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Economic Analysis: Corporate Tax Incidence Made Simple

Posted on October 24, 2017 by Martin A. Sullivan

From what we have seen so far of the Republican tax plan, it appears it will concentrate tax cuts on corporations and high-income households. Yet at the same time it is being marketed — to use President Trump’s words — as a “middle-class miracle.” This seems like the political economy version of squeezing a square peg into a round hole. But with seismic political pressure to pass this tax cut, Republicans will be less reluctant than usual to push the envelope on technical scoring issues. It is critical for Republicans to convince the public that workers, not shareholders, will benefit most from corporate tax relief.

Economists refer to the burden of the corporate tax as its “incidence.” Corporate incidence is one of the most uncertain and difficult-to-explain topics in tax economics. But let’s try to break it down here so readers won’t need blind faith in experts.

The General Idea

You probably already know that before folks thought a great deal about globalization, economists almost universally accepted the view that the burden of the corporate tax fell on both domestic corporate capital and noncorporate capital. The noncorporate sector was indirectly burdened because capital migrated to that sector, which drove down the rate of return for owners of noncorporate capital. In this model, labor bore none of the burden of the corporate tax, so the corporate tax was unquestionably progressive.

But this quaint view of the world fell to pieces as it became increasingly clear that significant amounts of capital crossed international borders. Clearly, if a country raised its corporate tax, capital would flow abroad. With less domestic capital available to labor, workers become less productive, and lower productivity means lower wages. This cut in workers’ income is the burden of the corporate tax on domestic labor. This chain of causation is straightforward economics. The hard part is determining the magnitude.

A very clear real-world example of cross-border capital flows affecting wages comes from the history of the Irish Republic. During the period from the mid-1980s to the mid-1990s, the government reduced the corporate tax rate from 50 percent to 12.5 percent, turning Ireland into the Celtic Tiger and raising wages in that country from among the lowest to among the highest in the European Union.

With cross-border capital flows, the burden of corporate tax hikes (or, as in the case of Ireland, the benefit of rate cuts) shifted from capital to labor in the form of wage cuts (wages increased for the Irish). In fact, economic theory says that if capital is perfectly mobile, all the burden of the corporate tax is on labor. This all seems sensible. And this is clearly the impression that Republicans want to leave with the American public about their proposed $2 trillion corporate tax cut from 35 percent to 20 percent.

Important Caveats

But this is a far cry from the end of the story, as exhaustive reviews of economic research by Jane Gravelle, Jennifer Gravelle, and Kimberly Clausing make clear (citations at the end of the article). First, not all capital is perfectly mobile. For example, consider housing and electric power plants. And not all businesses are ready to pick up and move to lands of new culture, language, and regulations unless there are significant cost savings.

Second, the substitutability of foreign and domestically produced goods plays a role. If U.S. consumers are indifferent between domestic- and foreign-manufactured furniture, then it is true that low-taxed foreign furniture could close U.S. furniture factories. But not all goods are perfect substitutes. For example, it is pretty clear that U.S. motorcyclists prefer Harley-Davidson to Kawasaki. And given the recent scandal over poorly produced Japanese steel, U.S. firms may prefer domestic steel. In these cases of imperfect substitutability, capital does not move across the border so quickly and the effect of corporate taxes on wages is smaller.

But wait, there is a lot more to consider. A third factor that determines corporate incidence is the degree to which capital and labor can substitute for each other in the production process. If capital and labor are not good substitutes and must be used in fixed proportions, then taxing one is like taxing the other (just as a tax on right shoes is the same as taxing pairs of shoes). In this case, the corporate income tax is borne by labor as well as capital. But there is of course some substitutability between capital and labor (in today’s world, think of robots vs. factory workers), and in this case the burden of a tax on capital falls less on labor because the tax can increase the demand for it.

A fourth important factor for determining incidence, especially in the case of the United States, is the size of the economy making the corporate tax change. To illustrate, take an extreme, fictitious example where one country accounts for 99.9 percent of the world economy and a second accounts for the rest. A tax increase in the large country could hardly be exported entirely to the small country, so domestic capital would bear most of the burden. On the flip side, a tax increase in the small country could easily drive capital out of that country and be absorbed into the large country. In this case, the entire burden falls on the small country’s labor. Because the United States has the world’s largest economy, a significant share of its capital will remain close to its markets, and therefore this will keep a portion of the burden falling on domestic capital.

A fifth factor to consider is the reaction of other governments to a corporate tax change. If a U.S. corporate rate cut precipitates rate cuts in foreign countries, the advantage of moving capital abroad is obviously reduced. There is good reason to believe that if the United States cuts its corporate tax rate, other countries will follow suit. When the United States cut its corporate tax rate from 46 percent in 1986 to 34 percent in 1988, several other major economies followed suit, as shown in the table. The average reduction for 20 OECD countries from 1986 to 1990 was from 47.1 percent to 40.8 percent, a drop of 6.3 percentage points. To the extent other countries follow suit in any future U.S. corporate rate cut, there will be less burden shifted to domestic labor.

Change in Corporate Statutory Tax Rates After the Tax Reform Act of 1986 
(includes national and subnational taxes)

 

1986

2000

Change

Australia

49%

39%

-10%

Austria

55%

30%

-25%

Belgium

45%

41%

-4%

Canada

49.8%

41.5%

-8.3%

Denmark

50%

40%

-10%

Finland

51.5%

44.5%

-7%

France

45%

42%

-3%

Germany

60%

54.5%

-5.5%

Greece

49%

46%

-3%

Ireland

50%

43%

-7%

Italy

46.4%

46.4%

0%

Mexico

42%

36%

-6%

Netherlands

42%

35%

-7%

New Zealand

48%

33%

-15%

Norway

50.8%

50.8%

0%

Portugal

50.3%

40.2%

-10.1%

Spain

35%

35%

0%

Sweden

56.6%

53%

-3.6%

Switzerland

31.7%

30.6%

-1.1%

United Kingdom

35%

34%

-1%

Average of a bove

47.1%

40.8%

-6.3%

United States

49.8%

38.7%

-11.2%

SourceOECD. Excludes Czech Republic, Hungary, Iceland, Japan, Korea, Poland, Slovak Republic, and Turkey because of incomplete data.

A sixth factor to consider is the difference between what economists call normal and excess profits (the latter also sometimes called “rents”). The normal rate of profit is the minimum rate necessary for a company to invest. The additional or excess rate of profit is greatly appreciated but not necessary for a business to undertake investment and make a profit. In economists’ idealized view of the world, free markets should drive excess profits to zero. But monopoly, oligopoly, patent protection, and intangible assets (like brand names) allow firms to earn excess profits. Because excess profits are expected to have a limited impact on firm investment behavior, the extent to which profits are excess, the lesser the effect of corporate taxes on wages. It is difficult to measure excess profits. Estimates vary from 10 percent to 60 percent of the total. But to whatever extent they exist, the burden of the corporate tax on labor is likely less. There is some research that indicates that unions, using their considerable power, can access excess profits through bargaining with employers. But that would seem to be unimportant in the United States, where such a small share of the workforce is unionized and much of that is in the public sector.

Two last points: one minor and one major. The first is that although the U.S. system of international taxation leaves most foreign income untaxed, there is some small amount of tax on income from U.S. multinational outbound investment. So to the extent an increase in the corporate tax increases tax on income from outbound investment, there is no burden on domestic labor, just on foreign capital and foreign labor.

The larger point may be difficult to grasp at first because its conclusion is counterintuitive: The corporate tax may increase domestic investment — and therefore potentially increase U.S. wages — because debt-financed investment is subsidized by the corporate tax. (This same phenomenon, by the way, is why there is so much discussion about disallowing interest deductions for investment that receives complete expensing.) Suppose in the extreme that only domestic investors buy shares in domestic companies (that is, equity-financed capital is not mobile across borders), but the market for corporate debt is totally open to international investors. If there is a reduction in the rate of tax on corporate capital, the value of that debt is reduced, and there are fewer debt-financed capital inflows into the United States. In fact, there is in the real world a stronger home-country bias by investors for corporate equity than corporate debt. And this is why a study by Treasury economist Harry Grubert and John Mutti found that foreign capital flowed inward with an increase in the corporate tax. That increase in domestic capital would raise domestic wages.

What Else You Should Know

On October 13 the president’s Council of Economic Advisers issued a 13-page report stating that the average household income increase under the corporate tax proposal of the yet-to-be-completed “Big Six” unified framework would be between $4,000 and $9,000. There are at least three reasons to be skeptical of this conclusion. First, the limited number of studies cited and used by the council all report from the high-incidence-on-labor end of the spectrum. Second, all of these studies have received substantial criticism, mostly because small changes in the statistical techniques used yield significantly lower estimates of labor’s burden from the corporate tax. Third, even if 100 percent of the benefit of a 10-year, $2.5 trillion corporate tax cut benefited labor, that would still be a less than 2 percent increase in total labor compensation over the next 10 years. (Employee compensation equals about 61 percent of national income.)

Any shifting of the burden of the corporate tax to labor should be expected to take considerable time as it depends on all types of adjustments that can’t happen overnight. On the contrary, in many economic models they take decades.

As emphasized by Alan Auerbach in 2005, not all corporate tax cuts are equal. Economics suggests that in the proposed Big Six framework, the largest benefit to workers from corporate tax reduction will come in the form of expensing because it is the provision per dollar of revenue loss that is most likely to increase domestic capital formation. The proposed corporate rate cut is not as potent in improving the lot of workers (especially in the short run) because it provides a windfall to existing capital and therefore current shareholders (even before the bill is enacted), since expected cuts will be capitalized into higher stock prices. If — and this is a big “if” at this stage — anti-base-erosion rules are tough and raise the effective tax rate on some foreign investment, this could reduce incentives to move capital offshore and thereby increase domestic wages.

In conclusion, it is absolutely correct to believe that as the world economy becomes increasingly integrated, more of the burden of corporate tax will be borne by labor. But by how much is highly uncertain. Nevertheless, a careful review of the evidence leaves no compelling reason to reject the assumptions of official estimators at the Joint Committee on Taxation and the Congressional Budget Office, and of Treasury Department staff economists whose views the current administration is trying to suppress with the removal from the Treasury website of a technical paper on incidence. The paper is published in the National Tax Journal anyway. It concurs with the bottom line of the JCT and CBO that in the long run, about one-quarter to one-fifth of the corporate tax burden is borne by labor. For a more thorough review of these issues, you will have to wade through the papers listed below. The second paper by Jane Gravelle is a two-page summary and an excellent place to start.

Further Reading

Alan J. Auerbach, “Who Bears the Corporate Tax? A Review of What We Know,” in James M. Poterba ed., 20 Tax Pol’y and the Econ. 1 (2006), National Bureau of Economic Research, Cambridge, Mass. (2005).

Céline Azémar and Glenn Hubbard, “Country Characteristics and the Incidence of Capital Income Taxes on Wages: An Empirical Assessment,” 48 Canadian J. Econ. 1762 (Dec. 2015).

Council of Economic Advisers, “Corporate Tax Reform and Wages: Theory and Evidence” (Oct. 2017).

Kimberly A. Clausing, “In Search of Corporate Tax Incidence,” 65 Tax L. Rev. 433 (2012).

Kimberly A. Clausing, “Who Pays the Corporate Tax in a Global Economy?” 66 Nat’l Tax J. 151 (Mar. 2013).

Julie Anne Cronin, Emily Y. Lin, Laura Power, and Michael Cooper, “Distributing the Corporate Income Tax: Revised U.S. Treasury Methodology,” 66 Nat’l Tax J. 239 (Mar. 2013).

R. Alison Felix, “Do State Corporate Income Taxes Reduce Wages?” 94 Federal Reserve Bank of Kansas City Econ. Rev. 77 (2009).

Mihir A. Desai, C. Fritz Foley, and James. R. Hines, “Labor and Capital Shares of the Corporate Tax Burden: International Evidence,” International Tax Policy Forum and Urban-Brookings Tax Policy Center Conference (Dec. 2007).

Jane G. Gravelle, “Corporate Tax Reform: Issues for Congress,” Congressional Research Service, Sept. 22, 2017.

Jane G. Gravelle, “Who Pays the Corporate Tax?” Congressional Research Service, Sept. 29, 2017.

Jennifer C. Gravelle, “Corporate Tax Incidence: A Review of Empirical Estimates and Analysis,” CBO Working Paper No. 2001-01 (June 2001).

Jennifer Gravelle, “Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis,” 66 Nat’l Tax J. 185 (Mar. 2013).

Harry Grubert and John Mutti, “International Aspects of Corporate Tax Integration: The Contrasting Role of Debt and Equity Flows,” 47 Nat’l Tax J. 111 (Mar. 1994).

Kevin A. Hassett and Aparna Mathur, “Spatial Tax Competition and Domestic Wages” (Dec. 2010).

Li Liu and Rosanne Altshuler, “Measuring the Burden of a Corporate Tax Under Imperfect Competition,” 66 Nat’l Tax J. 215 (Mar. 2013).

William C. Randolph, “International Burdens of the Corporate Income Tax,” CBO Working Paper No. 2006-09 (2006).