“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public …”
So spoke Adam Smith, who knew a little bit about capitalism.
I’d urge you to keep this quote in mind during the tax reform debate, as you are about to hear, if you haven’t already, a lot of soothing and seductive words about how large cuts in the corporate tax rate are great for the middle class and the poor. The Trump administration has, for example, proposed to cut the corporate rate by more than half, from 35 percent to 15 percent.
Perhaps it goes too far to label such rhetoric “a conspiracy against the public.” But, as I’ll show, it is demonstrably false. If you’re not wealthy, and you hear team Trump/Mnuchin/Ryan/Brady trying to sell a corporate tax cut on the basis of how much it’s going to help you, tell them Adam Smith told you they were full of it.
Let’s start by looking at who pays the corporate tax by income class. The Congressional Budget Office assigns 75 percent of the corporate tax to capital income (dividends, interest income, capital gains and rents) and 25 percent to labor income, apportioning both of these types of income to households by income class. The result in terms of the share of the burden shouldered by various groups is shown in the figure below. Note both the level and the trend. In the late 1970s, the wealthiest 1 percent of households paid 30 percent of corporate taxes; now they pay about half. The bottom 60 percent — the group I predict will soon be targeted by an ad campaign to sell these cuts — have seen their corporate tax share fall by half, from about 20 to 10 percent, implying that you won’t help them much by cutting there.
So, at first blush, cutting the corporate tax would mostly help the rich. But tax incidence — who ultimately pays a tax— is not always obvious, and as Richard Rubin writes here, economists argue about the incidence of the corporate tax. If the tax falls on profits, either directly or through the share prices of public firms, then the burden falls mostly on capital and cutting the corporate tax would be a windfall for the wealthy. But there’s an alternative incidence story wherein, yes, the corporate cut raises after-tax profits, but firms sink those profits into investment, which raises productivity growth, which boosts middle-class workers’ wages.
I’m congenitally wary of an economic argument with lots of links in its chain. But what does the research say? CC Huang and Brandon DeBot review it here, showing that most — not all — tax modelers, assume the majority of the incidence of the corporate tax — 75 percent to 80 percent — falls on capital. That’s consistent with most empirical research. However, count on the administration to flip that ratio for its analysis, contending that, contrary to decades of mainstream work in this area, the benefits of its corporate rate cut will show up in paychecks rather than stock portfolios.
But while I’m happy to engage all day in gnarly arguments about tax incidence, let’s get back to that alternative incidence story’s chain of events. Do changes in corporate profitability actually boost investment and productivity? Certainly not in recent years, as profits have climbed and business investment has been plodding. In fact, one good reason to raise eyebrows about this whole rationale for a corporate rate cut is that many companies are flush with cash, capital is already really cheap (interest rates — the cost of capital — have long been low across the globe), and companies are sitting on trillions of dollars in retained earnings that they could invest if they wanted to.
Moreover, I’ve run a long-term correlation between after-tax profit shares and the business investment share of GDP (with data going back to 1948), controlling for unemployment. The correlation is zero. I’ve long looked for correlations between tax changes and business investment, and, to say the least, they don’t jump out at you. Perhaps that’s because, in the words of Warren Buffett (from a piece called “Stop Coddling the Super Rich”): “I have worked with investors for 60 years and I have yet to see anyone — not even when capital gains rates were 39.9 percent in 1976-77 — shy away from a sensible investment because of the tax rate on the potential gain. People invest to make money, and potential taxes have never scared them off.” (If you want to see what really drives investment, look at Figure 2-xv here: “Businesses invest if they expect rising demand growth for their products.”)
Still, let me continue to bend over backward and suspend disbelief. Suppose we ignore the evidence and assume that corporate tax cuts do significantly boost investment, and then productivity. (In fact, I’d love to see faster productivity growth!) But as the figure below from the Economic Policy Institute shows, middle-class compensation has trailed productivity growth for decades. Even if the corporate cuts did lead to faster productivity, a claim of which we should all be huge skeptics, there’s still good reason to believe those gains wouldn’t reach the middle class.
In fact, the wedge you see between these two lines is just another way to look at the inequality problem. It would be a terrible mistake to exacerbate that problem by halving the corporate tax rate.
That’s not an endorsement of our current corporate tax code, which is a hot mess of loopholes and irrational preferences, very much in need of a major rethink. But from what I’ve heard so far, “rethink” amounts to retreaded trickle-down. That may provide “merriment and diversion” to the investor class, but for the rest of us, it’s just a bad deal.