Corporate profits are not driving the increase in the top-fractile income shares. So how would higher corporate taxes reduce inequality?

Jason Furman, guest-blogging at Free Exchange, advocates higher corporate taxes. He gets at least two important things wrong:

1. He seems to think that corporate taxes will be entirely paid by owners of capital. It's more likely that investors will bear approximately none of the tax.
2. He suggests that corporate taxes will help slow the growth of the income share that goes to the very top end of the income distribution.

I've already dealt with the first point. As for the second, let's take a look at the data so helpfully provided by Emmanuel Saez (excel file). Between 1980 and 2005, the income share of the top 0.1% of the distribution increased from 2.23% to 7.45%. But more than 90% of that income growth came in the form of wages, entrepreneurial income and capital gains - none of which are affected by corporate taxes. Dividend income paid after corporate taxes accounts for only about 5% of the income growth of this group.

It's hard to see how higher corporate taxes could help slow the concentration of income at the top.

Comments

[Jim Rootham]

What do you mean capital gains are not affected by corporate income tax? They are not taxed by corporate income tax but they are affected.

Capital gains are driven by profitability. It's just that many corporations do not pay much in dividends so the profits are taken in the form of capital gains. Otherwise price/earnings ratios would not be a useful analytical indicator.

You are correct about the compensation of upper level management not being profit linked. This is the fruition of a state of affairs identified many years ago by John Kenneth Galbraith.

[Stephen Gordon]

An increase in corporate taxes would generate a one-off reduction in asset prices as the new tax rates are incorporated into the price, generating a capital loss when the new tax is introduced. But once the new regime is priced in, asset price movements would continue to be generated by other factors. Capital gains (and losses) in the following years would not be affected by corporate taxes.

[Jim Rootham]

You are ignoring retained earnings. In general, outside of bubbles, capital gains are driven by using retained earnings to expand the business. Retained earnings are reduced by corporate taxes so (assuming that future expansion is capital limited) increases in taxes would reduce future capital gains. Alternative sources of capital require cash flow to finance so capital gains are also reduced by the sale of more stock or borrowing.

[Stephen Gordon]

Retained earnings are net of tax, so as I said before, yes, there would be a hit on capital gains. But it would all happen when the tax hike is announced, and it would only affect current owners of domestic assets. Future investors wouldn't be affected.

So yes, there would be a hit on capital gains. Short-lived and small, but a hit nonetheless.

But since capital gains accounted for less than 20% of the growth of the income of the top 0.1% income fractile, the effect on inequality would still be pretty small. More than 70% of the increase came from wage and entrepreneurial income.

[Jim Rootham]

Second point first. Point taken. Senior management has captured the economy.

In the context of the original article the following is a minor point. However, it seems to be a point where you have become disconnected from reality.

I don't understand why you seem to be saying that corporate taxes will have no effect on the firms ability to expand.

First, the analysis is different for each firm. The effect discussed depends critically on how much access to capital is constraining the expansion of the firm. If other things are constraining expansion the cost and availability of capital is moot.

Retained earnings are the cheapest and most flexible source of capital for business expansion. Corporate taxes reduce the supply of retained earnings.

If taxes reduce the amount of retained earnings below amount the firm wants to invest in expansion management has 3 basic options:

1) Don't expand. With obvious implications for capital gains.

2) Sell stock. The consequence is referred to as dilution and reduces capital gains.

3) Borrow. This is complex. The effects depend on the terms of borrowing, however, they are pretty much guaranteed to be worse than retained earnings.

Is what I am saying clearer now?

If you disagree with this, what is your explanation for the source of capital gains? Do you think all capital gains are simply bubbles?

[Stephen Gordon]

Any new information that generates an upward revision of expected future profits (or a downward revision of the interest rate used to calculate a present value) will generate capital gains.

I agree that increased corporate taxes will likely reduce retained earnings. And that this will affect (along with other things such as investment, employment and wages) the level of the stock price. But it won't affect its rate of growth after the tax increase has been incorporated into the price.

[Jim Rootham]

Ahh, I get what your model is now.

You are assuming a zero future prediction risk penalty, whereas I am assuming a 100% future risk penalty.

The successful implementation of corporate growth is new information.

I expect that stock prices will track real expansion, you expect the stock market to capitalize all future expansion immediately.

This really depends on how much the stock is being hyped.

[Stephen Gordon]

But corporate taxes don't affect earnings *growth*: [(1-t)*e] has the same growth rate as e.

[Jim Rootham]

I don't understand that equation. Is * multiplication or exponentiation? Is e the base of the natural log? I am guessing t is tax rate.

There is no general solution to this problem. You seem to think that all firms behave exactly the same way.

The growth rate of a firm depends on its ability to do stuff. That abilitiy may depend on how much retained earnings it has.

[Stephen Gordon]

e is earnings, * is multiplication, t is the tax rate.

If earnings are growing at a certain rate, and if you apply a constant tax rate, then earnings net of tax will grow at the same rate as before-tax earnings.

[Jim Rootham]

That's true but not relevant to the argument I am making.

If earnings are constrained by lack of capital, a reduction in retained earnings because of taxes will reduce the growth rate of earnings.

[Stephen Gordon]

It's certainly possible to set up models where an increased level of corporate taxes reduces the growth rate of earnings. But other things happen as well: the rate of growth of the economy as a whole - and real wages along with it - would also be reduced.

This brings us back to the question of the incidence of the corporate income tax. The entity that sends the money to the government isn't necessarily the one who pays the tax.