While they may lament the most extreme forms of dumping, like Bermuda’s zero tax rate, there is broad agreement among world leaders that the decline in corporate taxation is not necessarily a bad thing. Less tax means, after all, more profits that a firm can invest. And corporate investment is an engine of growth: business expansion supports employment and wages and ultimately benefits workers. Lowering taxes on capital can benefit the working class.
But does it? If the rich pay higher taxes, does it eventually hurt the rest of us? And conversely, does slashing the taxation of capital boost investment and wages?
Unfortunately, the public debate on these questions is mired in sterile, fact-free ideological posturing. There is no shortage of prophets who predict wonders from unfettered capital, offering grandiose growth forecasts if only “tax burdens” were to fall a bit more. These seers can divine a surge of investments and higher wages when after-tax profits are allowed to rise. Let’s try to think this through.
LABOR AND CAPITAL: THE SOURCES OF ALL INCOME
To understand what happens when governments tax capital, we must first define precisely the notions of “labor” and “capital.” Before any taxes are collected, all of the nation’s income is received by either workers or the owners of capital, because everything that we produce is made using labor and capital (machines, land, buildings, patents, and other capital assets). In some sectors of the economy such as restaurants, production mostly uses labor; economists say that sector is labor-intensive. Other sectors such as energy are capital-intensive. Sometimes capital can produce output on its own (houses produce “housing services” with no help from us humans). Sometimes labor can produce output on its own (this would happen, for instance, if Beyoncé gave a concert a cappella in a public place). Sometimes capital is tangible (houses, machines, etc.) and sometimes it is intangible (patents, algorithms, etc.). But always and everywhere, everything that is produced—and hence any income that we earn—derives from labor, capital, or some combination thereof.
Labor income is paid to workers. It is equal to the wages, salaries, and employment fringe benefits such as health insurance and pension benefits. Capital income accrues to the owners of capital independently of any work effort. It includes the profits earned by the owners of corporations (whether they are paid in dividends or reinvested), the interest paid to bondholders, the rents paid to landlords, and so on. Following common practice, we include under capital income 30% of the “mixed income” earned by self-employed individuals—such as private lawyers and doctors—and under labor income 70% of this self-employment income (the reason being that 30/70 is the capital/labor split observed by economists in the corporate sector).1
By definition, every dollar of income that does not go to labor goes to capital, and vice versa. Saying this is not making a judgment about whether workers and capital owners deserve their share of the pie: economists and the public at large have different views on this question, which has been a central factor in political conflict ever since capitalism was born. To observe this fact of labor and capital is merely to describe how the economy works.
Let’s take a concrete example. In 2018, according to its official accounts, Apple produced about $85 billion worth of goods and services (net of the cost of the raw materials and other inputs the company bought to produce its iPhones, iMacs, and other products). Out of that $85 billion, it paid about $15 billion to its employees: this is labor income.2 The remaining $70 billion accrued to Apple’s owners and creditors: this is capital income. Some of this capital income was distributed in dividends, some of it was paid in interest to bondholders and banks, some was reinvested. Similarly, some of the labor income was paid to Apple’s executives, some to entry-level engineers, some to salespersons in Apple stores. There are many forms of labor and many forms of capital, which encompass many different social realities, legal arrangements, and power relationships.
Economists have long observed that the labor share does not fluctuate much, with capital earning 25% of national income and labor the remaining 75%. Keynes famously described this stability as “a bit of a miracle.” This miracle, however, was not permanent.3 From 1980 to 2018, the labor income share has fallen from 75% to 70% in the United States (while the capital income share has increased from 25% to 30%). The trend has been particularly marked over the last two decades. Since the turn of the twenty-first century, the average labor income per adult has almost stagnated in the United States (+0.4% a year on average), while capital income rose +1.6% a year per adult—driven by the surging profits of corporate behemoths in tech, pharma, and finance. Capital prospers while labor lags behind.
CAPITAL IS TAXED LESS AND LESS; LABOR MORE AND MORE
Just as all forms of income derive from labor and capital, all taxes fall either on labor or capital. When choosing how much tax to impose on each of the two factors of production, there is a trade-off. Because capital is useful, we do not want to tax it too much, lest we reduce the productive capacity of the economy. But taxing it less means that labor must bear a heavier burden, making it harder for people who have not inherited assets to accumulate wealth, especially in a world of quasi-stagnant wages.
Where does the United States split the tax burden today? The most comprehensive way to answer this question is to contrast the evolution of three tax rates. The first is the average macroeconomic tax rate: the total amount of taxes paid divided by national income. The second is the average tax rate on capital income, that is, the total amount of capital taxes—adding up the corporate income tax, property taxes, the estate tax, and the fraction of the income tax that corresponds to levies on dividends, interest, and other forms of capital income—divided by the economy’s total flow of capital income. The third and last factor is the average tax rate on labor income, defined similarly as the ratio of total labor taxes to total labor income.4 What do we see?
In contrast to other wealthy countries, where they have stabilized over the last decades, taxes in the United States have fallen. The macroeconomic tax rate is significantly lower today than at the end of the twentieth century. It is only recently, with the tax cuts of 2018, that this trend has become fully apparent: in the short run, tax revenues rise with economic expansions and fall in recessions, and these business cycle effects can obscure the trend line. But the medium-run trend is now clear. During the second half of the 1990s, the overall US tax rate peaked at about 31.5%. In 2019, following nine years of economic growth, and with unemployment at a historically low level, it is almost four points lower, at around 28%. Given that tax collections typically fall by several percentage points during recessions, it is safe to predict that when the next recession hits, the ratio of taxes to national income will reach its lowest level since . . . the 1960s!
A decline in the tax-to-GDP ratio of almost four percentage points over the course of two decades is an exceptional historical development. Until recently, nobody—neither Ronald Reagan, nor Margaret Thatcher, nor any other conservative leader—had managed to pull off such a feat. Under Reagan, tax revenues fluctuated as a share of GDP, with no discernible trend. In the United Kingdom, tax collections were higher when the Iron Lady left Downing Street in 1990 than when she arrived in 1979. In both cases taxes fell for the wealthy. But they rose for the rest of the population, leaving total tax collection mostly unchanged. The United States over the last twenty years is the first example of a large and sustained decline in the tax take in a developed country.
All of the decline in the macroeconomic tax rate in the United States comes from the collapse in capital taxation. In the second half of the 1990s, the average tax rate on capital was 36%. In the wake of Trump’s tax reform, it barely reaches 26%.
Except for property taxes, which have remained broadly stable, all capital taxes have contributed to this downfall. The corporate tax, as we’ve seen, has collapsed. Dividend taxation has been halved, as the top tax rate fell from 39.6% under Clinton to 20% today. Revenues from the estate tax have been reduced by a factor of almost four, from 0.4% of national income in the late 1990s to about 0.1% today.
Taking a longer perspective, the changes in the balance of taxation across labor and capital are even more striking. From wealth taxation in Massachusetts as far back as the seventeenth century to the 50% effective corporate income tax rates under Eisenhower, capital taxes have contributed prominently to the public coffers in America. From the 1940s to the 1980s, the average tax rate on capital exceeded 40%, while labor paid less than 25%. Since its peak of the 1950s, however, the average capital tax rate has been cut by twenty percentage points. At the same time, labor taxation has risen more than ten points, driven by the upsurge in payroll taxes. To capital owners who have prospered, the tax system has given more. From workers whose wages have stagnated, it has taken more. In 2018, for the first time in the modern history of the United States, capital has been taxed less than labor.
5.1 THE COLLAPSE OF CAPITAL TAXATION
(Macroeconomic tax rates on labor and capital in the United States)
Notes: The figure depicts the evolution of the macroeconomic tax rates on capital income, labor income, and total income since 1915. Capital income and labor income add up to total national income. All federal, state, and local taxes are included and allocated to either capital or labor. Historically, the tax rate on capital was much higher than the tax rate on labor. This gap has shrunk a lot. In 2018, for the first time, the tax rate on labor is higher than on capital. Complete details at taxjusticenow.org.
HEALTH INSURANCE: A BIG BUT HIDDEN LABOR TAX
Even these numbers grossly underestimate the fiscal advantage that capital owners now have over workers. For these statistics only take into account public—but not private—mandatory levies. Taxes paid to governments are included, but those paid to private collectors are disregarded. Amid these taxes in everything but name, the most prominent one is health insurance paid by workers to insurance companies through their employers. Because the cost of health care is exorbitant in America (due to the much higher prices for standard medical procedures than in other wealthy nations),5 this hidden labor tax is gigantic. The average contribution for workers covered through their employers exceeds $13,000 a year today. And it has skyrocketed over the last decades.6
To better understand this hidden tax, it’s worth reviewing how health care is financed in the United States. Elderly Americans and low-income families are covered by public insurance programs (Medicare and Medicaid, respectively), funded by tax dollars (payroll taxes and general government revenue). The rest of the population must seek coverage by a private company; insurance, in that case, is funded by nontax payments. In practice, people most often obtain private insurance through their employers rather than pay separately. Since the passage of the Affordable Care Act in 2010, it has become compulsory to be insured: contributing to a private plan—for those not covered by Medicare or Medicaid—is mandatory. Conservatives dislike this obligation and are still trying to weaken it, but even if they succeed the situation would not fundamentally change. Whether insurance premiums are paid to a public monopoly (the government) or to a private monopoly (the notoriously uncompetitive US private health insurance system)7 makes little difference. Both payments reduce the take-home pay of workers; and although it’s always possible to evade taxes or to refuse to pay one thin dime to insurance companies, in practice almost everyone abides.
The main difference between these two forms of health coverage is their effect on the overall tax-to-GDP ratio. A greater reliance on private insurers lowers the official macroeconomic tax rate. This bias is particularly pronounced in the United States, but it also exists in countries like Switzerland and Japan that rely on compulsory or quasi-compulsory private health insurance (managed by unions, employers, or nonprofits) for the provision of health care. Like the United States, they can boast low tax-to-GDP ratios compared to the countries (such as the United Kingdom, Sweden, and France) where health insurance is fully or primarily funded by tax revenue.8 But the boast isn’t all that meaningful.
To provide a more accurate and internationally comparable picture, Figure 5.2 treats mandatory premiums paid to private insurers as taxes. These hidden taxes alone add up to 6% of national income in 20199—the equivalent of one-third of all federal income tax payments! They increase the macroeconomic tax rate from 28% of national income to 34%, which is comparable to Canada and New Zealand, and barely lower than in the United Kingdom and Spain.10 Since, by definition, these hidden taxes only fall on labor, the labor tax rate jumps even more sharply, from 29% to 37%. With this extended (and in our view more meaningful) view of taxation, we can see that during the 1980s and 1990s labor and capital tax rates converged. Since the turn of the twenty-first century—and particularly after the 2018 tax reform—capital has been taxed much less than labor.
In this broader view we can also see that the United States, contrary to a widely held belief, is not a particularly low-tax country—at least once we make apples-to-apples international comparisons. After including mandatory private health insurance contributions, America’s macroeconomic tax rate (34%) is still lower than France’s (52%). But that’s for the most part because in France, virtually all contributions to pensions (16.5% of national income) are counted as taxes too, while in the United States only contributions to Social Security (4.5% of national income) are. In the end, the basic truth is that after they’ve paid their taxes, health insurance (privatized taxes), and pension contributions, Americans on average keep about the same fraction of their pre-tax income as their European brethren; the main difference is that Europeans then pay higher consumption taxes (13% of national income in France against 5% on the other side of the Atlantic). In both Europe and the United States, moreover, the burden of funding the government and health expenditures increasingly falls on labor.
5.2 THE RISE OF LABOR TAXATION
(Macroeconomic tax rates on labor and capital in the United States)
Notes: The figure depicts the evolution of the macroeconomic tax rates on capital income and labor income since 1915. Capital income and labor income add up to total national income. All federal, state, and local taxes are included and allocated to either capital or labor. The figure also includes a series where employer sponsored health insurance is added to labor taxes. Health insurance costs create an increasing and now very large extra burden on labor. In 2018, when including health insurance, the tax rate on labor is about 40%, much higher than on capital. Complete details at taxjusticenow.org.
THE OPTIMAL TAX RATE ON CAPITAL: 0%?
Should we worry about the decline in capital taxation and the concomitant rise of labor taxes? There is no doubt that this process is a powerful inequality engine. Always and everywhere, working- and middle-class families derive the bulk of their income from labor. Eighty-five percent of the pre-tax income earned by Americans in the bottom 90% of the income distribution comes from labor today—capital contributes only 15%. For the wealthy, it’s the opposite. Top one-percenters derive more than half of their income from capital, the top 0.1% more than two-thirds.11 It’s a constant of capitalist societies: as one moves up the income ladder, the capital share of income rises—until it reaches 100% at the tip-top. When governments reduce the tax burden on capital, they almost always reduce taxes for the wealthy.
Less capital taxation means that the wealthy—who derive most of their income from capital—can mechanically accumulate more. This feeds a snowball effect: wealth generates income, income that is easily saved at a high rate when capital taxes are low; this saving adds to the existing stock of wealth, which in turn generates more income, and so on.12 This snowballing effect contributes significantly to the surge in wealth concentration in America. The share of wealth owned by the top 1% richest adults has exploded from 22% in the late 1970s to 37% in 2018. Conversely, the wealth share of the bottom 90% of adults has declined from 40% to 27%. Since 1980, the top 1% and the bottom 90% have exchanged their slices of the total wealth pie: what the bottom 90% has lost, the top 1% has gained.13
5.3 THE UPSURGE IN US WEALTH INEQUALITY
(Top 1% and bottom 90% shares of total private US wealth)
Notes: The figure depicts the evolution of shares of total household wealth owned by the top 1% wealthiest adults and the bottom 90% poorest adults. Wealth includes all private assets owned directly or indirectly by households (including housing, pension funds, and all financial assets) net of all debt. Wealth within married couples is split equally. The top 1% wealth share has almost doubled from 20% in the late 1970s to almost 40% today. Meanwhile, the bottom 90% wealth share has collapsed from 40% to about 25%. Complete details at taxjusticenow.org.
Yet if we subscribe to certain economic theories, we should rejoice at this development. For the collapse in capital taxation moves us closer to what’s in the long-run interest . . . of ordinary workers. According to these theories, developed in the 1970s and 1980s, the optimal tax rate on capital is zero: all taxes on corporate profits, interest, dividends, capital gains, rents, residential properties, business properties, personal wealth, estates, and inheritances should be abolished and replaced by higher taxes on labor income or consumption.14 Taken literally, this logic leads to striking recommendations: the Bill Gateses of the world should go completely tax-free, and governments should make up for the lost tax revenue by imposing on secretaries and retirees more. Even the poorest members of society—who own no wealth at all and earn no capital income—would benefit from such a move, at least in the long run, because they would see their pre-tax income rise.
This may sound like mere ivory-tower speculation, until you realize that it is the canonical theory taught to graduate economics students all over the world, and it’s a standard benchmark in policy discussions in Washington, DC. There are, of course, numerous variations on the basic theory, according to which rates higher than zero are desirable. But these refinements often tend to be lost in policy discussions. Ask American tax law experts whether capital should be taxed. You will be surprised (it’s been our experience) how many assert that “economists have proven” it should not. No large country, to be sure, has cut all its capital taxes, and in practice few people advocate for an immediate repeal of all capital taxes. But the notion that capital taxation is particularly harmful is mainstream.
Where does this belief come from? Essentially from the view that the supply of capital (the fraction of its income that the population saves each year plus the net flow of capital a country attracts from abroad) is very sensitive to changes in after-tax rates of return. So sensitive that even tiny taxes invariably end up destroying a huge swath of the capital stock in the long run. Since capital is useful—it makes workers more productive—taxing it ends up hurting wages. In economics lingo, capital taxes are entirely shifted to labor. The corporate tax, in this world view, is perceived as particularly likely to be shifted to workers. Tax companies and plants will move abroad; firms will stop purchasing capital assets, depleting the capital stock and reducing wages. In this analysis, the incidence of the corporate tax, in the jargon of economists, is on labor.
Incidence is a key part of any tax policy analysis, so let’s pause on this concept to understand the merit of the arguments wielded by the opponents of capital taxation. What would happen if the corporate tax were slashed? Dividends and share buybacks might soar, boosting the income of shareholders. But firms could also increase their purchases of machines and equipment, making workers more productive and thus leading to higher wages. Or they could cut the price of the products they sell, in effect benefitting both labor and capital (to the extent that both forms of income are ultimately consumed). Tracing the myriad ways in which changes in taxation affect economic behavior, the level of economic output, and the distribution of income across the population is what tax incidence is all about.
The main result from economic research in this area is intuitive: the most inelastic factor of production bears the burden of taxes, while the most elastic factor dodges them. Concretely, if capital is very elastic—saving and investment collapse whenever capital is taxed—then labor bears the burden of capital taxation. But just as capital taxes can be shifted to labor, so too can labor taxes be shifted to capital. This happens if labor is very elastic—that is, if people work substantially less when the taxation of their earnings rises. In one of the oldest and most famous analyses of tax incidence, Adam Smith in The Wealth of Nations explained how taxes on wages could be shifted to capital. If farmers are at the subsistence level (they earn no more than what they need to barely survive), taxing their wage would make them starve. In that event a wage tax would be shifted away from poor peasants toward wealthier landowners, as those owners would be forced to increase pay to keep their workforce alive.
Tax incidence boils down to simple empirical questions: How elastic are capital and labor? Does the capital stock, in particular, vanish when capital taxes rise? If it does, then taxing capital is indeed harmful and slashing corporate taxation can be in the long-run interest of workers.
A LONG-RUN PERSPECTIVE ON CAPITAL TAXATION AND ACCUMULATION
According to most commentators, capital’s extreme elasticity is a law of nature, as certain as gravity. But this belief—like other stark predictions from basic economic theory (for instance, that the minimum wage must destroy employment)—needs a reality check. Although there are many ways to conduct such a check, a reasonable starting point involves comparing the long-run evolution of investment rates and capital taxes. Historically, has US investment significantly declined when capital was more highly taxed? If yes, this would mean that capital taxes reduce the capital stock and ultimately impoverish workers.
The short answer, however, is no. With data on saving and investment going back to the early twentieth century, we can contrast those figures with the average tax rates on capital incomes. It turns out that the period of high capital taxation—from the 1950s to the 1980s—was also a time when saving and investment were historically high, above 10% of national income on average. This is true whatever the measure of capital accumulation one looks at: private saving (the saving of individuals and corporations), national saving (private saving plus government saving), or domestic investment (national saving minus net foreign saving—in practice, because net foreign saving is most of the time quite small, domestic investment is close to national saving). There is no indication that capital accumulation has risen since capital tax rates started their descent in the 1980s. Quite the contrary: the national saving rate gradually fell after 1980, to reach close to 0% in the middle of the aughts. The saving rate of the rich remained stable but that of the bottom 99% of the population (and of the government) collapsed. This is the opposite of what the “zero-capital-tax” theory must assume to arrive at its strong policy recommendation.
5.4 CAPITAL TAXATION AND CAPITAL ACCUMULATION
(Macroeconomic capital tax rate versus saving rates in the United States)
Notes: The figure depicts the evolution of the macroeconomic tax rate on capital income (total taxes on capital over total capital income), the private saving rate (household plus corporate saving, as a percent of national income), and the national saving rate (private plus government saving, as a percent of national income). From 1940 to 1980, the United States had both a high tax rate on capital and high saving rates. Since 1980, the tax rate on capital has come down and saving rates have also declined. In the macroeconomic data, taxing capital does not seem to reduce saving. Complete details at taxjusticenow.org.
Over the last hundred years, there is no observable correlation between capital taxation and capital accumulation. Before 1980 the saving and investment rates in the United States fluctuated around 10% of national income despite enormous variation in capital taxation. The main exceptions involve the Great Depression, when saving collapsed in a context of massive unemployment and unprecedented decline in real income, and World War II, when saving rose as consumption was rationed. Apart from these exceptional historical episodes, US saving was trendless. A similar regularity is observed in France, Germany, and the United Kingdom, three countries for which savings data go back to the nineteenth century. With the exception of the world wars, the private saving rate in these economies has fluctuated around 10% of national income, despite considerable changes in the average capital tax rate over time, from less than 5% in the nineteenth century, to more than 50% in the post–World War II decades.15
Let’s be clear: this evidence does not prove that capital taxation has no economic cost. What it shows is that since saving and investment rates do not change much, capital taxes are borne by capital owners in the long run—not labor. Since the capital stock is no lower (and hence wages no lower) when capital taxes are high, the incidence of capital taxes falls squarely on capital. Because the rich derive most of their income from capital, while the working class and the middle class derive most of theirs from labor, capital taxes primarily hurt the rich—not the working class. Of course, saving decisions are not completely insensitive to taxes. If capital were taxed at 100%, there would probably be much less wealth in the economy. But for a broad range of after-tax returns to capital (say for returns between 2% and 5%, as has been the case over the course of the twentieth century), the available empirical evidence suggests these effects are small.
WHAT BOOSTS CAPITAL ACCUMULATION: REGULATION, NOT TAXES
Which brings us to a fundamental question: Why does capital accumulation seem to respond relatively little to capital taxation? In a nutshell, capital taxation is only one factor—and a relatively minor one—in the myriad of economic and social forces that affect wealth accumulation. The more important of these forces are the regulations that affect private saving behavior.
For most Americans, wealth primarily consists of housing and retirement savings on the asset side, and mortgage debt, consumer credit, and student loans on the liability side.16 Public policies directly affect each of these forms of assets and liabilities. In the post–World War II decades, regulations encouraged firms to provide funded pensions to their employees. The federal government sponsored the creation of thirty-year mortgages, providing an effective tool to save over a lifetime—because paying down your mortgage debt and building home equity, now that’s saving. After the 1980s, by contrast, student loans boomed as public funding for higher education retreated. Financial deregulation made it easier for people to get into debt, for example by facilitating the perpetual rollover of mortgage debt through refinancing, or by boosting the supply of consumer credit.
This is perhaps the main lesson of behavioral economics, the fast-growing field of research that strives to take a more realistic view of human behavior than the standard, hyper-rational economic model: when it comes to influencing the saving rate, nontax policies swamp tax incentives.17 Take default options, for example. Newly hired workers are four times more likely to enroll in a 401(k) retirement savings account—the now dominant form of retirement saving in the United States—when that’s the default option offered to them (80%, in that case, do enroll) than when they have to voluntarily opt in (20%).18 Default options not only boost retirement saving, they increase the overall saving rate of workers: the money put in retirement saving accounts does not crowd out other forms of wealth accumulation (such as the reimbursement of housing debt). By contrast, the traditional tax incentive that’s supposed to boost retirement saving—namely, exempting investment returns from taxation—encourages people to shift money from nonretirement investments into tax-free retirement saving accounts without measurably increasing saving rates.19 Simple “nudges” like default options have dramatically larger real effects on wealth accumulation than tax incentives.20
This is not to say that capital taxation has no effect. Capital is not very elastic, but it can be obscured. Rich people can hide wealth offshore. Multinational companies can shift profits to Bermuda. People can shift their investments into tax-free accounts. Because the supply of tax dodges is targeted at the rich, and capital income is primarily earned by the rich, the opportunities to dodge capital taxes are numerous when the tax-avoidance industry is not kept in check. But none of this tax dodging affects the real accumulation of wealth—how much stocks, bonds, and real estate people own. Therein lies a source of confusion in the debate about these questions. Yes, capital can respond strongly to taxes. But that response is to the countless ways to shift paper around—not because people start consuming much more today whenever the taxation of their saving increases. And that avoidance response is not a law of nature, but a choice that governments make. It’s been large since the 1980s because governments have tolerated tax dodging, but it was weaker before.
The same conclusion holds true for the taxation of corporate profits, the form of capital income that’s widely seen as most elastic. The way that corporations respond to international differences in tax rates is not primarily by moving their factories to low-tax places, but by shifting paper profits to tax havens. Profit shifting swamps true capital mobility. More generally, a host of evidence suggests that the corporate tax rate affects behavior in various domains.21 When it rises, businesses are less likely to incorporate and more likely to opt for organizational forms that are not subject to corporate taxation, like partnerships. Companies also tend to borrow more money, as interest is tax deductible. If they get a temporary investment tax credit, firms will accelerate their investment plans. None of these choices, however, changes a firm’s long-run capital stock—its stock of buildings, machines, and equipment. None of this implies that taxing corporate profits less will increase workers’ wages.
Contrary to what many ideologues would like you to believe, economics has not “proven” that workers “bear the burden” of the corporate income tax. If this were true, then unions all over the world would be begging governments to slash it. In the real world, the most vocal proponents of the view that ordinary workers—not wealthy shareholders—suffer from high corporate taxes are . . . wealthy shareholders. During the 2018 US midterm elections, lobbies supported by the Koch brothers (worth about $50 billion each) spent $20 million to convince voters that President Trump’s corporate tax cut was good for wages.22 By the same token, economics has not proven that labor taxes are borne by capital. In the long run, capital taxes fall by and large on capital, and labor taxes fall by and large on labor. Poor people do not suffer from the taxes levied on the wealthy, no more than the wealthy suffer from the taxes levied on the poor.
TOWARD THE DEATH OF THE PROGRESSIVE INCOME TAX
Taxing capital less and labor more does not have proven benefits, but it has real costs. It not only undermines the sustainability of globalization—increasing the risk of a protectionist backlash, should globalization remain synonymous with lower taxes for its main winners. But it also opens the door to a potentially lethal form of tax avoidance: the shifting of income away from labor toward capital. Low capital tax rates encourage the wealthy to reclassify their highly taxed wages into lightly taxed capital income. The higher the gap in tax rates between the two forms of income, the greater the incentives to shift. As that shift takes hold, it creates a big problem: the death of the individual income tax, the main progressive component of modern tax systems.
There are, of course, many instances when it’s not possible to shift income. Teachers, clerks, and most other employees will never be able to pretend their wages are in fact dividends. But for the wealthy, shifting income is child’s play. The way this is done in practice is by incorporating.
Take John, a successful lawyer who earns a million dollars a year but only spends $400,000 for his ordinary personal expenditures. And picture yourself in 2050, in a world where tax competition has finally done away with the corporate tax. In such a world, what would John do? He would create his company, John LLC, which would pay him (as dividends) the $400,000 he needs to buy his meals, suits, vacations, etc., and would save the remaining $600,000. Despite earning a million, John would thus pay individual income taxes on $400,000 only. No tax would be charged on the rest: his savings would be tax-free. The income tax would be a simple consumption tax.
Any number of rich people can morph into companies and benefit when corporate tax rates are low. Lawyers, doctors, architects, and other self-employed individuals can choose to operate as corporations. Owners of financial assets can move their portfolios of stocks and bonds into holding companies. The owner-managers of private businesses can decide to slash their wages to keep more of their earnings within their firm. Even highly paid employees—software engineers, financial analysts, columnists—can become independent contractors, incorporate, and bill Google, Citigroup, or the Washington Post for their labor.
The threat of wealthy individuals incorporating is why all countries that have a progressive income tax also have a corporate tax. The corporate tax is a safeguard: it prevents wealthy individuals from shielding their income from the taxman by pretending it’s been earned by a firm. This is not its only role; the corporate tax also ensures that companies contribute to funding the infrastructure from which they benefit, for example. But preventing tax dodging has always been its prime justification—and the reason why, historically, corporate income taxes were created at the same time as individual income taxes. Like the O-rings of the space shuttle Challenger, if the corporate tax malfunctions, the whole system of progressive income taxation collapses.
Once every rich person has become a company, not only is the progressive income tax dead (it is now a mere consumption tax), but the possibilities of evading this residual consumption tax become limitless. How so? By consuming within firms. Instead of paying John a (taxable) dividend, John LLC will pay for John’s meals, suits, vacation, and other personal expenses. This is tax evasion, pure and simple: an allowable corporate expense is strictly regulated and does not include spending on personal consumption. But enforcing these rules and monitoring firms becomes impossible when everybody’s a company—a fake company that’s not accountable to anybody but its single owner. For a striking illustration, look no further than Chile today, where the vast majority of rich people have their own personal companies and routinely evade taxes by charging them for their personal expenses.23
The fundamental problem now comes into view: With the sharp cut in the American corporate tax rate to 21% in 2018—and the similar trend followed by corporate taxes globally—incorporating is becoming more valuable than ever for the rich. For anybody who can save a significant fraction of their income, morphing into a company is now worth the trouble, for all income that’s not consumed is taxed at 21% only.
Is this idle fantasy? Examples of shifting abound throughout the world.24 There is just one difference between the available historical record and today’s situation: Until recently, governments were careful to limit the gap between labor and capital tax rates for the wealthy. Differences existed, but they were typically a few percentage points. With the collapse of capital taxation globally, we’re entering unchartered territory.
If you’ve been appalled by the tax shelters of the 1980s, dismayed by the profit-shifting frenzy of America’s corporate behemoths, hold your breath—we’re now entering a third phase of tax injustice. Nothing is permanent, and positive change may well arrive in time. But under business as usual, a new wave of tax dodging is about to break. As tax competition rages and pushes corporate rates down globally, it is high noon on the clock of the next disaster.