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For better or worse, the ways in which changes to tax policy would redistribute wealth drives many of today’s debates in Washington. The fiscal cliff fight that ushered in the year hinged on whether the Bush tax cuts should be extended for all Americans or only the bottom 98 percent. Last year, a report on Republican presidential candidate Mitt Romney’s tax proposal aroused intense controversy and scarred the Romney campaign when it claimed that “a revenue-neutral individual income tax change that incorporates the features Governor Romney has proposed … would provide large tax cuts to high-income households, and increase the tax burdens on middle- and/or lower-income taxpayers.”
But it’s anything but easy to reliably estimate the impact of tax policy on various income groups.
Perhaps the greatest challenge is figuring out who actually bears the burden of a tax. For some taxes, it’s relatively easy and a strong consensus has emerged among economists. For example, the individual income tax is largely borne by the wage earners liable for the tax. The tax could also decrease the amount of labor available to capital owners, but that would be a secondary effect. Similarly, the employer’s half of the Social Security-Medicare payroll tax likely shows up as lower employee wages and is thus borne by wage earners too. Excise taxes are typically collected from the seller, but the buyer usually bears much of the burden in the form of higher prices.
For some tax changes, the resulting growth really can cause all income groups to benefit, without the need for any accounting illusions.
For other taxes, it’s harder to know who ends up bearing the burden. Corporate income taxes — likely to play a large role in any tax reform — are a particular challenge. In fact, until this month, the Joint Committee on Taxation (JCT), which is responsible for preparing official revenue estimates of all tax legislation considered by Congress, had always excluded the corporate income tax from its distributional analyses of taxes.
Such an approach was badly flawed. A corporation, after all, is just a legal structure that brings together owners and employees. The true burden of a tax collected from corporations has to be borne by some of these people, not by legal structures. Assuming otherwise can yield absurd conclusions. For example, we can look like miracle workers simply by raising the corporate tax rate by 5 percentage points and cutting all individual income tax rates by 1 percentage point across the board — a combination that would leave revenues roughly unchanged. If one measures the benefits that each income group gets from the individual rate cut but leaves the effects of the corporate rate hike out of the analysis, it would falsely appear that we cut taxes for every tax-paying income group while still collecting the same revenue — this illusion likely yields a political incentive to tax corporations.
The JCT’s recent step to identify who will bear the tax burden of corporate income tax changes will help policymakers analyze the true cost of tax policy proposals. It also gives new latitude to Congress to propose a reform that pays for a corporate tax cut with increased revenue from individual taxes — likely a growth-enhancing tradeoff.
We can look like miracle workers simply by raising the corporate tax rate by 5 percentage points and cutting all individual income tax rates by 1 percentage point across the board.
Not only must the JCT decide to assign the burden of the corporate income tax, it must distribute the burden appropriately among those individuals bound together by the corporate structure: owners and workers. If the burden is assigned to capital holders, cutting the corporate tax looks like it benefits the rich far more than if the burden is assigned to labor, because workers tend to be less concentrated in higher income groups than holders of capital.
Historically, capital holders were generally assumed to bear the entire burden of the corporate income tax. That may seem like a reasonable approach because the tax is collected from entities owned by capital. And, indeed, if capital holders had no way to avoid the tax, then its burden would fall on them.
But in today’s globalized economy, that is not the case. Capital can be shielded from U.S. corporate income taxes by funding projects outside of the United States rather than within its borders. If capital flees the country in response to higher corporate income taxes, then American workers have less capital to work with, reducing their productivity and, ultimately, their wages. The wage decline means labor bears a share of the burden of the corporate tax, not just capital. The exact portion of the corporate tax burden that ends up getting shifted to labor depends upon a number of factors, including the extent to which the flight of capital from the United States drives down worldwide returns, the degree of international mobility of capital and labor, and the substitutability of capital and labor.
The JCT has decided to assign 25 percent of the burden of corporate income taxation to labor and 75 percent to capital. The Congressional Budget Office recently made the same allocation after assigning for many years the entire burden to capital. The Office of Tax Analysis at the Treasury Department also began assigning part of the corporate tax burden to labor in 2009; it now allocates 18 percent of the burden to workers and 82 percent to capital.
These agencies’ recognition that workers bear some of the burden of the corporate income tax is a good first step, but there is more to do. The empirical literature, which American Enterprise Institute economist Aparna Mathur and I reviewed in a 2011 Tax Notes article, indicates that the share borne by labor is higher, possibly much higher, than the agencies assume. Several studies have shown that a $1 increase in corporate tax revenue might decrease aggregate wages by more than $1 — high-end estimates show them falling $2 to $4. That means a corporate tax cut might be a big gain for lower-income Americans. But more empirical work should be done by economists if the agencies are to be convinced that the large wage effects found in the data after corporate tax changes are caused by those changes and not by other factors.
If the burden is assigned to capital holders, cutting the corporate tax looks like it benefits the rich far more than if the burden is assigned to labor.
To understand the burden of taxes more broadly, it would also be useful to know how policies affect individuals over a lifetime rather than over a 10-year period. For one, the effects of a policy in the long run, after it has been fully phased in, are often very different than its effects in the first 10 years. Secondly, many individuals change income groups due to aging and economic mobility, and the momentarily penniless engineering doctoral student, for example, should not be included in the low-income group alongside the 50-year-old with no high school diploma and no job.
Likewise, the impact of tax policy changes on economic growth ought to be considered — growth often motivates tax reform in the first place, and for good reason. For some tax changes, the resulting growth really can cause all income groups to benefit, without the need for any accounting illusions.
While work remains, it is heartening to see a real effort toward providing better numbers to help politicians and the public understand how different people of different incomes are affected by tax policy changes.
Matthew Jensen is a research associate at the American Enterprise Institute.
Image by Dianna Ingram / Bergman Group
Government agencies are beginning to recognize that the corporate income tax is a burden on workers, not just owners.
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