Halfpoint
In the worlds of economic theory and conservative political orthodoxy, corporate tax cuts, such as the 2017 tax reform in the United States, should create benefits beyond businesses. As the thinking goes, middle class workers will see their compensation increase as employers invest tax savings to drive growth.
What actually results, however, is something of a surprise, according to a new study. Corporate tax cuts end up widening the income gap between those at the top of the pay scale and those at the bottom, and they don’t help workers earning less than $200,000 a year.
“We find that corporate tax cuts lead to greater income inequality,” says Ethan Rouen, an assistant professor at Harvard Business School and a co-author on the research. “They lead to greater investment, but our evidence suggests that investment is not going to workers. If it’s not going to the workers, then they’re more likely to be investing in capital. So, it would increase returns, but those returns are going to the capital owners.”
Compensation and income inequality are very relevant to managers
In the paper Corporate Tax Cuts Increase Income Inequality, Rouen and his collaborators, Duke University professors Suresh Nallareddy and Juan Carlos Suárez Serrato, analyze data created by tax filings to compare effects on workers at varying compensation levels in different US states with and without tax cuts.
The result: Tax cuts significantly increase income inequality and are responsible, on average, for more than 10 percent of the meteoric growth in inequality in the last 20 years.
Wages remain static despite tax cuts
Wage data gleaned from their research shows marked differences for those making less than $200,000 and those earning more. For those falling below the threshold, the tax cuts have no impact on their income.
“The proponents of corporate tax cuts have argued that it will increase wages for workers, but a lot of things have to go right for that to happen,” Rouen says.
Companies need to increase their investments; those investments need to lead to greater worker productivity; and then workers need to capture those productivity gains through higher wages.
“What we find is that’s not the case,” Rouen says. “We have seen corporate profits rise and unemployment fall to historic lows, but wages have been stagnant. So far, there is no evidence that the tax cuts are changing this pattern.”
For those earning more than $200,000 a year, their income classified as salary decreased while their capital income–which is what the corporate tax cut is applied to–increased. The capital income increase was more than twice the size of the salary income decrease. It suggests the wealthy shifted how they categorize their income to take advantage of the tax cuts, widening the income gap in the process.
The paper uses state rather than federal data because corporate tax cuts happen much more frequently at the state level, and because the Tax Cut and Jobs Act of 2017 hadn’t occurred when Rouen began his research. That being said, the same principles may apply.
“Our evidence shows that the increase in inequality from a tax cut happens in part because the wealthy are shifting their income to take advantage of the change in rates,” Rouen says. “On average, that [rate] change is 0.5 percent. The federal tax cut reduced rates by 14 percent, so the income-shifting motivation is likely to be much stronger.”
Prior research largely focused on how personal taxes impact income inequity, and Rouen wanted to take a different approach by studying their corporate counterparts.
“Income inequality is a phenomenon that’s been studied for centuries,” Rouen says. “You can probably root it back to the French Revolution, if not before that. It’s received a lot of attention in the last two decades in part because we’ve seen a significant increase in income inequality in many developed nations.”
What’s driving income inequality?
This income inequality is happening for any number of reasons, he adds. One is mechanical. If corporate taxes are lowered, corporate profits will be greater. Since shares in corporations are held disproportionately by the wealthy, those investors will have more money in their pockets. Other factors that contribute to income disparity are more based in societal issues or on how companies go about their business. For example, large companies may pay more for a similar job than a smaller firm; lower relative salaries can result from racial and gender discrimination; and pay increases for CEOs has far outpaced gains for the regular worker.
Added to that is what the Organization for Economic Co-operation and Development calls “the race to the bottom”—countries frequently lowering their corporate tax rates to compete with other countries to attract new business.
“The logic is that we’ll lower our corporate tax rates, which will attract companies to invest in our countries, which will mean more employment, which will mean everybody benefits. That argument is one that has been made over and over again, but has not been proven,” Rouen says. “And our results tend to suggest that’s not the case.”
Our evidence shows that the increase in inequality from a tax cut happens in part because the wealthy are shifting their income to take advantage of the change in rates
Instead, such tax advantages in one area attract “ghost companies” moving patents and valuable intangible assets to low-tax jurisdictions. Nobody benefits except capital owners because the companies are using it as a tax strategy, not as a springboard for building plants and hiring droves of workers.
Rouen emphasizes he’s trying to inform the debate rather than make a normative statement about whether income inequality is bad or good or how tax cuts should be structured.
“Compensation and income inequality are very relevant to managers,” Rouen says. “This is something that they’re now having to deal with in terms of SEC disclosures and having to disclose CEO pay ratio. Active managers are often the face of income inequality, in that these are the people who set the pay for everyone else and also are the highest paid employees in their organizations.”
Related Reading:
If the CEO’s High Salary Isn't Justified to Employees, Firm Performance May Suffer
Research Paper: Rethinking Measurement of Pay Disparity and Its Relation to Firm Performance
Studying How Income Inequality Shapes Behavior
What do you think of this research?
Should corporate tax cuts benefit workers as well?