The Economic Burden of Corporate Taxation

Executive Summary

As other countries lower their corporate tax rates, U.S. corporations are reincorporating in lower tax countries (engaging in “tax inversions”) to reduce their tax burdens. Permanently eliminating or lowering the U.S. corporate tax rate would reverse this tax calculus and establish the United States as a tax haven. The result would be a huge infusion of capital into the United States, made all the greater by other U.S. advantages, such as access to capital, rule of law and infrastructure.

The Laffer Curve shows the relationship between the level of taxation and government revenue. Once the corporate tax rate reaches a level where the percentage change in the tax rate is larger than the percentage change in the tax base, there is no additional revenue to be gained from further increases. The policy goal is to choose the rate that makes the optimal tradeoff between the needs of government and the level of economic activity, as measured by the size of the tax base. An important matter to keep in mind when estimating the economy’s position on the Laffer Curve is how a reduction in the tax rate on one kind of income might cause total tax revenues to rise because of the resulting expansion in revenues collected on other kinds of income. Thus a reduction in the corporate tax rate might cause corporate tax revenues to fall but cause a larger rise in revenues from income and payroll taxes.

In a simplified, but widely used, model of the economy, there are two factors of production — labor and capital — to be considered in making this tradeoff. A reduction in taxes on capital reduces the cost of capital — which is to say, the before-tax return an investment has to yield in order to make the after-tax return high enough to obtain financing. This makes capital cheaper relative to labor and induces the firm to substitute capital for labor, pushing down wages in the process. Second, it increases production and, by doing so, pushes up the demand for labor and therefore wages. Which effect on wages is greater — the positive or the negative effect — depends on how sensitive savers are to changes in the after-tax return to capital.

If a slight fall in the cost of capital (and thus a slight rise in the after-tax return to capital) induces savers to expand greatly the amount of capital they are willing to provide U.S. firms, then the effect on wages will be positive. A reduction in the U.S. corporate income tax would draw a lot financial capital into the United States, causing production and wages to rise. Contrarily, an increase in the corporate tax rate would reduce investment and output. As to distributional considerations, under the (defensible) assumptions made here about the high sensitivity of savers to differences in intercountry tax rates, the burden of the higher tax would fall mostly on labor.

The cost of capital depends on taxes imposed at both the firm level and the individual level. The willingness of stockholders to provide financial capital though stock purchases depends on the dividends and capital gains they receive after all taxes are collected at both levels.

An important matter for assessing corporate tax policy is the effective marginal tax rate (EMTR) — the change in tax liability from a one dollar change in taxable and nontaxable income. There have been many estimates of the EMTR in the United States, but previous estimates did not account for all taxes on capital:

  • Economist Jack Mintz found that among G-7 countries, the United States had the second lowest effective marginal tax rate in 1994, at 25.4 percent, but had the highest EMTR in 2013, of 35.3 percent.
  • However, broadening Mintz’s methodology to incorporate all taxes on capital at the both the firm and the individual level, we find the U.S. EMTR in 2013 was 48.03 percent.

The United States operates in a way that is particularly punishing to corporate investment. As a result, savers in the United States just move their capital abroad in response to higher U.S. taxes on capital. Under the assumption of a closed economy, taxes on capital will be borne by the owners of capital, but in an open economy, where capital can move freely, the burden falls on labor, lowering average wage rates.

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