Game theory and corporate tax rates: the Ontario Liberals are almost certainly wrong
Jun 4, 2014

Game theory and corporate tax rates: the Ontario Liberals are almost certainly wrong

I don't know what the optimal corporate tax rate is. I suspect neither does anyone. I believe there is reasonable evidence out there that given the kinds of goals and values we likely share, that a somewhat higher corporate tax rate is preferred, but what exactly that rate is - what the Game Theoretically Optimal or GTO rate is, I don't know.

Among the Ontario parties, the Liberals want to keep the tax rate fixed at the new 11.5% level they have introduced since being in power. The PCs want a 30% (3.5 percentage points) further reduction. The NDP wants to kick the rate up 8.5% (one percentage point).

Which of these is best? I don't know, but we can say one thing for sure: the Liberals are almost certainly wrong. The chance that 11.5% is really the optimal level is exceedingly unlikely. Outside of a huge coincidence, it should either be higher or lower than this. The evidence points, I think, to the idea that it should be somewhat higher, probably quite a bit more than the timid one percentage point increase the NDP proposes as well.

Most people, when trying to decide, aren't going to pour into the economic analysis here. They are going to do what Andrew Coyne regrettably did: reduce this economic point to a gut feeling about whether taxes, as a whole, should go up or down. If you are going to do that, well fine, but know this: where they are right now is almost certainly not correct.

A poker analogy:
There is a fun little poker analogy here. In tournaments, and to a lesser degree cash games, there is some debate as to what the optimal preflop bet sizing should be. Should we open raise 2x the big blind from the button? 2.5x? 3x? Shove all in? The state of game theory for poker is such that nobody is currently capable of computing what the optimal preflop bet sizing is, much in the same way we don't really know what the optimal corporate tax rate is. But we can say for sure that if the answer is the small multiple of the big blind, by far the most likely is that the answer is the minimum possible bet, 2x. As in, if smaller bet sizes were allowed we would have all the options from 1.1x up to our entire stack. And if we have reason to think the very large options are "obviously" bad, then the answer is in some range from just above 1 to, say, 4x the big blind. Raising the minimum 2x, thus "covers" a solid chunk of that range. Raising something silly like 2.1 or 2.2x the big blind is very unlikely to be correct except by complete coincidence. If the answer is higher than 2x, which it may well be, the chance of it being that 2.1x is exceedingly low just in terms of a percentage of the allowable values.

Thoughts on this post? Comment below!

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Ron Waller said...

According to KPMG, Canada has the lowest effective corporate tax rate among all major economies. The federal government cut corporate taxes by 50%. Harper's 25 points are pegged at $14.9-billion/yr in his 2009 budget.

McGuinty cut corporate taxes by $2.4-billion/yr: from 14% to 11.5%. He planned to cut them to 10% but the NDP stopped him.

According to KPMG:

"Corporate income taxes are lowest in Canada (7.3 per cent effective corporate income tax rate), France (14.7 per cent), and China (14.8 per cent).

"At the other end of the scale, effective corporate income taxes exceed 30 per cent in Japan (31.5 per cent), Brazil (36.1 per cent), and Italy (37.6 per cent).

"These effective income tax rates are significantly lower than the nominal tax rates in most countries due to the inclusion of various tax incentives, including R&D tax incentives, in these calculations."

In short, the optimal - competitive - rate is higher than before the Harper and McGuinty tax cuts.

Also try comparing the corporate tax revenues from resource-based economies from public OECD stats: Canada 3.1%, Australia 5.2%, Norway 10.7%. Every point is $19-billion a year.

Over the past decade, we had a resource boom that killed 300,000 manufacturing jobs in Ontario. At the same time we were giving resource corporations big breaks with tax cuts and subsidies.

KPMG Competive Alternatives 2012 — Focus on Tax (Chp 3, pg 7)

OECD tax revenue stats

bazie said...

Having relatively low corporate tax rates doesn't by itself imply that low corporate tax rates are a bad thing. Don't get me wrong, I do think the body of evidence supports increased corporate tax rates. But we don't get to conclude that just just from the relative comparison.

Ron Waller said...

Actually, politicians and economists concluded Canada's nominal corporate tax rate was too high when compared to other developed countries. And that was one of the top justifications for many of the cuts. So a relative comparison is clearly enough reason to reverse excessive corporate tax cuts especially considering they have provided little economic benefit for the huge cost in resources.

Economists make relative international comparisons all the time. One would have to come up with a reason why Canada is unique among all other major economies and should have half the corporate tax rate of the lower end of the scale to support your argument. But economists don't think like that.

With corporate taxes, they might compare nominal or effective rates of a number of relatively similar economies and try to find a correlation between taxes and productivity. Then come out with a paper that concludes "corporate tax cuts boost productivity." Unfortunately, macroeconomics is not a science and economists often cherry pick data to bolster a self-serving economic policy.

In short, a lot about economics boils down to rule of thumb. As Keynes might say if he were alive: "To-day we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand."

Economics is merely politics with math thrown in to lend authority to political agendas.

bazie said...

As a mathematician by trade who dabbles in economics from time to time, it is sad to see such a dismissive view of the field. You are certainly right that, particularly when intersecting politics, many politicians and some economists will tend towards substantiveless adherence to ideology, cherry picking data and offering empty rules of thumbs to fit their political agendas such as "if other countries have X and we have Y then we should be more like X".

But as a scientist, I reject the claim that economics, or macroeconomics in specific, is not a science. One can and should do the kinds of more substantive analysis that does lead to meaningful policy recommendations. As indicated in the post, we can't clearly claim a precise corporate tax rate, but we can meaningfully look at date and construct arguments to change it. I believe that the body of evidence supports an increase from our current levels. Andrew Coyne might want to reduce the arguments to a gut feeling on whether taxes should go up or down. I, however, want to hold ourselves to a better standard than that.

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