Will Lower Corporate Tax Rates Yield Higher Wages?

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Corporations may have benefited the most from the Tax Cuts and Jobs Act of 2017 (TCJA). Chapter C corporations were subjected to graduated tax rates of 15% for taxable income up to $50,000, 25% (over $50,000 to $75,000), 34% (over $75,000 to $10,000,000), and 35% (over $10,000,000). Personal service corporations1 pay tax on their entire taxable income at the rate of 35%. TCJA makes the corporate tax rate a flat 21% and eliminates the corporate alternative minimum tax.

Reducing the tax rate on businesses has been one of the cornerstones of President Trump’s tax reform plans. The President’s early proposal was to cut the corporate income tax (CIT) rate to 15%. The United States had one of the highest CIT rates in the world. The effective rate is even higher when both state and federal taxes are considered.

Argument to Lower Corporate Income Tax Rate

Early analysis suggests that the new CIT rate of 21% will make U.S. corporations more competitive with their global competitors. The Trump administration believes the lower CIT rate will also benefit individuals in the form of increased wages. A 2007 study2 found that a 10% increase in CIT reduced mean annual wages by 7%.

Many feel corporate tax rates should be lower because the income is taxed twice. A corporation pays income taxes on its earnings (profits) now at the new rate of 21%. The owners of that corporation (shareholders) are taxed again on the dividends they receive from those earnings at the individual tax rate of 23.8% (maximum tax rate including the Medicare Surtax).

President Obama had considered similar reforms to minimize the double taxation of corporate profits and simplify taxes on businesses. While the Obama administration’s framework for reform3 focused heavily on small business, it recognized the competitive disadvantage our high CIT had on the ability to compete in a global market. The Commerce Department reported that Gross Domestic Product (GDP) growth remained sluggish and was expanding at an annual rate of less than 2%.

CIT’s Impact on Investing

It is hoped that the lower CIT will encourage corporations need to start investing their cash, which has remained at historically high levels. Corporate cash sitting on the sidelines neither creates jobs nor maximizes innovation. Analysts will be watching in the coming months to see if corporations will ramp up investment and start creating new products and services that produce more jobs and improve the economy.

This is not a new concept. Corporations invest their tax savings in productive economic activities such as building plants and equipment to produce more products and services. These activities are thought to reinvigorate economic growth and, in the end, generate more tax revenue from the corporate income tax, shareholders, and employees in the form of higher wages and more wage earners. According to the theory, this boost in growth will ultimately help everyone in the country through a stronger economy. Lowering the CIT rate will likely provide more available cash flow to corporate stakeholders, both large and small.

In speaking about his railroad, Burlington Northern Santa Fe, Warren Buffett said the lower CIT will make companies more valuable by giving owners a bigger share of profits. Buffett said, “We own 100 percent of the assets of BNSF, but we don’t own 100 percent of the profits. And we went from 65 to 79 percent of the profits of BNSF and that is a more than 20 percent increase.”4

It is still early. How corporations choose to use their tax savings remains to be seen. Will it spur job creation? Lead to more mergers and acquisitions? Provide an incentive to create new products? Any of these activities could spur the economy and should grow the economy and ultimately increase tax revenue for the government.

Will the lower CIT be the fuel needed to achieve sustained GDP growth of 3 to 4%?
A healthy GDP growth rate is one that is sustainable and holds the economy in the expansion phase of the business cycle. GDP is the nation’s entire economic output for the past year. In a healthy economy, unemployment and inflation are in balance. The natural rate of unemployment should be between 4.7% and 5.8%, and the target inflation rate should be 2%. The U.S. economy currently has low unemployment and low inflation, but economic growth has been sluggish. Wage growth has also been very weak. There have been several theories presented to explain this apparent contradiction from the retiring of baby boomers to the increased number of involuntary part-time workers.

It remains to be seen whether the tax law changes will make a difference. Just remember, the economy moves slowly. It will be several months before changes are noticed.

Rick’s Tips:

• The new corporate tax rate is a flat 21% and the corporate alternative minimum tax has been eliminated.
• Studies have found that a decrease in the corporate income tax rate could lead to increased wages.
• Analysts are hoping the lower tax rate on businesses will increase economic growth and lead to higher wages.

 

1 The IRS classifies a personal service corporation as a type of C corporation where more than 10% of the stock by value is owned by professionals who provide personal services for the corporation in the fields of accounting, architecture, actuarial science, consulting, engineering, health, law, or the performing arts.
2 Passing the Burden: Corporate Tax Incidence in Open Economies, by R. Alison Felix, October 2007
3 THE PRESIDENT’S FRAMEWORK FOR BUSINESS TAX REFORM, A Joint Report by The White House and the Department of the Treasury, February 2012.
4 Warren Buffett: Tax Cut Will Make Companies More Valuable, Fortune Magazine

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