INTRODUCTION

Under a “classical” corporate tax system such as that prevailing in the United States, income from equity-financed corporate investment is taxed twice: at the corporate level a tax is levied on corporate profits after deduction for interest payments, and at the shareholder level dividends and realized capital gains on shares are subject to full personal income tax.

Over the years, many economists have argued that this system of “double taxation” significantly reduces the overall investment level and drives capital from the corporate sector into lower yielding projects in the noncorporate sector. Influenced by this line of argument, many governments in the OECD area have introduced measures to alleviate the double taxation of corporate-source income, e.g., by granting a credit for the underlying corporate tax against the personal tax on dividends, and/or by offering favorable personal tax treatment of capital gains on shares.

On the other hand, some economists have claimed that the traditional view greatly overstates the distortionary effects of a classical corporate tax system, implying that double tax relief may cause a considerable loss of government revenue without generating much stimulus to investment.

It is clearly important for public policy which view of the corporation tax is the more correct one. This article attempts to explain in a nontechnical manner the different viewpoints on the nature and impact of the corporate income tax. I will focus on the effects of double taxation of corporate-source income on the cost of corporate capital, defined as the minimum pretax rate of return a corporate investment project must earn to be profitable.