As expected, a reduction of the corporate income tax rate from 35% to 20% is included in the GOP’s tax reform bill, a summary of which was released today. That rate cut would be a welcome development for workers, consumers, and corporate shareholders. It should be no surprise that the burden of the U.S. corporate income tax is not borne exclusively by owners of capital. In fact, it might hurt workers and consumers substantially while imposing relatively little burden on shareholders.
John Cochrane’s post on the incidence of the tax on corporate income is very interesting, though by turns it rambles and may be too technical for some tastes. He notes that the incidence of the corporate tax can fall on only three different groups: shareholders, workers and customers:
“As an accounting matter, every cent [of taxes] corporations pay comes from higher prices, lower wages, or lower payments to shareholders. The only question is which one.“
Cochrane quotes Lawrence Summers and Paul Krugman, both of whom are of the belief that the incidence of the corporate tax must fall primarily on capital and not on labor. That’s consistent with their view that a reduction in corporate taxes amounts to a gift to shareholders. But Cochrane isn’t at all convinced:
“The usual principle is that he or she bears the burden who can’t get out of the way. So, how much room do companies, as a whole, have to raise prices, lower wages, lower interest payments, or lower dividends?”
In fact, owners of capital can get out of the way. Capital is very mobile relative to labor. Here’s a counterfactual exercise Cochrane steps through in order to illustrate the implications of ownership bearing the incidence of the tax: if equity markets are efficient, share prices reflect all available information about the firm. If wages and product prices are unchanged after the imposition of the tax, then shareholders would suffer an immediate loss. Once the tax is discounted into share prices, there would be no further impact on current or future shareholders. Thus, future buyers of shares would escape the tax burden entirely. As a first approximation, the share price must fall to the point at which the ongoing return on the stock is restored to its value prior to imposition of the tax.
Cochrane notes that evidence on the reaction of stock prices to corporate tax changes is mixed at best, which implies that the incidence of corporate taxation falls more weakly on shareholders than many believe. That leaves consumers or workers to bear a significant part of the burden. Workers and consumers are mostly one and the same: economy-wide, higher prices mean lower real wages; lower wages also mean lower real wages. So I’ll continue to speak as if the incidence of the tax falls on either labor or capital, and we can leave aside consumers as a separate category. Cochrane says:
“It used to be thought that it was easy to lower payments to shareholders — ‘the supply of savings is inelastic’ — so that’s where the tax would come from. The newer consensus is that companies as a whole have very little power to pay less to investors, … so the corporate tax comes from lower wages or, equivalently, higher prices. Then, indirectly, reducing the corporate tax would increase capital, which would result in higher wages.”
Cochrane’s post and another on his blog were prompted by an earlier piece by Greg Mankiw showing that real wages, in an open economy, will have a strong negative response to a corporate tax increase. Here is the reasoning: the tax reduces the return earned from invested capital in the short run. Ideally, capital is deployed only up to the point at which its return no longer exceeds the opportunity cost needed to attract it. Given time to adjust, less capital must be deployed after the imposition of the tax in order to force the return on a marginal unit of capital back up to the given opportunity cost. That means less capital deployed per worker, and that, in turn, reduces labor productivity and wages.
Another issue addressed by Cochrane has to do with assertions that monopoly power in the corporate sector is a good rationale for a high tax on corporate income. You can easily convince me that the “average” firm in the corporate sector earns a positive margin over marginal cost. However, a microeconomic analysis of monopoly behavior by the entire corporate sector would be awkward, to say the least. Despite all that, Cochrane notes that monopolists have more power than firms in competitive sectors to raise prices, and monopsonists have more power to reduce wages. Therefore, the “tax the monopolists” line of argument does not suggest that labor will avoid a significant burden of a corporate tax. A safer bet is that firms in the U.S. corporate sector are price-takers in capital markets, but to some degree may be price-makers in product and labor markets.
Cochrane also emphasizes the inefficiency of the corporate tax as a redistributional mechanism, even if shareholders bear a significant share of its burden. It is still likely to harm workers via lost productivity, as discussed above. It is also true that many workers hold corporate equities in their retirement funds, so a corporate tax harms them directly in their dual role as owners of capital.
The cut in the corporate tax rate is but one element of many in the GOP bill, but a related provision is that so-called “pass-through” income, of the type earned via many privately-owned businesses, would be taxed at a maximum rate of 25%. These businesses generate more income than C-corporations. Currently, pass-through income is taxed as ordinary income, so capping the top rate at 25% represents a very large tax cut. As Alex Tabarrok points out at the last link, tax treatment should be neutral with respect to the form of business organization, but under the GOP bill, the effective gap between the top rate for pass-throughs versus corporate income would be even larger than it is now.
Critics of a reduction in corporate taxes should bear in mind that its incidence falls at least partly on labor, perhaps mainly on labor. The U.S. has the highest corporate tax rate in the industrialized world. That undermines U.S. competitiveness, as does the complexity of corporate tax rules. Tax planning and compliance burn up massive resources while drastically reducing the tax “take”, i.e., the revenue actually collected. The corporate income tax is something of a “show” tax that exists to appease populist and leftist elements in the electorate who consistently fail to recognize the unexpectedly nasty consequences of their own advocacy.