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Monday, January 20, 2020

Another Reason Why The Corporate Tax Is Bad

There are many reasons why Wyoming should not pass a corporate income tax. 

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I have already reported on how adding a corporate income tax will destabilize tax revenue - exactly the opposite of what proponents of the tax say they want. Today, let us add another angle to the same issue.

We often hear our politicians talk about economic development as some sort of "holy grail" of economic growth and business investment in Wyoming. Remember Governor Mead's ENDOW project? Not only did he want to create a state airline, but the project was also supposed to be a major boost for tax-funded corporate-welfare spending. 

Mead has moved on to new projects (will he run for Enzi's Senate seat?) but corporate welfare, a.k.a., economic development, is still very much a favorite among many Wyoming lawmakers. With a corporate income tax, calls for more of this kind of very wasteful spending will certainly increase. The latest version of the corporate-tax bill expects even less revenue than the original version, even though the tax base has expanded. 

To compensate for the tepid expected tax grab, many lawmakers - and probably our governor - will do everything they can to boost tax revenue. In their mind, the only way they can do that is by spending more money; tax cuts, structural spending reforms and deregulation are not on their horizon. Therefore, it is very likely that if the corporate income tax passes, it will be followed by proposals for more spending on corporate welfare. 

The logic - to use the term loosely - behind such thinking is that corporate welfare boosts business investments, which in turn increase corporate income and, as a result, yields more tax revenue. The problem for this line of reasoning is that business spending on fixed investments is not a very good predictor of corporate-tax revenue. If we go back far in time, forty years and more, there was a reasonably good correlation between business investments and corporate tax revenue, but that correlation has softened up significantly and, in the most recent data, actually disappeared.

In short: we won't get more revenue from a corporate income tax just because businesses invest more. 

Let us start with a historic review of growth in business investments and total corporate-tax revenue - both state and federal - since 1948 (the period for which relevant data is consistently available). Prior to circa 1980, corporate tax revenue rises and falls fairly smoothly with business outlays on fixed investments. After circa 1980, the trend weakens gradually:

Figure 1
Source of raw data: Bureau of Economic Analysis

Why does the trend change? Here is why. Watch the blue segment in Figure 2, representing the share of total fixed investments that goes to intellectual property rights (IPR) products such as computer software:

Figure 2
Source of raw dataBureau of Economic Analysis

Before 1980, the IPR category accounted for, at most, ten percent of total spending on fixed investments. During the 1980s and 1990s the share accelerated to 20 percent. In recent years it has hovered between 25 and 30 percent. 

The larger the share of corporate investments going to IPR products, the less sustainable will be the tax revenue that comes out of the production that the businesses invest in. 

To see this correlation shift more clearly, let us break up Figure 1 into two periods, 1948-1979 and 1980-2019. First...

Figure 3a
Source of raw dataBureau of Economic Analysis

When businesses boosted investment, corporate-tax revenue followed.

But here comes the second period:

Figure 3b
Source of raw dataBureau of Economic Analysis

The correlation weakens already in the 1980s, but it becomes more visible when the IPR share of fixed investments rises above 20 percent (around the turn of the millennium). 

In the very last stretch of this time series, things get really interesting. The decline in tax revenue in 2018 is the result of the Trump tax reform. So is the uptick in business investments, suggesting that we are witnessing an anomaly to what would otherwise be a weak but continuing correlation. 

There are two reasons why this is not the case. First, the corporate tax code has for a long time been complicated and riddled with deductions and other features hollowing out the rate that businesses pay. As a result, some businesses and industries have been favored over others, but the correlation between the rate itself and tax revenue has also been weaker than what proponents of a high tax rate sometimes suggest. 

Since the tax rate itself has been less significant than often claimed, the correlation between fixed investments and corporate tax revenue has historically had more to do with the nature of investments than with the rate itself. The Trump reform has changed the relationship between tax revenue and fixed investments, but not in the strict linear sense often suggested. While the rate itself is not insignificant, the greatest impact of the reform is likely in giving businesses a boost in confidence that the tax code is long-term stable, simple and will remain predictable and competitive over time. 

Secondly, IPR investments are much more fluid when it comes to tax domicile. By default, a business pays taxes where it is domiciled, but corporations specializing in computer software do not have the same physical presence requirement as, for example, a manufacturer, a construction contractor or a logistics company. This makes it easier to locate software businesses to lower-tax jurisdictions.

As IPR products have become more important to our businesses, so has the practice of leasing software rather than owning it. This also affects the tax-domicile issue: a manufacturer of, say, pharmaceutical products will buy software services rather than the software itself. This keeps the costs down and allows the manufacturer to lower its prices. By lowering its prices, it also lowers its taxable income (all other things equal). If the manufacturer is located in Wyoming, our state will get revenue from the corporate income that the manufacturer makes - but the software company will pay a corporate income tax in its domicile state (if it has a corporate income tax). 

In other words, thanks to the leasing contract the investment in the creation of an IPR product is separate from the investment in the business activity where the software is applied. The software investment still happens, but somewhere else.

The changing nature of modern business investments is yet another reason for our lawmakers to reject the idea of a corporate income tax. There are plenty of good ideas they could focus on instead, such as a TABOR for Wyoming, and a long list of nice spending reforms that would permanently reduce the size of government. 

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