|
Given that corporate tax reform feels more likely now than ever before in our careers, we would like to share an approach that anyone can use to generate reasonable estimates of how economy-wide investment and GDP would respond to corporate tax changes. While the estimates we derive are stylized and apply best to revenue-neutral tax reform, this approach is quite useful when considering alternative paths for corporate income tax reform.
A novel aspect of this approach is that we account for a multinational corporation’s international investment decision, and the influence of the statutory rate on the location of projects that are anticipated to generate economic profits. Also, it is nice to generate a useful measure like the GDP estimate, albeit somewhat stylized, in a simple model that anyone can understand and discuss.
The first step in this approach is to calculate the Devereux-Griffith Effective Average Tax Rate (DG-EATR). A fruitful line of research by UK-based economists Michael Devereux and Rachel Griffith demonstrates that the DG-EATR is a useful proxy for the influence that taxation has on a firm’s decision over where to invest.
The DG-EATR can be thought of as an average of the statutory tax rate and the effective marginal tax rate (EMTR is defined as the tax rate on a marginal, breakeven investment), weighted by the supernormal and normal returns on investment, respectively. The normal return to savings consists of the risk free rate and a premium for risk; the supernormal return consists of windfall gains. When a firm expects that there will be a windfall associated with a project, then it is likely to choose the location of the project based on the DG-EATR. Note that the DG-EATR is forward-looking. This makes it more relevant for investment decisions, but it is distinct from the concept of an average tax rate used in other contexts.
Alongside other colleagues here at AEI, we have developed a simple spreadsheet model that allows us to calculate the DG-EATR for alternative tax systems. An essential caveat is that our spreadsheet model only allows us to calculate DG-EATRs for specific asset classes, and so the estimates are not necessarily representative of the overall economy. That said, the asset classes that we have chosen (equipment with 5 and 7 year tax lives for depreciation) are fairly representative of the capital stock — they apply to assets like computers, office machinery, any property used in research and experimentation, automobiles, office furniture and fixtures, agricultural machinery and equipment etc. These analyses could be done with a broader set of asset classes, and we will attempt to do so in future work.
We make numerous assumptions in the DG-EATR calculation, such as the expected inflation rate, the real discount rate, and more. Notably, we assume that the marginal corporate stockholder and debtholder face the top statutory individual rates based on the evidence in Harris and Kemsley (1999) and Gentry, Kemsley and Mayer (2003). The capital gains tax rate is adjusted for deferral until realization.
We also assume the tax rules use double declining balance depreciation and a half-year convention. We exclude bonus depreciation because it is set to phase out under current law by 2020. If you would like to examine the assumptions or generate these estimates for yourself (under our assumptions or others), you can download the spreadsheet here.
Effect of the corporate tax reform on the EATR
Table 1 reports the DG-EATR under several alternative corporate tax reform scenarios. We apply these reform scenarios to a corporate income tax (the current system) as well as to a cash flow tax, which allows the immediate deduction of the full cost of an investment (expensing) but eliminates the interest deduction. Because we focus on short-lived assets, the switch to expensing has only slightly greater value than the interest deduction. However, for longer-lived assets, expensing reduces the DG-EATR by substantially more than the elimination of interest deductibility raises the DG-EATR.
Table 1. DG-EATR under Corporate Tax Reform Scenarios
Impact on investment
The next step to calculating how corporate tax reform proposals will affect investment is to draw on the empirical literature for the measures of the responsiveness of investment to changes in the DG-EATR. We use a measure called the semi-elasticity, which measures the percent change in investment resulting from a percentage point change in the tax rate. If the semi-elasticity between the DG-EATR and investment is -1, then reducing the EATR by 10 percentage points (such as reducing the DG-EATR from 30% to 20%) will lead to a 10% increase in private investment. By our reading of the literature (for instance, Devereux and Griffith, 1998; Devereux and Lockwood, 2006; Altshuler and Grubert, 2004; de Mooij and Everdeen, 2008), a reasonable range for the semi-elasticity of investment with respect to the DG-EATR could be as small as -0.5 in the short run, but it would likely range between -1.5 and -6 in the long-term. Note that the elasticity values described here are not necessarily specific to the US but for comparable OECD economies. For a conservative estimate, we use the long-term investment semi-elasticity of -1.5 from Devereux and Lockwood (2006). Based on this semi-elasticity and the results in Table 1, Table 2 below estimates the percentage change in investment that could be expected as a result of tax reform.
Table 2. Investment Response to Corporate Tax Reforms, Percent Change
This exercise shows that corporate income tax reform proposals might be expected to substantially impact investment in the US economy. The estimates we produce are stylized — they assume deficit-neutrality and that 5 and 7 year assets are representative of the entire capital stock — yet we believe they are valuable for comparing alternative corporate income tax proposals.
Impact on GDP
Taking this further, we can also compare the effects of competing reform proposals on GDP. We apply a simple growth accounting framework, using estimates of the productive capital stock and investment from the Bureau of Labor Statistics Multifactor Productivity Capital Tables. From these data, we estimate the productive capital depreciation rates by major asset type: equipment, structures, intellectual property and rental residential capital. We also collect each major asset type’s share of total income in 2015. We assume that these capital income shares remain constant in the future.
We then extend these estimates of investment and the capital stock forward through 2028 by indexing real investment to the real GDP forecast from the Congressional Budget Office. Using the investment response estimates and the capital income shares of each major asset type, we can forecast the change in real GDP caused by reducing the corporate tax rate. We apply the adjustment only to the corporate share of investment. This ignores any effects of business tax reform on investment by pass-through businesses.
Table 3 shows the percentage point difference between the average GDP growth rate under each of the tax reform policies compared to the baseline, as well as the cumulative increase in GDP by 2028. This analysis applies the corporate investment response based on the conservative elasticity of -1.5 as well as a more intermediate elasticity of -3, assuming that the investment impact begins in 2018. Our calculations can be found here. These estimates also rely on the same assumptions as the investment response, as well as the assumption that the increased investment will not directly affect the labor supply or interest rates.
Note that in the long run, the corporate income tax affects the level of GDP, not the growth rate. Corporate tax reform raises growth rates temporarily as we shift to the new steady-state GDP level; in the long run, the real growth rate returns to the potential growth rate as GDP converges to its higher steady state. Table 3 also shows the change in the steady-state GDP — the long-term level of GDP, growing at a fixed rate — assuming that the government share of production remains constant beyond 2028 in the baseline.
Table 3. GDP Effect of Corporate Tax Reforms
These results show a modest to high impact of corporate tax reform on long-run GDP, depending on the elasticity chosen. During the transition path, GDP growth rates are higher than baseline, but in the long run, only the GDP level is higher and GDP growth rates converge back to the baseline GDP growth rates, assuming higher elasticities leads to greater estimated impacts from tax reform.
For example, using the conservative long-run semi-elasticity of -1.5, switching to a 20% tax on cash flow would increase corporate investment by 16.81% in the long run and would increase the steady state GDP by 4.4%. If we instead rely on a medium investment semi-elasticity of -3, then switching to a 20% cash flow tax would increase investment by 33.62%, and would increase the steady state GDP by 8.4%. We compare these two scenarios in the graph below. As described earlier, because corporate tax reform increases the steady-state GDP level, real GDP growth rates are temporarily higher as the economy transitions to its new GDP level, but the impact on the income level is permanent.
Of course, all of these analyses rely on two key assumptions for tax reform: deficit neutrality and permanence. If tax reform increases federal deficits, it produces temporarily higher growth rates in the short run from a Keynesian stimulus effect, but it raises interest rates in the medium and long term; higher interest rates crowd out private investment, offsetting some of the additional investment from corporate tax reform. Permanence also has an important role in the investment response to corporate tax reform. If a tax policy change is not permanent, then the economy will experience only temporarily higher growth, followed by much lower growth rates as the economy returns to its baseline GDP steady-state.
Our primary goal has been to provide a framework for thinking about how to estimate the GDP effect of corporate tax reform proposals, not, at this point, to generate a growth estimate for any particular bill. While the estimates we have derived are preliminary, we hope that the approach is valuable for comparing alternative reform proposals during this tax reform season. This will not be the last we write on this issue, as there are obvious follow ups, like assessing the sensitivity of the GDP estimates to key parameters and assumptions.
Given that corporate tax reform feels more likely now than ever before in our careers, we would like to share an approach that anyone can use to generate reasonable estimates of how economy-wide investment and GDP would respond to corporate tax changes.
|
|
