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How Corporate Income Taxation is Misunderstood

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by Richard McKenzie

"Don't tax me, don't tax thee, tax the man behind the tree!"
~ The late U.S. Senator Russell Long (D-LA)

trade.jpg Republicans are being excoriated by pundits, journalists and Democrats for proposing to lower the corporate income tax rate from 35 percent to 20 percent. The critics claim the reduction is an unjust and extravagant tax break for President Donald Trump and his rich business compatriots. The reduction will transfer the country's tax burden onto the backs of the middle-class and lower-income groups, or so we are told.

The critics, however, don't appreciate two major problems with corporate taxes:

First, the critics fail to grasp the wisdom in a widely repeated tenet of public finance economics: Corporations don't pay taxes, people do. This is to say that while corporate taxes are directly drawn from corporate profits, those taxes must ultimately come out of the pockets of real people - and the real people affected are not just stockholders whose dividends are undercut by the tax.

These taxes also come partially out of the hides of consumers as corporate managers seek to offset any reduction in after-tax profits (and dividends and share prices) by charging higher prices. More generally, to the extent that corporate taxes reduce companies' after-tax rates of return, investments in their production facilities will be impaired, curbing the supplies of products and further raising market prices. Hence, high corporate taxes can impair American firms' ability to sell abroad and to fend off foreign competition in their domestic markets.

Workers do not get off scot free, either. With curbs in corporate production attributable to the corporate tax, the demand for labor can be tempered, undercutting worker wages and fringe benefits.

How much are the stakeholders - investors, workers, and consumers - affected by corporate income taxation? It's hard to say, because the so-called "incidence" of the corporate tax depends on a multitude of factors, not the least of which are the elasticity (or responsiveness) of supply and demand in capital, labor, and product markets. The incidence of corporate taxation necessarily varies from market to market and even firm to firm.

The corporate tax is, effectively, a means of taxing people hidden "behind trees," which is one of its chief attractions to politicians interested in garnering additional tax revenues for the government. They don't have to admit that the corporate tax is a disguised tax hit on median and low-wage workers and low-income consumers and not on just the rich Trumps, Bill Gates, and Warren Buffets of the world. The exact size of the various hits felt by all income classes are literally unknown and unknowable (although many econometricians feign that their statistical equations reveal truth).

This means that the proposed corporate-tax-rate reduction will likely pad the pockets of the rich by some undiscernible amount, but it will also increase the disposable income of people all the way down at the bottom of the income ladder.

Second, capital - financial and real - and goods and services are now more mobile across national boundaries than ever before. This is because many highly valued modern products - such as the iPhone - are relatively lightweight and can be shipped economically (and in volume and rapidly) by air. Other valuable modern products weigh nothing. Consider the digital nature and economic value of operating systems and the multitude of apps for smartphones and the growing value of "big data." Financial capital and services are also weightless. These products can be shipped globally with a few strokes on a computer and at the cost of a few electrons.

A major and unheralded problem for modern governments is that they are landlocked, while firms and their plants and equipment and job bases can move with growing ease among countries at decreasing cost. The growing mobility of production has, of course, forced companies to compete by finding the most cost and tax-effective venues in the world. Their corporate prosperity, if not survival, depends on their doing so.

Of course, the growth in the mobility of firms, and the greater demands they face to be cost competitive, mean that governments have necessarily been forced to consider in the development of their tax policies the tax rates charged by other countries. Indeed, the most important, powerful, and least touted argument in favor of the Republicans' corporate-tax-rate reduction is that the United States has the highest tax rate in the industrial world, which puts the country and its firms at a distinct competitive disadvantage, domestically and globally.

For example, Ireland has a corporate tax rate of just 20 percent, but which is a third higher than Canada's, at 15 percent. Austria, Demark, and Finland have corporate tax rates of, respectively, 15, 22, and 20 percent. Socialist France has a corporate tax rate just under the United States', at 34.43 percent, but the French government is now proposing to lower the rate to 28 percent. The reason given? Its rate is noncompetitive.

No wonder American firms now have a tax-induced bias toward producing and selling their products abroad, and then holding their profits there as well.

Just as firms must keep their prices competitive with rivals, so do governments have to keep their tax rates competitive vis a vis other governments, now more than ever. It's the nature of the global economy. The reality of the fluidity of capital and goods in the global economy can be, and will be, a hard taskmaster.

Richard McKenzie is the Walter B. Gerken Professor of Enterprise and Society (emeritus) in the Merage School of Business at the University of California, Irvine. He is also co-author, with Dwight Lee, of Quicksilver Capital: How the Rapid Movement of Wealth Has Changed the World.


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COMMENTS (13 to date)
Josh S writes:

And again these data are repeated without even a mention that corporations don't really pay the statutory rates. The tax code is certainly too complex, but it also means there are many loopholes such that the tax rates paid are on average much lower (in the range of 24-28%, depending on which source you believe). Will all of these loopholes be closed with the new proposed lower rate? Since these factors are usually left out of such anti-tax articles, my guess is no.

So how does the US compare to other countries based on taxes actually paid? Do other countries have similar loopholes? Do they have simple tax structures we should emulate, not just statutory rates? You'd never know from this article. These numbers are effectively meaningless without that information.

It's fair to make your point about who the taxes affect, but unfair to claim the tax rates you cite back up your claims.

Sanghyeon writes:

Josh, why does the new proposed lower rate need to close any tax loophole, at all? As I understand, the goal is to make tax system competitive, and competitiveness depends on actual tax paid, not on statutory tax rate.

Since tax loopholes are often distortive, it probably is a good idea to close them, but I can't really understand demand to close them specifically when lowering tax rate.

Kevin Erdmann writes:

It seems to me that the elasticity of supply for labor and capital and demand for consumption already are basically the factors that lead to the distribution of income among labor and capital now. As a starting point, it seems like we should expect a change in corporate taxation to have an effect roughly similar in scale, so that the tax should fall proportionately on labor and capital, leaving the after-tax proportion of national income similar regardless of the level of corporate income taxation.

Is there anything wrong with this intuition?

john hare writes:

It seems clear to me that all taxes are eventually paid by a single class of people, the productive. The non-productive produce nothing to tax. It may be said that non-productive people or corporations pay taxes, those taxes are just a percentage of whatever is extracted from the productive.

Productive people include those that produce code, useful economic theory, and mowed lawns as well as farmers and factories. Any tax directed at any sector will 100% fall on these people every time. Talk of tax rates and loopholes often miss this point.

Thaomas writes:

Perhaps McKenzie and I read different “journalists and Democrats,” but I have heard rather little complaint about the cut in corporate taxes per se but rather

a) of the models being used to estimate the benefits (e.g. eliding the fact that part of the theoretical benefits go the foreigners)
b) the increase it the structural deficit,
c) reductions in the estate tax and rates applicable to high-income individuals, and
d) the shift in after tax income toward high income people generally.

Likewise, I have not run across any journalists or Democrats that do not appear to understand that the incidence of business taxes is “real people.” Indeed, I’ve read discussions of different estimates of how much is borne by shareholders v consumers and employees/suppliers.

It would have been more useful if McKenzie had identified some representative exponents of view he disagrees with to make his arguments. Otherwise he appears to be arguing with a straw man.

Thaomas writes:

@ Josh S

Just so. The best reason to reduce corporate tax rates (ideally to remove the corporate tax entirely except possibly as an administrative step in the enforcement of personal income taxes) is that it would reduce the deleterious effects of the plethora of loopholes and special tax treatment if different kind of income that cause differences in before tax returns on investment among different economic activity.

Alan Goldhammer writes:

T.R. Reid's excellent op-ed in the Washington Post argues along the lines of what Thaomas wrote - zero out the Corporate Income Tax. His book published earlier this year argues for massive Tax Reform (not Tax Cuts) so that we have a more fair tax system. That's something that even this liberal can get behind!!

Vivian Darkbloom writes:

@Thaomas

"Likewise, I have not run across any journalists or Democrats that do not appear to understand that the incidence of business taxes is “real people.”"

Who wrote this?:

"There is, however, one big difference between corporate persons and the likes of you and me: On current trends, we’re heading toward a world in which only the human people pay taxes."

Of course, the author of that understood (I think), but chose to mislead instead. And, does that sound like someone who is for a corporate tax cut?

Quite Likely writes:

"It seems clear to me that all taxes are eventually paid by a single class of people, the productive. The non-productive produce nothing to tax. It may be said that non-productive people or corporations pay taxes, those taxes are just a percentage of whatever is extracted from the productive.

Productive people include those that produce code, useful economic theory, and mowed lawns as well as farmers and factories. Any tax directed at any sector will 100% fall on these people every time. Talk of tax rates and loopholes often miss this point."

Isn't the corporate tax rate issue that we're discussing a perfect example of how taxes can fall on the non-productive? Even with McKenzie bending over backwards to argue that some of the costs of corporate taxes are passed on to workers and consumers, he can't deny that some of the costs are born by the owners of the companies being taxed - in a real way the corporate income tax is just a sort of indirect wealth tax.

Having taxes come out of dividends paid out to stockholders is about as close to a pure taxing the unproductive situation as you can get to.

Richard McKenzie writes:

Josh S.,

You make a fair point on how the effective corporate tax rates in countries can vary after accounting for deductions, loopholes, and several other factors (for example, asset allocation among countries). After making a set of careful assumptions, the Congressional Budget Office found, as expected, absolute and relative changes in the average corporate tax rates paid in different countries. I was aware of this issue, as any economist with a public finance background would be, but I chose to go with the statutory rates to keep the argument straightforward and to stay within my proscribed word limit, which I was close to exceeding.

In terms of its effective corporate tax rate, the United States ranks fourth, according to the CBO study cited. However, I hasten to add this change in ranking does not change what I considered the central focus of the last half of my blog, which is to point to how the growth in the cross-country mobility of real and financial capital and goods and services means that all governments – maybe especially the United States – must take account as never before of its competitors’ tax rates.

I am confident – and I suspect you are too – that if different reputable organizations estimated countries’ effective tax rates, the averages would likely differ somewhat from the CBO’s, as could the ranking. I am certain that effective tax rates for U.S. corporations vary about the mean, depending upon their industries and circumstances (access to deductions and loopholes) and the corporations with above average effective rates are most likely to look to venues with relatively lower effective rates, and statutory rates will certainly catch attention. The actual or prospective movements of such firms (and others) can be expected to put pressure on Congress to lower the statutory rates, as well as increase deductions. No one should be surprised if countries’ effective tax rates are strongly correlated with their statutory rates, right? Run the numbers.

I don’t deny the effects of domestic politics on tax policies, a central concern of pundits and policymakers. At the same time, my point is a largely unheralded one, that global economic forces can impose pressures on domestic tax politics.

You noted my analysis is “meaningless.” Really? Can’t you see my point, even if the number fall short of perfection? My guess is that the absence of full self-identification in name slection caused you to be more aggressive in the selection of that word than would otherwise have been the case.

See: ttps://www.cbo.gov/sites/default/files/115th-congress-2017-2018/reports/52419-internationaltaxratecomp.pdf

Richard McKenzie
November 21, 2017

James Pass writes:

Mr. McKenzie, I don't think Josh meant that all of your points were "meaningless." He said "these numbers are effectively meaningless without that information." "These numbers" and "that information" were referring to effective taxes and rankings.

I can sympathize with Josh's frustration because it's true that "these factors are usually left out." You mentioned the word limitations for your article, but I think you could have made the same points with the same number of words if you used effective tax rates and rankings.

Once in a while Russ Roberts grumbles about what's "usually left out" about median income. It's a challenge to discuss complex economic topics when time and space are limited. Even many books are prone to simplifications.

In any case, I think Josh was only trying to say he's interested in more details. I don't think he was dismissing your entire article.

Regarding my thoughts on your article, I'll say that I've heard some discussions in recent years about the issue of comparative national tax rates and a need for global standards for a global economy. It's been said that the price of civilization is taxation. Of course the devil is always in the details.

john hare writes:

@Quite Likely
The taxes paid by non-productive stockholders is actually based on the production of their investments which presumable originated in productivity.

If the taxes are indeed from non-productive stockholders, then they are just a conduit from actual productive people. Non productive people can get value, but they didn't produce it, by definition. If you prefer, the burden will always fall to the productive eventually.

Stephen Gradijan writes:

Actually Ireland has a headline corporate tax rate of 12.5%; it is Iceland that has a 20% corporate income tax rate.

Those names look so much alike....

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