Do Subnational Business Taxes Reduce a Region's Competitiveness? A Computational General Equilibrium Analysis

By Williams, Michael F. | Competition Forum, July 1, 2006 | Go to article overview
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Do Subnational Business Taxes Reduce a Region's Competitiveness? A Computational General Equilibrium Analysis


Williams, Michael F., Competition Forum


EXECUTIVE SUMMARY

A common sentiment among economists is that business taxation by a subnational government is a bad way to raise revenue compared to other forms of taxation (such as wage taxation) because business taxes discourage capital formation, reduce the economic competitiveness of the region and harm the region's residents. We reject this view, construct a two-region, four-good, three-factor computational general equilibrium model of an economy, and perform simulations that show that state business taxes compare favorably to state wage taxes.

Keywords: Taxation, Factor Mobility, Regional, Business, Capital, Labor

INTRODUCTION

The prevailing view among economists who study state and local public finance is that business taxation at the subnational level should be avoided, since it discourages modernization and/or expansion of existing businesses, drives businesses out of the taxed region, discourages new businesses from locating within the region, and creates substantial economic losses. Economists who hold this view contend that other forms of subnational taxation, such as wage taxes, can raise revenue without this substantial deleterious effect on capital formation. We believe that this prevailing view is inaccurate for two reasons-first, because it is based on an overly simplistic model of subnational capital and wage taxation, and second, because it relies upon a theoretical construct-the small open economy-that is not a descriptively valid model of a state economy. To examine our belief, we build a computational general equilibrium (CGE) model of a hypothetical economy comprising two open, interacting subnational economies that both initially fund government expenditures with wage taxes. We then replace the wage tax with a business capital tax in one region while maintaining a constant level of government expenditure in the region. The results of these simulations support the notion that business capital taxation is an effective way to raise revenue for a subnational government compared to wage taxation, and that a subnational government can use such taxation to modestly increase its residents' welfare.

This paper proceeds as follows. We first review the claims made by others criticizing business taxation by subnational governments, and we point out flaws in the theoretical construct that leads to these criticisms. We then discuss an existing theoretical framework, developed by Arnold Harberger (1962) and extended by Peter Mieszkowski (1972) that can more realistically examine subnational tax issues. Then we adapt a CGE model of a hypothetical economy, first developed by Williams (2005), which we use to demonstrate the modest power of subnational business capital taxation to raise the welfare of the taxed region's residents relative to an equal yield wage tax. Finally, we discuss the importance of these results to policymakers and suggest avenues for further research.

BUSINESS TAXATION IN A SUBNATIONAL ECONOMY: CONVENTIONAL VIEW

Subnational taxation of business can take many forms, including corporation income taxes, sales taxes that fail to exclude business purchases, and business property taxes. Each of the aforementioned types of taxation impact business capital formation-business spending on buildings, equipment, and other hard assets in order to start a business, expand it, or replace depreciated equipment. The business property tax is perhaps the most direct tax on business capital formation and is one of the taxes most derided by economists (who generally refer to a tax on business capital formation as a business capital tax).

This negative sentiment against business capital taxation has its roots in the optimal taxation literature originated by Diamond and Mirrlees (1971), in which the existence of a small open economy is posited that by definition has zero market power in the much larger product and factor markets in which it participates. Readers who are non-economists may be unfamiliar with the small open economy construct.

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