Corporate Income Taxation

We have stressed that tax incidence must be traced to people, since corporations cannot bear the burden of a tax. Why then tax corporations at all? There are several possible justi…cations. First, there are valuable bene…ts, such as limited liability, to incorporation. The corporate tax could be seen as simply a tax on that value. However, the current corporate tax system does not re‡ect a sensible tax on this bene…t since it is based on income. Limited liability is actually less valuable as pro…ts increase, so an income-based tax does not correspond to this rationale at all. Furthermore, the infrastructure the government provides to corporations, such as the regulation of capital markets, has a marginal cost near zero. E¢ ciency requires that the price of these bene…ts be equal to their marginal cost, so using the corporate tax as a fee for those services implies a corporate tax of near zero. A second rationale often given for taxing corporations is that they may earn some pure economic pro…ts, pro…ts that are in excess of the return to capital. This does not, of course, justify taxing such pro…ts at the corporate level rather than when the individuals owning the corporation receive them. The corporate tax is also seen as a way to soak up foreign tax credits or export taxes to foreigners who own capital. Since individuals who live in other countries cannot be taxed on their income, the corporate tax is a way to get at their income from domestic assets indirectly. Such tax exportation is di¢ cult for small countries, since taxes on domestic capital cause capital ‡ight. A large country may be able to force investors to accept a lower return and thereby export some tax. Finally, the corporate income tax can serve as a backstop for the personal income tax. Individuals may try to avoid the personal income tax by making it di¢ cult for the government to observe the recipients of corporate income. In this case, it may be more e¢ cient to tax corporations instead. Each of these rationales for the corporate income tax has speci…c implications for how an e¢ cient corporate tax will be structured.