The corporate income tax is a jobs program

The Biden Administration’s “American Jobs Plan” is aptly named. Obviously, spending on infrastructure and other things will provoke activity that contributes to employment. But less widely understood is that the “pay for” part is also employment supportive, perhaps more importantly and durably than the expenditure side. The proposal would increase the corporate tax rate from 21% to 28%. That’s good, but not enough. It would be better for employment if the corporate tax rate would be reset to the pre-Obama 35% rate, and better yet if it were set to the 50%-ish rates that prevailed during the worker-friendly 1950s. In addition to the top-line rate increase, the plan includes provisions to counter jurisdiction shopping and close loopholes in the corporate tax system. To the degree these reforms increase effective corporate tax rates, they too are employment supportive.

The reason is obvious. Wages and benefits (including employer-side payroll taxes) are tax-deductible expenses. When the corporate tax rate is just 21%, the opportunity cost to shareholders of every dollar spent on all-in compensation is 79¢. Only 21¢ gets covered by the tax writeoff. When the corporate tax rate is 50%, 50¢ out of every dollar spent on worker compensation comes out of Uncle Sam’s pockets, rather than out of shareholders’. Hiring workers is a much better deal for firms when the corporate tax rate is high than it is when corporate tax rates are low. For the same reason raising income tax rates would be a boon for tax-exempt nonprofits, increasing corporate tax rates is a boon for labor.

The counters to this are rote, and wrong. “High corporate tax rates reduce job creators’ incentive to build and grow businesses, swamping any benefit from reduced wage costs.” That might be plausible in a world that is not this one. In this world, there is little evidence that variations in the corporate tax rate much affect aggregate economic activity one way or another. In the US postwar experience, the higher corporate tax decades were the highest growth decades. And that might be causal, given the lower opportunity cost, and so effective stimulus, of wages and other business expenditures. It might also just be coincidence. But the supply-side claim that low corporate and income taxes would turbocharge investment and entrepreneurship has been tested over decades, and only really motivated squinting can scry the merest hint of it. There is little evidence for even the more plausible claim that jurisdictional differences between tax rates shape the location of real activity (as opposed to the location where profits are incorporeally booked).

This shouldn’t be surprising. The rewards to active entrepreneurship can be immunized from the effect of high corporate tax rates, because entrepreneurs earn salaries, which are deducted from profits. It is passive shareholding that is inescapably penalized by a higher profits tax, but given the concentration of shareholding among the very wealthiest, and the fact that these shares are now worth a greater fraction of the economy than ever before, balancing the distribution of wealth away from this group would be a good rather than bad thing. Smaller businesses are often “pass-thrus” — S corporations or LLCs in the United States — limiting any impact of the corporate tax on startups and local entrepreneurs.

From a neoclassical corporate finance perspective, every investment that is profitable at a low corporate tax rate is profitable at a higher corporate tax rates. Under certainty, a profits tax shouldn’t affect business investment decisions at all. Under uncertainty, the IRR of projects declines with a higher rate, but the riskiness of projects (and so the hurdle rates imposed) decline as well, since the state absorbs the impact of losses as well taxing gains. Any effect is likely to be ambiguous and small, and overwhelmed by the effect of macro policy on risk appetites and hurdle rates.

But once we pierce the veil of abstraction that surrounds the neoclassical firm, we see very clearly that a high profits tax creates incentives among firm stakeholders to distribute the pretax surplus in ways that don’t flow through to accounting profits. In the United States, research and development is treated as an expense even though it creates valuable intangible assets. Under a high corporate profits tax that can’t be circumvented, firms are more likely to behave as Amazon has, laundering its profits into R&D projects to avoid the squeeze. Research and development contributes to hiring and growth, much more than the same dollars distributed into the pockets of wealth shareholders ever would.

Similarly, a content, well-organized, loyal workforce is an asset to a firm. For any given corporate tax rate, a rational firm will “overpay” workers (relative to the lowest wages that would fill their vacancies) as long as the value captured from an additional dollar in “efficiency wages” is greater than (1-t), where t is the tax rate. It’s the same math as before. With a 21% tax rate, the firm will pay efficiency wages until it captures back less than 79¢ of value it sends to workers. With a 50% tax rate, the firm will be rationally more generous, paying workers until it captures back less than 50¢ of each dollar as “organizational capital“. Firms’ selfish generosity can take the form of higher payments to its existing workforce, amenities or upgrades to working conditions that engender employee loyalty and morale, or new hiring to lighten the load and improve output quality.

Incentives to expand R&D or pay workers are prosocial “distortions” of the corporate tax. But there are less lovely ways firm stakeholders might try to prevent the pretax surplus from flowing into profits. Most garishly, the corporate income tax already encourages firms finance themselves with debt, rather than equity. Interest payments are deductible, so debt investors get paid like workers, from pretax income rather than taxed profits. That’s terrible, and a destructive subsidy to the banking industry. Leveraged capital structures create financial fragility, exposing firm stakeholders and the rest of us to risks of unpredictable losses and financial crisis. It has always been time to end the tax deductibility of interest payments. Raising the level of the corporate income tax would be a great occasion to close the very antisocial tax loophole created by deductible interest payments.

The American Jobs Plan proposes

to fix the corporate tax code so that it incentivizes job creation and investment here in the United States, stops unfair and wasteful profit shifting to tax havens, and ensures that large corporations are paying their fair share… these corporate tax changes will raise over $2 trillion over the next 15 years and more than pay for the mostly one-time investments in the American Jobs Plan and then reduce deficits on a permanent basis

I don’t know whether that revenue number will materialize, whether it accounts for the fact that accounting profits are likely to decline even as activity expands if the plan succeeds at raising effective tax rates. Raising and tightening enforcement of the corporate tax is a good idea regardless. It will redirect wealth, away from shareholders, to some mix of the state and other firm stakeholders including customers and suppliers and especially workers. CEOs are better people when the tax system constructs firm dollars not as shareholder dollars, but as resources of a range of competing claimants. We don’t tax because it is a bad thing that we have to endure in order to pay for stuff. We tax because it is a good thing that promotes a broad prosperity and helps reconcile generous provision of public goods with stable prices. (I like the @jdcmedlock term “tax positivity“.) Raising the corporate income tax, ideally back to 50%, and ensuring the rate is actually effective with respect to earnings attributable to shareholders, would support all of these goals. It’s a great tax.

 
 

5 Responses to “The corporate income tax is a jobs program”

  1. Benjamin Cole writes:

    Fascinating post.

  2. John writes:

    The claim here seems to be, roughly, that

    1. The incidence of the corporate tax is on capital.
    2. Taxing capital is a free lunch, capital available to US firms will not change.
    3. Because of the above, firms will both be better incentivised to invest and employ workers rather than produce profits.

    In the medium-to-long term, I don’t think (1) or (2) is likely to be true, and I don’t see either point addressed in this post.

    In terms of (1), in the short run a “shock” is likely to mostly be paid by capital, since allocations were made before the increase in the tax came into effect and are likely no longer efficient. But in the long run, capital will be reallocated to maximize risk-adjusted returns, including international equities, bonds, and corporate debt. Since US equities are a prominent and historically successful asset class, this will slightly reduce returns to capital available to investors, but ultimately the cost is going to be borne in other ways, bringing us to point (2).

    in this case likely out of US firms, potentially into international equities, and bonds of many kinds. Although firms may be better incentivised to spend whatever capital they have on employment, capital available will fall and it’s not clear that the net effect on jobs will be positive.

    For (2), since capital will in fact be distributed away from US firms, we will see a few responses to this. One will be a reduction in US startup activity and dynamism. Another is resource constraints that will reduce investment, wages, and employment. Ultimately these will result in increased prices (relative to baseline) for consumers, as US firms become less competitive and efficient. Finally, of course, companies that are effective at evading taxes will be rewarded and there will be strong incentives to develop and invest in “tax efficient” accounting strategies and lobbying, with the advantage going to larger firms.

    (3) is a useful point, partly counteracting the above reduction in firm investment and employment. My prediction would be that if we raise corporate taxes considerably, employment would be net unchanged, wages should fall, consumer prices should rise, return on capital should fall. Ideally one should compare these effects in an apples-to-apples way with other tax strategies.

  3. Sa writes:

    I am small business owner and have long argued this. Especially hiring people is held back by too low tax rates. When you are a small business owner, you are alays looking out for the worst case scenarios. When hiring, the worst case scenario is that my revenue hardly goes up even with the extra manpower. When the tax is 22% I lose 78 c on the dollar. With 50% m worst case is only 50 c on the dollar.

    I have long been surprised that this argument hasn’t been put more forcefully by the left.

  4. JKH (redux) writes:

    A lot of moving parts in this analysis.

    The part that puzzles me most is why we should celebrate a comparatively lower after-tax cost of incremental expenses under a higher tax rate, when that marginal benefit pales by comparison to the more fundamentally crushing effect of higher taxes on after-tax income and the return on equity.

    Are we to be concerned about the return on shareholder’s equity, or indifferent to it? Which is it?

  5. JKH writes:

    (cont’d)

    I mention this as an isolated point of logical consistency (it seems to me) within the larger scope of analysis to be considered in terms of factor income distribution, as you have done

    i.e. at the margin of the combined consequence for the equity owner, a mildly favorable convexity effect trails a more fundamentally punishing linearity aspect

    (other things held held equal in considering just the marginal tax and expense math)

    I mention this only as an isolated point of logical consistency (it seems to me) within the larger analysis of aspects to be considered in factor income distribution, as you have done

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