Personal Taxation, Portfolio Choice, and the Effect of the Corporation Income Tax

Extending the traditional treatment of the corporate tax to an econ-omy with a progressive personal tax fundamentally changes the analysis. While the corporate tax system (CTS) does increase the total tax rate on corporate source income br some investors, the exclu-sioti of retained earnings implies that the Cl'S lowers the tax rate for high-income investors. Analyzing such an economy requires replac-ing the traditional "equal—yield " equilibrium condition with a more general portfolio balance model. In this model, introducing a CTS can actually increase the corporate share of the capital stock even though the relative tax rate on corporate income rises. The current theory of public finance views the corporate income tax as an extra tax on income in the corporate sector. ' This implies that the corporate income tax penalizes activity in the corporate sector. As a result, the corporate sector uses a smaller fraction of the nation's capital stock than it would use if corporations were taxed like partner-ships. This paper is part of the National Bureau of Economic Research's program of research in Business Taxation and Finance. The views expressed here are the authors' and should not be attributed to any institution. We are grateful to the referee for his very helpful comments on the earlier version of this paper. 1 Harberger (1962) is the best and most widely known statement of this theory. Th