Effects of Corporate Tax on Economic Growth : The Case of Sweden

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EFFECTS OF CORPORATE TAXES ON ECONOMIC

GROWTH: THE CASE OF SWEDEN

Bachelor’s thesis within Economics Author: Essoh Forbin

Tutors: Johan Klaesson Johan P Larsson Jönköping August 2011

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[Bachelor’sThesis in Economics

Title: Effects of Corporate Tax On Economic Growth: The Case of Sweden Author: Essoh Forbin

Tutors: Johan Klaesson Johan P Larsson

Date: 2011/08/31

Subject terms: Corporate tax, economic growth, and distortionary effects of taxes

Abstract

This paper examines the empirical effect of corporate Income tax on GDP growth rate using historical data from 1951-2010 for Sweden. Economic theory postulates that cor-porate tax rates should significantly negatively affect GPD growth rate. Some past em-pirical works on cross-country panel data also supports this significantly negative corre-lation between growth rate and corporate tax. However, empirical works using country specific time-series data show deviations and contradictions to this conventional wis-dom. Using time series data, I find that corporate income tax rates have no significant effect on Swedish economic growth.

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1 INTRODUCTION

1.1 Background

Economic growth has always been a hot topic of deliberation on political and economic forums. To match this, numerous research works have been done on this field in general and the effects of taxes in particular. In many cases, the purpose for these research works has been political basis, be it as a campaign tool for some new presidential can-didate or an empirical finding to back congress’ repeal/enactment of a law. In fact, eco-nomic performance is, besides other factors, the main assessment of a politician’s tenure in office. This discernibly should be the case for obvious reasons. However, a retrospect into many economies annals reveals that meddling political goals with pure economic methodology can lead to results that deviate from reality. This paper is not about the politics of economic growth or of taxation systems but it is imperative to note that the purpose of such research works have been proven to greatly affect the results (Romer & Romer, (2007)).

In simple terms, economic growth is a long-term increase in the productive potential of an economy. This outlines one important aspect: the distinction between economic growth, a long-term change, and business cycles, which are simply short-term economic variations mostly characterized by booms and burst within months or a few years. Being a typical social process, there can hardly be any definite causes and precise periodic fig-ures for growth rate. There has been a wide variation in yearly economic growth in countries, and there is still a lot unknown as to the interaction of complex sociological, economic and political factors that bring about economic growth (Muten and Faxen, 1966). Solow (1970) asserts that growth depends on accumulation of labor and capital. As such, empirical studies on the effects of taxation on labor and capital do accommo-date the effects of these factors on growth.

In recent times, more factors have been given to account for growth. Lee and Gordon (2004) affirm this, stating that positive externalities omitted from neoclassical model provide more explanation to growth. They go further to cite R&D and entrepreneurial activity as sources of these externalities. Lucas (1998) emphasizes the potential of edu-cation as one other source, De long and Summers (1991) provide evidence of the possi-bility of equipment investment as vital positive spillovers. Evans and Rauch (1999) add (Webberian) bureaucracy as a contributing factor to growth.

Ideally, tax has one simple purpose, to raise adequate revenues to fund government in-terest and at the same time do the least possible harm to the economy. In more realistic world, tax policy acts as a steering wheel with which government exert control over the economy. Gentry and Hubbard (2000) offer evidence that a progressive personal tax structure discourages risk-taking. Gordon (1998) shows that the option to incorporate means that a low corporate tax rate relative to personal tax rates encourages risk-taking. Cullen and Gordon (2002) explore the many potential effects of the tax system on en-trepreneurial activity, and find strong empirical support for these tax effects using U.S. individual income tax return data during 1964-93. As such, investigating effects of taxes on GDP provide a suitable way to monitor economic growth (Johansson et al, 2008). Economic theory predicts that corporate tax rates should have a negative correlation with GDP. That is, the corporate tax multiplier effect has been shown to be negative. Since it is a deduction from income, it reduces the supposed profits of companies and

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thus is regarded as added cost. Since companies aim to minimize cost and maximize profits, tax run directly against their primary goal. However, it is mandatory, cost but for a few exceptions.

Theory aside, real life evidence proves that high rates lead to revenue losses from exo-dus, as investment is directed towards economies with low rates. Major firms are mov-ing to lower tax economies. In UK, Lloyd’s insurer Hiscox announced plans for reloca-tion to Bermuda in 2006 to avoid high corporate tax rates and excessive regulareloca-tion. Shire Pharmaceuticals, an FTSE-100 company, relocated to Ireland for tax purposes. Today, Ireland boasts seat of many US companies. Even more interesting and seeming-ly not coincidental, Ireland also has the lowest corporate income tax rate among OECD countries.

Empirical evidence for this claim is ambiguous. Some past works find that corporate taxes do negatively affect economic growth using cross-country panel data. Price Wa-terhouse Coopers (2010) not only confirm this, but also find that corporate tax is the most harmful type of tax to an economy based on evidence from research findings of Joint Committee on Taxation study (2005). Lee and Gordon (2004) too find similar re-sults using country data. Engen and Skinner (1996) confirm this too using cross-country panel data, but strongly note that this viewpoint is not necessarily evident from both theory and data. Gravelle and Hungerford (2007) find no compelling evidence from theory and historical data for a negative correlation between corporate tax and economic growth. Romer and Romer (2007) find a negative effect using time series data for the US economy, though they strongly emphasize that disregarding the causes of tax changes can result in significantly biased estimates of the macroeconomic effects of fis-cal action.

1.2 Purpose and Problem Statement

The purpose of this thesis is to investigate the empirical effects of corporate taxes on Swedish economic growth using time-series data from 1951-2010. More formally, in this thesis, I aim to find out the answer to the question:

Does the statutory corporate income tax rate for Sweden have a significantly negative effect on its economic growth?

1.3 Corporate Taxes and Economic Growth: SWEDEN

A thorough glance at the Swedish economy reveals some interesting facts. Sweden is a highly diversified export oriented economy. Its main industries include pharmaceuticals, telecommunications, automobile, household appliances, industrial machine, forest prod-ucts, chemicals, iron, steel and other investment goods. Sweden boasts multinational corporations like AstraZeneca, Nordea Bank, Forex bank, Ericsson, H&M, and Electro-lux. It is also noted for the birthplace of several other corporate big names like IKEA, Biacore, Volvo, and Saab. Worthwhile noting too, it was the founding place of tech start-ups like MySQL AB, Spotify AB and Skpye (Swedish-Danish). While high taxes might be a possible reason for the relocation of some of these ventures, access to a large customer base can be another. Companies in Sweden are in overwhelming private con-trol.

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Substantial studies have been made on the Swedish tax system. Note mentioning are Genberg (1942), Jakobsson and Normann (1972), Rodriguez (1980, 1981), Gårestad (1987), Södersten (1984, 1993, 2004), Birch-Sörensen (2008). These studies incorporate extensive information about the Swedish tax system. However, none of them explore on the effects of corporate tax on economic growth. Muten and Faxen (1966) dwell on Swedish economic growth, but their paper predates most of the period upon which this thesis focuses.

Sweden experienced rapid increases in living standards during the 1950s and 1960s, af-ter which economic growth slowed, trailing behind those of most other developed coun-tries. In the early 1990s, due to the culminating effects of imprudent regulations, myop-ic econommyop-ic polmyop-icies and bursting of the property bubble, Sweden was hit with an eco-nomic crisis, plunging figures of its ecoeco-nomic indicators. By 1994 the economy was back again on track and was again abreast with its other industrialized counterparts. Over time however, other industrialized countries like Canada, Norway, Netherlands and Ireland have outpaced Sweden in terms of GPD per capita; thus it has lost its high rank as one of the world’s richest nations (Jacobsson et al, 2001). That not withstanding, throughout most of its recent history, it has always kept abreast with some of its indus-trialized counterparts in economic growth.

Sweden learnt a great deal from its ordeals. After its banking crashes in the early 1990s, it has adopted austere budgetary rules and strict bank supervisions helping it deter risks of another bubble. Despite being hit by the recent 2008/2009 global financial crisis, Sweden bounced back with profusely with a GDP growth rate of 5.7. It has maintained its renowned social welfare system, but has also gradually modified it towards lower taxes and smaller welfare benefits and thus taken Sweden out from welfare excesses. Inheritance and wealth taxes have been discarded. Retirement age stands high at 67. Sweden is noted for having the highest tax-to-GDP ratio in the world second only to fel-low Scandinavian member Denmark at some occasional years (Rodrigues, 1981; Riksskatteverket, 2002). Being a socialist nation, a progressive personal income tax sys-tem obtains. Personal income taxes stands out relatively high. During the 1960s, interest in taxation shifted from economic growth to income redistribution. Launching his sting-ing complaint, Myrdal (1978) asserted that the progressive income tax had driven up vehement incentives for high-income individuals to exploit the various tax avoidance clauses in the system and even outright tax fraud to the extent that the Swedish tax sys-tem no longer redistributed income. Corporate income taxes also stood high at around 58%. According to Agell et al (1996), non-corporate investments in general and housing in particular were given tax preference. Even worse, in the 1980s, the previously en-couraged profit reinvestment stance orchestrated through tax breaks was seen as an ob-stacle to efficient capital allocation. All these foul cries spelled an imminent reformation of the Swedish tax system.

In 1990, Sweden radically restructured its tax system to be applicable from 1991 on-wards. Its main goal was to lower tax rates while broadening the tax base. Consequent-ly, corporate tax rates were dropped by almost half from 57% to 30%, marginal income taxes were dramatically lowered and various tax shelters eliminated. Pre-reform esti-mates projected a revenue loss on the order of six percent of gross domestic product (GDP) due to the rate cuts. Moreover, this reform made the previously estrange Swedish tax system similar to those of other countries by keeping tax on corporate investment constant and reducing behavioral distortions associated with various incentive schemes.

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Thanks to this reform, Sweden’s rates have stayed moderate, slightly reducing further. Currently at 26.3%, its corporate tax rate is ranked median among OECD countries. Auebach et al (1995) in their investigation, conclude with some confidence that the ef-fect of the 1991 tax reform itself (as opposed to contemporaneous macroeconomic fac-tors) on equipment investment are likely to have been minor. However, they noted that it was difficult to tell precisely how the tax system influenced investment before the re-form. In this thesis, I use a dummy variable to measure the effect of this tax reform on both economic growth and slope intercept.

1.4 Thesis Outline

The remainder of the paper is structured as follows: section 2 delves further into the es-sential theoretical details of the distortionary effects of corporate tax on economic growth. Section 3 outlines the methodology used in this thesis, section 4 provides the result from the empirical findings, discusses the implications and various analytical per-spectives of the results and finally section 5 concludes the thesis and offers suggestions for further research.

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2 THEORETICAL FRAMEWORKS

Corporate taxes affect the economy in different ways. Previous research on the topic has identified several ways in which corporate taxes can act on economic growth, referred to as distortionary effects. By charging enterprise unevenly, taxes in general distort in-centives. Since taxes are a burden to efforts, by levying different rates to different activ-ities and at different locations, the more taxed enterprise tends to shrink and the less taxed proliferates. In a bid to minimize taxes, economic activity shifts from its most valuable opportunities, lead to misallocation of resources and hence economic ineffi-ciency. This section outlines these effects. Since this paper is about the effects of corpo-rate taxes on economic growth and the empirics on historical single country data, the theoretical framework here focuses on motivating those aspects of corporate taxes that actually affect growth and are measureable.

2.1 Statutory Vs. Effective Corporate Tax Rates

Before delving further, it is imperative to first note the difference between statutory and effective tax rates. Statutory rate is that stated in legislature to be levied on corporate earnings. Usually it applies as deduction from the sum of corporate receipts minus cost of labor and input materials and depreciation of capital assets. Effective rate on the oth-er hand is the actual tax a corporation pays. It is realized as an actual poth-ercentage charge on corporate economic profit. Various methods exist for computing effective tax rates, but an underlying characteristic is that it accounts for all other official tax payments, tax offset and a company’s tax base. It always tends to be less than the statutory rate, due to the numerous accounting and legal maneuvers within this tax code that corporations ex-ploit. Below are the most notable of these techniques:

Accelerated depreciation

In reporting net stock value, companies value their capital investments based on ac-counting rules guiding rate of depreciation. Usually there exist flexibility within the tax code on this asset valuation. Companies tend to write of their assets faster than they ac-tually wear out based on the technicality of tax deferral. This tax deferral can last as long as company’s investments continue. Thus they report a less than actual value of as-sets that transcribes as more cost incurred.

Stock Options

Most huge corporations offer their management and employees a stock preference by way of options to purchase the company’s stocks at lower price in the future. Upon ex-ercising these options, corporations can get tax deductions from these losses equal to the difference in actual market stock price and the stock option price. Such stock option transactions are not reported as business expenses when reporting profits to sharehold-ers. The argument presented is that the market value of a company’s stocks has a very weak effect on its earnings; thus in actual fact these discounted stocks render little or no reduction to profits.

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Tax credits

For several different reasons (mostly as investment incentives), many countries’ tax codes offer tax credits for corporations that engage in certain activities; like employing low-wage workers, some forms of oil drilling, renting of affordable housing, export, ex-ploiting alternative energy sources and research. These tax credits directly reduce a cor-poration’s taxes.

Tax shelters

Companies exploit several other legal strategies to reduce or completely avoid tax pay-ment. A very commonly applied tax sheltering activity is offshore sheltering, where a company creates a subsidiary abroad in a country with lower tax rates where it reports it operating transactions. In even bolder steps corporations completely relocate their head-quarters to these tax haven countries like British Virgin Islands, Bermuda, Ireland, Cayman and Switzerland. In most cases the only actual change per se is change in paper works (registration of headquarter) while the business transactions of these relocating corporations continue as usual. Other tax sheltering activities include abuse of transfer pricing, inflated transactions among related parties and leasing.

Tax shelters do not just roll along with impunity. Tax agencies query transactions based on fair market value and the relationships between the parties involved. Moreover, pro-fessional organizations question the business ethics of its propro-fessionals in such cases. Due to this bounty of deductions and loopholes in the corporate tax code, many pundits and policymakers readily argue that statutory corporate tax rate is of less importance than perceived since the actual revenue-fetching effective rate is lower. This point is du-ly watered down by evidence from Johansson et al (2008) that lowering statutory corpo-rate can result in significantly high gains in firms that are innovative and profitable. These firms do not only have a high potential to make the largest contribution to GDP growth, but they are also increasing in number in recent times. The statutory rate is the effective rate to these firms because they produce ideas and services and their revenue models are derived from intellectual property and licensing as opposed to large fixed as-sets upon which depreciation applies. Low fixed asas-sets in the current Internet era plus free business mobility within most economic areas implies a high sensitivity to statutory rates. Therefore, although statutory corporate tax rate may not be the actual rate that ap-plies to corporations, it does not necessarily deviate very much from the true figure ei-ther. Through out this thesis, corporate tax rate refers to the statutory rate.

2.2 Corporate Taxes and Growth Theory

2.2.1 Growth Theory

Tracing growth theory entails referring as far back as to the neo-classical growth models where the Harrod-Domar model first alleged that long-term growth is exogenously de-termined by saving rate (Roy Harrod, 1939; Evsey Domar, 1946). Later on, Solow ex-tended this by identifying the rate of technical progress as the determinant of economic growth. He added labor as a factor of production, included diminishing returns to both

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labor and capital separately, plus a constant returns to both factor combine. Finally, he introduced a technology variable, distinct from both labor and capital and which varies with time. Capital production is based on technology improvement that varies with time; thus new capital is more valuable than old one (Solow, 1956).

Per Lee and Gordon (2004), in a neoclassical model, growth simply depends on the ac-cumulation of human and physical capital over time. In the long run, any given tax structure leads to an equilibrium capital/labor ratio and an equilibrium level of educa-tion per worker. Any further growth in per-capita output is generated from an exoge-nous rate of technical change. There should be no permanent effects of the tax structure on the growth rate in per capita output, irrespective of the size of the misallocations generated by the tax structure. Nevertheless, a change in the tax policies can generate changes in this equilibrium and thus lead to temporary growth effects. These periods of temporary change can be measured in decades, however. Consequently, tax effects on the equilibrium capital stock can take quite some time for its impact to be noticed. This is due to adjustment costs to new investment in an open economy or the limited elastici-ty of savings rates in a closed economy. But Hall and Jorgenson (1967) maintain that low current effective tax rates on new investment have a high potential to stimulate short-run growth, since the temporarily lower tax rates lead an investment boost. Lee and Gordon (2004) estimate this will most likely be periods with low corporate tax rates.

2.2.2 Corporate tax and growth theory: mechanism

In clearer terms, consider the growth rate function first developed by Solow, (1956):

Y

i

= α

i

K

i

+ β

i

L

i

+ µ

i

where Yi denotes real GDP growth rate in country i, Ki is the net investment rate ex-pressed as a fraction of GDP or the change over time in the capital stock, Li is the per-centage growth rate in the effective labor force over time, µ_i measures the economy’s overall productivity growth. The coefficients αi and βi measure the marginal productivity of capital K labor respectively.

This framework underscores the five different mechanisms (corresponding to each of the five variables on the right hand side) through which taxes in general affect economic growth (Engen and Skinner, 1996). However, for the purpose of this thesis, the empha-sis is laid on the distortionary effects of corporate tax in particular. Firstly, high corpo-rate tax can be a disincentive to investment corpo-rate (K). Moreover, a higher corpocorpo-rate tax rate relative to personal income tax rate can lead to business proprietors avoiding taxes by reporting corporate profits under personal income instead. Also, the corporate tax policy can stifle productivity growth by discouraging research and development (R&D) and development of venture capital for industries highly dependent on advanced tech-nology, two activities whose effects on productivity is crucial. Furthermore, taxing sec-tors unequally leads to distortion of investment from heavily taxed secsec-tors to those taxed less, in which case a corresponding inefficient allocation of labor is possible. In so doing, tax policy alters marginal productivity of labor (Harberger, 1962, 1966).

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Using another route, the conventional method of measurement of economic growth is by computing change in a country’s quarterly or annual GDP or GNP which also equals total factor productivity (Y) above.

GDP= C+ I + G + EX.

Taxes directly affect all four determinants of GDP above. Corporate tax for the most part has direct bearings on investment. To some extend, it determines (or is determined by) government spending decisions since tax is one source of government revenues. Corporate tax rate also reflects a level of attractiveness of a country for businesses, with potentials to stimulate output for export, create more employment and thus generate consumption income. More details on how corporate tax distorts determinants of GDP are given below.

2.3 Distortion of Entrepreneurial/Business Activity

Entrepreneurial activity is known to be a crucial ingredient in stimulating economic growth. It spawns new ideas, innovations or even location advantages that lead to more productivity. Schumpeter (1942) laid emphasis on the role entrepreneurship in econom-ic activity. When these new ideas and innovative techniques succeed, they do not only introduce new value, but other businesses too copy and use them, leading to an even greater effect of entrepreneurial activity in economic growth. This entrepreneurial crea-tivity leads to business start-ups, job creation and income generation, which promote economic growth and are also bound to be affected by tax structures.

Cullen and Gordon (2002) offer the most general analysis so far, showing that there are several possible ways that tax structures can affect the amount of entrepreneurial risk-taking. If the tax levied on business income is less than that on wages and salary in-come, then there is an incentive to be self-employed. This will arise as long as corporate tax rate is below marginal personal tax rate.

Levying different marginal tax rates to profits and losses can gravely affect risk-taking. If entrepreneurs can rotate income and losses flexibly between the corporate and per-sonal tax base, or alter even their business as a whole between different organizational forms, then differences between corporate and personal tax rates offer a subsidy to risk-taking. More specifically, when personal tax rates are higher than corporate rates, there is the tendency for entrepreneurs to record any losses under non-corporate losses and profits under corporate. Gordon and Slemrod (2000) present evidence of income shift-ing between the corporate and personal income tax bases. Clausshift-ing (2006) finds a small but statistically significant effect of shifting income earned from corporate activity to that earned from non-corporate activity when corporate income tax rate is higher than the highest personal income tax rate. By so doing, they benefit by saving income that would have otherwise been lost to taxes. These tax savings to risk-taking to the differ-ence between the relatively higher personal income tax rate and corporate tax rate. Gordon (1998) puts forth some salient points on this topic. Firstly, despite being a sig-nificant factor, tax rates are not the only factor affecting entrepreneurial creativity, since these rates more or less equal effect on most other activities in general, and not entre-preneurial activity in particular. Also, personal and corporate income tax rate differen-tial in particular, is only one cause of income shifting among organizational forms. There is inherent high riskiness attributed to new businesses. As such, the treatment of

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tax losses and shape of the tax schedule can more generally affect the attractiveness of undertaking such risky investment. Moreover, start-ups usually need external finance. But a huge obstacle is outside investors most often have limited information about the financial prospects of these start-ups. At best, they could acquire this information for a cost, but their motivation for doing so is highly contingent on the tax treatment of the resulting income and precisely on the capital gains tax relative to the personal income tax rate.

Gentry and Hubbard (2000) stress that if businesses decide to remain non-corporate, then risk-taking is discouraged as long as personal income tax schedule is progressive. The argument here is that losses plunge the entrepreneur into a lower tax bracket result-ing in some amount of tax savresult-ing while profits drive him to a rather undesirable higher tax bracket. On the other hand, given that the nontax factors demand that the business should be corporate instead, then the no-loss offset provisions in the corporate tax code become very decisive. Here, the higher the corporate tax rate, the greater the net disin-centive to risk-taking.

Lee and Gordon (2004) raise the issue of entrepreneurial activity and tax evasion. They state that tax evasion is easier for the self-employed than for employees. In this regard, high personal tax becomes an incentive for entrepreneurial activity since its effect its felt more on employees than on self-employed. Furthermore, for a risk-averse entrepre-neur, taxation acts as a means of risk sharing with government. If financial markets fail at effectively distributing risks efficiently, at least for small firms, then entrepreneurial activity can be an increasing function of overall effective tax rates. In order to capture the aforementioned effects of discrepancies between both kinds of taxes, the methodol-ogy in this paper controls for the personal income tax rate corresponding to each annual corporate tax rate.

2.4 Distortion of Corporate Finance

Corporate Tax policy dictates method of finance of corporations. Acquisition of capital for corporate investment is either through equity, retained earnings or debt. Stiglitz (1973) showed that assuming perfect certainty and given various provisions in a tax sys-tem, the cost of capital, and therefore a firm’s optimal investment policy, is unaffected by the corporate income tax. Thus, cost of capital is simply the rate of interest. Hence a company continues to invest until when the marginal pre-tax rate of return net of depre-ciation is equal to the rate of interest. This would be a perfect axiom, but for the fact that firstly it assume perfection, which simply cannot be relied on in the real world. Moreover, apart from the fear inherent in interest rates hikes, the aforementioned stance does not fully represent the role of equity finance, especially in recent times. In a mod-ern economic era where technological momentum has seen an ever-increasing number of business start-ups, bubbles and bursts, both the high uncertainty involved and yet fast track profit opportunities have seen equity finance (and its tools like investment bank-ing, financial derivatives) sour high in popularity.

Equity finance is rewarded by payment of dividends from after-tax profit. A high corpo-rate tax implies less dividends to be paid out. Corporations usually allocate only part of their profit to shareholders and creditors. The other part is retained for reinvestment. This reinvested profit in turn goes to increase firm value in the form of rise in stock price and thus more income for equity holders if the decide to sell their stocks. Personal income tax already sucks up shareholders’ income from both dividends and sale of

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share. Paying corporate income tax adds up to double the tax burden on shareholders. Thus it acts as a disincentive to equity finance and a shift towards debt since no tax is levied on return to debt-financed investment. Being a form of investment and hence capital formation, which is crucial to economic growth, by discouraging equity finance, corporate tax leads to misallocation of capital and hence economic inefficiency.

Randolph (2005) argues that policy makers could well eliminate this double charge by simply elimination corporate income taxes but firstly this will create new distortions, as it will tend to favor corporations that did not dispense profits but instead accrued and ploughed back these profits. Also, some of the distortions arising from corporate taxes are intrinsic to the taxation of capital in general. As such, eliminating corporate taxes and its underlying distortions will entail integrating corporate and personal income taxes together.

Peter Merrill (2007) also highlights that high corporate tax also daunts the sale of ap-preciated corporate assets.

2.5 Distortions In The International Economy

The above distortions justify popular calls that taxes should be levied on economic rent only, since this will be expected to have no effects on investment and financing deci-sions in a traditional framework. This argument could be a remedy to the harm caused by corporate taxes, but it raises a problem: corporate taxes also render distortions in in-ternational economic activities. In a hypothetical closed economy, aggregate domestic investment is equal to aggregate domestic savings. As such, the effect of corporate in-come tax on investment is therefore contingent austerely on the degree to which this tax affects savings. However, realistically, there is openness of economies to international capital flow. Availability of funds for domestic investment in each country is not only based on total available worldwide savings, but also by where suppliers choose to direct their funds. As Randolph (2005) argues, irrespective of its effect on worldwide savings, by varying across countries, corporate tax may affect where savers decide to invest. In-ternational variations thus distort the amount of investment in each country, the corre-sponding tax revenues they generate and the costs corporations incur in planning ways to minimize the taxes they are obliged to pay. In addition, these variations raise even farther-reaching concerns for an economy: reductions in business efficiency as corpora-tions allocate capital for specific uses based on tax consideracorpora-tions, reduction in real wages due to reduction in capital available for worker and reduction in the tax base since businesses with operations in multiple countries can adjust operations to shift their taxable income to more tax minimizing countries (Randolph, 2005). By directing in-vestment location and labor productivity, corporate tax policy tends to affect a country’s import/export activity and employment.

Notwithstanding, the way a country alters its rate affects and is affected by other coun-tries. In enacting tax policies, countries are guided by their own self-interests. A country sets its tax rate as it deems adequate enough to attract investment and boost its econom-ic welfare. Historeconom-ical trends show that most countries reduce their rates to maintain competitiveness. Based on data for countries from 1982 to 2003, Randolph (2005) re-ports that countries do not change their corporate tax rates independent of one another. As Devereaux and Sørensen (2005) put it, countries are in a race to the bottom to attract either inward investment or mobile profit. Ireland stands out as an outlier with the

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low-est corporate tax rate in the OECD and has become seat of headquarters of many corpo-rations.

To sum up, as highlighted above, corporate taxation affects an economy by distortions to entrepreneurial/business activity, acquisition of corporate finance and internation-al/open economic activities. These result to readjustments in investment, wages, em-ployment, labor productivity and business location; all of which lead to economic inef-ficiency. The figure below summarizes this framework:

Figure 1: Mechanism through which corporate tax affects GDP

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3 DATA, METHOD AND VARIABLES

The empirical approach here is one that aims to captures the effects of corporate tax on real growth rate of the GDP for Sweden. As seen in the theoretical framework, corpo-rate tax has its hugest impact on investment. Using a model with investment as depend-ent variable and corporate tax as independdepend-ent variable plus controls would be a good way to measure these effects, but this will fail to account for the other effects of corpo-rate tax above which lead to inefficiency in the economy apart from investment. There-fore using economic growth rate instead would be more suitable. Based on this logic, investment is excluded from the model. I use time series data from 1951-2010. In order to compare with the multiplier effects of other macroeconomic factor affecting GDP growth, net export and total government expenditures are set as controls. All variables have been adjusted for inflation. Furthermore, to measure the effect of the 1990/1991-tax reform, I use a dummy variable. Table 1 in the appendix shows the descriptive sta-tistics of these variables.

3.1 Regression Model

Previous works have shown that cross-country panel data most often reveals the ex-pected negative correlation since many of the authors who deployed this method found corporate taxes to be negatively related with GDP. However, country-specific time se-ries data method is less common. In particular, Engen and Skinner (1996) first use country-specific time series data but find a positive correlation in some decades and negative in others. Next they fall back to the usual cross-country panel data and get the obvious result-a significantly negative correlation. Romer and Romer (2007) use US historical quarterly time series data, taking 12-quarter lag periods and find a negative correlation.

For the purpose of this thesis, I use historical annual time series data for Sweden. First I use a simple regression model that captures the effects of statutory corporate income tax rates on GDP while controlling for other relevant determinants of GDP. Thus the model used is as presented in equation (0) below:

Y = B0 + B1 CTR + B2GE + B3 NETx + B4 Rf + u (

0)

Where Y = real annual growth rate of Sweden’s GDP CTR = Statutory corporate tax rate

GE = Total government expenditures NETx = Net Export

U = error term

Rf = dummy variable D= 0 for years before 1991 and 1 from 1991-‐2010

Time series data involving GDP and its determinants usually reveals autocorrelation and multicollinearity problems. Table 1 below shows multicollinearity between CTR and

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GE. Moreover, there is expected to be autocorrelation among variables and their lags in time.

Table 2: Correlation Matrix of all Variable

Variable GR CTR GE NETx Rf RfCTR GR 1.000 CTR 0.137 1.000 GE -0.287 -0.683* 1.000 NETx 0.184 -0.317 -0.081 1.000 Rf -0.207 -0.966* 0.801* 0.259 1.000 RfCTR -0.215 0.963* 0.797* 0.250 0.999* 1.000

*Correlation between variables

These econometric problems are resolved by de-trending, that is taking first difference on growth rates, corporate tax rates, government expenditures and net trade. The result-ing correlation matrix is shown in table 2 below:

Table 3: Correlation matrix of all variables after taking first difference

Variable dGR dCTR dGE dNETx Rf RfCTR

dGR 1.000 dCTR 0.157 1.000 dGE 0.185 -0.031 1.000 dNETx -0.157 -0.032 -0.168 1.000 Rf 0.053 -0.176 -0.054 0.144 1.000 RfCTR 0.044 -0.188 -0.051 0.154 0.999* 1.000

*Correlation between variables

Note: The letter “d” before the abbreviation of each variable imply the variable has been de-trended by taking first difference

For a proper account of the 1990/1991 tax reform I investigate its effect on both the slope and on the corporate tax multiplier effect, that is by running two separate regressions on the de-‐trended variables as shown below

First for the effect of the 1990/1991-‐tax reform on intercept, when the dummy turns from 0 to 1 in equation (0) above, collecting like terms gives:

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Y = (B0 + B4) + B1 dCTR + B2 dGE + B3 dNETx + u (1)

where ( B0 + B4)

= intercept shift due to dummy.

Next, for the effect on corporate tax multiplier effect, the dummy is multiplied by the corporate tax rate in equation (0) above and the equation is as below:

Y = B0 + B1 dCTR + B2 dGE + B3 dNETx + B4 RfCTR + u

Collecting like terms when Rf =1 gives:

Y = B0 + (B1 + B4) dCTR + B2 dGE + B3dNETx + u (2)

Where (B1 + B4) = slope shift due to dummy.

Therefore both regression models (1) and (2) are run for the data set.

De-trending results in loss in contemporaneous long run effects. However, corporate taxes in themselves do not seem to have immediate effects on an economy. Whatever the case, to counter this de-trending and also account for the lag effects of corporate tax, I used lagged values of taxes from 0 to 6 years. Moreover, a five-year moving average of CTR is used as well to further make allowances for the time frame upon which cor-porate tax affects economic growth.

3.2 Control Terms

GDP can be affected in several ways by numerous economic, political and social fac-tors. Government expenditure and net export are set as control since both are macroeco-nomic determinants of GDP growth. Moreover, government expenditures is of rele-vance since Sweden has high social welfare and collective goods. Sweden is a huge ex-porting economy, running trade a surplus since 1980 and heavily dependent on export thus net export is a vital explanatory variable the for Sweden’s GDP..

Notwithstanding that, some factors offer little contribution or are simply irrelevant here. Political stability, corruption index, accessibility and institutionalization are of rele-vance only in cross-country studies where development is a strong determinant of eco-nomic growth and involves developing countries. These determinants of GDP tend to be of less relevance when dealing with a specific country.

Education is an important determinant of GDP (Mankiw et al.1992). Despite the many debates on the best measure of education, it has been expected to be the most influential factor affecting economic growth, (e.g. Benhabib and Spiegel, 1994; Pritchett, 1996). However, it is deliberately omitted in this thesis due to difficulty in finding the annual literacy rate for Sweden from 1951-2010 from both Swedish and international data banks. Nevertheless, this omission implies the effects of taxes on growth rates in GDP now incorporate any effects of taxes on education.

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3.3 Data

Statutory corporate tax rates for Sweden were gotten as exogenous data. Figures from 1951-1991 are gotten from Henrekson (1996), while those from 1992-2010 were ex-tracted from tradingeconomics.com. All the other Swedish data were obtained from Swedish statistics board (SCB) website.

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4 RESULTS

4.1 Table Summary of Regression Results

Table 4 below shows the results of regressions on the intercept effects; the coefficients of both CTR and intercept dummy Rf with their respective t-statistics in bracket below each. The last column shows the result for a five year moving average of corporate tax. A complete result table showing the coefficients of all the regressors, AIC and R2 is found on table 6 in appendix 1.

Table 4: Result on intercept effects: Coefficients of CTR and intercept dummy Dependent variable: Real annual growth rate

Coeff Yearly lag of Corporate tax rates(dCTR)

Lag 0 Lag 1 Lag 2 Lag 3 Lag 4 Lag 5 Lag 6 MA5

Corp Tax (dCTR) 0.148 0.021 0.055 -0.171 -0.123 0.130 0.049 -0.017 (1.342) (0.165) (0.452) (-1.503) (-0.05) (0.118) (0.400) (-0.642) Dummy (Rf) 0.006 0.004 0.005 0.002 0.002 0.007 0.005 0.001 (0.849) (0.582) (0.703) (0.270) (0.301 ) (0.888) (0.671) (0.119)

t-statistics in parentheses, P-value: *** p < 0.01, ** p < 0.05, * p < 0.1

Table 5 below shows the results of regression on slope effects; the coefficients of both CTR and slope dummy Rf CTR with their respective t-statistics in brackets below each. The complete results showing the coefficients of all the regressors, AIC and R2_{is found} on table 7 in appendix 1.

Table 5: Result of slope effect: Coefficients of CTR and slope dummy (RfCTR) Dependent variable: Real annual growth rate

coeff Yearly lag of Corporate tax rates (dCTR)

Lag 0 Lag 1 Lag 2 Lag 3 Lag 4 Lag 5 Lag 6 MA5

Corp Tax (dCTR) 0.148 0.021 0.054 -0.174 -0.125 0.128 0.047 -0.018 (1.340) (0.165) (0.449) (-1.519) (-1.07) (1.098) (0.380) (-0.687) Dummy (RfCTR) 0.020 0.014 0.017 0.005 0.006 0.022 0.017 0.002 (0.802) (0.521) (0.649) (0.195) (0.236) (0.820) (0.607) (0.050) t-statistics in parentheses, P-value: *** p < 0.01, ** p < 0.05, * p < 0.1

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4.2

Interpretations

Firstly the tables show that all the coefficients are statistically insignificant along over a time frame of zero to six years; even the five year moving average. This implies empiri-cal evidence does not back theoretiempiri-cal claims that corporate taxes do discourage eco-nomic growth.

Next, comparing regressions, the 1990 tax Reform had a weak effect on corporate taxes, which translates to an insignificant effect on the economic growth. Again the five-year moving average on corporate tax yields no effects on both the pre and post 1990 era. These results reaffirm Auebach et al (1995) findings that the 1990/1991-tax reform had a weak effect on the economy. However, before diving into firm conclusions, a number of issues ought to be addressed.

4.3

Discussion

Firstly, empirical strategy is critical to any results. Engen and Skinner (1996) point out some shortcomings in time series analysis. To begin with, time-series analysis between tax rates and economic growth rates produces ambiguous results. In some decades, they found a positive correlation and in others it was simply negative. There was a similar situation in this methodology where, some lag years yielded positive correlations while others gave negative. As they suggested, more proper econometric methods that control for other determinants affecting output independent of taxes might produce purer re-sults. Moreover, time-series analysis is more suitable for identifying short-term effects of tax changes on output growth. The problem is this in itself may portray elements of unmeasured factors associated with tax changes. Also, in aggregate time-series analysis, it is particularly tricky to pinpoint which exact characteristic in a tax reform (reduction in top marginal tax rates, allowances for depreciation, tax progressivity) caused changes in growth rates. Thus they dropped time-series and used cross-country panel data in-stead, which yielded the expected negative effect of corporate tax rates on economic growth. In addition, apart from tax reforms, due to the many other economic activities occur in the economy during these 60year span, it is a bold demand to expect time series analysis to detect these probably miniscule changes in economic growth caused by cor-porate taxes alone.

The next issue questions what exactly in the tax system distort economic activities. It is not obvious whether business stakeholders are concerned about the high tax rate in par-ticular or the complexity of the tax code in general. More so, there is no clarity as to what proportion of these stakeholders have like mind in these concerns. For instance, in one study conducted in Britain in the early 1960s, out of 181 executives, not even one indicated that they abandoned the introduction of a new plan or equipment during the past seven years because of tax changes (Corner and Williams, 1965). In a more recent survey studies, a larger impact of taxation is borne by discount rates used to evaluate private investment projects instead (Poterba and Summers, 1995). This tax survey ex-pressly asked Fortune 1000 executives whether a tax cut would change the minimum rate of return required for approval of internal corporate investments. Even with their sound tax know-how, 36% indicated that a cut from 34 to 25% does not make them more likely to undertake new investment projects. These surveys reveal that tax rate in itself might not be the only determinant of investment decisions.

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It is also worthwhile noting the argument put forth by Hall and Jorgenson (1967) that the traditional justification for usefulness of tax stimulus is not founded on grounds of empirical evidence, but on the credible explanation that the lower the cost on capital in-vestments, the more attractive they are to profit-seeking businessmen.

The discrepancy between statutory and effective rates is also called to question. Until the 1990/91-tax reform, the effective corporate tax rate was markedly lower than the statutory rates. Most of this was due to the allowances of profit deductions for reinvest-ment, generous allowances of up to 50 percent of inventory value in the 1980s, and the small mitigation on the double taxation of dividends. Once again, it will sound mislead-ing to investigate the effects of corporate tax on the Swedish economy usmislead-ing statutory and not effective corporate tax rates. But in addition to the arguments previously men-tioned, it can also be claimed that the higher the profit rate is, the more the effective corporate tax rate increases and approaches statutory rates (Södersten, “2004). Anders-son (2002) affirms this viewpoint by contending that when profit levels are low, depre-ciation and inventory write-down allowances in the tax base are relevant, but when prof-it levels are high, statutory rates tend to be more relevant.

If corporate taxes have such adverse effects as theory suggests, a foreseeable question will be: what then stops all corporations from relocating into tax havens? The loopholes in tax systems corporations exploit as tax avoidance schemes are also deliberate means by which governments use tax policy to control corporate activities. In Sweden for in-stance, reinvestment deductions was used to promote growth of large corporations in the pre-reform era. Apart from tax avoidance schemes, there is a movement constraint in-herent in the nature of some corporations. Unlike Knowledge-based companies whose inputs are human and IT related resources can be mobile or readily delivered thanks to technological advancements, traditional manufacturing companies are built on plant and equipment and other fixed assets. Relocation of such firms can only occur in the long run. Even so, this will hardly be without the trade off of underpriced quick disposal of fixed assets. Moreover, bilateral tax treaties not only define primary taxing rights and help avoid double taxation of dividends, but it also ensures to a great extent that tax regulations of member countries are observed.

Furthermore, the harmful effects of corporate tax on entrepreneurial/business activities tend be overstated or even confused with those of (progressive) personal income tax and other kinds of tax. According to Engström and Holmlund’s (2006) estimates, house-holds with at least one self-employed member underreport their total income by at least 30% and underreporting is twice more prevalent among the self-employed with unin-corporated businesses than those with inunin-corporated businesses. Also, considering Swe-den’s most renowned company-IKEA, founded in Sweden but now relocated in differ-ent tax havens under complex organizational forms for tax purposes. Its relocation is en-flamed by far more by the personal income, wealth and inheritance taxes than by corpo-rate tax. Tax expert and Chairman of IKEA parent company Göran Grosskopf is quoted by Swedish newspaper The Local to have said that if the abolition of gift, inheritance and wealth taxes had occurred before its relocation, then IKEA would still be head quar-tered in Sweden. In fact these abolitions have transformed Sweden into a tax paradise (The Local Newspaper, 01/03/2011, 17:00 CET). In like manner, high (progressive) personal income tax rates and other forms of tax like wealth, dividends and inheritance taxes share a large part of the disincentive for equity finance.

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On a broader picture, although many studies have pointed to corporate tax as a determi-nant upon which the economy is highly sensitive to, there are other determidetermi-nants with equal, if not higher propensity to affect growth, like the fiscal state of the economy, nat-ural, human and technological resources. Ireland’s corporate tax rate is among the low-est at 12.5%, yet it is currently facing a debt crisis. Even so, a more stringent analysis of the effects of corporate taxes on a country’s GDP reveals other seemingly microscopic yet pertinent factors like corporatization and corporate profitability in that country. Pi-otrowska and Vanborren, (2008) noted that in Sweden, both the level of corporatization and corporate tax revenues relative to corporate income increase, while the share of total business income relative to GDP significantly decreases.

In any case, several theoretical justifications confirm that corporate tax rates harm eco-nomic growth, but hardly has any opposing argument been anything close to these justi-fications. However, the empirical findings in this thesis do not back claims that taxes do harm economic growth, albeit econometric shortcomings and technicalities in the Swe-dish tax system. Despite being considered as moderate rates at Sweden still lowered its rates from 28% to 26.3% in 2008. International competition might be a reason for this recent cut, but one can hardly say for sure that it is without concerns for economic growth. For an economy with almost 70% of its GDP generated by the service sector, there is expected to be substantial sensitivity to tax rates.

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5 CONCLUSION AND FURTHER RESEARCH

This paper began with an expose´ of the various possible correlations that corporate tax rates have with economic growth. The question as to the case of Sweden was raised. Af-ter presenting several theoretical frameworks on the distortionary effects of corporate tax on an economy and previous empirical findings as well I then laid particular empha-sis on Sweden. Using time series analyempha-sis, I conducted empirical analyempha-sis from1951 to 2010. Based on the results, I conclude that there is no empirical evidence that corporate taxes do have a negative effect on Swedish economic growth. Also this thesis reveals that a he 1990/1991-tax reform had a weak effect on the Swedish economy, also in line with previous findings.

For further research on this topic, a number of suggestions could be of relevance. One such is obtaining more data. Conducting this research with more data, preferably quar-terly data may be more promising since econometric analysis in general and time-series in particular gets more reliable with a larger number of observations. Also, controlling for other factors that affect economic growth independent of taxes will also yield more reliable results. Moreover, marginal effective tax rate (METR) on new investment, which measure how corporate tax rates affects the rates of return on new investments, is a better measure of how corporate taxes affects a firms incentives to undertake new in-vestments. Investigating this correlation will be a more precise way of determining one of the main effects of corporate taxes on the economy.

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Appendix 1: Tables of regression results

Table 1: Descriptive statistics of variables in the regression models

GR Mean 0.027 Median 0.030 Maximum Minimum 0.068 -0.053 Std. Dev. 0.0219 Skewedness -1.039

CTR 0.451 0.504 0.622 0.263 0.125 0.192

GE 65.585 67.830 106.399 17.893 27.101 0.193

NETx -6.17 -6.517 0.301 -11.943 2.731 0.194

Table 6: Complete result table for Intercept effect Dependent variable: Real annual growth rate (dGR) Statistic Yearly lag of Corporate Tax rate (dCTR)

Lag 0 Lag 1 Lag 2 Lag 3 Lag 4 Lag 5 Lag 6 5yr Av

Corporate Tax (dCTR) 0.148 (1.340) 0.021 (0.165) 0.055 (0.449) -0.171 (-1.519) -0.123 (-1.07) 0.130 (1.098) 0.049 (0.380) -0.017 (-0.687) Reform Dummy (Rf) 0.006 (0.849) 0.004 (0.582) 0.005 (0.703) 0.002 (0.270) 0.002 (0.301) 0.007 (0.888) 0.005 (0.671) 0.001 (0.119) Control: Go-verment spending (dGE) 0.002 (1.311) 0.002 (1.239) 0.002 (1.184) 0.002 (1.184) 0.002 (1.233) 0.002 (1.117) 0.002 (1.071) 0.002 (1.231) Control: Net trade (dNETx) -0.002 (-1.040) -0.002 (-1.006) -0.002 (-0.906) -0.002 (-1.054) -0.002 (-1.100) -0.002 (-0.994) -0.003 (-1.034) -0.002 (-1.006) Intercept -0.005 (-0.937) -0.004 (-0.840) -0.004 (-0.885) -0.004 (-0.875) -0.004 (-0.791) -0.005 (-0.893) -0.004 (-0.783) 0.004 (0.303) AIC -4.450 -4.404 -4.394 -4.428 -4.402 -4.385 -4.342 -4.425 R2 _0.088 _0.060 _0.061 _0.099 _0.077 _0.080 _0.059 _0.064

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Table 7: Complete result table for slope effect

Dependent variable: Real annual growth rate (dGR) Statistic Yearly lag of Corporate Tax rate (dCTR)

Lag 0 Lag 1 Lag 2 Lag 3 Lag 4 Lag 5 Lag 6 5yr Av

Corporate Tax (dCTR) 0.148 (1.340) 0.021 (0.165) 0.054 (0.449) -0.174 (-1.519) -0.125 (-1.070) 0.128 (1.098) 0.047 (0.380) -0.018 (-0.687) Dummy (RfCTR) 0.020 (0.802) 0.014 (0.521) 0.017 (0.649) 0.005 (0.195) 0.006 (0.236) 0.022 (0.820) 0.017 (0.607) 0.002 (0.050) Control:Gov’t spending (dGE) 0.002 (1.305) 0.002 (1.231) 0.002 (1.179) 0.002 (1.181) 0.002 (1.232) 0.002 (1.109) 0.002 (1.067) 0.002 (1.229) Control: Net trade(dNETx) -0.002 (-1.040) -0.002 (-1.003) -0.002 (-0.905) -0.002 (-1.044) -0.002 (-1.094) -0.002 (-0.993) -0.003 (-1.030) -0.002 (-0.995) Intercept -0.004 -0.004 -0.004 -0.004 -0.004 -0.004 -0.004 0.005 (-0.912) (-0.806) (-0.856) (-0.835) (-0.757) (-0.855) (-0.747) (0.355) AIC -4.448 -4.403 -4.393 -4.427 -4.401 -4.382 -4.340 -4.424 R2 _0.086 _0.058 _0.060 _0.098 _0.076 _0.078 _0.057 _0.064

t-statistics in parentheses, P-value: *** p < 0.01, ** p < 0.05, * p < 0.1

Effects of Corporate Tax on Economic Growth : The Case of Sweden

EFFECTS OF CORPORATE TAXES ON ECONOMIC

GROWTH: THE CASE OF SWEDEN

[Bachelor’sThesis in Economics

Abstract

Table of Contents

Table of Contents

1

INTRODUCTION

1.1

Background

1.2

Purpose and Problem Statement

1.3

Corporate Taxes and Economic Growth: SWEDEN

1.4

Thesis Outline

2

THEORETICAL FRAMEWORKS

2.1

Statutory Vs. Effective Corporate Tax Rates

2.2

Corporate Taxes and Growth Theory

Y

= α

K

+ β

L

+ µ

2.3

Distortion of Entrepreneurial/Business Activity

2.4

Distortion of Corporate Finance

2.5

Distortions In The International Economy

3

DATA, METHOD AND VARIABLES

3.1

Regression Model

0)

3.2

Control Terms

3.3

Data

4

RESULTS

4.1

Table Summary of Regression Results

Interpretations

Discussion

5

CONCLUSION AND FURTHER RESEARCH

List of references

Appendix 1: Tables of regression results