The 80s Are Over: Why Tax Rates Matter More than Incentives

Changes in the makeup of economies, cross-border issues, and transportation and communication - among other things - make corporate tax rates more important than incentives.

In this new era of corporate taxation, it is not accelerated depreciation and tax credits that are the big draw for corporate investment. It's the reduction of corporate tax rates.

Why the change? There are several reasons.

First, as economies move away from manufacturing - as intangible assets become more important than plant and equipment, as the rate of profitability per dollar of physical capital increases - it is a straightforward matter of arithmetic that rates play a larger role than conventional incentives in determining the after-tax profit of investment decisions.

Second, as transportation and communications costs have dropped, and trade barriers and currency-controls have also declined, there is more cross-border investment than ever. In the old days – say, before 1995 – economists were thinking about how to use taxes to get a domestic firm to boost its domestic investment on the margin, for example, by 3 or 4%. In that case – that is, in the case of investment of borderline profitability – traditional incentives can mean a lot. And because this was the type of investment governments were trying to encourage, using tax credits and depreciation was a revenue-efficient way for governments to provide investment incentives. But with increased capital mobility, economists have changed their thinking about how taxes motivate investment. Under the new paradigm, governments are trying to influence location decisions of multinationals. Because these decisions involve large chunks of investment – not just those marginally profitable – tax rates matter more than tax credits.

Finally, as mobile as capital may be, profits are more mobile. In deciding where to channel profits, tax rate differentials are all important, and conventional incentives don't matter at all.

Terms like "globalization" and the "new economy" can often seem like weak catchall justifications for controversial reforms, so it's useful to have someone drill down and articulate why these ideas can and do influence tax policy. There will always be debate about how much tax rates matter in business investment decision-making. However, there is general consensus that tax rates do matter more now than ever before, and this excerpt effectively captures why this is so.