“Corporations do not pay taxes.” This statement may be uncontroversial among large swathes of the population, but to free-marketeers – and economists – it means a very different thing. Whereas most people will interpret it as suggesting that large multinationals, often in cahoots with government, are able to eschew their tax obligations and book their profits offshore – wherever that may be – an economist is likely to regard it as asserting the obvious. Of course corporations do not pay taxes – they are not people, and only people pay taxes.

Corporations may be the ones handing the cheque to HMRC, but it can only be people who bear the economic burden of the tax. They are the ones who have to give up resources as a result of the levy.

So, who pays corporation tax? Under a narrow – and thus not very economic – definition of the tax burden, limited to the direct cost of taxation, it is investors – the owners of corporations – who pay corporation tax. They are the ones whose return on capital is reduced by virtue of having a portion of corporate profits sent to the government each quarter or each year, as the case may be.

But, to think like economists, we must broaden the definition to take account of the losses brought about by the tax as a result of its shifting the supply curve for investment capital upwards. This happens because corporation tax cuts the marginal rate of after-tax return on invested capital, and it is after-tax returns that investors care about.

If we do this, we can identify an additional set of losers, namely the workers whose productivity depends in large part on the capital that they can work with. Other things equal, the higher the effective rate of corporation tax, the less capital will be invested and thus the lower the productivity of the workforce. And, because wages in the long run can only grow with productivity increases, corporation tax suppresses wage growth. A 2014 survey of the literature by the ASI’s Ben Southwood found that, on average, workers have been found to bear 57.6 per cent of the burden of corporate taxation in the form of lower wages.

Free trade and globalisation – which are immensely beneficial and desirable in all sorts of ways, not least steadily reducing poverty around the world, and should therefore be encouraged – magnify the adverse effects of corporation tax on workers. The more a country taxes returns from capital in its jurisdiction, the greater the share of capital that investors – domestic and foreign – will choose to deploy in ventures outside that jurisdiction. If all countries choose to tax capital very highly, then little capital will be invested because its owners will be better off putting it in the bank, buying other assets such as houses, or consuming it.

In less-than-perfectly-competitive markets, some of the share of the corporate tax burden may fall on consumers as higher prices, but in free economies markets – especially those in which multinationals are involved – are generally competitive and so studies have found this share to be relatively small.

The point of this discussion is, firstly, to dispel the myth that corporation tax is a tax paid by companies rather than people, and secondly, to show that it is not working in the way intended, namely to raise government revenue from the income that investors obtain from their capital, in the same way that workers pay tax on their income from work. In other words, corporation tax is inefficient in two ways: it fails to fall largely, or even primarily, on the taxpayers it is intended for, and it discourages productive activity, harming wage growth and depressing economic growth over the long term.

In a paper released on Friday, I argue that it is time to abolish corporation tax and introduce a replacement which will achieve what corporation tax currently does not: to tax investors’ income from capital – and only that – and not to discourage productive investment. A tax on distributed profits, levied at the level of the shareholder, would achieve this purpose, raising revenue for the Exchequer in a less distortionary, more growth-friendly way.

It is hard to imagine that a tax as inefficient as corporation tax would have survived for so long, were it not for the widespread fallacy that it is somebody else – “corporations” – who pay it. Let’s dispose of that myth and replace the current system with something better.

 

Read Diego Zuluaga’s recent IEA paper “Why corporation tax should be scrapped – bringing capital taxation into the 21^st century” here.