The Agenda

A Riff on John Cochrane’s Latest Riff on Taxes

If you’re not reading John Cochrane’s excellent blog, you’re missing out. I very much enjoyed his recent discussion of how federal taxes changed between 1960 and 2004. He quotes Piketty and Saez as follows:

The larger progressivity in 1960 is not mainly due to the individual income tax. The average individual income tax rate in 1960 reached an average rate of 31 percent at the very top, only slightly above the 25 percent average rate at the very top in 2004. Within the 1960 version of the individual income tax, lower rates on realized capital gains, as well as deductions for interest payments and charitable contributions, reduced dramatically what otherwise looked like an extremely progressive tax schedule, with a top marginal tax rate on individual income of 91 percent.

The greater progressivity of federal taxes in 1960, in contrast to 2004, stems from the corporate income tax and the estate tax. The corporate tax collected about 6.5 percent of total personal income in 1960 and only around 2.5 percent of total income today. Because capital income is very concentrated, it generated a substantial burden on top income groups. The estate tax has also decreased from 0.8 percent of total personal income in 1960 to about 0.35 percent of total income today. As a result, the burden of the estate tax relative to income has declined very sharply since 1960 in the top income groups.

Cochrane makes the following observation as part of a larger discussion of the issues Piketty and Saez raise:

This assignment of corporate taxes takes us into the dark territory of who bears the burden of taxes rather than who actually pays them. Saez and Piketty are assuming that rates of return on investments are reduced because corporations pay taxes, so rich people get less return than they would otherwise. Hence, it’s “like” paying more taxes.

This reminded me of Aparna Mathur’s recent work on the incidence of corporate taxes:

In a recent paper that I co-authored with Kevin Hassett, we explored the effect of high corporate taxes on worker wages. The motivation for the paper came from the international tax literature (summarized by Roger Gordon and Jim Hines in a 2002 paper1) that suggested that mobile capital flows from high tax to low tax jurisdictions. In other words, in any set of competing countries, investment flows are determined by relative rates of taxation. The current U.S. headline rate of corporate tax is 35 percent. The combined federal and state statutory rate of 39 percent is second only to Japan in the OECD. With Japan set to lower its statutory rate later this year, the U.S. rate will soon be the highest in the OECD and one of the highest in the world. What effect do these high rates have on worker wages?

When capital flows out of a high tax country, such as the United States, it leads to lower domestic investment, as firms decide against adding a new machine or building a factory. The lower levels of investment affect the productivity of the American worker, because they may not have the best machines or enough machines to work with. This leads to lower wages, as there is a tight link between workers’ productivity and their pay. It could also lead to less demand for workers, since the firms have decided to carry out investment activities elsewhere.

Our paper was one of the first to explore the adverse effect of corporate taxes on worker wages. Using data on more than 100 countries, we found that higher corporate taxes lead to lower wages. In fact, workers shoulder a much larger share of the corporate tax burden (more than 100 percent) than had previously been assumed. The reason the incidence can be higher than 100 percent is neatly explained in a 2006 paper by the famous economist Arnold Harberger.2 Simply put, when taxes are imposed on a corporation, wages are lowered not only for the workers in that firm, but for all workers in the economy since otherwise competition would drive workers away from the low-wage firms. As a result, a $1 corporate income tax on a firm could lead to a $1 loss in wages for workers in that firm, but could also lead to more than a $1 loss overall when we look at the lower wages across all workers.

To be sure, this argument wouldn’t be as readily applicable in the 1960s, when capital flows were far less mobile for a variety of reasons, thus making it easier for governments to extract resources from households and firms. But of course this is a point that many critics of nostalgia for midcentury America’s fiscal policy mix often raise: the world was a very different place in the postwar era. As Scott Sumner has argued, the fact that growth slowed across the affluent market democracies (for a variety of familiar reasons, e.g., improving labor force quality is easier when secondary education is not near-universal than when it is, the Olsonian accretion of regulation, etc.) suggests that we should play closer attention to relative economic performance. And by this standard, there is at least some reason to believe that countries that embraced neoliberal policies proved more successful in increasing GDP per capita (PPP) in a changing global economic environment than those that did not.

There is much more to say about Cochrane’s post, and about the recent arguments raised by Diamond and Saez regarding taxes. I’ll have two guest posts on related themes for you soon. 

Reihan Salam is president of the Manhattan Institute and a contributing editor of National Review.

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