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Public Finance: The Economics of Taxation
(Part D)
by
Charles Lamson
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The Incidence of Corporate Profits Taxes
Another tax that requires careful analysis is the corporate profits tax that is levied by the federal government, as well as by most states. The corporate profits tax or corporation income tax, is the tax on the profits of firms that are organized as corporations. Corporations are firms granted limited liability status by the government. Limited liability means that shareholders/owners can only lose what they have invested. The owners of partnerships and proprietorships do not enjoy limited liability and do not pay this tax; rather, they report their firms' income directly on their individual income tax returns. We can think of the corporate tax as a tax on capital income, or profits, in one sector of the economy. For simplicity we assume there are only two sectors of the economy, corporate and noncorporate, and only two factors of production, labor and capital. Owners of capital receive profits, and workers (labor) are paid a wage. Just to reiterate from last post, the simultaneous reactions of many households and/or firms to the presence of a tax may cause relative prices to change, and price changes affect households' well-being. Households may feel the impact of a tax on the sources side or on the uses side of the income equation. (We use the term income equation because the amount of income from all sources must be exactly equal to the amount of income allocated to all uses including saving in a given period.) On the sources side, a household is hurt if the net wages or profits that it receives fall; on the uses side, a household is hurt if the prices of the things that it buys rise. If your wages remain the same but the price of every item that you buy doubles, you are in the same position you would have been in if your wages had been cut by 50 percent and prices hadn't changed. In short:  Like the payroll tax, the corporate tax may affect households on the sources or the uses side of the income equation. The tax may affect profits earned by owners of capital, wages earned by workers, or prices of corporate and noncorporate products. Once again, the key question is how large these changes are likely to be. When first imposed, the corporate profits tax initially reduces net (after-tax) profits in the corporate sector. Assuming the economy was in long-run equilibrium before the tax was levied, firms in both the corporate and noncorporate sectors were earning a normal rate of return; there was no reason to expect higher profits in one sector than in the other. Suddenly, firms in the corporate sector become significantly less profitable as a result of the tax. [The United States imposes a tax on the profits of U.S. resident corporations at a rate of 21 percent (reduced from 35 percent by the 2017 Tax Cuts and Jobs Act)(taxpolicycenter.org)]  In response to these lower profits, capital investment begins to favor the nontaxed sector because after-tax profits are higher there. Firms in the tax sector contract in size or (in some cases) go out of business, while firms in the nontaxed sector expand and new firms enter its various industries. As this happens, the flow of capital from the taxed to the nontaxed sector reduces the profit rate in the nontaxed sector: More competition springs up, and product prices are driven down. Some of the tax burden shifts to capital income earners in the noncorporate sector, who end up earning lower profits. As capital flows out of the corporate sector in response to lower after-tax profits, the profit rate in that sector rises somewhat because fewer firms means less supply, which means higher prices, and so forth. Presumably, capital will continue to favor the nontaxed sector until the after-tax profit rates in the two sectors are equal. Even though the tax is imposed on just one sector, it eventually depresses after-tax profits and all sectors equally. Under these circumstances, the products of corporations will probably become more expensive and products of proprietorships and partnerships will probably become less expensive. But because almost everyone buys both corporate and noncorporate products, these excise effects (that is, effects on the prices of products) are likely to have a minimal impact on the distribution of the tax burden; in essence, the price increases in the corporate sector and the price decreases in the noncorporate sector cancel each other out. Finally, what effect does the imposition of a corporate income tax have on labor? Wages could actually rise or fall, but the effect is not likely to be large. Taxed firms will have an incentive to substitute labor for capital because capital income is now taxed. This could benefit labor by driving up wages. In addition, the contracting sector will use less labor and capital, but if the taxed sector is the capital-intensive corporate sector, the bulk of the effect will be felt by capital; its price will fall more than the price of labor.  The Burden of the Corporate Tax The ultimate burden of the corporate tax appears to depend on several factors: the relative capital/labor intensity of the two sectors, the ease with which capital and labor can be substituted in the two sectors, and elasticities of demand for the products of each sector. in 1962 Arnold Harberger of the University of Chicago analyzed this and concluded: Owners of corporations, proprietorships, and partnerships all bear the burden of the corporate tax in rough proportion to profits, even though it is directly levied only on corporations. (Case & Fair, 2004) He also found that wage effects of the corporate tax were small and that excise effects, as we just noted, probably cancelled each other out. Although most economists accept Harberger's view of the corporate tax, there are arguments against it. For example, a profits tax on a monopoly firm earning above-normal profits is not shifted to other sectors unless the tax drives profits below the competitive level. You might be tempted to conclude that because monopolists can control market price, they will simply pass on the profits tax in higher prices to consumers of monopoly products. But theory predicts just the opposite: that the tax burden will remain with the monopolist.  Remember that monopolists are constrained by market demand. That is, they choose the combination of price and output that is consistent with market demand and that maximizes profit. If a proportion of that profit is taxed, the choice of price and quantity will not change. Why not? Quite simply, if you behave so as to maximize profit, and then I come and take half of your profit, you maximize your half by maximizing the whole, which is exactly what you would do in the absence of the tax. Thus, your price and output do not change, the tax is shifted, and you end up paying the tax. In the long run, capital will not leave the monopoly sector, as it did in the competitive case. Even with the tax, the monopolist is earning higher profits than are possible elsewhere. The great debate about whom the corporate tax hurts illustrates the advantage of broad-based direct taxes over narrow-based indirect taxes. Because it is levied on an institution, the corporate tax is indirect, and therefore it is always shifted. Furthermore, it taxes only one factor (capital) in only one part of the economy (the corporate sector). The income tax, in contrast, taxes all forms of income and all sectors of the economy, and it is virtually impossible to shift. (Tax shifting takes place when households can alter their behavior and do something to avoid paying a tax). It is difficult to argue that a tax is a good tax if we cannot be sure who ultimately ends up paying it. The Overall Incidence of Taxes in the United States: Empirical Evidence Many researchers have done complete analyses under varying assumptions about tax incidence, and in most cases their results are similar: State and local taxes (with sales taxes playing a big role) seemed as a group to be mildly regressive (where the average tax burden decreases with income). Federal taxes, dominated by the individual income tax but increasingly affected by the regressive payroll tax, are mildly progressive (based on taxpayer's ability to pay). The overall system is mildly progressive.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 364-365* end |
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