Do Corporate Tax Cuts Boost Investment Over the Hurdle?
Andrew Jackson has engaged perhaps the strongest theoretical argument for corporate tax cuts: that they make more new investments viable by lowering the pre-tax return needed to get over an after-tax hurdle rate of return. (Indeed, I remember the C. D. Howe Instituteâ€™s Finn Poschmann lionizing Andrew Coyne for making this argument halfway through TV Ontarioâ€™s last post-budget panel.)
Imagine that a corporation needs at least a 10% return to justify making new investments. When Canadaâ€™s combined federal-provincial corporate tax rate was 36%, only investments with a pre-tax return of 15.6% or more would have cleared that hurdle (15.6*(1 – 0.36) = 10).
With Jim Flahertyâ€™s target corporate tax rate of 25%, investments would need a pre-tax return of only 13.3% (13.3*(1 – 0.25) = 10). So, recent corporate tax cuts should prompt the corporation to make some tranche of new investments with pre-tax rates of return between 13.3% and 15.6%.
But as Andrew Jackson notes, investments with pre-tax returns above 15.6% would have happened anyway. On all of those investments, corporate taxes were a perfectly efficient and costless source of public revenue. Corporate tax cuts were a pure giveaway that did nothing to improve incentives.
Also as noted by Andrew, pre-tax rates of return are not constant. If there is insufficient demand for a corporationâ€™s output, the potential return on new investments will be close to zero. Public spending financed by corporate taxes can get potential investments over the hurdle by increasing demand and/or by providing needed inputs like infrastructure.
The hurdle rate of return is not constant either. If an investment is financed with debt, then its return must exceed the interest payments on that debt.
Critically, interest payments are deducted from profits in tax calculations. Corporate income tax does not touch the returns needed to cover interest costs and applies only to returns above that hurdle. (As Paul Samuelson demonstrated back in the 1960s, corporate tax does not affect investment decisions if interest is deductible.)
Of course, the cost of equity capital is less clear. But it seems reasonable that investments financed with equity will be made only if the return at least equals any dividends due on the newly issued shares.
For Canadian shareholders, the dividend tax credit refunds all corporate taxes on profits paid out as dividends. So, corporate taxes do not cut into the returns required to justify Canadian equity investments.
Foreign shareholders do not receive the dividend tax credit. But if the foreign shareholder is a US corporation, it ultimately faces a 35% tax rate. Cutting Canadian corporate taxes below that rate does not increase its after-tax returns.
More broadly, other factors like generally low business costs, a well-educated workforce and abundant natural resources make pre-tax returns higher in Canada than in many other countries. As Jayson Myers admits, corporate tax cuts have had no apparent effect on inflows of foreign investment.
Canadian corporate taxes do not decrease returns paid as interest, distributed as Canadian dividends, or repatriated by US corporations. Therefore, corporate tax cuts will not help investments funded by debt, Canadian equity, or US corporations get over a hurdle rate of return.
To a substantial extent, corporate taxes just skim off excess profits from investments that are already over the hurdle. Rather than simply defending corporate taxes as a necessary source of revenue, there is a case to be made that they are a particularly efficient means of raising revenue.