Corporate Tax

Company tax cuts won’t increase development – Philip Heimberger and Sebastian Gechert

The global “race to the bottom” in corporate taxation over the past few decades has implied that this will fuel growth. But does it do that?

Philipp Heimberger

Researchers have long had the idea that corporate tax cuts could boost economic growth. The claim that a spate of corporate tax cuts will lift all boats with more growth has been a core element of the supply-side economy, from the US presidency of Ronald Reagan in the 1980s to the opportunistic power politics of his eventual successor Donald Trump. And in the current economic policy debates on recovery from the pandemic, this idea has found political supporters in a number of European countries – including the conservative and liberal parties in Germany, which are facing the federal elections in the autumn.

Corporate tax cuts, economic growthSebastian Geschert

The perceived impact of corporate taxation on growth is also relevant to the recent G7 and G20 debate on a global minimum tax rate for multinational corporations and, if there is one, the level of the threshold. While Joe Biden’s new administration argues that the growth effects of previous tax cuts have often been exaggerated, those who argue with caution counter that a minimum tax will have a negative impact on growth – and the higher the minimum, the greater the impact.

Economic theory

One camp argues that tax cuts will increase profit margins, stimulating investment and hence growth and employment; the other doubts this mechanism and points to the opportunity cost of lower tax revenues. But what does economic theory suggest?

In the neoclassical growth model around the experienced US economist Robert Solow, long-term growth arises through exogenous technological progress. Tax policy can then “only” influence the level of gross domestic product and the transition to steady growth. Lower corporate taxes encourage companies to save and invest and thus imply higher GDP in the long term.

In newer “endogenous” growth models, corporate tax cuts can also have a positive effect on the long-term growth rate by increasing overall factor productivity (which goes beyond the discrete use of capital and labor) and innovation. Since the ultimate tax incidence would anyway be borne by the natural persons (shareholders, employees and consumers) and the tax passing on is associated with losses in efficiency, some standard models argue that the optimal corporate tax rate should therefore be zero.

However, others argue that higher taxation on capital can fuel economic growth by shifting the tax burden away from work and / or by funding productive government spending. Since corporate tax cuts also tend to benefit richer households with less propensity to consume, they generate only weak growth on the demand side. The supply-side effects are also likely to be significantly weaker if they benefit households with higher incomes.

Nonetheless, the prevailing theoretical prediction on which most empirical work is based remains that corporate tax cuts will encourage growth.

Empirical studies

Empirical studies have examined the growth effects of corporate taxation for different groups of countries and time periods using different data sets and econometric methods. Relevant factors are how studies measure tax changes (be it in the legal or effective rates or the income accruing in relation to the output), how they address endogeneity (because growth in turn influences tax revenues), whether they are geared towards short-term or long-term effects Which countries and time periods they choose and whether they control other budget components (other taxes or government spending).

A careful reading of the literature suggests that the reported results vary significantly. Some studies find significant and robust positive growth effects from corporate tax cuts. However, others report significantly negative, insignificant, or mixed results.

In a meta-review we collect 441 estimates from 42 primary studies. We use the meta-analysis toolbox to analyze how large the precision-weighted effect (which attaches greater significance to studies with more accurate results) turns out to be when corrected for factors that can bring about a bias. And we provide model-based results on the impact of certain data and specification options on the estimates given in the literature.

Positive growth effects imprecise

The following graphic shows that the results are indeed widely spread and show different levels of accuracy. The strongest positive growth effects of corporate tax cuts reported in the literature tend to be imprecise: they have large standard errors. The unweighted average of all studies suggests that a one percentage point decrease in corporate tax is associated with an increase in economic growth of about 0.02 percentage points per year – a moderate but significant effect (a 10 percent decrease in corporate tax rates would be an annual GDP growth increased by 0.2 percentage points).

Corporate tax cuts, growth

However, this result could be influenced by the selection in the publication process: study authors and journal editors may prefer results that are in line with the theory and significant, which leads to publication bias. A look at the correlation between the estimated effect size and its standard error can help determine whether there is such a bias – otherwise econometric theory suggests that there should be no systematic correlation.

However, we note a negative and significant correlation, suggesting that the growth effects of corporate tax cuts are being overstated. If we control the impact of this publication bias, we are left with no positive effect of corporate tax cuts on growth rates – we can no longer reject the hypothesis that the effect is zero.

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We confirm this result by using different approaches to detecting publication bias. All of our estimates find a negligible effect of corporate tax cuts on economic growth, close to zero. Publication of a statistically significant, growth-enhancing effect of a corporate tax cut is four to five times more likely than publication of an insignificant effect.

More insights

Our study provides some further insight into the factors relevant to explaining higher or lower growth effects of corporate tax cuts.

First, country samples (members of the Organization for Economic Co-operation and Development or non-OECD countries) do not seem to make any significant difference in industrialized countries compared to emerging countries. Second, more recent studies tend to find less growth-promoting effects of corporate tax cuts. Third, the control of government spending seems relevant: tax cuts are somewhat more conducive to growth if government spending is not cut at the same time. This finding is in line with the theory of endogenous growth, which suggests that using government revenue from corporate taxation to increase (productive) government spending can have positive effects on growth.

Our results suggest that the prominent role that corporate tax cuts play in political debates is exaggerated. While tax cuts have stimulated international tax competition over the past few decades, they do not appear to encourage growth.

Corporate tax cuts, economic growth

Philipp Heimberger is an economist at the Vienna Institute for World Economic Research (wiiw) and at the Institute for Comprehensive Economic Analysis (Johannes Kepler University Linz).

Corporate tax cuts, economic growth

Sebastian Gechert is head of the Macroeconomics Department of Income Distribution at the Institute for Macroeconomic Policy (IMK) In Dusseldorf.

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