Corporate Profits, Corporate Taxes and Business Investment
I have been reflecting a bit on the CME study of corporate taxes which Erin has previously covered quite comprehensively.
This subject is clearly very much in political play at the moment. With the Liberals and the NDPÂ opposing cuts to the federal corporate income tax rate championed by the Conservatives, it merits further debate.
The key argument made by Jayson Myers of CME is that there is a link between after tax corporate profits (or some proxy thereof) and business investment, such that increased profits result in increased investment, which raises GDP, which generates offsetting tax revenues from all sources for all governments.
I don’t dismiss this chain of reasoning out of hand. But I do think Myers over-states the linkage between after-tax profits and investment for theoretical reasons. At the end of this post, I have a Chart which also suggests a weaker empirical relationship.
As Erin noted, MyersÂ did not argue (as didÂ Neil Reynolds and Finance Minister Flaherty) that corporate income tax cuts are self-financing in the sense that corporate income tax revenuesÂ are unaffected by a rate cut. This is pretty important, since it confirms the Liberal and NDP argument that the federal government has to find other resources to finance corporate tax cuts or deficit finance them.
Myers does, however, argue that cuts to corporate income taxes are self-financing from a total government perspective given what he sees as very strong linkages from after tax profits, to cash flow, to business investment, to GDP growth.Â (See his Summary Table 1.)
If this were true,Â corporate tax cuts would not have to be financed by spending cuts or increases to other taxes,Â and we would be foolish to tax corporations at all.
I think the CME argument is far too strongly put. (Erin calls it voodoo economics.)
First, let us concede that profits and investment are linked. We should not argue that there is no linkage at all from after tax corporate profits to investment and thus to GDP growth. We do, after all, live in an open capitalist economy where the investment decisions which largely determine productivity in the business sector are based on maximizing rates of return to capital in a context of global competition for investment. Effective corporate tax rates will have some impact on investment decisions at the margin.
(As an aside which I will not elaborate upon, effective corporate tax rates in the absence of international co-operation and strong tax enforcement measures may divert the profits of companies operating in more than one country to the lowest tax jurisdiction, but that is a different issue.)
While effective tax rates may have some impact on investment at the margin,Â progressive economists (and many mainstream economists) would argue that the effective corporate tax rate is only one determinant ofÂ the after tax rate of return on capital, and a pretty modest determinant at that.
The main motivation for a corporation to invest is an expectation of profits from future sales of goods and services. This mainly boils down to demand side expectations. Thus auto companies will invest in new cars and new plant and equipment if they expect sales of particular products which generate positive margins to rise. That is why there is – as Erin noted – a strong correlation between GDP growth and growth of business investment.Â In upswings, sales will expand, capacity will be squeezed, and investments will be made. In recessions, sales will fall, unused capacity will rise, and expectations may be bleak. This will result in a fall in investment, even if corporations have cash in hand and confront very low tax rates.
On the supply side, corporate taxes are a factor in investment decisions but – as shown in, for example, the regular KPMG surveys of Canada’s international competitive position – they are only a small portion of total corporate costs. They will be one factor among many others in making a specific investment decision.
Ultimately, an investment will be made ifÂ expected returns exceed a hurdle rate ofÂ return. Canada does not have to be the lowest tax jurisdiction in North America or the world to sustain a set of good corporate investment opportunities so long as corporations can find other things they value – accessible natural resources; cheap power; good infrastructure; skilled workers; low benefit costs due to public health care etc. etc. (Many of these things have, of course, to be financed through taxes.)
Further, at any given time, especially in periods of strong economic growth, some corporations will be earning profitsÂ which exceed average and previously expectedÂ rates of return.Â If they anticipate continued high rates of return, an increase in effective rates of tax will not decrease investment so long as profitability remains above the threshold level. And any tax cut would make no difference to the investment decision but would simply result in lost government revenue.
This is the case today in much of the energy and minerals sector. An increase in the effective rate of corporate income tax would not slow investment, and any cut in the corporate tax rate will simply divert high resource rents from citizens to corporate shareholders (and half of the assets are foreign owned.)
Similarly, profitability has in recent years generally been much higher in the financial sector, and there is little reason to believe that bank and insurance profits are a major driver of business investment in the real economy. Higher taxation of excess corporate profits in these sectors could raise additional revenues at little cost in terms of lower real investment.
Further, it has to be underscored that the corporate income tax system is itself designed to tax profits retainedÂ within the corporation or paid out to shareholders, as opposed to profits which are put to productive use. Taxes apply only to profits as opposed to assets now that capital taxes have been scrapped. They do not apply to companies with losses, andÂ losses can be carried forward. Rates of return on capital are thus loweredÂ for very profitable companies, but not by much for those making modest profits. And there are generous depreciation rates for new capital investments, so rates of return on capital are not lowered very much for companies which re-invest a large share of their profits.
Put simply, taxing corporate profits amounts to squeezing, but not harming ,let alone killing, the goose that lays the golden eggs.Â There is scope for taxing corporate profits without squeezing real investment and GDP growth.Â And we could greatly improve any trade-off between revenue generation and impacts on investment by increasing the tax rate on excess profits while improving tax measures in support of real investment, such as refundable tax credits for investment in machinery and equipment. (Jayson Myers has championed investment tax creditsÂ in the past.)
One last point – I am skeptical as to whether there is a very close correlation between rates of return on capital and the level of business investment. As progressive economists have been noting for some time, high profitability in corporate Canada has not been accompanied by a very impressive investment record.
The Chart below shows return on equity(profit less extraordinary gains as a percentage of equity) , and non residential business investment as a share of nominal GDP, from 1988. (Data from the Canadian Economic Observer Historical Statistical Supplement. Table 7 and Table 38.)Â As can be seen, there are similarities in the movements of the two series. But there has been an upward trend in return on equity,Â while there has been no trend increase in business investment.