Incidence of Corporate Income Tax and Optimal Capital Structure: A dynamic analysis

In this study, we analyze the incidence of corporate income tax using a dynamic general equilibrium model. The dynamic macroeconomic model enables us to analyze both the instantaneous and the intertemporal incidence of corporate income tax. We include capital structure (i.e., choices of equity, debt, and retained earnings) in the proposed model in order to implement investment. The model also includes a progressively increasing per unit agency cost on debt. We implement a simulation based on the dynamic model, and measure the incidence of corporate income tax on labor income, when the (effective) corporate income tax rate decreases from 34.62% to 29.74% in Japan. We find that the percentage of the incidence on labor income is about 20%-60%, in the short term (one year), and the percentage of the incidence on capital income is about 40%-80%. In the long term, about 90% of the incidence is on labor income. Thus, almost all of the incidence shifts to labor income in the long term. In contrast, in a neo-classical dynamic general equilibrium model, the entire incidence shifts to labor income in the long term. The difference between these results is caused by the inclusion of the agency cost on debt.