Order Code RL34229
Corporate Tax Reform: Issues for Congress
October 31, 2007
Jane G. Gravelle
Senior Specialist in Economic Policy
Government and Finance Division
Thomas L. Hungerford
Specialist in Public Finance
Government and Finance Division

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Corporate Tax Reform: Issues for Congress
Summary
H.R. 3970, introduced by Chairman Charles B. Rangel of the House Committee
on Ways and Means, includes corporate tax revisions, trading a lower rate for a
broader tax base as part of the revenue neutral reform package. Some participants
at a recent Treasury conference, and some discussions by economists in opinion
pieces, suggest there is an urgent need to lower the corporate tax rate, but not
necessarily to broaden the tax base.
Arguments for lowering the corporate tax rate include the traditional concerns
about economic distortions arising from the corporate tax and newer concerns arising
from the increasingly global nature of the economy. Some claims have been made
that lowering the corporate tax rate would raise revenue because of the behavioral
responses, an effect that is linked to an open economy. Although the corporate tax
has generally been viewed as contributing to a more progressive tax system because
the burden falls on capital income and thus on higher income individuals, claims
have also been made that the burden falls not on owners of capital, but on labor
income — an effect also linked to an open economy.
The analysis in this report suggests that many of the concerns expressed about
the corporate tax are not supported by empirical data. Claims that behavioral
responses could cause revenues to rise if rates were cut do not hold up on either a
theoretical basis or an empirical basis. Studies that purport to show a revenue
maximizing corporate tax rate of 30% (a rate lower than the current statutory tax rate)
contain econometric errors that lead to biased and inconsistent results; when those
problems are corrected the results disappear. Cross-country studies to provide direct
evidence showing that the burden of the corporate tax actually falls on labor yield
unreasonable results and prove to suffer from econometric flaws that also lead to a
disappearance of the results when corrected. Similarly, claims that high U.S. tax
rates will create problems for the United States in a global economy suffer from a
misrepresentation of the U.S. tax rate compared to other countries and are less
important when capital is imperfectly mobile, as it appears to be.
While these new arguments appear to rely on questionable methods, the
traditional concerns about the corporate tax appear valid. While an argument may
be made that the tax is still needed as a backstop to individual tax collections, it does
result in some economic distortions. These economic distortions, however, have
declined substantially over time as corporate rates and shares of output have fallen.
Moreover, it is difficult to lower the corporate tax without creating a way of
sheltering individual income given the low rates of tax on dividends and capital
gains.
A number of revenue-neutral changes are available that could reduce these
distortions, allow for a lower corporate statutory tax rate, and lead to a more efficient
corporate tax system. These changes include base broadening, reducing the benefits
of debt finance through inflation indexing, and reducing the tax at the firm level
offset by an increase at the individual level. This report will not be updated.

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Contents
The Corporate Tax as a Revenue Source . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Magnitude and Historical Pattern . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Role of the Corporate Tax in Backstopping the Individual Tax . . . . . . . 4
Behavioral Responses and Revenue Maximizing Tax Rate . . . . . . . . . . . . . . . . . 6
Theoretical Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Empirical Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Brill and Hassett Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Clausing Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Distributional Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
The Harberger and Randolph Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
The Hassett and Mathur Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Economic Efficiency Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Allocation of Capital Within the Domestic Economy . . . . . . . . . . . . . . . . . 19
Savings Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
International Capital Flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Potential Revisions in the Corporate Tax . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Eliminating Corporate Tax Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Interest Deduction Inflation Correction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Reducing Tax at the Firm Level and Increasing Individual Level Taxes . . 29
Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Appendix A. Revenue Maximizing Tax Rates in an Open Economy . . . . . . . . 31
Appendix B. Data and Estimation Methods . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Identification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
List of Tables
Table 1. Tax Rates For Alternative Forms of Organization Under Alternative
Rate Structures, Individual at 35% Rate . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 2. Revenue Maximizing Tax Rates and Share of Variance Explained
in the Clausing Study . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Table 3. Coefficient Estimates — Dependent Variable is Corporate Revenues
as a Percentage of GDP (Brill and Hassett Model) . . . . . . . . . . . . . . . . . . . 12
Table 4. Coefficient Estimates — Dependent Variable is Corporate Revenues
as a Percentage of GDP (Clausing Model) . . . . . . . . . . . . . . . . . . . . . . . . . 13
Table 5. Coefficient Estimates — Dependent Variable is 5-year Average
of the Logarithm of Wage Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Table 6. Coefficient Estimates — Dependent Variable is Annual Logarithm
of Real PPP-adjusted Wage Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Table 7. Differential Tax Rates across Asset Types . . . . . . . . . . . . . . . . . . . . . . 21

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Table 8. Effective Tax Rates by Sector and Type of Finance . . . . . . . . . . . . . . . 22
Table 9. Corporate Tax Preferences and Projected Revenue Costs,
FY2008-2017 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Table 10. Corporate Revenue Raisers in H.R. 3970 . . . . . . . . . . . . . . . . . . . . . . 28
Table B1. Standard Deviation of Corporate Tax Rate Variables
in the Three Data Sets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 35

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Corporate Tax Reform: Issues for Congress
On October 25, 2007, Ways and Means Committee Chairman Charles B. Rangel
introduced H.R. 3970, a tax reform plan that included revisions in the corporate tax
to lower the rate and broaden the base. This proposal would cut the corporate tax
rate and, in a roughly revenue-neutral sub-section of the proposal, broaden the tax
base.
Interest in corporate rate cuts and other corporate revisions has been developing
for some time. In November 2005, President George W. Bush’s Advisory Panel on
Tax Reform reported on a variety of proposals for major reform of the tax system,
including those for corporate and business income taxes.1 Hearings were held on
these proposals in 2006, but no further action occurred. On July 16, 2007, The Wall
Street Journal published an opinion article by Treasury Secretary Henry M. Paulson
addressing concerns that the U.S. corporate tax rate is high relative to other countries
and announcing a conference to be held July 26 that would examine the U.S. business
tax system and its effects on the economy.2
On July 23, the Treasury Department released a background paper (hereafter,
the Treasury Study) that addressed several issues associated with the corporate tax:
(1) special tax provisions that narrow the corporate tax base; (2) the efficiency effects
of the tax (distortions in the size and allocation of investment); (3) the size of the
unincorporated sector; and (4) a comparison of corporate taxes in the United States
with other countries.3 The paper, however, did not discuss important justifications
for a corporate tax, such as its role in the progressivity of federal taxes assuming the
burden of the tax falls on capital, and the need for a corporate tax to avoid the use of
the corporate form as a tax shelter by high income individuals.
While the Treasury Study focused largely on efficiency issues and international
comparisons, on the day of the conference, R. Glenn Hubbard, President Bush’s first
chairman of the Council of Economic Advisors, also published an opinion article in
The Wall Street Journal referring to the conference.4 His article echoed some
arguments that have been made in recent months that are based partly, or largely, on
empirical studies of differences across countries. He addressed the distributional
1 Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System, November 2005,
which can be found at [http://www.taxreformpanel.gov/].
2 Henry M. Paulson, Jr., “Our Broken Corporate Tax Code,” The Wall Street Journal, July
19, 2007.
3 United States Department of the Treasury, “Treasury Tax Conference on Business
Taxation and Global Competitiveness: Background Paper,” July 30, 2007 at
[http://www.ustreas.gov/press/releases/hp500.htm].
4 R. Glenn Hubbard, “The Corporate Tax Myth,” The Wall Street Journal, July 26, 2007.

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issue, but referred to some evidence that the burden of the corporate tax falls on
labor. In addition to theoretical arguments, he cited an empirical paper by Kevin
Hassett and Aparna Mathur of the American Enterprise Institute.5 His article also
discussed empirical evidence suggesting that the U.S. might raise revenue by cutting
corporate tax rates because of large behavioral responses.6 Hubbard concludes by
suggesting that cutting the corporate tax rate would reduce a tax that is largely, or
even fully, borne by labor and that behavioral responses would offset much of the
static revenue cost.
During the conference, discussions included whether business representatives
would trade tax preferences for lower rates, whether reform should take the form of
lower rates or write-offs of investments, and methods of avoiding the corporate tax
by income shifting in a global economy. Some participants complained that the
corporate tax is outdated, too complex, distorts decisions, and undermines the ability
of firms to complete in a global economy. Echoing some issues raised in Hubbard’s
article, Kevin Hassett indicated that the corporate tax was not an effective way to
raise revenues and suggested that lowering the rate would raise revenues.7
Prior to the 2007 conference, Congress held hearings in 2006 on the Advisory
Panel’s proposals, with a general hearing followed by one concentrating on business
tax issues. In the 110th Congress, attention to capital income taxes has been targeted
to narrower issues such as the tax gap and offshore tax havens.8 At the time of the
Treasury conference, Chairman Charles B. Rangel of the House Ways and Means
Committee released a statement inviting the Bush Administration to discuss such
issues as tax reform, especially the Alternative Minimum Tax (AMT), addressing
tax havens, and increasing equity and fairness in the tax structure.9
H.R. 3970 includes some of the base broadeners included in the Treasury Study
and others that were not. The rate reduction, from 35% to 30.5% was not as large as
5 Kevin A. Hassett and Aparna Mathur, Taxes and Wages, American Enterprise Institute,
working paper, March 6, 2006, presented at a conference of the American Enterprise
Institute on May 2, 2006.
6 Hubbard’s article cites Michael Devereux, and apparently refers to a paper also presented
at the American Enterprise Institute Symposium.
7 This summary and other references to the issues discussed at the conference are based on
two detailed media accounts of the conference; although the conference was televised, there
is no transcript at this time. The articles are Heidi Glenn, “Business Leaders would Give
Up Tax Breaks for Lower Rates,” Tax Notes, July 30, 2007, pp. 324-327, and Joanne M.
Weiner, “U.S. Corporate Tax Reform: All Talk, No Action,” Tax Notes, Aug. 27, 2007, pp.
716-728.
8 Hearings were held by the Senate Finance Committee on Aug. 3, 2006, with a follow-up
focused on business tax issues on Sept. 20, 2006. The Committee also held hearings on
May 3, 2007 on tax havens.
9 Statement released by the Honorable Charles B. Rangel, Chairman, Ways and Means
Committee, July 26, 2007.

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that discussed in the Treasury Study, 27%. Base broadeners in H.R. 3970 have
already been criticized by some business groups.10
This report provides an overview of corporate tax issues and discusses potential
reforms in the context of these issues, with particular attention to some of the recent
research concerning large behavioral responses and their implications for revenue and
distribution. The first section reviews the size and history of the corporate income
tax, and discusses an important issue that has been given little attention by those who
propose deep cuts in the corporate tax: its role in preventing the use of the corporate
form as a tax shelter by wealthy business owners. This section also discusses the
potential effect of behavioral responses on corporate tax revenues. The second
section examines the role of the corporate tax in contributing to a progressive tax
system and discusses claims that the burden falls on workers. The third section
reviews arguments relating to efficiency and revenue yield, and traditional criticisms
of the corporate tax as one that causes important behavioral distortions. One aspect
of this discussion is the question of how the tax might be viewed differently in a
more global economy. The final section examines options for reform.
The Corporate Tax as a Revenue Source
The corporate tax is the third largest source of federal revenue, but its
importance as a revenue source has diminished considerably over time.
Magnitude and Historical Pattern
Despite concerns expressed about the size of the corporate tax rate, current
corporate taxes are extremely low by historical standards, whether measured as a
share of output or a based on the effective tax rate on income.11 In 1953, the
corporate tax accounted for 5.6% of GDP and 30% of federal tax revenues. In recent
years the tax has fluctuated round 2% of GDP and 10% of revenues, reaching a low
of 1.2% of GDP in 2003, and standing at 2.7% in 2006. The tax is projected to
continue to raise revenues of around 2% of GDP. Today, it is the third largest federal
revenue source, lagging behind the individual income tax, which is about 8% of GDP
and the payroll tax, which is about 6.5%. It is much more significant, however, than
excise taxes, which are slightly over 0.5%, and estate and gift taxes at 0.2%. (Note
that the income tax share is expected to grow and will exceed 10% if the 2001-2003
tax cuts are not made permanent; estate and gift tax revenues will also rise slightly.)

Much of the historical decline arises from legislated reductions in the corporate
effective tax rate on the return to new investment, which has fallen from 63% of
10 See Jeffrey H. Birnbaum, “Democrat Overhall of Taxes: Rangel Would Annul AMT,
Shift Burden,” Washington Post, Oct. 26, 2007, p. D1.
11 The data discussed in this paragraph are taken from Jane G. Gravelle, “The Corporate
Tax: Where Has it Been and Where is it Going?,” National Tax Journal, vol. 57 (Dec.
2004), pp. 903 — 923; U.S. Congressional Budget Office, Historical Data,[http://cbo.gov/
budget/historical.shtml] and The Budget and Economic Outlook, Fiscal years 2008-2017
[http://www.cbo.gov/ftpdoc.cfm?index=7731&type=0].

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corporate profits in 2003 to about 30% today. These changes include a reduction in
the top statutory rate from 52% to 35% and much more liberal depreciation rules.
The total tax burden on corporate source income has declined even more due to lower
rates on dividends and capital gains at the shareholder level and the increased fraction
of stocks held in tax exempt form.
While a large fraction of the decline in corporate tax revenues is associated with
these changes in rates and depreciation, other causes may be more liberal rules that
allow firms to obtain benefits of corporate status (such as limited liability) while still
being taxed as unincorporated businesses and tax evasion, particularly through
international tax shelters. The Treasury Report documents the significant rise in the
share of total business net income received by unincorporated businesses since 1980,
from 21% of total net income to 60%. While the share of proprietorships (which
have no limited liability) has declined slightly, from 17% to 14%, the share of
Subchapter S firms (firms that are incorporated but are allowed to elect taxation as
an unincorporated business) rose from 1% to 15%. These changes followed a
dramatic increase in the number of shareholders allowed for the election (the limit
of 10 was raised to 35 in 1982, to 75 in 1996, and to 100 in 2004). Partnerships
(including limited liability corporations and limited liability partnerships) increased
from 3% to 21%, with most of the increase occurring after 1990. This growth
reflects in part the growth of limited liability corporations established under state law
(the first state adopted such a provision in 1982), which qualify as unincorporated
business for corporate tax purposes. While Subchapter S firms are constrained by the
shareholder limit, partnerships are not.

Although it has declined considerably in importance, the corporate tax remains
a major source of federal revenue, and a significant change in individual income
taxes would be required to offset a substantial reduction in corporate taxes. Current
pressures to find revenue sources to pay for relief from the AMT make an overall
corporate tax cut difficult to envision. For that reason, the Bush Administration has
proposed trading off rate reductions, or possibly broad investment subsidies that
reduce the effective burden on new investment, for base broadening, through
reduction of corporate tax preferences.
The Role of the Corporate Tax in Backstopping
the Individual Tax
Measuring corporate tax revenue falls short of describing the full role of the
corporate tax in contributing to federal revenues because the corporate tax protects
the collection of individual income taxes. As long as taxes on individual income are
imposed, a significant corporate income tax is likely to be necessary to forestall the
use of the corporation as a tax shelter. Without a corporate tax, high income
individuals could channel funds into corporations, and, with a large part of earnings
retained, obtain lower tax rates than if they operated in partnership or proprietorship
form or in a way that allowed them to be taxed as such. As suggested by the growth
in unincorporated business forms above, wealthy business owners may be quick to
take advantage of tax rate differentials, which currently tend to favor unincorporated
businesses. (Since 1986, when individual tax rates were lowered dramatically, the
corporate tax rate has been high relative to the individual tax rate). The Treasury

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Study indicated that 61% of the income of unincorporated businesses was associated
with taxpayers in the top income tax bracket.
Although the top tax rate on corporations is equal to the top individual rate
(35%), the corporate tax is graduated. Consequently, for high income taxpayers, there
is an advantage to shifting part of one’s income into a corporation because corporate
tax rates are graduated (15% on the first $50,000 and 25% on the next $25,000) and
are lower than the top marginal tax. This opportunity, however, is restricted by: (1)
limiting to one the number of corporations income can be shifted to; (2) the amount
on which rates are graduated; and (3) disallowing graduated rates for personal service
corporations. There are over 600,000 corporations with earnings less than $50,000,
according to Internal Revenue Service statistics, suggesting some shifting occurs. In
recognition of the potential use of the corporation as a shelter, tax law has in the past
contained a tax on accumulated earnings. As long as dividends were taxed as
ordinary income and the accumulated earnings tax was strict enough, it was difficult
to use the corporate form to shelter a great deal of income.
This tax shelter constraint on lowering the corporate rate is arguably more
binding today because of the lower rates on dividends and capital gains enacted as
part of the Administration’s corporate relief package in 2003. Table 1 calculates the
effective tax rate for operating through a corporation, versus an unincorporated
business, for an individual in the 35% tax bracket. If dividends are taxed at 15% and
the corporate rate is lowered to 27% as suggested in the Treasury conference, the tax
rate in the corporate form would be less than the tax rate on unincorporated
businesses. In fact, with a 15% rate on dividends, corporations that distributed less
than 73% of their income would present a tax shelter opportunity with a 27% tax rate.
This outcome would occur even without the benefit of graduated rates and could
potentially benefit labor income as well as individual capital income. Moreover,
although there are rules restricting accumulated earnings, it is common for
corporations to reinvest a significant fraction of their earnings. This unlimited
sheltering option would not exist as long as the corporate tax were as high as the
individual tax, and its scope would be limited if dividends and capital gains were
taxed at higher rates.
Some reforms might address these shelter issues directly, including raising tax
rates on dividends and capital gains at the individual level while lowering the rate at
the firm level, eliminating the graduated rate structure, and more formal methods of
integrating the individual and corporate income taxes.

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Table 1. Tax Rates For Alternative Forms of Organization Under
Alternative Rate Structures, Individual at 35% Rate
100% of
50% of
No Income
Income
Income
Distributed
Distributed
Distributed
Corporate Business
Dividends Taxed at 15% Rate
Corporate Tax Rate of 35%
45
40
35
Corporate Tax Rate of 27%
38
32
27
Dividends Taxed at Ordinary Rates
Corporate Tax Rate of 35%
58
46
35
Corporate Tax Rate of 27%
46
36
27
Unincorporated Business
35
35
35
Source: CRS analysis
Behavioral Responses and Revenue Maximizing
Tax Rate
Although it has long been recognized that there are behavioral responses to the
corporate tax (even aside from the tax sheltering issues indicated above), and that
these responses have important implications for the efficiency of the economy and
the burden of the tax, the issue of a revenue maximizing tax rate, popularly
associated with the “Laffer” curve, has rarely entered into the discussion. A Laffer
curve graphs revenue against the tax rate, and is based on the notion that revenue is
zero at a zero tax rate and zero at a 100% tax rate (at least with respect to some
taxes).12 In a Laffer curve, the revenue first rises with the tax rate and then falls, and
at the point it reverses direction is the revenue-maximizing tax rate.
A Laffer curve for the corporate tax has been proposed or alluded to recently in
several articles in the popular press. One is the article by Glenn Hubbard, cited
above. In National Review, Kevin Hassett discusses the Laffer curve and presents
a chart that he indicates is an illustration that appears to show a negative relationship
between corporate revenues as a share of GDP and the tax rate.13 Only 13 countries
are shown on this graph, however, and the negative relationship is clearly strongly
affected by an outlier, Ireland, which is a well known tax haven; most economists
would not find this illustration persuasive proof. Another discussion of this issue
12 Excise taxes can be set at more than 100% and still yield revenue. Taxes on real capital
income in excess of 100% can also yield revenues because inflation is an implicit tax on the
holding of cash.
13 Kevin A. Hassett, “Art Laffer, Righter Than Ever,” National Review, Feb. 13, 2006.

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appeared in an editorial in The Wall Street Journal, which also presented a chart with
a number of OECD countries on it.14 In this chart, the editors simply drew a curve,
which passed through a couple of points. There was no statistical fitting to the data
and no informative value to such an analysis; moreover the two points through which
the freehand curve was drawn were questionable: one was the United Arab Emirates
with no tax, which is neither a typical country nor in the OECD, and the other was
Norway, whose corporate tax revenue tends to be high because of oil. The bulk of the
data showed no obvious trend.15
The Hubbard and Hassett articles do, however, cite some more sophisticated
research. Hassett referred to a paper by Kimberly Clausing,16 and Hubbard referred
to a paper by Michael Devereux.17 In addition, Alex Brill and Kevin Hassett also
prepared a statistical analysis examining the change in the relationship over time.18
Clausing, who is referred to in the Hassett article, is quoted as claiming that the
United States is likely to the right of the revenue maximizing point on the Laffer
curve, but this statement, presumably from an earlier draft, is not found in her
published article. That article finds a revenue maximizing tax rate of 33%, in her
simple specification, but as she added variables and accounted for other features the
revenue maximizing tax rate seemed to rise, as indicated in Table 2. Large countries
and countries that are less open, such as the United States, have a revenue
maximizing tax rate of 57% — much larger than the combined federal and state rate
for U.S. firms of 39%.19
14 “We’re Number One, Alas,” The Wall Street Journal, July 13, 2007, p. A12.
15 For insight into how this graph was viewed by economists, see Brad DeLong, an
economist at Stanford and author of a website, Brad DeLong’s Daily Journal, who titled his
entry “Most Dishonest Wall Street Journal Editorial Ever.” There was some perception,
which was incorrect, that this graph was prepared by Kevin Hassett because he was
mentioned as a source, but that was not the case; he provided some of the data (personal
communication with Kevin Hassett). Based on data provided by one of the correspondents
in that debate, a simple regression of corporate share on tax and tax squared showed no
significant coefficients for tax variables, indicating no relationship:
[http://delong.typepad.com/sdj/2007/07/most-dishonest-.html].
16 Kimberly A. Clausing, “Corporate Tax Revenues in OECD Countries,” International Tax
and Public Finance, vol. 14 (Apr. 2007), pp. 115-133.
17 Michael P. Devereux, Developments in the Taxation of Corporate Profit in the OECD
Since 1965: Rates, Bases and Revenues, May 2006 presented at a conference of the Alliance
for Competitive Taxation and the American Enterprise Institute, June 2, 2006.
18 Alex Brill and Kevin Hassett, Revenue Maximizing Corporate Income Taxes, AEI
working paper # 137, American Enterprise Institute, July 31, 2007.
19 The 33% tax rate is from the simplest regression; the other regressions, which include
other variables, or control for country size and/or openness, lead to higher revenue
maximizing rates.

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Table 2. Revenue Maximizing Tax Rates and Share of Variance
Explained in the Clausing Study
Specification
Tax Rate
R-Squared
(1) Basic
33%
0.13
(2) Additional Variables
39
0.43
(3) Additional Variables
42
0.46
(4) Additional Variables
41
0.23
(5) Additional Variables
37
0.21
(6) Openness
43
0.27
(7) Size
45
0.23
(8) Openness and size
57
0.28
Source: Kimberly Clausing (2007).
Note: The R-Squared is a statistical term that measures the share of the variance in the dependent
variable explained by the independent variables.
Michael Devereux’s paper indicates that, while he finds a revenue maximizing
rate of 33% under the same specification as Clausing, he finds only weak evidence
of a relationship between tax rates and corporate tax revenues as a percentage of
GDP. Many of his specifications do not yield statistically significant effects. Brill
and Hassett find a rate of around 30%, which has been falling over time.
In the remainder of this section, we first discuss theoretical expectations of this
relationship and then examine these empirical studies. Both the theoretical and
empirical assessments suggest that the results of these analyses are questionable.

Theoretical Issues
The issue of a Laffer curve has not been a part of the debate because the notion
of a revenue maximizing tax rate other than at very high tax rates is inconsistent with
most of the models of the corporate tax. Traditionally, the main behavioral response
associated with the corporate tax was the substitution of noncorporate capital for
corporate capital within an economy where the amount of capital was fixed.
Imposing a corporate tax (in excess of the noncorporate tax) caused capital to earn
a lower return in the corporate sector and to flow out of that sector and into the
noncorporate sector, thereby lowering the return in the noncorporate sector and
raising the return, before taxes, in the corporate sector. The higher pre-tax return on
capital also caused prices to go up in the corporate sector and fall in the noncorporate
sector, causing a shift towards non-corporate sector total production. The corporate
profits tax base, therefore, had two opposing forces: the amount of capital was falling
but the profit rate was rising. The taxable base could, therefore, either increase as tax
rates increased, or it could decrease. The direction depended on the substitutability
of capital and labor in the corporate sector. The central tendency of most models
(with unitary elasticities) suggested, however, that the tax base was relatively

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invariant to tax rates, and revenues would always rise with the tax rate.
Consequently, under any reasonable set of assumptions there would either be no
revenue maximizing tax rate or an extremely high one.20
If behavioral responses caused the total capital in the U.S. economy to contract,
the outcome could be different. One such model, the open economy model, appears
to be a motivation for the belief in a relatively low revenue maximizing tax rate.
Brill and Hassett discuss elasticity estimates of foreign capital flows to after tax
returns in the range of 1.5 to 3 (they also cite a recent study with an elasticity of 3.3)
in their paper that finds a revenue maximizing tax rate of around 30%. They
conclude that “[t]hese high elasticities are consistent with the view that reductions
in corporate rates could lure a significant enough amount of economic activity to a
locality to create a Laffer curve in the corporate tax space.”21
As shown in the Appendix A, however, one cannot achieve this tax rate even
with infinite elasticities. In the most extreme case, where: (1) the country is too small
to affect worldwide prices and rates of return; (2) capital is perfectly mobile; and (3)
products in international trade are perfectly substitutable, the revenue maximizing tax
rate would be the ratio of the labor share of income to the factor substitution
elasticity. Assuming fairly common values for a model without depreciation of 75%
for labor’s share of income and a factor substitution elasticity of 1, the tax rate would
be 75% — far above the rates of around 30% reported by Brill and Hassett. This rate
could rise as these conditions are relaxed. If the U.S. is assumed to have 30% of
world resources, the rate rises to 81%; if imperfect substitutability between
investments across countries and between foreign and domestic products is allowed,
it would rise further.
While it is possible to have a revenue maximizing tax rate that does not
asymptotically approach 100% it is probably not possible to find a rate that
maximizes revenues as a percentage of GDP, because GDP falls as well as tax
revenues. In this case, we are back to the same circumstances as in the reallocation
of capital in the closed economy: with unitary elasticities, the corporate share of
income is constant relative to GDP, and with other elasticities it can rise or fall.
A related circumstance where capital can contract would be in a model where
savings responds so powerfully that the savings supply is infinitely elastic, that is,
when a tax is imposed, the capital stock must contract so much, and the pre-tax rate
of return rises so much that the after-tax return comes back to its original value. This
extreme savings response model yields the same revenue maximizing tax rate as the
extreme open economy, 75%, and probably no revenue maximizing tax rate for
revenues as a percent of GDP. Moreover, the slowness with which the capital stock
20 An invariant tax base would occur when both production and utility were of the Cobb
Douglas form, that is unitary factor substitution elasticities and unitary product substitution
elasticities. At 100% tax rate a corner solution would be presumably be reached where the
corporate sector would entirely disappear, but only at that extreme rate would such an effect
occur.
21 Brill and Hassett, Revenue Maximizing Corporate Income Taxes, p. 6.

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CRS-10
adjusts (most models allow 150 years for full adjustments) means that the revenue
would be affected by tax rates in the past.
The result of this discussion makes it clear that revenue maximizing tax rates
cannot arise from physical reallocations or contractions of capital. Nor are they likely
to arise from a substitution between debt and equity, since the debt share has changed
very little despite significant changes in the relative tax burden, and estimates of
elasticities that do exist are small.
A remaining source of a different outcome is profit shifting. This could involve
firms maintaining the same activity and shifting the form of operation to
unincorporated businesses. This could be a possibility (although the point of revenue
maximization would be much too low because much of the tax has not disappeared,
but rather has shifted). But, at least in the United States, this shift is probably less the
result of high corporate tax rates and more the result of increasingly loose restrictions
on operating with limited liability outside the corporate form, actions that have not
been taken by other countries.22 The other profit shifting issue is the shifting of
profits (rather than activity) to foreign countries. Such effects are possible, but it
would seem unlikely that tax avoidance could be of this magnitude, given that only
5% of the U.S. capital stock is invested abroad. While a small low income country,
as is characteristic of most tax havens, might have little enough domestic capital that
they could afford the loss from lowering the rate in order to attract more capital, such
an outcome is much less likely for the United States.

Empirical Analysis
As noted above, several recent studies have examined the relationship between
corporate tax rates and corporate tax revenues as a percentage of gross domestic
product (GDP). We obtained the data used for two of these studies to replicate and
extend the analyses. Both studies and our analysis estimate the effect of the top
corporate tax rate (and its square) on corporate tax revenues as a percentage of GDP.
Panel data for 29 OECD countries is used for the analysis.
Brill and Hassett Study
In their study, Brill and Hassett use panel data for the OECD countries from 1981 to
2003.23 They use regression analysis (OLS) to estimate the effects. Brill and Hassett
22 The Treasury Study provides data on the growth over time in unincorporated business
forms and suggests that the large share of this income in the United States relative to other
countries is due to the ability to avoid the corporate tax and still retain limited liability in
the United States. The growth in Subchapter S income (partnerships that can elect to be
taxed as corporations) corresponds to increasing limits on the number of permissible
shareholders, and the growth in partnership income to the growth in the number of states
allowing limited liability companies that do not fall under the corporate tax. Proprietorship
income shares have changed very little. In any case, this growth occurred during a period
when the corporate tax was constant or falling.
23 See Alex Brill and Kevin A. Hassett, Revenue-Maximizing Corporate Income Taxes: The
(continued...)

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CRS-11
find that the corporate tax rate has at first a positive effect on corporate tax revenues
as a percentage of GDP and then a decreasing effect — the effect looks like an
inverted U, the shape of the classic Laffer curve. All of their coefficient estimates
are statistically significant. However, they do not account for problems often
encountered with the use of panel data, and their coefficient estimates would appear
to be biased and inconsistent.24
The estimation results from our re-analysis of the Brill and Hassett study are
reported in Table 3. The regression includes a tax rate and a tax rate squared to
allow for a curve. Panel A of the table displays the results for central government
corporate tax data (in the case of the U.S., this is federal government tax data). The
coefficient estimates for the full time period (1980 to 2003) and the four subperiods
defined by Brill and Hassett are reported. In all cases, the coefficient estimates are
fairly small and none are statistically significant at conventional confidence levels.
Panel B of the table displays the results for total government (that is, governments
at all levels) corporate tax data. Again, the coefficient estimates are fairly small and
none are statistically significant. Once appropriate estimation methods are used to
correct problems arising with panel data, there appears to be no statistically
significant relation between corporate tax rates and corporate tax revenues as a
percentage of GDP.
23 (...continued)
Laffer Curve in OECD Countries. We obtained our data from the same sources as Brill and
Hassett.
24 The terms “biased” and “inconsistent” are technical statistical terms. See Appendix B
for a description and the consequences of these problems, and the statistical definitions for
biased and inconsistent.

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CRS-12
Table 3. Coefficient Estimates — Dependent Variable is
Corporate Revenues as a Percentage of GDP (Brill and Hassett
Model)
1980-1986
1987-1992
1993-1997
1998-2003
1980-2003
A. Central government corporate tax revenues; federal corporate tax rate
-0.037
-0.110
0.048
0.049
-0.040
Tax rate
(0.090)
(0.081)
(0.087)
(0.117)
(0.040)
Tax rate
0.087
0.122
-0.082
-0.060
0.052
squared
(0.109)
(0.100)
(0.129)
(0.178)
(0.053)
F
3.00
1.59
3.02
2.62
3.23
Prob>F
0.000
0.161
0.016
0.023
0.000
B. Total government corporate tax revenues; total corporate tax rate
0.204
-0.042
0.069
0.037
-0.016
Tax rate
(0.195)
(0.077)
(0.076)
(0.094)
(0.038)
Tax rate
-0.193
0.044
-0.106
-0.008
0.028
squared
(0.214)
(0.091)
(0.109)
(0.123)
(0.047)
F
2.55
1.74
3.10
3.13
3.46
Prob>F
0.026
0.110
0.013
0.006
0.000
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other
variables include time dummy variables.
Clausing Study
Clausing uses panel data for the OECD countries from 1979 to 2002 to study the
effect of corporate tax rates on corporate tax revenue as a percentage of GDP.25 She
includes more explanatory variables than did Brill and Hassett, but her overall
research findings and conclusions are essentially the same as theirs — there is a
Laffer curve relationship between corporate tax rates and corporate tax revenue as a
percentage of GDP. However, her estimation methods would lead to biased and
inconsistent coefficient estimates.26
The estimation results for five different specifications are reported in Table 4.
The five specifications differ by what explanatory variables are included in the
25 See Kimberly A. Clausing, “Corporate Tax Revenues in OECD Countries.” The authors
thank Kimberly Clausing for providing her data.
26 Clausing included two variables in her analysis indicating the type of corporate tax system
that do not vary over time for a country. The coefficients of these variables are not
identified when using the fixed effect estimation method, which is probably why she
estimated the coefficients using OLS. While she obtained coefficient estimates for these
two variables, the estimates are biased and inconsistent.

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CRS-13
analysis. In all five specifications, the coefficient estimates of the corporate tax rate
(and its square) are smaller than those estimated by Clausing and have the opposite
signs. Most of the coefficient estimates are not statistically significant at
conventional confidence levels, but two are statistically significant at the 10% level
only. (In these cases where the coefficients are significant on the tax squared term
they still do not produce the Laffer curve shape but rather suggest rising revenue with
a rising tax rate). Overall, these results suggest that the corporate tax rate has little
effect on corporate tax revenues as a percentage of GDP. Consequently, there is little
evidence to support the existence of a corporate tax Laffer curve.
Table 4. Coefficient Estimates — Dependent Variable is
Corporate Revenues as a Percentage of GDP (Clausing Model)
Specification
(1)
(2)
(3)
(4)
(5)
-0.055
-0.073
-0.075
-0.048
-0.067
Tax rate
(0.035)
(0.111)
(0.046)
(0.036)
(0.047)
Tax rate
0.078*
0.118
0.102*
0.069
0.093
squared
(0.047)
(0.147)
(0.061)
(0.048)
(0.061)
Profit rate
X
Corporate share
X
Unemployment
X
X
rate
Per capita GDP
X
X
growth rate
Per capita GDP
X
X
Openness
X
X
F
2.75
2.46
2.58
2.83
2.61
Prob>F
0.000
0.000
0.000
0.000
0.000
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other
variables include the indicated variables and time dummy variables. *significant at 10% level.
Distributional Effects
A second issue that was a focus of the Hubbard article, but was not in the
Treasury Report was the distributional effects of the corporate income tax. If the
corporate tax falls on owners of the corporation, or on capital in general, it
contributes to a progressive tax system, since higher income individuals have more
income from capital than from labor. Based on tax data, for taxpayers with incomes
up to $100,000, over 90% of income is labor income, while for those over

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CRS-14
$1,000,000, less than a third is labor income.27 The traditional analysis of the
corporate income tax indicates that the burden generally spread to all capital, but
does not fall on labor income. Most government and private agencies that routinely
do distributional analysis allocate the corporate tax to capital income.28
Hubbard refers to three studies in his article: one a working paper by economist
Arnold Harberger,29 one a working paper by William Randolph of the Congressional
Budget Office,30 and one a recent empirical cross-country study using data similar to
the studies discussed above, by Hassett and Mathur.31

The Harberger and Randolph Studies
The first two studies explicitly focus on the effects of an open economy. It is
a standard finding that for a small open single-good economy with perfect capital
mobility and perfect product substitution, the burden of any source based capital
income tax falls on labor (whereas for residence based taxes, that is taxes that apply
to domestic owners of capital regardless of where they are domiciled, the burden
would fall on capital). The corporate tax has some aspects of a source based tax and
some of a residence based tax.
Both the Harberger and the Randolph studies are based on this simple model of
perfect substitution, altered to account for the United States as a large county (which
lowers the elasticities) and to account for multiple sectors. Randolph’s study does
not so much predict the burden of the tax as explore incidence in certain types of
models; he acknowledges that less capital mobility causes the burden to shift from
labor to capital. Harberger’s model has four sectors, corporate and non-corporate
tradeable sectors and corporate and non-corporate nontradeable sectors. He assumes
that the corporate tradeable sector is more capital intensive that the average industry,
which leads to a burden of greater than 100% of the tax falling on capital. Despite
the vision of the manufacturing sector as highly capital intensive, it actually is not:
housing services, which are 100% capital, accounts for over a third of the capital
stock in the country, and many other industries, such as utilities and agriculture are
also more capital intensive than manufacturing. Using the same assumptions about
mobility, but with a less capital intensive manufacturing sector, Randolph finds 70%
of the corporate tax burden falls on labor.
27 See CRS Report RL33285, Tax Reform and Distributional Issues, by Jane G. Gravelle.
28 This is the allocation used by the Congressional Budget Office, the Treasury Department,
and the Urban-Brookings Tax Policy Center.
29 It is not clear which of Harberger’s papers is being referred to, but it is presumably the
more recent one: Arnold C. Harberger, Corporate Tax Incidence: What is Known,
Unknown, and Unknowable, University of California, 2006. This paper was presented at
a conference at Rice University in 2006, and will be published with other papers.
30 The paper in question is not an official CBO paper but rather a working paper by William
Randolph. William C. Randolph, International Burdens of the Corporate Tax, CBO
working paper 2006-09, Aug. 2006.
31 Kevin A. Hassett and Aparna Mathur, Taxes and Wages, American Enterprise Institute,
working paper, 2006.

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CRS-15
To permit other than perfect substitutability, a much more complex computable
general equilibrium model would be required, which neither Harberger nor Randolph
has provided. Such a model has been developed by Gravelle and Smetters32 who
find, with reasonable elasticities, that capital still bears most of the burden, about
80%.
While the Gravelle and Smetters model is a very complex, it still abstracts from
some important features of the corporate tax. There are two other factors that would
further push the corporate tax burden towards capital. First, the current corporate tax
has elements of a residence based tax, and the burden of a residence based tax falls
on capital. Second, the current corporate tax actually subsidizes debt finance at the
firm level, and if debt is much more substitutable than equity, total capital would be
less likely to be exported: indeed, raising the corporate tax could cause capital to flow
in.
Finally, note that as long as countries tend to choose tax rates similar to each
other, which appears to be the case, the world becomes like the original closed
economy, a model stressed by Harberger, with the burden falling on capital.
According to the Treasury Study, the U.S. combined state and federal corporate
statutory rate is 39%, the G-7 average is 36% and the OECD average is 31%.
Effective tax rates, which should govern the movement of capital, are even closer
together, and in some cases are lower for the U.S. than for other countries.
An argument is often made that the burden of any capital income tax tends to
fall on labor because it reduces savings, an effect that would also occur in a closed
economy. While one model predicts that the entire burden of a capital income tax
eventually falls on labor, this model requires some extreme assumptions about human
behavior such as perfect information, an infinite planning horizon, perfect liquidity,
and asexual reproduction. Models allowing for finite lives (such as the life-cycle
models) find results that vary, but if the revenue loss is made up by higher taxes on
labor, there is little or no effect. Some economists believe that these models are
inappropriate, as they assume too much information and skill on the part of
individuals; they suggest that individuals use rules of thumb, such as fixed savings
rates or targets, instead. These rules of thumb suggest that a cut in capital income
taxes either has no effect on saving or reduces savings. These economists also point
out that most empirical evidence does not point to an increase in savings; historically,
savings rates do not appear to respond to reduced tax rates.33
32 Jane G. Gravelle and Kent A. Smetters, “Does the Open Economy Assumption Really
Mean That Labor Bears the Burden of a Capital Income Tax?” Advances in Economic
Policy and Analysis, vol. 6, No. 1, 2006.
33 These issues surrounding savings are discussed in greater detail in CRS Report RL32517,
Distributional Effects of Taxes on Corporate Profits, Investment Income and Estates, by
Jane G. Gravelle; CRS Report RL33545, The Advisory Panel’s Tax Reform Proposals, by
Jane G. Gravelle; and CRS Report RL33482, Savings Incentives: What May Work, What
May Not, by Thomas L. Hungerford. The recognition that replacement of capital income
taxes by wage taxes in a life cycle model could have little effect on savings or contract them
can be found in numerous simulation studies, for example, Alan Auerbach and Laurence
(continued...)

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CRS-16
The Hassett and Mathur Study
While the theoretical models do not provide much support for the corporate tax
burden falling on labor, Hubbard also refers to an empirical study by Hassett and
Mathur that uses the corporate tax rate to explain differences in manufacturing
wages. They find a statistically significant result that indicates a 1% increase in the
corporate tax causes manufacturing wages to fall by 0.8% to 1%. These results are
impossible, however, to reconcile with the magnitudes in the economy. Through
competition, wage changes in manufacturing should be reflected in wages throughout
the economy, implying that a 1% rise in corporate revenues would cause an 0.8% to
1% fall in wage income. However, corporate taxes are only about 2.5% of GDP,
while labor income is about two thirds. These results imply that a dollar increase in
the corporate tax would decrease wages by $22 to $26 dollars, an effect that no model
could ever come close to predicting.
The lack of theoretical reasonableness of the results may be explained by
statistical issues. The Hassett and Mathur study used data from 72 developed and
developing countries for the 1981 to 2003 period.34 For their analysis, their
dependent variable is the logarithm of the five-year average of the average
manufacturing wage. They justify their use of the five-year average wage by noting
that due to capital adjustment costs, the economic effects of corporate tax rate
changes show up over longer time periods.35 The wage rates for all countries were
converted to U.S. dollars using annual exchange rates. Since their dependent variable
is in nominal terms (that is, not inflation adjusted), Hassett and Mathur include the
price deflator as an explanatory variable. The main explanatory variable of interest
is the logarithm of the top corporate tax rate. Hassett and Mathur also use the
average effective and marginal effective corporate tax rates (in logarithms) as
explanatory variables in some specifications.
We replicated the Hassett and Mathur estimation results, which are reported in
the first row of Table 5.36 The coefficient estimate reported in the first column (-
0.836) suggests that a 10% increase in the top corporate tax rate will lead to an 8.4%
decrease in the average manufacturing wage rate. This estimate is statistically
significant at the 1% level.37 The results are not as strong (the estimates are closer
33 (...continued)
Kotlikoff, Dynamic Fiscal Policy (Cambridge, MA: Cambridge University Press, 1987).
34 Hassett and Mathur, Taxes and Wages. We are grateful to Kevin Hassett and Aparna
Mathur for providing their data. Several of the countries only have data for shorter periods.
35 Their independent or explanatory variables take their value from the beginning of the five-
year period over which wages are averaged. It should also be noted that Hassett and Mathur
calculate the five-year average with nominal wages (that is, they are not corrected for
inflation).
36 See Appendix B for a description of the estimation method.
37 The specific test of statistical significance of the coefficient estimates is the t-test. This
is a test of whether or not the estimate is equal to zero (the null hypothesis is the estimate
is equal to zero). The significance level indicates the risk of rejecting the null hypothesis
(continued...)

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CRS-17
to zero) when using alternative measures of the corporate tax rate (see the next two
columns of Table 5).
Table 5. Coefficient Estimates — Dependent Variable is 5-year
Average of the Logarithm of Wage Rates
How Wage
Corporate Tax Rate Variable
Variable
Converted to U.S.
Effective
Dollars
Top Tax Rate
Effective Average
Marginal
-0.836***
-0.608*
-0.336
Exchange Rate
(0.294)
(0.333)
(0.226)
Purchasing Power
-0.743**
-0.529
-0.229
Parity Exchange
(0.284)
(0.324)
(0.220)
Rate (PPP)
-0.512*
-0.257
-0.110
Real PPP
(0.285)
(0.308)
(0.209)
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model. Other variables include time
dummies, log personal tax rate, log real value-added, log consumer price variable (except for real
PPP). ***significant at 1% level; ** significant at 5% level; *significant at 10% level.
The exchange rate between two currencies reflects the relative supply and
demand for those two currencies, and is affected by financial markets and
government policies. Exchange rates may not be good indicators of the relative
buying power of wage rates in two countries. Purchasing Power Parities (PPPs),
however, are specifically designed to equalize the internal purchasing power of the
currencies. Workers in Australia, for example, are concerned with what their wages
will purchase in Australia, and not how many dollars their wages will buy. Using
PPPs is a more appropriate way to convert national currencies to a common currency
(U.S. dollars).
The second row of Table 5 reports the coefficient estimates when the wage rates
are converted to U.S. dollars using the PPPs. Again, nominal wages are the
dependent variable and the price deflator is included as an explanatory variable. The
coefficient estimates are closer to zero than the estimates reported in the first row.
The coefficient estimate reported in the first column (-0.743) is statistically
significant at the 5% level but not at the 1% level. The estimates for the alternative
measures of the corporate tax rate are not statistically significant at the conventional
confidence levels.
The most appropriate measure of wages is the real or inflation-adjusted PPP-
adjusted wage rate. The final row of Table 5 displays the coefficient estimates for
37 (...continued)
when it is, in fact, true. A significance level of 1% indicates that the null hypothesis will
be inadvertently rejected only 1% of the time. Significance levels commonly used in
empirical social science work are the 1%, 5%, and 10% levels.

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CRS-18
the model using this measure as the dependent variable. The estimates are closer to
zero than in the other two cases. The coefficient estimate in the first column (-0.512)
is statistically significant at the 10% level but not at the 5% level. The other two
estimates in columns two and three are not statistically significant at the conventional
confidence levels. While there is still some evidence of corporate tax rates having
a negative influence on wage rates in manufacturing, the effect is smaller and less
robust than reported in the Hassett and Mathur study.
Averaging the wage data over five years and using the beginning of period value
for the explanatory variables eliminates much of the variation in wages and tax rates,
thus throwing away much of the information needed to estimate the economic effects.
The statistical analysis is repeated using annual data and including various lagged
values of the corporate tax rate as explanatory variables.38 The results are reported
in Table 6. The first column of the table displays the coefficient estimates for the
current value of the corporate tax rate (labeled t in the first column) and the values
for the previous five years (t-1 to t-5), which allows for longer term effects of tax
rates on wages. In each case, the coefficient estimates are negative but very close to
zero; none are statistically significant at the conventional confidence levels. The next
six columns report the results when the corporate tax rate values (current and lagged)
are entered individually. In every case, the coefficient estimates are close to zero and
are not statistically significant at conventional confidence levels. In using annual
data, we can find no evidence that changes in the top corporate tax rate affects wage
rates in manufacturing.39
38 Including the lagged values of the corporate tax rate allows the tax rates for the previous
five years to individually have an impact on wages. All tax rates are entered into the model
in logarithms.
39 We obtain the same estimation results when the exchange rate is used to convert wage
rates to U.S. dollars — the method used by Hassett and Mathur.

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CRS-19
Table 6. Coefficient Estimates — Dependent Variable is Annual
Logarithm of Real PPP-adjusted Wage Rates
Tax Rate
(1)
(2)
(3)
(4)
(5)
(6)
(7)
Lag
-0.001
0.020
t
(0.204)
(0.176)
-0.201
-0.190
t-1
(0.184)
(0.141)
-0.076
-0.080
t-2
(0.163)
(0.142)
-0.041
0.011
t-3
(0.156)
(0.142)
-0.100
-0.060
t-4
(0.152)
(0.144)
-0.155
-0.169
t-5
(0.152)
(0.144)
F
1.13
1.47
1.23
1.64
1.52
1.82
2.74
Prob>F
0.304
0.092
0.220
0.037
0.061
0.011
0.000
Source: Authors’ analysis.
Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other
variables include time dummies, log personal tax rate, log real value-added. ***significant at 1% level;
** significant at 5% level; *significant at 10% level.
Economic Efficiency Issues
The traditional criticism of the corporate tax, as spelled out in the Treasury
Study, is that the tax causes distortions, and that these distortions are exacerbated by
corporate tax preferences that prevent, for a given level of tax revenue, a lower tax
rate. The issues discussed in this section include allocation of capital within the
domestic economy, savings effects, and international capital flows.
Allocation of Capital Within the Domestic Economy
Traditionally, the efficiency concern about the corporate tax is related to the
misallocation of resources between corporate and noncorporate production (including
owner-occupied housing). Over time, efficiency issues have also encompassed
differential taxation of the returns to assets of different physical types, and financial
distortions, which affect the debt-equity ratio, payout choice, and decision to realize
capital gains.
Some efficiency costs, including those that alter the mix of a firm’s physical
assets, arise not so much from the existence of a corporate tax but from its design.
Table 7 captures the effects of the two most significant generally available

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CRS-20
provisions that affect tax burdens on different assets: depreciation rules and the
recently enacted production activities deduction, which in effect allows a lower tax
rate on certain domestic activities that are deemed production (manufacturing,
construction, etc.). The tax rates in this table account only for the corporate tax (that
is, they do not include the benefits of deducting interest or the tax at the individual
level on interest, dividends, and capital gains). They are also forward looking and
marginal: they estimate the share of the return on a prospective investment that is
paid in tax. If income were correctly measured and taxed that share would be the
statutory rate; most assets face lower tax rates.
The variations within a column illustrate the distortions firms face in choosing
the mix of capital within a firm. Overall the variations not only distort the mix of
capital within a firm, but also the allocation of capital across different industries. In
general, the most favored major industry is oil and gas extraction where a large
fraction of investment is deducted when incurred. Other things equal, firms eligible
for the production activities deduction and firms that have a larger share of their
capital stock in equipment than average will be favored.
In the aggregate, the tax rate on equipment is estimated at about 25%, a full 10
percentage points below the statutory tax rate, while structures (covering the last
seven rows of Table 7) are subject to a 30% rate. Inventories are subject to a 37%
rate and the overall rate on reproducible capital is 29%.40
The Treasury Study reports aggregated asset specific data, which provide a
similar result, indicating that equipment is favored. Their measures include the total
tax burden, including the benefit of deducting interest, and individual level taxes.
They estimate a tax rate of 25% on equipment, 34% on structures, and 33% on land
and inventories.
These estimates are somewhat overstated because they do not include intangible
investments, such as research and advertising. Some research and experimentation
expenditures are expensed (leading to a zero tax rate on those expenditures) and
eligible for a credit as well (leading to a negative rate, but only intangible
expenditures, however, are eligible). Spending on advertising is expensed and
subject to a zero rate even though some advertising has future benefits.
40 These estimates are reported in CRS Report RL33545, The Advisory Panel’s Tax Reform
Proposals, by Jane G. Gravelle.

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CRS-21
Table 7. Differential Tax Rates across Asset Types
No Production
With Production
Asset
Deduction
Deduction
Autos 34
31
Office/Computing Equipment
31
28
Trucks/Buses/Trailers
29
26
Aircraft
29
26
Construction Machinery
23
21
Mining/Oilfield Equipment
28
25
Service Industry Equipment
28
25
Tractors
27
24
Instruments
28
25
Other Equipment
27
24
General Industrial Equipment
25
23
Metalworking Machinery
23
21
Electric Transmission Equipment
33
30
Communications Equipment
19
17
Other Electrical Equipment
24
21
Furniture and Fixtures
23
20
Special Industrial Equipment
21
19
Agricultural Equipment
21
19
Fabricated Metal
29
26
Engines and Turbines
36
33
Ships and Boats
17
15
Railroad Equipment
18
16
Mining Structures
7
6
Other Structures
40
37
Industrial Structures
37
34
Public Utility Structures
27
24
Commercial Structures
34
3 1
Farm Structures
26
23
Residential Structures
31
NA
Source: Congressional Research Service, from CRS Report RL33545, The Advisory Panel’s Tax
Reform Proposals, by Jane G. Gravelle.

---

CRS-22
Table 8 reports the types of distortions that are an artifact of the corporate tax
as a separate tax. These estimates, unlike those in Table 7, take into account all
levels of taxes. One of the complications of estimating these tax rates is whether the
estimates should consider the significant (over 50%) fraction of individual passive
income that is held in tax exempt form through pensions, IRAs, life insurance
annuities and non-profits. In some ways, these sources can be viewed largely as not
affecting marginal investment (for example, overall savings) because they are capped
or not controlled directly by the investors and in other ways they affect choices (such
as debt or equity of pension funds). For this reason, in addition to the estimates
presented by Treasury, two sets of CRS estimates are provided which assume either
no tax exempt investment or half is tax exempt.
Table 8. Effective Tax Rates by Sector and Type of Finance
CRS Estimates,
CRS Estimates,
Treasury
Sector
No Tax Exempt
Half of Investment
Estimates
Investment
Tax Exempt
All Business
26
28
22
Corporate
Business
30
32
25
Debt -2
9
-11
Equity
40
37
33
Non-corporate
business
20
20
14
Owner Occupied
Housing
4
-3
-13
Economy wide
17
18
11
Source: Treasury Report; CRS Report RL33545, The Advisory Panel’s Tax Reform Proposals, by
Jane G. Gravelle.
Within the corporate sector, in addition to asset differences, there is a larger
differential with respect to debt versus equity finance. The aggregate tax burden on
debt is slightly negative, while equity is taxed at close to 40%. If economic income
were measured correctly, interest would be subject to the individual income tax rate,
which is typically slightly above 20%. Debt is subsidized at the firm level, however,
because nominal interest is deducted (including the inflation premium) while
corporate profits before this deduction are effectively taxed at a rate below the
statutory rate on real income. The result is that at the firm level, equity is subject to
a tax rate of around 30% while debt is subsidized at about the same level (a negative
32% tax rate). At the individual level, the tax on interest for taxable recipients is
higher than the statutory rate because nominal interest is taxed, which pushes the
overall tax rate towards a small but negative rate.
Evidence on the size of this distortion is limited, but since there appears to be
limited substitution between debt and equity, it is probably less than 5% of corporate

---

CRS-23
tax revenue.41 Some simple measures, however, could significantly reduce this
distortion (such as indexing interest payments for inflation). Lower corporate tax
rates would also reduce this distortion.
The distortion that has probably received the most attention by those studying
the corporate tax is the misallocation of capital between the corporate and
noncorporate sectors. One source of the distortion arising from the corporate tax
system is the taxation of corporate business at around 30%, while unincorporated
business is taxed at only 20%. The higher corporate tax also contributes to a larger
wedge between corporate production and owner-occupied housing, which is
generally taxed at a negligible rate. The magnitude of the estimated distortion
produced by having a separate corporate tax varies depending on the model used and
ranges from less than 10% of corporate tax revenue to about a third.42 Since the
deadweight loss varies with the square of the tax rate, the recent decline in the
differential due to lower tax rates on dividends and capital gains suggests the
distortion relative to revenue would be smaller — probably no more than 4% to 7%
of revenue.43
A distortion not captured in Table 8 is the one that affects corporate payouts.
Given that appreciation in stock values is not taxed until realized, there is a benefit
to retaining earnings. There is a dispute about what determines payout ratios, and
what the consequences of the tax are, but, in general, the welfare cost is small. There
is also some distortion due to the lock-in effect for capital gains realizations.44
Considering all of these distortions together, they are probably in the range of
10% to 15% of corporate tax revenues, a magnitude that could be considered as a
41 See Jane G. Gravelle, The Economic Effects of Taxing Capital Income (Cambridge: MIT
Press, 1994), pp. 82-83, suggesting a distortion of about 0.17% of total consumption. With
consumption (including government spending) about 83% of output, and the corporate tax
2.7%, this amounts to about 5% of corporate revenue. This amount has fallen slightly due
to lower rates on capital gains and dividends.
42 See the review in Gravelle, The Economic Effects of Taxing Capital Income, pp. 77-82.
43 The distortion is proportional to the square of the wedge between pretax returns, which
is t
(1 − t ) − t (1− t) , where t is the corporate tax rate and t the unincorporated.
c
c
c
The corporate tax fell from about 44% in the mid-1980s to 32% today, while the
noncorporate tax fell from 22% to 20% and the rate on owner occupied housing remained
about the same (roughly zero). Holding the after-tax return constant, the wedge between
corporate and noncorporate capital fell by over a half, and the square of the wedge by 80%.
A calculation for owner-occupied housing suggests that the wedge fell by 40% and the
deadweight loss by two thirds. For the largest deadweight loss estimates, virtually all of the
distortion was due to the corporate non-corporate differential, so that the current deadweight
loss would be only 20% as large, while for the others, both assets played an important role.
44 Estimates of 0.04% to 0.11% of consumption translate into 1% to 4% of corporate
revenues, see Gravelle, The Economic Effects of Taxing Capital Income, p. 89. With the
reduction in tax rates of almost 50%, and the welfare cost proportional to the square of the
tax wedge, the welfare cost would be about 30% of its former value or less than 1%. There
is also a welfare cost from the realizations response of about 1%, but recent evidence has
shown this response to be small, about the same size as the pay-out distortion.

---

CRS-24
significant component of the burden of the tax. However, given the revenue needs
of the government, there would also be distortions, perhaps smaller, associated with
alternative taxes. Ways to reduce these distortions may, however, be worth
considering.
Savings Effects
Much of the Treasury Study’s discussion emphasized effects on savings
although this is not normally the focus of efficiency concerns about the corporate
income tax. This distortion is not unique to corporate income taxes, but occurs with
all capital income taxes. There are many difficulties with analyzing this issue. The
first is that, as noted above in the discussion about the potential effect of savings on
the wage rate, the economic distortion depends on the behavioral response of savings
to tax changes, and what tax replaces them. Some economists have a strong view
that taxes on the rate of return are always distorting, but these views are based on
dynamic infinite-horizon models that may not be very realistic. With life-cycle
models, the distortions depend on what revenue substitute is provided; substituting
taxes on wages for taxes on capital, the most likely substitute in the U.S. tax system,
could potentially increase distortions, depending on the responses in the models.45
In models of bounded rationality, where savings are based on rules of thumb such as
fixed shares of income or fixed targets, there is no response, or only an income effect,
which would not produce a distorting effect.
International Capital Flows
Tax rules can affect the efficiency of allocation of capital around the world, and,
if the U.S. rate is different from other countries, it can cause misallocations of capital.
Despite claims that the U. S. tax rate is much higher than other countries, its rate of
39% (including state and local rates) is only slightly above the G-7 rate of 36%
according to data in the Treasury Study. Since the production activities deduction
acts in the same way as a statutory tax rate reduction, the actual U.S. rate is not 39%,
but rather about 37%, virtually the same as the G-7 average.46 The G-7 rate would
be higher if weighted by GDP. The U.S. rate is below the 38% rate in Germany and
40% rate in Japan, the two largest of the G-7 other than the U.S. In addition, it is at
the same rate as Italy, just above the 36% rate of Canada, and slightly above the 30%
rate of Great Britain. The 19 OECD countries had an average of 31%, but this
average would be higher if weighted by country size because larger countries have
higher rates (if Ireland, with a 13% tax rate were eliminated, the average would be
33%). Although these rates put the United States rate close to those of other large
developed countries, the report also indicates that several countries, in particular
Germany, are planning to cut their corporate tax rates.
45 See Jane G. Gravelle, “Income Consumption and Wage Taxation in a Life Cycle Model:
Separating Efficiency from Redistribution,” American Economic Review, vol. 81, no. 4
(Sept. 1991), pp. 985-995.
46 This reduction of two percentage points was based on the estimates for the production
activities deduction relative to corporate revenues presented in the paper.

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CRS-25
The Treasury Study also reports effective marginal tax rates on equipment
investment (which accounts for tax preferences such as depreciation): the effective
tax rate for the United States at 24%, was the same as the G-7 average, and just 4
percentage points above the 19 OECD country average. For debt finance, the U.S.
had a higher negative rate, -46% (and thus more beneficial tax treatment) than the G-
7 average at -39%, and the average for 19 OECD countries of -32%. If the measure
is simply the average tax rate (corporate tax dividend by corporate surplus), which
accounts for various corporate preferences, the U.S. average rate is 17%, which is
below the OECD average of 22%.
These data do not indicate the U.S. is a high tax country with respect to
investment, and would probably not become so even if some reductions occur in the
future in other countries. The main source of international distortion, therefore, is
probably the increased investment that occurs in low tax and tax haven countries
because the United States and other developed countries do not tax that income at all
or tax it on a deferred basis. This inefficiency is not due to the corporate effective
tax rate, but rather is due to the provision of a tax benefit for investment abroad.47
Even when tax rates diverge, the efficiency costs may not be significant because
the evidence suggests, as noted in previous sections, limited mobility of capital as a
result of varying tax rates.
Potential Revisions in the Corporate Tax
There are a variety of potential revisions that could be made to the corporate tax
to permit lowering the rate. The revisions discussed here include (1) broadening the
corporate tax base and using the revenues to reduce the rate or to provide investment
incentives, (2) correcting interest deductions and income for inflation, and (3)
increasing the individual level tax to permit a lower tax at the firm level.
Eliminating Corporate Tax Preferences
One type of revision that would probably be supported by most economic
analysts, is to eliminate corporate preferences in exchange for a lower statutory
corporate tax rate. The Treasury Study estimates that eliminating corporate
preferences would allow the tax rate to be lowered to 27%. Table 9 shows the
preferences the Treasury Study lists and the FY2008-2017 revenue costs.
47 The issues of efficiency in international taxation are discussed in much more detail in
CRS Report RL34115, Reform of U.S. International Taxes: Alternatives, by David L.
Brumbaugh and Jane G. Gravelle.

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CRS-26
Table 9. Corporate Tax Preferences and Projected Revenue
Costs, FY2008-2017
Revenue Cost
Preference
($ Billions)
Expensing and accelerated depreciation
410
Deduction for U.S. production activities
210
Exclusion of interest on state and local debt
135
Research and experimentation (R&E) credit
132
Deferral of income of controlled foreign corporations
120
Low income housing credit
55
Exclusion of interest on life insurance savings
30
Inventory property sales source rule
29
Deductibility of charitable contributions
28
Special Employee Stock Ownership Plan (ESOP) rules
23
Exemption of credit union income
19
New technology credit
8
Special Blue Cross/Blue Shield Deduction
8
Excess of percentage over cost depletion
7
Other corporate preferences.
27
Source: Treasury Study.

The largest preference in the list is expensing and accelerated depreciation ($410
billion) and the second largest is the production activities deduction ($210 billion);
both provisions are captured in effective tax rates cited above. Other significant
provisions (worth over $100 billion each in these years) include the exclusion of
interest on state and local bonds, the research and experimentation tax credit, and the
deferral of income from foreign sources, which is probably responsible for much of
the international distortions.48
Interestingly, their list does not include graduated rates for small corporations,
which costs slightly over $4 billion per year, and would, allowing for growth, raise
over $50 billion in revenue over the period if were eliminated. Since owners of small
48 The purpose of most of the provisions is self explanatory; note, however, the property
sales source rule (also known as the title passage rule) is effectively an export subsidy.
Percentage depletion benefits independent oil and gas producers and mineral and coal
producers and allows a deduction of costs based on a percentage of receipts rather than the
actual costs.

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CRS-27
corporations are typically as wealthy (or more wealthy) than owners of large ones,
there appears to be little economic justification for not including these rates.
A full discussion of the economic merits of these provisions is beyond the scope
of this paper, but are discussed in the Senate Budget Committee Print, Tax
Expenditure Compendium;49 most would be regarded as provisions that lead to
economic distortions. One possible exception is the Research and Experimentation
(R&E) credit, since social returns to research and development appear higher than
private returns, but many economists believe that the credit is probably poorly
targeted and possibly abused. Arguments could also be made that the tax exempt
bond benefit is shifted to state and local governments (which can charge lower
interest rates) and that these assets and revenue loss would be shifted to individuals.
Arguments could also be made that the benefits of the charitable contribution
deduction and the low income housing credit ultimately accrue to charities and lower
income tenants, at least in part. Many other provisions have some support, and may,
therefore, be difficult to repeal.
H.R. 3970 would lower the tax rate to 30.5% (at a 10 year cost in FY2008-
FY2017 of $363.8 billion), as well as a permanent extension of provisions allowing
expensing for small business (at a cost of $20.5 billion). As shown in Table 10,
eliminating the production activities deduction is the proposal’s largest base
broadener. It also includes a provision that is somewhat more limited than
eliminating deferral: disallowing expenses associated with foreign source income that
is tax-deferred. The proposal also includes two other international provisions, one
eliminating a provision adopted in 2004 that included worldwide (rather than
domestic) interest in allocation rules for the foreign tax credit limit and one
restricting the availability of lower withholding tax rates on income invested in the
United States under treaty rules. Another major revenue raiser is a restriction in
inventory accounting rules. The only depreciation base broadener in the proposal is
one to extend the depreciation period for acquired intangibles. As is often the case
in tax legislative proposals, revenue raisers are not always in the tax expenditure list.
The Treasury Study also discussed the possibility of using this base broadening
to provide an investment incentive, such as a partial expensing. Such a provision
would have a larger effect on lowering the tax rate on new investment than is the case
for a rate reduction. It is difficult, however, to design investment subsidies in a
fashion that is both neutral across types of assets and generates an even revenue loss
pattern over time. Historically, investment subsidies have been restricted to
equipment. The provision used most frequently in the past is the investment tax
credit which, if allowed at a flat rate, favors short-lived assets. Partial expensing is
neutral across investments if allowed for all types but its revenue loss is very large
in the short run. Accelerated depreciation can be designed to be neutral, but it also
has an uneven revenue loss pattern and cannot be applied to non-depreciable assets,
49 See U.S. Congress, Senate Committee on the Budget, Tax Expenditures, committee print,
109th Cong., 2nd sess., Dec. 2006, S. Prt. 109-072 (Washington: GPO, 2006). The document
is posted at [http://frwebgate.access.gpo.gov/cgi-bin/useftp.cgi?IPaddress=
162.140.64.88&filename=31188.pdf&directory=/diskb/wais/data/109_cong_senate_com
mittee_prints].

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CRS-28
such as inventories. A benefit of lowering the statutory rate is that it reduces the
incentive to shift profits abroad to tax havens, although that incentive would probably
be considerably lessened in any case if deferral of taxation of foreign source income
were ended.
Table 10. Corporate Revenue Raisers in H.R. 3970
10-Year Revenue
Provision
Gain ($billions)
Production Activities Deduction
114.932
Allocation of Expenses for Deferred Income
106.385
Repeal of Worldwide Allocation of Interest
26.204
Limitation Eligibility for Reduced Treaty Withholding
6.397
Repeal Last-In First-Out Inventory Accounting
106.506
Repeal Lower of Cost or Market Inventory Method
7.146
Special Rule for Service Providers
0.225
20-Year Amortization of Intangibles
20.967
Economic Substance Doctrine
3.787
Reduction in Dividends Received Deduction
4.596
Ordinary Tax on S Corporation Stock Options in an ESOP
0.606
Terminate Domestic International Sales Corporation Benefit
0.881
Tax Debt Securities as a Tax Free Spin Off
0.235
Source: Joint Committee on Taxation.
The ending of deferral might be a controversial provision, and indeed some
pressure has been exerted to move in the other direction, toward a territorial tax.50
There are, however, some more limited approaches. For example, the President’s
advisory panel proposed to exempt dividends of active businesses but disallow costs
such as interest to the extent income is exempt. And, as proposed in H.R. 3970, one
could also defer interest deductions associated with deferred income without making
any other changes, or direct restrictive rules to tax havens.
50 A territorial tax system is one where the tax is imposed only in the country where business
activity occurs and not in the country of ownership. While the present international tax
system results in distortions, it is not clear how moving to a territorial tax would reduce
these distortions, and even less clear how it would improve tax compliance and profit
shifting. For a more detailed discussion see CRS Report RL34115, Reform of U.S.
International Taxes: Alternatives, by David L. Brumbaugh and Jane G. Gravelle

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CRS-29
Interest Deduction Inflation Correction

If the inflation premium were disallowed for interest deductions, assuming that
about half of interest is inflation, the savings would eventually be $30 billion per year
at the corporate level, which would be offset by about a $10 billion loss at the
individual level. This could allow a 2.5 percentage point reduction in the corporate
tax rate. The important aspect of this change is that it would virtually eliminate the
distortion between debt and equity, which is responsible for a significant portion of
the overall distortion in the corporate tax, while maintaining the overall corporate tax
burden.
Reducing Tax at the Firm Level and Increasing
Individual Level Taxes
Given the value of lowering the corporate tax rate to reduce the shifting of
income into tax havens and concerns over the U.S. position among other countries,
one change that would allow this reduction is to raise the tax at the individual level
and use the revenues to lower the corporate tax rate. Since individual taxes tend to
be collected regardless of where income is earned, these taxes are neutral with respect
to international allocation. This approach also allows more scope for lowering
corporate tax rates without creating sheltering opportunities for high income
individuals. If the 2003 tax changes that lowered rates on dividends and capital gains
to 15% were rolled back, the federal corporate tax rate could be reduced to 31%.51
Taxing capital gains at full rates, as was enacted in 1986 and remained largely in
place until 1997 would allow two or three more percentage points in reduction. One
could go even further, by taxing corporate capital gains on an accrual basis, which
would yield dramatically more revenue. This type of change would also eliminate
distortions arising from payout policies and realizations response. Even lower
corporate rates could be achieved by taxing non-profits enough to offset their savings
from the lower corporate rates — a change that would leave them unaffected, but
would simply shift the source of tax collection. These latter proposals would
arguably be broad enough to move much of the way towards an integration of the
corporate and individual income taxes.
Conclusion
Is there an urgent need to lower the corporate tax rate, as some recent
discussions and analyses have suggested? On the whole, many of the new concerns
expressed about the tax appear not to stand up under empirical examination. The
claims that behavioral responses could cause revenues to rise if rates were cut does
not hold up on both a theoretical basis and an empirical basis. Studies that purport
to show a revenue maximizing tax rate of 30% contain econometric errors that
produce biased and inconsistent results; when those problems are corrected the
results disappear. Cross-country studies to provide direct evidence showing that the
51 Details of these proposals are provided in CRS Report RL34115, Reform of U.S.
International Taxes: Alternatives, by David L. Brumbaugh and Jane G. Gravelle.

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CRS-30
burden of the corporate tax actually falls on labor yield unreasonable results and
prove to suffer from econometric flaws that also lead to a disappearance of the results
when corrected. Similarly, claims that high U.S. tax rates will create problems for
the United States in a global economy suffer from a mis-representation of the U.S.
tax rate compared to other countries and are less important when capital is
imperfectly mobile, as it appears to be.
While these new arguments appear to rely on questionable data, the traditional
concerns about the corporate tax appear valid. While many economists believe that
the tax is still needed as a backstop to individual tax collections, it does result in
some economic distortions. These economic distortions, however, have declined
substantially over time as corporate rates and shares of output have fallen. There are
a number of revenue-neutral changes that could reduce these distortions, allow for
a lower corporate statutory tax rate, and lead to a more efficient corporate tax system.

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CRS-31
Appendix A. Revenue Maximizing Tax Rates in an
Open Economy
For an exploration of corporate tax revenue, consider a very simplified example
where there is a U.S. corporate sector and the rest of the world with no tax. The
lowest revenue maximizing rate would apply in a case where there is a small country
which is a price-taker (that is, worldwide price and rate of return after tax are fixed
because there is perfect capital mobility and perfect product substitutability). To
determine the revenue maximizing tax rate, begin with the equation for corporate tax
revenues:
tRK
REV =
(A1)
1 − t
where K , the corporate capital stock, and R , the after-tax rate of return, are
potentially functions of the tax rate, t . Revenue is maximized when the total
differential of equation (A1) with respect to taxes is equal to zero, which is:
⎛
dK
dR⎞
(1 − t) tR
+ tK
RK
0
(A2)
⎝⎜
dt
dt ⎠⎟ +
=
Assuming the rest of the world can be treated as a aggregate and has a zero
capital income tax rate, Gravelle and Smetters show that, in a case of a small country
with perfect substitutability, R does not change and
dK
µ dt
= −
(A3)
K
σ (1− t)
where µ is the labor share of income and σ is the factor substitution elasticity.
Substituting equation (A3) into equation (A2) we obtain the revenue
maximizing rate of µ σ . To use some common values, if µ is 0.75 and σ is 1,
the revenue maximizing rate is 75%.
Since the United States is a large country, the rates would be even higher,
because the tax can affect the world wide interest rate. The Gravelle and Smetters
paper provide effects for R and K for a given country share, which can also be
substituted into equation (A2). As a result, the revenue-maximizing tax rate is
µ (µγ + σ(1− γ )) where γ is the output share. For example, if the United
States has approximately 30% of the total output, the tax rate would be 81%. The
rates would rise further if capital were not perfectly mobile or products not perfectly
substitutable, since these factors would allow R to fall further. At the extreme, it
would return to a closed economy solution. Gravelle and Smetters present evidence
to suggest that the outcome is more similar to a closed economy than a small open
economy solution.

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CRS-32
This same outcome, a 75% rate, would also apply for the most extreme case of
growth models, the Ramsey model, where the supply of savings is perfectly elastic.
Note that in both of these extreme cases, the after tax return is fixed and the total
burden falls on wage income, so that labor income would fall. One could also
calculate a corporate tax rate than maximizes revenue while taking into account the
effect on wages and keeping the wage rate constant. Again, relying on the model in
Gravelle and Smetters and maximizing,
tRK
REV =
+ t WL
(A4)
(1 − t
l
)
Where t is the tax rate wages, we obtain a revenue maximizing corporate tax rate
l
of t = (µ(1 − t )) (σ − t µ) . With an approximate 20% tax rate on labor
l
l
income, the revenue maximizing corporate tax rate is 70%. Note however, that this
is not the rate that would be found in the cross-section analysis.

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CRS-33
Appendix B. Data and Estimation Methods
We obtained the data used in the Hassett and Mathur study and the Clausing
study.52 The data used to replicate the Brill and Hassett study were obtained from the
original sources cited in the study.53 We were able to replicate the results reported
for all studies.
The data we use are for several countries for a period of several years, and are
known as panel data. The model of the relationship between the corporate tax rate
(the independent variable) and the various dependent variables takes a linear form:
Y = α + X
β
+ ε
(B1)
it
it
it
where Y is the dependent variable, X is the independent variable (the corporate
it
it
tax rate in our case), α and β are the regression parameters to be estimated, and εit
is a random error term.54 The subscripts, i and t, indicate that information for a
particular observation comes from country i for year t (for example, information for
Australia for 1992). The random error term, ε , is a random variable and captures
it
omitted and unobservable factors or variables that affect the dependent variable. The
error term will be discussed in further detail below.
If the following conditions are met:
! the expected value (mean) of the random error term, ε , is zero;
it
! the variance of the random error term is constant for all
observations;
! the random error term for one observation is uncorrelated with the
error term for another observation; and
! the random error terms are uncorrelated with the explanatory
variables...
then the ordinary least squares (OLS) estimators will yield the best linear unbiased
estimators of the parameters ( α and β ). The β parameter shows the true
relationship between the dependent variable and the independent variable, and is the
52 We thank the authors for providing their data to us. The studies are Kevin A. Hassett and
Aparna Mathur, Taxes and Wages, American Enterprise Institute, working paper, 2006; and
Kimberly A. Clausing, “Corporate Tax Revenues in OECD Countries,” International Tax
and Public Finance, vol. 14 (2007), pp. 115-133.
53 Alex Brill and Kevin A. Hassett, Revenue-Maximizing Corporate Income Taxes: The
Laffer Curve in OECD Countries, AEI working paper #137, American Enterprise Institute,
July 31, 2007.
54 For ease of exposition only one independent variable is written in the equation.
Generally, several independent variables are included in the linear model. This
simplification does not change the following discussion of our model and estimation
techniques.

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CRS-34
parameter of interest to us. Denote the estimate of β as $
β . Since $β is an estimate,
it is a random variable drawn from a probability or sampling distribution with an
expected value (mean) and variance. This estimator will have the following desirable
properties:
$
! unbiased: the expected value of β is β ;
$
! efficient: the variance of β is smaller than the variance of all other
unbiased estimators; and
$
! consistent: the probability distribution of β collapses on β as the
number of observations gets arbitrarily large.
Estimation problems often arise with panel data because one or more of the
conditions listed above are not met. The result is the OLS estimator will be biased
and inconsistent. Problems arise with panel data, as is demonstrated when equation
(B1) is rewritten as:
Y = α + X
β
+ ν + φ + η .
(B2)
it
it
i
t
it
The term ν is an effect (unobserved heterogeneity) specific to a particular country
i
capturing differences among countries in (1) the measurement of economic data, (2)
economic institutions, (3) laws and regulations applying to business, and (4) attitudes
toward business, among other things. The term φ is a time specific effect capturing
t
such things as the international business cycle. Since the corporate tax rate is a
reflection of the attitudes toward business in a country, X and ν will be correlated.
it
i
Ignoring the country-specific unobserved heterogeneity means that the OLS estimate
of β is biased and inconsistent because the error term in equation (B1) is correlated
with the explanatory variable — one of the conditions listed above is violated.
Another problem often encountered with data that has a time dimension is the error
terms are correlated from one year to the next year (called autocorrelation).
Statistical tests indicate that these problems exist with the data we obtained.
Consequently, we estimate the parameters of the model using the fixed effect
estimation procedure allowing for an AR(1) error structure.55
Identification
Neither Brill and Hassett nor Clausing offer any justification in their studies for
using OLS rather than the fixed effects method to estimate the parameters of their
model. A well-known drawback of the fixed effects method is variables that vary
across countries, but not across time within a country, cannot be included in the
estimation (that is, the parameters associated with these variables are not identified).
55 See Christopher F. Baum, An Introduction to Modern Econometrics Using Stata (College
Station, TX: Stata Press, 2006) for a description of this technique. Our overall results and
conclusions are not changed when using the random effects estimation procedure allowing
for an AR(1) error structure.

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CRS-35
Devereux (2006) claims “changes in the statutory [corporate tax] rate within a
country are comparatively rare. In practice, as found by Clausing (2006), there is not
enough variation within country to identify an effect of the statutory rate, conditional
on country fixed effects.”56
To check the correctness of this statement and the justification for using OLS,
we directly examine the variation of the corporate tax rate across countries and over
time. Table B1 displays the results for the data from the three studies we reanalyzed.
The first row displays the relevant explanatory corporate tax rate variable used in the
study. The second row reports of mean of the variable. The third row reports the
standard deviation (a measure of variation of a variable) of the corporate tax rate
variable. The last two rows decompose the standard deviation into the between
country component and the within country component. If there is no variation in the
variable over time within countries, then the within component of the standard
deviation will be zero. Consequently, the effect of that variable on the dependent
variable is not identified conditional on fixed effects (that is, it cannot be estimated
using the fixed effects procedure). As can be seen from the table, there is almost as
much variation within countries (the within component) as there is between countries
(the between component).
Table B1. Standard Deviation of Corporate Tax Rate Variables in
the Three Data Sets
Brill and Hassett
Hassett and
Clausing Data
Data
Mathur Data
Logarithm of
Variable
Corporate tax rate
Corporate tax rate
corporate tax rate
Mean
0.362
0.354
-1.106
Overall Standard
0.092
0.101
0.396
Deviation
Between
0.065
0.078
0.307
Component
Within
0.064
0.063
0.248
Component
Source: Authors’ analysis of data.
In addition, we find that all OECD countries changed their corporate tax rate at
least once between 1979 and 2002. Four countries (Ireland, Norway, Spain, and
Switzerland) changed their corporate tax rate only once during this period. In
contrast, Luxembourg changed their corporate rate 12 times over this period. On
average, OECD countries changed their corporate tax rates once every five years.
Therefore, we can find no evidence to support the argument that the effect of the
corporate tax rate on corporate tax revenues is not identified conditional on fixed
effects.
56 Michael P. Devereux, Developments in the Taxation of Corporate Profit in the OECD
Since 1965: Rates, Bases and Revenues, University of Warwick, working paper, May 2006,
p. 20.

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