Research shows that higher corporate income taxes increase income inequality

Yesterday, I wrote about some of the research on the effects of corporate taxes on entrepreneurship. But the positive observation that higher rates of corporate taxation lead to lower rates of economic growth, for example, does not tell us that we should not raise corporate income taxes. The empirical research only tells us what will happen if we do do that.

Some, after all, would trade a smaller national or state income for one which was divided more ‘fairly.’ So, the question of whether or not we ought to raise corporate income taxes has both positive and normative elements: what will happen and what we ought to do given that.

But we aren’t quite done with the empirical content just yet. Not only is there research showing the effects of corporate income taxes on overall economic growth, among other things, but there is also research on the impact of corporate income taxes on the distribution of income.

In a recent paper at the National Bureau of Economic Research, economist James R. Hines Jr. looks at the relationship between corporate taxation and the distribution of income. High‐​income individuals tend to own corporate shares, so imposing greater tax burdens on corporations might seem like a way of increasing taxes on wealthy owners of corporations. But:

As is now well understood, however, this possibility depends critically on certain general equilibrium aspects of the incidence of the corporate tax. While it is perhaps intuitive that the burden of corporate taxation would fall on capital owners, there are realistic settings in which greater corporate taxation depresses business demand for labor and thereby reduces market wages; and these effects can be so strong that labor bears all, or potentially even more than all, of the corporate tax burden.

I have written before about this question of who actually bears the burden of a tax, its incidence. As I noted then:

The Minnesota Department of Revenue estimates tax incidence for our state. In its 2019 Minnesota Tax Incidence Study, they calculate the “incremental incidence of a change in the corporate tax”. They find that 46% of the burden of this increase falls on Minnesota’s consumers in the form of higher prices and 27% falls on our state’s workers in the form of lower wages and employment opportunities. None of the burden falls on capital in the form of lower dividends.

Hines explains:

This paper considers the effect of corporate taxation on the distribution of after-tax
income, which requires a somewhat different perspective than the usual tax incidence
calculation. Tax incidence evaluates the extent to which differently situated groups, typically defined on a pre-tax-reform basis, bear the burdens of tax changes. To the extent that taxation also affects the riskiness of economic activity, it will change patterns of realized returns, thereby changing the resulting distribution of income. In order to understand the effect of taxation on the distribution of income, it is therefore necessary to supplement standard tax incidence analysis with consideration of the effect of taxation on income dispersion.

One of the important forces determining the incidence of the corporate tax is the effect of the tax in encouraging noncorporate business activity. Higher corporate taxes discourage corporate activity and therefore indirectly stimulate greater activity by unincorporated businesses. This reallocation can—if the noncorporate sector is particularly capital-intensive—impose considerable burdens on labor. Furthermore, rising levels of noncorporate business activity have the potential to increase levels of idiosyncratic risk in the economy, thereby leading to greater disparities in economic outcomes.

There is growing evidence that, from the standpoint of individual investors, noncorporate business investments are very risky and that as a result, individual incomes at the top of the distribution include sizeable components that represent returns to successful noncorporate businesses. The riskiness of noncorporate business investment reflects both the characteristics of the business activities that tend to be undertaken by unincorporated firms and the nature of their ownership. For various reasons, investors in unincorporated business ventures generally incur much greater idiosyncratic risk than do investors in publicly traded corporations. 

“The consequences of the risky profile of noncorporate investment are predictable,” Hines finds:

“…some noncorporate business owners are very successful, whereas others lose significant portions of their investments. Investors in unincorporated businesses can face return distributions similar to those available by playing lotteries; and with more lotteries, the economy’s income distribution widens.”

Hines concludes:

“Higher levels of corporate taxation change the composition of economic activity both by encouraging entrepreneurs to establish their firms as unincorporated businesses, and – more importantly – by reducing the size and growth of corporations, thereby causing noncorporate businesses to expand. This reallocation of economic activity represents substitution away from relatively safer economic forms and styles of business organization into those that offer high returns to some and low returns to others. As a consequence, there will be greater numbers of entrepreneurs who are highly successful and join the ranks of the rich, just as there will be greater numbers of unsuccessful business people. The result is to make the distribution of income less equal – and evidence from the United States for 2014-2017 suggests that this process may reverse half or more of the distributional effect of the corporate tax that arises from reducing average capital returns.”

This finding is difficult for those who would seek to use higher corporate income taxes to target the rich and equalize the distribution of income. As a normative point, we might choose to trade more growth for more ‘equity’, however defined, but this research suggests that such a trade off doesn’t exist: that, by hiking corporate income taxes we are not only sacrificing growth but ‘equity’ as well. What, then, is the upside?

John Phelan is an economist at the Center of the American Experiment.