Changes in Effective Tax Rates due to Fundamental Corporate Tax Reforms: Analysis of Financing Neutrality Using a Forward-Looking Model

While the current corporate tax system in Japan allows interest expense on debt to be deductible, no such mechanism exists for other financing, leading to a "debt bias." Therefore, the Comprehensive Business Income Tax (CBIT), Allowance for Corporate Equity (ACE), and Allowance for Corporate Capital (ACC) have been proposed. According to international comparisons by the OECD, the marginal effective tax rates in ACE-adopting countries are low, and these countries have reformed their corporate tax systems toward financing neutrality. This study conducts a comprehensive survey of empirical analyses of Japan's effective corporate tax rates and classifies them into four effective corporate tax rates. Further, fundamental corporate tax reform proposals using forward-looking effective tax rates are analyzed in line with Hanappi (2018), OECD (2020), and Spengel et al. (2020), who conducted international comparative studies of effective corporate tax rates. This study makes improvements to Japan's 2020 parameters in Spengel et al. (2020) to obtain the cost of capital (user cost of capital), marginal effective tax rate, and average effective tax rate values by financing and assets. The parameters of the proposed reforms are then incorporated into a model of the effective corporate tax rate to conduct a simulation analysis under a constant statutory tax rate. First, a simple CBIT that does not allow deductions of interest expenses increases the cost of capital, marginal effective tax rate, and average effective tax rate for debt financing. Second, a simple ACE that allows the deduction of opportunity cost at the notional interest rate on equity lowers the cost of capital, the marginal effective tax rate, and the average effective tax rate for retained earnings and new equity. Third, a simple ACC that allows all financing to deduct opportunity costs at the notional interest rate lowers the cost of capital, marginal effective tax rate, and the average effective tax rate for all financing. However, these results are difficult to compare due to different average effective tax rates. Therefore, conducting similar simulations under a constant average effective tax rate results in statutory tax rates of 25.57% for CBIT, 42.33% for ACE, and 42.62% for ACC, compared with 31.30% for the base case. Thus, CBIT reduces its tax rate by five percentage points from the current rate, but ACE/ACC requires a ten percentage point increase. It is also indicated that CBIT increases the cost of capital and the marginal effective tax rate while ACE/ACC reduces these rates. The above simulations are conducted assuming a simple CBIT with no deductible interest expense, a simple ACE/ACC where the notional interest rate matches the nominal interest rate, and the rate at which ACE/ACC is applied matches the statutory corporate income tax rate. Simulations that relax these conditions are conducted under a constant average effective tax rate. First, under CBIT, varying the deductibility of interest expenses has a limited effect on the cost of capital and the marginal effective tax rate. Second, when the notional interest rate is set lower than the nominal interest rate or when the tax rate to which ACE/ACC is applied is set lower than the statutory tax rate, the effect on the marginal effective tax rate is significant. These results have some implications: CBIT can ensure financing neutrality, but it increases the cost of capital and the marginal effective tax rate, which may negatively affect investment. On the contrary, ACE/ACC decreases the cost of capital and marginal effective tax rate, which can positively affect investment. In particular, the ACE has been introduced in many countries and is considered a promising proposal for future corporate tax reform in Japan.