Friday, July 31, 2009

Corporate Tax Incidence

Two supersmart profs emailed me this question:

"[x] and I have a disagreement that you should be able to settle. I claim that the corporate income tax (a tax on profits) does not result in higher prices since a proportional tax on profits doesn't change the firm's profit maximizing output and hence price.

[x] believes that the tax literature indicates that some of the tax is passed on to consumers in terms of higher prices. Who is right?"

Tax incidence is a fascinating subject, but (at least the version of it that actually uses economics) is terribly out of fashion, so I cannot cite a credible empirical study that looks for, and finds an effect on prices.

In theory, if the corporate tax were really a tax on economic profits, then [y] would be right. But, if the corporate tax were really a tax on economic profits, it would get no revenue!

In reality, corporate profits are part of the return on a particular type of capital is not productively organized in some noncorporate way (small business, or nonprofit), or outside of the tax jurisdiction, and cannot be entirely used to collateralize debt. Although I confess that that "particular type" is a bit vague, it's easy to see that some industries ultimately rely on it more than others. This is the mechanism by which the corporate income tax would likely change relative output prices (raising some, and lowering others).

For example, the housing and health service industries are organized with little corporate capital. Manufacturing is pretty corporate intensive. So a corporate income tax would raise the price of manufacturing goods relative to housing and health services. The famous Harberger model had this effect.

I have written some empirical papers about the effect of corporate income taxes on the after-tax return to capital (not the type of price you were asking about), and believe that the return to capital is essentially unaffected in the medium and long run. The corporate tax does reduce the total amount of capital (that's why its after-tax return is ultimately unaffected), and by this mechanism would reduce wages (and push employment outside of the tax jurisdiction) -- probably the most important price effect of all.

Commenters: what do you think? Are there empirical studies of effects on the prices corporations charge to their consumers?

1 comment:

Tino said...

1. “the mechanism by which the corporate income tax would likely change relative output prices.”

A citation for this point is:

Mclure and Thirsk (1975) “A simplified Exposition of the Harberger Model, II” National Tax Journal 28(1).

Incidence goes through relative prices (in Harberger it goes through factor prices)

2. The kind of forward shifting the second professor, and the public generally, seems to be is thinking of happens in non-fully-competitive (or perhaps short term) markup models, such as these

And the classical American one
Krzyzaniak, M. and R. Musgrave (1963), “The Shifting of the Corporation Income Tax”, John Hopkins University Press.

I guess American economists don’t believe in these models anymore, but here is a recent empirical test (no idea about quality) from Australia.

Good policy articles on the incidence of the corporate tax.

3. Beside the point that ex ante economic profits are empirically small, it is questionable if they theoretically exist. Why would a working market systematically leave unexploited opportunities, even 2% of GDP?

More likely what appears as “rents”, a residual when capital and labor have been accounted for, is really returns to factors of production that have not been modeled, such as entrepreneurial talent.