How taxing the rich harms the middle class

President Obama’s budget speech on Monday expanded on the theme of economic “fairness,” like his State of the Union speech in January. He lectured Americans that if critical steps are not taken, the rise of the middle class will be threatened and disparities between the rich and the rest will continue to grow. A general theme was that taxing the rich would get us a long way towards reducing income inequality. This may be why President Obama failed to extend the promise he made last year to fight for corporate tax reform. Why lower tax rates on “rich” corporations if inequality is what really matters?

But when it comes to the corporate tax rate, all is not as it seems. In a recent paper that I co-authored with Kevin Hassett, we explored the effect of high corporate taxes on worker wages. The motivation for the paper came from the international tax literature (summarized by Roger Gordon and Jim Hines in a 2002 paper1) that suggested that mobile capital flows from high tax to low tax jurisdictions. In other words, in any set of competing countries, investment flows are determined by relative rates of taxation. The current U.S. headline rate of corporate tax is 35 percent. The combined federal and state statutory rate of 39 percent is second only to Japan in the OECD. With Japan set to lower its statutory rate later this year, the U.S. rate will soon be the highest in the OECD and one of the highest in the world. What effect do these high rates have on worker wages?
"The current U.S. headline rate of corporate tax is 35 percent. The combined federal and state statutory rate of 39 percent is second only to Japan in the OECD." - Aparna Mathur

When capital flows out of a high tax country, such as the United States, it leads to lower domestic investment, as firms decide against adding a new machine or building a factory. The lower levels of investment affect the productivity of the American worker, because they may not have the best machines or enough machines to work with. This leads to lower wages, as there is a tight link between workers’ productivity and their pay. It could also lead to less demand for workers, since the firms have decided to carry out investment activities elsewhere.

Our paper was one of the first to explore the adverse effect of corporate taxes on worker wages. Using data on more than 100 countries, we found that higher corporate taxes lead to lower wages. In fact, workers shoulder a much larger share of the corporate tax burden (more than 100 percent) than had previously been assumed. The reason the incidence can be higher than 100 percent is neatly explained in a 2006 paper by the famous economist Arnold Harberger.2 Simply put, when taxes are imposed on a corporation, wages are lowered not only for the workers in that firm, but for all workers in the economy since otherwise competition would drive workers away from the low-wage firms. As a result, a $1 corporate income tax on a firm could lead to a $1 loss in wages for workers in that firm, but could also lead to more than a $1 loss overall when we look at the lower wages across all workers.

Following our paper, several academic economists substantiated our results, using different data sets and applying varied econometric modeling and techniques. Some examples of these studies include a 2007 paper by Mihir A. Desai and C. Fritz Foley of Harvard Business School and James Hines Jr. of Michigan University Law School, a 2007 paper by R. Alison Felix of the Federal Reserve Bank of Kansas City, a 2009 paper by Robert Carroll of The Tax Foundation, and a 2010 paper by Wiji Arulampalam of the University of Warwick and Michael Devereux and Giorgia Maffini of Oxford.3 A recent Tax Notes article that I co-authored summarizes these various studies and also the lessons from the theoretical literature on the topic. The general consensus from theory and empirical work is that while we may argue academically about the size of the effect, there is no disagreement among economists that a sizeable burden of the corporate income tax is disproportionately felt by working Americans. On average, a $1 increase in corporate tax revenues could lead to a dollar or more decline in the wage bill.

"When capital flows out of a high tax country, such as the United States, it leads to lower domestic investment, as firms decide against adding a new machine or building a factory." - Aparna Mathur

The Obama administration has often disputed the effect of the high corporate tax rate by suggesting that while the statutory rate is high, the effective taxes paid by corporations are minimal. Hence, the high corporate tax rates are not a real issue. In another article that I wrote last year, I pointed out the flaws in this argument. Even if we look at effective tax rates (both average and marginal) facing U.S. corporations, these are among the highest in the OECD. It is no wonder that firms try to avoid these rates by locating investments overseas or minimizing capital expansions in the United States. The low tax revenue that the United States generates from the corporate income tax is a reflection of the behavioral response of rational firms to high rates.

President Obama is against reducing corporate tax rates because he wrongly believes that the corporate income tax is a tax on the rich. The true story, as research suggests, is that in a free market where capital is globally mobile, “rich corporations” don’t pay taxes, workers do. The sooner we learn this lesson, the faster will be the road to recovery for the middle class.

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Aparna
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