Does Capital Bear the U.S. Corporate Tax After All? New Evidence from Corporate Tax Returns

• Date: 01 March 2020
• Author: Edward Fox
• DOI: http://doi.org/10.1111/jels.12243
• Published date: 01 March 2020

Journal of Empirical Legal Studies

Volume 17, Issue 1, 71–115, March 2020

Does Capital Bear the U.S. Corporate Tax

After All? New Evidence from Corporate

Tax Returns

Edward Fox*

This articleuses U.S. corporate tax return data to assesshow government revenue would have

changed if, over the period 1957–2013, corporations had been subject to a hypothetical cor-

porate cash flow tax—that is, a tax allowing for the immediate deduction of investments in

long-lived assets like equipment and structures—rather than the corporate tax regime actu-

ally in effect. Holdingtaxpayer behavior fixed, the data indicateactual corporate tax revenue

over the most recentperiod (1995–2013) differedlittle from that under the hypotheticalcash

flow tax. This result has three important implications. First,capital owners appear to bear a

large fraction of the corporate tax today. This is because economic theory holdsthat corpo-

rate cash flow taxes arelargely borne by capital owners and my result implies that the actual

tax behaves in practice muchlike a cash flow tax. This theory is embodied in the Treasury’s

most recent modelof corporate tax incidence. Applying the modelto my results implies that

only a small portion(2–10 percent) of the U.S. corporatetax was borne by labor in the years

before the 2017Act and thus capital providers are theprimary beneficiaries of the Act’s large

corporate rate cut. Second, the results suggest that the United States could switch fully over

to a cash flow tax, which is likelyto be administratively simpler for both the government and

corporations,at relatively low revenue cost. Third,the impact of fully switching to a cash flow

tax on the operationsof the real economy and its efficiency are likely to be fairly small. This

is precisely because the corporate tax has already evolved to largely mimic a cash flow tax,

and the articleexplores the reasons underlyingthis evolution using a noveldataset.

I. Introduction

The centerpiece of the 2017 Tax Act was the reduction in the corporate tax rate from

35 percent to 21 percent.

1

The Congressional Budget Office (CBO 2018) estimates the

*Address correspondence to Assistant Professor of Law, University of Michigan Law School, 625 S. State St., Ann

Arbor, MI 48109; email: edfox@umich.edu.

I would like to thank Dawn Chutkow and the two anonymous referees for their help in editing and improving the

article, as well as the participants at the ALEA, NTA and CELS conferences along with Reuven Avi-Yonah, Ian Ayres,

Dhammika Dharmapala, Katarzyna Habu, JacobGoldin, Zach Liscow, Paul Rhode, Joel Slemrod, Nora Sennett, and,

especially, Jim Hines for their comments and suggestions. All errors are of course my own.

1

The previous name of the bill, the Tax Cuts and Jobs Act, was stricken shortly before passage. I will refer to it as

the 2017 Tax Act or simply the 2017 Act.

71

rate cut will reduce tax revenue by well over $1 trillion over the next decade. The Act also

allows for the immediate deduction (“expensing”) of nearly all physical equipment pur-

chased by businesses.

2

The political parties are—to say the least—divided on the likely

effects of the rate cut. Republicans claim that the changes will spur capital accumulation,

raising labor productivity, which in turn will lead to higher employment and increasing

wages. Democrats, by contrast, have painted the corporate rate cut as a giveaway to

wealthy shareholders who will receive the vast majority, if not all, of the benefits. The aca-

demic debate, more than 50 years after Harberger (1962) published his seminal analysis

of corporate tax incidence, is more civil, but not much less divergent. Scholars have used

several methodologies and even those using similar methodologies have reached widely

different conclusions, ranging from labor bearing almost 0 percent to more than 100 per-

cent of corporate taxes (Auerbach 2018).

This article gives another view of the (corporate tax incidence) cathedral using

new empirical evidence from aggregate U.S. corporate tax return data. It uses these data

to construct a hypothetical cash flow tax covering 1957 to 2013, though I focus more

intensely on 1995–2013 (the “primary study period”).

3

As the name implies, a cash flow

tax allows businesses to deduct their expenses as soon as the cash is paid. This includes

allowing an immediate deduction for investments in long-lived assets like equipment and

structures. By contrast, under an income tax like the U.S. corporate tax,

4

these invest-

ments would usually be capitalized and deducted over time as they depreciate. Because a

cash flow tax provides taxpayers with more generous deductions, it will generally raise less

money than the U.S. corporate tax. The main empirical question this article seeks to

answer is: How much less?

I find that, holding corporate behavior fixed, the actual tax raised only slightly

more than the hypothetical cash flow tax over the most recent period from 1995–2013.

The difference was about 4 percent on average.

5

One important implication from this result is that capital owners appear to bear a

large fraction of the corporate tax as it is currently constituted. This is because economic

theory holds that corporate cash flow taxes are largely borne by capital owners and the

results imply that today’s actual tax behaves in practice much like a cash flow tax. Thus,

the result suggests that capital providers are the primary beneficiaries of the large corpo-

rate rate cut in the 2017 Act.

2

Expensing is scheduled to phase out slowly over 2023 to 2027 (IRC § 168(k)(6)), but it is quite possible it will be

made permanent prior to the scheduled phase out.

3

The cash flow tax I construct has the same tax rate as prevailed from time to time under the actual U.S. corporate

tax over the 1957 to 2013 period.

4

Although the U.S. corporate tax is nominally an income tax (IRC § 11), many of its features—even before the

2017 Act provided full expensing for equipment—were more similar to a cash flow tax, making it in reality more

like a hybrid tax than a pure income tax. For more discussion see Section III.

5

This 4 percent figure is based on assumptions commonly utilized in the literature. More conservative assumptions

yield 21 percent on average.

72 Fox

This economic theory flows from the different tax bases of income and cash flow

taxes. Corporate income taxes raise revenue from the normal return to capital—the

return savers demand for the use of their funds for a period of time. This kind of return

is thought to be the most easily distorted by taxation, and as capital flows out of the coun-

try to escape taxes on the normal return, those taxes are partly passed on to labor via

lower productivity and lower wages. By contrast, by allowing for immediate deduction of

investment, cash flow taxes exempt the normal return from tax.

6

However, both types of

taxes do raise revenue when corporations earn “supernormal” returns through monopoly

power or some other nonreproducible advantage. Taxes on this income are less likely to

be passed on to labor, however, because these economic rents are so profitable that inves-

tors will not respond to tax increases on them by shifting capital elsewhere.

The Treasury’s most recent model of corporate tax incidence embodies this theory.

It concluded that 100 percent of taxes on supernormal returns (i.e., 100 percent of cash

flow taxes) are borne by capital owners, while 50 percent of the additional revenue raised

by a corporate income tax from taxing the normal return to capital is passed on to labor

(Cronin et al. 2013).

7

Applying this model to my results suggests that only 2–10 percent

of the corporate tax fell on labor over the primary study period.

8

It also provides, as

noted, a clear prediction of who will receive the lion’s share of the benefit from the 2017

rate cut: capital providers. Indeed, the switch to full expensing of equipment as part of

the 2017 Act will only reinforce this conclusion as it further pushes the U.S. corporate

tax toward being like a cash flow tax and reduces revenue from the normal return.

9

6

The intuition for why the cash flow tax exempts the normal return is as follows: (1) cash flow taxes allow for the

immediate deduction of the costs of investment long before any economic depreciation takes place; (2) this means

the government in effect puts up a fixed percentage of the cost of investing and takes the same percentage of the

cash flows; (3) this makes the government a full equity partner in the investment; (4) the private rate of return on

projects earning the normal return is unchanged by having an additional equity partner; (5) which means the cash

flow tax exempts the normal return.

7

The Treasury unceremoniously removed the white paper describing the Cronin et al. model and data from its

website in 2017 (Rubin 2017). The hasty removal of the paper, reminiscent of Roman damnatio memoriae, left a

noticeable gap in the sequencing of the white papers on the website—now numbered 3, 4, 6. The Treasury does

not appear, however, to have published a new methodology for distributing the corporate tax burden. In the

absence of another model and consistent with earlier drafts of this article, however, I continue to refer to the Cro-

nin et al. model as the “Treasury Model.”

As discussed below, the Treasury model’s assumption that taxes on supernormal returns fall entirely on the

owners of corporate capital is likely too extreme. Nevertheless, I employ this assumption in much of my analysis

below, and one limitation of this paper is that I reserve for further research the important question of empirically

testing that assumption in this context.

8

I put aside the issue for now of whether the cash flow tax would also fall, in part, on the return to risk. To the

extent it does, it would do so in the same manner as the actual corporate tax. Under the Treasury’s model, taxes

on the return to risk are also borne by capital owners (Cronin et al. 2013). I return to this question in greater

detail in Section VII.

9

In addition, my explanations for why the corporate tax raised so little revenue from the normal return are likely

to apply to pass-through businesses as well. Thus, although I do not formally model it, it seems likely that the

20 percent Qualified Business Income Deduction (IRC § 199A) will have similar incidence to the corporate rate

cut, with the vast majority benefiting business owners rather than flowing down to employees of those businesses.

Does Capital Bear the U.S. Corporate Tax After All? 73