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    • Finally we show that the optimal corporate tax rate is

    2023-02-13

    Finally, we show that the optimal corporate tax rate is strictly positive, balancing the increase in tax revenues against the loss in consumer surplus due to higher prices and fewer firms (products). This result is related to the well-known “excessive entry theorem” that shows, for a large class of oligopoly models, that the market equilibrium results in too many firms from a welfare perspective (e.g., Vickrey, 1964, Salop, 1979, Mankiw and Whinston, 1986). The corporate tax mitigates the welfare loss due to excessive entry, and we find that the optimal tax rate implements the first-best outcome, which is defined by maximizing the sum of (gross) consumer surplus net of production and entry costs. A positive corporate tax rate also implies that the benchmark result in the optimal tax literature that a small open economy should not levy any source-based taxes on the normal return to capital does not hold (e.g., Gordon, 1986). A key finding from our study is that the effects identified under Salop SANT-1 carries to a large extent over to a setting of monopolistic competition à la Dixit and Stiglitz (1977). Thus, our results suggest that corporate tax reform does not trigger (substantial) adverse effects across industries/sectors under imperfect competition. This conjecture holds if the economy is characterized by excessive entry (i.e., too many industries) and too little production per industry/sector. The rest of the paper is organized as follows. The next section presents and discusses related literature. In Section 3, we present the oligopoly Salop model. In 4 Oligopoly equilibrium, 5 Free entry equilibrium, we derive the market equilibrium and analyze the effects of corporate tax schemes in a static economy and with free entry, respectively. In Section 6, we conduct a welfare analysis of ACE and CBIT, as well as the optimal corporate tax. In Section 7, we present an extension where we use a monopolistic competition framework. In Section 8, the paper is concluded. Appendix A provides proofs of Propositions and Lemmas, whereas Appendix B presents the derivation of the monopolistic competition equilibrium.
    Related literature Previous studies of ACE and CBIT systems have been undertaken in a perfectly competitive setting. Radulescu and Stimmelmayr (2007) using computable general equilibrium (CGE) model. They show that welfare is higher under an ACE type of reform even if the loss of tax revenue is financed by an increase in the VAT. De Mooij and Devereux (2011) use an applied general equilibrium model for the EU calibrated with recent empirical estimates of elasticities to study a balanced budget reform. They focus on investment and profit shifting incentives following a tax reform and find that most European countries would benefit from a unilateral CBIT type of reform. A coordinated tax reform within the EU, however, would work in favor of an ACE reform. Keuschnigg and Ribi (2013) use a model of competitive markets and show that, if firms are cash-constrained, an ACE tax will affect investment decisions. However, the ACE tax still remains less distortive than a CBIT system. Köthenbürger and Stimmelmayr (2014) study how agency problems (such as empire building) are affected by systems of corporate taxation. They find that, depending on how severe the internal agency problem is and to which extent dinoflagellates can be mitigated by external (bank) monitoring, financing cost allowances (such as an ACE tax) may hamper welfare. Our analysis is also related to the literature that stresses the efficiency-enhancing effect of taxation under imperfect competition. Konishi (1990) sets up a Cournot oligopoly model in which firms produce a good by using labor and intermediate goods as input factors. Fixed costs induce IRS and free market entry leads to an excessive number of firms that enter the market (and charge a too high price). Taxation can improve the market outcome by reducing the number of firms and inducing each firm to produce a larger quantity. Konishi points out that a tax on entry costs (a ‘franchise tax’) in combination with a subsidy on production can achieve a first-best allocation. Konishi (1990) expand the Konishi-model to a general-equilibrium setting with labor and capital as input factors. These authors generalize the excessive entry theorem by Mankiw and Whinston (1986), which was derived under partial equilibrium, and confirm the main tax-policy findings by Konishi (1990). The combination of a tax on fixed costs and a subsidy on marginal costs (i.e., a negative factor tax) reduces the number of active firms and induces each firm to sell a higher quantity at a lower consumer price.