Higher corporate taxes aren't a fiscal gold mine

Last week the Alberta NDP asked the provincial government to release its cost estimate for the “Job Creation Tax Cut,” its name for a reduction in the provincial corporate tax rate, from 12 to eight per cent. Since losing the 2019 election, the NDP has repeatedly claimed the four-year cost would be $4.7 billion, which is obviously substantial. But that back-of-the-envelope estimate ignores how lowering corporate tax rates can enlarge the tax base.

Economic studies regularly find that lower corporate tax rates encourage investors to put profits into a jurisdiction. Alberta now has the lowest general corporate income tax rate in Canada, which will encourage many companies to move profits there, thus expanding the province's corporate tax base even in a recession. If president-elect Joe Biden eventually gets his way and raises the federal U.S. corporate income tax rate from 21 to 28 per cent, Alberta's combined federal-provincial rate of 23 per cent could be the lowest in North America. That would be a boon for its economic and fiscal prospects in a post-COVID world.

Judging the effects of rate cuts isn't easy, however. You have to disentangle the effects of booms, busts, monetary policy and changes in tax rules from the impact of rate reductions. The government's pre-COVID 2020 budget estimated that, taking into account investment and tax planning effects, the rate reduction would cost half what the NDP estimates. But even that might turn out be unduly pessimistic, according to a new paper —

“Why is corporate tax revenue stable while tax rates fall?” — by distinguished German tax economist Clemens Fuest and co-authors, Felix Hugger and Susanne Wildgruber.

Using a financial database covering 33 countries and 2.5 million companies, the economists find that between 1995 and 2016, the average OECD corporate income tax rate fell by almost a third, from 37 to 24 per cent. At the same time, however, pre-tax profits rose as a share of corporate value-added, effectively cancelling out any revenue loss from the rate cuts.

About 37 per cent of the growth in the corporate tax base was from lower interest expenses (net of financial income). The declining interest rates of that period should have encouraged companies to borrow more. They did, but only a little as a share of assets, as the reduction in corporate tax rates reduced the tax saving from issuing (tax-deductible) debt.

Another 37 per cent of the growth in the tax base was due to lower depreciation costs as a share of value-added — either because of a shift to longer-lived and knowledge-based assets or because of less investment in buildings and machinery overall. Again, with deductible costs lower, more income is eligible for taxation.

The rest of the base growth was due to a rise in pre-tax earnings, the result of more investment, productivity and tax planning to put profits into jurisdictions where corporate tax rates have been reduced. With the corporate tax base expanding, just about every industrial sector except construction paid more tax over the past two decades despite the decline in corporate tax rates.

Many other factors affect corporate tax revenues, of course. Regulatory and economic considerations caused the corporate share of the economy to expand in many countries. Lower corporate rates themselves encouraged owners to choose incorporation over sole proprietorships or partnerships, for which tax rates did not change in many countries. Limits on deductions for capital expenses and corporate losses also expanded the corporate tax base.

There is widespread angst about multinational companies not paying their “fair share” of taxes. But Fuest and his colleagues show that while the corporate tax rate declined by over 17 percentage points on average in the 33 countries over the two decades they studied, corporate tax payments as a share of value-added did not change at all.

The paper also looked at high-tax countries (France, Germany, Italy, Spain and the U.K.). From 1995 to 2016, Germany was most aggressive with its corporate tax rate, cutting it 29 points, followed by Italy at 22 points. (France's cut was only three points.) In the high-tax countries, the average rate cut was 19 points yet the tax base rose 8.2 percentage points as a share of value-added, almost the same as in other countries.

If profits remain the same, a rate reduction does lower corporate tax revenues. But if the tax base grows enough, lower rates may even bring higher tax revenues. Several studies suggest the revenue-maximizing corporate rate lies between 26 and 33 per cent. Anything above that and tax revenues actually fall.

The Alberta NDP raised the corporate tax rate from 10 to 12 per cent in 2015 and predicted revenues would rise as a result. They didn't. Falling oil prices and federal policies clearly hurt profits. But the rate hike also discouraged industries from investing or keeping their profits in Alberta. Based on the German analysis, the NDP rate hike may have raised very little corporate tax revenue.

Alberta's experience is a lesson for the new U.S. administration. If Joe Biden is hoping corporate tax rate hikes will pay for all his new social policy changes and the Green New Deal to boot, he's going to be disappointed.

DISCOURAGED INDUSTRIES FROM INVESTING OR KEEPING THEIR PROFITS IN ALBERTA.