Sanders’ Inequality Tax Trap

Senator Bernie Sanders has a new tax plan to tackle income inequality. Specifically, it requires increasing the top marginal corporate tax rate on companies by anywhere between half a percentage point to 5 percentage points, depending upon the ratio of CEO pay to median worker wages within that company. The tax hike would apply to all companies with annual revenues of more than $100 million. Even privately held corporations would have to disclose the pay gap information. Here’s why this plan could exacerbate income inequality.

The first problem with the proposal is that it calls for a hike in the corporate tax rate rather than a direct increase in personal income taxes on executives. The simple reasoning is that companies that pay their CEOs much more than the typical worker need to be penalized, as the typical workers’ wages compare unfavorably with those of top executives. But who would a higher corporate tax rate actually punish? While people often assume that higher corporate rates directly hurt CEOS and executives, academic research on this topic is mixed. The extent of the burden on workers varies across studies, but nearly all studies show that higher corporate taxes do adversely affect workers. A 2017 study for Germany finds that, on average, 51 percent of the corporate tax burden is passed onto workers. How does the burden of corporate taxes get passed to workers? As companies face higher tax rates, they are less likely to invest in physical capital, which leads to lower worker productivity and lower worker wages. Of course, some share of the tax burden is likely to be borne by consumers and shareholders as well, in the form of higher prices and lower returns on stocks. In its recent report on the distributional effects of Trump’s tax reform bill of 2017 (the Tax Cuts and Jobs Act), the Joint Committee on Taxation assumes that workers bear 25 percent of the corporate tax burden, while capital bears 75 percent. Given the preponderance of evidence that there is in fact a burden on workers, this should give policymakers pause when proposing such penalties on companies. A policy that results in lower wages for average workers, and lower levels of physical capital investment, is likely to further exacerbate inequality, in direct contrast to the intended aim of the policy.

The proposal is also unlikely to raise much revenue. While the Sander’s team estimates that the proposal will raise about $150 billion over 10 years, this seems unrealistic because there is almost never a simple relationship between corporate tax rates and revenues due to taxpayer responses. In 2017, when the US had the highest federal corporate tax rate in the OECD at 35 percent, corporate tax revenue was $297 billion, or about 9 percent of total federal revenue.  In 2018, when the corporate tax rate for all corporations dropped to 21 percent, there was a total of $205 in corporate revenue. Sanders’ proposal does not change the rate for all companies, and even for the same company, the tax base could go down if there was, in fact, a response to the tax penalty. Behavioral responses to corporate tax changes matter for revenue estimates. Questions arise as to how CEO compensation will be measured—will it include awarded stock options and grants or only cash income and realized options? If it includes only realized options, will CEOs income-shift realizations into future years (as my research shows) so that current income is lower to avoid paying the tax? What about workers—can companies reduce benefits while boosting wages so that on net workers are no better off, but companies can avoid the tax? Or hire contractors instead of wage workers?  There are lots of ways corporate income can be manipulated in order to minimize tax penalties, which could result in lower revenues than estimated. At the very least, such responses should factor into calculations of the projected revenue.

The proposal also does not directly address the issue of low wages. We know that poor economic outcomes and upward mobility are usually a combination of multiple factors, such as poor access to decent schools, poor social networks, unstable family structures, a lack of good jobs in close proximity to low-income neighborhoods combined with a lack of affordable and easy-to-access transportation methods, and more. The problem is not simply one of less cash, but also guaranteeing that better systems exist and work efficiently to address these concerns. For instance, a low-cost apprenticeship program that trains workers for better jobs may be more effective at addressing poverty and low wages than raising corporate tax rates, whose effects are less direct and less well-understood.

It makes sense to me that a proposal that is better targeted towards lifting people out of poverty has a higher likelihood of success than one that primarily aims to pull rich taxpayers down. And to be fair, like the Sanders’ proposal, many Democratic proposals  use the revenue collected to ease existing burdens on households, such as costs of childcare, healthcare, education, and others. The strategy appears to be to lift all boats, while sinking a few yachts. The concern is that sinking a few yachts could pull many workers into the undercurrent as well, thus minimizing the benefits of the other policies to help the poor.  An increase in inequality is likely to be an unintended consequence of these types of ideas.

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