# Corporate Tax Reform: Issues for Congress > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/crs%3ARL34229 ## Record - **Collection:** Congressional research report - **Document type:** CRS Report - **Published:** December 3, 2021 - **Citation:** RL34229 ## Text Corporate Tax Reform: Issues for Congress Updated December 3, 2021 Congressional Research Service https://crsreports.congress.gov RL34229 SUMMARY Corporate Tax Reform: Issues for Congress In 2017, the corporate tax rate was cut from 35% to 21%, major changes were made in the international tax system, and changes were made in other corporate provisions, including allowing expensing (an immediate deduction) for equipment investment. Recently, proposals have been made to increase revenue from corporate taxes, including an increased tax rate, and revise the international tax provisions to raise revenue. These revenues may be needed to fund additional spending or reduce the deficit. RL34229 December 3, 2021 Jane G. Gravelle Senior Specialist in Economic Policy Some level of corporate tax is needed to prevent corporations from becoming a tax shelter for high-income taxpayers. The lower corporate taxes adopted in 2017 made the corporate form of organization more attractive to individuals. At the same time, higher corporate taxes have traditionally led to concerns about economic distortions arising from the corporate tax and newer concerns arising from the increasingly global nature of the economy. In addition, leading up to the 2017 tax cut, some claimed that lowering the corporate tax rate would raise revenue because of the behavioral responses, an effect that is linked to an open economy. Although the corporate tax has generally been viewed as contributing to a more progressive tax system because the burden falls on capital income and thus on higher-income individuals, claims were also made that the burden falls not on owners of capital, but on labor income—an effect also linked to an open economy. The analysis in this report suggests that many of the concerns expressed about the corporate tax are not supported by empirical evidence. Claims that behavioral responses could cause revenues to rise if rates were cut do not hold up on either a theoretical or an empirical basis. Studies that purport to show a revenue-maximizing corporate tax rate of 30% (a rate lower than the prior statutory tax rate) contain econometric errors that lead to biased and inconsistent results; when those problems are corrected the results disappear. Cross-country studies to provide direct evidence showing that the burden of the corporate tax actually falls on labor yield unreasonable results and prove to suffer from econometric flaws that also lead to a disappearance of the results when corrected, in those cases where data were obtained and the results replicated. Many studies that have been cited are not relevant to the United States because they reflect wage bargaining approaches and unions have virtually disappeared from the private sector in the United States. Overall, the evidence suggests that the tax is largely borne by capital. Similarly, claims that high U.S. tax rates created problems for the United States in a global economy suffer from a misrepresentation of the U.S. tax rate compared with other countries, because the comparisons focus on statutory rate. Tax rates are less important when capital is imperfectly mobile, as it appears to be, and because these concerns did not address the fundamental issues of efficiency in international taxation. Although these new arguments appear to rely on questionable methods, the traditional concerns about the corporate tax appear valid. Although an argument may be made that the tax is still needed as a backstop to individual tax collections, it does result in some economic distortions. These economic distortions, however, have declined substantially over time as corporate rates and shares of output have fallen, even before the 2017 tax cut. Lower corporate taxes also create a way of sheltering individual income given the low tax rates on dividends and capital gains. In addition to higher tax rates, a number of revisions could be made to increase corporate tax revenue, including    eliminating preferences in the corporate tax that mismeasure income or lead to economic inefficiencies, revising the tax treatment of foreign source income, and changing shareholder level taxes. Congressional Research Service Corporate Tax Reform: Issues for Congress Contents Introduction ................................................................................................................... 1 The Corporate Tax as a Revenue Source ............................................................................. 4 Magnitude and Historical Pattern ................................................................................. 5 The Role of the Corporate Tax in Backstopping the Individual Tax.................................... 6 Behavioral Responses and Revenue-Maximizing Tax Rate .................................................... 8 Theoretical Issues .................................................................................................... 10 Revenue Feedback from a General Equilibrium Model to Illustrate Likelihood of a Laffer Curve Near Pre-2017 Rates ........................................................................... 13 Reduced Form Empirical Analysis ............................................................................. 13 Brill and Hassett Study............................................................................................. 13 Clausing Study........................................................................................................ 14 Cross-Country Investment Estimates: The Djankov Study.............................................. 16 Theoretical Issues .................................................................................................... 16 Empirical Analysis................................................................................................... 17 Distributional Effects..................................................................................................... 18 The Harberger and Randolph Studies .......................................................................... 20 The Hassett and Mathur Study................................................................................... 22 Other Empirical Wage Studies ................................................................................... 26 Other Cross-Country Studies of General Burden ..................................................... 26 Cross-State Regressions ...................................................................................... 28 Rent Sharing Studies........................................................................................... 29 What Should Be Concluded About Incidence? ............................................................. 35 Economic Efficiency Issues ............................................................................................ 35 Allocation of Capital Within the Domestic Economy..................................................... 36 Savings Effects ....................................................................................................... 40 International Capital Flows ....................................................................................... 40 Potential Revisions in the Corporate Tax........................................................................... 41 Corporate Tax Expenditures ...................................................................................... 42 CBO Budget Options ............................................................................................... 43 Biden Administration’s Proposals .............................................................................. 43 Congressional Proposals ........................................................................................... 45 The House Ways and Means’ Build Back Better Act ..................................................... 46 Draft Proposal by Senators Wyden, Brown, and Warner................................................. 50 Other Options Proposed in Prior Congresses ................................................................ 50 Evaluating Tax Revisions.......................................................................................... 53 Increasing Individual Level Taxes; Shifting Between Corporate and Individual Form......... 54 Conclusion................................................................................................................... 54 Tables Table 1. Effective Tax Rates for Alternative Forms of Organization Under Alternative Rate Structures, Individual at 39.6% (43.4%) Rate ............................................ 8 Table 2. Revenue-Maximizing Tax Rates and Share of Variance Explained in the Clausing Study ................................................................................... 10 Congressional Research Service Corporate Tax Reform: Issues for Congress Table 3. Coefficient Estimates: Dependent Variable is Corporate Revenues as a Percentage of GDP (Brill and Hassett Model) ........................................................... 14 Table 4. Coefficient Estimates: Dependent Variable is Corporate Revenues as a Percentage of GDP (Clausing Model) ...................................................................... 15 Table 5. Coefficient Estimates: Key Independent Variable is Constructed Effective Tax Rate (Djankov, Ganser, McLiesh, Ramalho, and Shleifer Model) ....................................... 18 Table 6. Coefficient Estimates: Dependent Variable is the Logarithm of the Five-Year Average of Wage Rates ............................................................................................... 24 Table 7. Coefficient Estimates: Dependent Variable is Annual Logarithm of Real PPP-Adjusted Wage Rates ................................................................................ 25 Table 8. Differential Tax Rates Across Asset Types............................................................. 36 Table 9. Effective Tax Rates by Sector and Type of Finance................................................. 38 Table 10. Ten-Largest Corporate Tax Expenditures, 2020 .................................................... 42 Table 11. Revenue Gain from CBO Budget Options, FY2021-FY2030 .................................. 43 Table 12. Estimated Revenue Gain from the Biden Administration’s Corporate Tax Proposals, FY2022-FY2031......................................................................................... 43 Table 13. Revenue Gain from International Provisions in S. 991 (Sanders), FY2022FY2031 .................................................................................................................... 46 Table 14. Revenue Gain from Corporate-Related Provisions in the House Build Back Better Act, FY2022-FY2031 ........................................................................................ 47 Table 15. Revenue Gain from Corporate-Related Provisions in the House-Passed Build Back Better Act, FY2022-FY2031 ................................................................................ 48 Table 16. Relevant Corporate and Business Tax Provisions in the Wyden-Gregg Bill, S. 3018, Introduced in 2010............................................................................................. 51 Table B-1. Standard Deviation of Corporate Tax Rate Variables in the Three Data Sets ............ 60 Appendixes Appendix A. Revenue-Maximizing Tax Rates in an Open Economy...................................... 56 Appendix B. Data and Estimation Methods ....................................................................... 58 Appendix C. Modeling Problems of the Desai, Foley, and Hines Study ................................. 61 Appendix D. Bargaining Models and Rent-Sharing of Corporate Taxes ................................. 63 Contacts Author Information ....................................................................................................... 66 Congressional Research Service Corporate Tax Reform: Issues for Congres s Introduction As Congress considers tax revisions, an important and challenging component is the tax treatment of the corporation. Following an extensive debate, corporate tax rates were reduced and other major changes were made to the corporate tax system in 2017 (P.L. 115-97), especially to the international tax treatment. Proposals have now been made to increase the corporate tax rate, revise international tax rules, and make other changes to raise revenue. The traditional arguments surrounding the corporate tax, which largely focus on distortions introduced by the tax, were discussed in a January 2017 Treasury study.1 This study also discussed choice of organizational form and international issues. The debate leading up to the 2017 revision included arguments that cutting the corporate tax rate would stimulate economic growth, and even raise revenue, or on claims that the tax is a burden not on capital but on labor. Leading up to the revision, Steven Mnuchin, then-Secretary of the Treasury, advanced the argument that the corporate tax is paid by workers, citing a study by Azémar and Hubbard as evidence. 2 A news report indicated three additional articles referenced by the Treasury press office in support of the burden falling on wages (although the Treasury Office of Tax Analysis currently assigns most of the burden to capital income): studies by Randolph, Hassett and Mathur, and Lui and Altshuler. 3 Opinion pieces at that time referenced a variety of other studies that found large effects of corporate taxes on economic growth or the burden of the tax falls on wages, 4 whereas others expressed disagreement. 5 These issues remain important ones to consider with a new debate on the corporate tax rate and on revisions in international tax rules. The current debate raises issues similar to one that began more than 10 years ago and might be viewed as the beginning of the 2017 reduction in the corporate rate, 6 as well as the more recent proposals for partially reversing the 2017 rate cut and revising the international system. Before 1 U.S. Department of the T reasury’s Office of T ax Analysis, The Case for Responsible Business Tax Reform , January 2017, https://home.treasury.gov/system/files/131/Report-Responsible-Business-T ax-Reform-2017.pdf. 2 Richard Rubin, “Who Ultimately Pays for Corporate T axes? T he Answer May Color the Republican Overhaul,” Wall Street Journal, August 8, 2017. T he paper referenced is Céline Azémar and Glenn Hubbard, “Country Characteristics and the Incidence of Capital Income T axes on Wages: An Empirical Assessment, ” Canadian Journal of Economics, vol. 48, iss. 5 (December 2015), pp. 1762-1802. 3 Robert Farley, “Who Benefits from Corporate T ax Cut, T he Wire, September 7, 2017 at http://www.factcheck.org/2017/09/benefits-corporate-tax-cut/. T he papers cited are William C. Randolph, International Burdens of the Corporate Tax, Congressional Budget Office, Working Paper no. 2006-09, August 2006; Kevin A. Hassett and Aparna Mathur, “A Spatial Model of Corporate T ax Incidence,” Applied Economics, vol. 47, no. 3 (2015), pp. 1350-1365; and Li Liu and Rosanne Altshuler, Measuring the Burden of a Corporate Tax Under Imperfect Competition, Oxford Working Paper no. 11/05. A version was subsequently published in the National Tax Journal, vol. 66, no. 1 (September 2013), pp. 215-237. Gordon Gray, “ Corporate T ax Reform and How It affects Economic Growth, American Action Forum,” April 18, 2017, https://www.americanactionforum.org/research/corporate-tax-reform-affects-economic-growth-2/. Kevin A. Hassett, “T he Cure for Wage Stagnation,” Wall Street Journal, August 14, 2016, at http://www.aei.org/publication/thecure-for-wage-stagnation/. 4 5 Center on Budget and Policy Priorities, “Corporate Rate Cuts Are a Poor Way to Help the Economy and Most Workers-and Could Hurt T hem,” June 9, 2017; Kimberly Clausing, “In Search of Corporate T ax Incidence,” Tax Law Review, vol. 65 (2012), pp. 433-471, http://piketty.pse.ens.fr/files/Clausing2012.pdf. 6 T his report was initially prepared to discuss some of the issues raised at that time and has been updated to follow the developments in research, especially concerning whether the tax burden falls on capital or labor. Congressional Research Service 1 Corporate Tax Reform: Issues for Congress turning to the basic issues surrounding the corporate tax, it is useful to trace this history of the discussion of issues and proposals for corporate reform. In November 2005, President George W. Bush’s Advisory Panel on Tax Reform reported on a variety of proposals for major reform of the tax system, including those for corporate and business income taxes. 7 Hearings were held on these proposals in 2006, but no further action occurred. On July 16, 2007, The Wall Street Journal published an opinion article by Treasury Secretary Henry M. Paulson addressing concerns that the U.S. corporate tax rate is high relative to other countries and announcing a conference to be held July 26 that would examine the U.S. business tax system and its effects on the economy. 8 The Department of the Treasury also released a background paper that addressed several issues associated with the corporate tax and identified some base broadening provisions. 9 An opinion piece by R. Glenn Hubbard, President Bush’s first chairman of the Council of Economic Advisors, referred to the conference as well as to a study by Hassett and Mathur finding that the tax fell on labor and a study by Devereux considering the revenue-maximizing tax rate. 10 Hubbard concluded by suggesting that cutting the corporate tax rate would reduce a tax that is largely, or even fully, borne by labor and that behavioral responses would offset much of the static revenue cost. During the conference, discussions included whether business representatives would trade tax preferences for lower rates, whether reform should take the form of lower rates or write-offs of investments, and methods of avoiding the corporate tax by income shifting in a global economy. Some participants complained that the corporate tax is outdated, too complex, distorts decisions, and undermines the ability of firms to complete in a global economy. Echoing some issues raised in Hubbard’s article, Kevin Hassett indicated that the corporate tax was not an effective way to raise revenues and suggested that lowering the rate would raise revenues. 11 At the time of the Treasury conference, Chairman Charles B. Rangel of the House Ways and Means Committee released a statement inviting the Bush Administration to discuss such issues as tax reform, especially the alternative minimum tax (AMT), addressing tax havens, and increasing equity and fairness in the tax structure.12 Chairman Rangel introduced a bill, H.R. 3970, on October 25, 2007, with a revenue-neutral subsection that included some of the base broadeners included in the 2007 Treasury paper noted above. The rate reduction, from 35% to 30.5%, was 7 T ax Policy Center, Simple, Fair, and Pro-Growth: Proposals to Fix America’s Tax System , November 2005, at http://www.taxreformpanel.gov/. 8 Henry M. Paulson Jr., “Our Broken Corporate T ax Code,” The Wall Street Journal, July 19, 2007. U.S. Department of the T reasury, “Treasury T ax Conference on Business T axation and Global Competitiveness: Background Paper,” July 30, 2007, at https://www.treasury.gov/press-center/press-releases/Documents/07230%20r.pdf. 9 10 R. Glenn Hubbard, “T he Corporate Tax Myth,” The Wall Street Journal, July 26, 2007. T he paper was the first version of the Hassett and Mathur study: Kevin A. Hassett and Aparna Mathur, Taxes and Wages, American Enterprise Institute, working paper, March 6, 2006, presented at a conference of the American Enterprise Institute on May 2, 2006. T he reference to Michael Devereux apparently refers to a paper also presented at the American Enterprise Institute Symposium. 11 T his summary and other references to the issues discussed at the conference are based on two detailed media accounts of the conference: Heidi Glenn, “Business Leaders would Give Up T ax Breaks for Lower Rates,” Tax Notes, July 30, 2007, pp. 324-327, and Joanne M. Weiner, “U.S. Corporate T ax Reform: All T alk, No Action,” Tax Notes, August 27, 2007, pp. 716-728. 12 Statement released by the Honorable Charles B. Rangel, chairman, Ways and Means Committee, July 26, 2007. Congressional Research Service 2 Corporate Tax Reform: Issues for Congress not as large as the 27% discussed in the 2007 Treasury study. Base broadeners in H.R. 3970 were criticized by some business groups.13 The corporate tax debate and the issues of burden and effects on growth continued to be in the news. In May 2008, N. Gregory Mankiw published an article suggesting that most of the burden of the tax falls on labor, citing research suggesting the corporate tax is borne by labor and that revenue losses may be fully or largely offset by behavioral responses.14 In the 111th Congress, S. 3018, introduced by Senators Ron Wyden and Judd Gregg, also provided for a lower corporate tax rate in exchange for a somewhat broader corporate tax base. A similar bill, S. 727, was introduced by Senators Wyden and Coats in the 112 th Congress. The Fiscal Commission proposed a corporate reform similar to the Wyden-Gregg bill. In addition to the Wyden-Gregg and Wyden-Coats proposals and the Fiscal Commission proposals, there were general proposals by Republican leaders in the House (Majority Leader Eric Cantor, Ways and Means Chairman Dave Camp, and Budget Committee Chairman Paul Ryan) for corporate tax reform with rate reductions. In 2014, Chairman Camp introduced H.R. 1, a comprehensive proposal that reformed both individual and corporate income taxes and was revenue neutral during the 10-year budget horizon, as well as distributionally neutral. It cut the corporate tax rate to 25%. President Barack Obama also supported revenue-neutral corporate tax reform, although some groups proposed raising additional revenue from corporations. 15 During 2016, Senator Hatch, chairman of the Senate Finance Committee, indicated an interest in corporate tax integration (where only one level of tax would be imposed on corporate income). 16 Subsequently, Speaker Paul Ryan and Ways and Means Committee Chairman Kevin Brady proposed a major revision in the tax treatment of business income in their “Better Way” blueprint. It partially transformed the current income tax into, effectively, a domestic consumption tax. The border adjustments that make this proposal a domestic consumption tax appeared no longer on the table and a new plan was under discussion in cooperation with the House, Senate, and Administration. 17 See Jeffrey H. Birnbaum, “Democrat Overhaul of T axes: Rangel Would Annul AMT , Shift Burden,” Washington Post, October 26, 2007, p. D1. 13 14 N. Gregory Mankiw, “T he Problem with the Corporate Tax,” New York Times, June 2, 2008. For empirical evidence on incidence he cites an empirical study by Wiji Aralampalam, Michael P. Devereux, and Giorgia Maffini, The Direct Incidence of Corporate Income Tax on Wages, Oxford University Center for Business T axation, May, 2008. For empirical evidence on the feedback effects on revenue, he cites Alex Brill and Kevin Hassett, Revenue Maximizing Corporate Income Taxes, American Enterprise Institute, Working Paper no. 137, July 31, 2007. 15 See “Leader Cantor Unveils Pro-Growth Economic Plan at Stanford University,” press release, March 21, 2011, http://majorityleader.house.gov/newsroom/2011/03/embargoed-leader-cantor-unveils-pro-growth-economic-plan-atstanford-university.htm and “Obama Backs Corporate T ax Cut If Won’t Raise Deficit,” Bloomberg, January 25, 2011, http://www.bloomberg.com/news/2011-01-26/obama-backs-cut-in-u-s-corporate-tax-rate-only-if-it-won-t-affectdeficit.html. For proposals in the deficit reduction plans, see CRS Report R41970, Addressing the Long-Run Budget Deficit: A Comparison of Approaches, by Jane G. Gravelle and CRS Report R41641, Reducing the Budget Deficit: Tax Policy Options, by Molly F. Sherlock. 16 See CRS Report R44638, Corporate Tax Integration and Tax Reform , by Jane G. Gravelle. 17 Although the border adjustments that led it to be a domestic consumption tax appear ed no longer on the table, the proposal was similar in its effects on investment to a consumption tax in that it had expensing and disallowed interest deductions, which means it did not tax the return to marginal investments. For a more detailed discussion , see CRS Report R44823, The “Better Way” House Tax Plan: An Economic Analysis, by Jane G. Gravelle. For a discussion of the plan under development , see Jonathan Curry, Luca Gattoni-Celli, and Asha Glover, “’Big Six’ T out T ax Reform Unity, Drop Border T ax,” Tax Analysts, July 28, 2017, http://www.taxanalysts.org/content/big-6-tout-tax-reform-unitydrop-border-tax. Congressional Research Service 3 Corporate Tax Reform: Issues for Congress The 2017 tax revision, which included temporary individual tax revisions and permanent corporate and business tax changes that reduced revenue, lowered the corporate tax rate from 35% to 21%. It made major changes to international tax rules by moving from a regime where income of foreign subsidiaries was taxed only when profits were repatriated as dividends were paid to the U.S. parent to one where dividends were exempt but foreign profits taxed after an exemption for a deemed return on tangible assets and after a deduction to lower the rate. This provision was designed to tax global intangible low-taxed income (GILTI) at a lower rate and is referred to as a global minimum tax. (In prior and current law, credits were allowed against U.S. tax for foreign taxes paid, although these credits are allowed on an overall basis that allows foreign taxes in high-tax countries in excess of the U.S. rate to shield income in low -tax countries from U.S. tax). GILTI allowed a deduction for a deemed return on tangible assets of 10%. The GILTI regime was accompanied with a deduction for foreign derived intangible income (FDII) that allowed a deduction for U.S. firms based on their share of foreign sales, with a similar deduction for a deemed return on tangible assets. It was designed to equalize the treatment of return on intangible investments whether held in the United States or abroad. International provisions also included the base-erosion and anti-abuse tax (BEAT), which imposed an alternative tax at a lower rate on a base that included certain payments by U.S. multinationals to foreign related parties (such as interest and royalties) and that denied certain credits. Numerous other revisions were made in the corporate tax base, most notably allowing the expensing (an immediate deduction) of the cost of equipment, although this treatment is scheduled to be phased out over four years beginning in 2023. 18 The revision also provided for a five-year period to deduct the cost of research expenses after 2021, which are currently deducted immediately. This report provides an overview of corporate tax issues and discusses potential reforms in the context of these issues, with particular attention to some of the research concerning large behavioral responses and their implications for revenue and distribution. The first section reviews the size and history of the corporate income tax, and it discusses an important issue that has been given little attention by those who proposed deep cuts in the corporate tax: its role in preventing the use of the corporate form as a tax shelter by wealthy business owners. The second section discusses the potential effect of behavioral responses on corporate tax revenues. The third section examines the role of the corporate tax in contributing to a progressive tax system and discusses claims that the burden falls on workers. The fourth section reviews arguments relating to efficiency and revenue yield and traditional criticisms of the corporate tax as one that causes important behavioral distortions. One aspect of this discussion is the question of how the tax might be viewed differently in a more global economy. The final section examines options for reform. The Corporate Tax as a Revenue Source The corporate tax is the third-largest source of federal revenue, but its importance as a revenue source has diminished considerably over time. 18 For a summary of the 2017 changes, see CRS Report R45092, The 2017 Tax Revision (P.L. 115-97): Comparison to 2017 Tax Law, coordinated by Molly F. Sherlock and Donald J. Marples. For a detailed explanation of the international changes, see CRS Report R45186, Issues in International Corporate Taxation: The 2017 Revision (P.L. 115 -97), by Jane G. Gravelle and Donald J. Marples. Congressional Research Service 4 Corporate Tax Reform: Issues for Congress Magnitude and Historical Pattern Despite concerns expressed about the size of the corporate tax rate, current corporate taxes are low by historical standards, whether measured as a share of output or based on the effective tax rate on income. 19 In 1953, the corporate tax accounted for 5.6% of GDP and 30% of federal tax revenues. In recent years, prior to the 2017 revision, the tax has fluctuated at around 2% of GDP and 10% of revenues, reaching a low of 1.2% of GDP in 2003, and standing at 2.7% in 2006 before falling as a share due to the recession and certain measures to stimulate the economy. By 2014, the tax was 1.9% of GDP falling to 1.5% in 2017; after the 2017 revisions, the tax was 1.0% of GDP. Projections indicate that the tax, after falling to 0.7% of GDP in FY2021 due to the recession, will rise and remain at around 1.3% of GDP. Today, it is the third-largest federal revenue source, lagging behind the individual income tax, which is 7.7% of GDP in 2020, rising to 9.4% in FY2031, and the payroll tax, which was about 6% of GDP. It is more significant, however, than excise taxes, which are 0.4% of GDP, and estate and gift taxes at less than 0.1%. In FY2020, the corporate tax is estimated at 6.2% of revenues, rising to 6.85% by FY2031. Much of the historical decline arises from legislated reductions in the corporate effective tax rate on the return to new investment, which has fallen from 63% of corporate profits in 1953 to about 3% today. These changes include a reduction in the top statutory rate from 52% to 21%, more liberal depreciation rules, and the growth of tax favored intangibles investments. 20 The total tax burden on corporate source income has declined even more due to lower rates on dividends and capital gains at the shareholder level and the increased fraction of stocks held in tax exempt form. Although a large fraction of the decline in corporate tax revenues is associated with these changes in rates and depreciation, other causes may be more liberal rules that allow firms to obtain benefits of corporate status (such as limited liability) while still being taxed as unincorporated businesses and tax evasion, particularly through international tax shelters. The 2007 Treasury study documented the significant rise in the share of total business net income received by unincorporated businesses from 1980 to 2004, from 21% of total net income to 50%. Whereas the share of proprietorships (which have no limited liability) had declined slightly, from 17% to 14%, the share of Subchapter S firms (firms that are incorporated but are allowed to elect taxation as an unincorporated business) rose from 1% to 15%. These changes followed a dramatic increase in the number of shareholders allowed for the election (the limit of 10 was raised to 35 in 1982, to 75 in 1996, and to 100 in 2004). Partnerships (including limited liability corporations and limited liability partnerships) increased from 3% to 21%, with most of the increase occurring after 1990. This growth reflects in part the growth of limited liability corporations established under state law (the first state adopted such a provision in 1982), which qualify as an unincorporated businesses T he data discussed in this paragraph are taken from Jane G. Gravelle, “T he Corporate Tax: Where Has it Been and Where is it Going?,” National Tax Journal, vol. 57 (December 2004), pp. 903-923; U.S. Congressional Budget Office (CBO), Historical Data, http://cbo.gov/publication/42911; CBO, The Budget and Economic Outlook, Fiscal Years 2012-2022, http://cbo.gov/sites/default/files/cbofiles/attachments/01-31-2012_Outlook.pdf; and CBO, The Budget and Economic Outlook, Fiscal Years 2017-2027, https://www.cbo.gov/sites/default/files/115th-congress-20172018/reports/52370-outlookonecolumn.pdf and supplementary data at https://www.cbo.gov/about/products/budgeteconomic-data#2. More recent data and projections are at https://www.cbo.gov/about/products/budget -economicdata#2. 19 20 See CRS Report RS21706, Historical Effective Marginal Tax Rates on Capital Income, by Jane G. Gravelle and CRS Report R45186, Issues in International Corporate Taxation: The 2017 Revision (P.L. 115-97), by Jane G. Gravelle and Donald J. Marples for current effective tax rates. T he 63% rate may be slightly overstated because that rate does not capture the effect of intangible investments. Intangible investments were taxed at zero (but not at negative rates since there was no research tax credit). If the share of intangibles were the same as currently (23%) , the tax rate in 1953 would be 57%; however, intangibles were likely less important at that time. T hese tax rates are for equit y investments. Congressional Research Service 5 Corporate Tax Reform: Issues for Congress for corporate tax purposes. Whereas Subchapter S firms are constrained by the shareholder limit, partnerships are not. 21 The latest data (for 2015) indicate that unincorporated businesses accounted for 50% of the total of flow through and corporate business net income, with S Corporations accounting for 15%, partnerships for 25%, and proprietorships for 11%. 22 The Role of the Corporate Tax in Backstopping the Individual Tax Measuring corporate tax revenue falls short of describing the full role of the corporate tax in contributing to federal revenues because the corporate tax protects the collection of individual income taxes. As long as taxes on individual income are imposed, a significant corporate income tax is likely to be necessary to forestall the use of the corporation as a tax shelter. Without a corporate tax, high-income individuals could channel funds into corporations, and, with a large part of earnings retained, obtain lower tax rates than if they operated in partnership or proprietorship form or in a way that allowed them to be taxed as such. As suggested by the growth in unincorporated business forms above, wealthy business owners may be quick to take advantage of tax rate differentials, which currently tend to favor unincorporated businesses. In 1986, individual tax rates were lowered dramatically (the top rate fell from 70% to 28%, although it was eventually increased to 39.6%), but the combined corporate tax rate (on the firm and on distributions) has been high relative to the individual tax rate. The 2007 Treasury study indicated that 61% of the income of unincorporated businesses was associated with taxpayers in the top income tax bracket. Although the top tax rate on corporations prior to the 2017 revisions (35%) was close to the top individual rate (39.6%), the corporate tax was graduated. Consequently, for high-income taxpayers, there was an advantage to shifting part of one’s income into a corporation because corporate tax rates are graduated (15% on the first $50,000 and 25% on the next $25,000) and are lower than the top marginal tax. This opportunity, however, was restricted by (1) limiting to one the number of corporations income can be shifted to; (2) the amount on which rates are graduated; and (3) disallowing graduated rates for personal service corporations. In recognition of the potential use of the corporation as a shelter, tax law has in the past contained a tax on accumulated earnings. As long as dividends were taxed as ordinary income and the accumulated earnings tax was strict enough, it was difficult to use the corporate form to shelter a great deal of income. This tax shelter constraint on lowering the corporate rate may have become more binding because of the lower rates on dividends enacted as part of the Administration’s corporate relief package in the Jobs and Growth Tax Relief Reconciliation Act of 2003 (P.L. 108-27), although rates were increased in 2010 and 2013. 23 The 2017 revision also changed the relative benefits of operating in corporate versus noncorporate form by lowering the corporate rate to 21% and the individual rate to 37%, which would tend to make the corporate organizational form more attractive to high21 See also CRS Report R42113, Reasons for the Decline in Corporate Tax Revenues, by Mark P. Keightley, which traces the decline in average effective tax rates, the reduction in the share of business income represented by the corporate sector, and the falling rate of profit. 22 Internal Revenue Service, Statistics of Income, Integrated Business Data, Table 1, at https://www.irs.gov/uac/soi- tax-stats-integrated-business-data. 23 T he law lowered the top rate to 15%, although subsequent legislation taxed very high -income individuals’ dividends and capital gains at 20%. In addition, a 3.8% additional tax was enacted in 2010, applying to dividends and capital gains. Congressional Research Service 6 Corporate Tax Reform: Issues for Congress income individuals. It also, however, eliminated the graduated rates that allowed a restricted opportunity for use of the corporate form as a shelter and also, allowed a deduction for 20% of pass-through income for unincorporated businesses, although the deductions was phased out for certain taxpayers. 24 The individual provisions are scheduled to expire after 2025, but the corporate rate cut is permanent. Businesses at high income levels are subject to an additional 3.8% tax on their income either due to the Medicare A hospital insurance tax or the net investment income tax applied to passive investment income, passive business income, dividends, and capital gains. Active income from a Subchapter S firm that is not wages is not subject to the tax. Table 1 calculates the effective tax rate for operating through a corporation for high-income taxpayers versus an unincorporated business for several cases: (1) pre-2017 law (a 39.6% top individual tax rate with and without the 3.8% and a 35% corporate rate), (2) current law (a 37% top rate with and without the pass-through deduction or the 3.8% additional tax and a 21% corporate tax rate), and (3) law after the lapse of the individual tax rates (a 39.6% tax rate with and without the 3.8% tax and a 21% corporate tax rate). In all cases, corporate dividends are subject to a top rate of 23.8% (a tax rate of 20% plus the 3.8% investment tax). 25 Table 1 also presents proposals discussed by the Biden Administration to raise the corporate tax rate to 28%, the top individual rate to 39.6%, and to tax capital gains at ordinary income. Under prior law, the effective corporate tax rate ranged from 35% to 50.5% depending on the share of dividends, whereas the top effective individual rate was typically 43.4%. Unless a corporation distributed very little of its income, corporate tax rates were usually higher than individual rates, favoring the unincorporated form even more for individuals in lower tax rates. After the 2017 revision, the corporate form could sometimes become beneficial even without the graduated rates. For taxpayers not eligible for the pass-through deduction and especially those subject to the net investment income tax, the corporate form becomes preferable, whereas for firms eligible for the pass-through deduction the noncorporate form would often become preferable. However, if the lower tax rate and pass-through deduction expire, as scheduled in 2025, corporate organization becomes more attractive. (Individuals with lower individual rates could still find noncorporate organization preferable.) Although the 2017 changes weakened the preference for noncorporate form and therefore could be argued to weaken the use of the corporation as a backstop for the individual tax, it also eliminated the graduated corporate rates. All of these changes, along with the uncertainty about the future, create a complex picture of organizational preference. The proposals advanced by the Biden Administration to raise the corporate rate to 28% and restore the 39.6% top individual rate, as well as taxing dividends and capital gains at ordinary rates, would make the corporate form unattractive as a tax shelter as long as the pass-through deduction expires and the corporation distributes dividends. 24 T he deduction is phased out at high income levels for personal service businesses and, for other businesses subject to the phase out limited to a share of wages or a combination of wages and depreciable assets. See CRS Report R46650, Section 199A Deduction: Economic Effects and Policy Options, by Gary Guenther for further information. 25 T he 3.8% additional tax on high-income individuals applies to all earnings of proprietors and general partners, because they are classified as labor income for purposes of the payroll tax, as well as the labor share of income in any other unincorporated business. Active participants in Subchapter S firms with a small amount of labor income could have lower taxes in the Subchapter S form approaching the ordinary income tax rate. Congressional Research Service 7 Corporate Tax Reform: Issues for Congress Table 1. Effective Tax Rates for Alternative Forms of Organization Under Alternative Rate Structures, Individual at 39.6% (43.4%) Rate 100% of Income Distributed 50% of Income Distributed No Income Distributed Corporate Business Dividends Taxed at 20% Rate Corporate Tax Rate of 35% 50.5 42.7 35.0 Corporate Tax Rate of 21% 39.8 30.4 21.0 Corporate Tax Rate of 28% 45.1 36.6 28.0 Dividends Taxed at Ordinary Rates Corporate Tax Rate of 35% 63.2 49.1 35.0 Corporate Tax Rate of 21% 55.3 38.1 21.0 Corporate Rate of 28% 59.2 43.6 28.0 39.6% No Net Investment Income Tax 39.6 39.6 39.6 39.6% With Net Investment Income Tax 43.4 43.4 43.4 39,6% No Net Investment Income Tax with Pass-Through Deduction 31.7 31.7 31.7 39.6% With Net Investment Income Tax with Pass-Through Deduction 35.5 35,5 35,5 37% No Net Investment Income Tax 37.0 37.0 37.0 37% With Net Investment Income Tax 40.8 40.8 40.8 37% No Net Investment Income Tax with Pass-Through Deduction 29.6 29.6 29.6 37% With Net Investment Income Tax With Pass-Through Deduction 33.4 33.4 33.4 Unincorporated Business Source: Congressional Research Service (CRS) analysis. Behavioral Responses and Revenue-Maximizing Tax Rate Although it has long been recognized that there are behavioral responses to the corporate tax (even aside from the tax sheltering issues indicated above), and that these responses have important implications for the efficiency of the economy and the burden of the tax, the issue of a revenue-maximizing tax rate, popularly associated with the “Laffer” curve, has rarely entered into the discussion. A Laffer curve graphs revenue against the tax rate, and is based on the notion that revenue is zero at a zero tax rate and zero at a 100% tax rate (at least with respect to some Congressional Research Service 8 Corporate Tax Reform: Issues for Congress taxes). 26 In a Laffer curve, the revenue first rises with the tax rate and then falls, and at the point it reverses direction is the revenue-maximizing tax rate. The notion that a corporate tax cut could pay for itself continued to enter the debate in 2017, 27 as it did 15 years ago during that corporate debate, where it was proposed or alluded to in several articles in the popular press during the debate. One is the article by Glenn Hubbard, cited above. In National Review, Kevin Hassett discussed the Laffer curve and presented a chart that he indicated is an illustration that appears to show a negative relationship between corporate revenues as a share of GDP and the tax rate. 28 Only 13 countries are shown on this graph, however, and the negative relationship is clearly strongly affected by an outlier, Ireland, which is a well-known tax haven; most economists would not find this illustration persuasive proof. 29 The Hubbard and Hassett articles do, however, cite some more sophisticated research. Hassett referred to a paper by Kimberly Clausing, 30 and Hubbard referred to a paper by Michael Devereux. 31 In addition, Alex Brill and Kevin Hassett also prepared a statistical analysis examining the change in the relationship over time. 32 A cross-country study was also prepared by Jack Mintz. 33 Clausing, who is referred to in the Hassett article, is quoted as claiming that the United States is likely to the right of the revenue-maximizing point on the Laffer curve, but this statement, presumably from an earlier draft, is not found in her published article. That article finds a revenue-maximizing tax rate of 33%, in her simple specification, but as she added variables and accounted for other features the revenue-maximizing tax rate seemed to rise, as indicated in Table 2. Large countries and countries that are less open, such as the United States, have a revenue-maximizing tax rate of 57%—much larger than the combined federal and state rate for U.S. firms of 39%. 26 Excise taxes can be set at more than 100% and still yield revenue. T axes on real capital income in excess of 100% can also yield revenues because inflation is an implicit tax on the holding of cash. Peter Baker, Arthur Laffer’s theory on T ax cuts Comes to Life Once More, New York Times, April 25, 2017, https://www.nytimes.com/2017/04/25/us/politics/white-house-economic-policy-arthur-laffer.html. 28 Kevin A. Hassett, “Art Laffer, Righter T han Ever,” National Review, February 13, 2006, https://www.aei.org/articles/art -laffer-righter-than-ever/. 27 29 Another discussion of this issue appeared in an editorial in The Wall Street Journal, which also presented a chart with a number of OECD countries on it. (“We’re Number One, Alas,” The Wall Street Journal, July 13, 2007, p. A12.) In this chart, the editors simply drew a curve, which passed through a couple of points. T here was no statistical fitting to the data and no informative value to such an analysis; moreover the two points through which the freehand curve was drawn were questionable: one was the United Arab Emirates with no tax, which is neither a typical countr y nor in the OECD, and the other was Norway, whose corporate tax revenue tends to be high because of oil. T he bulk of the data showed no obvious trend. For insight into how this graph was viewed by economists, see Brad DeLong, an economist at Stanford and author of a website, Brad DeLong’s Daily Journal, who titled his entry “Most Dishonest Wall Street Journal Editorial Ever.” T here was some perception, which was incorrect, that this graph was prepared by Kevin Hassett because he was mentioned as a source, but that was not the case; he provided some of the data (personal communication with Kevin Hassett). Based on data provided by one of the correspondents in that debate, a simple regression of corporate share on tax and tax squared showed no significant coefficients for tax variables, indicating no relationship: http://delong.typepad.com/sdj/2007/07/most-dishonest-.html. 30 Kimberly A. Clausing, “Corporate T ax Revenues in OECD Countries,” International Tax and Public Finance, vol. 14 (April 2007), pp. 115-133. 31 Michael P. Devereux, Developments in the Taxation of Corporate Profit in the OECD Since 1965: Rates, Bases and Revenues, May 2006 presented at a conference of the Alliance for Competitive T axation and the American Enterprise Institute, June 2, 2006. 32 Alex Brill and Kevin Hassett, Revenue Maximizing Corporate Income Taxes, American Enterprise Institute, Working Paper no. 137, July 31, 2007. 33 Jack M. Mintz, 2007 Tax Competitiveness Report: A Call for comprehensive Tax Reform , C.D. Howe Institute, No. 254, September 2007. Congressional Research Service 9 Corporate Tax Reform: Issues for Congress Table 2. Revenue-Maximizing Tax Rates and Share of Variance Explained in the Clausing Study Specification Tax Rate R-Squared (1) Basic 33% 0.13 (2) Additional Variables 39 0.43 (3) Additional Variables 42 0.46 (4) Additional Variables 41 0.23 (5) Additional Variables 37 0.21 (6) Openness 43 0.27 (7) Size 45 0.23 (8) Openness and size 57 0.28 Source: Kimberly Clausing (2007). Note: The R-Squared is a statistical term that measures the share of the variance in the dependent variable explained by the independent variables. Michael Devereux’s paper indicates that, while he finds a revenue-maximizing rate of 33% under the same specification as Clausing, he finds only weak evidence of a relationship between tax rates and corporate tax revenues as a percentage of GDP. Many of his specifications do not yield statistically significant effects. Brill and Hassett find a rate of around 30%, which has been falling over time. Mintz finds a rate of 28%, but his data span only a few years (2001-2005). 34 The remainder of this section first discusses theoretical expectations of this relationship and then examines these empirical studies. Both the theoretical and empirical assessments suggest that the results of these analyses are questionable. Theoretical Issues The issue of a Laffer curve has not been a part of the historic debate on corporate taxes because the notion of a revenue-maximizing tax rate other than at very high tax rates is inconsistent with most of the models of the corporate tax. Traditionally, the main behavioral response associated with the corporate tax was the substitution of noncorporate capital for corporate capital within an economy where the amount of capital was fixed. Imposing a corporate tax (in excess of the noncorporate tax) caused capital to earn a lower return in the corporate sector and to flow out of that sector and into the noncorporate sector, thereby lowering the return in the noncorporate sector and raising the return, before taxes, in the corporate sector. The higher pretax return on capital also caused prices to go up in the corporate sector and fall in the noncorporate sector, causing a shift toward noncorporate sector total production. The corporate profits tax base, therefore, had two opposing forces: the amount of capital was falling but the profit rate was rising. The taxable base could, therefore, either increase as tax rates increased, or it could decrease. The direction depended on the substitutability of capital and labor in the corporate sector. The central tendency of most models (with unitary elasticities) suggested, however, that the tax base was relatively invariant to tax rates, and revenues would always rise with the tax rate. 34 Hence, most of the variation is across countries, which, as discussed below, is a potentially serious problem. Congressional Research Service 10 Corporate Tax Reform: Issues for Congress Consequently, under any reasonable set of assumptions there would either be no revenuemaximizing tax rate or an extremely high one. 35 If behavioral responses caused the total capital in the U.S. economy to contract, the outcome could be different. One such model, the open economy model, appears to be a motivation for the belief in a relatively low revenue-maximizing tax rate. Brill and Hassett discuss elasticity estimates of foreign capital flows to after tax returns in the range of 1.5 to 3 (they also cite a recent study with an elasticity of 3.3) in their paper that finds a revenue-maximizing tax rate of around 30%. They conclude that “[t]hese high elasticities are consistent with the view that reductions in corporate rates could lure a significant enough amount of economic activity to a locality to create a Laffer curve in the corporate tax space.”36 As shown in the Appendix A, however, this tax rate even with infinite elasticities cannot be achieved. In the most extreme case, where (1) the country is too small to affect worldwide prices and rates of return; (2) capital is perfectly mobile; and (3) products in international trade are perfectly substitutable; the revenue-maximizing tax rate would be the ratio of the labor share of income to the factor substitution elasticity. Assuming fairly common values for a model without depreciation of 75% for labor’s share of income and a factor substitution elasticity of 1, the tax rate would be 75%—far above the rates of around 30% reported by Brill and Hassett. This rate could rise as these conditions are relaxed. If the United States is assumed to have 30% of world resources, the rate rises to 81%; if imperfect substitutability between investments across countries and between foreign and domestic products is allowed, it would rise further. It would also rise if the tax system included elements of a residence-based system that increases the tax rate on foreign investment by imposing a tax on foreign branch income and on dividends paid by foreign subsidiaries to the U.S. parent, reducing the tax advantage of outbound investment. Although it is possible to have a revenue-maximizing tax rate that does not asymptotically approach 100%, it is probably not possible to find a rate that maximizes revenues as a percentage of GDP because GDP falls as well as tax revenues. In this case, the same circumstances apply as in the reallocation of capital in the closed economy: with unitary elasticities, the corporate share of income is constant relative to GDP, and with other elasticities, it can rise or fall. A related circumstance where capital can contract would be in a model where savings responds so powerfully that the savings supply is infinitely elastic, that is, when a tax is imposed, the capital stock must contract so much, and the pretax rate of return rises so much that the after-tax return comes back to its original value. This extreme savings response model yields the same revenuemaximizing tax rate as the extreme open economy, 75%, and probably no revenue-maximizing tax rate for revenues as a percentage of GDP. Moreover, the slowness with which the capital stock adjusts (most models allow 150 years for full adjustments) means that the revenue would be affected by tax rates in the past. The result of this discussion makes it clear that revenue-maximizing tax rates cannot arise from physical reallocations or contractions of capital. Nor are they likely to arise from a substitution between debt and equity, since the debt share has changed very little despite significant changes in the relative tax burden, and estimates of elasticities that do exist are small. 37 35 An invariant tax base would occur when both production and utility were of the Cobb Douglas form, which is unitary factor substitution elasticities and unitary product substitution elasticities. At 100% tax rate a corner solution would be presumably be reached where the corporate sector wo uld entirely disappear, but only at that extreme rate would such an effect occur. 36 Brill and Hassett, Revenue Maximizing Corporate Income Taxes, p. 6. 37 See Ruud de Mooij, The Tax Elasticity of Corporate Debt: A Synthesis of Size and Variations, International Congressional Research Service 11 Corporate Tax Reform: Issues for Congress A remaining source of a different outcome is profit shifting. This effect could involve firms maintaining the same activity and shifting the form of operation to unincorporated businesses. Profit shifting could be a possibility (although the point of revenue maximization would be much too low because much of the tax has not disappeared, but rather has shifted). But, at least in the United States, this shift is probably less the result of high corporate tax rates and more the result of increasingly loose restrictions on operating with limited liability outside the corporate form, actions that have not been taken by other countries. 38 The other profit shifting issue is the shifting of profits (rather than activity) to foreign countries. Such effects are possible, but it would seem unlikely that tax avoidance could be of this magnitude, given the amount of profits shifted and the behavioral response. Although a small low-income country, as is characteristic of most tax havens, might have little enough domestic capital that it could afford the loss from lowering the rate to attract more capital, such an outcome is much less likely for the United States. Recent estimates of elasticities also suggest that cutting the corporate tax rate would lower revenue much more than enough to offset the tax on profits shifted back into the United States. 39 In addition, profit shifting can be prevented or limited by revisions in international tax rules. Concerns about this issue led to the imposition of tax on GILTI in 2017, which imposes a minimum tax on foreign source intangible income. Early evidence indicated, however, that the share of related company profits reported in tax havens did not change despite the lower tax rate or the global minimum tax. 40 One explanation is that a smaller tax rate may not result in much change in the location of profits from intangible assets, which can be shifted easily as much as the law allows to zero-tax rate countries. That is, even if the U.S. rate is lowered from 35% to 21%, both rates are still higher than a zero rate and there is little incentive to shift profits back to the United States. GILTI lowered the rate to 10.5% although the cross crediting of foreign taxes means zero rates can persist in some locations. One solution is to tax income from tax havens at the full U.S. rate by raising GILTI rates and imposing a per country limit on the foreign tax credit so income in tax havens cannot be shielded from U.S. tax by credits from foreign taxes in hightax countries. Monetary Fund, Working Paper no. WP -11-95, April, 2011, http://www.imf.org/external/pubs/ft/wp/2011/wp1195.pdf. 38 T he T reasury study provides data on the growth over time in unincorporated business forms and suggests that the large share of this income in the United States relative to other countries is due to the ability to avoid the corporate tax and still retain limited liability in the United States. T he growth in Subchapt er S income (partnerships that can elect to be taxed as corporations) corresponds to increasing limits on the number of permissible shareholders, and the growth in partnership income to the growth in the number of states allowing limited liability companie s that do not fall under the corporate tax. Proprietorship income shares have changed very little. In any case, this growth occurred during a period when the corporate tax was constant or falling. 39 Jane G. Gravelle, “Policy Options to Address Profit Shift ing: Carrots or Sticks?” Tax Notes, July 4, 2016, pp. 121134. Even the largest elasticities suggested that a dollar of revenue loss would be offset by only nine cents due to induced profit shifting; the smallest suggested only one cent. 40 See Joint Commit tee on T axation, U.S. International Tax Policy: Overview and Analysis, JCX-16R-21, April 19, 2021, https://www.jct.gov/CMSPages/GetFile.aspx?guid=aa66e305 -74cc-40bc-acad-55bb3e6d5971, which compared 2017 and 2018 tax data; and T estimony of Kimberly A. Clausing, Deputy Assistant Secretary, T ax Analysis, Before the Senate Committee on Finance, U.S. Department of the Treasury, March 21, 2021, https://home.treasury.gov/news/press-releases/jy0079, which compared data from 2000 through 2019 from the Commerce Department. Congressional Research Service 12 Corporate Tax Reform: Issues for Congress Revenue Feedback from a General Equilibrium Model to Illustrate Likelihood of a Laffer Curve Near Pre-2017 Rates A Laffer curve with a revenue-maximizing tax rate implies that there is a point where the tax base contracts so much that no revenue is gained from a tax increase, and, conversely that cutting tax rates could raise revenue. Revenue offsets that arise from behavioral responses are often referred to as a revenue feedback. For a tax cut, revenue feedback would be the revenue gain from an expanded base as a percentage of the original revenue loss (for a tax increase, it would be the loss from a contraction in the base as a percentage of the original gain). The revenue-maximizing tax rate is the point where induced changes in the tax rate provide 100% revenue feedback. An approach that is empirically based but which is not the result of a direct estimate involves using a general equilibrium model, which is based on empirical estimates of underlying relationships (such as capital mobility). A CRS report used such a model and concluded that cutting the corporate tax from 35% to 25% in isolation would result in a revenue offset of 5% due to taxes on increased output in the United States. 41 This effect was not due to the increase in corporate taxes on the additional output, which was negligible, but to an increase in both labor and capital income taxes on increased output. Thus the revenue-maximizing tax rate cannot be near the current 35% tax rate. As noted earlier, some have argued that the revenue feedback for the corporate tax arises not from real changes in investment but from artificial profit shifting, where multinationals use a variety of techniques to declare income in low tax countries. Analysis and evidence, however, does not support this effect. Finally, all of these feedback effects would eventually be swamped for a stand-alone tax cut by the increase in the debt, which would crowd out capital and reduce output, leading to an additional loss of revenues of 23% by the 10 th year. This loss of revenues on reduced output is in addition to the direct effect on the budget deficit due to an increase in interest costs of 25% of the revenue loss over the first 10 years. Reduced Form Empirical Analysis As noted above, several recent studies have examined the relationship between corporate tax rates and corporate tax revenues as a percentage of GDP. The data used for two of these studies were obtained to replicate and extend the analyses. Both studies and the analysis estimate the effect of the top corporate tax rate (and its square) on corporate tax revenues as a percentage of GDP. Panel data for 29 OECD countries is used for the analysis. Brill and Hassett Study In their study, Brill and Hassett use panel data for the OECD countries from 1981 to 2003. 42 They use regression analysis (OLS) to estimate the effects. Brill and Hassett find that the corporate tax rate has at first a positive effect on corporate tax revenues as a percentage of GDP and then a decreasing effect—the effect looks like an inverted U, the shape of the classic Laffer curve. All of their coefficient estimates are statistically significant. However, they do not account for problems 41 CRS Report R41743, International Corporate Tax Rate Comparisons and Policy Implications, by Jane G. Gravelle 42 See Alex Brill and Kevin A. Hassett, Revenue-Maximizing Corporate Income Taxes: The Laffer Curve in OECD Countries. T he authors obtained data from the same sources as Brill and Hassett. Congressional Research Service 13 Corporate Tax Reform: Issues for Congress often encountered with the use of panel data, and their coefficient estimates would appear to be biased and inconsistent. 43 The estimation results from the re-analysis of the Brill and Hassett study are reported in Table 3. The regression includes a tax rate and a tax rate squared to allow for a curve. Panel A of the table displays the results for central government corporate tax data (in the case of the U.S., this is federal government tax data). The coefficient estimates for the full time period (1980 to 2003) and the four subperiods defined by Brill and Hassett are reported. In all cases, the coefficient estimates are fairly small and none are statistically significant at conventional confidence levels. Panel B of the table displays the results for total government (that is, governments at all levels) corporate tax data. Again, the coefficient estimates are fairly small and none are statistically significant. Once appropriate estimation methods are used to correct problems arising with panel data, there appears to be no statistically significant relation between corporate tax rates and corporate tax revenues as a percentage of GDP. Table 3. Coefficient Estimates: Dependent Variable is Corporate Revenues as a Percentage of GDP (Brill and Hassett Model) 1980-1986 1987-1992 1993-1997 1998-2003 1980-2003 A. Central government corporate tax revenues; federal corporate tax rate Tax rate -0.037 (0.090) -0.110 (0.081) 0.048 (0.087) 0.049 (0.117) -0.040 (0.040) Tax rate squared 0.087 (0.109) 0.122 (0.100) -0.082 (0.129) -0.060 (0.178) 0.052 (0.053) F (joint) 5.15 1.21 0.33 0.21 0.51 Prob>F 0.008 0.303 0.719 0.809 0.603 B. Total government corporate tax revenues; total corporate tax rate Tax rate 0.204 (0.195) -0.042 (0.077) 0.069 (0.076) 0.037 (0.094) -0.016 (0.038) Tax rate squared -0.193 (0.214) 0.044 (0.091) -0.106 (0.109) -0.008 (0.123) 0.028 (0.047) F (joint) 2.25 0.21 0.51 0.74 0.44 Prob>F 0.112 0.811 0.602 0.481 0.612 Source: CRS analysis. Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other variables include time dummy variables. Clausing Study Clausing uses panel data for the OECD countries from 1979 to 2002 to study the effect of corporate tax rates on corporate tax revenue as a percentage of GDP.44 She includes more explanatory variables than did Brill and Hassett, but her overall research findings and conclusions 43 T he terms biased and inconsistent are technical statistical terms. See Appendix B for a description and the consequences of these problems, and the statistical definitions for biased and inconsistent. 44 See Kimberly A. Clausing, “Corporate T ax Revenues in OECD Countries.” T he authors thank Kimberly Clausing for providing her data. Congressional Research Service 14 Corporate Tax Reform: Issues for Congress are essentially the same as theirs—there is a Laffer curve relationship between corporate tax rates and corporate tax revenue as a percentage of GDP. However, her estimation methods would lead to biased and inconsistent coefficient estimates. 45 The estimation results for five different specifications are reported in Table 4. The five specifications differ by what explanatory variables are included in the analysis. In all five specifications, the coefficient estimates of the corporate tax rate (and its square) are smaller than those estimated by Clausing and have the opposite signs. Most of the coefficient estimates are not statistically significant at conventional confidence levels, but two are statistically significant at the 10% level only. (In these cases where the coefficients are significant on the tax squared term they still do not produce the Laffer curve shape but rather suggest rising revenue with a rising tax rate). Overall, these results suggest that the corporate tax rate has little effect on corporate tax revenues as a percentage of GDP. Consequently, there is little evidence to support the existence of a corporate tax Laffer curve. Table 4. Coefficient Estimates: Dependent Variable is Corporate Revenues as a Percentage of GDP (Clausing Model) Specification (1) (2) (3) (4) (5) Tax rate -0.055 (0.035) -0.073 (0.111) -0.075 (0.046) -0.048 (0.036) -0.067 (0.047) Tax rate squared 0.078* (0.047) 0.118 (0.147) 0.102* (0.061) 0.069 (0.048) 0.093 (0.061) Profit rate X Corporate share X Unemployment rate X X Per capita GDP growth rate X X Per capita GDP X X Openness X X F (joint) 1.39 0.75 1.45 1.04 1.21 Prob>F 0.251 0.473 0.236 0.354 0.298 Source: CRS analysis. Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other variables include the indicated variables and time dummy variables. *significant at 10% level. Even if an empirical study found a statistically significant relationship that indicated a revenuemaximizing tax rate, such results could not be considered reliable if they do not control for base changes. If the rate is lowered but the base is broadened, the data could show rising tax revenues that would be due to the base changes. In a recent paper, Slemrod and Kawano provide estimates controlling for the direction of changes in the base (although not the magnitude, a much more 45 Clausing included two variables in her analysis indicating the type of corporate tax system that do not vary over time for a country. T he coefficients of these variables are not identified when using the fixed effect estimation method, which is probably why she estimated the coefficients using OLS. While she obtained coefficient estimates for these two variables, the estimates are biased and inconsistent. Congressional Research Service 15 Corporate Tax Reform: Issues for Congress daunting task) and find these controls raise the estimated revenue-maximizing tax rate. 46 Thus, until studies can adequately control for the magnitude of changes in the base, they cannot be the basis for estimating a revenue-maximizing tax rate. Cross-Country Investment Estimates: The Djankov Study Cross-country empirical studies, as noted above, have recently been employed to address the Laffer curve issue and, as will be discussed subsequently, the incidence of the corporate tax on wages. In addition to these direct estimates, there are numerous empirical studies that examine underlying relationships, such as the effect of the user cost of capital (which incorporates the tax rate along with other variables) on investment. Most of these studies have found modest effects on domestic investment and have employed times series estimates within the United States. 47 One recent study on investment, Djankov et al., 48 is similar to the other studies in that it employs a cross-country data base and an independent variable reflecting the tax rate to directly estimate the effect of the corporate tax rate on investment, entrepreneurship and other variables. The study found no effect on investment for statutory tax rates, but very large effects for constructed first year and five year cash flow tax rates. This study, unlike the others discussed in this paper, is a single cross section, so there is no way to introduce fixed country effects. Theoretical Issues Several difficulties arise in the Djankov analysis. First, the cash flow tax rate variable they construct is a hypothetical one (for a hypothetical firm), which is not representative of the capital stock or the firm size in a country (or in all countries). The denominator is income measured before labor income taxes paid by the firm (such as social security taxes in the United States) and economic depreciation. The first is very problematic because the capital income tax rate increases as the labor income tax rate falls, which is a relationship that seems to have no obvious economic justification. It also measures taxes on a cash flow basis for the first year (or the first five years in an alternative scenario), rather than over the life of the investment. An examination of scatter-plots of their data suggest that the results are highly affected by outliers, particularly Bolivia (which has a very high tax rate and a very low investment rate) and Mongolia, a low tax country where investment has been flowing in recently due to mining. The tax rate for Bolivia is about twice the typical tax rate and is inconsistent with the corporate rate in Bolivia. According to the authors, the tax rate reflects an alternative transactions tax. However, a transactions tax is not a tax on corporate income but falls on all income in the economy. Assuming that about a quarter of income is capital incomes, the tax should be reduced by 75%. 46 Laura Kawano & Joel Slemrod, “ How Do Corporate T ax Bases Change When Corporate T ax Rates Change? With Implications for the T ax Rate Elasticity of Corporate Tax Revenues,” International Tax and Public Finance, vol. 23, no. 3 (June 2016), pp. 401-433. 47 For reviews, see Robert Chirinko, “Investment T ax Credits,” in The Encyclopedia of Taxation and Tax Policy, ed. by Joseph J. Cordes, Robert D. Ebel and Jane G. Gravelle, Washington, DC, the Urban Institute, 2005, pp. 226-229 and Kevin A. Hassett and R. Glenn Hubbard, “T ax Policy and Business Investment ,” Handbook of Public Economics (New York: Elsiever, 2002), pp. 1293-1343. 48 Simeon Djankov, T im Ganser, Caralee McLiesh, Rita Ramalho, and Andrei Shleifer, “T he Effect of Corporate T axes on Investment and Entrepreneurship,” National Bureau of Economic Research, Working Paper no. 13756, January 2008. T his paper was subsequently published in the American Economic Journal: Macroeconomics, vol. 2, pp. 31-64. Congressional Research Service 16 Corporate Tax Reform: Issues for Congress As with the Laffer-curve estimates, the results of this study, at least for the United States, are not plausible. According to their estimates, a 10 percentage point drop in corporate tax increased investment by 2.2 percentage points. According to an open economy model developed by Gravelle and Smetters, 49 however, U.S. capital would increase a maximum of 0.7 percentage points with the elimination of corporate tax; with more reasonable elasticities, it would increase by 0.3 percentage points. (This study was directed at the question of tax incidence and will be discussed in more detail in the section below which addresses distributional issues and the burden on labor). Moreover, these effects may understate the investment effects because they do not take into account debt. Thus, their results suggest an investment increase that is at least 11 times too large and that could be 25 or more times too large. Empirical Analysis Although the issue of fixed effects would cause this study to remain problematic in any case, this section explores the effects of the tax rate changes and of specifications that include multiple control variables. The Djankov et al. sample consists of 2004 tax and economic data for 85 countries. They examine the effect of the corporate tax rate on (1) aggregate investment, (2) foreign direct investment, and (3) two measures of entrepreneurial activity. The main results of their study and the authors’ reanalysis are reported in Table 5. The first row of the table displays the coefficient estimate of the effective corporate tax rate variable taken from the Djankov et al. study. Their basic specification includes only the tax rate as an independent variable. The second row of the table reports the range of estimates when a single additional independent variable is added—the authors add 10 variables, one at a time. In all but one instance, the estimates are statistically significant at the 1% or 5% confidence level, and at the 10% level in the remaining case. Their data was reanalyzed after correcting an error in their tax rate for Bolivia, and cumulatively adding selected independent variables that Djankov et al. included in their analysis; the new analysis also included a region-of-the-world variable for each country. The first row of the bottom panel in Table 5 presents the coefficient estimates for the basic model with only a single independent variable: the effective corporate tax rate. For each dependent variable, the coefficient estimate of the tax rate variable is smaller than Djankov et al.’s estimate, which illustrates the importance of Bolivia to their results. Furthermore, the estimated effect of the tax rate on aggregate investment is not statistically significant. The final row of Table 5 reports the coefficient estimate of the tax rate when the full set of independent variables is included in the analysis. The estimated effect of the tax rate on aggregate investment is much smaller than Djankov et al.’s estimate and not statistically significant. The estimated effect of the corporate tax rate on foreign direct investment and entrepreneurial activity is somewhat smaller than the effects estimated by Djankov et al., but the estimates are statistically significant. 49 Jane G. Gravelle and Kent A. Smetters, “Does the Open Economy Assumption Really Mean T hat Labor Bears the Burden of a Capital Income T ax?” Advances in Economic Policy and Analysis, vol. 6, no. 1, 2006. Congressional Research Service 17 Corporate Tax Reform: Issues for Congress Table 5. Coefficient Estimates: Key Independent Variable is Constructed Effective Tax Rate (Djankov, Ganser, McLiesh, Ramalho, and Shleifer Model) Dependent Variable Investment Foreign Direct Investment Business Density per 100 People Average Business Entry Rate Original Basic Estimate -0.218 a (0.074) -0.226 a (0.045) -0.194 a (0.063) -0.138 b (0.057) Range of Estimate -0.165 to -0.236 -0.189 to -0.233 -0.090 to -0.196 -0.110 to -0.141 Coefficient Estimates of Tax Rate Variable with Corrected Data Basic Estimate -0.108 (0.073) -0.194 a (0.044) -0.150 b (0.060) -0.116 b (0.055) -0.046 (0.071) -0.191 a (0.045) -0.115 b (0.058) -0.126 b (0.056) -0.031 (0.070) -0.190 a (0.045) -0.148 a (0.050) -0.146 a (0.055) -0.025 (0.076) -0.179 a (0.048) -0.154 a (0.055) -0.097 c (0.057) PLUS Region Indicators PLUS Per Capital GDP PLUS Number of Tax Payments Employment Rigidity Index Procedures to Start a Business Source: CRS analysis. Notes: Standard errors in parenthesis. a. Significant at 1% level. b. Significant at 5% level. c. Significant at 10% level. Distributional Effects A second issue that was a focus of the Hubbard article was the distributional effects of the corporate income tax. (Note that these distributional effects are driven by some of the same effects that drive the issue of a revenue maximizing tax rate or economic growth: the inflow of capital from abroad.) The distributional issue also had been referenced by then-Treasury Secretary Mnuchin, who cited a study by Azémar and Hubbard as evidence that most of the corporate tax is paid by workers. 50 If the corporate tax falls on owners of the corporation, or on capital in general, it contributes to a progressive tax system, since higher income individuals have more income from capital than from labor. Based on tax data, for taxpayers with incomes up to $100,000, over 90% of income is labor income, whereas those with incomes over $1 million, less 50 Richard Rubin, “Who Ultimately Pays for Corporate T axes? T he Answer May Color the Republican Overhaul,” Wall Street Journal, August 8, 2017. T he paper referenced is Céline Azémar and Glenn Hubbard, “Country Characteristics and the Incidence of Capital Income T axes on Wages: An Empirical Assessment,” Canadian Journal of Economics, vol. 48, iss. 5 (December 2015), pp. 1762-1802. Congressional Research Service 18 Corporate Tax Reform: Issues for Congress than a third is labor income. 51 The traditional analysis of the corporate income tax indicates that the burden generally spread to all capital, but does not fall on labor income. Most government and private agencies that routinely do distributional analysis allocate the corporate tax largely to capital income. 52 Hubbard referred to three studies in his article: a working paper by economist Arnold Harberger, 53 a working paper by William Randolph of the Congressional Budget Office (CBO), 54 and a recent empirical cross-country study using data similar to the studies discussed above, by Hassett and Mathur. 55 At about the same time or shortly thereafter three other empirical studies that use crosscountry data were released in 2006-2008, by Felix, 56 by Desai, Foley and Hines, 57 and by Arulampalam, Devereux, and Maffini. 58 Mankiw referred to the Randolph and Arulampalam, Devereux, and Maffini studies, although as will be shown subsequently the Arulampalam et al. study is examining an entirely different phenomenon which is unlikely to be very relevant to the United States corporate tax, as is the case with the Azémar and Hubbard article referred to by then-Treasury Secretary Mnuchin. 51 CRS Report RL33285, Tax Reform and Distributional Issues, by Jane G. Gravelle (out of print, but available from the author upon request). 52 In the past, the Congressional Budget Office (CBO), the Department of the Treasury, and the Urban-Brookings T ax Policy Center attributed 100% of the tax to capital income. In the past few years, all three organizations have moved to assigning a small share to labor income. CBO assigns 25%, the Department of the T reasury 18%, and the UrbanBrookings T ax Policy Center 20%. T he Department of T reasury and the T ax Policy center assign a large share of the tax to stockholders based on the idea that a large share of income is supra-normal returns. T his share is based in part on an estimate of the share of the corporate tax that is above a risk-free return. While some part of this return may be rent, it probably also largely reflects risk premiums. T here is, however, little justification for assigning the part of a return due to anticipated risk as an “excess return” since such return s compensate for risk-taking. With risk and imperfect loss offset, the tax on the risk premium falls in part in the same way as the normal return, in part on taxpayers to the extent the tax reduces the variance of return but increases variance in revenues, and to some extent disappears because the government is less risk-adverse than individuals. T he CBO allocates the tax based on results from general equilibrium models, modified for certain issues such as debt finance and rents. For further explanation, se e CBO, The Distribution of Household Income and Federal Taxes, 2008 and 2009 , http://cbo.gov/sites/default/files/cbofiles/attachments/4337306-11-HouseholdIncomeandFedT axes.pdf; Julie-Anne Cronin, Emily Y. Lin, Laura Power, and Michael Cooper , Distributing the Corporate Income Tax: Revised U.S. Treasury Methodology, Office of T ax Analysis T echnical Paper 5, May 2012. T his paper was subsequently published in the National Tax Journal, March 2013, vol. 66, no. 1, pp. 239262, https://www.ntanet.org/NT J/66/1/ntj-v66n01p239-62-distributing-corporate-income-tax.pdf; Jim Nunns, How the TPC Distributes the Corporate Income Tax, Urban-Brookings T ax Policy Center, http://www.taxpolicycenter.org/ UploadedPDF/412651-T ax-Model-Corporate-Tax-Incidence.pdf. 53 It is not clear which of Harberger’s papers is being referred to, but it is presumably the more recent one: Arnold C. Harberger, Corporate Tax Incidence: What is Known, Unknown, and Unknowable, University of California, 2006. T his paper was presented at a conference at Rice University in 2006, and subsequently published as in Fundamental T ax Reform: Issues, Choices, and Implications, ed. John W. Diamond and George R. Zodrow, Cambridge, MA, MIT Pr ess, 2008. 54 T he paper in question is not an official CBO paper but rather a working paper by William Randolph. William C. Randolph, International Burdens of the Corporate Tax, CBO, Working Paper no. 2006-09, August 2006. 55 Kevin A. Hassett and Aparna Mat hur, Taxes and Wages, American Enterprise Institute, Working Paper, April 2008. 56 Rachel Alison Felix, Passing the Burden: Corporate Tax Incidence in Open Economies, November 2006. T his paper was a dissertation essay, University of Michigan. 57 Mihir A. Desai, C. Fritz Foley, and James R. Hines Jr., Labor and Capital shares of the corporate Tax Burden: International Evidence. Prepared for the International Tax forum and Urban -Brookings T ax Policy Center conference on Who Pays the Corporate T ax in an Open Eco nomy, December 18, 2007. 58 Wiji Aralampalam, Michael P. Devereux, and Giorgia Maffini, The Direct Incidence of Corporate Income Tax on Wages, Oxford University Center for Business T axation, May, 2008. A revised version was subsequently released in March, 2011. T he paper was published in the European Economic Review, vol. 56 (2012), pp. 1038-1054. Congressional Research Service 19 Corporate Tax Reform: Issues for Congress These studies reflect differing fundamental approaches to studying corporate tax incidence. One approach uses a general equilibrium model that estimates incidence based on empirical estimates of various behavioral responses and other aspects (such as size). The burden that falls on labor versus capital depends on international capital flows and how well they can be used in different countries (which in turn depend on the technology of production and the preferences of consumers). The second approach is to directly estimate wages as a function of tax rates and other variables from a set of data (this approach is called a reduced form estimate). These direct estimates, in turn, fall into two types: (1) some studies are considering the effects of international capital flows and (2) others are examining the share of the tax on excess profits (or rents) that is born by labor by reducing the share of rents that is captured by labor in wage bargaining. Of the studies mentioned in the previous paragraph, two (Harberger and Randolph) are of the general equilibrium type; three (Hassett and Mathur, Felix, and Desai, Foley, and Hines) are reduced form empirical estimates that reflect capital flows; and two (Arulampalam, Devereux, and Maffini and Azémar and Hubbard) are estimating rent sharing through wage bargaining. A news report indicated three articles referenced by the Treasury press office in support of the burden falling on wages (although the Treasury Office of Tax Analysis currently assigns most of the burden to capital income): two studies already mentioned, Randolph, and Hassett and Mathur, and a study by Lui and Altshuler. 59 The last study does not clarify what behavioral response it is measuring, but because it is based on considering wage effects by industry it would be capturing wage bargaining effects. The Harberger and Randolph Studies The first two studies explicitly focus on the effects of an open economy. It is a standard finding that for a small open single-good economy with perfect capital mobility and perfect product substitution, the burden of any source based capital income tax falls on labor (whereas for residence based taxes, that is taxes that apply to domestic owners of capital regardless of where they are domiciled, the burden would fall on capital). The corporate tax had some aspects of a source based tax and some of a residence based tax. Both the Harberger and the Randolph studies are based on this simple model of perfect substitution, altered to account for the United States as a large county (which lowers the elasticities) and to account for multiple sectors. Randolph’s study does not so much predict the burden of the tax as explore incidence in certain types of models; he acknowledges that less capital mobility causes the burden to shift from labor to capital. Harberger’s model has four sectors, corporate and noncorporate tradable sectors and corporate and noncorporate nontradable sectors. He assumes that the corporate tradable sector is more capital intensive than the average industry, which leads to a burden of greater than 100% of the tax falling on capital. Despite the vision of the manufacturing sector as highly capital intensive, it actually is not: housing services, which are 100% capital, account for over a third of the capital stock in the country, and many other industries, such as utilities and agriculture are also more capital intensive than manufacturing. Using the same assumptions about mobility, but with a less capital intensive manufacturing sector, Randolph finds 70% of the corporate tax burden falls on labor. 59 Robert Farley, “Who Benefits from Corporate T ax Cut, T he Wire,” September 7, 2017, at http://www.factcheck.org/2017/09/benefits-corporate-tax-cut/. T he last study is Li Liu and Rosanne Altshuler, Measuring the Burden of a Corporate Tax Under Imperfect Competition , Oxford Working Paper no. 11/05, subsequently published in the National Tax Journal, vol. 66, no. 1 (March 2013), pp. 215-238. Congressional Research Service 20 Corporate Tax Reform: Issues for Congress To permit other than perfect substitutability, a much more complex computable general equilibrium model would be required, which neither Harberger nor Randolph has provided. Such a model has been developed by Gravelle and Smetters 60 who find, with reasonable elasticities, that capital still bears most of the burden, about 80%. A recent CBO working paper by Jennifer Gravelle provides an extensive review of the existing general equilibrium models and the factors that drive the results. 61 She finds that five factors tend to move the burden toward falling on capital: a smaller willingness of consumers to substitute between foreign and domestic products, a higher substitutability of labor and capital in the production process, a smaller willingness of investors to substitute investments in different countries, a less capital intensive corporate tradable sector, and a larger country. Her review of the evidence on these factors suggests that, based on these models, the majority of the tax (about 60%) is born by capital, with results differing from the Gravelle and Smetters findings due to a lower substitution elasticity between capital and labor in production. 62 She subsequently considers, however, other factors that could increase the burden on capital (and even benefit labor), including the use of debt (discussed below). Although the general equilibrium models can be very complex, they still abstract from some important features of the corporate tax. There are several other factors that would further push the corporate tax burden toward capital. First, if some share of profits is rent, it would be expected to fall on capital in the United States, because only a small share of the private sector (less than 7%) is unionized. 63 Second, the current corporate tax actually subsidizes debt finance at the firm level, and if debt is much more substitutable than equity, total capital would be less likely to be exported: indeed, raising the corporate tax rate could cause capital to flow in. A study by Grubert and Mutti found that in a general equilibrium model that included debt, such a capital inflow occurred when capital income taxes were raised, an outcome that would lead to labor benefitting from the corporate tax. 64 The burden would also be likely to fall on capital if elements of a residence tax were reimposed in the United States (there are some minor current elements because branch income abroad is subject to tax). The current international tax regime under GILTI allows a deduction for 10% of tangible income, largely exempting the income from tangible investments of foreign subsidiaries from tax. Eliminating that exemption and raising the GILTI rate to the full U.S. rate would lead to a worldwide, or residence-based tax (such a change could be accompanied by an elimination of the deduction for FDII, whose exemption for tangible investment discourages the investment tangible capital in the United States because an increase decreases the deduction). Finally, note that as long as countries tend to choose tax rates similar to each other, which appears to be the case, the world becomes like the original closed economy, a model stressed by 60 Jane G. Gravelle and Kent A. Smetters, “Does the Open Economy Assumption Really Mean T hat Labor Bears the Burden of a Capital Income T ax?” Advances in Economic Policy and Analysis, vol. 6, no. 1, 2006. 61 Jennifer Gravelle, Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis, CBO, Working Paper no. 2010-03, May 2010, http://www.cbo.gov/ftpdocs/115xx/doc11519/05-2010-Working_PaperCorp_T ax_Incidence-Review_of_Gen_Eq_Estimates.pdf. A version of this paper was published in the National Tax Journal, vol. 16, no. 1 (March 2013), pp. 185-215. 62 Note that a lower ability to substitute capital for labor in production, while increasing the burden on labor, reduces the capital inflow, leads to a smaller increase in output, and a higher revenue maximizing tax rate. 63 See Megan Dunn and James Walker, Union Membership in the United States, Bureau of Labor Statistics, September 2016, https://www.bls.gov/spotlight/2016/union-membership-in-the-united-states/pdf/union-membership-in-the-unitedstates.pdf. 64 Harry Grubert and John Mutti, “International Aspects of Corporate T ax Integration: T he Role of Debt and Equity Flows,” National Tax Journal, vol. 47, March, 1994, pp. 111-133. Congressional Research Service 21 Corporate Tax Reform: Issues for Congress Harberger, with the burden falling on capital. According to the 2007 Treasury study, the U.S. combined state and federal corporate statutory rate was 39%, the G-7 average was 36%, and the OECD average was 31%. In 2013, the rates had declined slightly, with rates of 29% in the OECD and 30% for the largest 15 countries (both excluding the United States). Effective tax rates, which should govern the movement of capital, are even closer together, and in some cases are lower for the United States than for other countries. More recent updates of tax rates indicated that U.S. rates were similar to the rest of the world. 65 Jennifer Gravelle used OECD tax rates to estimate the share of the U.S. tax falling on labor using a global approach and finds that over 90% falls on capital. 66 An argument is often made that the burden of any capital income tax tends to fall on labor because it reduces savings, an effect that would also occur in a closed economy. While one version of the model predicts that the entire burden of a capital income tax eventually falls on labor, this version requires some extreme assumptions about human behavior such as perfect information, an infinite planning horizon, perfect liquidity, and asexual reproduction. Models allowing for finite lives (such as the life-cycle models) find results that vary, but if the revenue loss is made up by higher taxes on labor, there is little or no effect. Some economists believe that these models are inappropriate, as they assume too much information and skill on the part of individuals; they suggest that individuals use rules of thumb, such as fixed savings rates or targets, instead. These rules of thumb suggest that a cut in capital income taxes either has no effect on saving or reduces savings. These economists also point out that most empirical evidence does not point to an increase in savings; historically, savings rates do not appear to respond to reduced tax rates. 67 The Hassett and Mathur Study Whereas the general equilibrium models do not provide much support for the corporate tax burden falling on labor, Hubbard also referred to an empirical study by Hassett and Mathur that uses the corporate tax rate to explain differences in manufacturing wages. 68 They find a statistically significant result that indicates a 1% increase in the corporate tax causes 65 See CRS Report R41743, International Corporate Tax Rate Comparisons and Policy Implications, by Jane G. Gravelle. 66 Jennifer Gravelle, Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis, CBO, Working Paper no. 2010-03, May 2010, http://www.cbo.gov/ftpdocs/115xx/doc11519/05-2010-Working_PaperCorp_T ax_Incidence-Review_of_Gen_Eq_Estimates.pdf. 67 T hese issues surrounding savings are discussed in greater detail in CRS Report R42111, Tax Rates and Economic Growth, by Jane G. Gravelle and Donald J. Marples; CRS Report RL32517, Distributional Effects of Taxes on Corporate Profits, Investment Income, and Estates, by Jane G. Gravelle and Sean Lowry (available upon request from the author); CRS Report RL33545, The Advisory Panel’s Tax Reform Proposals, by Jane G. Gravelle; and CRS Report RL33482, Saving Incentives: What May Work, What May Not, by T homas L. Hungerford, which is available upon request. T he recognition that replacement of capital income taxes by wage taxes in a life cycle model could have little effect on savings or contract them can be found in numerous simulation studies, for example, Alan Auerbach and Laurence Kotlikoff, Dynam ic Fiscal Policy (Cambridge, MA: Cambridge University Press, 1987). 68 T his study is one of a number of empirical studies that try to estimate incidence from a direct examination of wages (as opposed to embedding capital flow and other elasticities into a m odel). For other reviews of these studies see William M. Gentry, A Review of the Evidence on the Incidence of the Corporate Income Tax, U.S. Department of T reasury, Office of T ax Analysis, Working Paper no. 101, December 2007, http://www.treasury.gov/resource-center/ tax-policy/tax-analysis/Documents/ota101.pdf; Jennifer C. Gravelle, Corporate Tax Incidence: A Review of Empirical Estimates and Analysis, CBO, Working Paper no. 2011-01, June 2011, http://www.cbo.gov/ftpdocs/122xx/doc12239/ 06-14-2011-CorporateTaxIncidence.pdf; and Kimberly A. Clausing, In Search of Corporate T ax Incidence, September 2011, Presented at a Conference of the American T ax Policy Institute, http://americantaxpolicyinstitute.org/15papers/ Clausing%20AT PI.pdf. Congressional Research Service 22 Corporate Tax Reform: Issues for Congress manufacturing wages to fall by 0.8% to 1%. These results are impossible, however, to reconcile with the magnitudes in the economy. Through competition, wage changes in manufacturing should be reflected in wages throughout the economy, implying that a 1% rise in corporate revenues would cause a 0.8% to 1% fall in wage income. However, corporate taxes are only about 2.5% of GDP at best, whereas labor income is about two thirds. These results imply that a dollar increase in the corporate tax would decrease wages by $22 to $26, an effect that no model could ever come close to predicting. 69 The lack of theoretical reasonableness of the results may be explained by statistical issues. The Hassett and Mathur study used data from 72 developed and developing countries for the 1981 to 2003 period. 70 For their analysis, their dependent variable is the logarithm of the five-year average of the average manufacturing wage. They justify their use of the five-year average wage by (1) noting that due to capital adjustment costs, the economic effects of corporate tax rate changes show up over longer time periods, and (2) arguing that this may control for possible measurement error induced by the business cycle. 71 The wage rates for all countries were converted to U.S. dollars using annual exchange rates. Hassett and Mathur include the price level of consumption as an explanatory variable to capture cost of living differences across countries. The main explanatory variable of interest is the logarithm of the top corporate tax rate. Hassett and Mathur also use the average effective and marginal effective corporate tax rates (in logarithms) as explanatory variables in some specifications. The Hassett and Mathur basic estimation exercise was replicated: the results are reported in the first row of Table 6. 72 The coefficient estimate reported in the first column (-0.759) suggests that a 10% increase in the top corporate tax rate will lead to a 7.6% decrease in the average manufacturing wage rate. This estimate is statistically significant at the 5% level. 73 The results are not as strong (the estimates are closer to zero) when using alternative measures of the corporate tax rate (see the next two columns of Table 6). The exchange rate between two currencies reflects the relative supply and demand for those two currencies, and is affected by financial markets and government policies. Exchange rates may not be good indicators of the relative buying power of wage rates in two countries. Purchasing Power Parities (PPPs), however, are specifically designed to equalize the internal purchasing power of 69 T o convert an elasticity into an incidence measure, the coefficient should be multiplied by the ratio of labor income to the corporate tax. T wo other studies using cross-country data have examined the incidence of the tax on labor income. Passing the Burden: Corporate T ax Incidence in Open Economies, by Rachel Alison Felix, November 2006, finds smaller effects than Hassett and Mathur, but ones that are still too large to be predicted by a theoretical model. T his study has problems similar to those that are discussed subsequently and, in addition, do not control for country fixed effects. 70 Hassett and Mathur, Taxes and Wages. T he authors are grateful to Kevin Hassett and Aparna Mathur for providing their data. Several of the countries only have data for shorter periods. 71 T heir independent or explanatory variables take their value from the beginning of the five -year period over which wages are averaged. It should also be noted that Hassett and Mathur calculate the five-year average with nominal wages (that is, they are not corrected for inflation). 72 See Appendix B for a description of the estimation method. Visual inspection of the Hassett and Mathur data uncovered some errors with their five-year averages of wage rates—some averages were based on six years of data and others were based on less than five years of data. T he authors corrected the errors so that each five-year period for each country contains five years of data. Some of the averages are based on less than five years of data because of missing values in the wage series; most of the missing values are in the 2001 to 2005 period. 73 T he specific test of statistical significance of the coefficient estimates is the t -test. T his is a test of whether or not the estimate is equal to zero (the null hypothesis is the estimate is equal to zero). T he significance level indicates the risk of rejecting the null hypothesis when it is, in fact, true. A significance level of 5% indicates that the null hypothesis will be inadvertently rejected only 5% of the t ime. Significance levels commonly used in empirical social science work are the 1%, 5%, and 10% levels. Congressional Research Service 23 Corporate Tax Reform: Issues for Congress the currencies. Workers in Australia, for example, are concerned with what their wages will purchase in Australia, and not how many dollars their wages will buy. Using PPPs is a more appropriate way to convert national currencies to a common currency (U.S. dollars). The second row of Table 6 reports the coefficient estimates when the wage rates are converted to U.S. dollars using the consumption PPPs. Consumption PPPs are more appropriate for converting wages than using general PPPs (over GDP) because they omit national expenditures for government and investment goods. Again, nominal wages are the dependent variable. The coefficient estimates are closer to zero than the estimates reported in the first row, but the coefficient estimate reported in the first column (-0.728) is statistically significant at the 5% level. The estimates for the alternative measures of the corporate tax rate are not statistically significant at the conventional confidence levels. Table 6. Coefficient Estimates: Dependent Variable is the Logarithm of the Five-Year Average of Wage Rates How Wage Variable Converted to U.S. Dollars Corporate Tax Rate Variable Top Tax Rate Effective Average Effective Marginal Exchange Rate -0.759 a (0.297) -0.630 b (0.334) -0.384 b (0.226) Purchasing Power Parity Exchange Rate (PPP) -0.728 a (0.303) -0.528 (0.340) -0.334 (0.230) PPP—Constant Dollars -0.488 b (0.298) -0.294 (0.318) -0.218 (0.215) Observations with Five-Year Averages Based on Five Years of Data Exchange Rate 0.089 (0.353) -0.229 (0.363) -0.184 (0.240) Purchasing Power Parity Exchange Rate (PPP) -0.037 (0.354) -0.187 (0.373) -0.156 (0.246) PPP—Constant Dollars -0.064 (0.350) -0.230 (0.351) -0.180 (0.231) Source: CRS analysis. Notes: Standard errors in parenthesis. Fixed effects linear model. Other variables include time dummies, log personal tax rate, log real value-added, log consumer price variable (except for real PPP). a. Significant at 5% level. b. Significant at 10% level. The most appropriate measure of wages is the inflation-adjusted consumption PPP-adjusted wage rate. Wages in each country were converted to U.S. dollars using the consumption PPP and then converted to constant (inflation-adjusted) dollars using the CPI-U before calculating the five-year average. The final row of Table 6 displays the coefficient estimates for the model using this measure as the dependent variable. The estimates are closer to zero than in the other two cases. The coefficient estimate in the first column (-0.488) is statistically significant at the 10% level but not at the 5% level. The other two estimates in columns two and three are not statis tically significant at the conventional confidence levels. Although there is still some evidence of corporate tax rates having a negative influence on wage rates in manufacturing, the effect is smaller and less robust than reported in the Hassett and Mathur study. Hassett and Mathur averaged wages over five-year periods. They justify using five-year averages by arguing that it helps to control for possible measurement error induced by the business cycle. Congressional Research Service 24 Corporate Tax Reform: Issues for Congress But, because of missing values in the wage data, 66 observations have the average wage based on less than five years of data (60 observations use only two consecutive years of data for the calculation of the average, which would likely not affect any measurement error). The bottom panel of Table 6 reports the estimation results when these 66 observations are excluded from the analysis (leaving 153 observations). In all cases, the coefficient estimates for all measures of the corporate tax rate are not statistically significant. Averaging the wage data over five years and using the beginning of period value for the explanatory variables, however, eliminates much of the variation in wages and tax rates, thus throwing away much of the information needed to estimate the economic effects. The statistical analysis is repeated using annual data and including various lagged values of the corporate tax rate as explanatory variables. 74 The results are reported in Table 7. The first column of the table displays the coefficient estimates for the current value of the corporate tax rate (labeled t in the first column) and the values for the previous five years (t-1 to t-5), which allows for longer term effects of tax rates on wages. In each case, the coefficient estimates are negative but very close to zero; none are statistically significant at the conventional confidence levels. Furthermore, all the tax rate variables in column (1) are not jointly statistically significant. The next six columns report the results when the corporate tax rate values (current and lagged) are entered individually. In every case, the coefficient estimates are close to zero and are not statistically significant at conventional confidence levels. In using annual data, there is no evidence that changes in the top corporate tax rate affects wage rates in manufacturing. 75 Table 7. Coefficient Estimates: Dependent Variable is Annual Logarithm of Real PPP-Adjusted Wage Rates Tax Rate Lag (1) t -0.031 (0.208) t-1 -0.217 (0.188) t-2 -0.076 (0.166) t-3 -0.040 (0.159) t-4 -0.113 (0.156) t-5 -0.154 (0.155) F (joint) 0.49 Prob>F 0.819 (2) (3) (4) (5) (6) (7) 0.010 (0.140) -0.219 (0.143) -0.074 (0.144) 0.021 (0.145) -0.070 (0.146) -0.165 (0.147) Source: CRS analysis. 74 Including the lagged values of the corporate tax rate allows the tax rates for the previous five years to individually have an impact on wages. All tax rates are entered into the model in logarithms. 75 T he authors obtain the same estimation results when the exchange rate is used to convert wage rates to U.S. dollars— the method used by Hassett and Mathur. Congressional Research Service 25 Corporate Tax Reform: Issues for Congress Notes: Standard errors in parenthesis. Fixed effects linear model with AR(1) disturbance. Other variables include time dummies, log personal tax rate, log real value-added. ***Significant at 1% level; **significant at 5% level; *significant at 10% level. Hassett and Mathur subsequently produced a revision of their initial paper. 76 One of several generic problems with cross-country wage studies is that a proper specification should take into account not only the country tax rate but the rates of other countries. (Other generic problems include the direction of causation, for example, that countries with lower or slowly growing wages may choose to rely on corporate taxes as a revenue source, so that the wage changes may drive the corporate rate.)77 Hassett and Mathur address the first issue, in a limited fashion, by adding tax characteristics of neighboring or economically similar countries. This addition, in some cases, reduced the coefficient on taxes and made it statistically significant at a lower level. The study also included some local price indices, but this change did not fully address the issue of comparing wages using purchasing power and did not address other issues raised about the original Hassett and Mathur study. Their results continued to produce implausible estimates. In the case where average tax rates of countries with similar income levels was added, the percentage change in wages for a 1% change in corporate taxes is 0.5%. This level implies a decrease of $13 in wages for each dollar fall in corporate taxes. 78 Other Empirical Wage Studies Several other studies have examined the incidence of the tax on labor income. They are discussed in three different categories: studies that rely on cross-country data as in the case of Hassett and Mathur, studies that rely on cross-state data, and studies that examine not the general incidence of the tax, but the share affecting wages through bargaining over excess profits. The Arulampalam, et al. study cited by Mankiw was the first of these latter types of studies. Other Cross-Country Studies of General Burden Four studies in addition to the Hassett and Mathur study have relied on cross-country data. Felix, 79 in a study that controls for education, finds much smaller effects than Hassett and Mathur, but ones that are still too large to be predicted by a theoretical model (about $4 for each dollar of corporate tax revenue). This study has problems similar to those for Hassett and Mathur and, in addition, does not control for country fixed effects, therefore not controlling for unobserved country-specific factors. The sample is unusual as well, with 19 countries covered for varying years. Out of the total of 65 observations (countries and years), about a quarter of the sample is drawn from Italy and Mexico and seven of the 19 countries had only one or two years of data. Kevin A. Hassett and Aparna Mathur, “Spatial T ax Competition and Domestic Wages,” December, 2010, http://www.aei.org/docLib/SpatialT axCompetitionandDomesticWages.pdf. A version of this paper was published as “A Spatial Model of Corporate T ax Incidence,” Applied Economics, vol. 47, no. 3 (2015), pp. 1350-1365. 76 77 T hese generic problems are discussed by Jennifer C. Gravelle, Corporate Tax Incidence: A Review of Empirical Estimates and Analysis, CBO, Working Paper no. 2011-01, June 2011, http://www.cbo.gov/ftpdocs/122xx/doc12239/ 06-14-2011-CorporateTaxIncidence.pdf. 78 T hus authors indicate that the fall in wages is $4, a lower but still implausible number. However, they calculate this incidence with the ratio of wages to taxes in the manufacturing sector, which is much smaller. Effects of the corporate tax on wages are, however, economy wide effects that should lower wages in the other sectors, including noncorporate sectors. 79 Rachael Alison Felix, Passing the Burden: Corporate T ax Incidence in Open Economies, November 2006. T his paper was a dissertation essay at the University of Michigan. Congressional Research Service 26 Corporate Tax Reform: Issues for Congress Another study, by Desai, Foley and Hines 80 uses observations on foreign owned affiliates of U.S. firms across countries and in different time periods. This study uses data on multinational subsidiaries of U.S. firms to estimate the allocation of the tax burden between labor and capital using a seeming unrelated regression for capital income (which they measure by the interest rate) and labor income. In their model, labor and capital burdens are restricted to the total of taxes, and they impose a cross-equation restriction on the estimated burdens. They find the share of the burden on labor income to fall between about 45% and 75% of the total, a number that is not inconsistent with theoretical expectations. This approach, however, has the fundamental theoretical problem that wages at an individual firm should not reflect tax burdens at an individual firm. In deriving a model that assumes it does, they assume that the price level of their goods is fixed and base their results only on their sample of firms (which is comprised solely of multinational corporate sector firms). This approach creates both econometric problems in their analysis and also means that their results cannot be construed as reflecting actual burdens in any of their economies, as discussed in more detail in Appendix C. They also represented equity returns through the interest rate, under the assumptions that investors equate (net of risk) debt and equity returns. If these assets are generally substitutable, the increase in corporate tax should cause portfolios to shift toward debt and drive the interest rate up (while driving the equity return down). Moreover, the tax burdens on debt and equity differ at the individual level and those differences depend, among other things, on any special tax rates for dividends and capital gains, the deferral advantage of capital gains, and the inflation rate. Aside from these theoretical problems, an important issue with their study is that it appears that their results are forced by the cross equation restriction. William Randolph, a discussant at a 2008 conference, found that if the restriction is eliminated there are no statistically significant results from their study. 81 In an example he presented, the estimates of the wage effect was 48% of the burden, with a standard error of 18% in the original study; in a regression without the restriction the share was 19% with a standard error of 100%.82 Randolph considered a number of other specifications, including excluding the largest countries, but found no statistically significant results. He also suggested that only manufacturing subsidiaries be considered since other subsidiaries may be involved in tax sheltering operations. In the case where he considered only manufacturing subsidiaries, the sign reversed (indicating labor benefitted from the tax) but it was not statistically significant. Across-country study by Clausing used a data set covering the OECD countries. 83 Her study examined a number of different specifications, econometric approaches, and alternative data measurements. Two aspects that differed from the Hassett and Mathur study were comparing wages using purchasing power parity and excluding value-added variables, which Clausing suggests is capturing the effect of corporate taxes (whose burden on labor operates by reducing labor productivity). She expects this latter change would make results for the corporate tax variable larger. Overall, however, while trying many specifications and approaches, she characterizes the results as indicating no robust evidence that corporate tax burdens have large Mihir A. Desai, C. Fritz Foley, and James R. Hines Jr., “Labor and Capital Shares of the Corporate T ax Burden: International Evidence,” prepared for the International T ax Policy Forum and Urban -Brookings T ax Policy Center conference on Who Pays the Corporate T ax in an Open Economy?, December 18, 2007. 81 His remarks were made at a seminar at the American Enterprise Institute, March 17, 2008. 80 82 T he coefficient must be close to twice the standard error to be statistically significant; thus the result from the unrestricted regression showed no relationship between taxes and wages. 83 Kimberly A. Clausing, “In Search of Corporate T ax Incidence,” November 2011. Congressional Research Service 27 Corporate Tax Reform: Issues for Congress depressing effects of wages. She notes, however, that this outcome does not necessarily mean there is no incidence on labor, but that these effects cannot be detected with aggregate crosscountry data, a point also made by Jennifer Gravelle in her review of empirical studies. 84 The most recent study, by Ebrayet and Geys, estimates a model that allows for countries to compensate for high labor costs by reducing the corporate tax. Their estimates, using 24 OECD countries, indicate that a 1% increase in the corporate tax rate reduces the average wage by from $0.51 to $0.89, implying a $6 to $11 increase in wages for a dollar increase in the corporate tax, an implausible result. 85 Cross-State Regressions Three studies estimate tax incidence based on cross-state comparisons, as if each state were a separate country. Felix examines wages by residents of states depending, among other factors, on the state corporate tax rates. 86 She finds a smaller effect than the Hassett and Mathur or her own cross-country study, although the results remain implausible, suggesting that a $1 dollar increase in taxes reduces wages by between $1.40 and $3.60. 87 Other problems with her data set is that it is not a panel, so there is no individual specific control, and the data set also does not allow the identification of place of work, but rather place of residence. Felix and Hines use a similar cross-state data set. 88 Although the stated objective of this study is to examine rent sharing by considering union and nonunion differentials, the paper also contains direct estimates of the effects on tax rates on wages. The relationships, however, are positive, not negative. Although the authors conclude that higher corporate tax rates reduce union wage differentials (a point associated with bargaining over surplus discussed in the next section), this differential arises in their empirical estimates because union wages rise less with corporate taxes than do nonunion wages. Thus these results directly contradict the results in the previous Felix study. Carroll also examines individual workers across the states using a different data set. He estimates the effects of the statutory rate (combined federal and state) and also an average state tax rate. 89 The first is only marginally statistically significant (and he does not highlight that result), but the second is highly significant. However, the average tax rate is measured not as taxes divided by profits but as taxes divided by personal income. Since personal income is strongly correlated with wages, this measure of tax would likely produce a powerful negative relationship without any direct relationship with taxes. As with other studies, the incidence estimated in this study is very large relative to the expected shares (he c [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/crs%3ARL34229. Public record. Not legal advice.