Two of the three principal candidates for governor want to eliminate Minnesota’s corporate income tax. Tom Emmer would ax it as soon as possible, while Tom Horner wants it to end eventually, just not right now. Is this a good idea? What are the economic ramifications of a corporate income tax imposed at the state level?
The questions have several aspects. First, what are the effects of a state-level corporate income tax on economic efficiency and fairness in the abstract world where many economists operate? Secondly, what are its effects on real-life Minnesotans? And thirdly, is there a politically feasible way to eliminate the tax while finding some alternate source for the revenue it currently produces that is less distorting than the status quo?
Start with the economic efficiency of corporate income taxes. All taxes create incentives, some desired and some perverse. The most direct effects motivate behaviors that minimize taxes paid: Tax labor, and you create an incentive to work less; tax capital, and you motivate reduced saving; tax real estate, and it becomes a less attractive asset for people to hold.
Specifics also are important. For example, since corporate income taxes must be paid on profits before distribution to stockholders but not on interest payments sent to lenders, there is a tax-driven incentive for corporations to raise more money from bonds and less from stocks than is economically optimal.
Without going into more detail, there is considerable evidence that corporate income taxes as imposed at the federal and state levels in our country are not very good in terms of economic efficiency. They are costly to administer, considering both the businesses taxed and government itself, and they motivate wasteful resource use, all compared to the revenue they produce.
Then there are fairness considerations. Democrats often argue that corporate income taxes are fairer since they hit rich businesses, not working households. Republicans argue that these taxes are passed on to consumers in the form of higher product prices and that they slow business growth and destroy jobs. Neither view is fully correct.
Ultimately, taxes are borne by people, not corporations. The Democratic assumption that taxes on corporate profits hit only wealthy stockholders or top executives is largely incorrect. They can, as Republicans often argue, be passed along in the form of higher-priced products. But they also can cause lower wages and salaries for employees. And some portion may result in lower dividends or share-price appreciation for stockholders, which are as likely to be pension plans or mutual funds as wealthy plutocrats.
Exactly how the burden of the corporate income tax is distributed depends on technical factors such as the degree of competitiveness in that specific business sector and the elasticity of supply or demand for what the company buys or products it sells. Exactly whose income gets hit by a corporate income tax thus is highly variable from company to company.
Overall, Republicans are right that the largest fraction gets incorporated in the cost of goods sold, but significant exceptions exist. And to the extent the cost is borne by consumers, as with a sales tax or value-added tax, the smaller the tax’s negative effects on business growth and employment.
So on a general level, corporate income taxes engender some economic inefficiency and have variable and unclear effects on fairness. But for any given level of government services, money has to be raised somehow. If we cut or eliminate the corporate income tax, we need to raise some other tax or cut spending. There has been much fine rhetoric over the years about the latter, but little of it has occurred and some of the loudest proponents of cutting government are most resistant to any goring of their own oxen.
In any case, federal corporate income tax revenue relative to GDP has fallen by half, from about 4.5 percent in the Truman-Eisenhower years to less than 2 percent since 1980. At 0.97 percent of GDP in 2009, it was at the lowest level in 70 years. (Personal income taxes came to 6.4 percent of GDP in 2009, the lowest level since 1951, making one wonder where all the public hoopla about ever-growing tax levels comes from.)
There are additional practical considerations at the state level. First, states compete for corporate headquarters and tax levels are a consideration in where corporations choose to do business. But such considerations are far from overwhelming. When Boeing moved its headquarters from Seattle, it went to Chicago — not Little Rock or Sioux Falls.
A second consideration is that businesses do use expensive state services. Local governments can tax the land and businesses owned by incorporated entities to defray services including police and fire protection. But there is no direct way for a state to recoup some costs of administering the court system or post-secondary education system — both often used by corporations — without some tax on corporations, whether in the form of a corporate income tax or a value-added tax.
Corporate income taxes at the state level have many flaws. But don’t expect their abolition to spawn any economic miracles. And the bills have to be paid somehow.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.