A tax on profits is not a tax on capital
I’ve spent time talking to tax policy experts inside and outside the Biden administration, and they point out that what may seem obvious – taxing profits deters companies from investing. that they might otherwise – is not at all obvious.
Imagine a business that is considering borrowing money to invest in a new project. If there was no income tax, he would proceed if and only if he expected the rate of return on the project to exceed the interest rate on the loan. Now suppose there is, say, a 35% profit tax. How does this change the company’s decision? It’s not.
Why? Because the interest on the loan is tax deductible. If the investment is financed by debt, income taxes fall only on returns above the interest rate, which means they should not affect investment choices.
Okay, not all investments are financed by debt, although this in itself poses a conundrum: there is an obvious tax advantage to issuing debt rather than selling stocks, and the question of why companies do not use more leverage is subtle and difficult. The immediate point, however, is that the corporate income tax is not a capital tax, it is a tax on a particular aspect of the financial structure of businesses. Analyzes – mine included! – who treat it simply as an increase in the cost of capital are far too generous for tax cutters.
Business investment is not that sensitive to the cost of capital, anyway
Suppose we ignore interest deductibility for a moment and consider a company that for some reason finances all of its investments with equity. Also imagine that investors know they can get a rate of return r in the world market. In this case, they will demand that the company earns r / (1-t) on its investments, where t is the profit tax rate. This is how proponents of the Trump tax cut looked at the world in 2017.
Under these conditions, cut t, reducing the required rate of return – in fact, reducing the cost of capital – should encourage firms to increase the stock of US capital. For example, the Tax foundation predicts that the capital stock would increase by 9.9%, or more than $ 6 trillion.
But those predictions missed a key point: Most business assets have a fairly short lifespan. Equipment and software are not like houses, whose useful life is measured in decades, if not generations. They are more like cars, which are usually replaced after a few years. In fact, most business investments are even less durable than cars, usually wearing out or becoming obsolete quite quickly.