Corporate Taxes Have Hidden Costs

January 17, 2014

Corporate income tax revenue has fallen as a share of federal revenue from 30 percent in the 1950s to around 10 percent today, says Tim Sablik of the Federal Reserve Bank of Richmond.

After accounting for state tax burdens, the United States boasts the highest corporate tax rate in the developed world -- a whopping 39 percent rate. Many economists suggest that the rate should be dropped to zero.

As to who actually pays the corporate income tax -- shareholders, workers (in the form of lower wages) or consumers (in the form of higher prices) -- economists are mixed.

  • Arnold Harberger, in a 1962 study, found that the burden of the tax fell on the shareholders.
  • On the other hand, Alison Felix, an economist at the Kansas City Federal Reserve, found that a 1 percent increase in the marginal state corporate tax rate led to a reduction of wages between 0.14 percent and 0.36 percent.
  • But Jane Gravelle, economic policy specialist at the Congressional Research Service, insists that there is no evidence that wages suffer from higher corporate taxes.

Regardless, the corporate tax leads to market inefficiency and a number of consequences:

  • Corporations can raise money through equity or debt financing. But because debt financing has an effective marginal tax rate of -2 percent (versus a 40 percent effective marginal tax rate on equity financing), debt financing is more preferred. Highly leveraged firms, however, have a much greater risk of bankruptcy.
  • The tax also creates incentives for companies to retain their earnings rather than pay them out in dividends. By retaining earnings, shareholders' overall tax liability is kept lower due to the fact that dividends are taxed twice. But keeping those dividends out of shareholder hands prevents shareholders from reinvesting those funds in other projects, leading to market inefficiency.
  • Multinational corporations also have an incentive to keep earnings abroad rather than bring them to the United States due to the tax rate, because bringing that money back into the country requires the taxpayer to pay the U.S. tax on that income. Even though companies are given a credit on the difference between the U.S. and foreign rate, many companies choose to keep that money abroad rather than pay the higher U.S. tax.

There are a number of policy proposals to deal with the corporate income tax. Some lawmakers have advocated changing to a territorial tax system rather than the United States' current worldwide tax system. A territorial tax system -- which more than 80 percent of Organization for Economic Cooperation and Development countries employ -- would only tax domestic corporate income, meaning that multinational corporations would be more likely to invest at home because they are not taxed when they try to bring those profits back into the United States.

Source: Tim Sablik, "Taxing the Behemoths," Federal Reserve Bank of Richmond, 2013.

 

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