Aggregate Implications of Corporate Taxation over the Business Cycle

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Corporate tax deductions are widely employed as countercyclical policies across countries, yet their impact on the business cycle and interactions with other policies remain largely understudied. I examine the cyclical implications of such deductions by developing a novel dynamic stochastic general equilibrium model in which firms face credit market imperfections and idiosyncratic productivity shocks. In my model, firms’ investment decisions are distorted by collateralized borrowing and partial irreversibility due to corporate taxation. Investment expenditures can be deducted from taxable income in two ways: through targeted policy that grants full deductions to firms with smaller investments, or through untargeted policies that allows partial deductions. My model quantitatively replicates empirical estimates of the short-run elasticities of investment across firm size to changes in deduction policies. I show that raising deductions can reduce the severity and persistence of recessions by alleviating capital misallocation for productive firms. Applying my model to the policies in the 2017 Tax Cuts and Jobs Act, I find that the targeted policy is 30 percent more effective than the untargeted policy in stimulating aggregate output. Furthermore, combining both policies reduces the overall effectiveness by 17 percent, revealing potential inefficiencies in current US tax policy implementation.

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