What Happens With a Zero Corporate Income Tax? Evidence From a Corporate Payout Tax System

Abstract:

Academics and policymakers frequently suggest replacing the traditional corporate income tax system—where both corporations and their shareholders are taxed—with a tax on payouts (“corporate payout tax”). Arguably, this approach could reduce administrative burdens for firms and incentivize investment. However, there is limited empirical evidence on the economic effects of such a tax system. Our study addresses this gap by examining a unique corporate tax reform in Latvia, which introduced a corporate payout tax in 2018. Using a difference-in-differences design, we find that firms affected by the reform decrease investment, increase payouts, and reduce leverage. These results suggest that payout incentives resulting from the shift from the old to the new tax system crowd out the expected positive investment effects of the payout tax. Additionally, by eliminating the preferential tax treatment of interest expenses as common under the traditional corporate income tax, the payout tax reduces incentives for debt financing. All effects persist several years after the reform, except for payouts, which decline in the long run consistent with the payout tax incentivizing corporations to retain profits. Our study provides novel evidence on firm responses to a corporate payout tax, informing reform deliberations in the U.S. and globally.

Keywords: payout tax, distributed profits tax, capital investment, payout, debt financing