Sunday, April 8, 2007

How To Tax Corporations - And Grow The Economy Doing It

Optimal Corporate taxation is something that I have been thinking about for a while and it comes up on in the comments on Greg's Kennedy Tax Cut post.

A few of my readers will be scratching their heads now, wondering when I missed the lecture that the optimal tax rate on corporations was zero. If we tax income or consumption then why in the world would we want to slap a separate tax on a particular form of income that will eventually be used for consumption. Isn't the essence of the corporate tax distortion and inefficiency.

Maybe. Almost Certainly as it is now designed. However, I am not convinced that an optimally designed corporate tax would be distorting - at least not in a "bad" way.

The basic problem as I see it is not that the corporate tax represents double taxation. Its that it represents one sided taxation. Allow me to explain.

Corporations pay taxes when they earn a profit and they don't when they take a loss. This is all wrong. When corporations take a loss they should still have tax liability, its just that the liability should be negative.

Paying taxes on profits but not on losses discourages risk taking and innovation. If you stick your neck out and you win, you only get a fraction of your winnings, if you loose, however, you loose the whole enchilada. That doesn't seem like such a great deal.

What if on the other hand, when you lost, you didn't loose everything? What if the government covered the same fraction of your losses that it takes from your winnings? What would that do to risk taking?

Well, its pretty straight forward to show that if the world works the way we think it usually works, then this type of tax could actually encourage you to take more risks.

Why?

Well, because for most people the pain of loosing is greater than the joy winning the same amount. This is why people will pay money to take out insurance. On average people would be better off just putting the money they pay towards insurance premiums in a rainy day savings account. However, sometimes your account would be more than enough to cover your losses and sometimes it would come up short.

People don't want to take that risk so they fork over a little bit more to an insurance company that promises to come through for you with exactly the right amount each and every time.

A similar logic would apply to investors. Without any corporate tax, you win what you win and you loose what you loose. With my kind of corporate tax you win part of what you win and you loose part of what you loose. Its almost like insurance for investing.

That type of insurance makes investing safer and perhaps more attractive. Now because on average corporations win more than they loose the tax will tend to raise revenue. That also means that the tax will be reducing returns more than it will be shoring up losses and so the average return to investors will also go down.

The question is how the trade-off between risk and reward under the tax will effect investment. As far as I can tell right now this is an empirical question. By that I mean that I don't think there is anyway I can figure that out by just thinking about it. Someone has to actually go out and gather data on risks and rewards to find out.

If someone is interested in doing that with me, by the way, let me know.

Depending on what I (we) find the optimal tax rate on corporations could be zero, positive or even negative. Its negative if it turns out that we can increase economic growth by actually rewarding corporations when they make a profit and taxing them when their down. Though, I don't think the idea of sending billions to high profit tech companies while pouring salt into the wounds of the dying auto industry is going to win very many sponsors in Congress.

There are some additional fuzzy details like:

1) Even if we can increase investment by taxing corporations does that mean its optimal? Maybe we will end up with too much investment. I don't think that's correct but it needs to be worked out.

2) How exactly do you plan to pay some of a corporation's losses? Isn't this a prescription for fraud?! I have some ideas about this one. The short story is that I would pay them in a special way that makes it more difficult to cheat.

More on all of this later.

Oh and by the way this has nothing to do with the paper idea I had a few days ago. Which by the way I need to get back working on . . .

Side Note: Angry Bear gets in on the general tax/growth theme.

14 comments:

Anonymous said...

Karl, if you succeed in doing this, you would be a strong contender for the John Bates Clark Medal.

Anonymous said...

Karl Smith for Nobel Prize in Econ in 2041.

Chris said...

Very interesting and the type of creative solution I come to expect from this blog. I do worry about #1 of your fuzzy details. We might not be risking "too much" rationale investment (though I do this is a very valid concern, increased access to capital does lead to MORE risky investing, so companies would not "win more than they lose" to the same degree.) I do think we would certainly run the risk of irrational investment, bubbles might multiply in degree.

This would seemingly shift American business toward the singular multi-divisional corporation model, such as that found in China. Divisions compete, but the corporation absorbs a degree of the divisions' risks. in your model, companies would compete, and the loss insurance would perform a similar role. For the record, I think this is positive, and avoids the pitfalls of the Chinese multi-divisional corporation model.

Your proposal would be akin to 'Worker's compensation' -- designed to help participants recover from injuries sustained participating int he market and reengage the market as soon as possible. In both cases, a negative externality may be an increased willingness to absorb risk. The difference between the plan and worker's compensation, however, is telling of a potential shortfall. Workers have relatively little incentive to push themselves to the point of injury when compared to the head of a corporation, who's financial incentive is much more direct and significant.

But yes, I would certainly be interested to read empirical studies, but I am a bit wary of the nightmare of technocrats deciding what tax rates would not lead to unproductive investing. I would be concerned of such a system being perverted by the interested powers into a oppressive apparatus for the rich owners to force all of society to underwrite their adventures.

We don't want good companies running ground because of bad luck or a single bad decision, but we also don't want 'The Producers.'

Yancey Ward said...

Karl,

Just a note on your spelling, and you are far from the only person who does this, but the words are spelled "lose" and "losing", not "loose" and "loosing".

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