A profit tax is not a capital tax
I have spent some time speaking with tax policy experts inside and outside the Biden administration, and one point they are making is that what seems obvious – taxation of profits, is preventing companies from investing that they otherwise make could – is not at all obvious.
Imagine a company considering borrowing money to invest in a new project. If there was no corporate income tax, it would continue exactly when the return on the project was expected to exceed the interest rate on the loan. Now suppose there is, for example, a profit tax of 35 percent. How does this change the company’s decision? It doesn’t.
Why? Because the interest on the loan is tax deductible. When debt finances investments, corporate income taxes only fall on returns above the interest rate, which means they shouldn’t affect investment decisions.
OK, not all investments are debt-financed, although that itself poses a mystery: there is a clear tax benefit to issuing debt rather than selling stocks, and the question of why companies are not leveraging more is subtle and difficult. The immediate point, however, is that corporate income tax is not a capital tax, but a tax on some aspect of the company’s financial structure. Analysis – mine included! – who simply treat it as if they are increasing the cost of capital are far too generous for tax reductions.
Business investments aren’t that sensitive to the cost of capital anyway
Suppose we ignore interest deductibility for a moment and consider a company that for some reason is funding all of its investments with equity. Also, imagine that investors know they can make a return in the global marketplace. In this case, they require the company to earn r / (1-t) on its investments, where t is the rate of corporate income tax. This is how the proponents of Trump’s 2017 tax cut saw the world.
Under these conditions, cutting t by reducing the required rate of return – ultimately by lowering the cost of capital – should encourage companies to increase US capital. For example, the tax foundation predicted that its share capital would grow 9.9 percent, or more than $ 6 trillion.
However, these predictions missed an important point: most corporate resources are relatively short-lived. Equipment and software are not like houses, the useful life of which is measured in decades, if not generations. They are more like cars that are usually replaced after a few years. In fact, most business investments are even less durable than cars. They generally wear out or become outdated pretty quickly.