Predicting the revenue from a reform of firm taxation may seem difficult, given the numerous instances of missed forecasts in this area. However, if the amount of profit to which the firm tax rate applies remains unchanged when that rate is altered, then it is sufficient, to determine the expected revenue from such a reform, to multiply the amount of taxable profits observed before the reform came into force by the difference in rates between the pre- and post-reform periods. In economic jargon, this is described as the elasticity of pre-tax profits with respect to post-tax profits being zero.
In reality, companies often report higher profits when the corporation tax rate falls, and the elasticity in question is therefore positive. A simple back-of-the-envelope calculation even shows that if, for a current tax rate of t%, this elasticity exceeds (1-t)/t (‘for a 1% increase in firms’ after-tax profit 1-t, pre-tax profit increases by more than (1-t)/t%’), then a slight reduction in the corporation tax rate does not reduce corporation tax revenue. We are therefore on the wrong side of the ‘Laffer curve’, where too much tax kills tax revenue. It is therefore difficult to predict corporation tax revenue without knowing this elasticity, which is the Holy Grail for specialists in the field. Aware of this difficulty, forecasters assume zero elasticity, which seems reasonable for a short-term budgetary analysis, particularly because companies have already, without realising it, made profits that will be subject to the new tax measure. But that does not mean it is correct in the longer term…
