White House tax plan doesn't move past Econ 101

White House tax plan doesn't move past Econ 101
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This week the White House Council of Economic Advisors argued for cutting the corporate tax as a way to raise wages. In other words, CEA touted helping capital as a way to help labor.

This is the kind of idea that is basic to an economist, but leaves laypersons befuddled. In fact there’s good cause for befuddlement. The Econ 101 argument that CEA is invoking stops well short of where CEA would like to carry it.

The economic idea is that tax burdens, like water, find their own level. If you have two tanks of water connected by a pipe from below, it doesn’t matter where you add the water; both levels rise the same amount.

Similarly, if you have two participants in an activity, like a business, it doesn’t matter whose tax is cut. The two are connected by the pipe of price adjustments. If business profits are cut, owners pass some of the benefit along to workers through higher wages; conversely, if wage taxes are cut instead, wage reductions act to pass the benefit in the other direction. Why? If business profits are taxed more lightly, businesses expand, which means hiring more workers, which means having to pay higher wages. If instead wage taxes are lowered, wage-earners want to work more, and, taking home more of each paycheck after tax, are willing to work for less.

Actually, tax is not quite like water. Water tanks always level out. Not so with tax burdens. How much of a tax on either business profit or wages flows to the other side depends on a host of factors, the most important of which is probably well summarized as “market power.”

If, for example, there is nowhere else to work, but many potential workers waiting on the sideline, businesses can expand without creating upward wage pressure, and the benefit of a tax reduction on business profits will reside mainly with owner.

It is still true, however, that how the benefit of reducing a given tax is shared among employers and owners depends on the underlying structure of their economic relationship — the piping as it were — rather than which side is actually liable for the tax.

What is controversial and uncertain is what that economic piping looks like. The degree to which corporate tax reductions are passed through to labor is far more uncertain than many economists and their advisees let on, especially when they act as policy advocates. What is “known” on this issue flows largely from unrealistic modeling, unhampered by actual institutional detail, tested with data riddled with back-of-the-envelope behind-the-spreadsheet approximations. The output is a set of widely varying conclusions none of which give any real sense of their own reliably.

What would someone outside Washington, outside the economics profession, but nevertheless well informed about theory, statistics, and institutional detail conclude having read in full the literature on this question? It’s hard to say, because there really aren’t any such people. Even so, the following seems like a defensible nonpartisan, guild-free takeaway from the current state of knowledge: Labor enjoys 50 percent of the benefit of a corporate tax reduction give or take 45 percentage points.

In any event, you don’t need any real qualifications to raise a more basic question — a question whose nagging existence might be part of what lies behind some of the befuddlement among lay persons, who after all must have some understanding that tax burdens can shift, that a tax on soda sales will raise the price of soda.

If the object is really to help labor, why go through the rigmarole of lowering the tax on business profits and waiting for the benefit to flush through? Why not just lower the tax on labor directly?

One could say: Yes, but this replacement will make no difference, as the tax burdens will find their own level in the sense described above. But in that case, the speaker should be indifferent between lowering either tax rate. That’s not the message one gets from CEA or the rest of the administration.

Or one could say: This replacement will indeed make a difference, because the leveling is subject to inertial friction due to imperfect markets and is itself thereby imperfect.  But that’s all the more reason to reduce wages taxes directly, rather than relying on the flush-through.

The CEA’s presentation of economic science is largely pretense. No one knows how much employees would benefit from a corporate tax reduction, and no one has a good answer to why directly lowering wage taxes wouldn’t better serve employees — assuming, that is, that this is the goal.

Chris William Sanchirico is the Samuel A. Blank Professor of Law, Business and Public Policy and co-director of the Center for Tax Law and Policy at the University of Pennsylvania Law School.