Tuesday, January 10, 2012

The corporate tax Laffer curve

Given the mobility of the headquarters of financial holding firms, there is much more diversity in corporate tax rates than tax competition would call for. Looking at OECD countries, the effective tax rate peaks at 40% in Japan and the US, while it is half this, or below, in other countries. Given the high mobility, would it be government revenue maximizing to reduce the tax rate in the US or Japan? In other words, are these two countries to the right of the Laffer curve peak?

Kazuki Hiraga asks this question for Japan, but in a closed economy, thus ignoring international tax competition. Japan is still on the wrong side of the corporate tax Laffer curve. Decreasing the tax not only increases tax revenue, it leads to more growth through stronger capital accumulation. Add tax competition, and you have even better reasons to cut the corporate tax rate. Hence, the argument likely also applies to the US.

But wait a moment, let us have a look at the model. It is a standard real business cycle model with various distortionary taxes. The collected revenue is rebated in lump-sum fashion to households, which own the firms. In other words, this is a model where taxes a never optimal. Indeed, nothing useful is done with tax revenue, and there is no redistribution going on. No need for fancy solution techniques to understand the results...

1 comment:

NormanB said...

A lesson not learned comes from the Japanese Real Estate Profits Tax code. It is this that resulted in the Japanese Bubble and its subsequent pop.

Prior to 1990 profits on real estate sales were taxed at 90%. Obviously, this dried up the supply of properties available for sale. This in turn produced a rise in real estate prices. This rise in prices more than enduced banks to loan on property (both on new buildings and refinancing) as they were protected by rising equity on their loans. The BOJ seeing how great things were going found it easy to rationalize increasing the money supply. And on and on until the land under the Imperial Palace if normalized in price by the land surrounding it had a 'value' of all of the real estate in the state of California.

A real life, distasterous experiment in taxation. Unfortunately, this is forgotten and to my knowledge never written about nor explained.