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Corporate Taxes Suffocate Growth

July 9, 2008

Tags Free MarketsTaxes and SpendingInterventionism

The cover story of the June 17, 2008 issue of the Wall Street Journal is, "Obama Plans Spending Boost, Possible Cut in Business Tax." The story indicates that presidential hopeful Barack Obama would consider lowering the corporate tax rate if tax breaks and loopholes were eliminated. It reads,

He stressed the idea was not a broad move toward Sen. McCain's broader tax-cutting philosophy. While Sen. McCain has argued that tax cuts — particularly on business — spur growth, Sen. Obama dismissed that as flawed economics. "I've seen no evidence that … would actually boost the economic growth and productivity."[1]

No evidence? Really? Maybe I can help.

The historical and current belief is that taxes in America are low, compared to the world in general. America is the model of free markets, low regulation, and economic freedom. Right? This is simply not the case. The United States has high taxes in general and higher corporate taxes in particular.

In the 2008 Index of Economic Freedom, assembled by the Heritage Foundation, personal income taxes and corporate tax rates are compared across the globe — along with many other economic measures. In regard to personal income taxes, the United States ranks 87th out of 156 nations. And in corporate rates, it ranks 125th out of 156. In other words, 86 nations have lower tax rates on personal income than the United States, and 124 nations have lower corporate tax rates.[2]

Venezuela, India, Finland, Haiti, Burma, Canada, Mexico, Egypt, Cambodia, and Russia are among the many nations whose top personal income tax rate is lower than the rate in America.

The only nations who have a higher corporate tax rate than America are Suriname, Pakistan, Togo, Benin, Republic of Congo, Cameroon, Chad, Libya, and Vietnam. No information was available for The Democratic Republic of Congo, Iraq, North Korea, Montenegro, Serbia, or Sudan. I cannot imagine why.

Lower corporate taxes are associated with economic growth. This can be shown a priori and empirically.

A Priori

Corporate taxes reduce the profits of business owners. This is true because net income is reduced by the tax rate. For example, Firm X, with a $100 investment, earning a 7% return has an income — before taxes — of $7. With a 10% corporate tax rate, net income — after taxes — is $6.30. Firm X now has earned a 6.3% return. In contrast, a corporate tax rate of 40% reduces net income after taxes by $2.80 to $4.20, or a 4.2% after-tax return. This rise in taxes, on the margin, reduces the profit-seeking incentive to take business risks. Why risk starting a biotech company when inflation-protected T-bill's will give you the same return? Entrepreneurs and venture capitalists less willing to take risk means less innovation and fewer innovative ideas being economically viable. This results in less economic growth. Conversely, higher returns on invested capital encourage investment and savings. All of this leads to more capital savings, more innovation, better technology, and higher wages.

Further, the above example of Firm X is true if the firm does not have the pricing ability to transfer the tax to its customers. If the ability does exist, an increase in the corporate tax rate is really a tax on customers of the firm. In this case, consumers now have less to spend and save and the end result is the same.

Finally, a firm unable to pass on a tax increase or bear the reduced profit will either attempt to cut costs by reducing wages (among other costs) or be forced to go out of business.

The main point is this: by definition, corporations do not pay taxes — people pay taxes. A corporate tax is either a tax on shareholders of the firm, customers of the firm, or employees of the firm. Less corporate tax means more innovation, capital savings, and spending by these groups — also known as economic growth.

Empirically

After theory and logic tell us what is true, empiricism can confirm our result.

Thankfully, Professors Young Lee (Hanyang University) and Rodger Gordon (UC — San Diego) have done the work for us. In a 2005 journal article they concluded,

This paper finds that the corporate tax rate is significantly negatively correlated with economic growth in a cross-section data set of 70 countries during 1970–1997, controlling for many other determinants/covariates of economic growth.

More specifically, they continue, "The estimates suggest that cutting the corporate tax rate by 10 percentage points can increase the annual growth rate by around 1.1%."[3]

Using these figures, Andrew Chamberlain of the Tax Foundation opines,

by cutting the U.S.'s combined federal and average state corporate tax rate from roughly 40 percent to 30 percent we could boost U.S. economic growth by around 1.1 percent per year — enough to double our nation's wealth every 63 years.[4]

Even better, a cut from the actual corporate tax rate of 35% to a rate of 10% would double our nation's wealth every 30 years.

Life Savers moved production to Canada. Nabor Industries and Tyco International moved to Bermuda. Halliburton has announced a move to Dubai. In a globalizing economy, is it really a puzzle that firms prefer to operate in lower-taxing, less-regulated environments?

These are examples of what can be seen. As Frédéric Bastiat reminds us, however, it is imperative to also account for what cannot be seen. What would the wealth of our nation be today if the corporate tax rate had always been 10% or less? What creature comforts would have been innovated? What new technologies brought to market? What diseases cured?

Due to a history of high corporate taxes these answers are not known, and we are worse off because of it.

Notes

[1] Bob Davis, Amy Chozich, "Obama Plans Spending Boost, Possible Cut in Business Tax", Wall Street Journal, June 17, 2008.

[2] The Heritage Foundation: Index of Economic Freedom.

[3] ScienceDirect - Journal of Public Economics : Tax structure and economic growth

[4] Tax Foundation: "Do Corporate Taxes Impede Economic Growth?"

 


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