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Tax Cuts for "the Rich" Are Taxing Everybody

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As soon as it was revealed, the Trump administration’s framework for tax reform was instantly attacked by Charles Schumer, Nancy Pelosi and friends, trying to bludgeon it to death with assertions that it was just “tax cuts for the rich.” A letter from Senate Democrats said “Tax reform cannot be a cover story for delivering tax cuts to the wealthiest. We will not support any tax reform plan that includes tax cuts for the top one percent.”

Such attacks, which focused primarily on proposed reductions in corporate tax burdens, were premature, in that there were too few crucial details provided for thorough analysis. But the criticisms revealed a focus on the politics of envy rather than joint benefits to society, and reliance on assumptions that, if aligned with recent theoretical and empirical work, would undo their conclusions.

“Tax cuts for the rich,” along with cousins like “trickle down,” “voodoo” and even “déjà voodoo” economics, misdirect attention away from how voluntary market arrangements benefit all. They erroneously presume that taxing high-income earners less benefits only those high earners. This idea is reinforced by a mistaken zero-sum view that more income for some must reduce others’ incomes.

Voluntary Exchange Benefits Everyone 

When people, however rich or poor, get richer through voluntary arrangements, they do not hurt anyone except those suffering from envy. Each party is better off, as they see it, or they would not participate.

If I create a massively successful product, such as a software program, my income will jump substantially. But every buyer will also gain because I provided them better options than they had before. This holds true even if their measured share of total income is lower because my income has risen.

Unfortunately, those determined to punish higher income earners (given rhetorical cover as paying their “fair share,” which is a progressive synonym for “more”) misdirect attention from the core issue for society — are others helped or hurt? And here, the key is that facing higher income people with worse incentives induces them to do less for others with their resources.

That is why supporters of tax cuts often stress improving productive incentives where they are most adverse (i.e., where the tax and regulatory burdens are highest, even if they are imposed on those demonized as “the rich”). That is where reduced burdens most improve incentives to produce for others. Further, since investment decisions are also crucially influenced by future tax policy, they stress making those improvements as durable as possible, enabling much greater cumulative responses over time.

Improved incentives from the corporate income tax will, if durable, increase rewards for improving techniques and advancing technology, and for added capital investments which provide tools to increase worker productivity and earnings. They will expand rewards for risk-taking and entrepreneurship in service of consumers. They will reduce the substantial distortions caused by the tax. Each of those changes benefits other Americans as workers and consumers. In fact, if you simply omitted any reference to “the rich,” so as to not prick up the ears of the envious, these results are very positive. And the fact that “the rich” might also gain does not alter those good consequences for others.

Opposition to reducing America’s high corporate tax rate is abetted by the assumptions used to “score” corporate tax changes by government bodies, such as the Joint Committee on Taxation, Treasury’s Office of Tax Analysis and the Congressional Budget Office. Their evaluations assume that the vast majority (75-82%) of corporate taxes are borne by the owners of capital. Since higher income people hold the greater part of current financial assets, this all but guarantees corporate tax reform will be evaluated as “tax cuts for the rich.”

However, positing such high shares of corporate tax burdens on capital owners is inconsistent with current theory and evidence.

Taxes for "The Rich" End Up Being Paid By Many of the Non-Rich

The key is the esoteric-sounding issue of tax incidence — the distribution of the burdens of a tax. Every economics principles student learns that is not the same as who has the legal liability to pay the tax (e.g., the actual burden of Social Security contributions is not changed by whether or not employers have the legal responsibility to pay half of the tax).

The intuition can be understood in terms of the game of dodge ball. When a tax is imposed, nobody — not buyers, not sellers, not workers — wants to be hit with it. So they try to dodge by changing their choices of what, how or where to buy and what, how or where to produce and sell, to avoid it. The less well one can dodge, the more of the burden they will bear; the better one can dodge, the less of the burden one will bear, and the more will be borne by those on the other side of a market.

As recently detailed by Adam Michel in an excellent summary article for the Heritage Foundation, the assumption that capital owners bear the greatest proportion of the corporation taxes traces back to Arnold Harberger’s 1962 work. At that time, in a famous article, he found that essentially all of the corporate tax burden is borne by capital owners. But the reason was that he assumed a closed domestic economy. That meant there was nowhere for capital, restricted by assumption to the U.S., to go to avoid the federal tax burdens. Unable to dodge, owners of capital would be forced to bear the entire burden.

However, Harberger has twice revisited his seminal analysis, in 1995 and 2008. And he reversed his conclusions. The main reason is that he switched to modelling an open economy. Given the increasing openness to capital flows over the years, capital has become very internationally mobile, given time to adjust. That means owners of capital can now dodge burdens of a given country’s corporate taxes quite well. Since they can dodge so well, they will largely escape the burdens. But adverse treatment of capital in a given place will shift large amounts of capital elsewhere. That, in turn, will substantially reduce the tools workers have to add to their productivity, which will reduce their real incomes. Workers will therefore bear essentially all the burden of corporate income taxes, once capital has fully reacted to the changed incentives. In fact, when the fact that the corporate income tax is one of the most distorting and inefficient ways of raising tax revenue, including those inefficiencies induced by the corporation tax, he concluded workers “must end up bearing more than the full burden of the tax.”

The incorporation of more mobile international capital and its effects, supported by analytical and empirical studies, almost completely reverses earlier incidence conclusions and with them, “tax cuts for the rich” conclusions. However, that more recent research has not been incorporated in government agency attempts to score proposed changes, dramatically overestimating gains to the owners of capital and underestimating the gains to workers, virtually guaranteeing “tax cuts for the rich” conclusions.

While such official attempts to score the effects of changes in after tax returns on capital investments rely on assumptions out of line with current analyses, the public conversation is not only less sophisticated, but further distorted by a serious measurement issue.

The Long Run vs. The Short Run 

The incidence analysis we have discussed is for longer run effects of corporate taxation, given the time it takes for capital to fully respond to changed incentives. But opponents of such tax rate reductions focus attention on the short run, as a way to get people to overlook the positive effects of improvements in capital owners’ incentives on workers’ situations over time. And to the extent opponents succeed in focusing public discourse in the short run, they can generate apparent proof of “tax cuts for the rich” conclusions.

When the tax burden applied to an asset is reduced, that will lead to an immediate increase in those asset price, which capitalizes the expected increased after-tax profits that can be expected over the foreseeable future. And the more durable the improvements are likely to be, the greater will be the asset price surge. Since most financial resources are owned by those with higher wealth and income at any given time, that gets measured as huge current asset gains to “the rich.” But there is no similar measure effect of the effects on American workers.

The improved incentives from the higher after-tax returns current owners will face are the mechanism which produces benefits to workers. The higher after-tax returns triggers greater investment, which produces a larger stock of capital equipment, which, in turn, increases worker productivity and real wages. However, that takes time. So the immediate effects on workers are small, even when the cumulative effects are very large. And unlike financial assets, there is no marketplace in which the higher future real earnings of workers gets capitalized into an easily-observed current asset price increase. So when public discourse focuses on the short run effects, it triggers a comparison of current gains to “the rich,” which actually capitalize into asset prices benefits that are anticipated well into the future, against virtually no gains for workers, because they take time to occur and there is no similar market to reveal those future effects now.

In sum, the opponents of reduced corporate tax disincentives focus on the wrong thing—measured effects on incomes of “the rich” rather than benefits produced for others. They focus on the wrong time period—short-run effects rather than long-run effects. They do so using assumptions out of line with recent research—that capital owners rather than workers bear the vast majority of corporate tax burdens. And they use biased measures—which compare the capitalized future effects on capital into easily measured asset prices with the effects on workers for whom there is no similar capitalization. With all those problems, it is hard to take their conclusions seriously, unless you are determined to find the answer you want regardless of reality.


Gary Galles

Gary M. Galles is a professor of economics at Pepperdine University. He is the author of The Apostle of Peace: The Radical Mind of Leonard Read.


Image source:
"UCL Occupation" www.flickr.com/photos/ucloccupation/

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