Wednesday, June 11, 2008

The Incidence Brigade

*Update, Sept 2008: see how accountants deal with incidence, here.*

Greg Mankiw of Harvard University, a former chairman of US President George W. Bush’s Council of Economic Advisers, has wheeled out an old argument about tax incidence: that “a corporation is not really a taxpayer at all. It is more like a tax collector.” The ultimate payers of the corporate tax, he continues, are “those individuals who have some stake in the company on which the tax is levied. If you own corporate equities, if you work for a corporation or if you buy goods and services from a corporation, you pay part of the corporate income tax.” He then goes on to cite a report produced by a member of the U.S. Congressional Budget Office estimating that “domestic labor bears slightly more than 70 percent of the burden.” Shareholders suffer too, as do consumers, in the form of higher prices.

Many U.S. Republicans, like some in Europe (such as Mike Devereux of the Saïd Business School in Oxford,) love this argument, or variants of it, as reasons for abolishing or cutting corporation taxes. Richard Murphy calls these people "the Incidence Brigade". A key line of thinking goes like this: “labour” and “workers,” and shareholders and consumers (in other words, you and me) ultimately carry the burden of corporate taxation. So why tax corporations? Taxing corporations won’t help workers and by extension, they argue (more subliminally,) it won’t tackle inequality, one of the great challenges of our age. (Others argue that corporation tax cuts pay for themselves – which has been exposed as palpable nonsense.) So you can cut, or even eliminate, corporation taxes, the argument goes.

This is a matter of great importance. It is a kind of slippery-slope argument – and it lacks any solid foundation. Any reasonable person would immediately (and rightly, as it happens) have a strong gut feeling that the proposal – that letting corporations pay little or no tax won’t make our countries more unequal - is nonsense. The gut feeling would be right. But we need more than gut feeling to dispose of this pernicious argument – which is, admittedly, one of the more sophisticated and sly lobbying efforts in favour of corporate tax cuts.

There are many ways to demolish this argument (as a result, this blog is longer than usual). Here are just a few.

First, the entire premise is mistaken. Why do these proponents of willy-nilly tax-cuts on corporations focus only on the narrow issue: labour, in this case (and, to a lesser extent, shareholders and consumers)? This should instead be viewed in the context of broader society. Do or can corporation taxes make the whole tax system more progressive? The fact that corporation taxes fall (as they do) on different groups in different ways say absolutely nothing about the distributional implications of these taxes. What these lobbyists are trying to do is this: they are trying to conflate in our minds the word “labour” with the notion of “ordinary Joes like you and me” - then hoping that nobody will notice that they have said nothing of any significance at all. (It is a bit like what happens when rain falls on a football match, and somebody argues that the rain doesn't really fall on the football match - it falls instead on the players, the referee, the other match officials, etc.- in other words, it's a pretty meaningless argument.)

Are corporation taxes progressive (i.e. they tend to reduce inequality), when viewed from the point of view of a whole tax system? It’s easy to work it out. Instead of trying to crunch through all the numbers, working out who gets what, it’s easiest to turn the question on its head. Consider the distribution of wealth and income between “labour” (as Mankiw and others would say) and “capital” (or the owners and controllers of wealth.) Raising the relative share of taxes on “capital” tends to reduce inequality; and vice versa. All we need ask is: do corporation taxes fall in any meaningful way on “capital”? It doesn’t take a rocket scientist to answer: of course they do. Why, after all, would the business lobbyists fight so hard against these taxes, if it didn’t sting them? How does this square with the evidence of companies spending so many millions on tax avoidance? So corporation taxes clearly make for a more progressive tax system – and significantly so.

Even then, let’s also think about what “labour” might mean. Ask yourself what “labour” means in the context of ExxonMobil, which earned $40.6 billion in annual profits last year (and that, by the way, is after the company paid many local taxes in places like Angola)? Or what “labour” means in the context of Microsoft’s gargantuan profits. Or take this story, for example: the average Goldman Sachs employee (that is, “labour” or the ordinary Joe at Goldman) gained $661,000 just in bonuses last year – out of a total $1.1m average in total benefits. They will be taxed at the highest rates, so corporation taxes, even when they fall on “labour,” will make the tax system more progressive when considered from a holistic point of view.

Also, the real beneficiaries of corporation tax cuts are so often directors who see the value of tax cuts translated into higher values for their personal stock options – they are the representatives of capital. Take a look, for example, at this unhealthy state of affairs at Citigroup, and read this fascinating exploration of one such case by Richard Murphy.

What is more, many individuals, and especially wealthier ones, incorporate themselves as corporations so as to obtain favourable tax treatment. What does “labour” mean in the context of corporations like these? Tax cuts on corporations will benefit these wealthier individuals.

A problem with the arguments put forwards by people like Mankiw and Devereux is the unworldliness of their analyses. Take, for example, a mining company working in Zambia. It might not have a large labour content, and few or no stockholders in Zambia. However, a large proportion of its profit arises in Zambia, as its activities are in Zambia. Would Devereux seriously argue that tax avoidance or tax cuts are a good idea in this case? This company ain’t relocating anywhere if it’s taxed more highly (within limits): the minerals are there, so that’s where the company must be (and if it goes, another one will come along.) If Zambia raises its tax rates, this means more money for a poor African country and less for the western owners of capital. (As an aside, this then brings us to the question of source -based and residence -based taxation – which we’ll blog about shortly.)

“Ah!” The lobbyists may then cry. “But if you lower taxes on corporations, they can grow their profits faster, and re-invest, and then you can bake a bigger cake, with more goodies for everyone!” Wrong: once again this uses narrow reasoning to obscure the broader picture. If you raise taxes on corporations, you could use this to finance tax cuts for everyone else – so you might be able to bake just as big a cake – and certainly a less unequal cake too (which is one of the key goals of tax policy, especially these days.) In fact, plenty of research has shown that less unequal countries tend to grow more quickly in the long run, so you get even more bang for your buck when inequality is reduced. And if it’s your own country you’re worried about, poorer people tend to buy more locally-sourced goods, boosting domestic demand more.

So the lobbyists turn to another argument. “Tax the corporations,” they say, “and they will simply relocate to another jurisdiction. This harms the workers – by losing them their jobs!” Once again the argument looks alluring, until you dissect it. First, the former U.S. Treasury Secretary Lawrence Summers recently made this comment in the Financial Times.

"Financial regulation is only one example of where the mantra of needing to be “internationally competitive” has been invoked too often as a reason to cut back on regulation. There has not been enough serious consideration of the alternative – global co-operation to raise standards."

He was writing about regulation, but he could just as easily have been writing about tax. The correct solution is this: tax corporations properly – then co-operate internationally to prevent the free-riding of corporations that choose to extract all the benefits of an appropriately taxed economy – while failing to pay their share of those taxes.

Also, while this free-riding does take place – and is used as Exhibit One by the lobbyists for corporate tax cuts, there is less evidence that high taxes actually do scare real corporations away: the reverse is true, in fact. In case it needs pointing out, taxes don’t go up in smoke. They pay for the essential ingredients that make markets and corporations tick: roads, education, healthcare, regulatory authorities, inflation-fighting central banks, and so on. So taxpayers generally get their money back, at the end of the day – with interest. It’s a question of how the benefits are shared out. Take Denmark, as an example, described in this long article in Foreign Affairs:

"The Danes are passionate free traders. They score well in the ratings constructed by pro-market organizations. The World Economic Forum's Global Competitiveness Index ranks Denmark third, just behind the United States and Switzerland. Denmark's financial markets are clean and transparent, its barriers to imports minimal, its labor markets the most flexible in Europe, its multinational corporations dynamic and largely unmolested by industrial policies, and its unemployment rate of 2.8 percent the second lowest in the OECD (the Organization for Economic Cooperation and Development). . . On the other hand, Denmark spends about 50 percent of its GDP on public outlays and has the world's second-highest tax rate. "

We don’t advocate all countries should adopt Denmark-sized high tax rates: that’s for voters, not us, to choose. But this shows that taxes work when done properly. Let’s give another example, from the current edition of Foreign Affairs.

"For more than a century after 1894, most of the cars manufactured in North America were made in Michigan. Since 2004, Michigan has been replaced by Ontario, Canada. The reason is simple: health care. In the United States, car manufacturers have to pay $6,500 in (private) medical and insurance costs for every worker. If they move a plant to Canada, which has a government-run healthcare system, the cost to them is around $800 per worker.. . . jobs are going not to low-wage countries but to places where well-trained and educated workers can be found."

As if all that isn’t enough – there is more. A whole literature has developed and is developing about the “no taxation without representation” argument. As a recent academic book on developing countries says:

"The political importance of taxation extends beyond the raising of revenue. We argue in this book that taxation may play the central (their emphasis) role in building and sustaining the power of states, and shaping their ties to society. The state-building role of taxation can be seen in two principal areas: the rise of a social contract based on bargaining around tax, and the institution-building stimulus provided by the revenue imperative. Progress in the first area may foster representative democracy. Progress in the second area strengthens state capacity. Both have the potential to bolster the legitimacy of the state and enhance accountability between the state and its citizens."

It is direct taxation (such as income taxes or corporation taxes), in contrast to indirect taxes (such as value added taxes or customs duties), that promote these kinds of relationships of accountability.

And then the lobbyists argue that corporation taxes hit consumers, by raising prices. But is this true? Even in the most basic economic theory, in competitive markets companies are “price-takers” (in other words, they have to at least match the prevailing market price to stay in business) rather than “price-makers” where they have, say, a monopolistic position and can set their prices where they want them. Corporation taxes won’t change that equation. And if the company has a monopolistic position and is a price-maker, it will likely as not be receiving supernormal profits from its position – which makes it an excellent candidate for higher corporation taxes.

Apart from all this, it’s easy enough to dissect the specific points in the reports such as from the Congressionial Budget Office (CBO) which are so often quoted by the “tax incidence” brigade in the army of corporation tax-cut lobbyists. But this blog is long enough: we’ll get to that in due course.

But if you still want to read more, try our recent blog, citing a new report, which raises a whole different set of points. And don’t forget Richard Murphy’s set of arguments, which contain plenty that is not in this blog. Try this one, for example.

A few months ago TJN’s John Christensen debated some of these issues with Michael Devereux on BBC radio (the link’s no longer available, sorry). Those of you who heard it will remember that Devereux substantially conceded point after point on these issues, once pressed by Christensen. It’s rather odd that he has not incorporated any of those points into his subsequent analysis.

Update, Feb 5, 2009: new comment article on this:

"Others contend that avoiding corporate taxes doesn't really count, because companies aren't real people. If companies avoid tax, they say, this simply pushes up the value of shareholders' investment. And since the extra value will be taxed as either dividends or capital gains, corporate tax avoidance is really just a form of tax deferral.

This is a seductive but misleading argument. First, and most obviously, not all company shareholders are UK tax resident. If shareholders live in a tax haven, shifting income from companies to individuals does not defer tax, it eliminates it. Second, corporate taxes cannot be looked at in isolation; they are part of the national fiscal fabric. If there were no UK corporation tax, other taxes would increase to compensate. In the current model, stripping out part of the expected corporate tax take puts a strain on the rest of the fiscal system.

But does avoidance bring backdoor benefits? Pension funds are some of the biggest shareholders in UK companies, so does reducing corporate tax benefit pensioners? It is of course true that pension funds invest in the stock market. But it is a stretch to believe tax planning feeds through to higher pensions. For most people, this simply isn't the case.

Those on old-fashioned final salary pension schemes receive the same pension whatever the investment return. Those on state pensions depend directly on future tax revenues, and so are disadvantaged by avoidance. In the case of with-profits pension funds, the sum an individual receives on retirement depends on the discretion of the insurer - there is no direct relationship with increases in the fund.

When it comes to unit-linked pension funds, however, value does directly reflect underlying investments, and it is thus true that holders might benefit from tax avoidance. But even here there are problems. The company could spend the increased revenue on other goodies, such as bigger offices or better bonuses. And even if lower taxes do translate into higher profits, this doesn't automatically increase the company share price. As anyone who has lost money in the recent downturn knows, a company's after-tax profit is just one of many factors affecting the price of its shares.

It is simply disingenuous, therefore, to see tax planning as providing backdoor help for tomorrow's pensioners. It is of course legitimate to advocate the abolition of corporate taxes, and perfectly valid to argue that UK rates are anti-competitive in a global market. But this isn't what avoidance is about. Tax avoidance means taking a unilateral decision to minimise your company's tax."


Anonymous Anonymous said...

I have never seen so much text dedicated to saying nothing of substance. Your "analysis" does nothing to rebut the notion of incidence, which even the most liberal professors in the Grad Tax Program at NYU accept as fact.

As was once said in a famous judicial order "we are all stupider for having read it."

Nom De Plume, J.D., LL.M.

3:00 pm  
Blogger TJN said...

Nom de Plume

Do, pray, elaborate on your points . . . broad brush condemnation and rejection doesn't shed much light. Arguments, please.

2:03 am  
Anonymous Anonymous said...

I agree with the first anonymous comment. There are several arguments being mixed together.

One argument is that understanding the tax incidence is vital to understanding the effect on economic outcomes and behaviour. This is uncontroversial.

A second argument is that special taxes for corporations (eg Corporation Tax) are economically redundant. They have the same economic effect as taxes levied on the natural persons on whom the corporation taxes are incident. TJN is not seeking to refute this argument either.

A third argument is that workers and shareholders are the main disbeneficiaries of corporation taxes. This of course is nonsense, as TJN explains in this article. The political right then tries to use this to claim that it is simpler and easier to move the burden onto these two groups to get the same economic incidence. It probably would be simpler to do so, and the ultimate incidence would be broadly similar to tax corporations - but it would take decades to move to this new equilibrium.

The problem in all this of course is that the ultimate incidence of all these taxes is on the owners of the economic rents of natural resources, land, "intellectual property" and credit creation privileges.

So while the incidence argument is right to challenge corporation taxes, the obvious response is to shift the payment directly to the owners of these rents. The Republicans should call for corporation taxes to be replaced by a Carbon Tax (cutting net fuel and air rents), a Land Value Tax, a Credit Creation Charge and a charge on IP. The surplus collected should be used to pay a Citizens' Dividend (Basic Citizens' Income).

Abolishing corporation taxes in favour of labour and capital taxes would be economic lunacy - further cutting the returns on productive activity and boosting the unproductive sectors (Finance, Insurance, Real Estate - Prof. Michael Hudson's "FIRE" sectors which are parasitic on the real economy).

While I find the TJN analysis generally strong, it seems to have a blind spot for the value of taxation of economic rents. Taxing rents can be economically stable, transparent, efficient. I'd like to read more from TJN about why they favour Transaction Taxes (TransTaxes) over (say) Land Value and Carbon taxes.

8:03 am  
Anonymous TJN said...

"Special taxes for corporations (eg Corporation Tax) are economically redundant. They have the same economic effect as taxes levied on the natural persons on whom the corporation taxes are incident."

Actually, no. They would be redundant if you could, in a fantasy world, find a way to mimic the exact effects by imposing an equivalent tax on warm bodies. But obviously that's impossible, for so many reasons. Abolish the corporation tax, for example, and all the rich and clever ones will turn themselves into corporations and - hey presto! No tax bill!

Taxing rents is something we do agree with - the argument is very clear - though we haven't done any specific detailed work on land value taxes. We'll get around to it, but in our own time.

12:30 am  

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