A Corporate Tax Cut Isn't Just a Giveaway to the Rich
Corporate tax cuts are becoming a hot-button issue. Economist Larry Summers, a frequent policy adviser to Democrats, has denounced President Donald Trump’s corporate tax plan as a giveaway to the rich. Meanwhile, Kevin Hassett, the chairman of Trump’s Council of Economic Advisers, has claimed that the plan would increase average wages by anywhere from $4,000 to $20,000 a year. The Tax Policy Center, a think tank made up of economists from previous Democratic and Republican administrations, sided with the skeptics, prompting conservative commentator Larry Kudlow to denounce the think tank.
With all this partisan fur flying, it’s hard to see clearly. On top of that, the corporate income tax is a devilishly tricky issue for economists to analyze.
The reason the corporate income tax is so confusing is that it can affect so many things. When business owners see their profits getting taxed, how do they respond? They could just shrug their shoulders and accept being less wealthy than before. But who wants to do that? As an alternative, shareholders -- who often include companies’ top management -- can try to get around the tax. And there are a lot of ways to do that.
First, shifting profits to an overseas subsidiary -- or even incorporating in another country, for example through a reverse merger -- will shield you from having to pay the U.S. corporate tax. This is because the U.S. taxes companies based on where their headquarters are, not where sales occur. Earlier this year, some legislators proposed changing to a new system that would tax profits based on where business activity actually takes place, but that idea looks dead, at least for now.
You could also do real investment overseas -- for example, by building a factory elsewhere and importing the things you sell to American customers. That will cost a bunch of American workers their jobs, and add them to the surplus labor pool competing for the remaining U.S. jobs. Wages will then fall. This reflects the general principle in economics that anything that can move around easily in response to taxes -- for example, international capital -- ends up paying less than something that is stuck in place, like labor.
That’s the theory. But what does the data say? It’s very hard to know. Because investment happens over a long period of time, smart economists like the University of California Berkeley’s Alan Auerbach have pointed out that you can’t just look at a snapshot. But when you track economies over a number of years, there are many confounding factors -- changes in trade, technology and a country’s industrial mix, as well as recessions, booms and lots of other policy changes. As Reed College’s Kimberly Clausing wrote in a 2011 paper, this uncertainty means that a true understanding of corporate tax depends on how you model economic growth and investment -- and since there are a bunch of models to choose from, estimates of how much corporate tax falls on profits versus wages are all over the map.
These pitfalls are apparent in a 2010 paper Hassett and co-author Aparna Mathur wrote for the American Enterprise Institute. Looking at a large number of countries over a period of 25 years, they report a large negative correlation between taxes and wages -- a headline corporate tax rate that’s 1 percent lower, they report, is associated with wages that are 0.78 percent higher over the following five-year period.
That’s an unreliable methodology for a number of reasons. First, it’s not clear whether Hassett and Mathur should be comparing big rich countries like the U.S. to small or undeveloped nations. Second, the tax rate isn’t the rate companies actually pay -- when Hassett and Mathur measure the response to the effective tax rate, the estimated impact on wages falls by more than half. Third, when Hassett and Mathur use an average of recent tax rates to try to control for other factors that might affect both taxes and wages, their estimate falls even further, to about 0.25 percent. Hassett and Mathur do a number of more complex procedures, which generally result in effects that are larger than average for the literature. But the big variation in response to simple changes in methodology should show how difficult it is to pin down the effect of the corporate tax.
A better (though still far from perfect) approach would be to look at multiple regions within a single large, rich country. This is exactly what economists Clemens Fuest, Andreas Peichl and Sebastian Siegloch do in a new paper about Germany, which has different business tax rates in different regions. Looking at how wages change after corporate tax goes up or down, they find that about 51 percent of the tax ends up getting paid by workers. That’s still not a perfect analogy to what would happen if the U.S. cut corporate taxes -- Germany has strong unions, implying that workers share more in corporate profits, and investment capital can probably shift around more easily within Germany than it can between countries.
But the case of Germany shows that workers probably do pay a substantial fraction of the corporate tax. Whether that fraction is 20 percent or 50 percent, it means that a corporate tax cut isn’t just a giveaway to the rich -- it’s also a way of giving workers a raise.
That means that the best tax policy isn’t to simply cut the corporate tax -- as Trump is proposing -- but to pair corporate tax cuts with increases in taxes that affect the rich more directly. Raising top marginal income tax rates, along with estate taxes, would keep a corporate tax cut revenue-neutral, while encouraging investment, reducing the waste associated with tax avoidance, and shifting some of the tax burden from the middle class to the rich.
So although Hassett’s numbers might be a bit exaggerated, his overall principle is sound. And Summers’s concerns can be allayed by raising taxes on rich individuals. Of course, Trump’s tax plan doesn’t do the latter part. But this would be the best policy.
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