On October 16, 2017, the White House released the Council of Economic Advisers’ Report, entitled Corporate Tax Reform and Wages: Theory and Evidence.  The Report comes in the wake of the current administration’s push for major tax reform.  With $299 billion in corporate profits abroad in 2016, the focus of the Report is to make the U.S. corporate tax rate more competitive in a global market.  The ultimate goal is for the benefits of the competitive U.S. corporate tax rate to trickle down to an increase in wages.  The Report reaches the conclusion that decreasing the U.S. corporate tax rate from the current thirty five percent to twenty percent will increase the average household income by $4,000 up to $9,000 annually.

Theory

The Report is rooted in the economic theory that there is a correlation between corporate tax rates and labor wages.  The Report states that U.S. companies move capital abroad to take advantage of lower capital tax rates in other countries.  It offers data showing that U.S. corporate profits have soared while wage growth has stagnated.  Over the past eight years, U.S. corporate profits increased at an average rate of eleven percent, but the average household income only increased at a rate of 1.1 percent.

The Report states that lowering the U.S. corporate tax rate to a more global competitive rate would not only bring profits back to the U.S., but also create an incentive for companies to invest the extra capital domestically.  It cites to research suggesting that increased domestic capital investments increases the demand for labor.  An increased demand for labor would theoretically create jobs and raise the price for labor, or workers’ wages.  Under this theoretical basis, the Report uses empirical data gathered from various sources to calculate an estimated dollar amount of the average wage benefits to the proposed lower corporate tax.

Empirical Evidence

The Report relies on different sources that use economic models to predict how a country’s corporate tax rate affects labor.  First, the Report cites to different sources that each offer a percentage of how much workers’ wages bear the burden of corporate tax in order to support the theory that wages bear most of the burden of corporate tax.  The percentages offered in the Report range from twenty-one to ninety-one percent, depending on the specifications used in the economic model.  This means that there are sources cited in the Report that calculated that workers’ wages bear the burden of only twenty-one percent of corporate tax, while other sources cited calculated that workers’ wages bear the burden of ninety-one percent of corporate tax.  The Report concludes that the disparity among the percentages depends on how much the economic model accounted for the flow of corporate capital to other countries, expressing the notion that workers’ wages bear more corporate tax burden as more corporate capital moves abroad.

Next, the Report cites to sources that used economic models to measure the direct relationship between corporate tax and workers’ wages to determine the elasticity of average wages, which is how much wages change when the corporate tax rate changes.  Each economic model cited in the Report offers a different elasticity, meaning that each economic model produced a different result as to how much a one percent change in the corporate tax rate affects workers’ wages.  This is because each model used slightly different variables.  The Report uses results from these different economic models to conclude that for every one percent increase in U.S. corporate tax, workers’ wages decrease by about 0.3 percent.  Using these figures, the Report concludes that these various economic models suggest that decreasing the current corporate tax rate by fifteen percent will raise the average household income annually by, conservatively, $4,000, and up to $9,000, using the higher range of the figures.

Lastly, the Report states that data from the Bureau of Economic Analysis shows that increasing the U.S. corporate tax rate by one percent results in 2.25 percent higher corporate profit shifting to lower tax jurisdictions.  The Report suggests that reducing the U.S. corporate tax rate by fifteen percent would reduce corporate profit shifting to lower tax jurisdictions and result in $140 billion of repatriated profit, based on the figures from 2016.

Review of Sources Cited

A review of the sources cited to in the Report highlight that the disagreement among economic theorists depends on the variables used in the economic model.  First, an economic model can be based on either a closed or open economy.  In a closed economy model, the supply of capital and labor are restricted to that country’s economy.  A closed economy model results in the owners of the capital bearing the burden of the corporate tax.  See Harberger, A.C., The Incidence of the Corporate Income Tax, Journal of Political Economy (1962).  The closed economy model is found more often in older economic literature, as the modern U.S. economy is more global.  In an open economy model, the capital is mobile, meaning that the supply of capital can move to different countries, but the labor remains immobile.  The open economy model shifts the corporate tax burden onto workers’ wages.  Although the Report ultimately uses figures from open economy models to reach its conclusion, this consistency among economic models does not necessarily decrease the variability in results.

Even among economic models that use an open economy, there is drastic variability in results.  Sophisticated economic models based on an open economy can take many forms, such as analyzing data across countries or restricting the model to data from only one country.  For example, the Report used a combination of results from economic models that analyzed data across countries and from economic models that analyzed data across states within the U.S. to calculate the figure for elasticity of wages.

Each open economy model can also account for a different rate of openness, or capital mobility.  The economic models that found that workers’ wages bear a lower percentage of the burden of corporate tax used moderate estimates of capital flow overseas.  On the other hand, economic models that found that workers’ wages bear a high percentage of the burden of corporate tax used figures to account for a free flow of capital abroad.  The differences in percentages cited in the Report show the drastic effect on results when an economic model adjusts figures for just one variable: openness.

Within these sophisticated economic models, there are assumptions and variables that are manipulated.  For example, two sources cited in the Report note the differences in outcomes when an open economic model does not assume that domestic and foreign products are perfect substitutes.  See Felix, R.A. Passing the Burden: Corporate Tax Incidence in Open Economies, LIS Working Paper Series (2007; see also Gravelle, Jane and Smetters, Kent, Does the Open Economy Assumption Really Mean that Labor Bears the Burden of Capital Income Tax?, B.E. Journal of Economic Analysis & Policy, (2006).  This variability is also seen in the conclusions drawn in the Report, as it notes that the estimated $4,000 annual increase to the average household income was calculated based on economic models that used countries and time periods that have less foreign corporate profit activity than the U.S. and less corporate profits held abroad.

Conclusion

Overall, the Report offers a conclusion that is supported by modern economic theorists and empirical data; a sophisticated economic model using an open economy can show that workers’ wages bear most of the burden of corporate tax, and a decrease in corporate tax may increase workers’ wages.  Importantly, the Report’s estimated effects of lowering the corporate tax rate in the U.S. suffer the same uncertainty as the results from any sophisticated economic model.  Adjustments to even one variable can create significantly different results.  Although sophisticated economic models offer valuable insight, it is crucial to investigate the information used in order to gain a clear picture of the basis of economic predictions, which in turn become the basis of major tax reform.

[View source.]