Corporate tax cuts, the cost of capital, and economic activity

Several real-world patterns of tax structures since the 1980s exhibit reductions in corporate income tax rates—most notably exemplified by the 2017 U.S. fiscal reform and the current U.S. government tax policy agenda. This paper provides a general equilibrium model of production and financial choices by firms under distortionary taxation and characterizes the long-run and dynamic effects of corporate tax cuts. It shows that these effects depend not only on production decisions, as set forth by the existing literature, but also on the mode of corporate finance and the stance of monetary policy. It establishes conditions under which, contrary to what is commonly believed, corporate tax cuts can dampen — rather than boost — the capital-labor ratio and real wages. A key underlying mechanism is the negative pass-through from the corporate tax rate to the equilibrium weighted average cost of capital, driven by the tax shield effect of nominal interest deductibility. The results derived in this paper lend analytical support to the view that accounting for both the capital structure employed by firms and the monetary variables pinned down by the central bank’s interest rate policy is essential when evaluating theoretically and empirically the properties of corporate tax policies.