It’s Not Fake News. Corporate Tax Reform Can Deliver Higher Paychecks to Households

By Aparna Mathur of AEI.

"The Council of Economic Advisers recently published a report reviewing several academic economic papers studying the incidence of the corporate income tax on worker wages. Over the last decade, a relatively new empirical literature has emerged to study this question, which consistently finds that a significant burden of the corporate income tax is borne by workers. The CEA report specifically cites a study published by the Federal Reserve Bank of Kansas City, and shows that the results from that study imply that a 1 percent increase in the U.S. state corporate income tax rate would lead to about a 0.1 to 0.2 percent decline in average wages. A mechanical application of that result shows that the proposed corporate tax rate cut in the Republican tax plan from 35 to 20 percent (a decline of 42 percent in rates) would lead to an approximately 4 to 8 percent increase in average wages. With average wages at approximately $50,000, as per data from the Bureau of Labor Statistics, this roughly implies a $2000 to $4000 increase in wages.

This analysis has come under a lot of criticism because it sounds implausible that the average household would benefit so much from a corporate rate reduction. While the exact amount of the benefit is obviously debatable, the controversy surrounding the number has also sparked an interesting back-and-forth between economists, policymakers and other individuals following this debate. Here are the basic points that need to be understood as we tackle corporate tax reform.

Can a corporate tax cut lead to higher wages?

Yes. While there may be a wide range of estimates about the magnitude of the impact, most studies that have investigated the relationship between corporate tax cuts and wages find a strong negative link. Simply put, higher taxes drive away capital investments from the U.S., which reduces workers’ productivity and lowers their wages.  Workers thereby bear part of the “incidence” of the corporate tax. The empirical research reviewed in the CEA paper quantifies this effect. Some papers find that between 45 and 75 percent of the incidence of the corporate income tax is on workers. An analysis by William Randolph at the Congressional Budget Office puts the number at 70 percent. Government agencies such as the CBO and the Treasury assume a smaller share of the incidence on workers, at 18 to 25 percent. A recent report from the Tax Foundation suggests an incidence closer to 50-50. All of this suggests that workers could get a big boost from corporate tax cuts.

How much of an increase in wages could you get?

In terms of dollars, the CEA review suggests an elasticity of -0.1 to -0.2, implying that a 1 percent reduction in the tax rate would lead to an approximate 0.1 to 0.2 percent increase in wages. Some other studies, although not specific to the U.S., also find the elasticity of total wages to total corporate tax revenue near -0.1, while others find elasticities that are larger. The differences in estimates arise because of differences in the data, geographic regions, and time periods covered. While some studies use firm-level data, others use cross-country analysis. Yet others have studied differences across states within a country. As noted in the example in the introduction, if these elasticities apply to the U.S., households could see wage increases that could vary from roughly $2000 (if the elasticity is -0.1) to $4000 or higher in the long run.

Theoretically, can a $1 reduction in revenue lead to a more than $1 increase in wages?

This question has intrigued economists and many others reading the report. The CEA report shows that workers would on average gain $2000-$4000, which, with 150 million workers, means an aggregate gain of $300 billion to $600 billion. The static corporate tax revenue loss, however, is only $133 billion. How is it possible to transfer more money to workers than the loss in corporate tax revenue? For a theoretical exposition, see Greg Mankiw’s recent blog and Arnold Harberger’s original 2006 paper, which started the debate about corporate tax incidence in an open economy.
But intuitively, the logic is straightforward: when you cut the corporate rate, the burden of taxation on firms and workers goes down. Some papers suggest that this might lead to a direct increase in wages if workers have greater bargaining power and are able to claim some share of the higher after-tax profits. But the more interesting impacts occur over the longer term.

Firms that already plan to invest in the U.S. will expand their investments, contributing to a higher capital stock, higher worker productivity and higher wages. Moreover, in a globalized economy there is an additional international investment effect. As recent empirical evidence suggests, multinational firms deciding where to locate their investments will more likely invest in a relatively lower tax country. These pressures are intensified in open economy settings where global capital is highly mobile. An increase in multinational investment in the U.S. increases the demand for workers, leading to an increase in wages.

However, all of these effects are likely to take time, and therefore the wage increases will take years to materialize. But the actual impact on worker wages is not just the mechanical reduction in the share of the tax borne by workers; it also includes the economic changes that a more competitive U.S. economy would bring. So it is indeed possible that the benefit to workers of a $1 loss in corporate tax revenue is more than just $1 in the long-run, through a reduction in what economists call the “deadweight loss” of a tax.

Could families actually get $4000 more in their paychecks at some point?

While the empirical literature suggests this is indeed possible, in practice a lot would depend upon how the overall tax package is framed, not just the corporate tax cut. If the tax package adds $1.5 trillion to the government debt, the additional debt will crowd out private investment, reduce the growth impact and limit the wage increase. Moreover, a deficit-financed tax cut may increase the likelihood of a tax increase at some point, which may create uncertainty and discourage investment and hiring. In addition, if other aspects of the tax package constrain investment or hit middle class households, then household incomes may not increase significantly.

Further, it would also depend upon the types of investments that are made, the types of jobs that are created and whether workers are readily able to match with these positions or upgrade their skills sufficiently to match productively with the new capital investments. So a lot needs to fall into place for us to reap the full benefits of moving the U.S. corporate tax code to one that is more in line with the rest of the developed world. But while it may seem out of reach, we owe it to ourselves to adopt the right set of policies that will get us there.

It’s not surprising that there is a tremendous amount of skepticism about the promise of corporate tax reform. After all, we haven’t had a major change to the corporate tax code for almost 30 years, so we cannot be sure about what to expect from such a move. Further, since the U.S. is a large economy, the international investment impact of corporate tax reform may be lower, though clearly not negligible, relative to small countries like Ireland and Switzerland. I think the best approach is to be cautious and to proceed down this path in a manner that opens up the most possibilities for our workers and for our economy. Evidence from around the world suggests that countries that do so tend to help middle class workers through higher wages. As a country, we are all invested in the goal of helping working families. A corporate tax rate cut is a policy that might help us get there. Let’s do it right."