Modelling Responses to Profit Taxation over the Economic Cycle

This paper considers behavioural responses of companies' declared profits to changes in profit tax rates. Using microsimulation modelling based on the UK corporate tax system, it argues that the cyclical volatility of firms' gross profits and off-setting deductions are potentially important but distinct determinants of the size of these behavioural responses. This arises both because deductions claimed are typically a relatively large fraction of declared gross profits and because of the endogenous relationships between various deductions and those profits. The endogeneity arises mainly from asymmetries in the tax treatment of losses, which generates an asymmetric cycle in the claiming of losses and capital allowances as profit off-sets. Microsimulation modelling shows that these aspects can be sizeable compared with recent estimates of firms' profit-shifting responses found in the empirical literature.