On the Neutrality of Flow-of-Funds Corporate Taxation

Abstract

real income-earning business activities of firms rather than the financial ones. Furthermore, it has virtually ignored the implications of the financial structure of the firm for the neutrality of flow-of-funds taxation of both real and financial activities of the firm in a model of the firm in which the financial structure has been explicitly included. We shall be particularly concerned with the sorts of flow-of-funds tax systems suggested by the Meade Report, the so-called R and R + F bases. We will show that whether the investment decision is distorted under such corporate tax bases depends on how the financial structure of the firm is determined. The R base is neutral under some financial constraints, while the R+F base is neutral under others.3 We also extend the analysis to incorporate personal taxes impinging on capital income and the effects of inflation. Finally, we introduce financial assets held by the firm. We show that the R base can be generalized to what we call the R + A base. This base will be neutral under the same borrowing constraints for which the R base is neutral. In general, the R+F base as defined in the Meade Report will not capture all the profits arising from financial intermediation and may