When Republicans passed a major reduction of the corporate income tax rate in December 2017, they touted it as a way to spur economic growth. Yet critics balked at the idea that corporations would invest in jobs or boost wages. The question that underlies this debate is: Just how much can lower corporate taxes improve the economy as a whole?
As it turns out, Kellogg’s Sergio Rebelo recently conducted research addressing just this question. Rebelo and his coauthor Nir Jaimovich from the University of Zurich conclude that cutting the corporate tax rate can, indeed, spur growth—but only if the current rate is exceptionally high.
This conclusion may be good news for proponents of the U.S. corporate tax cut. At 35 percent, the U.S. had the highest corporate tax rate in the world before the new law lowered the rate to 21 percent. But since many companies had found ways to get around paying the full 35 percent, Rebelo says the overall economic impact may be less dramatic.
Resolving a Tax Puzzle
Jaimovich and Rebelo began their analysis by trying to resolve a puzzle about the relation between tax rates and economic performance.
On the one hand, history shows no real link between tax rates and economic growth. The economy of the United States, for example, has grown at a steady rate since 1870 (an average of about 3 percent per year)—despite ups and downs in the corporate income tax rate.
“If taxes made a huge difference, we should see their impact in U.S. data, and we don't really see it,” Rebelo says.
On the other hand, it is clear that the equivalent of extremely high taxes, what Rebelo calls “implicit taxes,” puts a major damper on growth. In communist China, implicit taxation came in the form of abolishing property rights. When China in 1979 restored individuals’ incentive to invest, growth picked up dramatically. The same happened in India during and after its 20th-century experiment with socialism.
What is clear from the data is that it is the actual tax rate that affects growth, not the change from the previous rate.
How is it possible that, in general, fluctuating tax rates don’t seem to matter for growth, yet extreme levels of taxation matter a lot?
The Extraordinary Entrepreneur
To reconcile these conflicting observations, the researchers designed an economic model where the effects of taxation on growth are nonlinear.
“What that means,” Rebelo explains, “is that a small tax rate change has a small impact, but a large tax rate change has a disproportionately large impact.”
The key to this model is the assumption that entrepreneurial ability follows a Pareto distribution—the statistical pattern popularly known as the 80/20 rule, whereby a small number of individuals create a huge proportion of the outcomes.
“A few companies account for most of the growth in the economy,” Rebelo notes. An obvious example is Apple with Steve Jobs as its driving entrepreneurial force.
Plenty of ordinary entrepreneurs start companies, too, and the economy certainly needs people to open small businesses like restaurants and laundromats. But none of these run-of-the-mill businesses create the kind of growth that Apple has generated. Whether they succeed or fail, typical entrepreneurs are simply not as innovative and productive as extraordinary entrepreneurs.
Both types of entrepreneurs, the typical and the extraordinary, respond to tax incentives: as corporate tax rates rise, becoming an entrepreneur (and paying a higher tax for it) becomes less attractive than getting a regular job. But the two types of entrepreneurs respond differently to tax incentives.
Small increases to the corporate tax rate may affect a typical entrepreneur’s decisions but will not deter someone like Steve Jobs, Rebelo explains.
“His company was so profitable that there was no way that he was going to say, ‘Well, if you raise corporate income taxes, I'm going to do something else.’”
Similarly, if you lower corporate taxes a little, more people might start businesses. “But a typical firm that reacts to this change,” Rebelo says, “is generally not very important for the economy.”
The situation is different when corporate taxes are very high.
“When tax rates are high, we are crowding out firms that might be important contributors to the growth process,” Rebelo says. “You might start affecting whether Steve Jobs becomes an entrepreneur or not.”
How High Is Too High?
The notion that low corporate tax rates have negligible effects on growth can be deceiving, Rebelo says, creating the impression that you can raise taxes with impunity.
Policymakers might say, “well, we raised tax rates from 10 percent to 15 percent, and we didn't see the economy slow down,” Rebelo says, so they might think that raising them to 30 will have no impact, either. “But the more you raise them, the bigger the effect, because then you’re crowding out more productive entrepreneurs.”
By discouraging these superstars from starting businesses, you lose out on the creation of a large number of jobs. “The more you do that, the more you slow down the economy,” he says.
So how high a corporate tax is too high?
Unfortunately, there just isn’t enough data to pin down a specific tipping point, Rebelo explains. What is clear from the data is that it is the actual tax rate that affects growth, not the change from the previous rate. For example, going from 10 to 5 percent is a huge change in proportional terms (a 50 percent cut!), while a change from 35 to 30 is much smaller, percentage-wise. Yet in the researchers’ model, the latter tax cut would have a much bigger impact on the economy.
“What drives the effect of a tax cut are the entrepreneurs we are encouraging,” he says. “When the tax rate is 35 percent, there might be a lot of people who want to set up their business, but instead get a regular job. If we lower taxes relative to that, that might bring them in, and they might be quite productive. Now suppose that tax rates are 10 percent. Basically, everybody who's a productive entrepreneur has already set up shop. If we lower the tax rate from 10 percent to 5 percent, who are we going to bring in? We've already exhausted the pool of entrepreneurial talent.”
Voters Weigh In
It is no accident that extremely high tax rates, the equivalent of what China or India once had, do not arise in well-functioning democracies. That is because in the Jaimovich–Rebelo model, voters who are workers understand that high corporate taxes are a double-edged sword.
Clearly, workers see the upside of taxing corporations: these taxes generate revenue that can be redistributed to everyone in the economy. Workers also understand, however, “that if you have very punishing tax rates, the economy will slow down, lowering wage growth,” Rebelo says. Even if many workers wanted to impose high corporate taxes, the argument goes, a rival political party would rise up to lower the tax burden.
The new tax law seems like a case in point. But will it propel economic growth?
Yes, says Rebelo—though not as much as the change in tax rate might suggest. He notes that when the U.S. tax rate was 35 percent, large multinational companies found ways to shelter their earnings and lower their effective tax rate. For these companies, lowering the statutory rate may not feel like that much of a change. For companies that are actually paying the statutory rate, which includes several large companies included in the S&P 500, the new tax does add incentives to invest in new projects or new markets.
“Don't expect the effects on growth to be transformational,” Rebelo concludes, “but you might expect an extra boost to the economy.”