Taxation of Corporate Capital Income: Tax Revenues vs. Tax Distortions

Since the average tax rate on corporate capital income is very high, economists often conclude that taxes have caused a substantial fall in corporate investment, a movement of capital into noncorporate uses, and a fall in personal savings. The combined efficiency costs of these distortions are believed to be very important. This paper attempts to show that when uncertainty and inflation are taken into account explicitly, taxation of corporate income leaves corporate investment incentives basically unaffected, in spite of the sizable tax revenues collected. In addition, in some plausible situations, such taxes can result in a gain in efficiency. The explanation for these surprising results is that the government, by taxing capital income, absorbs a certain fraction of both the expected return and the uncertainty in the return. While investors as a result receive a lower expected return, they also bear less risk when they invest, and these two effects are largely offsetting.