In the first commentary in this three-part series, I discussed the supply side of the capital market in Canada, and the personal taxation of dividends and capital gains. Here, I turn my attention to the demand side, and the corporate income tax. Specifically, I argue that replacing the current CIT with a tax on “economic rents” earned by businesses can make our tax system more efficient and equitable.
The corporate income tax (CIT) is a source-based tax levied on income earned in Canada by both domestic and foreign firms. Unlike the research on savings, research on the impact of the CIT on investment is relatively definitive, and suggests that the CIT reduces capital investment to a significant degree. For example, a recent study on Canada by the International Monetary Fund estimates that the elasticity of the capital stock with respect to the tax-adjusted user cost of capital is about –1.33. Thus, an increase of 10% in the cost of capital due to the CIT leads to a reduction of about 13.3% in investment in machinery and equipment in the long run. This is roughly consistent with other studies. There is thus relatively strong evidence that demand-side taxes on capital, such as the CIT, have a significant negative impact on investment, and therefore generate sizable efficiency costs. Indeed, economists Bev Dahlby and Ergete Ferede refer to the CIT as the “costliest tax of all” from an efficiency perspective.
To assess the equity implications of the CIT, it is important to understand that the entity that legally pays a tax (incurs the statutory incidence) does not necessarily bear the economic burden of the tax (incurs the economic incidence). Statutory incidence differs from economic incidence because taxes change prices and distort choices in the economy.
The question of who bears the burden of the CIT is one of the more contentious issues in public finance. At an Oxford Centre for Business Tax conference in the summer of 2015, Jim Hines, a leading scholar on the issue, stated that “[i]f I had ten questions to ask God, . . . one of . . . [them] would be what is the incidence of the corporation income tax.”
One thing we know for sure is that someone bears the burden of the CIT. This point may seem obvious, but it is often lost in public discussions, where we commonly hear statements along the lines of “Corporations should pay their fair share of taxes.” This statement reflects the common misperception that corporations are entities that somehow exist independently of the people who own them, the people who work for them, and the people who buy goods and services from them. However, corporations are merely conduits through which money passes from some individuals to others. People, not corporations, ultimately bear the burden of the CIT.
Since any tax imposed on a business will ultimately be passed on to people—to consumers through higher prices, to employees through lower wages, and/or to the owners of capital (shareholders) through lower returns—the question is, which people? The answer to this question has implications for the distribution of the CIT across different income groups and, thus, for the equity of the tax system.
Much of the focus in the literature and in policy discussions is on the allocation of the burden of the CIT between labour and the owners of capital (shareholders). Broadly speaking, if the burden of the CIT falls mostly on owners of capital through lower returns, the CIT increases the progressivity of the tax system. If, on the other hand, labour bears more of the burden of the CIT in the form of lower wages, the system is less progressive.
The indirect transmission mechanism by which the burden of the CIT is thought to be shifted to wages is relatively straightforward, at least in theory. A rise in the CIT reduces investment by increasing the cost of capital to firms. Under reasonable assumptions, this causes the marginal product of labour to decline, lowering the demand for labour, which in turn causes a reduction in wages (or perhaps a decrease in the growth rate of wages). Thus, the CIT can affect wages indirectly through its impact on investment.
The incidence of the CIT has recently received attention in the United States owing to the work of Emmanuel Saez and Gabriel Zucman on establishing a set of “distributional national income accounts,” which would seek to determine a distribution of income that includes all national income. This is a difficult task, and it relies on many sometimes arbitrary assumptions about who bears the burden of various taxes. Controversially, and contrary to much of the theory and evidence, Saez and Zucman assume that the entire burden of the CIT falls on owners of capital. Thus, they argue, the significant corporate tax cut included in the US Tax Cut and Jobs Act in 2017 benefited owners of capital exclusively.
Analysis of the incidence of the CIT yields an insight that is especially relevant from a Canadian perspective: the smaller is the economy relative to world capital markets, and the more mobile is capital relative to labour, the greater is the share of the burden of the CIT that falls on labour. Indeed, in a stylized small open economy setting, where capital is perfectly mobile across jurisdictions (while labour is immobile), and the country is very small relative to the size of the world capital market (so as to have no impact on the world rate of return to capital), the burden of the CIT falls entirely on labour. This is because in this case the after-tax rate of return to capital is fixed and determined by international financial markets.
While this is a stylized caricature to be sure, it does suggest that an analysis of the incidence of the CIT in Canada must keep in mind that ours is a relatively small economy (compared to, say, the United States), and that we have a very open economy, which allows for goods and capital to flow relatively freely between jurisdictions, both interprovincially and internationally.
Recent research has sought to empirically estimate the distribution of the CIT between capital and labour. It turns out that this is not easy: the economy has a lot of moving parts, and it is difficult to empirically identify the impact of specific policy changes.
Nonetheless, a consensus seems to be emerging that labour bears a non-trivial share of the burden of the CIT, even in larger economies, though there is not strong agreement on the magnitude of that share. My read of the empirical research is that estimates of labour’s share range from 30% and 80%—a wide range, to be sure.
Unfortunately, not many studies have focused on Canada. In a recent study, Ergete Ferede and I explicitly consider the indirect transmission mechanism discussed above, examining the impact of an increase in the CIT rate first on capital investment, and then the impact of changes in capital investment on wages. Figure 1 plots capital per worker in Canadian provinces from 1981 to 2014 against the combined federal and provincial statutory CIT rates. A clear negative relationship exists (also evident are different fixed effects across provinces). Figure 2 plots the real average hourly wage rate in provinces against capital per worker. Here we see the expected positive association. Figure 3 then plots the real hourly wage rate against the combined CIT rate. This is noisier but it suggests a negative relationship.
The cautionary adage “correlation does not imply causation” most certainly applies here, and so we undertake standard statistical analysis to control for various confounding factors. We estimate that, controlling for other factors that affect investment, a 10% increase in a provincial CIT rate (that is, an increase from 10% to 11%) is associated with a reduction of 2.3% in capital per worker. Controlling for other factors that affect wages, we in turn estimate that a 10% decrease in capital per worker is associated with a 4.6% reduction in the real average provincial hourly wage rate. Taken together, these estimates suggest that a 10% increase in a provincial CIT rate in Canada is associated with a 1.07% reduction in the real average hourly wage rate. This is generally in keeping with other empirical studies showing that the CIT affects wages, although it is on the low end of the spectrum, perhaps because of the use of aggregate data.
Thus, while debates of the magnitude of the burden remain, it is virtually certain that at least some, and perhaps much, of the burden of the CIT as it is currently designed falls on labour. One form of corporate tax, however, offers greater clarity in this regard—namely, one that taxes “economic rent.”
Economic rent refers to profits earned in excess of those arising from what would be considered a “normal” rate of return on capital. The normal rate of return is related to the idea of the “hurdle” rate of return employed by businesses. The hurdle rate of return is the minimum expected rate of return that an investment project must generate in order to be acceptable to the firm’s shareholders. A “marginal” investment project generates the normal/hurdle rate of return exactly, earning just enough to satisfy shareholders. Above-normal returns may arise because of a variety of factors: market power, firm-specific knowledge and intellectual property, natural resources, locational advantages, agglomeration effects, and even luck.
The CIT as it is designed in Canada (and most countries) imposes a tax on both the normal and the above-normal return to equity financed capital. This is because while debt interest explicitly paid by firms is tax-deductible, the hurdle rate of return implicitly required by shareholders is not. By taxing the normal return to equity financed capital, the CIT distorts investment decisions at the margin and generates efficiency costs in the economy. As discussed above, this can feed through to lower wages. Moreover, by allowing for the deduction of debt interest, but not for the required return to equity, the CIT distorts firm financing decisions. It thus introduces “debt bias” into the system—another efficiency cost.
A tax imposed on economic rent does not distort investment (or financing) decisions because it does not tax the normal return to capital. This makes rent taxes attractive from an efficiency perspective, which is the typical argument put forward by economists in their favour.
Perhaps not as well appreciated is that replacing the CIT with a tax on economic rent also has implications for the equity of the tax system. Because a corporate tax levied on economic rent does not distort investment, the indirect transmission chain to lower wages is eliminated. This means that the burden of a rent tax falls largely on the owners of capital. Moving to a rent tax at the corporate level would therefore be considered progressive relative to the existing CIT.
How can we target economic rents through tax reform? The simplest approach is a cash flow tax, whereby all capital expenditures are deducted immediately for tax purposes, rather than depreciated over time, and there is no deduction for debt interest. Another approach is the so-called allowance for corporate equity (ACE), which is closer to the current CIT in that it depreciates capital expenditures over time but, unlike the CIT, allows a notional deduction for the cost of equity finance along with debt. It is not the purpose of this commentary to discuss the implementation of a rent tax in Canada, though this is an important issue that deserves attention.
To conclude, there are three key take-aways from this commentary. The first is that investment on the demand side of the capital market is relatively responsive to changes in the CIT. The second is that in a small open economy like Canada’s, it is likely that labour bears a significant share of the burden of the CIT. Finally, moving to a tax on economic rent would shift much of the burden of the corporate tax from labour to owners of capital, which could enhance both the efficiency and the equity of the corporate tax system.
In the third and final commentary in this series, I bring together the insights from the first two commentaries to discuss changes to the capital tax system in Canada that would generate what I believe to be attractive results when viewed through the equity-efficiency lens.
 J.F. Wen and F. Yilmaz, Tax Elasticity Estimates for Capital Stocks in Canada, IMF Working Paper WP/20/77 (2020).
 For a survey, see K. Hassett and G. Hubbard, “Tax Policy and Business Investment,” in A. Auerbach and M. Feldstein, eds., Handbook of Public Economics, vol. 3 (Elsevier Science, 2002). Another Canadian study is M. Parsons, The Effect of Corporate Taxes on Canadian Investment: An Empirical Investigation, Department of Finance Working Paper (Government of Canada, 2008). A meta-analysis by Feld and Heckemeyer estimates that a 1 percentage point reduction in the CIT rate results in an increase in foreign direct investment of 2.49%: see L. Feld and J. Heckemeyer, “FDI and Taxation: A Meta-Study” (2011) 25:2 Journal of Economic Surveys 233-272.
 B. Dahlby and E. Ferede, “The Costliest Tax of All: Raising Revenue Through Corporate Tax Hikes Can Be Counter-Productive for the Provinces” (2016) 9:11 SPP Research Papers [University of Calgary School of Public Policy].
 E. Saez and G. Zucman, The Triumph of Injustice: How the Rich Dodge Taxes and How to Make Them Pay: Online Appendix, 1st ed. (Norton, 2019). Kopczuk and Zwick offer a critical discussion: see W. Kopczuk and E. Zwick, Business Incomes at the Top, NBER Working Paper no. 27752 (2020).
 R. Felix and J. Hines Jr., Corporate Taxes and Union Wages in the United States, NBER Working Paper no. 15263 (2009); W. Arulampalam, M. Devereux, and G. Maffini, “The Direct Incidence of Corporate Income Tax on Wages” (2012) 56:6 European Economic Review 1038-1054; R. Altshuler and L. Liu, “Measuring the Burden of the Corporate Income Tax Under Imperfect Competition” (2013) 66:1 National Tax Journal 215-238; K. Hassett and A. Mathur, “A Spatial Model of Corporate Tax Incidence” (2015) 47:13 Applied Economics 1350-1365; C. Fuest, A. Peichl, and S. Siegloch, “Do Higher Corporate Taxes Reduce Wages? Micro Evidence from Germany” (2018) 108:2 American Economic Review 393-418; and J. Hines, Corporate Taxation and the Distribution of Income, NBER Working Paper no. 27939 (2020).
 K.J. McKenzie and E. Ferede, “The Incidence of the Corporate Income Tax on Wages” (2017) 10:7 SPP Technical Paper [University of Calgary School of Public Policy].
 It should be noted that if economic rent is firm-specific, any corporate tax, including a rent tax, could affect a firm’s decision as to where to locate its investment. This is not a consideration if rents are location-specific. For a discussion of this in a Canadian context, see K.J. McKenzie and M. Smart, Tax Policy Next to the Elephant: Business Tax Reform in the Wake of the U.S. Tax Cuts and Jobs Act, C.D. Howe Institute Commentary no. 537 (2019).
 For a discussion in a Canadian context, see R. Boadway and J-F Tremblay, Modernizing Business Taxation, C.D. Howe Institute Commentary no. 452 (2016).
 Not addressed here is the issue of whether the rent tax should be levied on a source basis, like the current CIT, or a destination basis. See A.M. Auerbach, Devereaux, M. Keen, and J. Vella, Destination-Based Cash Flow Taxation, Oxford Legal Studies Research Paper no. 14/2017 (2017); S. Hebous, A. Klemm, and S. Stausholm, Revenue Implications of Destination-Based Cash-Flow Taxation, IMF Working Paper no. 19/7 (2019); J. Becker and J. Englisch, “Unilateral Introduction of a Destination-Based Cash-Flow Tax” (2020) 27:3 Journal of Public Economics 495-513; and S. Hebous and A. Klemm, “A Destination-Based Allowance for Corporate Equity” (2020) 3:20 Journal of Public Economics 753-777.