, 2005, at http://www.heritage.org/cda/upload/TPA_
4, 2009). The methodologies, assumptions, conclusions, and opinions in
this paper are entirely the work of Heritage Foundation analysts. They
have not been endorsed by and do not necessarily reflect the views of
TPA. The TPA model is used by leading government agencies to indicate
the probable effects of economic events and public policy changes.
economic theory shows how individuals value leisure and consumption.
Since individuals must use their labor to earn income for consumption,
they must trade off some of their valuable leisure time. The more that
individuals can consume with a given amount of labor, the better off
they are. In fact, as consumption possibilities increase, empirical
evidence shows that individuals will often forgo additional consumption
(work less) and spend more time on their other valuable non-work
priorities. This arguably improves one's quality of life because one
can consume the same amount of goods and services and have more time to
enjoy personal activities. In this case, there may be somewhat less
measured employment, all else equal, but this is due to the decision
not to supply employment rather than a lack of demand for employment.
Furthermore, measured gross domestic output may be somewhat less
because the national income and product accounts do not capture the
value of having additional leisure time.
Ruud A. De Mooij and Sjef Ederveen, "Taxation and Foreign Direct Investment: A Synthesis of Empirical Research," International Tax and Public Finance,
Vol. 10, No. 6 (November 2003), pp. 673–693. Increases in foreign
direct investment would increase the capital account of the U.S. as
more dollars are purchased to buy U.S. investments. A capital account
surplus implies a current account deficit, which is the balance of
C corporation is a legal entity that limits the liability of the owners
of the corporation. This allows many individuals to participate in the
ownership of a corporation through stocks without exposing other
personal assets, beyond those invested in the shares, to lawsuits or
creditors. This allows corporations to raise large amounts of equity
finance that can be invested to take advantage of economies of scale.
Since the owners are an investing class, rather than involved in
day-to-day operations, public C corporations have more stringent
financial reporting requirements and therefore may not make sense for
smaller entities. Privately held C corporations may make sense from a
liability standpoint for smaller entities.
is an over-simplified example to illustrate a potential consideration
for policymakers implementing this reform. Many other factors,
particularly social insurance contributions, would affect the dividend
versus salary decision.
Carroll, "Comparing International Corporate Tax Rates."
the behavioral change in the model is driven by this substitution
effect, the natural rate of unemployment could also increase for
another reason that is not captured in current models. Repealing the
corporate income tax would increase the competitiveness of U.S.
businesses. This would create more job opportunities and greater
investment in new technology. More job opportunities would increase
frictional unemployment (individuals changing jobs more often as new
opportunities become available), while greater investment would
increase structural unemployment (new technology requiring new skills,
displacing individuals as demand for new skills increases).
David Cutler, "Tax Reform and the Stock Market: An Asset Price Approach," American Economic Review, Vol. 78, No. 5 (December 1988), pp. 1107–1117.