Congress’ potential faulty tax logic

By David Cay Johnston
March 2, 2012

With President Barack Obama and leaders in both parties favoring lower corporate tax rates, Washington seems poised to enact change next year. They need only resolve details like how much the rates should be cut, which tax avoidance strategies should be barred and whether to give manufactures a discounted rate.

If the corporate tax rate is cut, should the rates for dividends and long-term capital gains be increased?

That issue was inadvertently put on the table by a leading free market organization, the American Enterprise Institute. The AEI, as part of its support for cutting the corporate tax, promoted the idea last month that workers, not investors, bear the burden of that tax. In taking that line, however, the AEI has undercut its own argument for tax relief for investors. Indeed, it shifts the debate toward higher taxes on capital gains and dividends and lower taxes on wages.

We’ll follow that logic later. But first, who bears the burden of the corporate tax? Is it the owners of a corporation, through a lower return on their investments, or is it workers, through lower wages? This question is endlessly debated by economists.

Many people assume corporations just pass the corporate tax on to consumers through higher prices. This is true for monopolies, such as corporate-owned electric utilities, whose prices are set by governments. But it is not true in a competitive market.

The idea that owners bear the tax burden took hold after economist Arnold Harberger wrote a 1962 paper that quickly became a classic of tax economics. I studied his work in more than one economics course in the late 1960s and into the mid-1970s.

When that paper was written, the United States dominated industrial production, the legacy of the devastation of World War Two on the economies of Japan and Europe. As global manufacturing increased, Harberger, who taught at the University of Chicago, refined his theory. In later works, Harberger wrote that while the corporate tax burden falls on owners in a closed economy, in a global economy, where capital flows freely, the burden shifts toward workers, who cannot move so easily.

TAXES & THE MIDDLE CLASS

AEI economist Aparna Mathur makes this case in the current issue of the organization’s online magazine, in a piece headlined “How Taxing the Rich Harms the Middle Class.”

“Workers bear a large portion of the burden” of the corporate income tax, Mathur told me. She suggested that half or more of the cost falls on workers, and perhaps all of it.

Her views, to which AEI drew my attention amid the debate on cutting the corporate tax, grow from research between 2006 and 2010 by Mathur and Kevin Hassett, AEI’s director of economic policy studies. In their latest paper they looked at official data on manufacturing wages from 65 countries. They concluded that higher corporate income tax rates depress wages.

Mathur noted that if capital stocks are depleted, because taxation encourages new investment to shift to lower tax countries, the result must be falling wages. In this she and Hassett rely on economic theory going back at least to Adam Smith.

On the face of it, the AEI argument suggests workers should be joining the calls for Congress to cut corporate income tax rates. But, if the argument is correct, then workers should also be calling for cuts in their own income taxes and an end to reduced rates on dividends and capital gains.

Here’s why. Investors often complain they are taxed twice on their profits: once through the corporate income tax and again through taxes on their dividends and capital gains.

But if the AEI’s argument is correct — that workers bear the burden of the corporate income tax – then investor complaints that they are taxed twice are false. Under the AEI argument, it is workers who are taxed twice: first through lower wages due to the corporate tax and then through levies on their wages, however low they may be.

Double taxation of investor returns was the logic used to justify the capital gains tax cuts in 1997 under President Bill Clinton and in 2003 under President George W. Bush, who also included dividends.

Without double taxation of corporate profits, that justification evaporates. Workers can now use AEI’s arguments to bolster their arguments for higher pay and lower taxes. I put this to Mathur of the AEI, who agreed that it is reasonable to conclude that double taxation is falling on workers. But, she said, lowering taxes on workers would not encourage investment.

Let’s debate this thoroughly before Congress changes the corporate income tax again, lest more relief go to those who do not deserve it at the expense of those who do.

16 comments

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In many countries, a VAT takes care of the problem without having to define “income” at all. You cannot compare a VAT tax regime to that of the USA. Another disparity is that most countries actually want to provide their citizens with benefits paid for by “insurance contributions” (or taxes, which is what they are). In the USA the only value the Government sees in FICA taxes is money to pay for more wars. It is flatly dishonest to claim the USA is committed to a public pension and medical care scheme. It is only interested in collecting the premiums.

Corporate tax rates a just a straw man. The real money corporations get from the public here comes in the form of “incentives” that are not incentives but payoffs. It also comes in the provision of tax money to entities that ship production and service facilities offshore and then get credit for “investment” intended to benefit the USA as a whole.

Romney does have a wise idea in bringing back the old notion that savings invested by the bottom 90% by income should be treated very lightly indeed. This encourages mass participation in the economy and self sufficiency. Dividends and capital gains taxes for those with up to 2 times the median household income should be very low indeed.

Corporations divert money into the pockets of management, not shareholders. That is where the taxes should fall.

Posted by txgadfly | Report as abusive

In California small business corporations are taxed (among) the highest in the world… so let’s lower some to be globally competitive.

Both business owners and employee will benefit for sure perhaps even creating more jobs.

Posted by robb1 | Report as abusive

You state, “Let’s debate this thoroughly before Congress changes the corporate income tax again, lest more relief go to those who do not deserve it at the expense of those who do.” You’re right, but for the wrong reasons.

The real problem in the US economy is lack of revenue — basically from the Bush II era tax cuts to the wealthy.

So, corporate taxes are NOT the issue. The real issue is taxing income on investors properly. IF this were done, we could afford to lower corporate tax rates to be competitive with the OECD.

You CANNOT lower corporate and investor taxes simultaneously without seriously damaging the economy further.

Cutting taxes on the wealthy is NEVER a good idea, since they do not (regardless of what the wealthy claim) end up as investments in the US, nor more US jobs.

The problem we have is the free trade/tax legislation that encourages corporations to move operations overseas.

NONE of this would be an issue, IF we could stop that.

Posted by Gordon2352 | Report as abusive

The whole argument of corporate double taxation is false. Corporations are not double taxed. A basic premise of our corporate tax structure is to encourage investment. The sole reason to tax cash on-hand is to instill a “spend it or lose it” mentality. That is why expenses are deducted from earning and such expansive write-offs and amortizations are allowed. Only corporate profit is taxed. That is very different than we mere individuals that pay based on earnings with few deductions. Corporations are separate entities from their stockholders. Corporations pay tax once and individuals pay once. Taxing dividends encourages reinvestment into the company rather than taking profit out. What benefit is it to the company to pay dividends? It removes money that could be used for reinvestment. In that sense, it is excess profit and should not receive the benefit of tax avoidance.

If the owners of a corporation wish to avoid what they think of as double taxation, they simply need to use different ways of payment than capital gains. Of course, doing so also takes away the deductions, write-offs and amortizations so they will not do that!

In the end, what corporations want is no tax. Already, corporations enjoy huge positive externalities at the expense of individuals. My suggestion is to stop whining before the truth of just how good corporations have it comes out. If it does, let’s see how much tax is paid then.

Posted by mhbenton | Report as abusive

“Many people assume corporations just pass the corporate tax on to consumers through higher prices. This is true for monopolies, such as corporate-owned electric utilities, whose prices are set by governments. But it is not true in a competitive market.”

In fact, the reverse is closer to the truth!

If the government sets the price for a monopoly, the price could well ignore the ‘cost’ of corporate taxes … happens all the time in India where a number of such monopolies run at a loss.

On the other hand, multiple players in a competitive market will demand a “normal” profit. If taxed, they will pass those ‘costs’ onward to consumers.

Posted by RudyF | Report as abusive

@robb1

“Both business owners and employee will benefit for sure perhaps even creating more jobs.”

The key word in what Robb1 says, particularly with respect to all that saved tax money on the part of employers creating jobs, is “perhaps.”

And perhaps not. This is an empirical matter.

So let’s go to the videotape.

How is this supply side nonsense working out currently, where corporations are awash in cash and their borrowing costs for further investments are at rock bottom?

“Oh,” say the supply siders, “they’re sitting on the sidelines wracked with uncertainty about what their future tax rates will be.”

Also known as: “Invocation of the Confidence Fairy.”

In 1975 and 1976, when Microsoft and Apple were founded, capital gains rates were at their highest in history, nudging up against 40%. Thank heavens Bill Gates and Steve Jobs disdained acting “rationally.”

Posted by billyblog | Report as abusive

Both workers and share holders pay corporate taxes. Most goods and services cannot be imported fast at low cost. Therefore, the workers producing goods or services that can be made offshore pay or when trust busting is lax (price fixing allowed). Share holders of companies that cannot off shore and under the trust buster lens (cannot fix prices). When porice fixing is the rule consumers pay.

Posted by SamuelReich | Report as abusive

I think one of the main issues with corporate taxes is that they transfer , to some degreee, taxing authority to corporate management. While I agree that management is certainly constrained as to how it can pass taxes on, it is inevitable that those taxes will eventually be paid by some combination of employees, shareholders and customers. It would certainly seem to make sense that management would transfer the bulk of the tax burden to those who are least able to resist it, most likely unskilled labor. This would mean that not only are corporate taxes paid primarily by workers but that they are highly regressive as well. I can’t imagine that management would decide to transfer the tax burden to itself (and their income growth over the past few decades would certainly support that view) and market conditions for professionals and skilled labor, though certainly not ideal at the moment, would probably limit their ability to restrict wage growth in those areas. However, unskilled labor, particularly in the current situation of high unemployment and high resistance to collective bargaining efforts, really has no option other than to accept lower wages.

The fairest solution would seem to be for the government to take full control and resposibility for assessing taxes by completely eliminating corporate taxes and transferring that burden to higher capital gains and dividend taxes as well as a more progressive income tax. Unfortunately, I can’t imagine that this would have a tremendous net effect on income disparity.

The argument of double taxation has always been somewhat of a non starter for me since, once you tax income, essentially every other form of taxation (sales, property, excise, etc.) can be viewed as double taxation for the vast majority of those who do not or cannot itemize deductions.

Posted by jtfane | Report as abusive

We should be reforming taxes even if there’s no change in revenue or burden whatsoever. Those are added bonuses.

The stated US corporate tax is 35%. Almost no one actually pays that. The rate that companies pay is almost always lower, occasionally negative, and extremely variable. I for one, just want some transparency and simplicity. If the public knows and understand the problems, solutions will become very apparent. We will have to pay unemployment for all those pesky tax lawyers though.

Posted by CapitalismSays | Report as abusive

Once again the only fair solution is to have a progressive tax rate with no deductions, no exemptions, no loopholes, no tax credits or incentives and this for corporations and the individual. Make the poor pay at a lower rate (they no logner get away with paying nothing) , the middle at a middle rate, the rich at their rate, and the mega rich at their rate. Let the rates range from 7% to 25% and keep it between those levels. That should be it in a nutshell. No one payes less than 7% and no one pays more than 25%. Forget all the other games as that is just a new scheme for the rich to pay less. There is no other fair way in my opinion!

Posted by JLWR | Report as abusive

Pardon me, but what’s the point? Oooooh, lower rate, flat rate, no loopholes…until they want to start handing out ‘tax incentives’ to friends and contributors, and then we’re back down this f’ing rabbit hole, but from a starting point much closer to zero.
Unless you can come up with a method that prevents Congress from handing out lollipops to the un-needy, I say raise the damned corporate rate, and make GE’s tax accountants really sweat to get its net tax burden back to zero.

Instead, how about parking tickets? Holding some multiple of your tax bill’s bottom line in liquid assets for more than, oh, 180 days earns a 1% fine against those assets. Larger tax bill means you can hold more cash and short-term bonds out of the economy, smaller bill means you have more liquidity exposed to the parking meter. Tune it a bit, so can’t just keep rolling over at 179 days, or carouseling various assets from cash to bonds and back. Specify those as tax evasion. Maybe more money will fall into the hands of those non-participants in the economy, the 99.5% who work for a living.

Posted by CalDamage | Report as abusive

DCJ is a smart man and does thorough research but he presents evey argument with a heavy liberal slant. Those are his beliefs and he is entitled to them, but his bias is apparent – this article is an exemplification of that. Reverse this argument and logic could be used to support the counterargument. The problem with political spin is that the average American voter is too ignorant to understand the truth and WHY it’s the truth; instead they jump on one side and chant the partisan mantra du jour, excerbating the problem.

Billyblog…you forgot to mention a terrible regulatory environment in which to deploy capital, uncertainty is very high and businesses won’t invest in the face of uncertainty. We need tax, regulatory, and fiscal reform; let alone issues like infrastructure and education.

All those businesses are sitting on capital that they will deploy when the time is right – given the current rate environment, they certainly aren’t getting paid to sit on cash right now. Further, it is not the governments job to dictate when and where capital is deployed.

Free markets, capitalism, and supply side theorems will work if only we’d get out of the way and remove impediments to their success.

@JLWR has the right idea. Completely Wipe the whole thing clean. Progressive rates, say: 5%, 10%, 15%, 20%, and 25%. Remove ALL loopholes and deductions. You made $xx,xxx income, multiply times your rate and that’s it.

Then drop corporate rates to 10% or so and watch how quickly the economy picks up and investment + FDI flocks to the US.

Why won’t this happen? Monied interests…for example: What will the AICPA have to say about this degree of structural tax code simplification?

Posted by jaham | Report as abusive

Wow…. really??? Now it is uncertainty that is stiffening Job creation. Rush Limbaugh has such a hold on the simple minded masses…. its sad really.

Here is a clue for you. Supply side economics does not work, has never worked, and will never work.

Every time this country has been in trouble nothing short of liberal public works projects have been the only thing to save it. Putting money in the hands that actually supply the economy with cash flow…

How any times do we have to attempt voodoo economics to finally put it to bed.

Posted by Xnerd | Report as abusive

@jaham said “DCJ is a smart man and does thorough research but he presents evey argument with a heavy liberal slant.” and then, get this, no kidding “Free markets, capitalism, and supply side theorems will work if only we’d get out of the way and remove impediments to their success.”

Oh how I do love irony, thank you for that.

But, as you said “Those are his beliefs and he is entitled to them.” I Couldn’t agree more.

I would also agree with most of the remainder of your post, though I would truly be interested to see you “Reverse this argument and logic could be used to support the counterargument.” Mostly because I’m not really sure what that means. I do think those rates would have to go quite a bit higher than 25% unless you’re planning on significant revenue reductions. And as I mentioned above, why not just plain eliminate the corporate tax?

If you’re looking for “Monied interests” I think you’d be better advised to look to the clients of the members of the AICPA rather than the organization itself. These are the people who lobby for the creation of the loopholes and deductions, the tax accountants just pick up the scraps.

Posted by jtfane | Report as abusive

RE: Report: Just $31B from Buffett rule tax on rich
http://tinyurl.com/79s97kq

Using simple Math this calculation of the increased revenue from a proposed Buffett Rule says something very scary.

Since the wealthiest pay mostly 15% tax on their income, because the vast majority of their income is from capital gains and dividends, a Buffett Rule-based minimum tax rate of 30% should approximately double the tax revenue from the wealthiest.

Now consider that the projection in the article is an increased $31 Billion over 11 years. This implies only $31 Billion of expected revenue over the next ten years before the Buffett Rule. $2.8 Billion per year. How is that possible?

Posted by ebanker1999 | Report as abusive

Re: Report: Just $31B from Buffett rule tax on rich
“In an analysis provided to The AP on Tuesday, Congress’ Joint Committee on Taxation estimated that a bill introduced last month by Sen. Sheldon Whitehouse, D-R.I., attempting to enshrine Obama’s proposal into law would collect $31 billion through 2022. The measure has little chance of advancing soon, especially before the November elections.”

Using simple Math this calculation of the increased revenue from a proposed Buffett Rule says something very scary.

Since the wealthiest pay mostly 15% tax on their income, because the vast majority of their income is from capital gains and dividends, a Buffett Rule-based minimum tax rate of 30% should approximately double the tax revenue from the wealthiest.

Now consider that the projection in the article is an increased $31 Billion over 11 years. This implies only $31 Billion of expected revenue over the next ten years before the Buffett Rule. $2.8 Billion per year. How is that possible?

Posted by ebanker1999 | Report as abusive