Is the corporation tax an effective automatic stabilizer?

We investigate the extent to which the corporation tax can act as an automatic stabilizer by smoothing the effects on investment of shocks to income. The main stabilizing effect would be through a reduced tax liability affecting the internal funds available for investment by credit-constrained companies. We present evidence for the United Kingdom that most credit-constrained firms have also been likely to be in a tax loss-making position, implying that the tax does not smooth investment, and thus is not an effective automatic stabilizer. A more generous treatment of tax losses would introduce significantly more automatic stabilization.

2009

Is the corporation tax an effective automatic stabilizer?

In an economic downturn, taxes can act as an automatic stabilizer on the economy. For example, net personal income may fall proportionately less than gross personal income as individuals move to a lower marginal tax rate. For companies, the main stabilizing automatic effect would be through the treatment of losses. If companies could claim effective tax rebate, perhaps through losses carried back, then negative shocks to their profit are offset by taxes. In this case, corporation tax can act as an automatic stabilizer as more internal funds are available for investment by credit-constrained companies. However, if losses can only be carried forward, then this automatic stabilization does not exist. This project presents evidence that most credit-constrained firms are likely to be in such a position, implying that corporation tax has provided virtually no automatic stabilization in the downturn. A more generous treatment of tax losses would introduce significantly more automatic stabilization.

Michael Devereux, Clemens Fuest