A dynamic general equilibrium analysis of corporate tax integration

A Dynamic General Equilibrium Analysis of Corporate Tax Integration Alfredo M. Pereira.

UniversiO"of Califonlia. San Diego

The objective of this article is to study the intersectoral and intenemporal efficiency effects as ~eil as the distribution effects of integrating corporate and personal incom.e taxo. This article presents a dynamic general equilibrium m(~lei of the U.S. economy. The model accommodates optimal intertemporal investment decisions and optimal -,dkw.atmn of investment across sectors, intertemporal household consumption/~vings and labor leisure decishms, and government deficits and financial crowding-out. Simulation results suggest that the elimination of the corporate income tax and its replacement b~ increased personal income tax rates would yield long-run benefits that are at best. 17 percent of the pre~nt value of future consumption and leisure. Also. the average long-run gains are more than three times as large as the average shortrun gains: it takes time for the efficiency gains of integration to emerge. Finally. integration is shown not to be a Pareto improvement in that low-income hou~hold~ are ",~or~ o f f after integration.

I. INTRODUCTION The objeclive of this article is to study numerically the intertemporal and intersectoral efficiency effects as well as the distribution effects of integrating corporate and personal income taxes. The corporate income tax has long been criticized for its distortionary effects on the economy. In particular, the corporate income tax introduces a differential among the rates of return of capital in different industries according to their degree of incorporation. Thus. the allocation of investment in the economy is distorted in favor of lowly incorporated sectors. Furthermore. the existence of differentiated investment tax credits and depreciation allowances creates a wide variety of marginal

Addre~ ~orrespondence to Alfredo M. Pereira. Department of Economics. University of Cahforma. San Diego. La Jolla. CA 92093. ! would like to thank Douglas Bernheim. Michael Boskin. Karl Scholz. and John Shoven for helpful comments and suggestions on a previous draft. The usual disclaimers apply. Received Stptember 1991. final draft accepted January 1992.

Journal of Poli~ ~Modeling 15( ! 1:63-89 (1993) Society for Policy Modeling. 1993

63 0161-8938/93/$6.00

64

A.M. Pereira

corporate taxes across incorporated industries. Finally, the corporate income tax represents a "'double" taxation of income at both the personal and corporate levels; corporate earnings are subject to the corporate tax and the after-tax earnings are either distributed as dividends and taxed at the personal level or retained and potentially taxed as capital gains. The public finance literature has often proposed eliminating or reducing the distortions created by the taxation of corporate income by integrating the corporate and the personal income tax systems. Empirical evidence on the issue of corporate tax integration indicates that integration may have substantial effects. In the path-breaking work of Fullerton, King, Shoven, and Whalley (FKSW) (1981, 1985), total integration was found to yield gains that could be as large as $695 billion of 1973 dollars, or about 1.4% of the present value of consumption and leisure in the U.S. economy. Also, corporate tax integration is shown to be a Pareto improvement. Corporate tax integration leads to a U-shaped pattern of gains for the different consumer classes, the lowest and highest income groups reaping most of the benefits. The gains reported by FKSW result primarily from interindustry reallocations of investment after accounting for the additional distortions in labor-leisure decisions. However, there axe reasons to believe that FKSW's results may be severely biased upwards. First, FFSV~" postulate government yearly balanced budgets. No deficits are allowed to occur. It is true that resource crowding-out is still captured but financial crowding-out induced by government spending is not. Therefore, the effects of corporate tax integration upon government deficits are ignored. However, inasmuch as increased government deficits are generated under integration, private investment will face less favorable conditions. Second, in FKSW investment behavior passively acco~-,lmodates endogenous savings decisions. Investment is not derived from industry's optimization behavior. As a consequence, the differential impacts of policies on the incentives to save and to invest are not captured. Furthermore, the very nature of the effects of corporate income tax and corporate tax integration on interindustry allocation of investment requires the consideration of a meaningful investment behavior. Third, FKSW assume full capital mobility across sectors. Instantaneous and costless adjustments in the capital stock are also assumed. However, full capital mobility and costless adjustments rule out the possibility of different costs of capital across sectors and therefore of differentiated reactions to tax policy changes. Finally, the economy in FKSW is characterized by a sequencing of otherwise static

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

65

models. The transitions between adjacent periods are to a large extent exogenous. Like FKSW, this article focuses on the effect of corporate tax integration on interindustry reallocations of investment. However, this study attempts to address the modeling problems referred to above. The modeling of both government deficits and of optimal investment decisions necessitates the consideration of a dynamic framework. In turn, a dynamic framework highlights the efficiency effects of integration on the optimal intertemporal decisions of the different agents in the economy. This study analyzes the effects of corporate tax integration in the context of a disaggregated dynamic general equilibrium model of the U.S. economy along the lines of Pereira (1988, 1991). The model postulates forward-looking investment behavior in a technology with adjustment costs and optimal allocation of investment across sectors (see Bovenberg, 1986, and Goulder and Summers, 1989, for a similar modeling of investment behavior in a general equilibrium context). it allows for optimal government borrowing and financial crowding out (see Feltenstein, 1989, for an earlier attempt to model financial crowding out in a general equilibrium context). Also, it captures optimal labor, consumption, and savings decisions by households. Simulation results suggest strikingly that the elimination of the corporate income tax and its replacement by increased personal income tax rates would yield long-run benefits that are at best 0.17 percent of the present value of future consumption and leisure. The fact that the welfare gains from integration found in this investigation are much lower than those reported in FKSW is to be attributed to the optimality of investment behavior with adjustment costs and imperfect capital mobility. In particular, financial crowding-out effects are of secondary important. Another striking feature of the simulation results is that the average long-run gains from integration are more than three times as large as the average short-run gains: It takes time for the efficiency gains of integration to show up. This new intertemporal pattern of efficiency effects reflects an adjustment lag in the interindustry investment decisions that is due to the costs of adjustment. Finally, unlike the conclusion suggested in FKSW integration is shown not to be a Pareto improvement. In terms of the value of current consumption and leisure, the lowest income groups are worse off after the policy implementation. This article is organized as follows. Section 2 develops the dynamic general equilibrium model. It discusses the foundations of economic

66

A.M. Pereira

behavior as well as the nature of economic equilibrium. Section 3 presents the design of the policy experiments and the empirical evidence on corporate tax integration under different policy scenarios. Finally, Section 4 summarizes the results and provides some concluding remarks.

2. A DYNAMIC GENERAL EQUILIBRIUM MODEL OF THE U.S. ECONOMY This section provides a description of the dynamic general equilibrium model in this study. This model of the U.S. economy departs from that of Fullerton, King, Shoven, and Whailey (1981, 1985) and, for that matter, from most of the numerical general models for tax policy evaluation (see Shoven and Whalley, 1984, and Pereira and Shoven, 1988, for surveys of these models), in several fundamental directions immediately relevant to the issue of corporate tax integration. First, the model provides a comprehensive modeling of dynamic economic behavior. In particular, government deficits are optimally determined and investment decisions are forward-looking and are the result of optimizing behavior. Second, it encompasses an endogenous sequential equilibrium structure founded on dynamic economic behavior.

2.A. A General Overview In this model the U.S. economy is characterized by an incomplete, sequential market structure. At any time, several markets are open for the different consumption goods, and for physical capital, labor, and financial assets, in this economy there are three types of agents: consumer groups, industries, and government. Agents face a dynamic environment in a finite horizon framework. The economic behavior of every agent in this economy is derived from an intertemporal specification of the agents' objectives and constraints. The model considers four industrial sectors with different degrees of incorporation: sector I includes agriculture, mining, and energy: sector 2 includes food, textiles, paper, chemicals, lumber, and metals: sector 3 includes trade, finance, real estate, and services: and sector 4 includes capital goods such as construction, transportation, and machinery. Industries maximize the present value of the net cash flow in a technology with adjustment costs, to determine endogenously optimal supplies and optimal demands for the different production inputs. In particular, investment decisions are forward-looking. Real

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

67

investment is financed by retained earnings and issuance of new debt and equity. Government engages in several economic activities. First, it collects taxes on the use of labor by the different industries, on both corporate and personal income including capital gains, and on sales---dccording ~o an exogenously given tax regime. The taxation system in the model reflects the situation in the United States before the Tax Reform Act of 1986 (TRA86). Second, it transfers discretionary lump-sum amounts to the private sector. Finally, it purcF,a,~es consumption goods and primary inputs to accomplish general government activities. Government intertemporal behavior is obtained from the maximization of a social welfare function constrained by an inle~lew:poral budget constraint. Government is allowed to run yearJ,; t2~'[ici:.sIha! are optimally determined. Government engages in the saie e| pvblic bonds to finance such imbalances. The model considers three income classes: I,.~werclass with yearly income below 1973 $6,000; middle class with income of 1973 $6,00015,000, and upper class with income above 1973 $15,000. Optimal household behavior follows an intertemporal optimization model generating optimal consumption/savings and labor/leisure decisions. Household savings are invested in financial assets: public and private bonds and equity. In the absence of uncertainty, the composition of the asset portfolio is a matter of indifference for the households. Portfolio decisions accommodate the composition of the industry demand for funds. The concept of temporary Walrasian equilibrium is adopted to capture the incomplete and sequential aspects of real-world trading, and the limitations of foresight into the future that we want to capture in this model. All markets are assumed to clear: hence the Wairasian nature of equilibrium. Also, equilibrium in the short run is parametric on the expectations of future prices held by the different agents as well as future taxation parameters; hence the temporary or sequential nature of equilibrium. The link between adjacent periods is provided optimally by the recursive transitions of the stock variables in the economy. Given the temporary equilibrium structure of this model the computation of a t-dimensional intertemporal equilibrium path involves the computation of a sequence of t I-year equilibria parametrically on price expectations. The optimal transitions of the stock variables between adjacent I-year equilibria are determined endogenously, given the equilibrium prices and net demands. For the simulation experiments the model is run to produce an equilibrium sequence for a 25-year

68

A.M. Pereira

period in a decision horizon of i00 years. For the sake of making the result in this study comparable to those in Fullerton, King, Shoven, and Whalley ( 198 l, 1985), static expectations are maintained. Also, short-run results refer to the first i O years and long-run to the whole 25-year period. Each one-shot equilibrium is computed by NPSOL, an optimization algorithm developed by Gill, Murray, Saunders, and Wright (1986). The equilibrium conditions are seen as nonlinear equality constraints in the optimization of an artificial objective function. The algorithm computes an equilibrium by finding a (unique) feasible point to this "'bogus" minimization problem. 2.B. Producers' Behavior Industry j ' s production technology at t is represented by a twice continuously differentiable, strictly increasing, and concave production function Fj(Kj,,Lj,), on the domain of capital Kj,. and labor Lj,. The evolution of capital stock is given by the equation of motion: I,, =

K,,,,

-

(I

-

V,,)K,,,

tl)

where I, is investment in sector j at t and % is the depreciation rate of capital installed in sector j. This equation of motion reflects the idea that capital stock is fixed in the short run, that is, the capital stock in existence at t is not a decision variable at t. but it is determined by op6mal decisions in previous periods. However, at t. investment decisions will be made that will determine the capital stock at t + 1. Accordingly, in the long run, capital stock is variable. Adjusting capital towards its optimal level is costly. Also, capital is not perfectly mobile across industries. These ideas are captured by sector-specific cost functions defined over gross capital stock accumulation. Total cost of investment includes both acquisition costs p,,l,, where p, is the price of investment at t, as well as adjustment costs C(I,). The twice continuously differentiable adjustment cost functions arc nonnegative, strictly increasing, and strictly convex in investment demand. Industries face ad valorem taxes on the use of labor services, which represent the employer's portion of social security taxes. Therefore, if L., is the tax rate, assumed constant across industries; the unit cost of labor is (I + L.,)P,.,. where p,., is the wage rate at t. Each industry is subject to an ad valorem corporate tax on gross profits GPj,--sales revenucs minus noninvestment expenditures. The

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

69

after-tax gross profits are ( I - T,~,)GPj,. where T~j,is the sector-specific corporate tax rate at t, which reflects the different degrees of incorporation across industries. On the other hand, before the TRA86, investment expenditures benefit from a sector-specific investment tax credit/TCj,, which is an ad valorem subsidy. Accordingly, actual investment expenditures are (I - ITCj,)p~,lj, + C,(Ij,). Interest payments are deductible from the corporate tax base. Then, if r, is the market interest rate, ( I - T,~,)r, is the net rate of return on outstanding bonds Bj, Finally, depreciation allowances are to be deducted from the corporate tax base. Let lt'j, and K'j, be the depreciation rates for tax purposes and capital stock for tax purposes, respectively. Then the after-tax gross profits are increased by T.,~lj'](~',. From the above industry j ' s net cash flow at t NCFj, can be written as

NCF,, =

(!

-

-- l ( I

T.,,)ip, Y,(K,,. L,,) - ( I -- rrc,,)p,/,, + c , ( / , , ) l

+

T~,)pL]-,,!

+

E,, v~g;,-

(i

-

r,,)r~,,.

(2)

The producer's dynamic behavior is determined by the maximization of the present value of net cash flows, ~,,[II~ < ,(I + r~)- ']NCFj,. subject to the production technology, the adjustment costs technology, the equation of motion for the capital stock, and nonnegativity constraints on the decision variables. Investment activities and the payment of interest on outstanding debt at t are financed through retained earnings REj, and external funds F~j,, which represent the increment in the financial liabilities of the sector. Financial liabilities must be liquidated by the end of the model horizon. Dividend-retention policies are exogenously given. Corporate dividend-retention policies are represented by parameter k.j,, the fraction of the after-tax gross profits generated at t that is retained by industry j. The remaining after-tax profits are distributed among the shareholders as dividends. External funds totaling F~ are obtained by issuing additional equity Ej, +, - E, at price p~:j, and additional fixed price bonds Bj,+, - Bj,. Issuance of new bonds and equity is governed by exogenous corporate financing rules represented in this model by parameter ~,~.~,.the fraction of external funds that comes from equity financing. Perfect capital markets are assumed such that at time z the price of equity p~-j=is the present discounted value of the future expected stream of dividends per share Div~/E~,. P% = E,! I1 ..... ,(I + r,) 'lDiv~,/E~,,.

(3)

2.C. Household Behavior At each moment, utility of household i is represented by a wellbehaved, time-invariant function U,(-) defined over the space of the consumption goods .v's and leisure , L* S - L,,, where L*, is total ,.I available time and Li, is labor supply of household i. In turn. intertemporal preferences are represented by a time-separable additive function of U,('), discounted by a time-invariant, subjective rate of discount a,. Behavior of households is constrained by a intertemporal budget constraint relating the inter~emporai patterns of income, spending, and sa~'ings. The total present value of current and future income receipts has to be equal the present value of current and future spending. At t. consumer group i receives labor income pI,L, and lump-sum transfers from the government Tr, In addition, household i receives wealth-generated income. Wealth-generated income includes dividend payments ~,jej,(Divj,/p~:j, ,E,,JlW,, where e,, is the share of equity issued by industry j in wealth W,,, as well as capital gains ~i[P~.j, p~.~,_ z]Eo,, of household i. it also includes interest payments on private and government bonds ( ! - ~.,ei,)r,W ,, where ! - ~jei, represents the fraction of public and private debt in household wealth. Labor and wealth income are taxable according to a linear progressive income tax schedule. Lump-sum transfers from the government are considered tax-exempt. Under the previous tax law, capital gains are taxed at a different rate, CGT,,. Accordingly, disposable income at t is given by ~,e,,)r, + x.J.,e,,(Div,,/p~,, ,E,,)IW,,} + Tr,, + (I - CGT,,)v, Ip,,, - p,,, , IE.,,.

b, + (I

-

T,){p,,L,,

+ l(I

-

(4)

where, b, is negative to reflect the fact that marginal tax rates exceed average tax rates, and T, is the marginal income tax rate for household group i. At each t, Pj6',, represents pretax expenditure of group i in commodity j. Purchase of good j is subject to an ad valorem sales tax Tj,. Therefore, the total after-tax expenditure of household i is Ej(! +

r,,)p,,y,,,. Household i savings are given by the difference between disposable income as in (4) and after-tax expenditures in consumption goo4s. Savings are intertemporal transfers of wealth to finance future consumption. The total amount of new funds made available by group i to the rest of the economy is optimally determined and together with

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

71

the demand conditions determines the prevailing market equilibrium rate of return on wealth. Savings are invested in public and private bonds as well as corporate equity. The different financial assets in the economy are perceived by households as perfect substitutes in that they are expected to yield the same after-tax rate of return. Accordingly, the composition of the financial portfolio is a matter of indifference for households: The actual composition of the portfolio holdings is determined by the market equilibrium conditions. Furthermore, the portfolio composition will be the same for all household groups. Each household will own a fraction of the market portfolio that correspona_s te its share of total wealth in the economy. However, owing to the nature of the tax code different household groups have different after-tax rates of return on their portfolios.

2.D. Government Behavior The government raises revenues TT, by levying taxes on the private sector. The tax system and tax policies are institutionally given as the outcome of processes not captured by the model. Different taxes are considered in this model as described in the previous sections: ad valorem labor tax on the labor services used by the different industries and government, representing Social Security taxes, unemployment insurance, and workmen's compensation; ad valorem sales taxes on the purchases of different consumption goods; ad valorem corporate income tax on the different industries, net of depreciation allowances, interest payments on corporate debt, and ad valorem investment tax credits (under the previous tax law); a progressive personal income tax represented by a household-specific linear function (personal income includes capital gains taxed at a preferential rate before the TRA86). Government transfers discretionary lump-sum amounts to households. These redistributive transfers payments Tr, are exogenously given and include Social Security, food stamps, AFDC payments, and so forth. In addition, government purchases capital and labor services as well as intermediate inputs to accomplish general government activities through the production of an aggregate public good. Optimal government spending is derived from the maximization of a social welfare function over the domain of this public good. Such public good is produced from capital, labor, and intermediate inputs according to a well-behaved production function.

72

A.M.

Pereira

At each moment t the social welfare function over the domain of the aggregate public good can be expressed indirectly in terms of a well-behaved, time-invariant function ~ ( - ) defined in the domain of labor and capital services as well as the different commodities in the economy that are used in the production of the public good. The intertemporal social welfare function is additively separable in U~.(.). lntertemporal aggregation is discounted by a time-invariant subjective rate of discount for the government, ~ . The basic intertemporal consistency requirement imposed on government behavior is that its actions be constrained by an intertemporal balanced budget condition. The present value of government expenditures on commodities Y,p,,y~,,, labor ( ! + T~.,)p~L~,. and investment p,,l~, cannot exceed the present value of tax revenues net of transfers and interest payments on public debt PD,. The intertemporally recursive specification of the government intertemporai budget constraint can be written as PD,.,

= (I

+ r,~PD, + [Tr, + E,l,,~v~,, + ti

+ I,,,lp, L,., + P,],.,I -

TT,.

15)

it should be noted that government is seen as paying taxes to itself on the use of labor services. Consequently, the income effects of such a tax cancel out. However, the price effects reflect the opportunity cost of government hiring of labor. Government is allowed to r,an yearly deficits. Government deficits and surpluse.,,., v,:hich represent optimal changes in government public debt, are accommcxtated by open market operations in the bond market. These operations reflect the net demand for new funds by government. Implicitly, government expenditures can hc financed through taxation or public deficits. These two different methods have different effects in the economy, an issue that will be addressed later. Optimal government behavior, including optimal borrowing, is d e rived from the maximizati~m t~f the intertemporal social welfarc function subject to the recursive sequence of budget constraints as in (5). This optimization objective is consistent with the modeling of household behavior in which the public good is not a decision variable and its cost does not directly enter the household intertemporal budget constraint. This approach is equivalent to having the public good enter additive separately in the private utility functions. Thus the marginal rates of substitution between private goods do not depend on the level of availability of the public good. Also. the public good is not subject to market pricing. Accordingly, its production is financed by tax .revenues. The governmc~t is then a,,,,umed to act empathically with the

DYNAMIC ANALYSIS OF C O R P O R A T E TAX INTEGRATION

73

private consumers according to a constrained social welfare maximization problem.

2.E. Data and Parameter Specification The current data set and pavdmeter specification of the dynamic general equilibrium model in this study are consistent with data set and parameter specification of the version of the Shoven-Whailey model that is reported in Ballard, Fullerton, Shoven, and Whalley (1985). The data set and parameter specification have been enlarged to cover aspects not considered ~,l BFSW. This section concentrates on the additional information not contained in BFSW. (See Tables !-3 for a detailed description of the data set and parameter specification. ) The implementation of this model requires initial values of the stock variables in the economy. The capital stocks for the different industries in the model are obtained from BFSW by applying an average aftertax rate of return to capital income figures. !ndustry-spec|fic debt and equity are obtained by applying the debt/capital ratios reported in Fullert_on and Gordon (1983) to the capital stocks figures. Government capital stock is obtained from Boskin, Robinson, and Roberts (1985). Public debt is specified to reflect its current importance in the economy: Current debt and the debt/GNP ratio are applied to the figures reported in BFSW. The ownership of wealth in the economy by income class is obtained from the Office of Tax Planning as reported in Galper, Lucke, and Toder (1986). The number of households in each income class is as reported in BFSW.

Table I: Classification of Indus;rie,, and Household Groups .

Economic agent

.

.

.

Classification

Consumer groups" Group I Group 2 Group 3

$0-6.0t10 $6.1M10-15.1XlI) $ i 5.01MI+

Sector Sector Sector Sector

Industries Agriculture. Mining Energy Food. Textiles. Paper. Chemicals. Lumber. Metals Trade. Finance. Real Estate. Service,, Capital: Construction. Transp~rtation. M;~chine~'

i 2 3 4

"Households classilied by gross income in It~73 dollars.

74

A.M. Percira

Table 2: Base Case Parameter Values and Stocks for Each Industry ii

Sector I

Agriculture General parameters Cobb-Douglas labor share Adjustment cost parameter Depreciation rate Equity capital Retention/earnings

Sector 3

Sector 4

Manufacturing Services

Sector 2

Capital

0.400 0.035 0.099 0.840 0.630

0.80 0.02 0.07 0.78 O. 30

0.7(X) 0.025 0.(167 O. 350 O. 280

0.500 O.016 0.035 0.8 IO O. 250

Tax parameters Corporate tax Investment tax credit Depreciation rate (for tax purposes) Labor tax Sales tax

O.0 ! 0 0.038 O. 203

0.46 O.(M O. 13

O. 3(X) O.OI 3 O. ! 24

0.450 0.039 0.128

0.090 0.024

0.09 0.02

0.(19(I 0.010

O.0t~} O.(glO

Stock values (billions of 1973 doilarst Capital

795

946

2.509

I iO

iii

The implementation of this model requires the specification of functional forms and the selection of structural parameters. For iiactability, linear homogeneous Cobb-Douglas functional fornls are chosen for the utility and production functions. Individual preference, government, and technology share parameter values, and the input/output structure are obtained from BFSW. Quadratic adjustment cost functions are postulated. The values for the adjustment cost parameters are obtained from Summers (1981) and Goulder and Summers (1989). Finally, the private capital depreciation rates are from Fullerton and Gordon (1983), and public capital depreciation rates are from Boskin, Robinson, and Roberts (1985). Industry specific debt;equity ratios are obtained from Fullerton and Gordon (1983) and the industry-specific dividend/retention ratios are obtained from the Survey of Current Business ( ! 983). Tax parameters reflect sector-specific labor taxes, corporate tax rates, investment tax credits, and capital depreciation rates for tax purposes as reported by Fullerton and Gordon (1983). Marginal personal income taxes are those in BFSW, and capital gains taxes are set at 5 percent (upon accrual), as in Goulder and Summers (1989). The base case runs replicate the main relationships in the U.S.

DYNAMIC

ANALYSIS OF CORPORATE

TAX INTEGRATION

75

Ill

Table 3: Base Case Parameter Values and Stocks for Households and Government

General parameters C D Share of laborlleisme C D Sha~e--Sector I C D Shine--Sector 2 C D Shine--Sector 3

Discount rate Population distribution Wealth shares

Depreciation rate for government capital Tax parameters Personal income tax Capital gains tax Stock values (billions of 1973 dollars} Government capital stock Public debt

Low-

Medim-

HigW

iaeeme

iamme

iaeeate

0,201 0,011 0,226 0,562 0.050 0.380 0.060 m

0.371 0.008 0,203 0.418 0.050 0,410 0.250 __

0,350 0,008 0.190 0.452 0.050 0.210 0.690 m

O. i 0 0 0.050

0.200 0.050

0.300 0.050

m ~

~ --

Ge~mmml

0.432 0.004 0.169 0.O62 0.050

0.060

m

2.670

5OO

economy. In particular, household behavior impli¢~ a ~a~ :rig:; e!ast_icity with respect to interest rate of .20 and an average labor supply elasticity with respect to wage rate of .90. These values are well within the range of values in use in the literature (see BFSW). 3. CORPORATE TAX INTEGRATION: SIMULATION DESIGN Policy evaluations are carried out by contrasting a base case that reflects the status quo and several counterfactual equilibria that reflect different policy scenarios. The different equilibria are made comparable by the use of the concept of equal yield: To be comparable, base case and counterfactual equilibria should be such that the size of the government is kept constant in a meaningful way. This is usually interpreted to mean that government maintains the same level of social welfare in both the base case and the revised cases (see Shoven and

Whailey, 1977). The presence of government deficits necessitates a refinement of the concept of equal yield. The optimal level of public expenditures necessary to achieve base case social welfare can be financed either by changes in tax revenue with constant base case deficits (tar-financed

76

.~_M P ~

equal yield,) or by changes in deficits ~ h c c ~ ~ ~ ~.~e r ~ revenues (bond-financed equal ~ieM) ~ b], a m ~ of ~ & . ~ ~'~ ~ revenue changes (mLted-financed equal yieM~. ~ Pe~.~a. ~ 9 . ~.n" a detailed discussion of this point. The use of this generalized concept of equal ~ k ~ ~ ~rr~m.~r~ ~r~m the point of view of actual tax reform. This ~s p - ~ . ~ , ~. ~,en the current policy concern abfmt pub|ic defi¢~ts. Fm,~. r r ~ ~ - d ~ packages actually considered postulate co~tstau~ mx r - ~ ~ . "Fm~..,e~enue neutrality is usually perceived as a pro~y ~¥~r~ ~uc~s. Pereira (1989) shows that s ~ h is r ~ ~ e s s a , ~ F , ~ e ~ . Sec,~d. some measure of the marginal crowding-o~ effe~>, ~ ~, ~ ernment deficits c ~ be inferred from the compar~:m ~ff se-~,er',d eq~dyield alternatives Since tax-financed equa~ ~:k~ r - ~ ~ the same deficit in the base case and the counteff~ma~ e q ~ h ~ , ff~e ~II~-~--m~. between tax-financed and d e f i c i t - f i n n e d ~ a ~ i b ~ ~re ~=-r-,ae~ ~. optimal changes in government deficits. By concentrating on eq~l-yield a l t e m a ~ J ~ , tt~e ~ ~ k ~ re~n'e~ the computation of tax replacement c ~ g e s , t.~a ~,. r=~-~e of the changes in other tax rates neces.~a,~ to r~nr-,d~e m ~ e ~the tax changes under considerati~. R e p | ~ ~ s ~ be ~udtffq~cative (personal tax rates are m u l t i p [ ~ b~ a c e r ~ n ~ c ~ c~ ~ ~ e (a certain factor is added to the pers~-m~ ta.~ ~ ~.

3.A. Corporate Tax Integration Schemes Several ways of dealing with the distc~ov, a,.~ e f f ~ ~-~"~Je ~ ) ~ _ ~ of corporate income have been e i ~ s u g g ~ ¢~r ~ . ~ ~ m ~he United States. Several laws for ~,ariotts peri~.~ a n c r 0 ~ ~ ~ ~ the "'double" taxation of d i v i d e ~ a ~ ~ ~ ~ e { ~ for t ~ financing. In 1936-1937. a dividend.~pakt ~ - ~ - : m ~ m effe~. The corporations were allowed to dedu¢~ di~,~:.-~ds f r r ~ ~ e c ~ ~ , a e . tax base. More recently, dunng the p | ~ m g ~ p r ~ ~ ff~ T R A ~ . the U.S. Treasury Department p r o ~ ~ E¢~~ - - r ~ ~ . ~ ~ , ~ ~ _ be deductible by corporations. A d / ~ d e r ~ s - r e c e ~ , ~ c - r ~ t ~-~ individuals was in effect in the United SmL~ from n95_-~~-~ ~%3 H~a,,eholds were allowed to deduct 4 percer~ of d~,~r~:~. ~ - ~ e ~ a~. a credit against their income tax. %~en ~ s d~ ~der,d c-red~ ~as ~ e ~ in 1964, a dividend exclusion v,a.s m ~ c x ~ ~ . A ~.,~c e ) . z ~ ~ ~ ' ~ the personal income tax of dividend.s u ~ $ | ( ~ ~:$2~.i'~fr~rFnu~ ~ ~ . ~ was introduced. This dividend exc~u:si¢~r~ ~a~ e { ~ m ~ r ~ ~ the TRA86. All of the above methods pro~,ide on~, ~ ~ a ~ ~ ~ < . ~ ...."

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

77

personal and corporate income taxes. Full integration would be a way of eliminating all the distortions generated by the corporate income taxation. One possibility is a full integration mechanism in the form of partnership. Corporations would be treated like partnerships, and corporate income would be taxed at the personal income level whether distributed or not. The partnership method raises several difficult problems. The most important problem stems from having to impute corporate income to stockholders. To avoid the possibility of an individual having to liquidate assets to pay taxes on earnings he or she did not receive~ the corporate tax is kept as a withholding device. Under this full integration mechanism, corporations are treated the same way closely held corporations are treated under the current tax law. Corporations impute retained earnings among the shareholders in order to withhold their income taxes. Shareholders. in turn, include both imputed and actual dividends in their tax base and deduct the tax withheld by the firm from their tax payments. An alternative approach for achieving full integration is to repeal the corporate incom,, tax. All corporate income would be fully taxed at the personal income level. This form of full integration seems to have some political clout and has been occasionally suggested. In 1977, full integration was advocated by a group of experts from the U.S. Treasury Department in Blueprints for Basic Tax Reform, and it was subsequently considered by the Carter administration. Also, in early 1983 repeal of the corporate income tax was sugge ~ted in an offhand remark by President Reagan. In this article, two integration methods are considered. The first method is a partial integration scheme. It is designed to partially reduce or eliminate the "'double" taxation of dividends. The second method is a full integration plan.

METHOD 1: PARTIAL INTEGRATION BY DIVIDEND DEDUCTION FROM THE CORPORATE TAX BASE. Partial integration promotes equal treat-

ment of dividends and interest payments while maintaining a corporate income tax. This partial integration method specifies that dividends can ~ fully dedacted from the corporate income tax base. This eliminates the "'double" taxation of dividends. However, because divi,tends are now deductible, the corporate tax is levied solely on retained earnings. Therefore, this method discourages internal financing. This may be an undesirable feature when large deficits generate important financial crowding-out effects and tight fund markets. This partial integration scheme assumes particular importance in the

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light of TRA86. In fact, unlike other distortionary effects of the corporate income tax, the issue of "double" taxation of dividends was not addressed by TRA86. METHOD 2: FULL INTEGRATION ACHIEVED BY REPEALING THE CORPORATE INCOMETAX. Under this full integration scheme the corporate income tax is eliminated. Individuals pay income taxes on both corporate dividends and retained earnings. According to this integration scheme the different distortions associated with the taxation of corporate income are eliminated. Given the different nature of the two plans above, different efficiency effects are expected. The efficiency gains under full integration are potentially large compared with partial integration, because all the distortions are eliminated. However, the foregone tax revenues that have to be recovered through replacement mechanisms are higher under full integration. The relative size of the net efficiency effect of full integration is unclear on a priori grounds.

3.B. Simulation Results

EFFICIENCY EFFECTS OF INTEGRATION

Proposition !. The efficiency gains from full integration are very modest. The efficiency gains simulated by the model in this study are well below those in FKSW. Simulation results for full integration are reported in Table 4. The efficiency gains from such a radical measure as the elimination of the corporate income tax are at best very modest and often negative. Under the best scenario, the elimination of the corporate income tax under muitiplicative replacement has long-run ~elfare effects that are positive but very low. The gains range from 1973555 billions to 1973558 billions, or 0.158 percent to 0.165 percent of the present discounted value of intertemporal consumption and leisure, the adjusted GNP. On the other hand, the elimination of the corporate income tax under additive replacement has long-run welfare effects that are negative and

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79

T a b l e 4: Efficiency Effects of Full l,aegration Equivalent variat,.'~ns"

Tax replacement factor

Short run

Long run

Short run

Long run

Bond financing Muitiplicative replacement Additive re.placement

I 0.2 - 34.6

55.5 - 39. I

!.125 0.028

!.121 0.027

Tax financing Multiplicative replacement Additive replacement

! 2.7 - 28.0

57.7 - 34 5

!.117 0.025

!.121 0.026

Mixed financing Multiplic:-tive replacement Additive replacement

I I. I - 32.2

56.3 - 37. !

i.122 0.027

1.121 0.026

Note: Base case adjusted GNP is 1973 $34.991.6 billion. "Data in billions of 1973 dollars.

range from - 0 . 0 9 8 percent to - 0 . 1 1 2 percent of the present value of the adjusted GNP. The efficiency gains reported are certainly a minuscule proportion of the adjusted GNP. To put things in perspective let us compare the efficiency gains with the corporate tax revenues. The corporate tax revenues have been about 2 percent of GNP or 1.4 percent of the adjusted GNP. Therefore, the efficiency gains from integration are at the very best about 12 percent of corporate tz:~. revenues eliminated by integration. In FKSW lull integration with lump-sum replacement was found to yield dynamic gains as large as 1973 $695 billion, or about 1.4 percent of the present value of consumption and leisure in the U.S. economy. Dynamic gains under multiplicative replacement are about 0.62 percent of the present value of the intertemporal adjusted GNP. The efficiency gains predicted by the model in this study are well below the estimates in FKSW. The long-run gains from full integration simulated in this model are at least four times lower than comparable results in FKSW. This difference can be attributed to two factors. First, in this model, investment decisions are subject to rigidities: Capital is not perfectly mobile across industries; installation of capital is costly; and it takes time for capital ~:o adjust to the optimal level. Therefore, lower efficiency gains are to be expected. Second, while both models capture intertemporal consumption and labor/leisure decisions, the endogenously recursive nature of equilibrium in this model better captures

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the mtertemporal distortions induced by higher marginal income tax rates. More on this below.

Proposition 2. Results from full integration follow a sharply increasing intertemporal pattern: Long-run average benefits are much larger than short-run average benefits. The intertemporal pattern of efficiency gains from integration is characterized by relatively small short-run gains followed by relatively large Iong-~n gains. Average short-run muitiplicative replacement results are about 0.07 percent of the adjusted GNP, while in the longrun welfare effects are about 0.165 percent. Therefore, average longrun benefits are more than twice as large as the average short-run benefits, which implies a sharply increasing efficiency pattern. This is a persistent pattern in the simulation experiments. This intertemporal pattern is explained in part by the existence of adjustment costs. Since capital is not perfectly mobile across sectors and it takes time for capital to adjust towards the optimal levels, it also takes time for the investment eff, ciency effects to take place. The full benefits of integration on the allocation of capital will be reaped only in the long run. Other important factors for the intertemporal pattern of efficiency gains are the distortions generated by the replacement mechanisms in the intertemporal labor-leisure decisions. In fact, for both bondfinanced and mixed-financed equal yield, in contrast with tax-financed equal yield, the average long-run replacement is smaller than the average short-run replacement. In the two cases the intertemporal pattern is even more marked: Average long-run benefits are about three times as large as the average short-run benefits.

Proposition 3. The distortions induced by the tar replacement mechanisms on the intertemporal consumption~leisure decisions are of primordial importance in terms of the efficiency effects of full integration. The complete elimination of the corporate income tax under the best scenario of tax-financed equal yield and multiplicative replacement would require a permanent increase in the personal income tax rates of around 12 percent. The distortions induced by the tax replacement mechanisms on the intertemporal consumption/leisure decisions are of primordial importance in terms of the efficiency effects of integration. This idea. which has previoti,;ly been suggested in the literature (Ful-

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

81

lerton and Gordon, 1983) is confirmed by the simulation results of this investigation. The efficiency benefits from full integration are inversely related to the size of change in the personal income tax rates. With full integration, tax-financed equal yield requires the lowest increase in personal tax rates and yields the highest efficiency results. In turn, bond-financed equal yield requires the largest increase in personal tax rates and yields the lowest efficiency results. This is a persistent pattern in the simulation experiments. Also, the relative difference in efficiency gains among the several equal-yield alternatives is directly related to the differences in the tax replacement factor. Tax-financed experiments produce benefits 2.5 percent higher than mixed-financed simulations and require a tax replacement that is 2.4 percent lower. In turn, mixed-financed equal yield produces benefits 1.3 percent higher than bond-financed and requires a tax replacement that is 1.3 percent lower. On average, a l percent increase in the tax replacement generates a l percent decrease in the efficiency benefits. This is a persistent pattern in all the simulation experiments.

Proposition 4. Marginal financial crowding-out induced by changes in government deficits are of second-order importance. Simulation results in Table 5 illustrate the marginal financial crowding-out effects generated by changes in government deficits. Taxfinanced equal yield blocks additional changes in deficits and afortiori blocks marginal financial crowding-out. In turn, bond-financed and mixed-financed equal yield are in general accompanied by marginal financial crowding-out effects. The differences among the three equalyield schemes suggest the importance of marginal financial crowdingout effects. Full integration results show slightly lower deficits under both bondfinanced and mixed-financed equal yield, 0.024 percent and 0.005 percent, respectively. Therefore, no substantial changes in the path of government indebtedness are induced by corporate tax integration. That is not surprising, since the corporate tax revenues foregone by integration are actually being collected at the personal income level. This is essentially a constant tax revenue experiment. On the other hand, the small decreases in government indebtedness are associated with small decreases in both investment and adjusted GNP, mostly induced by higher marginal personal tax rates after integration. Even though lower deficits are expected to generate favorable

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Table 5: Other Effects of Full Corporate Tax Integration: Under Multiplicative

Replacement (Counterfactual Case/Base Case)

Deficit financing Tax financing Mixed financing

Deficits

Interest rate

Investment

GNP

0.99976 1.00000 0.99996

!.00135 1.00032 ! ¢30092

0.99703 0.99767 0.99763

0.99881 0.99876 0.99879

marginal financial crowding-out effects, these remain unnoticeable in the simulation results. Furthermore, efficiency gains with tax-financed equal yield are always higher than with bond-financed and mixedfinanced equal yield despite the fact that the latter two generate lower government debt. This suggests the second-order importance of marginal financial crowding out vis ~ vis the additional distortions in the intertemporai labor/leisure decisions. There is an important corollary to this proposition. The fact that FKSW postulate balanced budgets blocks not only financial crowdingout but also marginal financial crowding-out. The efficiency results are still biased upwards in absolute terms, since financial crowdingout is not considered. However, the absence of significant marginal crowding-out effects suggests that the comparisons of different scenarios in FKSW may not be seriously biased.

Proposition 5. The efficiency effects of partial integration are systematically negative. Simulation results for partial integration are reported in Table 6. Partial integration accomplished by dividend deduction from the corporate tax base yields systematically negative efficiency effects. The long-run negative effects are at best - 0 . 1 8 3 percent of present value of consumption and leisure in the case of tax-financed equal yield with multiplicative replacement. The persistently negative effects of partial integration contrast with the positive effects of full integration. This is an interesting secondbest situation. Partially alleviating distortions does not necessarily yield global efficiency gains. The elimination of double taxation does not directly generate efficiency gains in respect to allocation of investment across sectors. On the other hand, the tax replacement factors are substantially higher than under full integration. Therefore, larger distortions of efficiency in the intertemporal consumption savings and labor/leisure allocations are created.

DYNAMIC

ANALYSIS

OF CORPORATE

TAX

INTEGRATION

83

Table 6: E f f i c i e n c y E f f e c t s o f P a r t i a l I n t e g r a t i o n Equivalent variations*

Tax replacement factor

Short run

Long run

Short run

Long run

Bond financing Multiplicative replacement Additive replacement

- 39.4 - 124.0

- 70.5 - 244.9

1.246 0.052

i .230 0.049

Tax financing Multiplicative replacement Additive replacement

- 31.8 - 104.4

- 63.9 - 223.3

1.214 0.045

i .217 0.046

Mixed financing Multiplicative replacement Additive replacement

- 36.6 - 167.6

- 66.8 - 236. !

1.233 0.049

! ,224 0.048

Note: Base case adjusted G N P is 1973 $ 3 4 , 9 9 1 , 6 billion. aData in billions o f 1973 dollars.

The second-best nature of partial integration contrasts with previous results in FKSW. Comparable results in FKSW show long-run efficiency gains of about 0.32 percent of the intertemporal adjusted GNP. This is substantially lower than their full integration results. Still, there are efficiency gains from partial integration. Part of the difference between the results in this study and FKSW should be attributed to the fact that while both models capture intertemporal consumption and labor/leisure decisions, the endogenously recursive nature of equilibrium in this model better captures the distortions induced by higher marginal income tax rates. Another reason for the difference between the two models may have to do with the different types of replacement used in the two works. FKSW used increased corporate tax rates, not personal tax rates, as a replacement mechanism. Therefore, the primordial distortions on the intertemporal consumption/leisure decisions are not operating in FKSW. However, increased marginal corporate tax rates increase the wedge between the corporate and noncorporate sectors and introduce additional distortion into the allocation of capital in the economy. This second-best result in this work should be interpreted with some care. The partial integration mechanism alleviates not only the double taxation of dividends but also the distortion in favor of debt-financed investment vis ~ vis equity. Under this partial integration scheme the same treatment is given to dividends and interest payments on debt. This eliminates the tax preference towards debt. Equal treatment of

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dividends induces more equity financing and encourages dividend O~ltlays. Partial integration should induce lower debt/equity ratios, higher dividend/retention ratios and improved investment financing efficiency. However, as in the FKSW model, these effects are not captured in this study. In this sense the simulation results in both studies, in particular the partial integration experiments, are biased downwards. (~iee Fullerton and Gordon, 1983 for a study focusing on the effects of integration on corporate financial decisions.) Two final remarks are in order. First, unde~ partial integration, the first-order importance of the distortion in the mtertemporal household decisions is confirmed. The case of tax-fiaanced equal yield under multiplicative replacement requires the lowest marginal changes in personal income tax rates. It also shows the lowest losses of efficiency. Also, this case is unique in that it violates the intertemporal pattern discussed in Proposition 2. Long-term losses are on average higher than short-term losses. However, this case is also unique in that the average replacement factor is higher in the long run than in the short run. Second, the secondary importance of marginal financial crowdingout effects is illustrated here again. Bond-financed and mixed-financed equal yield generate slightly lower government deficits than taxfinanced equal yield. Despite this fact, tax-financed equal yield generates the lowest losses. DISTRIBUFION EFFECTS OF INTEGRATION

The distribution effects of integration are reported in Tables 7-9. All the results are obtained under full integration with multiplicative tax replacement.

Proposition 6. lntertemporal utility gains .from .full integration are positively correlated with wealth, in turn, wealth gains from fidl integration are negatively correlated with wealth. Therefore. utility gains and wealth gains are negatively correlated. Intertemporal utility gains from integration are positively correlated with wealth. High-income households benefit most from integration in terms of changes in intertemporal utility. They witness an increase of more than 12 percent in the present value of their consumption and leisure. In turn, the lowest-income class suffers a utility loss of about 6.5 percent. The intertemporal utility of the middle-income group remains essentially unaltered. To summarize, in contrast with the find-

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

85

Table 7: Intertemporal Utility Changes: Full Integration Under Multiplicative

Replacement (Counterfactual Case/Base Case

Deficit financing Tax financing Mixed financing

Low-income group

Middle-income group

High-income group

0.92845 0.94057 0.93782

1.00988 ! .00991 ! .00982

I. I 1260 I. I 1227 !. 11209

ings of in FKSW, integration is not Pareto-improving in terms of its utility effects. Wealth gains from integration (which represent potential for increased utility in the postterminal periods) are negatively correlated with wealth. Low-income households benefit most from_ integration in terms of changes in wealth ownership. Their wealth increases about 7 percent. In turn, the highest-income group shows a wealth increase below 1 percent. It should be noticed that integration is Paretoimproving from the standpoint of wealth accumulation. Utility gains and wealth gains are negatively correlated. The highestincome group shows the highest utility gains and the lowest wealth accumulation gains. Inversely, the lowest-income group shows the lowest utility gains (actually a utility loss) and the highest wealth accumulation gains. Accordingly, in this model the lowest-income group shows the highest savings elasticity with respect to interest rates. The highest-income group, in contrast, optimally uses the additional available income to finance current consumption and leisure.

Proposition 7. Integration induces small changes in the private capital formation. The highly incorporated sectors gain the most with tax integration. Integration induces small changes in the private capital formation. Sector 1 (the primary sector essentiali)~, which is Iowl)'o'.~te~rated,

Table 8: Changes in Wealth Accumulation: Full Integration Under Multiplicative Replacement {Counterfactual Case/Base Case l

Deficit financing Tax financing Mixed financing

Low-income group

Middle-income group

High-income group

1.07159 1.07077 1.07094

1.01291 1.0 ! 282 1.01288

1.00877 i .0087a 1.00879

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A.M. Pereira

Table 9: Changes in Capital Accumulation: Full Integration with Multiplicative Replacement (Counteffactual Case/Base Case) iiii

i

Deficit financing Tax financing Mixed financing

Sector !

Sector 2

Sector 3

Sector 4

0.99998 0.99998 0.99998

1.00949 1.00951 1.00951

1.00145 1.00146 ! .00 i 46

1.00034 i 00034 ! .00034

ii

shows a decrease in the capital stock. On the other hand, the other three sectors, which have relatively high degrees of incorporation, show increased capital stock. The elimination of the corporate income tax eliminates the wedge in price of capital for the corporate sectors. The sector with the highest degree of incorporation (Sector 3, the manufacturing sector essentially) gains the most with tax integration in terms of capital accumulationmabout a l percent increase. It should be noted that the gains in capital accumulation are relatively small compared with the findings of FKSW. That has to do with the modeling in this study of an investment behavior induced by adjustment costs. Capital is not fully mobile among sectors and it takes time for capital to adjust to its optimal levels. 4. SUMMARY AND CONCLUDING REMARKS

The results of the present study have important implications for the current policy debate on tax integration. Corporate tax integration is shown to generate very small efficiency gains and under some scenarios to yield efficiency losses. This casts some doubt on the practical desirability of integration. The benefits of integration may be too small compared with the costs of implementation and compliance associated with an actual policy change. If, however, the goal of corporate tax integration is to be pursued, the choice of the right implementation strategy is crucial for the success, if limited, of the policy. Furthermore, since it takes time for the benefits of integration to be generated, political difficulties may be expected in the short-run, when the benefits of integration are not yet apparent. Finally, tax integration would not be regarded unanimously as a desirable policy. In particular, lowincome groups would be likely to oppose integration while high-income groups would be likely to favor it. Beside the political difficulties that would be generated, the very fact |hat the lowest-income groups may be worse off after integration may make the desirability of integration questionable on grounds of equity.

DYNAMIC ANALYSIS OF CORPORATE TAX INTEGRATION

87

The single most important omission in this investigation is the analysis of the effects of tax integration on the optimal financial decisions by households and corporations. This study follows the traditional assumption in this type of model that financial decisions are exogenous. However, the integration of the corporate and personal income taxes should be expected to change the optimal household portfolio decisions. In fact, the different rates of return of the different financial assets change with integration. By not letting households optimally adjust their portfolios to the new market conditions after integration, a source of efficiency is not accounted for. Therefore, the results in this work may be biased downwards. (See Slemrod, 1980, for a model of optimal household portfolio decisions in a static general equilibrium environment. ) In turn, the integration of the corporate and personal income taxes should be expected to affect the optimal corporate financial rules and dividend/retention policies. With integration, the tax preference towards bonds against equity disappears or is alleviated. Therefore, the debt/equity ratios in the different corporate sectors would tend to decrease after integration. Also, with integration the tax preference towards retained earnings against dividends disappears. Therefore, the dividend/retention ratios in the different corporate sectors would tend to increase after integration. However, in the event that integration induces higher government deficits, the corporations may want to react by using internal funds more intensively. In this case, the net effect of integration on the dividend/retention ratios would be ambiguous. At any rate, by not letting the corporations adjust their debt/equity ratios and dividend/retention policies to the new market conditions after integration, some efficiency effects of integration that are not accounted for. Therefore, the results in this work may be biased downwards. In fact, it has already been suggested that the second-best nature of the partial integration results may be due in part to the lack of optimal corporate financial rules and dividend policies. While the adverse conditions for equity issuance and dividend payout disappear or are attenuated when dividends are exempted from the corporate income tax base, the model assumes that financial rules and retention policies do not change. (See Fullerton and Gordon, 1983, for a general equilibrium model in which debt/equity rules are endogenously determined by trading off the tax preference of debt against the potential bankruptcy costs of equity financing.) Despite its desirability, the treatment of financial decisions is a complex and somewhat controversial matter that is beyond the scope of this article. The apprc,ach followed here still allows the consideration

88

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of different financial assets in household portfolios, or different sources of corporate investment financing (bonds, equity, and retained earnings), the consideration of government deficits, and the differentiated tax treatment of different assets, both at the personal and at the corporate income levels. In addition, this treatment of the financial sector makes these results directly comparable with the findings of the previous literature, in particular Fullerton, King, Shoven, and Whalley (1981, 1985).

REFERENCES Ballard, C., Fullerton. D., Shoven, J., and Whalley, J. (1985) A General Equilibrium Model fi~r Tat Policy Evaluation. Chicago: University of Chicago Press for the National Bureau of Economic Research. Boskin, M., Robinson, M., and Roberts, J. (1985) New Estimates of Federal Government Tangible Capital and Net ln,Jestment. Stanford University Center for Economic Policy Research Publication No. 62, Stanford, California. Bovenberg, L. (1986) Capital Income Taxation in Growing Open Economies. Journal of Public Economics 3 !: 347-376. Feltenstein, A. (1986) A Dynamic General Equilibrium Analysis of Financial Crowding Out: Theory with an Application to Australia. Journal of Public Economics 31: 79-104. Fullerton, D., and Gordon, R. (1983) A Reexamination of Tax Distortions in General Equilibrium Models. in Behavioral Simulation Methods in Tax Policy Analwis (M. Feldstein, Ed.). Chicago: University of Chicago Press for the National Bureau of Economic Research. Fullerton, D., King, A., Shoven, J., and Whalley, J., (1981) Corporate Tax Integration in the United States: A General Equilibrium Approach. American Economic Review 71: 677691. Fullerton, D., King, A., Shoven, J., and Whalley, J. (1985) Corporate Tax Integration in the United States: A General Equilibrium Approach. in A General Equilibrium Model for Tax Policy Evaluation (C. Ballard, D. Fullerton, J. Shoven, and J. Whalley, Eds.). Chicago: University of Chicago Press for the National Bureau of Economic Research. Gaiper, H., Lucke, R., and Toder, E. (1986) Taxation, Portfolio Choice, and the Allocation of Capital: A General Equilibrium Approach (mimeo). Washington, DC: Congressional Budget Office. Gill, P., Murray, W., Saunders, M., and Wright M. (1986) User's Guide for NPSOL (Version 4.0): A Fortran Package for Nonlinear Programming. Stanford University Department of Operations Research Technical Report SOL 86-2. Goulder, L., and Summers, L. tl989) Tax Policy, Asset Prices, and Growth: A General Equilibrium Analysis. Journal t~ Public Economics 38: 265-290. Pereir:~. A. (1988) Corporate Tax integration in the US: A Dynamic General Equilibrium Analysis. Unpublished PhD dissertation, Stanford University. Pereira, A. (1989) Equal Yield Alternatives and Government Deficits. University of California, San Diego, Working Paper No. 88-43R. Pereira, A. ( I o91 ) The Efficiency Effects of Corporate Tax Integration and the Tax Reform Act of 1986. Public Finance. Vol. 46. Pereira, A., and Shoven, J. (!t)88) Survey of Dynamic General Equilibrium Models tor Tax Polic~, Evaluation, Jm~rmd of Policy Modeling IO: 40 !-436.

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Shoven, J., and Whalley, J. (1977) Equal Yield Alternatives: A General Equilibrium Computational Technique. Journal of Public Economics 8:2 ! !-224. Shoven, J., and Whalley, J. (1984) Applied General Equilibrium Model of Taxation and International Trade: An Introduction and a Survey. Journal of Economic Literature 23: 10071051. Slemrod, J. (1980) A General Equilibrium Model of Personal Income Taxation. Unpublished Ph.D. Dissertation, Harvard University. Summers, L. (1981) Taxation and Corporate Investment: A q-Theory Approach. Brookings Papers or~ Economic Activit).'. 1:67- ! 27. United States Department of Commerce (1983) Survey of Current Business. several issues. Washington, DC: U.S. Department of Cc-mmerce.