President Biden’s choice to fund new spending programs with increased corporate taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. es comes with trade-offs for American output and incomes. Our new book, Options for Reforming America’s Tax Code 2.0, compares the corporate tax increase with 36 other ways lawmakers could raise revenue. Throughout the Options book it is apparent that some tax changes are more efficient than others. For instance, a carbon taxA carbon tax is levied on the carbon content of fossil fuels. The term can also refer to taxing other types of greenhouse gas emissions, such as methane. A carbon tax puts a price on those emissions to encourage consumers, businesses, and governments to produce less of them. could raise more revenue and yet do less damage to economic output and after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize after-tax income. s for low-income households than would an increase in the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. rate.
Results from the Tax Foundation General Equilibrium Model show that raising the corporate income tax rate to 28 percent (a tax increase that would fall on capital) would cause a larger drop in economic output (0.7 percent compared to 0.2 percent), a larger drop in after-tax incomes for the bottom quintile (1.5 percent compared to 0.7 percent), and a smaller increase in conventional revenue ($886 billion compared to $999 billion) than a $25 per ton carbon tax (an increase that falls primarily on consumption).
The corporate income tax increase would, however, make the tax code more progressive, because it would place a higher burden on the top quintile than the carbon tax. But when factoring in the negative economic effects of each tax, the bottom quintile would still be worse off under a more progressive code with a higher corporate tax than under a more regressive code with a carbon tax.
|Raise the Corporate Income Tax Rate to 28 Percent||Institute a $25 per Ton Carbon Tax|
|Gross Domestic Product||-0.7%||-0.2%|
|Conventional Revenue (2022-2031)||$886 billion||$999 billion|
|Dynamic Revenue (2022-2031)||$694 billion||$860 billion|
|Long-run Dynamic Percentage Change in After-Tax Income, Bottom Quintile||-1.5%||-0.7%|
|Long-run Dynamic Percentage Change in After-Tax Income, Top Quintile||-2.0%||-0.5%|
Source: Tax Foundation General Equilibrium Model, March 2021.
The hierarchy of which taxes are most efficient to least efficient is determined in part by which factors are most mobile, and thus most sensitive to high tax rates. Empirical evidence demonstrates that capital is far more sensitive to changes in tax policy than labor. This is primarily because capital is far more mobile than labor. Capital can move quickly from jurisdiction to jurisdiction in search of lower tax costs, but it is more difficult for workers to move their families from place to place to lower their tax bills.
So capital taxes, like the corporate income tax, generally result in more economic harm per dollar of revenue raised because they distort investment decisions. Consumption taxA consumption tax is typically levied on the purchase of goods or services and is paid directly or indirectly by the consumer in the form of retail sales taxes, excise taxes, tariffs, value-added taxes (VAT), or an income tax where all savings is tax-deductible. es avoid the double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of saving and investment, so they do not distort decisions about whether to invest or consume. Consumption taxes would increase prices, and so reduce the return to labor—but because labor is generally less sensitive to taxation than capital, it’s a relatively efficient way to raise revenue. However, it comes with a trade-off of slightly less progressivity in the tax code.
A carbon tax is like a consumption tax, but it differs from a more broad-based consumption tax like a value-added tax because it would have an uneven impact across sectors and fall on some business inputs—aspects which we do not explicitly model. As such, our results may understate the economic harm of a carbon tax to a small extent.
The trade-off between how much revenue a tax change can raise, who bears the burden of the tax change, and the effect the tax change has on economic output cannot be avoided. Acknowledging such trade-offs can help policymakers steer clear of tax changes that would place an unnecessary hindrance on economic growth and instead craft a policy response that meets our present challenges—promoting economic growth, stabilizing the budget deficit, and protecting the most vulnerable while minimizing harmful trade-offs.