The Republican plan to slash the corporate tax rate permanently to 20% is a long-term reform that will improve growth prospects and increase wages across the economy. But it’s crucial that its advocates do not go wobbly in the face of stories about companies reacting to the lower tax rate in different ways.
Already, corporate-rate-cut skeptics have pounced on declarations from Pfizer, Coca-Cola and Cisco Systems, who say they intend to use after-tax gains from rate cuts to increase dividends to shareholders or buy back more of their own shares. Rather than creating jobs or increasing wages, critics say, this shows it will be wealthy shareholders who will overwhelmingly benefit from a lower statutory corporate rate.
These types of stories will proliferate in the coming year. But Republicans should stand firm and not panic. This is exactly what we’d expect to happen in the very short term; indeed, the key benefits to workers arise because of the incentive for new investment that will take time to filter through.
When the corporate rate falls dramatically, the first effect is that it provides an immediate windfall to “old capital.” Existing investments that have already been made receive a higher after-tax return than envisaged. This is a big reason why the stock market has surged as tax-reform prospects improved. It takes time for a fall in the tax rate to attract new capital to the corporate sector, so the key beneficiaries in the first instance are existing capitalists.
Now, theoretically this windfall gain can be avoided by phasing in the corporate rate cut. But this only works with the same long-term effects if there is political credibility for delivering on promises for further cuts. In reality, a phased approach would add uncertainty about what might happen, particularly with the possibility of political turnover in Congress. This risks undermining the longer-term pro-growth effects.
And these effects are what really matter. Of course, the initial windfall to shareholders is itself unlikely to be money that sits dormant, but will be reinvested elsewhere, and could help fund the growing industries of the future.
The really important consequence of a lower corporate tax rate though is that, in time, it will bring more capital into the corporate sector as domestic companies face an increased incentive to invest, foreign companies are more likely to expand investments or shift operations to the U.S., and U.S. companies are more likely to repatriate profits from foreign subsidiaries. Coupled with the introduction of immediate expensing of equipment, greater capital per worker stemming from this extra investment should in turn raise productivity and wages.
Basic economics would say that in the long run, capital is more responsive to changes in taxes. The factor of production most likely to bear the cost of a tax is that which is most immobile. Given labor is relatively immobile compared to capital flows, we’d expect a large part of any corporate tax to be borne by workers in the form of lower wages. The flip side is that corporate-rate cuts and full-expensing policies should increase them.
Between 2002 and 2008, a number of states adopted what amounted to a full-expensing policy in their state corporate income taxes. (The GOP plan includes full expensing on investment on equipment for the first five years.) Eric Ohrn’s research, which controls for other factors, found this raised the level of investment by 17.5% and wages by 2.5% within just two to three years. A more recent study by the same economist that looked at the effects of the experimental variation caused by the Domestic Production Activities Deduction, a corporate tax expenditure introduced in 2005, estimates that “a one percentage point reduction in [effective] tax rates increases investment by 4.7 percent of installed capital” in the near-term too.
Numerous other studies corroborate this evidence that labor, as well as shareholders, bear a large proportion of the burden of the corporate tax. A 2015 study from Germany indicated “that workers bear about 40% of the total tax burden.” A 2009 National Bureau of Economic Research paper looking at state level corporate taxes found “workers in a fully unionized firm capture roughly 54% of the benefits of low tax rates.” Though results can differ wildly, a literature review by the U.K. Adam Smith Institute concluded that the average estimated burden on workers was 57.6%. A recent Tax Foundation summary of the literature concluded it was higher still, at 70%.
When will these effects be realized? Certainly, we should see a pickup in trend investment in the next two to three years. Assuming that there are no other major economic confounding factors, productivity and wages should rise above current projected levels with a slight lag over that period. In order for higher wages to result, though, politicians must cut rates permanently and not react to short-term evidence of companies increasing dividends or buying back more shares.
The immediate benefit of reducing the corporate tax burden may well go overwhelmingly to owners of capital, but economic insights suggest in the longer term, workers will reap the rewards too.