Economics for Dummies
February 28, 2011 10:17 AM Subscribe
How much does the corporate tax rate really affect jobs?
As I understand things (which is minimal, so please correct me), corporations are taxed primarily on their net profits, meaning that expenses and reinvestments (into capital, inventory, wages, etc) are exempt. It seems to me therefore that a corporation wanting to maximize their profit would make the same investment regardless of the tax rate on those profits.
For example, a company may decide to spend $1Million on salaries, which would result in $2M in sales, for $1M profit, taxed at 25%. Spending $50k less would reduce revenue by more than $50k, and spending $50k more would increase revenue by less than $50k. This is therefore the optimal investment they can make for maximum profit. So they invest $1M, get back $2M, for $1M profit taxed at 25% for $750k.
If the tax rate were changed to 50%, they would now earn only $500k after taxes. However, they would earn even less they tried to compensate by laying people off, because they are already operating at the optimal spot, and the tax on their net profits doesn't change that. In fact, it seems that raising taxes on profits could actually stimulate hiring, since (untaxed) reinvestment of money into salaries would be all that much more attractive vs taking the money out of the business as profit.
Clearly, I am grossly simplifying things and reality must be much more complex (eg considering factors like available cash flow). So, how much does changing the tax rate actually affect corporate investment, specifically jobs? What do economists say about this? Is there historical data that shows the actual impact?
As I understand things (which is minimal, so please correct me), corporations are taxed primarily on their net profits, meaning that expenses and reinvestments (into capital, inventory, wages, etc) are exempt. It seems to me therefore that a corporation wanting to maximize their profit would make the same investment regardless of the tax rate on those profits.
For example, a company may decide to spend $1Million on salaries, which would result in $2M in sales, for $1M profit, taxed at 25%. Spending $50k less would reduce revenue by more than $50k, and spending $50k more would increase revenue by less than $50k. This is therefore the optimal investment they can make for maximum profit. So they invest $1M, get back $2M, for $1M profit taxed at 25% for $750k.
If the tax rate were changed to 50%, they would now earn only $500k after taxes. However, they would earn even less they tried to compensate by laying people off, because they are already operating at the optimal spot, and the tax on their net profits doesn't change that. In fact, it seems that raising taxes on profits could actually stimulate hiring, since (untaxed) reinvestment of money into salaries would be all that much more attractive vs taking the money out of the business as profit.
Clearly, I am grossly simplifying things and reality must be much more complex (eg considering factors like available cash flow). So, how much does changing the tax rate actually affect corporate investment, specifically jobs? What do economists say about this? Is there historical data that shows the actual impact?
Here's one article that hints at the complexity.
posted by dfriedman at 10:29 AM on February 28, 2011
posted by dfriedman at 10:29 AM on February 28, 2011
Response by poster: Lets limit it to profitable companies operating completely within the US and exclude things like tax shelters or other loopholes. It seems that assertion is often made that higher taxes corporate taxes directly results in lost jobs, and I'm just wondering how true that is, in a general sense.
posted by jpdoane at 10:40 AM on February 28, 2011
posted by jpdoane at 10:40 AM on February 28, 2011
Lets limit it to profitable companies operating completely within the US and exclude things like tax shelters or other loopholes. It seems that assertion is often made that higher taxes corporate taxes directly results in lost jobs, and I'm just wondering how true that is, in a general sense.
Well these days there are not too many companies "operating completely within the US." There's a reason that companies like Google end up putting offices in Ireland. The higher the tax, the more money and effort it's worth putting in to dodge it, which could include laying off a whole division of the company and moving operations overseas.
posted by burnmp3s at 10:50 AM on February 28, 2011
Well these days there are not too many companies "operating completely within the US." There's a reason that companies like Google end up putting offices in Ireland. The higher the tax, the more money and effort it's worth putting in to dodge it, which could include laying off a whole division of the company and moving operations overseas.
posted by burnmp3s at 10:50 AM on February 28, 2011
Canada has been having a healthy debate over corporate taxes lately, as the government's policy has been to reduce them over the last couple of years. This link and this link may interest you. Keep in mind it's from the point of view of a small (population wise) and open economy.
Essentially, the writer's idea is that the world chases higher returns and investment creates jobs. Corporate taxes reduce investment if they are higher then elsewhere as people (even people within the country being effected) move their money elsewhere to get those returns. So instead of say investing in a mining company in Canada, you'd go for one in Australia or Brazil. The Canadian company would suffer as it wouldn't be able to raise the same amount of capital and therefore expand (and hire). Of course, there are dozens of other factors. How (over)regulated are the jurisdictions? How much labour is available? How expensive are the market rates for labour? It is expensive to import machinery in one country than another due to tarrifs or distance?
posted by hylaride at 10:52 AM on February 28, 2011
Essentially, the writer's idea is that the world chases higher returns and investment creates jobs. Corporate taxes reduce investment if they are higher then elsewhere as people (even people within the country being effected) move their money elsewhere to get those returns. So instead of say investing in a mining company in Canada, you'd go for one in Australia or Brazil. The Canadian company would suffer as it wouldn't be able to raise the same amount of capital and therefore expand (and hire). Of course, there are dozens of other factors. How (over)regulated are the jurisdictions? How much labour is available? How expensive are the market rates for labour? It is expensive to import machinery in one country than another due to tarrifs or distance?
posted by hylaride at 10:52 AM on February 28, 2011
Yeah, you're basically skewing the results if limit this to your parameters and ignore the realities of the situation.
posted by buggzzee23 at 10:53 AM on February 28, 2011
posted by buggzzee23 at 10:53 AM on February 28, 2011
This is of course a very serious question for Ireland at the moment. The French and Germans argue that the relatively low Irish corporate tax rate gives Ireland an advantage in competing for foreign investment. So far the Irish response has tended to include the word "sovereignty" which can be roughly translated as "we'll do what we please to improve our position". But if the French and German pressure succeeds in getting an EU-wide uniform corporate tax rate (probably fairly unlikely) we may get a sort of experimental test.
posted by Logophiliac at 10:54 AM on February 28, 2011
posted by Logophiliac at 10:54 AM on February 28, 2011
Hm. At that point it becomes speculation because all companies large enough to worry about take advantage of various quirks in the tax law.
That said if a company pays more in taxes it has less cash with which to pay future employees.
Basically, an income statement is structured in the following manner:
Gross Revenues
Expenses
Operating Profit
Net Income Before taxes
Net Income
Tax is assessed on net income before taxes, also called Earnings Before Taxes. (Again, being extremely simplistic here.)
The effect on the cash flow statement is that the increase in cash is equal to the net income on the balance sheet minus the tax payments. The less that cash increases the less money the company has to spend on other things, including but not limited to, hiring more workers.
However, it doesn't follow that if taxes decline companies will hire more workers. All that you can conclude is that if taxes decline companies will have more cash on their balance sheet at the beginning of the following accounting period.
posted by dfriedman at 10:54 AM on February 28, 2011
That said if a company pays more in taxes it has less cash with which to pay future employees.
Basically, an income statement is structured in the following manner:
Gross Revenues
Expenses
Operating Profit
Net Income Before taxes
Net Income
Tax is assessed on net income before taxes, also called Earnings Before Taxes. (Again, being extremely simplistic here.)
The effect on the cash flow statement is that the increase in cash is equal to the net income on the balance sheet minus the tax payments. The less that cash increases the less money the company has to spend on other things, including but not limited to, hiring more workers.
However, it doesn't follow that if taxes decline companies will hire more workers. All that you can conclude is that if taxes decline companies will have more cash on their balance sheet at the beginning of the following accounting period.
posted by dfriedman at 10:54 AM on February 28, 2011
This paper compared corporate and individual tax rates among the Swiss cantons and concluded that higher rates in a canton deter firms from locating there. However, the abstract notes that the question is "widely debated in the tax competition literature" and "Empirical evidence on tax-induced relocation and subsequent economic development in the US and Europe is still inconclusive," or at least it was as of 2000 when the paper was written.
posted by jedicus at 10:55 AM on February 28, 2011
posted by jedicus at 10:55 AM on February 28, 2011
Just purely answering the question - not much. Corporate management cares a lot more about personal income tax rates. For precisely many of the reasons others have mentioned, most state taxes can be successfully mitigated, but even if they can't state taxes max out at 10%. And as others have said - almost no one pays full freight on taxes. Once you get up to the size of pre-tax profits needed to justify the math on relocating (don't forget the costs of laying people off who won't move and hiring their replacements) then you usually already have a pretty sophisticated tax planning mechanism in place.
To jedicus' point - yes a higher tax rate would deter relocation to a state, but it usually does not promote relocation from a state. However it does seem to be the case that companies will move due to personal income tax rates - partially because those are harder to avoid and because they more directly impact upper management.
posted by JPD at 11:01 AM on February 28, 2011
To jedicus' point - yes a higher tax rate would deter relocation to a state, but it usually does not promote relocation from a state. However it does seem to be the case that companies will move due to personal income tax rates - partially because those are harder to avoid and because they more directly impact upper management.
posted by JPD at 11:01 AM on February 28, 2011
@JPD I disagree. Corporate management doesn't decide how much of the profit it keeps from operations, the government does. Investors want those profits, as do executives. The Scandinavian countries (as well as Ireland) have decided to keep consumer (ie VAT and income) taxes relatively high, but their corporate taxes low. This has brought in much investment from foreign companies, and hence jobs. In theory, high income taxes could cause workers to leave, which would therefore have an effect on employment. There's a lot of debate about how much that happens, though.
Of course, this all assumes that all else is equal. Sometimes being in expensive and higher tax places, like NYC for finance or Paris if you're in the fashion industry, are considered a cost of business. You gotta be where the action is, though interestingly NYC had some stiff competition from lower tax/regulation London over the past decade.
posted by hylaride at 11:13 AM on February 28, 2011
Of course, this all assumes that all else is equal. Sometimes being in expensive and higher tax places, like NYC for finance or Paris if you're in the fashion industry, are considered a cost of business. You gotta be where the action is, though interestingly NYC had some stiff competition from lower tax/regulation London over the past decade.
posted by hylaride at 11:13 AM on February 28, 2011
Right now, very little. Corporations are sitting on cash now.
posted by Ironmouth at 11:21 AM on February 28, 2011
posted by Ironmouth at 11:21 AM on February 28, 2011
A big issue for manufacturing and similar capital intensive businesses in the U.S. faced with a choice of spending money on additional salaries (personnel) or capital improvements (new machinery, plant, process improvements, etc.) is that capital improvements usually qualify for at least depreciation (and sometimes, for real money, through investment tax credits), which means that over time, the capital investment is recovered in lowered tax payments, whereas salaries are simply an ongoing cost. Most American businesses want to automate, where they can, simply because if they don't, they have to feed salaries forever, whereas, via depreciation, they're essentially helped financially, through the tax code, to automate.
posted by paulsc at 12:36 PM on February 28, 2011
posted by paulsc at 12:36 PM on February 28, 2011
hylaride re-read what I said. I'm not disagreeing with you.
Tax rates have an impact on investment, but rarely have an impact on disinvestment. Secondly most of those examples you gave involve upper management staying in their old tax jursidiction. Ingersoll-Rand might be "headquartered" in Swords IE, but the CEO is still based in the US.
posted by JPD at 1:15 PM on February 28, 2011
Tax rates have an impact on investment, but rarely have an impact on disinvestment. Secondly most of those examples you gave involve upper management staying in their old tax jursidiction. Ingersoll-Rand might be "headquartered" in Swords IE, but the CEO is still based in the US.
posted by JPD at 1:15 PM on February 28, 2011
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Also, you need to take into account tax accounting, which is different than financial statement accounting. Believe it or not companies that adhere to GAAP keep two separate books, one for the financial statements and another for the tax returns, and then have reconcile between the two with tax loss carryforwards and other accounting arcana.
As you intuit this is an enormously complex topic that keeps many $1,000 per hour lawyers busy.
posted by dfriedman at 10:27 AM on February 28, 2011