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Saturday, May 31, 2008

Greg Mankiw: The Problem With the Corporate Tax

Greg Mankiw wants a cut in the corporate income tax:

The Problem With the Corporate Tax, by N. Gregory Mankiw, Economic Scene, NY Times: At this point in the presidential campaign, Senator John McCain is the candidate of ideas on issues of tax policy. Too many ideas, in fact. While some of his ideas are great, others are almost laughable. The one that has received the most attention recently — a gas-tax holiday — falls in the second category. ...

Lost in this hubbub, however, is a bigger idea that Mr. McCain and his economic team have put forward: a cut in the corporate tax rate, to 25 percent from 35 percent. It is perhaps the best simple recipe for promoting long-run growth in American living standards. ...

A cut in the corporate tax as Mr. McCain proposes would initially give a boost to after-tax profits and stock prices, but the results would not end there. A stronger stock market would lead to more capital investment. More investment would lead to greater productivity. Greater productivity would lead to higher wages for workers and lower prices for customers. Populist critics deride this train of logic as “trickle-down economics.” But it is more accurate to call it textbook economics. ...

Compared with other ways of funding the government, the corporate tax is particularly hard on economic growth. A C.B.O. report in 2005 concluded that the “distortions that the corporate income tax induces are large compared with the revenues that the tax generates.” Reducing these distortions would lead to better-paying jobs.

Of course, a corporate tax cut would affect the federal budget. ... Cutting the rate to 25 percent would seem to cost the Treasury about $100 billion a year.

Part of that revenue loss, however, would be recouped through other taxes. To the extent that shareholders would benefit, they would pay higher taxes on dividends, capital gains and withdrawals from their retirement accounts. To the extent that workers would benefit, they would pay higher payroll and income taxes. Increased economic growth would tend to raise tax revenue from all sources.

Some economists think that these effects are strong enough to make a corporate rate cut self-financing. A recent study by Alex Brill and Kevin A. Hassett of the American Enterprise Institute, looking at countries in the Organization for Economic Cooperation and Development, supports exactly that conclusion. But even if that turns out to be too optimistic, both theory and evidence make it reasonable to expect a significant discount from the sticker price. In the end, the net budgetary cost of the tax cut might be, say, $50 billion a year.

Senator McCain wants to fill that hole in the budget by restraining spending. If he can stop bloated legislation like the recent $300 billion farm bill from becoming law, more power to him.

But in case that quest proves quixotic, I have a back-up plan for him: increase the gasoline tax..., a gas-tax increase of about 40 cents a gallon could fund a corporate rate cut, fostering economic growth and reducing a variety of driving-related problems.

Indeed, if we increased the tax on gasoline to the level that many experts consider optimal, we could raise enough revenue to eliminate the corporate income tax. And the price at the pump would still be far lower in the United States than in much of Europe.

Don’t laugh. I’m serious.

I think a 50% recovery rate on tax revenues is far too optimistic, and I'm disappointed that Greg would even hint that the tax cut would be self-financing.

[He also discusses the distribution of the tax burden, but the 70% figure he cites as the amount of corporate taxes paid by labor relies upon an assumption of perfect capital mobility (and other assumptions), and he doesn't include how the burden of paying for the corporate tax cut would be distributed, i.e. how the gas tax or any other means of paying for the tax cut would be distributed across households. So the analysis of the tax burden is a bit incomplete and relies upon some fairly optimistic assumptions. I'm not opposed to either change, but the distributional consequences need more consideration. Predictions about the distributional consequences of policies that rely upon trickle down arguments have not been accurate in the past, and we should be wary when they are used to justify further cuts in taxes.]

From comments:

Corporate Tax Declines and U.S. Inequality, By John Irons, April 9, 2008: Over the last 60 years, the U.S. tax code has dramatically shifted away from corporate taxes and toward taxes on individuals, especially through the payroll tax, the financing backbone of Social Security and Medicare. In the 1950s, the corporate income tax brought in, on average, one of every four dollars in federal tax revenues. By the 2000s, however, it raised just one of every 10 tax dollars.

The shrinking share of corporate taxes was made up by an increase in payroll taxes to fund social insurance and retirement programs. Excise and other taxes—such as fuel taxes, phone taxes, etc.—shrank as well over the last 60 years, while the individual federal income tax rose slightly, from an average of 43% of total federal revenue in the 1950s to 46% in the 2000s.

This shift is important because of who pays these different taxes. The corporate income tax is significantly more progressive than other taxes. Those with incomes in the top 20% of the income distribution (those making more than about $86,000 a year in 2007) pay four times the average tax rate on corporate income than the middle 20% (those making between $27,000 and $48,000); while, for the payroll tax, those in the top 20% actually pay less than those in the middle as a share of their income.

This shift has been one of the factors leading to the drop in average federal tax rates for the very highest earners. Between 1960 and 2004, the average tax rate has fallen by about 14 percentage points (from 44.4% to 30.4%) for the top 1% of earners (those making more than $435,000 in 2007), while it has increased slightly (from 15.9% to 16.1%) for those in the middle 20%. 

Without offsets, further erosion of corporate tax revenues—either through lower statutory tax rates or through special preferences—would expand the already wide and growing income inequality in the United States.

Stephen Gordon makes the point that the countries with larger social insurance programs generally have lower corporate taxes than the U.S., but they also do much more redistribution after taxes are collected so that the net tax burden is fairly progressive even when they rely on fairly flat tax collection mechanisms such as a value-added tax. These redistribution programs are an important part of those systems.

Update: Brad DeLong comments on the article here.

    Posted by on Saturday, May 31, 2008 at 01:17 PM in Economics, Policy, Taxes | Permalink  TrackBack (1)  Comments (27)


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