Taxing corporate profits is generally viewed by the public as a progressive and relatively harmless way to raise government revenue. But economists have long argued that when firms face higher tax rates, the owners are likely to respond by reducing investment, lowering employment or simply relocating to lower-tax locations. As a result, some of the burden of the corporate tax will be shifted onto workers in the form of lower wages, consumers in the form of higher prices or others, such as landowners.
How much of the burden is shifted away from the owners of firms will depend on features of the market, such as how willing they are to move locations relative to workers. Some economists argue that most of the burden falls on owners (Gravelle, 2013; and Clausing, 2013), while others find that a substantial part is shifted onto workers (see, for example, Arulampalam et al, 2012; and Fuest et al, forthcoming) and is harmful to economic growth (see, for example, Hines, 2017; and OECD, 2001).
Understanding who bears the costs of corporate taxation is crucial to determine who will benefit from corporate tax cuts and whether they will exacerbate income inequality. Our research reassesses this central question both theoretically and empirically.
We first develop a model showing that the answer can be determined empirically through careful identification of the effects of tax cuts on the local economy. We then provide new empirical evidence documenting the effects of business tax changes in US states on the locations of workers and firms, and on local wages and living costs.
Our analysis suggests that the largest beneficiaries from a tax cut would be the owners of firms (40%), with landowners and workers splitting the remaining 60% of the economic gains. This implies that cuts to corporate taxes are likely to increase inequality.
Cuts to corporate taxes are likely to increase inequality.
A key factor driving this result is that the owners of firms may be unwilling to leave high tax locations if there are especially profitable investment opportunities in those places.
A spatial equilibrium approach to corporate taxation
The question of who bears the economic cost – or incidence – of corporate taxation goes back to the seminal model of Harberger (1962). The classic Harberger intuition is that the more that a factor of production (such as workers or capital) is able to shift to lower-tax alternatives, the less it will bear the economic incidence of taxation.
While Harberger’s original analysis was for a closed economy and suggested that capital bears all of the corporate tax, his logic has shaped how economists view corporate taxation in open economies. If we think that land is immobile and that workers are relatively less mobile than the owners of capital, then the burden of corporate taxation will fall on immobile land and relatively immobile workers, and not on the mobile owners of capital.
But this conclusion depends crucially on the assumptions we make about the relative mobility of the factors of production. Gravelle (2010) shows how conclusions from various studies hinge on their modelling assumptions, while Fullerton and Metcalf (2002) note that ‘few of the standard assumptions about tax incidence have been tested and confirmed.’
Our research develops a new framework in which empirical estimates rather than assumptions determine factor mobility. We build a model of the location decisions of workers and firms to analyse how corporate taxation will affect workers, landowners and the owners of firms.
We start with a standard spatial equilibrium model in which workers live in the location that maximizes their utility when considering local wages, living costs and amenities. The idea is that as more workers move into a location, house prices and wages will adjust until it no longer makes sense for people to move in.
Similarly, we consider how changes in local productive amenities, costs of production and business taxes affect the location decisions of firms. Equilibrium in the labour market connects the choices of workers and firms.
Figure 1 shows how a local business tax cut affects workers and firms in our model. Consider a location with L0 workers employed at wage w0. A cut in local business taxes means that more firms move to this location, which shifts the demand for labour to the right and puts upward pressure on wages. Wage increases are determined in the local labour market as workers move in, house prices increase, each establishment hires fewer workers and some marginal establishments leave.
Figure 1. How a local business tax cut affects workers and firms
Firms move to this area until the lower tax rate is no longer justified by the combination of the location’s productivity and the higher wage. As wages increase, workers relocate to this area until the increase in living costs and the local amenities no longer make this move desirable. The change in wages (the vertical distance between the two equilibria A and B) will be determined by the shift in labour demand following the tax cut and the effective labour supply elasticity, incorporating indirect housing market effects.
Key determinants of the location decisions of firms and workers
A key determinant of how the location decisions of firms and workers interact is how important specific locations are for firms’ profits and workers’ wellbeing. Formally, our model assumes that workers have idiosyncratic tastes for each location, and that there are location-specific factors that make firms more productive and profitable in certain places. For example, technology firms may find Silicon Valley a more profitable place to be than other locations, despite the fact that wages and taxes are high.
These location-specific business opportunities limit the degree to which firms and workers are willing to move purely for tax reasons. Indeed, this feature explains why a state like California, with a corporate tax rate of nearly 10%, is home to more than one in nine establishments in the United States, even though these firms would pay no corporate taxes in neighbouring Nevada.
Despite a corporate tax rate of nearly 10%, California is home to more than one in nine US establishments
Our model highlights the fact that the empirical effects of taxes on the location decisions of firms and workers – as well as effects on wages and living costs – determine the overall burdens of corporate taxation for workers, landowners and the owners of firms.
The effects on workers’ welfare and landowners’ profits are relatively easy to measure by examining how wages and land rents change when taxes change. But the gains for the owners of firms are harder to quantify because we do not observe profits at the establishment level.
One of the main insights of our study is that we can use the location decisions of firms to reveal information about the key determinants of firms’ profits and ultimately about the burden of corporate taxation. We show that the increase in profits is related to changes in wages and the responsiveness of firms’ location decisions to taxes.
Intuitively, if firms place themselves where their after-tax profits are highest, then looking at the number of firms that move to a location when taxes are cut reveals a measure of the relative importance of location-specific factors and ultimately how much profits must have changed to lead the firms to move.
We show that the change in wages is equal to the shift in labour demand divided by the difference in the slopes of the labour supply and demand curves. We then show that the change in the number of firms is related to both the elasticity of labour demand and the increase in the number of firms.
We can decompose this expression and use empirical estimates of the effects of taxes on firm location, employment and wages to determine how much the owners of firms benefit from a corporate tax cut.
New evidence of the impact of corporate tax changes
Quantifying the incidence of the corporate tax requires credible estimates of the effects of taxes on the local economy and on the location decisions of firms and workers. To get these estimates, we analyse every change in state business taxes in the United States since 1980.
Figure 2 plots our estimates of the effects of a tax change on firm location. The figure shows that as the owners of firms keep a larger fraction of their profits (through lower taxes), the number of firms in a given area increases over the following ten years. Importantly, we also show that tax changes are not related to any trends in firm entry before the tax change, something that would be a concern because it would suggest that changes in economic activity could be due to factors other than the tax changes.
Figure 2. Estimates of the effects of a tax change on firm location
Lessons for tax policy
The benefits of corporate tax cuts ultimately depend on how mobile firms and workers actually are. We highlight that many factors besides the tax rate can be key in shaping mobility and, in the case of state taxation, these factors are important enough that the gains are shared between firms, workers and landowners in roughly equal proportion.
Financing improvements in education and infrastructure might do more to attract businesses than corporate tax cuts.
There are a few lessons for tax policy from our analysis. Our evidence suggests the possibility that financing improvements in education, infrastructure and firm productivity might do more to attract businesses and increase growth than a reduction in the corporate tax rate. But it is also important to recognise that the gains from increasing the attractiveness of a location via productivity enhancements, rather than cuts to tax rates, are likely to vary across locations and to be context-specific.
Our work also highlights that many other policy parameters govern the tax base, such as investment and loss provisions, and these also affect the incidence of business taxes and firm location.
