Who pays corporate taxes?

Not corporations. Oh sure, maybe someone employed by a corporation has to write out a cheque to the order of the Receiver-General, and the cheque may even have a corporate logo on it. But corporations do not pay taxes - people do. The question is which people. Or, in the language of public economics, what is the incidence of corporate taxes?

It is typically the case that those who advocate increasing corporate taxes intend for them to be paid by the owners of capital. The analysis goes as follows: Corporate taxes are applied to profits, and since profits are distributed to their owners, corporate taxes are borne by capitalists.

But that’s far from being the end of the story, at least, not in a small open economy such as Canada. The rate of return on investment is determined by the world supply of savings and the world demand for capital, and since Canada has only a small share of the world capital markets, what happens here has essentially no effect on that world rate of return. If an investment project in Canada can’t generate that rate of return, there are any number of others that can.

Suppose that world rate of return in 9% a year (I’m picking number out of the air here so that the math works out nicely), and that the Canadian corporate income tax rate is 40%. Investors would therefore require that a Canadian corporation generate a pre-tax profit rate of 15%, so that the after-tax return is 9%. Now suppose that the tax rate goes to 50%. Since investors can always get a 9% rate of return on the world market, the only way a Canadian investment project can survive is if it generates pre-tax profits at a rate of 18%, so that the after-tax rate matches the world rate. If it can’t, investors will simply shut it down and move their capital elsewhere.

So how can firms increase their pre-tax profit rates? They can

• raise prices in order to pass the tax increase onto consumers, or
• cut costs – notably wages and/or employment, or
• both.

Who pays for corporate taxes? Not owners of capital, even if they were the original target – they still get the world rate of return. The people who really pay are consumers and workers.

Since 2000, Canadian corporate tax rates have fallen by over 8% - how does this compare with other countries? Here are the main rich countries' corporate tax rates, graphed against the openness of their respective economies (measured as the average of exports and imports as a percent of GDP):

It would appear that the other rich countries' policy-makers have learned this lesson: countries that are more open have found that they are obliged to keep corporate taxes low, while those that are less open can have higher rates. Moreover, the three countries with the highest taxes also have the largest economies.

How does Canada compare? According to that graph,

• All countries that have similar levels of openness have significantly lower corporate tax rates.
• The only countries with higher rates are the United States, Japan and Germany: all much bigger and less open to trade than Canada.

Despite the recent cuts, Canadian corporate tax rates are still pretty high.

Update: Empirical evidence that suggests that the entire corporate tax burden is shifted to workers.

Comments

[Brian Ferguson]

Have you looked at the Irish case?

Brian Ferguson

[Stephen Gordon]

Their corporate tax rate is 12.5%, and the openness measure is 89%. If you extended that line way down to the bottow-right, they'd be pretty close.

[Ian Welsh]

Is the return so easy to get? X%, and if you're getting less there is some other investment somewhere in the world where you can automatically move it to? Or, as the case may be, not invest in Canada becasue you know of an automatic opportunity somewhere else?

You're assuming those returns are available, are known, and are as safe and liquid as investing in Canada. For that matter you're assuming that investment capital is very liquid and that it is in a position to pick and choose and never has to take less than the average return. I'd suggest that that's certainly not the case, especially not in the current environment, where investment supply is less than investment demand (Bernanke's Global Savings Glut).

[Stephen Gordon]

I'd certainly agree that capital markets aren't completely flexible, which is why governments can still get away with corporate tax rates that are strictly positive. But they're definitely moving that way, and policy-makers have to take that trend into account.

[happyjuggler0]

Capital once it is invested in a factory for example is not so simple to "simply shut it down and move their capital elsewhere."

Youhave to figure out the costs of shutting down the factory, and the price you can get for the factory from another buyer, and only then compare your leftover capital from what you can get from opening a new factory elsewhere.

There is a significant amount of "trapped" capital that can be effectively stolen by tax increases. Or by coercive unions for that matter. Witness GM which would love to simply shut its factories down and go somewhere non-union. But this is expensive and must be weighed vs the costs of simply paying wages far above competitive market wages.

But as for new investment, the article is correct. Capital can and will seek the highest return. If that means government paper in the US, then that is where it will go. No one knows what the returns on new physical investment like a factory will be. Therefore every other alternative to safe US government paper must be weighed by higher returns if things go well vs lower or negative returns if things go poorly. Investors must use their best judgment, which is to say they must guess. Government attitudes, or voter attitudes, of "Stick it to those rich bastards" simply ensure new capital goes elsewhere since even if things look attractive enough now, they stand a good chance of getting worse later.

[Hulagu Khan]

Don't we need to take into account other factors too -- for example, Canada's semi-universal taxpayer-supported medicare system means that a car manufacturer deciding whether to build a factory in the USA or Canada would be inclined to choose Canada because he won't have to worry about huge health insurance payments for employees and pensioners...Corporate tax rates are only one of several criteria for people making direct industrial production investment decisions. Socialization of health care payments and portability of pensions and stability of currency and law may be better areas to work on if the goal is to attract investment. (This might include disconnecting pensions from the issue of which employer you happen to be working for, and attaching pensions as portable accounts to each person -- a CPP that is your whole pension pool, with your employers' responsibility limited to contributing some money to your CPP pension funding during your term of employment, if at all.)