Corporate Income Tax Harmonization and Capital Allocation

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

Abstract

The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.

I. Introduction

The effect of taxation of income from capital on economic growth and the allocation of capital is a subject of great interest to both academicians and policymakers. Economic theory suggests that high rates of taxation are likely to discourage capital formation and that differences in tax burdens across countries can be expected to induce an inefficient allocation of capital. This issue is particularly relevant to the European Community, as the drive to remove all barriers to the free flow of goods, people and capital, under the Single European Act of 1987, will fully expose investment decisions to differences in tax burdens across member countries.

Attempts to quantify the importance of these distortions have been complicated by the intricacy of modern tax systems, where the effective marginal tax rate on income from capital depends in a complex way on the statutory tax rates, depreciation allowances and other rules underlying the computation of the tax base, as well as on macroeconomic variables such as the rate of interest and the expected rate of inflation. Earlier studies used average tax rates computed from actual tax collections as approximations for the theoretically more relevant marginal tax rates. 1/ More recently, following a study by King and Fullerton (1984), researchers have constructed standardized measures of the marginal tax burden on capital directly from the tax code. 2/ In this approach, effective tax rates are based, more or less explicitly, on the user cost of capital formula derived by Jorgenson (1967) from the neoclassical theory of the firm. The user cost of capital provides a comprehensive measure of the real marginal cost of capital to the firm, inclusive of taxes and economic depreciation. By subtracting depreciation and the rate of return on the underlying financial asset from the user cost, one obtains a measure of the effective tax on the marginal unit of capital in the form of a wedge, driven by taxes between the net marginal product of capital and the return to the owners of the firm. The advantage of this approach is that it allows us to compare tax wedges across countries, sectors, or hypothetical changes in the tax code.

Section II discusses the conditions under which differences in company taxation (as opposed to personal taxation of income from capital) provide a sufficient description of potential tax distortions in the allocation of real capital. In Section III, we construct measures of effective tax burdens on corporate investment income for the twelve EC member countries under present tax rules and five alternative harmonization proposals. The dispersion of effective tax rates across countries serves to illustrate the potential allocative distortions of the tax systems. The analysis is based on the assumption that international capital movements take the form of portfolio flows but, under certain conditions, the same results would apply to the case of direct investment.

In Section IV, the estimated effective tax rates are used in the context of a simplified general equilibrium model to assess the long-run allocative effects of the different tax harmonization scenarios. Given the simplistic assumptions underlying our model, the exercise serves merely to indicate the direction and broad order of magnitude of the effects of the tax changes under scrutiny. Concluding remarks are contained in Section V. Differences in the taxation of income from capital also distort saving behavior and affect the location of financial intermediation. These issues remain, however, outside the scope of this paper.

II. Capital Income Taxation in the Open Economy

1. Corporate and personal tax wedges

Taxes on the income from capital drive a wedge between the gross rate of return on real assets (p) and the net rate of return received by households on their financial claims on those assets (s). 3/ The distortionary effects of taxation can, in turn, be related to this wedge: its size affects the degree of capital accumulation 4/, while differences across countries distort the international allocation of capital and of savings, and the location of financial intermediation.

Because income from capital is taxed at both the company and personal levels—with some degree of integration provided in certain countries—the total wedge can be broken down into two components: the corporate tax wedge, measured as the difference between the before-tax rate of return on the real asset (p) and the market rate of return on the underlying financial asset (r); and the personal tax wedge, measured as the difference between the market rate (r) and the after-tax rate of return on the financial asset (s) from the point of view of the final investor.

The decomposition of the overall tax wedge on investment income into a corporate and a personal component is analytically convenient in addressing allocative issues among small open economies when international capital movements take the form portfolio flows, i.e., transactions in foreign financial assets normally not involving controlling ownership. The integration of financial markets implies that r, though affected by the average level of taxation, is determined in world markets. The personal and company tax wedges of each country will then have separate and specific effects only on the after-tax rate of return on domestic financial assets (s), and on the gross rate of return on domestic real assets (p), respectively. A tax on capital income at the personal level reduces s and only affects saving behavior. Differences in personal tax wedges across countries thus induce an inefficient allocation of saving, and distort the pattern of ownership of capital. A tax on capital income at the corporate level raises, instead, the level of ρ necessary to cover r, the cost of financing, and thereby reduces the size of the desired capital stock. Differential rates of taxation of capital income at the company level thus prevent equalization of the marginal rate of return from capital and induce an inefficient allocation of capital. 5/

The integration of personal and corporate tax systems, intended to alleviate the problem of double taxation, reduces the size of the overall wedge (p-s) but also complicates the breakdown into its two components. The reduction in the size of the overall wedge can either translate in a rise in s or a reduction in p, with very different implications for saving and investment. In a small open economy, the effect depends on the mode of application of integration: if the method of integration extends to foreign shareholders, it will effectively lower the required rate of return on the underlying financial asset, and the benefit will be entirely captured by domestic corporations in the form of a lower cost of capital (p); if the method of integration does not reach the foreign shareholder, then integration of the two tax systems has no effect on the rate of return on the financial asset and the benefit is fully captured by resident households in the form of a higher after-tax return (s). 6/

2. Implications for the European Community

In the section above it is argued that, with integrated financial markets and small open economies, the source of tax distortions to the allocation of capital can be reduced to differences in corporate tax wedges. 7/ The specific conditions under which this simplification holds for the European Community are examined in this section. The assumption of integrated financial markets appears to be broadly consistent with the abolition of capital controls and is, in any case, consistent with the goal of the Single European Act.

The small economy assumption is clearly more questionable since it cannot be supposed that all member countries of the European Community are price takers in capital markets. In larger countries, domestic demand and supply conditions could affect the rate of return on financial assets, and the personal tax system could, consequently, distort the relative cost of funding investment in domestic and foreign markets. Under these circumstances, the potential for allocative distortions could not be traced to differences in corporate tax wedges alone.

The integration of credit markets in the European Community provides an alternative condition that ensures the irrelevance of personal income taxation to the allocation of real capital. If domestic firms have access to foreign and offshore financial markets on the same terms as foreign enterprises, they can effectively avoid absorbing the gross-up effect of local personal and withholding taxes on financing costs. The lowest cost financial market would then become the marginal source of financing for all enterprises—the Eurobond market being a case in point—and taxes at the personal level affect inframarginal savers and investors and affect the location of intermediation.

Access to foreign and offshore markets cannot, however, neutralize the allocative distortions of taxes on financial investment income when the tax treatment of domestic assets is more favorable than that of offshore or foreign assets. Such is the situation of dividend taxation when integration of personal and corporate tax systems is limited to resident shareholders and/or to locally earned profits. 8/ In this case, through integration, the larger economies can effectively reduce the cost of equity financing of domestic investments. The problem cannot be easily resolved analytically and, in the calculations below, the small economy assumption is retained, i.e., any form of integration that does not reach the international investor is assumed to be passed on to domestic households in the form of higher after-tax returns, rather than to firms in the form of lower financing costs.

Another condition under which taxes on financial investment income would not affect the allocation of capital even among large countries is if the residence principle of taxation were enforced. 9/ Under this principle, taxes do not discriminate among assets but only on the basis of the residence of the investor. This guarantees the convergence of the rates of return on all financial assets and hence of the cost of capital to enterprises residing in different countries.

While investors in all EC countries are, in principle, taxed on this basis, the residence principle fails to hold for at least four reasons. First, uneven enforcement implies that financial investment income is often taxed at source only and differences in source taxation can therefore be reflected in asset prices. In many countries, the exemption of source taxation for non-residents has long provided an important conduit for tax evasion—especially under the shelter of anonymity provided by bank secrecy and bearer instruments. A second reason for the failure of the residence principle is that foreign assets may be subject to a heavier tax burden than domestic assets. This possibility arises when foreign withholding taxes are not fully creditable in the country of residence, a problem that applies mostly to tax-exempt institutions. A third reason is that, with differences in inflation rates and compensatory exchange rate adjustments, the effective taxation of foreign and domestic assets will diverge, even under the residence principle, if exchange rate gains and losses are taxed at a different rate than ordinary interest income, or simply taxed on a realized rather than on an accrual basis. Finally, the fact that integration of personal and corporate income taxes, when available at the national level, is usually not extended to nonresidents or to domestic recipients of foreign-source dividends creates another form of discrimination among assets, as discussed above.

In order to account for these complications, the allocative issue could be examined by constructing a matrix of tax wedges (or effective tax rates), inclusive of both personal and corporate taxes, associated with investment flows to and from each of the twelve EC member countries. This approach was adopted by Bovenberg et al. (1990), who construct bilateral tax wedges for portfolio investment flows between the U.S. and Japan. However, the inclusion of personal income taxation in the tax wedges may be misleading for our purposes. First, widespread tax evasion at the personal level, the proliferation of tax avoidance schemes (such as pension accounts and non-distributing mutual funds), and the uneven tax treatment of individuals and institutional investors make it difficult to construct comparable effective rates of personal taxation. Second, as discussed above, the availability of offshore financing limits the adverse effect of personal taxes and withholding taxes on the cost of capital at the margin.

Our analysis supposes that foreign investment takes the form of portfolio flows but, under specific circumstances, the results would extend to investment channeled through financial intermediaries, or taking the form of corporate direct investment. In the case of foreign investment undertaken by financial institutions, the same allocative implications would obtain if these institutions were competitive and intermediated capital income were subject to the same tax treatment as personal portfolio income. 10/ The analysis of foreign direct investment can be subsumed by the present analysis if foreign direct investment income is taxed only in the source country. This effectively requires that the country of residence not exercise any claim on that income. While practices vary widely, there are two cases in which this condition is met if foreign source income is exempt outright in the country of residence, or if taxes in the country of residence can be postponed indefinitely by deferring the repatriation of foreign profits. The first condition is applied less frequently than the second one which normally can be used for subsidiary income. In general, however, the complexity of tax practices with regard to foreign direct investment income would require a separate analysis. Again, a matrix of effective tax rates would have to be constructed for flows to and from each of the EC member countries. 11/

III. Corporate Tax Wedges

1. Methodology

The methodology employed in this exercise is based on the concept of the required rate of return or user cost of capital. 12/ A profit-maximizing firm requires a gross return on the last unit invested that allows the firm to pay market returns on internal and borrowed funds after covering depreciation and corporate taxes. Subtracting depreciation from the user cost (divided by the price of capital goods), a measure of the before-tax rate of return on capital is obtained 13/

p=[1/(1u)]*(1zuk)*(ρ+δπ)δ(1)

where u denotes the statutory corporate income tax rate, z is the present value of the depreciation allowance, k is the present value of investment grants, ρ is the firm’s marginal cost of capital, δ the rate of economic depreciation and π the expected rate of inflation. The discount factor (ρ) depends in turn on the market rate of return on the underlying financial instrument.

If we denote by r the market rate of return on the financial instruments sold by the firm to raise capital, we can define the corporate wedge as:

w=pr(2)

This expression can be converted into an effective marginal corporate income tax rate, expressed in terms of the before-tax rate of return:

t=(pr)/p(3)

In practice, there are as many “market” rates as there are sources of financing available to the firm. With debt and equity as the two broad forms of financing, a single composite market rate reflecting the financing mix of the enterprise can be constructed and a single wedge derived from it. The alternative, followed here, is to compute separate tax wedges for debt- and equity-financed projects and then calculate a weighted average. 14/

In the case of debt (subscript d), the appropriate measure of the real market return is clearly the nominal interest rate less the expected rate of inflation.

rd=iπ(4)

Since interest payments are deductible as expenses for tax purposes, the (nominal) marginal cost of funds is given by:

ρd=(1u)*i(5)

and the corporate wedge on a debt-financed investment project is given by

wd=pdrd=(6)=[1/(1u)]*(1zuk)*(ρd+δπ)δ(iπ)

For equity (subscript e), the computation is complicated by the fact that the required market return (re) cannot be directly observed. A convenient way to derive re is to impose an arbitrage condition requiring that the net, risk-adjusted returns on debt and equity be equal from the perspective of a representative investor, willing to hold both instruments. 15/ This condition can be expressed as:

re=rd+h(7)

where h is an exogenous risk premium. Consistent with the assumption of an internationally integrated capital market discussed in Section II, the arbitrage condition (7) must hold for the same representative investor for the whole of the EC. To make matters tractable, the representative investor is chosen to be an international (institutional) investor with a nonresident status in each EC member country. Since nonresident investors are generally exempt from withholding taxes on interest income, the net return from a debt instrument is then simply the real interest rate, rd, as in eq. (4). 16/

We can now work back from re to determine the marginal cost of equity finance to the firm (ρe). We assume that a fixed fraction (v) of the firm’s real yield on equity (ρe - π) is distributed as dividends. 17/ The real return paid out by the firm (ρe - π) and that received by the representative investor (re) can differ for three basic reasons. First, dividends paid to nonresidents are generally subject to a withholding tax (wt) (Table 1). 18/ As a result, part of the firm’s payout does not reach the investor, and for a given required return re and payout ratio v, this tends to raise the firm’s cost of funding. Second, because of partial or full integration of the personal and corporate tax systems, dividends may receive a preferential tax treatment over retained earnings in the form of a dividend tax credit or deduction, or a split rate system (Table 2). 19/ In that case, each dollar distributed by the firm may be worth more than one dollar to the investor. This effect would tend to reduce the cost of equity financing. The degree of integration is measured by the integration variable θ, defined as the opportunity cost of retained earnings in terms of gross dividends foregone. Finally, the undistributed portion of earnings is presumably capitalized in the price of the stock and can be taxed, in principle, at the investor’s level through a tax on capital gains. In practice, such taxes are virtually nil, either by statutory treatment or by virtue of the fact that they are levied on a realized rather than accrual basis. Considering all these factors, the firm’s marginal cost (ρe) of providing the required return to the marginal shareholder can Be expressed as:

Table 1.

European Community: Taxation of Equity Income, 1990 1/

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Sources: International Bureau of Fiscal Documentation; OECD.

Rates expressed in decimal form.

Typical rate under treaty.

Share of gross corporate income that reaches the resident shareholder after corporate and personal income taxes (top marginal tax rate) and any form of integration.

In parentheses if it only applies to domestic shareholders.

Corporate income tax inclusive of local taxes.

Rate on industrial company quoted on the Athens stock exchange.

Special rate for industrial enterprises.

If the withholding tax on dividends is taken as a final tax, no dividend credit can be claimed; a 7 percent dividend credit can be claimed, otherwise, against regular income tax (at a top marginal rate of 40 percent).

Table 2.

European Community: Summary of Corporate Tax Systems, 1990

Notes: — = Not applicable.Sources: International Bureau of Fiscal Documentation; OECD; Price Waterhouse; and various national sources.

National and local income tax combined.

Staff estimates of effective tax rates on the value of capital, excluding local property taxes on land and buildings.

Split rate system: first rate applies to retained earnings, second rate to distributed earnings.

Rate for industrial companies quoted on the Athens Stock Exchange.

Rate for industrial companies, to remain into effect till the year 2000. The standard rate for other companies is 43 percent.

Taxe professionelle.

Gewerbesteuer and net worth tax. Rates for debt and equity financed capital, respectively.

Net worth tax and business capital tax. Rates for debt- and equity-financed capital, respectively.

Machinery only.

Notes: — = not applicable.Sources: International Bureau of Fiscal Documentation; OECD; Price Waterhouse; and various national sources.

Denmark allows depreciation to start at the time the capital is ordered or construction initiated. Also the depreciable base is indexed to the price level.

The first rate applies to the first three years.

The first rate applies to the first year.

The first rate applies to the first ten years.

The first rate applies to the first four years, the second one to the following three years.

Share of the year over which depreciation is allowed in the first tax year.

Prorated from date of acquisition or installation.

ρe=(i+hπ)/(v*θ*(1wt)+1v)+π(8)

The before-tax rate of return on equity-financed capital (pe) can then be computed by substituting (8) into (1) and the tax wedge on equity is then derived as:

we=pere(9)

where re is defined as (i + h - ρe).

The derived tax wedges provide a comprehensive measure of the effective tax burden on capital income but cannot, obviously, capture differences in the degree of enforcement of tax collection and in the scope for tax avoidance through financial transactions across member countries. Moreover, the tax wedges cannot account for differences in the tax treatment of losses.

2. Simulations

Simulations illustrate differences in the effective taxation of income from capital under current systems and alternative scenarios. The degree of dispersion of tax wedges measures the potential for distortions in the allocation of capital across countries, by type of asset, and by form of financing. Corporate tax wedges for domestic investment are calculated under six scenarios for all EC member countries. Under each scenario, tax wedges are computed separately for buildings and machinery investment, financed with either debt or equity. The real interest rate is assumed to be constant at 5 percent in combination with two alternative inflation rate assumptions: 20/ a common inflation rate of 2 percent; and different inflation rates for three groups, namely, 2 percent for Belgium, France, Germany, Ireland, Luxembourg and the Netherlands, 5 percent for Denmark, Italy, Spain, and the United Kingdom, and 10 percent for Greece and Portugal. 21/

The six tax scenarios can be summarized as follows.

Scenario 1 is based on tax systems effective 1990, qualified by proposed tax reforms (Table 2). 22/

Scenario 2 assumes adoption of the following rules for the determination of taxable profits of enterprises by EC member countries: 23/ full first-year convention for depreciation, allowing enterprises to claim the full amount of depreciation the first tax year, irrespective of when in the year the investment actually takes place; reduction of the depreciable base by the amount of the subsidy received through investment tax credits and deductions; elimination of accelerated depreciation; elimination of depreciation of capital not yet in use (advance depreciation); elimination of indexation of the depreciable base; and straight-line or declining-balance methods of depreciation (assumed at 2.5 times the existing the straight-line rate) allowed for both buildings and machinery with switchover from declining balance to straight line during the life of the asset (Table 3). 24/

Table 3.

European Community: Tax Base Harmonization 1/

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Note:

+ = Increase in effective tax rate.

- = Decrease in effective tax rate.

… = No effect or no change relative to current practice.

Scenario 2 relative to current systems (Scenario 1).

In the SL case, Denmark is assumed to move from a two rate (.06,.02) system to a single rate of .05 over the life of the asset.

The rate of 0.10 is in lieu of a system of three rates (0.10,0.05,0.02) over the life of the asset.

Scenario 3 includes equalization of corporate income tax rates at the weighted EC average rate of 43 percent and elimination of local income taxes, 25/ in addition to assumptions under Scenario 2 (Table 4).

Table 4.

European Community: Statutory Tax Rate Harmonization 1/

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Note:

- = Decrease in effective tax rate.

… = No effect or no change relative to current practice.

Harmonization of corporate tax rates (Scenarios 3-6) and of dividend withholding and dividend credit rates (Scenarios 4-6) relative to current systems (Scenario 1).

Payout rate defined as share of profits reaching the shareholder after corporate and dividend taxation (inclusive of dividend credit).

Derived assuming a common 15 percent withholding tax rate and a 50 percent dividend tax credit.

National and local income taxes combined.

Scenario 4 includes the elimination of taxes levied on the value of assets or net worth in France, Luxembourg and Germany, 26/ in addition to assumptions under Scenario 4, and assumes the adoption of a common imputation system consisting of credit on dividends equivalent to 50 percent of the corporate income tax extended to both residents and nonresidents, and a common withholding tax of 15 percent on dividends paid to nonresidents (Table 4); only differences in depreciation rates and investment grants remain.

Scenario 5 assumes the equalization of tax rates and imputation systems and the elimination of capital based taxes and investment grants, but maintains current differences in depreciation rates and in the definition of the depreciable base.

Scenario 6 assumes complete equalization of company income tax systems; only inflation rates differ among the three groups of countries.

For each scenario, 48 different tax wedges (12 countries, 2 types of assets, 2 sources of finance) are computed, summarized in Tables 5-9. Effective tax rates, calculated from the average wedges over both sources of finance and asset types, provide a normalized measure of the overall tax burden on capital income in each country (Tables 6 and 7). 27/ Standard deviations capture the degree of dispersion in tax burdens across countries. Differences in the tax wedges across sources of financing (Table 8) and asset types (Table 9) reflect the biases of the tax systems. (Detailed tables are contained in Appendix II.)

Table 5.

Summary of Harmonization Scenarios

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Table 6.

European Community: Average Corporate Tax Wedges 1/

(Percentage point difference between the gross and the net-of-tax real rate of return)

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Weighted average over buildings (0.4) and machinery (0.6) and over debt (0.4) and equity (0.6).

Weighted mean and standard deviation, with weights corresponding to the countries share of the EC capital stock.

Table 7.

European Community: Effective Corporate Tax Rates 1/

(In percent of after-tax rate of return)

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Weighted average over buildings (0.4) and machinery (0.6) and over debt (0.4) and equity (0.6).

Weights correspond to the countries’ share of the EC capital stock

Table 8.

European Community: Corporate Tax Wedges, by Source of Financing 1/

(Percentage point difference between the gross and the net-of-tax real rate of return)

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Weighted average over buildings (0.4) and machinery (0.6).

Weights correspond to the countries’ share of the EC capital stock

Table 9.

European Community: Corporate Tax Wedges, by Type of Asset 1/

(Percentage point difference between the gross and the net-of-tax real rate of return)

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Weighted average over equity (0.6) and debt (0.4).

Weights correspond to the countries’share of the EC capital stock

3. Results

a. Current tax systems (Scenario 1)

Under the tax practices that are likely to prevail in the absence of any concerted harmonization, on average Germany appears by far as the highest corporate tax country (Tables 6 and 7). In the low tax range are, starting from the lowest wedge, Ireland and Luxembourg followed by Denmark, Belgium and the United Kingdom—the ordering of the last three depending on the underlying inflationary assumption. The other countries’ wedges all lie well within one standard deviation from the mean. The ordering of countries according to the average wedge is quite sensitive to the weights assigned to the two types of assets and sources of financing.

As seen in Tables 8-9, tax systems generally discriminate in favor of machinery and in favor of debt financing. The relative tax advantage accorded to investment in machinery reflects more generous tax depreciation allowances, though the results also depend strongly on the assumed rates of economic depreciation. 28/ On the financing side, the corporate tax systems uniformly result in a subsidy at the margin for debt-financed investments. The subsidy results mostly from the deductibility of interest payments from the corporate tax which lowers the discount rate below the market rate of interest. Inflation raises the advantage of debt financing because of the deductibility of nominal rather than real interest payments. Under both debt and equity financing, inflation reduces the present value of depreciation allowances, based on historical cost, except for Denmark where the depreciable base is indexed for changes the price level. 29/ The difference between the debt and equity cases also depends on the chosen arbitrage assumption, which excludes any effect on the cost of capital of integration systems that are not extended to nonresidents. Hence, the wedge under equity financing and thus the distortion in favor of debt financing would be smaller in the cases of Germany and Italy, under a purely domestic arbitrage assumption. The average wedges do not change significantly under alternative inflationary assumptions. In countries with a higher inflation rate, the advantages of the increased nominal interest deductibility appear to be broadly offset by the reduced real value of depreciation allowances, although the distortion in favor of debt increases.

b. Harmonization (Scenarios 2 through 5)

Under base harmonization (Scenario 2) most country wedges would fall, mostly on account of more liberal depreciation allowances—specifically, more than double declining balance for buildings and full first-year convention for all assets. Only Denmark, because of the elimination of advance depreciation and of indexation of the depreciable base, and Luxembourg, because of the reduction of the depreciable base by the value of the investment tax credit, would experience a rise in their average wedge. However, base harmonization would on balance contribute minimally to the convergence of effective tax rates, as reflected in the virtually unchanged standard deviation of country wedges. Germany would remain the highest tax country, and Ireland the lowest tax country followed by the United Kingdom, Luxembourg and France.

The equalization of income tax rates at 43 percent (Scenario 3), superimposed on base harmonization—but without equalizing depreciation rates—produces a more significant contribution to the convergence of country wedges with a reduction of the weighted standard deviation from 1.1 in Scenario 1 to 0.7. The remaining dispersion is due to country differences with respect to depreciation rates and, more significantly, to the degree of integration, investment tax credits, wealth and net worth taxes. Italy replaces Germany as the highest tax country, and the United Kingdom, Luxembourg and France assume the low tax positions.

The added elimination of wealth and net worth taxes and the equalization of the method and degree of integration (Scenario 4) cause a significant drop in both the average wedge and in the standard deviation. The drop in the average wedge is a direct result of the arbitrage assumption whereby the extension of the dividend credit to nonresidents is entirely passed on to firms in the form of a reduction in the cost of equity financing. Italy and Luxembourg appear as the two outlying countries at the high and low ends of the spectrum, respectively.

The harmonization of tax rates and methods of integration superimposed, however, on differing definitions of the tax base (Scenario 5), produces slightly less convergence of tax wedges than the previous case (the standard deviation falls to 0.5 percent instead of 0.3 percent). Moreover, the benefits arising from greater transparency of the tax systems and lower compliance costs for enterprises operating throughout the European Community would be lost as long as national definitions of the tax base continued to vary as they do at present.

c. Inflation non-neutralities (Scenario 6)

The distortionary effect of inflation differentials is illustrated with full harmonization of company tax systems. As mentioned above, inflation non-neutralities arising from the deductibility of nominal interest payments and from historical-cost depreciation allowances tend to work in opposite directions, and the resulting net effect of inflation on tax wedges is nonlinear. The tax wedge rises from 0.4 to 0.7 as the inflation rate is increased from 2 to 5 percent, but falls back to 0.6 as inflation is increased further to 10 percent.

In general, the results do not change markedly between the two inflation variants of the simulations, suggesting that the harmonization measures considered do not exacerbate the inflation non-neutralities inherent to the corporate tax systems. Also, the standard deviation of wedges under current or proposed systems (Scenario 1) is virtually the same under the two inflationary assumptions, indicating that present differences in tax systems do not, in an average sense, compensate for or enhance the distortionary effects of inflation differentials on effective tax rates.

IV. Estimates of Allocative Effects

1. The model

A simple computable general equilibrium model is derived in this section to explore the potential effects of differential effective tax burdens and of changes in tax systems on the allocation of capital in the EC. 30/ The model is based on fixed and immobile labor endowments and profit-maximizing competitive firms and uses the wedge calculations from the previous section to simulate the allocation of a perfectly mobile capital stock under various harmonization scenarios. Simulations are conducted under two different assumptions about the supply of capital. The first assumption is that of a fixed but mobile capital stock within the European Community. This assumption allows us to isolate and quantify, albeit in a very simplified way, the purely allocative and efficiency implications of harmonization, leaving aside the effects of tax changes on the total capital stock. 31/ In this framework, the interest rate—common to the whole EC—adjusts endogenously to satisfy capital market equilibrium. 32/ Within each country the wage rate adjusts to clear the labor market, and the level of output of each country is endogenously determined. Given fixed factor supplies, changes in the level of output of the EC as a whole provide a convenient measure of the efficiency gains and losses of alternative scenarios in comparative static terms.

The second assumption is that capital is fixed but mobile worldwide—the world consisting of the EC, Japan and the United States. In this context, changes in effective company tax rates can alter both the total EC stock of capital and its allocation among member countries. The two effects cannot be isolated, but this exercise provides a gauge of the pressures exercised on the rest of the world by changes in the level of taxation in the EC.

Within each country we consider a representative firm that operates under competitive conditions. There is a single good produced under constant returns to scale, with production function F(K,L), where K and L are the capital and labor inputs respectively. The representative firm of country i maximizes profits, given in equation (10):

F(Ki,Li)giLiciKii=1,2,,n(10)

where gi is the gross real wage (inclusive of any tax on labor use or income) and ci is the user cost of capital 33/

ci=(r+δ+wi)qi(11)

where r is the real market rate of return on the underlying financial instrument, δ is the rate of economic depreciation and wi is the corporate tax wedge and q is the real price of capital goods in country i. The model is solved using a Cobb-Douglas production function: 34/

Qi=AKi(1α)Liα(12)

with α estimated from labor’s share in GDP, and the scale parameter A set to reproduce the real interest rate assumed to prevail under current tax systems (Scenario 1). 35/ A capital demand function can then be explicitly derived from profit maximization:

Ki(ci)=Li(Aα/ci)1/(1α)(13)

At the aggregate level, the model is closed by requiring that factor and good markets clear. With fixed and immobile labor endowments (Ni) in each country, and fixed but mobile global supply of capital (S), the factor market equilibrium conditions reduce to:

Li=Ni(14)
ΣiKi(ci)ΣiNi[Aα/ci(r)]1/(1α)=S(15)

Given a fixed supply of capital, whether in the EC or in the world, the goods market clears implicitly in the absence of net saving or capital accumulation.

The equilibrium values of the interest rate, each country’s wage rate, capital stocks and output levels can then be expressed as functions of factor endowments and tax parameters. The country corporate tax wedges from the previous section—averaged over the two types of financing and assets—are substituted for wi in equation (11) and then in (13), so as to solve the model, subject to conditions (14) and (15). 36/

By construction, a uniform change in wedges (Δwi = Δw) has no effect on the allocation of the capital stock across countries (dKi = 0) and capital market equilibrium obtains through a one-for-one offsetting change in the interest rate (dr = - dw) so as to leave the cost of capital unchanged (Δc = 0). Only relative changes in tax wedges have real effects. Specifically, the relative change of a country’s capital stock attributable to a change in its tax wedge is inversely related to its size. A tax rate increase in a large country will reduce significantly both the world demand for capital and the world interest rate. The fall in the interest rate compensates partly for the rise in the cost of capital due to the tax change, with a consequently smaller proportional decline in the country’s equilibrium capital stock.

Meanwhile, the other countries benefit in terms of lower interest rates and higher capital stocks. In the case of a small country, the induced effect of a tax rate increase on the world demand for capital, and by implication, on the interest rate is negligible. Menwhile, the loss of own capital is proportionately larger and the spillover effect on other countries is insignificant.

There are several limitations inherent to this exercise. First, the magnitude of the allocative effects of differential tax burdens depends entirely on the assumed technological parameters. Although the assumed form and the parameter values of the production function are broadly consistent with available estimates, more sophisticated specifications could alter the magnitude of the effects. Second, the assumption of a fixed capital stock ignores entirely the effect of taxation on capital formation, savings and growth. Thus, the results obtained are of a static general equilibrium nature. Third, the analysis does not provide an explicit treatment of the government sector; in particular, it is assumed that budgetary measures compensating for changes in corporate taxation—which anyway account for a relatively small share of general government revenue in most EC countries—do not affect the production function or relative labor costs. 37/ Fourth, international capital flows take the form of portfolio claims on foreign capital and only corporate taxation matters, a reasonable assumption in view of the large role of institutional investors and widely-held corporations. Finally, the absence of country-specific risk is being approximated by the creation of a Community-wide single market.

2. Results

The first column of Table 10 shows the equilibrium solution after the equalization of after-tax rates of return on capital, with capital stocks measured relative to their estimated current, stylized “autarchy” values, and the corresponding change in potential output, which are necessary as a benchmark for the harmonization scenarios. 38/ The reallocation of capital predicted by the model is considerable, with Portugal and Ireland more than doubling their capital stocks and Germany losing nearly 40 percent over the long run. The allocative results of the model are driven by the assumption that corporate taxes confer no associated benefits and by the fact that there are no other determinants of differences in the rate of return on capital across countries than taxes and factor proportions. If taxes were benefit charges, tax rate differentials would have no allocative effects. Moreover, if appropriate consideration were given to all other nontax factors affecting returns, greater uniformity in after-tax rates of return adjusted for such factors may be found in the “autarchy” case. Alternatively, the result may be explained by the fact that capital has not yet fully adjusted to equalize expected rates of return, in which case capital tends to move toward countries with a higher than average after-tax rate of return. Higher than average after-tax rates of return may be the result, ceteris paribus, of either lower than average taxes—in which case the reallocation of capital would cause an efficiency loss—or of low capital-labor ratios—in which case an efficiency gain would ensue. The fact that overall EC output rises by nearly 2 percent indicates that the efficiency gain from the equalization of capital-labor ratios would outweigh the efficiency loss from tax-induced distortions, under this interpretation. An additional explanation for cross-country differences in the deviations shown in the first column is the likely measurement error inherent to the underlying factor proportions.

Table 10.

European Community: Allocative Effects of Tax Harmonization 1/

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Common 2 percent inflation rate.

Weights are calculated from the capital stock distributions for each scenario. Average wedges differ from those of Table 6, because the weights and the interest rate are recalculated for each equilibrium solution

The allocative effects of harmonization are measured relative to the equilibrium results of column 1, i.e. after equalization of after-tax rates of return. The indices thus reflect solely the effect of changes in effective tax rates under selected harmonization scenarios. Because factor supplies are assumed fixed, albeit mobile in the case of capital, the aggregate output index provides a measure of the efficiency gain from harmonization. As discussed in the previous section, harmonization of the base (Scenario 2) does not significantly reduce the dispersion of effective tax rates and consequently produces no efficiency gain, i.e. the aggregate output index remains unchanged. In the EC context (i.e., EC isolated from the rest of the world), the reallocation of capital reflects the change in the country ordering, with the largest proportional loss for Denmark (8 percent) and the largest proportional gain for France (4 percent). Besides Denmark, Luxembourg, Belgium, Italy, Ireland and Spain would also lose capital. The reduction in the dispersion of effective tax rates under the added harmonization of statutory income tax rates (Scenario 3) would not be sufficient to produce a noticeable change in aggregate output. Tax rate harmonization would produce a relatively large gain in capital for Germany (9 percent), followed by France (3 percent) at the expense of all other countries; at the other end, Ireland would experience the largest proportional loss (16 percent). A small gain in overall output (0.1 percent) appears under complete harmonization (Scenario 6). Relative to base and rate harmonization (Scenario 3), most changes in capital stock would result on account of the elimination of investment tax credits (Luxembourg and Spain), the elimination of capital and net worth taxes (France, Germany, and Luxembourg) and the reduced cost of equity financing due to integration. The last change would affect all countries except France the United Kingdom where the effects of integration on the cost of capital are already accounted for in the arbitrage assumption.

By construction, the average wedge declines as harmonization is broadened from base to rates, with a consequent rise in the demand for capital. In the EC context, capital market equilibrium is restored through a rise in the interest rate. In a “worldwide” context, however, the rise in the interest rate spills over to the United States and Japan, forcing a reallocation of capital towards the Community. The net inflow of capital to the EC reduces the size of the capital losses—which in some instances turn into a gain—and raises the magnitude of the gains of individual countries. This effect derives purely from the specific (average) effective tax rate towards which the EC would converge. The large loss of capital for Japan and the United States due to complete harmonization (Scenario 6) relative to base and rate harmonization (Scenario 3), owes largely to the effect of integration on the cost of capital in the EC under the chosen arbitrage assumption. By assumption, the extension of corporate-personal tax integration to all EC residents (but not necessarily to non-EC residents) is fully passed on to the firm. How much the extension of integration to all EC residents can in practice contribut