Does Incorporation Matter? Quantifying the Welfare Loss of Non-Uniform Taxation across Sectors

According to Harberger’s 1962 and 1966 seminal papers, the corporate income tax distorts the allocation of capital between the corporate and the non-corporate sector and reduces therefore aggregate output. To quantify this efficiency loss we apply a dynamic, computable, general equilibrium growth model. We compare the allocation of capital under the current, non-uniform German tax system with the allocation of capital arising from a hypothetical, sector neutral tax system where both sectors face the same effective tax burden. Our numerical results underpin the theoretical finding, that the loss in overall output is highly sensitive to the source of investment funds. Accordingly, if investments are exclusively financed via new share issues the efficiency loss amounts to nearly 2 percent of aggregate output. However, if less than half of overall investments are financed via new equity injections the efficiency loss is almost negligible.