Question

For a corporation that can borrow freely at the current prime interest rate and seeks to maximize its expected profit over the next several years, how does the reduction in the marginal corporate income tax from 35% to 21% in the TCAJ act affect the amount it would choose to spend on new equipment, financed by new borrowing? Ignore other reforms in the TCAJ act that affect the corporation’s tax liability. Justify your answer.

Answer 1

The effective corporate tax rate on business is a measure of the actual tax liability of a company as a percentage of its before tax profits. In other words, it is a percentage of the before tax profits that companies are required to pay to the governments to conduct their business. Going by this definition, any reduction in the tax rates would therefore result in a direct increase in the after tax profitability of a company.

Some of the positive impacts of reduction in corporate taxes are-

• positive impact on foreign direct investments
• increase in after tax business profits
• positive impact on business investment
• improved capacity for planned expenses
• positive impact on employment as jobs depend on business protability
• positive impact on innovation

Lower corporate tax rates do encourage companies to invest more in new facilities, machinery, and equipment as lower taxes result in greater disposable income. There is a stron positive correlation between after tax cash flow and overall investment by companies. It has been historically observed that reduction in tazes have invariably resulted in increase in business investment in new facilities and equipment by three to six months. Some of the study suggest that for every percentage point change in the after tax cash flow there is a 0.86 percentage point change in total business expenditure.