Investment and Tax

The Classical View

We now investigate the effect of corporate tax on firms’ behavior. According to the classical view of corporation tax, tax on firms does not affect their behavior in the short or long run. Namely, changes in corporate tax do not affect any economic activities including investment. Let us explain this classical view.

The objective of the representative firm is to maximize its profit. In order to maximize after-tax profit, a firm must maximize its before-tax profit. The aim of investment is to maximize before-tax profit, the level of which is independent of corporate tax. The crucial assumption here is that after-tax profit corresponds to before-tax profit on a one-to-one basis.

Imagine that the firm intends to maximize “pure” profit, which subtracts normal costs including payment for capital. The classical view assumes that after-tax profit exactly corresponds to before-tax profit because the normal user cost of capital, namely the rental cost of capital, is subtracted from the tax base. Let us explain this point using a simple model of the firm.

The firm may rent capital from the capital market at a given rental cost, which is normally equal to the rate of interest. Let us denote corporate tax by tI, product price by p, the production function by F(K,L), labor by L, capital by K, the wage rate by w, and the rental cost of capital by r. Then, after-tax profit R is given as

The firm maximizes before-tax profit pF — wL — rK in order to maximize aftertax profit R. The optimal conditions for K and L are given respectively as

where FK denotes the marginal product of capital and FL denotes the marginal product of labor. Equations (8.16) and (8.17) are not affected by the tax rate, tI. Thus, optimal output and investment are independent of tI. Note that in Eq. (8.15), the rental cost of capital, rK, is subtracted from the tax base.

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