The Dirt On the Corporate Income Tax

23 Tuesday Mar 2021

Posted by pnoetx in Fiscal policy, Tax Incidence

Tags

Alan D. Viard, Biden Administration, Compliance Costs, corporate income tax, Edward Lane, Investment Incentives, Joseph Sullivan, L. Randall Wray, Milton Friedman, Off-Shoring, Peggy Musgrave, Physical Capital, Pricing Power, Regressive Tax, Richard Musgrave, Shifting the Burden, Tax Avoidance, Tax Foundation, Transfer Pricing, Transparency

The Biden Administration is proposing a substantial increase in the corporate income tax rate from 21% to 28%. This is another case of a self-destructive policy that serves as a virtue signal to the progressive Left. See? We’re taxing the rich and their powerful corporations! What none of them realize is that the tax on corporate income is actually a regressive tax on consumers and workers; it is a disincentive to the formation of productive capital; and it is a highly wasteful tax due to compliance costs and the impact of avoidance. And the Biden proposal would make the U.S. less competitive internationally, as the chart above from Joseph Sullivan demonstrates. Maybe some of the proponents realize it, but they still like it because it sounds so good to their base!

It’s not as if all these unhealthy characteristics of the corporate tax are new findings. Milton Friedman explained some of the basics in 1971 when he said:

“The elementary fact is that ‘business’ does not and cannot pay taxes. Only people can pay taxes. Corporate officials may sign the check, but the money that they forward to Internal Revenue comes from the corporation’s employees, customers or stockholders. A corporation is a pure intermediary through which its employees, customers and stockholders cooperate for their mutual benefit.”

In 1984, two giants of public finance economics, Richard and Peggy Musgrave, investigated how the corporate tax was shifted to households. Here’s a description of their findings from a recent paper by Edward Lane and L. Randall Wray:

“… the bottom quintile pays 4.6–5.5 percent of its income toward the corporate profits tax, the top decile pays 2.5–3.7 percent of its income, and the ninth decile pays 2.4–2.9 percent of its income. They conclude that the corporate profits tax is largely regressive while the federal personal income tax is progressive.”

The incidence of the corporate tax rate falls primarily on workers in the form of lower wages and lost jobs, and on consumers in the form of higher prices. Lane and Wray cite several influential studies over the years showing a substantial negative association between corporate taxes and wages. As the authors note, major corporations often have pricing power in both product and labor markets, at least relative to their power in capital markets where they must raise capital. Capital markets are highly competitive, so they don’t provide much opportunity for shifting the burden of the tax to owners of equity and debt. There are limits on a firm’s ability to pass the tax along to customers and workers as well, of course, but shareholders are relatively well-insulated from the burden of the tax.

There are still other reasons to avoid increasing the corporate income tax rate. It currently raises about $200 billion annually for the U.S. Treasury, or about 7% of estimated federal tax revenue for the 2021 fiscal year. It also has extremely high compliance costs. Lane and Wray quote a 2016 Tax Foundation estimate that U.S. businesses face tax compliance costs on the order of $193 billion a year. Not all of that figure applies to corporations, and not all of it is for federal tax compliance, but a great deal of it is. There are also a number of ways the tax can be avoided, such as off-shoring operations and using overstated transfer prices of inputs obtained from units overseas. This is not an economically efficient way to generate tax revenue.

Moreover, the corporate income tax creates perverse incentives. When new investment in productive, physical capital is penalized at the margin, you can expect less capital investment, lower wages, and fewer jobs. Alan D. Viard explains that the dynamics of this mechanism take time to play out, but the longer-run decay in the capital stock is perhaps the most damaging aspect of a high corporate tax rate. And indeed, while there are probably short-run effects, the reduction in the incentive to invest is the real mechanism linking a higher corporate tax to reduced wages and higher prices, not to mention reduced economic growth.

Finally, there is a pernicious political-economic aspect of the corporate income tax owing to the difficulty for the general public in identifying its true incidence. This was also discussed by Milton Friedman:

“… Indirect effects make it difficult to know who ‘really’ pays any tax. But this difficulty is greatest for taxes levied on business. That fact is at one and the same time the chief political appeal of the corporation income tax, and its chief political defect. The politician can levy taxes, as it appears, on no one, yet obtain revenue. The result is political irresponsibility. Levying most taxes directly on individuals would make it far clearer who pays for government programs.

If the government intends to tax the owners of corporate wealth (a significant share of which is held in retirement savings accounts), it should be honest about doing so. That would mean taxing capital income in a more consolidated way, as Lane and Wray put it, at the individual level. That kind of transparency might be too much to hope for because the politics of doing so are much less favorable.

Meanwhile, the Biden Administration wants to have it all: higher corporate taxes and higher taxes on relatively high-earning individuals. But a significant burden of the corporate tax increase ultimately is shifted to individual workers and consumers. It is a regressive tax, and it is an inefficient tax with outrageously high compliance costs. It is a destructive tax because it undermines the economy’s growth in productive capacity. And it offers tax revenue to politicians who have little budgetary resolve, and with little political consequence.

The House GOP Tax Plan’s Disparate Treatment of Income Sources

09 Thursday Nov 2017

Posted by pnoetx in Taxes

≈ 2 Comments

Tags

Bernie Sanders, Bubble Tax, corporate income tax, Double Taxation, FICA Tax, House GOP Tax Plan, Investment Incentives, Obamacare Surtax, Pass-Through Income, Scott Sumner, Tax Burden, Tax Incentives

Update: In writing the following post, I neglected to devote sufficient attention to the rules that would govern taxation of pass-through income under the House GOP tax plan. Those rules significantly alter some of the conclusions below. Those rules are discussed in a later post: Stumbling Through Pass-Through Tax Reform.

Double taxation of corporate income is a feature of the U.S. income tax code that is partially addressed in the tax reform bill proposed by the House GOP. Corporate income is taxed to the firm and again to owners on their receipt of dividends or when a company’s growth results in capital gains. Ultimately, the total rate of taxation matters more than whether it is implemented as single or double taxation of income flows. However, there is an unfortunate tendency to view corporate taxes as if they are levied on entitites wholly separate from their owners, so double taxation carries a stench of politically sneakiness. It also creates multiple distortions in the decisions of investors and the separately managed firms they own.

Non-corporate income taxation is reduced by the House plan even more substantially than the cut in taxes on corporate-derived income. However, the plan does not reduce taxes on high-earning professionals, many of whom are situated similarly to successful business owners and investors from an economic perspective.

Tax Burdens and Distortions

The federal corporate tax is not borne 100% by shareholders, as discussed in the previous post on Sacred Cow Chips. Some part of the burden is borne by labor via reduced wages. It is difficult to correct for this distortion in terms of calculating an effective marginal tax rate on corporate income. For example, suppose a new 35% tax would reduce corporate income from $100 to $65. The firm finds, however, that it can reduce wage payments by half of the expected tax payment, or $17.50. The firm would now earn $117.50 before tax and $76.38 after tax. Relative to the new level of pre-tax income, the tax rate is still 35%. It is no less than that by way of the reduction in wages, though the impact on the firm’s pre-tax income is mitigated.

The discussion here of tax rates, and even double taxation, is not intended as commentary on tax fairness. It might or might not be fair that the burden of the tax is shared with labor. Instead, the issue is the magnitude of the economic distortions caused by taxes. Tax rates themselves are a reasonable starting point for such a discussion, and they are easy to measure. Lower tax rates beget fewer distortions in economic outcomes than high tax rates. Low rates provide greater incentives to save and invest in productive assets, which enhances labor productivity, wages, and economic growth. Indeed, businesses go to great lengths to avoid taxes altogether, if possible, but typically those are non-productive uses of resources, which demonstrates the very distortions at issue.

Current and Proposed Marginal Tax Rates

Under current law, the top personal income tax rate on dividends is 20%. It is 23.8% if we include the Obamacare surtax. Adding that to the corporate rate yields the effective top tax rate paid by shareholders: 23.8% + 35% = 58.8%. The GOP bill does not alter the 23.8% top rate on dividends or capitals gains. By virtue of the corporate tax reduction, however, the plan would reduce the overall top rate on shareholders to 23.8% + 20% = 43.8%.

The income earned by investors in pass-through entities like proprietorships, partnerships and S-corporations is taxed as personal income under current law at rates ranging from 15% to 39.6% (43.4% at the top, including the surtax). Thus, under present law, the owner of a pass-through company is taxed less heavily at the top rate than the owner of a public company (43.4% vs. 58.8%). (I am ignoring the 15.3% FICA payroll tax owed by self-emloyed individuals in proprietorships or partnerships on incomes up to $127,200, and 2.9% above that level. The combined tax rates would be almost equal even if we include the FICA tax.)

The tax on pass-through business income would be reduced under the GOP bill via a cap of 25% on federal business income taxes. Presumably, this cap would nullify the House plan’s “bubble tax” of 6% on personal income between $1.2 million and $1.6 million of income, as well as the Obamacare surtax. Thus, the tax advantage for pass-through entities over corporations would be somewhat wider under the House plan than under current law (25% vs. 43.4%). (The FICA tax on owners of proprietorships and partnerships would not quite equalize the overall marginal tax rates over a certain income range.)

In addition, the House plan rewards the owners of pass-through businesses relative to individuals earning high levels of wage and salary income. If anything, the bill would penalize these individuals. For example, while the owner of a high-earning pass-through would face a 25% tax rate, a high-earning professional or corporate employee would pay the top marginal rate (39.6%) plus the surtax (3.8%) and possibly the bubble tax (6%). This is one reason why Scott Sumner says it looks as if the House plan was designed by Bernie Sanders!

The Upshot

The tax system should be neutral across different sources of income. Divergent effective tax rates on owners of corporations, pass-throughs, and high wage-earning individuals is undesirable and introduces arbitrary elements into private decision-making. If anything, the House GOP tax plan exacerbates those differences. By cutting marginal tax rates, it would reduce the magnitude of business tax distortions both for corporate and pass-through organizations and their owners, but the relative advantage of pass-throughs would increase relative to corporations, and owners of corporations and pass-throughs benefit relative to high-earning individuals. Let’s hope this is fixed as the bill evolves, but more balanced reductions in rates would require higher rates on business owners than contemplated in the current plan.