America’s corporate tax rate has two problems – it is too high and too low. Too low in that it collects very little revenue, through a combination of factors – loss harvesting, special tax exemptions, and booking profits overseas. Too high in that its statutory rate – 35% – is extremely high, driving a lot of this behavior. As a result, while the United States has one of the highest corporate tax rates in the developed world (as conservatives fixate on), its effective tax rate is one of the lowest in the developed world. It could be reasonably argued that the United States is on the wrong side of the Laffer Curve, at least with regards to corporate taxes. Conservatives like to use this to argue that the United States could reap huge rewards in terms of economic growth by lowering corporate taxes. This is wrong – but even so, there’s a solid political economy argument that the Democrats should move to lower and reform corporate taxes. Why? So the Republicans don’t get there first.
The last time Congress took up corporate taxes in 2004, it was to pass a “holiday” on repatriation – wherein corporations could bring home profits domiciled abroad without paying taxes on them. The problem? Well, it doesn’t provide any reason to pay taxes on the day after the holiday – and it in fact encourages domiciling profits abroad, because if Congress passes one holiday that’s an excellent reason to believe they might pass another. Indeed, right on cue in 2011 Congress took up this idea again until the Democrats killed it, pointing out that when this behavior is repeated it’s nothing more than a series of free giveaways to the wealthy, and effectively eviscerates the tax regime for anyone who can afford a decent tax lawyer.
The Democrats should move to permanently cut corporate taxes now, to head off Republicans passing a repatriation holiday when they retake Congress. Lowering taxes and perhaps providing a partial holiday would remove the gigantic stores of offshore profits that Republicans would point to when calling for a holiday, and the total amount of revenue recovered would be far greater. It may or may not result in the rational corporate tax system that everyone in Washington claims to want, but it’s surely better than the inevitable giveaway that will result when the Republicans retake Congress. And a corporate tax cut is one of the few policies the Democrats could propose that might make it through the GOP-controlled house.
I’m doing some guided self-study this summer, and today I read a very thought-provoking paper by David Wildasin on “fiscal competition”. Fiscal competition is most well-known at the local level, for example when two cities offer tempting tax breaks to corporations in order to lure their new factory. It’s extremely common at the state level as well – most notably, Texas just lured a new Toyota factory with 4,000 jobs for a whopping $40 million in incentives. However, Wildasin points out that there is another side to these fiscal incentives – subsidies must be paid for with taxes elsewhere, particularly in cities without the power to run large deficits. Since localities almost never charge income taxes, the main way this is done is via taxes on particular types of property. In his simplified model, there are four key results.
- Capital within a locality is fixed in the short run. A tax doesn’t affect the real resources available or real output, but it does reduce the rate of return to capital.
- In the long run, a local property tax can’t reduce the net return to capital because capital will leave or enter so as to equalize net returns to capital inside or outside.
- However, it does affect the owners of immobile resources within the locality, particularly landowners.
- The loss of income to the immobile resource owners exceeds the revenue collected, because of the deadweight loss of taxation.
An interesting extension to this reasoning is to consider what happens once the factory moves in. The move might well be popular, particularly if there are relatively more non-land-owning workers vs. landholders. It’s an obvious win for the politicians – and the net benefit to the community might be positive, depending on how savvy they were at negotiating terms. Here’s the neat thing about this, though: after Toyota comes in, the game changes. We’ve introduced a large new player to the game, one that controls a fairly large proportion of the capital available to the community. However, it has a characteristic that distinguishes it from the landowners, namely that its capital is more mobile. It thus can extract rents from the community, because it can threaten to relocate if its taxes go up and take the equipment with it to whatever new city offers it better incentives. We would expect that future tax increases will continue to fall mainly on immobile property and also that Toyota’s tax incentives long outlive their currently scheduled expiration date.
This actually has a fairly interesting and counter-intuitive empirical prediction – that we should see business incentives that are stronger, and possibly more long-lasting, the more mobile capital is. There is a spectrum here, and a Toyota factory is much more mobile than a farm but relatively immobile compared to a textile factory, and extremely immobile compared to a bank, insurer, or software company. The latter are extremely poor targets for taxes because they can relocate their capital extremely easily – whereas a city government might get a couple good years out of Toyota until a replacement factory can be built, or Toyota might decide to stay if relocation costs exceed the new tax. So we would expect the more mobile businesses to have firmer public incentives, and to extract more rent from the public.
This logic should make us pessimistic about the returns from higher taxes on the ultra-wealthy, by the way.
Warning – this is a post without empirical evidence.*
One of the most frustrating things ever is hearing the argument that tax incentives will bring startups to Our Depressed Rust-Belt Mid-American City. First of all, startups won’t replace the thousands of jobs lost when the old
cancer paper mill closed down – startups will employ far fewer people, and they will be mostly importing their talent from other cities/states/countries. That’s not terrible – those employees will still need meals cooked, lawns mowed, clothes cleaned, etc. The ancillary jobs of a thriving startup scene are often decent ones – but the good high-paying jobs won’t go to locals. No, the real issue with these policies is thinking that startups make decisions based on taxes.
A startup is a machine designed to turn ideas into products, and sometimes products into revenue, and products + revenue into growth. Notice a very important word that isn’t in that description? Profits. Very few startups are profitable from the get-go, and most aren’t meant to be – even the ones with massively positive cash flows show little or negative accounting profit. That’s because all of that cash is shoveled into growth. People starting startups couldn’t give two shakes about the statutory corporate tax rate because you need profits for taxes, and profits are unimaginably far away. When and if a startup becomes big enough to become profitable, it’ll already be domiciled someplace exotic with nice weather, secretive banking laws, and even more flexible tax codes.
There are tax incentives startups would care about a lot – incentives that make hiring talent cheaper. Rebates for payroll taxes are one very promising avenue. Today, payroll taxes are split half and half between employer and employee – for employers, it’s a tax on hiring people, and for employees it’s a flat tax on pay. If a local government offered payroll tax rebates to startups, that’s huge – it makes it cheaper for you to employ someone, and it makes their salary worth more. That’s actually a competitive advantage that could make it more appealing for a startup to relocate to Our Struggling Example Of Faded Mid-Century Glory And Metaphor For America’s Decline.
Tax incentives are good for existing businesses – but a narrow subset. Mid-sized businesses (small enough to feasibly relocate) with healthy profits (so the tax rate matters). Those are nice to have – but they’re hardly startups, and they’re not the type that grow quickly enough to revolutionize your city’s economy. Cutting corporate tax rates is basically orthogonal to the goal of encouraging startups, and I wish this tired old cliche were tossed out.
*: Don’t you wish more people warned you?
It’s a boring cliche that firms are relocating from California to Texas because of the punitive corporate taxes. Nevermind that this doesn’t really seem to be true – after all, nobody sane thinks Google is about to relocate. And in more narrow empirical terms, it’s clear that there’s no boundary effects between California and Nevada, which has no corporate income tax. It’s clear that firms prefer to locate in places where they can attract skilled and productive employees, and that corporate taxes are a much less important confirm.
More fundamentally, I would have thought the principal-agent theory should kill this argument stone-dead. Keep in mind that decisions about firm location, especially in public firms, are made by corporate management. On the other hand, corporate profits go to shareholders who do not exercise direct control of the firm. Corporations only pay corporate taxes on profits, not revenue. The main difference between revenue and profit is, of course, employee compensation. Corporations don’t pay taxes on the money that goes to their employees.
So…at the margin, firms should actually prefer high corporate taxes. The higher corporate taxes are, the less money goes to shareholders for every dollar of profit. Therefore there’s less incentive to keep employee salaries to a minimum, including of course executive salaries. You should expect management to prefer to locate in high-corporate-tax regimes in order to maximize their own salaries.
So..yes, “incentives matter”, but not always in the pat way in which people talk taxes.