The Unintended Consequences of Higher Corporate Taxes on Income Inequality

October 29, 2020

Taxes paid by corporations and income inequality are both topics of national attention, particularly during the ongoing 2020 presidential campaign. Increasing the corporate tax rate is often offered as a solution to income inequality because higher-income individuals tend to own more corporate shares than others and may bear the burden of a tax increase on corporate income.

However, this thinking neglects that corporate income taxes are not only borne by high-income shareholders but also by lower-income Americans who own corporate equities and by workers for those firms, reducing American incomes across the board.

Economists Gabriel Zucman and Emmanuel Saez recently published a piece revising their measure of U.S. income inequality and addressing criticisms of their previous work on the income distribution. As in their 2019 book, Saez and Zucman use a nonconventional method for allocating labor and capital taxes when measuring inequality by allocating labor taxes entirely on labor and capital taxes entirely on the owners of capital. While this move makes the tax distribution look more progressive when taxes on capital are higher, it also increases measured regressivity in the tax code when taxes on capital decrease.

This incidence assumption is outside of the norm. For example, standard economic analysis assumes at least a portion (between 25 percent and 50 percent) of the corporate tax burden falls on workers in the form of lower wages. Evidence indicates more than half the burden falls on workers in some situations. This means that workers would earn lower wages than otherwise in the face of a higher corporate income tax, resulting in lower after-tax incomes.

A second way in which higher corporate income taxes can result in lower after-tax incomes for many Americans is through the taxes’ direct effect on corporate equities. All else equal, a higher corporate income tax would tend to reduce the value of corporate equities as the expected after-tax rate of return on corporate investment falls.

For example, recent estimates show that retirement accounts hold about 30 percent of outstanding corporate stock. Pensions and retirement accounts provide the middle class with access to the stock market, though it is important to note that stock ownership remains skewed towards higher-income individuals. Even so, this means many average Americans would experience a lower-after tax income through the effect on corporate equities even if labor bears no portion of the corporate income tax.

The incidence of the corporate income tax has impacts on the state of income inequality too. In a recently updated working paper, economist James Hines explores how an increase in the corporate income tax can increase income inequality, even if the corporate income tax is borne entirely by capital. Hines’ findings suggest that the corporate tax exacerbates conditions which lead to economic disparities, casting doubt on the effectiveness of using the corporate income tax as a method to reduce income inequality.

Usual tax incidence analysis tries to determine how different income groups (defined by pre-reform income) bear the burden of a tax change. Hines’ paper builds on this by evaluating the extent to which a change in the corporate tax has an effect on the dispersion of incomes.

Specifically, an increase in the corporate tax discourages corporate activity and so leads to a reallocation toward noncorporate activity. Higher levels of noncorporate activity can potentially increase the level of idiosyncratic risk (due to inherent individual factors as opposed to broad market trends), leading to larger numbers of both very successful and failing business owners. Because of this effect, a reallocation toward noncorporate business activity can widen the income distribution, resulting in higher overall income inequality.

Hines develops a model to analyze this theory and fits it to U.S. tax return data. His findings suggest “that the greater income dispersion accompanying higher corporate tax rates may significantly dampen or even reverse the net effect of higher rates on the concentration of income in the top one percent.” Of course, as with all models, strong assumptions and some degree of imprecision are required; nonetheless, the analysis suggests that a corporate tax rate increase has a clear impact on income concentration, undermining the ability of the tax to reduce income disparities.

This research and the literature that finds under standard distributional analysis that workers bear at least part of the burden of the corporate income tax casts doubt on research pointing to the corporate income tax as a way of reducing income inequality. As election season nears completion and proposals to increase the corporate income tax are considered, it is important to recognize the negative effects such an increase would have on all levels of income.

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A 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.

After-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.