How corporate taxes can make or break an economy

When corporate taxing make sense

You might suppose that less efficient governments (Greece and Brazil, for instance), should not tax companies heavily because, in addition to the damage to firms’ bottom line, government spending financed by tax revenues will be mostly wasted. By this token, you might also imagine that very efficient public sectors (the UAE and New Zealand, for example) should not need to levy large taxes on corporations to guarantee a smooth functioning of their public services. But what are the indications for economies’ competitiveness, according to our research?

We classified countries by the size of their public sectors, measured by the ratio of total government expending to GDP. Countries with large governments include France and Brazil. Examples of small governments are Singapore and South Korea. We use this classification to assess the impact of corporate taxes on the efficiency of government (our so-called Government Efficiency criterion, defined as “the extent to which government policies are conducive to competitiveness”) as calculated in the 2020 IMD World Competitiveness Ranking. 

Figure 1 summarizes our findings: for countries with small governments, the relationship between government efficiency and corporate taxes is positive (that is, the larger the corporate tax rate, the worse the competitiveness ranking). On the other hand, as countries with large governments reduce corporate taxes, they subsequently increase the competitiveness of their public sector and increase overall prosperity.

For countries with small public sectors, it is therefore desirable to reduce taxes, with a view to spurring on corporate development and investment. When institutions work and corporate values are adequate, a reduction in corporate taxes increases corporate investment in technology, for example, instead of increasing annual executive bonuses. When the country is efficient, cash windfalls from tax reductions find a value-creating use (like building a new plant or investing in executive development).

The opposite is true for bigger governments. When, because of corruption or inefficient regulation, the public sector wastes resources and diverts them for useless purposes or to fill private pockets, increasing corporate taxes makes these countries even more corrupt and their spending more wasteful. In turn, they become less efficient.

Countries that lie in the top half of government size would be well advised to downsize their public sectors by reducing the money they levy from the private sector, if they want to be more competitive.

And so it is that corporate taxes play a dual role in competitiveness: on the one hand, they increase government revenues and therefore public investment. On the other, they stifle the competitiveness of the public and private sectors. In countries where the state plays a reduced role in the economy (which usually implies lesser corruption, business-friendly institutions and healthy public finances), the former dominates; and in governments with large public sectors, the latter prevails.

The outcome of the G20 and OECD resolutions is yet to be defined but corporate innovation always moves faster than government regulation, meaning companies find ways to optimize their corporate tax bill. Until recently, this was achieved via corporate mobility. The difference now is that it is going to require a different set of tools.