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What is Business Tax?

Business tax refers to the taxes that businesses must pay as a normal part of business operations. Whether you are a sole proprietor, partner, part of a limited liability company, or a corporation, your business is responsible for adhering to tax regulations. Each type of business will produce distinct tax consequences. Consider your business' tax concerns along with its non-tax concerns, so that you'll know which type of entity will help your business prosper and grow, or make it easier to pass on to heirs. View Related articles

Why Business Tax?

Business taxes are important because governments can fund this money back into the economy in the form of loans or other funding forms. Taxes help raise the standard of living in a country. For the business to flourish, there has to be good infrastructure such as roads, telephones, electricity. When governments collect money from taxes it ploughs this money into developing this infrastructure and in turn promotes economic activity throughout the country. The higher the standard of living, the stronger and higher the level of consumption most likely is.

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Taxes do factor into business location decisions. For example, a growing body of academic research indicates that foreign direct investment (FDI) can be quite sensitive to the corporate tax rates imposed by a state or country. One recent study of the effects of corporate income taxes on the location of foreign direct investment in the United States found a strong relationship between state corporate tax rates and FDI—for every 1 percent increase in a state’s corporate tax rate, FDI can be expected to fall by 1 percent.

A new study of income tax rates in 85 countries by economists at the World Bank and Harvard University found a strong effect of both statutory and effective corporate tax rates on FDI as well as entrepreneurship. For example, the average rate of FDI as a share of GDP is 3.36 percent. But a 10 percentage point increase in the statutory corporate rate can be expected to reduce FDI by nearly 2 percentage points.

Corporate income taxes raise the cost of capital firms must pay when investing. A higher corporate tax translates into less investment and capital formation. Lower capital formation means that workers have less capital to work with, which lowers their productivity. Lower labor productivity translates into lower real wages and living standards.

One factor that affects capital formation is differences in the cost of capital between nations. In today’s global marketplace, capital increasingly flows freely across borders. When a country lowers corporate taxes, it attracts capital.

Recent research has focused on the lower corporate tax rates enacted by OECD nations over the past two decades to explore the link between corporate taxes and wages. This research has found that wage rates have gone up the most in countries with the largest reduction in corporate taxes. This finding is important because is tells a story whereby the corporate tax is borne by workers, through lower real wages, rather than by owners of capital. The intuition is simple: a tax will generally be borne by the input that is the least mobile. In today’s world economy, capital flows freely across borders, while labor does. Thus, the corporate tax lowers workers’ real wages relative to where they would be set otherwise.

In a world of greater economic integration and increased trade and capital flows, a firm’s decision about where to locate and expand its operations is increasingly influenced by factors such as a country’s business tax system and investment climate. In the past, U.S. levels of education and training provided distinct advantages to the United States. As emerging countries begin to approach U.S. levels of education and training, other imbalances, such as a business tax system that is out of line with other nations, become more important.

By standing still, the United States can expect to see reduced inflows of foreign capital and investment because the United States will be a less attractive place in which to invest, innovate and grow. U.S. firms will face a higher cost of capital than foreign firms, making it more difficult to compete in foreign markets.

Taxes also influence the level and location of investment decisions made by foreign firms. Research has suggested that a 10 percent increase in taxes reduces a country’s inflow of foreign direct investment (FDI) by 6 percent. One might expect multinationals’ location decisions to be similarly sensitive to tax rates, but the economic literature on that issue is mixed.

A more disturbing possibility emerges as the disparity grows between corporate taxation in the United States and its trading partners: a slower pace of innovation in the United States. A key determinant of economic growth, innovation tends to take place where the investment climate is best. Firms and their workers reap no benefits from technological advances until they’re brought into production. For example, new technologies are often “embedded” in new types of capital; an important innovation such as a faster computer chip does not confer any benefit on firms until they purchase new computers. Higher investment spurs innovation by raising the demand for these new technologies. This interplay between innovation and capital accumulation makes failure to reform the U.S. business tax system more damaging to the economy. As the U.S. corporate tax becomes ever more burdensome, the United States may fall behind in innovation and productive capacity.

What are the potential economic benefits of reform? The recent Treasury report, *Approaches to Reform of the U.S. Business Tax System for the 21st Century*, found that wholesale replacement of the U.S. corporate income tax with a consumption-based tax would increase economic output by between 2.0 percent and 2.5 percent in the long run.

Importantly, because this estimate does not fully capture the positive effects of free-flowing capital in a global setting or technological change, it is likely to be a conservative estimate of the potential benefits of reforming the U.S. business tax system.

Reform should focus on the entire U.S. business tax system. One key problem with the U.S. business tax system is that the U.S. statutory corporate tax rate is high relative to other industrialized nations, exceeded only by Japan. But, this comparison only tells part of the story.

Another problem is that that the effective marginal tax rate on investment, a measure which captures most of the features of a tax system— the corporate tax rate, the tax depreciation systems, tax treatment of debt, investor level taxes, etc.—is also somewhat higher in the U.S. as compared with G-7 countries. This more complete measure suggests there are broader aspects of the tax system that need to be considered as part of a reform. Also, in some respects, the comparison to the G-7 may be more important from an economic perspective because the U.S. has very large capital and trade flows with these larger economies.

Finally, what drives the average corporate rate in the United States below the average for the OECD or the G-7 is that the U.S. corporate tax base tends to be more narrow than in these other countries. Two types of provisions explain the more narrow U.S. corporate tax base. First, the United States provides accelerated depreciation for business investment. According to a recent Treasury report, *Approaches to Reform of the U.S. Business Tax System for the 21st Century* accelerated deprecation accounts for roughly one-half of the more narrow tax base. Importantly, accelerated depreciation helps mimic an important aspect of the consumption-based VATs prevalent in other countries: removing the tax penalty on saving and investment.

Second, the U.S. tax base includes myriad special tax provisions from the research and experimentation tax credit to the new markets tax credit that are targeted to specific types of projects and corporate activities. While these provisions lower the average corporate tax rate, they only do so only for firms engaged in these particular activities. Because of these targeted provisions, other taxpayers must face higher taxes to raise a given amount of revenue.

More than 120 countries around the world have value-added taxes (VATs). Most countries with VATs have also retained their income tax systems, in part, to address concerns over the regressivity of VAT systems and, in part, to finance government sectors that tend to be larger than in the United States. VATs also have the advantage of being more conducive to economic growth by, unlike the income tax, not imposing a penalty on saving.

An often underappreciated feature of the U.S. income tax system is that it shares, to some degree, a key aspect of VATs: a lower tax on the return to saving and investment. Tax-free saving accounts (e.g., IRAs, 401(k)-type plans, pension plans, etc) eliminate or reduce investor level taxes on the return to saving and accelerated depreciation for business investment lowers the effective tax rate on business investment. Indeed, the U.S. income tax is not an income tax at all, but a hybrid income-consumption-based tax system.

The key to making the United States more competitive in the global marketplace is making the U.S. a more attractive place to invest. This can be accomplished through various types of reforms, such as allowing faster write-off of business investment, which also makes the U.S. tax system more VAT-like, or lowering the corporate tax rate. Thus, some types of business tax reforms that would help improve the competitiveness of the United States are also consistent with the trend elsewhere of increasing the emphasis on consumption-based taxes.

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