04/01/2004
Summary of working paper 10153
Capital gains taxes imposed on corporations are increasing in importance; they interact with other distortions in important ways; and they deter firms from realizing gains, thus impeding the reallocation of assets to their most efficient owners.
To mitigate the possibility of a third layer of taxation on corporate income, the U.S. tax code allows corporations a partial deduction for dividends received from other corporations; however, returns earned as capital gains on intercorporate holdings do not receive any such relief. Instead, U.S. corporations face the same tax rate on capital gains as on ordinary income. In The Character and Determinants of Corporate Capital Gains (NBER Working Paper No. 10153), NBER researchers Mihir Desai and William Gentry find that capital gains taxes imposed on corporations are increasing in importance; they interact with other distortions in important ways; and they deter firms from realizing gains, thus impeding the reallocation of assets to their most efficient owners.
Desai and Gentry isolate the importance of corporate capital gains by comparing them to individual realizations of capital gains and to other corporate income subject to tax. Corporate capital gains realizations amount to 30 percent of individual capital gains realizations over the last half a century, and have grown in relative importance through the 1990s. Corporate capital gains also appear to have increased in importance relative to other sources of income for corporations -- by 1999, capital gains realizations were 21 percent of income subject to tax for U.S. firms.
These large realizations are associated with a distinct set of distortions and policy implications relative to individual decisions about realization, according to Desai and Gentry. In particular, these taxes might impede the reallocation of assets between firms in an economy in a way that is not operative for individual shareholders where the identity of the owner is unlikely to impact the productivity of the asset.
Additionally, firms have been shown to face a variety of costs from raising external finance, and a realization-based tax on intercorporate holdings may exacerbate those costs by making asset disposal - an alternative to raising external finance - more costly. Finally, the favorable tax treatment of intercorporate dividends relative to capital gains earned by corporations may distort the pattern of stock ownership and is likely to trigger a number of tax planning efforts, detailed in the paper, to benefit from this tax rate differential.
In order to identify the impact of these taxes on corporate behavior, Desai and Gentry use time-series tests of aggregate realization behavior and panel data on individual firm realization behavior. The time-series tests provide evidence of elasticities for corporation capital gains taxes that are significantly higher than those for individual realizations. Given the highly correlated nature of individual and corporate realizations, Desai and Gentry include controls for a number of other possible omitted factors - including measures of market sentiment - and the measured elasticities are robust to the inclusion of these controls.
Given the difficulties inherent in such time-series tests, Desai and Gentry next use proxies for firm-level tax rates to identify how corporate capital gain realization behavior is influenced by these taxes. Controlling for firm characteristics and time-varying investment opportunities, Desai and Gentry find that the sales of investments and property, plant, and equipment are more likely and considerably larger in low-tax years. In addition to this evidence on disposal behavior, the likelihood and volume of gains, rather than losses, is particularly guided by tax considerations as predicted by the rules on corporate capital gains.
Desai and Gentry conclude by noting that the distortions to realization behavior that they identify are just one dimension of the distortions associated with this tax system. Specifically, they point out that "these taxes are likely to influence business planning on a variety of margins - including merger activity, the initiation and termination of lines of business, and the patterns of cross-holdings. In combination with the curious distinction between the treatment of intercorporate dividend payments and intercorporate capital gains, the results in this paper and these broader consequences suggest that tax policy for corporate capital gains may be ripe for reevaluation and that much more needs to be understood about how corporate capital gains taxes influence firm behavior."
