Investment and corporate taxes
Thanks to Stephen Gordon, who made a link to a new unpublished study (fourth draft, 2009), The effect of corporate taxes on investment and entrepreneurship, by Djankov, Ganser, McLiesh, Ramalho and Shleifer. Stephen claims this study settles the matter that Canada should not reverse corporate tax cuts made in recent years. That discussion was happening deep in the comments section of Toby’s recent post, so I figured I would start a new thread (and I have pasted a few of my observations from there over here).
My contention is that there is little impact on efficiency, growth or investment from corporate income tax cuts. There are theoretical arguments that corporate taxes have negative efficiency impacts but this is not settled in the least empirically. It is not that we should ramp up corporate taxes to 70% or anything, but there is no reason why recent corporate tax cuts â€“ that have taken Canadian rates well below US ones â€“ should not be repealed. And to the extent that there are efficiency impacts of corporate taxes they must be weighed against the beneficial impacts of any associated public spending. If spent in a pro-growth manner corporate income tax increases may have no efficiency losses whatsoever. But I still think within the range of taxes we have seen in recent years, efficiency impacts will be extremely small.
Most corporations in Canada have to be here to access the Canadian market, or resources they want to exploit. And there are many more other aspects to investment decisions than just CIT rates. Cheap electricity in BC or Quebec overwhelms most differences in CIT rates. These subtleties are almost never captured in empirical studies, so on balance Toby is right to be skeptical of them.
Finally, if you do want to cut CIT rates you must increase top marginal personal income tax rates or else you give windfall gains to the wealthy (I cite Jon Kesselman on this).
I did my own review of this literature a few years ago. Hereâ€™s a pertinent passage related to the corporate tax claims above. I still have yet to see any real economic evidence to the contrary:
Another group of studies often cited by advocates of smaller government comes from computer simulations that find that an extra dollar of government revenue actually costs the economy something like $1.38 or more in lost economic activity (see Dahlby 1994). It is important to note that these results are not derived from real-world data. They are quasi-empirical studies that start with a theoretical model where taxes impose large deadweight costs to the economy, then put some real numbers to the model to enable them to simulate what the cost of extra taxation is at the margin. They are â€œeducated fictionâ€ based on the virtual reality of computer models (Lindert 2004).â€
So that is the back story. Stephen rebuts by citing an unpublished paper, which starts by listing a series of studies initiated by Dale Jorgenson. But it is precisely those models that are what Peter Lindert calls educated fiction. They fit numbers to a model that assumes corporate taxes have large impacts on efficiency, then guess what they find …
The unpublished study Stephen cites is interesting but deeply flawed. Interesting because it finds that corporate taxes are not significant for investment. But they are significant for FDI, which makes sense given that the study has 85 countries and is thus treating the corporate tax rate in Ghana as an equivalent data point to Canada. Looking more closely at the data, on a simple correlation in Figure 1, they point to a loose linear relationship, but the observations are basically a blob that suggests little. For FDI, Figure 2, the relationship is stronger but heavily influenced by developing country outliers, with most observations tightly clustered together.
Which explains why this study has some of the lowest r-squared values I have ever seen reported in an empircal study (like .03 to .12). In case you missed the econometrics class on r-squared, low values mean poor goodness of fit. So basically no reason to believe their estimates have any traction at all. There is a later one that gets up to an r-squared high of .39, around the level one might actually start to pay attention, but this is for a simple regression that only includes corporate taxes as the determining factor behind investment, and is only based on 16 observations, which makes it a very weak estimation.
There is more to it, but econometrically this study is a dud. Anyway, for Canada, the main source of FDI is the US. But here the authors find no significant relationship for US FDI abroad vis-a-vis foreign tax rates!
For this, I get chastized by Stephen: he is “very, very disappointed” in me for not having done my homework and knowing that this unpublished study was out there. But I’m disappointed in him for coming back with such a weak piece of evidence. The jury is not convinced.
So I go back to my original contention: As far as I have seen there is no conclusive econometric evidence that lower corporate tax rates lead to higher rates of investment, GDP growth or productivity growth — not one unpublished study but many credible ones that come to the same conclusion. There are some cross-country and historical comparisons that small open economies with high levels of GDP per capita and decent productivity growth (ie the Nordics) do tend to rely less on corporate income taxes and more on consumption taxes, so we should take those lessons about tax mix seriously â€” that you should not have corporate taxes that are way out of line.
So I’m not saying there is zero impact of corporate taxes, but you would be looking at fairly large changes before there was,Â and that would vary greatly by sector and by country. Empirically, in the lit reviews I have seen, investment is mostly driven by demand side factors not supply side ones. To imply that lowering corporate rates will lead to increases in investment and thus faster growth is seriously misleading.
So if you are on the fence about increases taxes on, say, Canadian banks, back to the levels they paid a decade ago, you need not fear an economic collapse.