CORPORATE TAX REFORM AND LABOR

MARKET IMPLICATIONS

Francis Ogutu

Adriana Padua

Kevin Reuss

Hypothesis The United States needs to reform the tax code in order to

encourage more capital investments and reduce the tax burden for workers which lead to a stronger labor force participation.

BRIEF HISTORICAL OVERVIEW

Income Tax• Introduced 1791(distilled spirits, carriages, refined sugar

• 1817 congress eliminates internal taxes relying on imported good taxes

• 1862 to support Civil war first Income tax is enacted(fore runner of modern tax system

• People earning between $ 600 and $10000/year are taxed 3%

Brief historical overview Additional sales, Exercise taxes and inheritance tax are added

1862 Office of the Commissioner of Internal Revenue Established

1866 Revenue collections reached the first high ever of 310 million dollar

1868, taxes are more focused on tobacco and spirits

1872 income taxes eliminated as ruled by the supreme court as unconstitutional(though revived in 1894 and 1895.

1913, 16th amendment to the constitution makes the Income tax a permanent fixtures in the Us Tax System applied to both individual and the corporation.

1918, the first billion revenue collection from the taxes and by 1920, 5.4 billion was collected.

WWII increased employment and so did tax collection increasing up to 7.3 billion. Withholding tax on wages introduced in 1943, which increased the number of tax payers to 60 million leading to an increase of 43 billion tax revenue by 1945

1981, congress enacted the largest tax cut in US history. Approx. 750 billion over the next six years. This reduction was however, off set by two tax acts in 1982 and 1984 which decrease tax credits.

Tax Reform of 1986 and the Clinton Administration

Oct 22, 1986. Pres. Reagan signs into law the Tax Reform Act of 1986 to:

-lower the top tax rate from 50% to 28%

-Eliminate tax preferences to make up for the lost revenues

-Increase business tax rate a corresponding decrease in individual income tax.

Revenue Reconciliation Act of 1990 was signed into a bill and by which the emphasis was put on the increase of tax on Wealthy individuals

August 1993, Clinton Signed another Revenue reconciliation Act of 1993 into law to reduce approximately 496 billion Federal deficit budget which was anticipated to be big in the 1994 through 1998

1997, Clinton signed another act to cut taxes by 152 billion. This would include a cut in capital gain taxes, per child Tax credit and Incentive to education Tax.

Bush Tax Reforms 2001,Economic and Growth and Tax Relief Reconciliation:

-Save tax payers 1.3 trillion over ten years

-Created new lowest rate,10% for the first several thousand dollars earned-Established a slow schedule of increamental tax cuts that would eventually double the child -tax credit from 500 to 1000-Adjusted the brackets so that the middle income couples owed the same tax as comparable singlesCut the top four tax rates (28% to 25%, 31% to 28%, 36% to 33% and 39.6% to 35%)

2003, Jobs and Growth Tax Relief and Reconciliation Act

Accelerated the tax cut that had been executed in 2001

temporarily reduced the tax rates on capital gains and dividends to 15%

In 2004, US was forced to eliminate Corporate Tax provision that had been ruled illegal by the WTO

Two tax bills signed in 2005 and 2006 extended through 2010 the favorable rates on capital gains and dividends which had been enacted in 2003.

raised the exemption levels for Alternative Minimum Tax

Enacted new tax incentives designed to persuade individuals to save more for retirement.

Basics of the US Corporate Tax System

In 2007, a Treasury Department survey found that by one measure, the average tax rate paid by U.S. corporations from 2000-2005 was 13.4 percent—below the OECD average of 16.1 percent.29

The contrast between [the United States'] high statutory corporate income tax rate and low average corporate tax rate implies a relatively narrow corporate tax base, due to accelerated depreciation allowances, corporate tax preferences, and tax-planning incentives created by [the] high statutory rate.”30

280 of the largest U.S. corporations paid an average effective tax rate of 18.5 percent over 2008-2010—just over half of the statutory rate.31

The largest 100 U.S. companies and 100 largest European Union companies over the last decade found that the American companies paid lower income tax rates, on average, than their European

Corporate Taxation, Capital Formation, and the Substitution Elasticity between Labor and Capital

One model shows how tax policy legislation affects capital formation and output.

The user cost of capital can be written as

C = (R+δ)(PI/PY)(1-k-u*z) / (1-u)

where user cost of capital is equal to opportunity cost plus depreciation times the relative price times investment tax credits minus the rate of income tax times tax depreciation deductions divided by the rate of income tax.

Income taxes enter the model as an adjustment to the purchase price. Income taxes also lower the price of output and perhaps the financial cost of capital if nominal interest payments are tax deductible.

The price elasticity of the demand for capital is identical, according to this author, to the substitution elasticity between labor and capital.

Tax Policy in an Era of Internationalization

Despite these cuts in statutory income tax rates, the effective capital tax rate in the typical developed democracy has actually remained relatively stable.

Reduced rates retain taxable income that might be shifted through transfer-pricing to low tax nations while cuts in investment credits and allowances might also sustain revenue collections.

Increases in needs and demands for income maintenance, political limits on retrenchment in social spending, and the consequent specter or reality of rises in public debt constrain the reductions in capital tax burdens ad even prompt tax increases.

Low GDP growth, profits and domestic investment, as well as high structural unemployment, are associated with cuts in capital tax burdens.

Corporate and personal rates have been reduced and the tax base broadened through significant shifts away from significant investment credits and allowances in virtually all countries.

• Policymakers reduced statutory corporate tax rates from about 45% in 1981 to 34% in 1998, eliminated or reduced investment credits, exemptions and grants that had significantly lowered effective corporate tax rates.

• Tax rate cuts and base-broadening were meant to bolster economic efficiency and maintain government revenues.

Effective Tax Rates are Correlated with Where Income is Reported

The weighted average US effective tax rate on the domestic income of large corporations with positive domestic income in 2004 was 25.2%

About 1/3 of taxpayers had effective rates of 10% or less and a quarter of the taxpayers had rates over 50%

US tax credits had a relatively small effect on these effective rates

The US imposes only a residual tax on foreign income, after providing a credit for foreign taxes paid on that same income

A substantial portion of the foreign income earned by US multinationals is not taxed until it is repatriated to the US.

This lead to a tax rate on foreign-source income of large corporations at around 4% in 2004.

The residual US average effective tax rate on the foreign income of large US corporations in 2004 was less than 5%

Tax Policy and International Competitiveness

Tax measures which stimulate investment but do not affect savings will inevitably lead to declines in international competitiveness as long as capital is freely mobile internationally.

Investment will be associated with decreases in the trade balance.

These results challenge the commonly expressed view that reductions in tax burdens on business will improve competitiveness by enabling them to undertake more productivity-enhancing investment

If capital is not internationally mobile, stimulus to investment will not lead to capital inflows and therefore will not be associated with trade-balance deterioration

Tax policies which raise savings are likely to increase domestic investment significantly

Policies directed at investment are unlikely to lead to permanent increases in investment unless domestic savings are increased as well

Given that policies to limit net capital mobility are frequently pursued, their effects should be analyzed under the assumption that capital is perfectly mobile.

Business tax reductions appear to have stimulated a significant amount of capital formation and to have drawn capital in from abroad in large quantity

Economic Incidence

Who pays the burden of Corporate Income Tax (CIT)?

Who ends up paying tax depends on who receives the benefit of the tax and it is deeply intertwined with the supply and demand of the market.

Producers vs Consumers

If inelastic supply and elastic demand: burden is on the producers

If elastic supply and inelastic demand: burden is on consumers

Incidence Continued

Similar elasticities: burden is shared Who ends up paying tax depends on who receives

the benefit of the tax and it is deeply intertwined with the supply and demand of the market.

The Distribution of the Costs to Producers

Owners/Capitalists bear a portion of the burden of the CIT.

However, workers also bear a portion with a decrease in wages.

Capital is more mobile than labor: it can shift abroad to adjust for rates. The burden higher for workers when capital is shifted.

If capital and labor are not substitutes, then a decrease in capital will result in a surplus in labor

If they are substitutes, then labor will increase.

Capital vs Labor CIT has more impact today as trade

continues to become a larger part of the economy

If workers are unable to freely move between countries then wages will fall

Gravelle finds than about 60% of corporate tax is borne by capital and 40% is borne by labor

Effect on Wages

Aparna Mathur and Kevin Hassett (December 2010)

Regression controls for other factors that impact wages.

1% increase in the corporate income tax leads to almost a 0.5-0.6% decrease in hourly wages.

Policy Recommendation:

Lower the top corporate income tax rate.

Eliminate loopholes. Revenue neutral.

Revenue Neutral Tax rate has little

impact on the amount of revenue generated.

The state of the economy plays a much greater role.

Costs to producers is shifted to workers and consumers.

The United States Compared to the Rest of the World

Reduce the corporate tax rate from 35% to 25% in return for eliminating the tax credits and deductions.

Other Changes to the Tax Code

Improve economic efficiency by reducing special preferences.

Provide more neutral treatment of corporate and non-corporate businesses.

Take specific steps to discourage tax sheltering.

Reduce the tax code's bias towards debt financing.

Reduce the tax code's bias towards overseas investments.

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