High income individuals tend to own company shares along with other forms of capital, so imposing greater tax burdens on companies could implicitly tax wealthy company owners. However, as is now known, this possibility depends critically on certain general equilibrium aspects of corporate tax. While it may be intuitive that capital taxes should be borne by the owners of capital, there is a realistic framework in which higher corporate taxation depresses corporate demand for labor, thereby lowering market wages. These effects can be so strong that the worker bears the entire corporate tax burden, or possibly more.
My research examines the effect of corporate taxation on the distribution of after-tax income, which requires a slightly different perspective than the usual calculation of tax revenue. The tax incidence assesses the extent to which different groups, which are usually defined before the tax reform, bear the burdens of tax changes. As taxation affects the risk of economic activity, the patterns of realized returns will change, changing the resulting distribution of income. Therefore, in order to understand the effects of taxation on income distribution, it is necessary to complement the standard analysis of tax incidence, taking into account the effects of taxation on income distribution.
Since the publication of the 1962 paper by economist Arnold C. Harberger on the incidence of corporate income taxes, it has been clear that one of the main forces determining corporate income tax incidence is the effect of the tax on promoting non-corporate business. Higher corporate taxes hinder corporate activity and therefore indirectly stimulate greater activity by companies without their own legal personality. Harberger and subsequent analysts consider the effect of this redistribution of economic resources on the expected returns from labor and capital. This redistribution, when the non-corporate sector is particularly capital intensive, can create significant workloads. In a second sense, however, this redistribution affects the distribution of income: increasing non-corporate business activities can increase idiosyncratic risk in the economy and lead to greater disparities in economic outcomes.
There is increasing evidence that non-corporate corporate investments are very risky from an individual investor’s point of view and, therefore, that individual income at the top of the payout contains significant components that represent the return for successful non-corporate companies. The risk of business investment outside of the company reflects both the characteristics of the business that tend to be carried out by non-incorporated companies and the nature of their ownership. US investors in unincorporated companies are generally exposed to much greater self-willed risk than investors in publicly traded companies. Individual owners have property rights. Partnerships, including limited liability corporations (LLCs), must identify their owners in partnership agreements, making it difficult to diversify ownership and making it costly and cumbersome to change ownership in the first place. S companies must have 100 or fewer shareholders, and all shareholders must be US citizens or permanent residents and hold shares with equal rights. In practice, high-income individuals typically receive partnership and S-company income from companies that they are the sole owner. C companies, whose income is subject to corporation tax, are not subject to any of these restrictions and therefore can have diversified ownership much more easily. Given the undiversified ownership of unincorporated companies, the returns generated by their owners can be very risky, not to mention the undoubtedly greater business risks that these smaller companies tend to face.
The consequences of the risk profile of non-corporate investments are predictable: some non-corporate entrepreneurs are very successful while others lose significant parts of their investments. Investors in unincorporated companies can be faced with distributions of returns similar to those of lotteries, and the more lotteries increase the income distribution of the economy.
Higher corporate taxes are changing the composition of economic activity by encouraging entrepreneurs to set up their businesses as unincorporated businesses and, more importantly, by reducing the size and growth of businesses, thereby expanding without businesses. This redistribution of economic activity means a substitution of relatively safer economic forms and styles of business organization with those that offer high returns for some and low returns for others.
As a result, there will be greater numbers of entrepreneurs who are very successful and join the ranks of the rich, just as there will be greater numbers of unsuccessful business people. The result is a lower distribution of income – and the US for 2014-2017 shows that this process can reverse at least half of the corporate tax distributive effect that results from reducing average returns on capital.
This research report is based on James R. Hines Jr., “Corporate Taxation and Income Distribution,” NBER Working Paper No. 27939, October 2020, http: // doi .org / 1 0. 3 3 8 6 / w 27939.