Why tax corporations at all? Ben Southwood is Head of Policy at the Adam Smith Institute The art of taxation consists in so plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing. Louis XIV's finance minister Jean-Baptiste Colbert People want the government to provide certain services, as well as redistribute to make sure no one lacks for basic needs. People don't like being taxed to pay for it, but they notice the burden of some taxes more than others. I will argue that corporation tax is an invisible tax on everyone, and a particularly costly one, making us worse off through lower wages in the short term and worse off through lower investment and output per capita in the long run. Income taxes feel burdensome to most, but they feel more burdensome when you first get, and then hand the money over to the Treasury, than when the money is deducted automatically. Sales taxes feel more burdensome when you pay them 'on top' of the cost of the items you are buying, and less when they are automatically calculated into the price. There are many axes and margins on which taxes can feel more or less burdensome, but it seems like the least burdensome-feeling taxes are ones you don't think you are paying at all. For example, while the buyer actually pays George Osborne stamp duty land tax in a housing transaction, some economists think the seller actually bears a substantial fraction of the burden of the tax through lower house prices. Indeed, a 2013 paper found house prices rose by something from two times to as much as five times the size of the tax liability during the stamp duty holiday of 2008-9. But the seller will not count the money they would have got without stamp duty as 'theirs', and will not resent its loss nearly as much as if they were paid it then had it taken away. According to my review of the evidence, published early this year, the situation is similar for corporation tax. Empirical studies, using a wide variety of intra- and international methodologies, find that a large fraction of the burden is borne in the form of lower wages for workers. Or, as economists would say, the economic incidence of the tax falls mainly on workers. In fact, even excluding the three outlying very large results (which estimate that workers lose out by the entire size of the burden, or a cost even larger than raised by the tax) on average the paper finds workers bear 57.6% of the burden. Since then more evidence has come out. For example, a 2014 Australian study from Xavier Rimmer, Jazmine Smith and Sebastian Wende found that two thirds of the revenues of corporation tax came out of the pockets of workers, rather than those of capitalists, in the form of lower wages. The empirical literature seems pretty clear that regardless of what it actually looks like, workers pay corporation tax. But how do they actually find these results, one might ask? Do these results apply in every situation? The issue is quite complex. Economists think that the burden can fall on workers in two ways. The first is the direct effect: higher corporation taxes means lower net profits which means less surplus for the firm and workers to bargain over (the workers effectively have instantly lower productivity from the perspective of the firm's bottom line). The second is the indirect, medium- to long-term effect: higher corporation taxes means less incentive to invest in the corporate sector, or in a given country's corporate sector. Lower investment there means less capital to worker and lower productivity. Lower productivity means lower wages. The best paper on the direct effect is a 2007 study from Wiji Arulampalam, Michael Devereux and Giorgia Maffini. Picking through the unconsolidated records of 55,082 European companies between 1996 and 2003, they find that the effective incidence of an exogenous $1 rise in the tax burden leads to wage payments $0.75 lower, or $0.59 lower after the reduction in the tax burden from the lower wages is taken into account. To back this up, they find a symmetrical $0.57 gain to labour from a $1 rise in pre-tax value added. They also try to control for managerial ability to erase that possible reason for lower tax burdens. The indirect effect is harder to observe. An early contribution, from two scholars at the American Enterprise Institute, found that workers lost $22 in wages for every $1 raised extra in corporation tax, implying not just 100%, but 2,200% of the burden fell on workers! But this study, along with most other attempts in the literature, has been heavily criticised and none of the more authoritative reviews think that anything like 2,200% is a plausible estimate. Whatever the exact number, economists think it plausible that a substantial fraction of the burden falls on workers. However, almost no workers are likely to have read this counterintuitive research, and will tend to see corporation tax as something that falls on others. Indeed, some may think that somehow corporations can bear the burden of the tax, even though they do not consume goods or have utility functions and thus cannot be made better or worse off (they are just legal constructs!) Even those who realise that some households must bear the burden are likely to think it is rich capitalists, rather than their own pension funds and ISAs. This means that corporation tax functions a bit like a stealth tax. No one realises when they are paying it, and it is thus a popular way to raise revenues. Alleged tax avoidance and evasion by big companies such as Starbucks and Amazon and Vodafone is widely covered and cited by left-wing campaign groups like UK Uncut. To many, raising revenues through it seems like a free lunch. Although transparency is a virtue of tax systems, this particular 'secret' might not be so bad; if it is a secret income tax on workers then it allows for more plucking with less hissing. It wouldn't be so bad, that is, if it were not for the fact that the remaining portion falls on capital. Nearly all economists agree that taxes on capital reduce investment and future living standards. This is because they effectively tax future consumption at a higher rate than present consumption. A capital tax, ie. on saving, makes future goods more expensive because to buy them you also have to pay a capital tax, causing inefficient allocation of consumption over time. The upshot of this is that, since savings fund investments, less of them means less capital, lower economic output and lower living standards in the future. In the words of N Gregory Mankiw, a professor at Harvard and top economic advisor to the US federal government under George W Bush: "Perhaps the most prominent result from dynamic models of optimal taxation is that the taxation of capital income ought to be avoided. This result, controversial from its beginning in the mid-1980s, has been modified in some subtle ways and challenged directly in others, but its strong underlying logic has made it the benchmark." That is, the tax on capital should be as close to zero as possible - zero capital gains, zero corporation tax (if it falls on capital). And if we modify our results from above with the scepticism of the governmental reviews of corporation tax incidence, finding an 80% or higher burden on capital, not workers, we should be very worried about the costs capital taxes might be imposing on us in terms of reduced living standards for everyone in the future. In fact, two papers from the last year suggest the benefits we could obtain from scrapping corporation tax are huge. Daphne Chen, Shi Qi, and Don Schlagenhauf, working for Florida State University and the Federal Reserve Bank of St. Louis, found that completely eliminating corporation tax would decrease the total number of US unemployed by 5.4% or something like 400,000 people. They were building on a new avenue of research into what exactly corporation tax taxes, founded by Laurence Kotlikoff and Jianjun Miao. "This paper makes this point with a simple, capital-less model featuring entrepreneurs, with risky production technologies, deciding whether or not to go public. Doing so means selling shares, which is costly and triggers the firm’s classification as a corporation subject to income taxation. But going public has an upside. It permits entrepreneurs to diversify their assets. In discouraging incorporation, the corporate tax taxes business risk-sharing, keeping more entrepreneurs private and, thus, exposed to more risk. The added risk experienced by these entrepreneurs limits their demands for labour whose costs must be paid come what may. And less demand for labour spells a lower wage. Thus, the corporate tax is, as a general rule, borne, in part, by labour. But it is borne primarily by high-skilled entrepreneurs who decide to remain incorporated despite the attendant tax liability." Chen, Shi and Schlagenhauf put a number on the size of the effect: 86% of their 400,000 jobs came from the reduced costs of incorporation for entrepreneurs. So what the corporation tax is really doing is drastically reducing the efficiency and fluidity of firm organisation and hindering entrepreneurs, the men and women who take risks to direct resources to where they can do the most good for society. Another paper from Kotlikoff, this time written with Hans Fehra, Sabine Jokisch and Ashwin Kambhampati, found that: "Eliminating the model’s US corporate income tax produces rapid and dramatic increases in the model’s level of US investment, output, and real wages, making the tax cut self-financing to a significant extent." What's more, this doesn't come at the expense of foreign countries as their companies flee to the newly low-tax regime. And it doesn't harm certain generations for the benefit of others - everyone benefits. Of course, highly stylised mathematical models or simulations are never perfect and can never give us truly robust, exact answers. But the lesson that economics is repeatedly trying to teach us is that corporation taxes, far from being something that workers can happily call for, knowing they will fall on someone else, are actually some of the most costly we can impose. What are the alternatives? So-called 'lump sum' taxes are the ideal - they impose no efficiency costs since individuals cannot change their obligations by changing their behaviour. But the only practical lump sum tax is the poll tax, which is either too low to fund the activities governments want to do, or extremely unfair. In one sense we'd ideally like to tax individuals 'endowments' - their natural abilities and the impacts of their upbringing and schooling on the skills and output they bring to the table. But it's practically impossible to measure this in a way that would actually result in 'lump sum'-style efficiency - people can game tests and reduce investment into their children's human capital (education, skills). What's more, it feels a bit like 'slavery of the talented' - it doesn't matter whether you do a well-paid job, if you have skills you have to pay high taxes. So we move to next-best options: ones that ideally don't distort the allocation of consumption and production. Income taxes are popular but they don't completely remove taxation of savings: you are taxed on your whole income not just the portion you consume. This makes consumption taxes perhaps the most attractive on economic grounds. A common objection to them is that they are 'regressive' - ie. the poor pay a higher fraction of their income under them, since they consume a higher portion of their income - but this is only under certain regimes. If you taxed individuals' total consumption - their income minus their savings - then you could have a highly progressive system. And it would have other attractive features, since it would effectively tax luxury status goods very highly, and some evidence suggests that consumption at the very top follows a 'keeping up with the Joneses' pattern. Many economists think the ideal tax system is a progressive consumption tax system. Some governments have taken notice of this work, but the lesson has been learnt by far too few. Raising corporation tax is not a progressive move that gets us more revenue to help the badly-off or spend on public goods. Corporation tax is either a stealth tax on workers' wages or it comes out of investment and the wellbeing of our children and grandchildren. Scrapping it will not be very costly because investment and wages should rise rapidly, and even if some funds need to be raised elsewhere, we have a large number of existing taxes with lower efficiency costs. The alternative is a poorer future.
... corporation tax is an invisible tax on everyone, and a particularly costly one, making us worse off through lower wages in the short term and worse off through lower investment and output per capita in the long run