Who Ultimately Pays the Corporate Income Tax?

By UWE E. REINHARDT | JULY 23, 2010

I ended last week’s post by asking whether anyone knows which human beings ultimately pay the corporate income tax.

An intuitively appealing answer is that the tax is levied on profits, which are a return on capital invested in a corporation. Therefore, those who made that investment — the shareholders — absorb the tax fully in the form of a lower after-tax return on their investments.

That impression would be reinforced by the short-run, partial-equilibrium model of the individual company that we sometimes trot out in freshman economics courses.

In the partial-equilibrium model, the company’s capital stock is assumed to be fixed in the short run. Imposing or raising a tax on the profits will not change the company’s decisions on prices and production, because to maximize after-tax profits the company would take the same steps as to maximize pretax profits.

But economics professors quickly add that all bets are off in the longer run, when the company’s capital stock relative to the input of labor can change and when the owners of investable funds can decide whether to invest their money at home or abroad or in enterprises not subject to corporate taxation.

General-equilibrium models accommodating this wider view of the economy and the longer run go much beyond the compass of a freshman course and show that who actually pays the corporate income tax — the owners of capital or labor — is driven by a number of factors in complicated ways that elude simple intuition.

A fine review of these extended models can be found in Jennifer Gravelle’s recent paper, “Corporate Tax Incidence: Review of General Equilibrium Estimates and Analysis.” A broader review of the economic literature on all facets of the corporate income tax, not just its incidence, can be found in a paper by Jane G. Gravelle and Thomas L. Hungerford, “Corporate Tax Reform: Issues for Congress.” Be warned: while both papers avoid formal mathematical modeling, they might be a tough slog for anyone who did not major in economics in college.

The models in question typically divide a country’s economy into a corporate sector (the “taxed sector”) in which businesses are treated and taxed as if they were individuals, a concept known as legal persons, and another “non-taxed sector” in which business entities are not taxed as legal persons. Furthermore, the models can be for either a “closed economy” that does not trade goods or services and investable funds with the rest of the world or an “open economy” that engages in trade and financial capital flows with other countries.

Looking at the open-economy model, exactly how corporations shift the corporate tax either to labor or to the investors in the company, or to both in some proportion, depends upon the interplay of a number of factors, the most important of which are:

1. the relative ease with which investable funds can be shifted to other countries and how responsive such capital flows are to changes in the after-tax rate of return to capital in the taxing country;

2. how easy it is in the taxing country to substitute imported goods and services for all domestically produced goods and services;

3. how easy it is in the taxing country’s taxed and untaxed sectors to substitute labor for capital, and vice versa, in the domestic production of goods and services;

4. the relative capital intensity of production in the taxed and untaxed sectors of the taxing economy;

5. the size of that economy relative to the rest of the world’s economy. It matters, for example, whether the country is small, like Ireland, or large, like the United States.

The earliest formal general equilibrium model, published in 1962 by a University of Chicago economist, Arnold C. Harberger, in the Journal of Political Economy, assumed a closed economy. In that model, the burden of the corporate income tax ultimately fell entirely on the owners of capital.

When the model was modified as an open economy in which capital in the taxed country can escape by flowing abroad to untaxed or lower-taxed countries, some or all of the burden of the corporate income tax shifted to labor. Under the assumption of perfect international capital mobility and perfect substitutability of imported goods and services for all domestically produced goods and services, labor would then bear the entire corporate income tax, because labor is the only immobile factor than cannot escape the tax.

Other modeling efforts since that time, or econometric estimates inspired by these models, have ranged between these extreme incidence models.

Economists are divided on the issue. Some (including Gregory Mankiw) are persuaded that the corporate income tax ultimately falls mainly on labor, rather than on the presumably wealthier owners of capital. One can actually make a case for cutting the tax in the name of a more progressive income-tax structure, which should appeal to voters and politicians left of center.

Other economists, including the authors of the surveys cited above (Jane Gravelle, Jennifer Gravelle and Thomas Hungerford), are persuaded by the available empirical evidence on the five factors I note that the burden of the corporate tax ultimately rests mainly on the owners of capital. That also appears to be the operative assumption of the Congressional Budget Office, the Treasury and other agencies when they analyzethe distributional impact of various forms of taxation.

So, given that even economists cannot agree on who actually bears the burden of the corporate income tax, why not abolish the tax altogether and instead tax human beings directly? The arguments against such a move are twofold.

First, even bringing in only 12 percent or so of total federal taxes, the corporate income tax represents the third-largest source of federal revenue and could not easily be replaced with an alternative source, especially in these times of fiscal pressures.

Second, if the profits of corporations were not taxed, the corporate form of enterprise would become one more major tax shelter through which wealthy people could shield their income from taxation. That probably is the main reason why abolishing the corporate tax has never had any political traction, in the United States or abroad.