Macroeconomic effects of zero corporate income tax on retained earnings

Abstract

International tax competition has led to a lowering of corporate tax rates worldwide. Estonia was the first country to reduce the tax rate on retained earnings to zero, while distributed profits remained taxed at the pre-reform level. This paper seeks to analyse the effects of this unique tax reform implemented in year 2000. We apply a neoclassical exogenous growth general equilibrium model with an extension for endogenous corporate finance. Our findings indicate that the reform had a strong positive effect on capital accumulation and a modest positive effect on output and consumption, while preferential treatment of retained earnings increased equity finance and reduced debt finance.

Keywords:

• corporate income tax
• retained earnings
• endogenous corporate finance
• catching-up countries

JEL codes:

• H25
• O16
• E21
• P35