Congress’ Potential Faulty Tax Logic


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.

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.


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