by the Editor
May 14, 2021
These days, we are hearing calls from Democrats to increase corporate taxes as a way to partially pay for their extravagant spending proposals. It can be quite seductive to imagine we can simply tax corporations to finance government largesse and thereby spare hard-working American taxpayers. This idea is misguided because corporations don’t actually bear the burden of corporate taxes, individuals do. What’s more, taxing corporations is an inherently inefficient way to raise revenue because it leaves the economy worse off.
To properly evaluate this issue, we need to understand who bears the burden of corporate taxes. Let’s start at the beginning. A corporation is a legal construct organized to facilitate economic activity. In this role, corporations serve a beneficial function within society by allowing a wide range of investors, both big and small, to pool their resources to produce goods and services valued by society.
Economically, a corporation is not like an individual. Instead, it is made up of shareholders and employees who are focused on creating goods and services for consumers. These three constituencies are the only parties that can possibly bear the ultimate burden of corporate taxes. For example, higher corporate taxes might lower returns to shareholders or cause the corporation to reduce employee wages or increase consumer prices.
There have been many studies that explored the question of who bears the burden of corporate taxes. Unfortunately, it is difficult to scientifically determine the impact of tax policy because it is hard to run experiments in the real world in a way that can isolate discrete outcomes. Tax hikes never happen in a vacuum. There are always other factors at work such as recessions, regulatory modifications, changes in the labor force, competition, etc. And the impact of corporate taxation plays out over a long period of time, reflecting the process of capital reallocation as well as the emergence of alternatives for consumers and employees.
According to the Tax Policy Center, “Economists have long agreed that some of the corporate income tax burden is shifted away from shareholders, but there is no consensus on how the burden is divided among shareholders, other capital income recipients, workers, and consumers.” For example, the Tax Foundation finds that “studies appear to show that labor bears between 50% and 100% of the burden of the corporate income tax, with 70% or higher the most likely outcome.” Another study concludes consumers bear around a third of the cost, with the remainder distributed roughly evenly between shareholders and workers. Many of these studies are “thought experiments” instead of true empirical studies, reflecting the difficulty of performing actual tests in complex economies.
So we have a situation where there is agreement that the cost of corporate taxes is borne by some combination of shareholders, employees, and consumers, but no consensus on the distribution of the tax burden among these groups. This lack of clarity creates an opportunity for the tax and spend crowd. It is politically convenient for them to argue that shareholders will end up bearing the vast majority of the economic burden of corporate taxes. After all, they say, shareholders are rich and greedy, so we don’t need to worry about those people.
This narrative is misguided not only in its unwarranted scapegoating of investors who put their money at risk, it also ignores the huge number of everyday Americans that rely on stock investments for their pensions and retirement accounts. This line of argument also disregards the serious damage caused when high corporate taxes depress the investment activity that drives growth in the economy.
The details underlying this topic can sound technical and complex, but we can use common sense and a bit of role playing to understand how the impact of higher corporate taxes can be expected to play out.
Imagine you run a corporation, called Acme Corp., that is facing a tax hike. You operate in a competitive market not only for the sale of your product, but also for labor and capital. Acme, like every company, seeks to earn what is called its cost of capital. This simply means shareholders expect the capital they invest to earn an after-tax return that will compensate them for the risk they bear and the reduced time value of money they incur when tying up their funds. In the equity capital markets, you can imagine that each type of risk has its own cost of capital. For example, fast food restaurants will be expected to earn a certain cost of capital reflecting their underlying risk and pharmaceutical companies will be expected to earn a cost of capital compensating investors for the risk they perceive in that market segment. At Acme, your target after-tax return on equity capital is 10% and you are not allowed to invest in projects that are expected to earn below this target return.
Let’s say Acme’s corporate tax rate is increased from 25% to 35%. You need to figure out a way to make up for that increased expense and maintain your after-tax return. First, you try to reduce wages. Your labor market is fairly competitive, so you are only able to make up for a third of the higher taxes by cutting employee compensation. Next, you try to raise prices. Here again, you face competition but luckily rival firms are also dealing with higher taxes. This market dynamic allows you to pass on about a third of your higher tax expense in the form of increased prices.
That still leaves you stuck with a third of the higher tax expense and unless you do something Acme’s actual return on equity will be 6%. You need to find a way to bring your actual equity return back to your return target of 10%. Already, your shareholders are exploring ways to move their capital overseas to countries with lower tax rates. Others are planning to reallocate capital from the corporate sector to “pass-through” entities like partnerships and S-Corps that include business profits directly on their individual tax returns and thereby avoid the layer of corporate taxes altogether. Some have even decided if they can’t earn their target return by investing in Acme, they will buy gold and bitcoin instead. New investors are simply not interested in Acme unless you can get returns back up to 10%.
You conduct a review of all existing projects and cut out the least productive expenditures. This results in some job losses and a reduction in purchases from suppliers, negatively impacting the economy. But you are able to make up some ground and bring returns up to 8%, still short of your target of 10%. Over time, you have a plan to bridge this gap by being more selective about the projects you undertake. Each new project must meet the hurdle for your target equity return after factoring in higher taxes. This means that when you previously would have found 100 projects that would meet this hurdle, now in the higher tax environment, you only can undertake 80 new projects. This means less demand for employment and less purchases from suppliers, but at least you can achieve your mandate to earn the target return of 10% for your investors. With these adjustments, your shareholders will be fine, right back where they started with after-tax equity returns of 10%. Happy days! After all, you work for them.
Of course, it is appealing to imagine we can offload the cost of expanded government spending onto corporations and rich investors. But this narrative is a fundamentally misleading and damaging fiction. Shareholders may face some near-term pressure on their returns from higher corporate tax rates, but they will continue to reallocate capital until they can earn their target rate of return. Even worse, increasing corporate taxes is an inherently inefficient and damaging way to raise revenue because the result is lower wages, diminished employment opportunities, higher prices, reduced investment, and weakened economic growth.
Informed politicians know this, so why do some insist on promoting higher corporate tax rates? Sadly, the answer is they like to obfuscate the issue of who bears the burden of their proposed taxes. They believe this smokescreen makes it politically easier to hike taxes on corporations than to pursue more direct and transparent approaches like individual income taxes, sales taxes, or user fees.
Politicians should have the integrity to be honest about who bears the burden of the taxes they propose. Such transparency and clarity will enable us to make more informed decisions about the true costs and trade-offs of the taxes and spending proposed by lawmakers. Investment capital is mobile and quite unemotional in its quest for obtaining the appropriate return for risk. Inserting layers of confusion into our tax code merely shrinks the overall economic pie and increases the ultimate burden on our citizens. So whenever politicians promote the free lunch of corporate tax hikes, remember Acme Corp.