The Cost of Corporate Taxes

Chang-Tai Hsieh and Jonathan A. Parker say: don't tax retained earnings--especially in countries where cost differences between internal and external finance are large:

Taxes and Growth in a Financially Underdeveloped Country: Evidence from the Chilean Investment Boom: NBER Working Paper No. 12104 March 2006:

Abstract: This paper argues that taxation of retained profits is particularly distortionary in an economy with good growth prospects and poorly developed financial markets because it primarily reduces the investment of financially constrained firms, investment that has marginal product greater than the after-tax market real interest rate. Contrarily, taxes on distributed profits or capital gains primarily reduce the investment of financially unconstrained firms. Chile experienced a banking crisis over the period from 1982 to 1986 and in 1984 reduced its tax rate on retained profits from 50 percent to 10 percent. We show that, consistent with our theory, there was a large increase in aggregate investment after the reform which was entirely funded by an increase in retained profits. Further, we show that investment grew by more in industries that depend more on external financing, according to the Rajan and Zingales (1998) measure. Finally, we present some weak evidence from comparisons of investment rates across firms for several different measures of their likelihood of being financially constrained.

Comments

[robert waldmann]

Damn why didn't I think of that? Know anyone who wanted an equipment investment tax credit ?

Thanks for the link to a great paper and kudos for not saying "I told you so".

[Charles]

Robert Waldmann is correct.

This falls in the pigeonhole labeled, "If you throw enough money at a problem, you may succed in smothering it. You will also have no money for any other problems."

Targeted tax credits, yes. Burden shifting, no.

[masaccio]

Maybe someone could study the effect on investment in nations where we quit taxing large corporations altogether, like maybe here.

[anne]

A fine and timely paper, but there is a problem that is shown in Brad DeLong's interesting heading. The problem in development has long been how countries, especially resource rich countries, are to capture both investment that will involve technology transfer and a tax base from enterprise that will serve for infrastructure development and building a social safety frame. Latin America is thinking through these issues in light of Chinese or Brazilian development paths. Africa can also think to China and South Africa.

[anne]

There must be a cost of international investment, China has shown that a cost of technology transfer can be most powerful and actually Ireland followed an interestingly close model to China as well. Bolivia is a mountain of natural gas; how to capture the enormous value for the Bolivian people for whom the value of the gas resource has been an illusion?

[anne]

http://economistsview.typepad.com/economistsview/2006/04/latin_american_.html

April 13, 2006

Latin American Populism

Jeffrey Sachs finds reasons to be encouraged by recent developments in Latin American politics:

Populists Can be Right, by Jeffrey D. Sachs, Project Syndicate: Does the rise of left-leaning governments in Latin America, particularly the election of Evo Morales as President of Bolivia, presage a shift to the hard left across the continent? Does it mark a repudiation of United States foreign policy in the region? Will it, for example, lead to a re-nationalization of Bolivia’s vast natural gas deposits?

These are vital questions, but they miss the larger significance of the rise of someone like Morales, for he is Bolivia’s first indigenous elected head of state. His victory marks a step forward in Latin America’s overall democratization, with positive long-term significance for economic and social development in the region.

To understand why, it is helpful to take a broad view of Latin America’s history and economic development. The societies of the Americas were forged by European conquests of indigenous populations, and by the racial and ethnic divisions that followed....

The Europeans who conquered and colonized the Americas after 1492 did not find vast empty lands, as they sometimes proclaimed, but rather lands populated by communities dating back thousands of years. A large portion of the indigenous populations quickly succumbed to diseases and hardships brought by the European colonizers, but many survived, often in dominant numbers, as in Bolivia and much of the highlands of the Andes mountain region.

Almost everywhere, these surviving indigenous populations became subservient members of European-led societies. The Europeans then brought millions of African slaves to the Americas. After emancipation in the nineteenth century, the African-American communities remained impoverished and largely bereft of political rights.

Thus, vast inequalities of power, social standing, and economic well-being were part and parcel of the forging of the Americas. Indigenous, African-American, and mestizo (mixed) communities have been fighting for their social, political, and economic rights ever since.

Democracy in Latin America has been a hard-won struggle....

[anne]

There is reason to be encouraged by what appears a determined democratic activism gradually coursing through Latin America with an aim at broad spread and increasingly equitable economic development. What troubles me is a lack of participation in development projects by the United States. Why are we so short-sighted?

[ilsm]

Latin America looks to Spain more than the US.

Maybe the Spanish American War, maybe the Monroe Doctrine. Possibly Bush roll on toward fascism.

I think we are the second choice of many in the hemisphere.

Liberalizing Spain is a boon to this hemisphere.

They see Spain very bright since Juan Carlos eveolved after Franco's passing.

[anne]

An important comment, for Spain has been especially active through South America and we should pay attention to how this benefits both Spain and countries attracting significant Spanish investments. Spain has become much the banker of South America.

Also, I am increasingly intrigued at the remarkable strength of Brazilian currency, with seemingly no negative growth effect. Could growth in Brazil be more robust than I have recently assumed?

[anne]

Then, there is Chile; though Chile has been used for a model of development for 15 years, I find the rate of growth disappointing and the extent of equitable growth more disappointing. Chile has seemingly paid an awfully high cost for foreign investment, when the investment might have been as robust with more technology transfer to or infrastructure development for Chile.

[anne]

When I refer to the cost of investment to Chile, I am referring to a failure by Chile to capture a reasonable share of profitability, if not in taxes then in technology transfer.

[Bruce Ferguoson]

Maybe the easiest way to stimulate investment is to require it?
Chile enacted its national defined contribution pension system in 1981 after the prior government-run systems collapsed. The core element of the plan is that workers are required to set aside 10% of their earnings into private savings accounts.
http://knowledge.wharton.upenn.edu/index.cfm?fa=viewfeature&id=1263

[anne]

Actually, the Chilean private social security system is proving a singular failure. After an initial burst of investment that stimulated Chile's stock market, contributions have been severely cut by terrible costs and returns even from Chilean stocks have been the poorest in Latin America for almost 20 years. Pension costs and poor returns are putting severe pressure on those middle class workers who unfortunately chose to be part of private system.

[anne]

What makes the Chilean stock market performance so distinctive, no matter the cheer leader analysts, is that Chile has had the worst performing index in Latin America for 5 or 10 or 15 or almost 20 years as far back as the index is recorded.

[Charles]

Anne is, of course correct, Bruce. The Chicago boys decided to set up a worker's paradise in Pinochet's Chile. Some innovative things were done. But overall, it was an enormous failure.

I am disappointed by this thread. Look, here is the basic issue: Economies are a blend of industries varying in reliance on innovation, growth rates, and capital intensity. They are set in a political context that provides varying degrees of predictability. Net result: there's a supply and a demand for capital that reaches some kind of equilibrium. If the equilibrium price is so high that the core industries of a nation can't get what they need, it hurts growth. If the equilibrium price is too low, as it has been in the US for the last few years, money gets wasted.

There's one more bit of nuance. In addition to the overall equilibrium point, there are subdivisions of the capital markets.

Cutting corporate rates is a blunt instrument that encourages corporations to waste money. Sure, if an economy has a high and healthy growth rate (as in many underdeveloped countries), you want to lower the cost of capital. But what if an economy is pushing up against growth limits? Then tax breaks just enrich shareholders without producing any real investment.

But even targeted tax policy has to be carefully designed. Corporate officers are brilliant at coming up with ways to classify jets, palatial housing, and other perks as "investment."

If the United States wants to grow through innovation, there are many things it could do. An extraordinary amount of innovation occurs in small companies, yet they are the ones that face the highest capital barriers, with VC often charging 100% or more. There is also a lot too much politics in who gets funding. Large corporations are able to exploit the SBIR program in really disgusting ways. Since the Republican "Revolution," a corrupt system in funding has also begun to emerge, such that good ideas often aren't the ones that get the money. We see this clearly with the vaccines, and Rumsfeld's ties to firms that get grants and contracts.

Creating wealth is different from creating money. A lot of people don't understand that.

[meno]

"targeted tax policy "

What is it with you Americans and taxes?

You guys can't look at a tax system without complicating it.

Let's stick in some new tax credits! Add deductions! Reorganise! Wait, the tax system isn't working right - add more complexity! We're getting too much hiss and not enough feathers - slap the goose more, twist it's beak!

Frankly, pretty much damn simple tax system would be better than what you have now.

[meno]

"Cutting corporate rates is a blunt instrument that encourages corporations to waste money."

Only if you think that competition has no effect on corporate behaviour.

[PJGoober]

The chilean example shows why it is risky to invest only in your own country, especially the smaller that country is.