Incidence of corporate tax and optimal capital structure: Simulation of dynamic effects of tax reform in Japan

In this paper, we analyze the incidence of corporate income tax using a dynamic general equilibrium model. By building a dynamic macroeconomic model, I am able to analyze not only the instantaneous incidence of corporate taxation but also consider the intertemporal incidence. The dynamic model in this paper includes capital structure, that is, choice of equity, debt, and retained earnings to implement investment. It also includes agency cost on debt: per unit of agency cost on debt is progressively-increasing. We implement a simulation based on the dynamic model, and measure the incidence of corporate income tax on labor income, and obtain results that almost all, but not all, of the incidence shifts to labor income in the long term. In contrast, in a neo-classical dynamic general equilibrium model, the entire incidence shifts to labor income in the long term. The difference between these results is caused by the inclusion of the agency cost on debt.

Also, using the dynamic macroeconomic model, we investigates the effects of corporate tax reform in Japan, wherein the (effective) corporate income tax rate decreases from 34.62% to 29.74% and the rates of size-based business taxation (levy on the sum of labor cost and other factor payment) rise at 2.5 times in Japan. This tax reform implies that the tax base is shifted from corporate income to labor cost, because it accounts for the majority of factor payments for most firms on which the size-based business taxation or "pro-forma" taxation is imposed. We find that the benefit on labor income from reduction of corporate income taxation is decreased by about 30% by expansion of the size-based business taxation from a simulation result. A reason behind the phenomena is distortion stemming from the size-based business taxation. Labor income increases due to lowering the (effective) corporate income tax rate. Nevertheless labor income loses due to rising rates of size-based business taxation.