Friday, April 4, 2008

Comeback of corporation tax! Goodbye banking crisis!

The economics profession long ago doomed source-based taxes on real capital to a race to the bottom because of increased mobility of resources, capital in particular. Corporation tax is the major source-based tax on capital, having visible tax competition as regards the statutory rate.

Viewed from Finland, the reality shows quite an opposite development. Tax revenue from corporation tax has tripled over the past two decades!

Corporation tax typically raised revenue from 1% to 1.5 % of the GDP in the 1980’s but 3.7 % in 2006 while the statutory rate on corporations was simultaneously slashed from 60 per cent to 26 percent.

Hence the growth of tax revenue resulted from the broadening of the tax base. The companies are no longer forced to invest in machinery and structures to gain abundant tax depreciation charges for the purpose of hiding their taxable profits as in the 1980’s.

Instead of thinking the short-term tax savings brought about by business investments, the corporations think nowadays about their true long-term profitability. Hence the tax system of the 1980’s induced businesses to wasteful, inefficient real investments while the current tax system promotes efficient allocation of investment and capital.

How come did the politicians of Finland have such a foresight as regards the growth of tax revenue when they chose for a lower rate of corporate tax applied to a broader base of taxable income? They didn’t. The reason was the banking crisis in the beginning of the 1990’s.

Lax monetary policy from the mid 1980’s in the western world meant that international financiers flushed Finland with foreign money because the poor Bank of Finland did not understand how to control the growth of money and credit stocks in financial markets. The bank was accustomed to only give prescripts.

The Finnish bankers had previously rationed loans, granted them to their favored customers. At the end of the 1980’s bankers regarded themselves as businessmen. Their remuneration depended on the growth of loans granted.

And, everyone in Finland tried to hedge against galloping inflation by investing in real estate in particular. The other bugbear to hedge against was the taxman, but it offered ideal fiscal incentives for investments – accelerated tax depreciations combined with a high statutory tax rate.

The result was reckless bank lending and a classical banking crisis. One means to end it was to restore profitability of the enterprise sector and solvency of the bank customers. That is why the politicians parted from their old dirigible fiscal tools.

Connecting with the current calamity in financial markets, we have seen international investors financing the growth of consumption and investment in the USA and learnt from asymmetric incentives in its mortgage origination and repackaging businesses.

The only material difference from the crisis of Finland is that the US foreign debt is denominated in its own currency. Therefore the consequences on real economy from the debt crisis will not be so severe and long lasting in the USA as was the case with banking crises of both Sweden and Finland.

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