The tax incidence argument is wrong: corporate tax cuts are all about senior management greed

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I note that the argument that has been put forward by Mike Devereux and others that corporation tax is not a cost to companies has resurfaced in the USA.

I do not agree with this argument. I’m going to ignore for a minute the considerable technical issues I have with the paper that underpins the assertion noted here that:

a substantial part of the corporation income tax is passed on to the labor force in the form of lower wages.

I happen to think that this is wrong because the finding is dependent upon a considerable number of assumptions underpinning the analysis which I think implausible. But let me put that aside for now and deal instead with the other claim in that article that:

The ultimate payers of the corporate tax are those individuals who have some stake in the company on which the tax is levied. If you own corporate equities, if you work for a corporation or if you buy goods and services from a corporation, you pay part of the corporate income tax. The corporate tax leads to lower returns on capital, lower wages or higher prices – and, most likely, a combination of all three.

This, the author (Gregory Mankiw of Harvard) claims is true because it is ‘textbook economics’.

I guess that’s exactly why it is actually wrong. The biggest issues that make it so are that the text book economics to which he refers assumes:

1) That there are no such things as tax havens;

2) There’s one government and taxpayers who are solely subject to its will;

3) If there is more than one government then each is independent of all others.

There are a host of other assumptions required to reach these conclusions, most of them utterly implausible and incapable of existing in the real world, but we’ll live with these for now.

As a matter of fact we know that corporations can shift their activities between states, we do know they can hide their transactions from view in tax havens and we do know that governments are not independent one of another.

We also happen to know that corporations behave as if tax is a cost to them. They appear to do their very best to avoid paying it as a result. There is no evidence that they do so in the interests of creating higher wages (and it does not seem that this direction of causality has been tested by the research, which puzzles me) and nor do they appear to do so to lower prices. They do so because they claim that this behaviour increase shareholder value, despite the fact that they know (and there is ample evidence that this is the case) that both analysts and ordinary investors have no comprehension of the effective real tax rates of corporations either now, or in the past or future, and as such ignore variations in real tax rates when valuing corporate entities, apparently entirely negating the opinion expressed in the standard economics textbooks.

So, we’re left with a pretty stark choice. Those who say they pay the tax in business are either wrong or the economists are. For evidence that business thinks it is the economists who are wrong look at Tescos at the weekend saying they paid disproportionate tax: the Devereux / Mankiw argument is that they are deluded in saying so, since they actually pay none according to their hypothesis. Which is it to be?

Well, given that economists are pretty much wrong about everything else on business there’s a very good chance it is them. After all, if we were to believe economists all businesses set out to maximise profit which is defined as the net present value of future cash flows. Of course, no business actually knows what this might be which either makes it easy to achieve or an absurd assumption, depending on your point of view, but quite useless in practice either way. As a result it’s not hard to believe that the economists are wrong.

And in this case they are wrong. The reason is simple to state. Because business can tax plan across states, and because it can arbitrage tax between states, and because it can therefore choose when and where to pay its tax to a very large degree, and because government does combine, albeit it rather ineffectively at present, to tackle this issue, and because neither government or corporate taxpayers behave as if the economists are right on incidence, the facts on the ground are that corporations are not neutral participants acting as tax collectors but not as tax payers when it comes to corporation tax, as Mankiw claims. Indeed far from having a role as tax collection agents in this process, as he would suggest, all the evidence is that they are principal players in their own right.

Actually, even if Mankiw and Devereux were right, at the very least corporations do decide which employees suffer tax, which products have their price altered to cover the tax burden, and which government will benefit from the taxes they pay, and when. In itself this removes any neutrality in the process, even if, as I stress, they are right.

But note that this then means that it is entirely plausible that the government that benefits from the revenue need not be in the same location as the employees or customers who suffer the burden of the tax, even if it is passed on as is implied. As a result whilst exercising their decisions making option on tax for the benefit of the shareholder alone, as most corporations would claim, they do have significant external impact on the welfare of other groups in society.

In practice though I would challenge the further assumption inherent in the previous paragraph that corporations do actually make their tax decisions on behalf of shareholders. It would be quite irrational for management to do so given the very obvious lack of data that shareholders have on tax to appraise the consequences of management action, and the fact that it is known that most investors do not actually take tax management into consideration in their decision making process when choosing investments. In that case I do instead suggest that by and large the tax planning game is played by senior corporate management mainly for its own gratification by increasing the sum of retained profit over which they have control and to assist them in crystalising their own share incentive based gains.

The very obvious resistance of corporate management to disclosure of information on tax accounting which would clearly and very obviously benefit their shareholder’s decision making ability on the likely level of future cash flows seems to confirm this. They want to deny that information to shareholders so that they can use the resulting power over tax based information for their own advantage. The fact that Mankiw and Devereux are not even aware of this issue of transparency of information (which they simply assume to exist) is clear because, for example, Devereux’s analysis works solely on the profit and loss account tax charge in a company’s accounts, which is meaningless since that includes deferred tax which, as I have shown, is rarely or ever paid and is therefore eliminated from all informed investor’s analysis on this matter.

In my analysis the corporate tax charge should be viewed as something very different, as should pressure for change in the corporate tax rate. Reductions in tax rate, in particular, should be seen as a mechanism for leveraging wealth to executive management of companies. Let me give an example. Suppose a company with a profit of £10 million in the UK, a total tax charge of 28% split 8% deferred tax and 20% current tax and with a deferred tax balance on its balance sheet of £10 million enjoys a tax cut from 28% to 18%, as the CBI would wish. It has a P/E ratio of 16.

The immediate impact is a cut in the tax charge from a real 20% or £ 2 million to a likely 12.86% with the deferred tax charge falling to 5.14%. But, at the same time the deferred tax balance would be reduced from £10 million to £6.4 million as the rate at which it is now expected to crystalise is now only 18%, not 28% as previously stated, so the provision that is required to be set aside is reduced. The consequence is that in that year the tax charge will not be £2.8 million in total as previously expected, but £1.8 billion (combing current and deferred rates) less a tax credit of £3.6 million – giving an overall credit in the profit and loss account of £1.8 million. That is, in other words, the creation of a massive (albeit largely one off) boost to effective after tax income.

Now, the impact is that instead of post tax earnings being £7.2 million they are now £11.8 million – more than the pre tax profit. Of course, this might not all pass through into the share price – people aren’t quite that daft as to capitalise in that the full impact of a one year change. But suppose instead that the cut in rate was 1% a year, pretty much as the CBI has requested. Now the fall in current tax charge would be £100,000 each year and the cut in the deferred tax provision a very significant £35,000 (or thereabouts) a year. That would increase reported after tax earnings by £450,000 a year. Overall, if the full p/e ratio was applied to this change then the company value would increase from £115 million (£7.2 million x 16) to £122 million, or by more than 6% just because of a steady 1% fall in the tax rate. No value will have been generated in the company, but an absolute increase in the share price will have been generated. There is no clear indication that anyone else will benefit, whatever academic research says. Certainly those I have spoken to responsible for large corporate wage negotiations have mocked the idea that these are in any way influenced by corporate tax rates. I’m sure they’re telling the truth.

As such it could be argued that it’s just the shareholders who benefit from this share price increase. But look at most executive incentive schemes. They are share based, and a lot are driven by share price indicators. Here, simply by engineering a tax cut the share price has been boosted significantly with no real change in the underlying economic worth of what this company does. The people most geared to benefit from that are the company’s management, because in proportion to their basic pay the geared element of reward based on share price based incentive ratios is very high indeed. Such a boost in value created by a tax cut followed by immediate cash realisation of options by senior management could make them very rich indeed.

Do you think they don’t know that? I can assure you, they do.

And who pays for that gain to them? Shareholders do, because the shares they gain dilute the return to other shareholders.

So who are the likely biggest winners from corporate tax cuts? The senior management of our largest companies, that is who.

Do you think every other argument put forward in favour of tax cuts is just a smoke screen for this opportunity to increase the wealth of the financial elite in society still further? I do.

And I happen to think it suits business very well to allow these arguments to be presented even though not one accountant in a Big 4 firm that I know believes in the incidence argument, and not one shred of evidence that business believes in it exists. Nor does the World Bank believe in it come to that. If either accountants, the 100 Group of Finance Directors or the World Bank did think it true not one of them would have lent their name to PWC’s Total Tax Contribution because if ever there was a counter argument to the incidence argument that Devereux / Mankiw are promoting then this is it.

But it’s very convenient to those who will really benefit from corporate tax cuts that there is an argument in existence that the benefit of those cuts will trickle down to labour, just as all other market reforms that have benefited this tiny elite have started with other variations on the basis of the trickle down of benefit. But do not be deceived. Those who are arguing most strongly for corporate tax cuts are those in power in our largest companies and they are acting purely out of concern for their own self interest.