Who ends up footing the company tax bill?

My AFR op-ed today is on the economic incidence of company taxes. The draft benefited from comments by Nicholas Gruen and an anonymous friend. Full text over the fold.

‘Abbott Tax Hits Workers’, Australian Financial Review, 16 March 2010

On the morning that Tony Abbott released his proposal to pay for paid parental leave with a tax on Australia’s 3200 largest firms, I was reading Norman Lindsay The Magic Pudding to my three year old son. As you know, it involves a pugilist strolling around outback Australia, punching his enemies on the nose and promising his friends a free lunch. The Magic Pudding has a similar storyline.

Promising to raise company taxes has an visceral appeal to any ambitious opposition. Perhaps some voters will think that they will be borne by the companies themselves, leaving all living persons miraculously unharmed. Slightly savvier citizens might think that company taxes are entirely borne by investors.

A central tenet of public finance, however, is that the entity that has the legal obligation to pay a tax is not necessarily the one that bears the burden. For example, payroll taxes are levied on firms, but we know that they are mostly borne by workers. Raise payroll taxes, and firms cut wages. Lower payroll taxes, and most firms will pass on a pay rise.

The GST is another case in which the burden of a tax doesn’t fall on the entity that pays the tax bill. Although the law says that the tax is levied on those who supply goods and services, it is customers who end up bearing most of the burden.

Which brings us to company taxes. For decades, economists have argued over how the burden of company taxes are shared between investors, employees and customers. In the short-term, it is difficult to change prices and wages, so a higher company tax rate will be paid in the first instance by shareholders.

But over time, the burden is likely to shift. Investors are a footloose bunch, with the ability to shift their money into sectors like real estate where they can avoid company taxes. For an open economy like Australia’s, higher corporate income taxes will lead investors to buy foreign shares instead (which is why small countries have been cutting company tax rates over recent decades). To keep their investors, companies may respond to the tax rise by raising revenue and cutting costs.

What will a company tax rise do to prices? While the evidence is thin, theory suggests that companies will be most likely to put up prices on consumers when they do not face competition from importers. So an Australian shoe manufacturer (do we have any left?) may be unable to shift the burden to consumers. But a fast food outlet will have greater capacity to raise prices.

In the case of wages, the empirical evidence is stronger. In a recent review of the literature, William Gentry (Williams College) concludes that most of the impact of a corporate income tax rise falls on workers. Increase company taxes by 10 percentage points, and wages fall by 6-10 percent.

Assuming Gentry’s finding applies here, this means that Abbott’s paid parental leave plan will be mostly paid for by those who work for big firms. For these companies, Abbott proposes to raise the company tax rate by 1.7 percentage points. If Gentry is right, we should expect to see wage drops of at least 1 percent in these companies.

Which workers will cop the pay cut? Abbott’s plan applies to companies with taxable income over $5 million, and we know that employees of such firms tend to earn a bit more than the average worker. But the difference is largely due to managerial salaries (you can’t be a high-ranking manager in a small firm). Further down the pecking order, there are plenty of modestly-paid workers toiling in the retailers and banks that make up Australia’s largest businesses. If a company tax increase is passed on to employees, these are the people who will pay for parental leave.

Abbott’s plan aside, it is useful to recognize that company taxes are not as progressive as they may appear at first blush. If the corporate income tax was solely an investor tax, it would fall largely on the rich. But if it is mostly a worker tax, then this means that the corporate tax burden is spread broadly across Australian society.

Good economics doesn’t always make good politics. Indeed, politicians can sometimes look as through they’re living by Bill Barnacle’s maxim (‘as we’re perfessional puddin’-owners, we have to fight them on principle’). Enjoy the spectacle, but don’t forget who’s in the pud.

Andrew Leigh is a professor in the Research School of Economics at the Australian National University.

One point that Nicholas made – which I was unable to squeeze in – is that big businesses are already hit with a special tax that falls on workers, because the payroll tax doesn’t apply to small enterprises. Another reason not to be ramping up their company tax rate.