The economic effects of EU-reforms in corporate income tax systems

Moreover, losses are not indexed. Hence, they need to be discounted under loss carry forward to
compute them in net present value terms. Under consolidation, losses are more valuable. A loss
in one part of the company can be offset immediately against profits elsewhere as long as these
are positive. In that case, losses can always be offset against these profits and without
discounting. Therefore, the tax burden under loss consolidation is generally lower than under
loss carry forward.
To illustrate how much the corporate tax burden will fall under loss consolidation, consider
the following example (this closely resembles what we assume in CORTAX). Suppose there are
100 firms. Among them, 80 make a profit of 1000 and 20 make a loss of 1000 (this corresponds
to the loss probabilities and the loss size used in CORTAX). The total taxable base of profit
making firms is therefore 80 000 if the losses cannot be offset and 60 000 if losses are offset
immediately. Under loss consolidation, the tax base is thus 25% smaller. As the tax reduction
applies only to multinational firms, we multiply this by the share of multinationals in the
economy, which is approximately 60% in Europe. Consolidation would then reduce the
corporate tax burden by 15%. 12 In the steady state equilibrium of CORTAX, the reduction in
the tax base is smaller because losses can be carried forward from the past. In CORTAX, 80%
of the previous-year losses (i.e. the probability of profit) can be offset against profits in the next
year (the other 20% dry up because no profits are made). In our example, this equals a loss
compensation of 16 000. Yet, these profits need to be discounted at, say 5% interest, which
reduces its current value to 15200. Compared to immediate loss offset under consolidation of 20
000, the value of losses drops by 4 800. It implies a reduction of the corporate tax base by 4 800
/ 64 800 = 7.5% when moving from loss carry forward to loss consolidation. Assuming a share
of multinationals of 60% of all companies, the aggregate decline in the tax base in the steady
state would be 4.5%.
In the CORTAX simulations, loss consolidation indeed reduces corporate tax revenue in
Europe by slightly less than 5%, which is about 0.2% of GDP. The reduction is higher for
countries featuring high corporate tax rates and a large multinational sector. The incentive
effects of loss consolidation on investment and employment are subtle. The box “Incentive
effects of loss consolidation versus loss carry forward” explains this in more detail. 13 Despite
the lower corporate tax burden due to consolidation, it shows that the cost of capital does not
necessarily fall. Intuitively, marginal returns on investment can still be positive but taxed later
or only partially under loss carry forward. Under loss consolidation such positive marginal
12 Fuest, Hemmelgarn and Ramb (2006) find a decline in the tax base of 20% using data on German multinationals. ORBIS
suggests that the share of multinationals in Germany is 70%. It would imply a direct reduction of 17.5% in Germany.
13 Note that CORTAX does not capture three other potentially important effects of loss consolidation. First, higher after-tax
profits may stimulate investment if firms are liquidity constrained. Empirical evidence supports the positive investment effect
of net internal funds (see e.g. Hubbard, 1997). This argument seems most relevant, however, for small domestic firms and
not for multinationals. Second, a more symmetric treatment of profits and losses under consolidation may reduce the risk of
investment as the government better insures losses. This Domar-Musgrave effect may stimulate risk taking and raise returns
to capital in the economy. Finally, loss consolidation can remove a barrier for multinational firms to locate in certain countries
or to organise their affairs in the most efficient way.
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