"Tax Fairness" Debates

American Council for Capital Formation
July 1997
by Charls E. Walker*

*Charls E. Walker, an economist, is a former Deputy Secretary of the Treasury who has long been active in federal tax legislation. He is founder-chairman of the American Council for Capital Formation and its education and research affiliate, the ACCF Center for Policy Research.

The Republican congress is moving rapidly toward enactment of a five-year, $135 billion cut in taxes. The basic elements of the legislation are in place and the usual "tax-fairness" debate is under way. Is the tax bill heading soon for the President's desk likely to be a fair tax cut?

You won't find a definitive answer to that question here. Nor are you likely to get it by reading your newspaper or listening to broadcast journalists. As in the past, the debate is based on so many false premises as to make it useless or perhaps even counter-productive.

What false premises? Three stand out.

False Premise #1: That Corporations Pay Taxes

Let's start with the corporate income tax. Journalists give considerable space to "tax experts" who argue that the essence of tax fairness is to hit corporations as hard as possible while going easy on "people." That's an impossible goal. How can government construct a fair and sensible method for taxing entities that are only "tax collectors" and in fact pay no taxes? To be sure, corporations hand over a percentage of their taxable income to IRS. But a corporation is nothing more than a legal arrangement for doing business. Taxes levied on it are not paid by the company, but are passed on to customers through higher prices, to employees through lower pay, or to owners through lower earnings. The corporate income tax is a hidden tax.

Not only is the tax hidden; there is some uncertainty among economists as to who ultimately foots the bill. As is taught in Economics I, all taxes must be paid out of income which comes from one or a combination of three basic sources: natural resources, labor, or capital. Which takes the ultimate hit for the corporate income tax?

Back in the 1960s, Arnold Harberger, a bright young economist at the University of Chicago, developed a corporate tax model which the vast majority of his peers accepted and which was economic gospel for many years: The tax, concluded Harberger, zeroes in on capital and thus falls on the owners of a business. There was, however, a crucial assumption underlying the model: it applied only in a closed economy (that is, an assumption of no inflow or outflow of labor and capital). But a few years ago, Harberger (now the accepted "dean" of public finance economists) in effect said: "Hey, just a minute here! Globalization is a fact of life. Capital is free to flow almost anywhere in the world. The 'closed economy' assumption is now highly suspect. So let's take another look."

This Harberger did in 1994 (as, I should note, the John B. Byrne Scholar at the American Council for Capital Formation Center for Policy Research). Harberger's new look turned his earlier conclusion on its head. This time around he concluded that, with capital increasingly free to seek the highest after-tax rate of return almost anywhere in the world but with labor relatively "immobile," corporate taxes inevitably hit labor first and foremost. In other words, high business taxes in Country A will drive new investment to other nations; labor's productivity and earnings in A will lag as efficient machinery and equipment is, because of the capital "shortage," less available. Moreover, Harberger did not conclude but it seems to me implicit in his new theory that relatively unskilled labor, which is much less mobile internationally than skilled, will be hit the hardest. (Click here for a summary of this study.)

Harberger's peers have bought his basic theory but most doubt its full applicability in practice, especially in the short run. Still, the degree of shift in the profession from the old view to the new is impressive. A study in 1994 indicated that about 75 percent of the nation's public finance economists subscribed to the old Harberger view on incidence of the corporate tax. A 1997 study by highly respected economists Victor Fuchs, Alan Krueger, and James Poterba indicates that only about 40 percent of the top economists now believe that the current corporate income tax is "ultimately borne by capital."

The views of the corporate "high-taxers" are thus knocked into a cocked hat. If their pleas to raise taxes on corporations are heeded, employees will over time be hit hard while owners will be touched much more gently. This radical shift in professional opinion is especially important to the current tax fairness debate, in which the high-taxers and some editorialists have strongly attacked Republican efforts to reduce the so-called corporate alternative minimum tax, or AMT. The AMT was invented in 1986 to help make certain that profitable corporations pay at least some federal income taxes. The AMT-which is, of course, part of the corporate income tax-probably hits working people harder than business owners.

That's precisely the reverse of the fairness that the corporate high-taxers have in mind. The new view on incidence among professional economists tells us that over time cuts in corporate taxes are good, not bad, for working people.

False Premise #2: That Burden Tables Tell the Whole Tax Fairness Story

For years the press has used "burden tables" prepared by Treasury and Congressional tax staffs as the primary measure of fairness of any change in tax law. The concept is simple. Based on IRS data and various assumptions, tables are prepared that show the "static" before-and-after impact of the tax changes on families distributed by income class. If a tax cut is weighted toward higher-income families, it is said to be regressive, and therefore unfair. If toward low-income families, it tends to meet the fairness test.

It's that simple--or is it? There are two major problems.

First, since major tax changes invariably include changes in the corporate income tax, a burden table can tell the whole story only if the impact of the shift in the corporate tax on families is incorporated in the analysis. That is hard enough mechanically, but there is the basic question of incidence: Old Harberger? New Harberger? Split the difference?

That's a debate that has not been settled at this writing nor is it likely to be soon. It appears from the current burden tables that Congressional and Treasury staffs disagree on the treatment of proposed corporate tax changes (including the AMT). Thus the journalist who uses those tables is relying on a questionable system for gauging tax fairness.

That's bad enough, and sufficient cause for some significant surgery on the burden table concept. But that's not all. Burden tables fall far short of the mark as a guide to tax fairness because they assume-or rather their users assume-that the only proper measure of fairness is the regressivity, progressivity, or neutrality of the given tax change. According to this view, the data contained in the burden tables tell the whole the tax-fairness story.

That is simply not true. When taxes are cut, taxpayers change behavior. Some people will spend more on consumption; some will increase saving; some will do both. Increased spending on consumption can immediately foster real growth and job creation if resources are readily available, but if the economy is already going at full speed inflation is likely to result. More saving means lower interest rates and increased demand for housing. In addition, business will step up investment in plant and equipment (a major key to future growth and job creation) because the drop in interest rates lowers the cost of new capital. Moreover, cuts in corporate taxation directly reduce capital costs because the taxes that must be paid on the profit from new investments are an important part of those costs.

From the standpoint of fairness, jobs and living standards are much more important to most Americans than the shape of a theoretical income-tax curve implicit in a burden table. Yet we have been led to believe that, when it comes to fairness of a tax increase or decrease, burden tables are the be-all and end-all.

They are not. Burden tables as presently constructed are a very poor measure of tax fairness. They are a useful set of numbers which must be interpreted with care rather than taken as the answer to a very complex question.

False Premise #3: That "Tax Fairness" Is a Stand-Alone Issue

This false premise needs some explanation. By "stand-alone" issue, I am referring to the widely held view that the degree to which tax changes honor the ability-to-pay precept tells all with respect to their fairness. In fact, the shape of the tax change itself is only one factor, and often not the most important.

This is partly because tax legislative changes usually (but not always) represent a relatively minimal change in the tax system as a whole. The adjusted system will of course be different, and hopefully better, but it is not likely to be changed very much in its basics. This means that it is easy to overstate the ultimate impact on fairness of the tax system-however gauged-from a tax change that is manifestly unfair.

Note also that a regressive tax can be used for a popular and even lauded purpose. The payroll tax is highly regressive; the rate is the same for all taxpayers, rich and poor, and kicks in at the first dollar of worker income. But the use of the proceeds is so important to the income security of elderly Americans that the regressivity of the tax is generally accepted without significant complaint.

This leads to a very important general consideration. A number of experts argue that the regressivity, progressivity, or neutrality of the federal income tax system may be secondary to the thrust of the fiscal system as a whole. Even if taxes, from a fairness standpoint, were weighted in favor of the well-to-do-and that's highly arguable-that imbalance can be more than offset by a federal spending program that is weighted in favor of lower-income Americans. Studies of this relationship have been sparse but in general support the view that the fiscal system as a whole-both taxes and spending at Federal and State and local levels-is highly consistent with the ability-to-pay principle.

Conclusion

These arguments by no means imply that fairness is an issue that should not be raised with respect to tax legislation. It is instead a warning to those who have vastly oversimplified a highly complex issue. To do so reflects a superficial understanding of the relative importance of the several elements of good tax policy. It is a disservice to those Americans who are paying attention to what Congress is doing to their taxes. And it is a disservice that will continue until false premises are dropped from "tax fairness" debates.