On the Double Taxation of Corporate Profits

This paper studies the aggregate and distributional effects of switching from taxing corporate profits at the firm level to taxing them at the household level, in the form of dividend and capital gains taxes. It is argued that a careful analysis of the relevant trade-offs necessitates the construction of a model that incorporates substantial heterogeneity across households and across firms. Such a model is constructed and used to evaluate the effects of several alternative reforms, where the main focus is on how to finance a reduction in corporate profits taxes. It is shown that using shareholder taxes to finance such a tax cut represents a better alternative to using labor income taxes, because it generates welfare benefits for a majority of households and can thus gather popular support. Focusing on shareholder taxes, the option of increasing dividend taxes only is evaluated against another alternative in which both dividend and capital gains taxes are increased. The former reform has the unintended consequence of creating misallocation of capital and this reduces the overall welfare benefits. The latter reform avoids introducing this distortion and is found to be the best alternative. In this scenario, a complete elimination of corporate profits taxes leads to an increase in long run output of approximately 2% and welfare gains equivalent to 1% of consumption. A less dramatic reform, in which the tax rates on all types of personal income as well as on corporate income are equalized, yields smaller overall benefits but is found to benefit more than 95% of households in the economy.