by Laurence J. Kotlikoff, Voxeu.org
Though taxing corporations may be a political no-brainer, it may be a big economic mistake. This column discusses recent research showing that the tax is not paid primarily by rich corporate shareholders. They can, and do, move their capital away from countries that have high corporate rates. Eliminating the US corporate tax by, for example, taxing accrued global corporate profits as personal income can produce dramatic increases in US investment, output, real wages, and saving. Modest gains accrue to early generations with very sizable gains going to young and future generations, both skilled and unskilled.
Perhaps the most maddening aspect of America’s dangerous government’s political infighting is the failure of politicians in both parties to agree to reforms on which they agree.
Take, for example, taxing wealth, and taxing consumption. Many Democrats would love to enhance tax progressivity by taxing wealth and lowering taxes on workers. In contrast, Democrats think retail sales taxation is the most regressive tax around. For their part, many Republicans would applaud switching from wage to retail sales taxation, but would be appalled by wealth taxation.
Economists know replacing wage taxes with a consumption tax – whether implemented as a retail sales tax or otherwise – is equivalent to taxing wealth and using the proceeds to lower taxes on wages.
The wealth tax hidden in the retail sales tax
To see the wealth tax hidden in the retail sales tax, consider the legendary Uncle Scrooge McDuck swimming in a pool full of 50 billion $1 bills. Were the US government to enact today, say, a 34% retail sales tax, it would remove none of Uncle Scrooge’s precious greenbacks from his pool. But it would reduce their purchasing power by 25%, since it would now take 1.34 of these dollars to buy what cost $1 dollar yesterday.
Scrooge, being Scrooge, has no interest in spending his money. Instead, he’d likely bequeath all 50 billion pieces of paper to his nephew Donald Duck who would inherit less real wealth – namely, 25% less purchasing power. In other words, neither Scrooge nor Donald can escape the immediate, if implicit wealth tax arising from retail sales taxation by leaving their money to their heirs.
It’s easy to show mathematically that consumption taxation is equivalent to taxing wealth on a one time basis, and wages on an ongoing basis. The only difference between the two is in the choice of words used to describe their equivalent effects. Any wealth tax used to lower taxes on wages could be implemented as a consumption tax, coupled with a cut in wage taxes. Indeed, the former policy could simply be relabelled as the later policy, since they are equivalent. Perhaps we could get Democrats and Republicans to agree on this policy by writing the law in Russian, and letting each party translate the law in their preferred fiscal language.
Politicians mistake language for economic substance routinely. No surprise. Of the 535 members of Congress, not one has a PhD in Economics.
Gains from eliminating the corporate tax: New evidence
When it comes to corporate tax reform, the true incidence of who bears the tax is also lost in the words. Most people, regardless of political party, think the corporate income tax is primarily paid by rich corporate shareholders. But this is not necessarily the case (Felix and Hines 2009, Kotlikoff et al. 2013). In particular, a recent large-scaled dynamic simulation study, entitled “Simulating the Elimination of the US Corporate Income Tax,” (Kotlikoff et al. 2013) strongly suggests otherwise. As I discussed in a recent NY Times column (Kotlikoff 2014), corporate shareholders can, and do, move their capital and production away from countries that impose high corporate income tax rates to countries that impose low corporate income tax rates.
Our paper simulates corporate tax reform in the US and abroad, including the complete elimination of the US corporate income tax. The model features a single good produced in five regions – the US, Europe, Japan (plus Korea and Taiwan), China, and India – with skilled and unskilled labour. It also closely models demographics, including age-specific birth and death rates, as well as each countries’/regions’ fiscal policy.
We find that:
- Eliminating the US corporate income tax with no changes in the corporate tax rates of the other regions can produce rapid and dramatic increases in US domestic investment, output, real wages, and national saving.
- These economic improvements expand the economy’s tax base over time, producing additional revenues that make up for a significant share of the loss in receipts from the corporate tax.
The simulated economic gains from eliminating the corporate tax – while insufficient to fully finance the corporate tax cut (i.e., there is no Laffer Curve, per se) – are large enough to produce a Pareto improvement. Modest welfare gains accrue to early generations, both skilled and unskilled, and very sizable welfare gains go to young and future generations, both skilled and unskilled.
Importantly, these gains arise naturally with no special compensation mechanism required to transfer from winners to losers.
- Stated differently, the elimination of the US corporate income tax has the potential to be a win-win for all US generations.
These results are predicated on three assumptions – that taxes on wages, levied with the same degree of progressivity as current US wage taxes, are used to offset the loss in corporate tax revenues, that the US marginal effective corporate income tax rate is 35%, and that the US average effective corporate income tax rate is 13%.
Source of the Pareto gains: Corporate tax’s inefficiency
Relying on higher consumption taxes to offset the loss in corporate taxes leads to even larger long-run welfare gains, albeit at the price of small welfare losses to initial older generations. The difference between the 35% marginal effective US corporate tax rate, recently estimated by Mintz and Chen (2013), and the 13% average tax rate, suggested by the US National Income Accounts, tells us an important fact.
- A substantial share of the corporate tax’s distortionary impact – namely, dissuading investment in the US – comes with no gain in terms of extra revenue.
This makes the tax particularly inefficient, and helps explain the scope for a Pareto improvement. For example, when wage taxation is used as the substitute revenue source, eliminating the US corporate income tax, holding other countries’ corporate tax rates ﬁxed, engenders a rapid and sustained 23% to 37% higher capital stock, depending on the year in question, with most of the added investment reﬂecting capital inﬂows in response to the US’s highly favourable corporate tax climate.
Higher capital per worker means higher labour productivity and, thus, higher real wages. Indeed, in the wage-tax simulation, real wages of unskilled workers end up 12% higher, and those of skilled workers end up 13% higher.
There is some question in the literature about the magnitude of the US marginal corporate tax rate. Devereux and Bilicka (2012) put the rate at 23%, not at 35%. Our paper produces smaller, but still substantial, economic gains, and a Pareto path assuming a 23% rate. Importantly, we also find substantial, if smaller, gains to US workers – particularly young and future workers – if other countries match the US and also eliminate their corporate income taxes.
Eliminating the corporate income tax could be implemented (The Common Sense Tax) as part of corporate tax integration in which shareholders are required to pay tax at the personal level on their shares of their companies’ profits as those profits accrue.
In short, if Democrats and Republicans started thinking about what they want, not what they want to hear, we could begin making substantive tax reforms in the US that would make both sides happy.