What Is the Optimal Corporate Income Tax Rate?

This 10-minute podcast was released April 15, 2019.

The 2017 federal tax overhaul reduced the corporate income tax rate from 35% to 21%. In this podcast, Economist Don Schlagenhauf discusses the paper he wrote with two co-authors, “Corporate Income Tax, Legal Form of Organization, and Employment” and what their models say the optimal rate is.

Transcript

Karen: Welcome to the Timely Topics podcast series from the Federal Reserve Bank of St. Louis. I'm Karen Mracek, your host for this podcast. With me today is Don Schlagenhauf, an economist in the St. Louis Fed's Research division. Thank you for joining us today.

Don: Thank you for this opportunity, Karen.

Karen: Don, you’ve done research in a variety of topics, but the one we’re going to talk about today is corporate income taxes. This is particularly relevant given the corporate income taxes were reduced as part of the Tax Cuts and Jobs Act enacted in 2017. The corporate income tax went from 35 percent to 21 percent. But before we get into that, can you tell us a little bit about how you got interested in this topic?

Don: Yeah. I’d like to tell you that I anticipated the tax cut, but that’s not true. As with most academic research, it’s a long time coming before publication. So when this started, I was at Florida State as a faculty member, and a lot of people wanted to cut the corporate income tax. They thought it was going to be a job creator.

So myself and two assistant professors had lunch one day and we started talking about it and said, “Can we build a model? Why does this work?” What we did is we started with a very simple model you teach undergraduates: A competitive model of a firm. We put taxes in it, allowed them to fully expense all their costs, labor, capital, and low and behold, there were no employment effects.

So we said, “Well, what's going on here? We have to think a lot more seriously. It’s got to be more complicated.” So that was the thing, the kernel of insight that led to this paper.

Karen: OK. And your paper is called “Corporate Income Tax, Legal Form of Organization, and Employment.” First, can you explain what you mean by legal form of organization?

Don: Sure. What we mean there is any business entity has to legally file itself, and there’s a variety of choices that you can choose from. So for example, we're well aware of C-corporations, but another popular form is an S-corporation. And most people think, “Oh, it’s just another corporation,” but it’s very different. Let me explain what's going on here.

There are implications for fundraising. There are implications for taxing. So a C-corporation has to pay federal corporate income taxes, state income taxes if they’re a C-corporation and that state has a corporate income tax.

An S-corporation is different. It doesn’t have to pay federal corporate income taxes. It files under the personal income tax. So an S-corporation would also be called a pass-through firm.

Karen: OK. Now, can you walk us through the key findings of your paper?

Don: Yeah. So what we studied is the following scenario: We wanted a model that had different sized firms, because firms grow over time. We wanted to have big and small firms in the model. We wanted to have them choose the type of legal organization. And then we started studying that framework, and what do we find? If we lower the corporate income tax, would that generate jobs? Possibly. It depends on what the income tax rate is lowered to. But let’s take what we found was close to the optimal tax rate, about a 10 percent corporate income tax rate. Now remember, when the Trump plan started, the tax rate was about 28.5 percent approximately, and it was lowered to 21 percent. So we actually find, for our structure, the optimal tax rate is lower.

Now what else do we find? We find that at 10 percent we get more output, a 3 percent increase in output when all the features kind of wash out and we find the new equilibrium in the long run. But also what we find is employment will grow by about 1.3 percent. So there is employment growth out of this.

So the question has to be: Why? What generated this? Well, there’s a feeling in the economics profession that a lot of growth potential comes from startups, small firms growing into big firms. So we have that in our model.

Also, we don’t allow deficits. We have to pay for that right away in the model. That’s the tradition in economic research. We want revenue neutrality, it’s called. So we raise the personal income tax to pay for that loss of revenue.

Now that turns out to be an important feature of what’s going on. The corporate income tax is going to spur employment growth eventually in C-corporations. But what also happens is S-corporations who do not want to suffer the double taxation that a C-corporation does says, “Wait a minute. Personal income tax rates went up, C-corporations went down. Now my penalty for double taxation has been lessened. I still suffer, but I still pay and I still have double taxation. But what’s the benefit?” These highly productive entrepreneurs now have access to better capital because they’re less constrained in their funding by being a C-corporation, and that’s the transmission that we discovered will allow there to be employment growth and output growth.

Karen: So you talked about the taxes impacting how firms organize or what they choose to organize as. Can you just walk us through, then, how that translates into employment and wages?

Don: Sure. We actually find wages will go up some. And how does that happen? Well, the firms that are hiring as we observe in today's economy also having to bid up and pay higher wages to get people to work and move out of the unemployment state into the employment state. So that's exactly what our model predicts will happen.

Karen: One of the more recent examples of a business tax cut happened in Kansas in 2012. What was this tax cut all about?

Don: Yeah. What Kansas did was not touch the corporate income tax rate in Kansas. Remember, Kansas can only deal with taxes in Kansas, not the U.S. government tax rates. But what did Kansas do? Well, they wanted to spur employment. So what they decided to do was to give the tax rate to small firms.

Now, how did they do that? Well, small firms, they presume, pay personal income taxes because they're usually a pass-through firm. So they said, “Oh, if you're a pass-through firm and you make income in Kansas, don't worry about it. We're not going to tax you anymore.” So that was their tax plan.

Karen: And how did this fit with your model?

Don: Well, we ran what would happen in the model. And what we found was, surprisingly, exactly what happened in Kansas: Output didn't grow, employment didn’t happen, and government deficits went up.

One interesting example of why revenue fell in Kansas is the way some people get paid. And the classic example in Kansas is their basketball coach, the famous Bill Self. Bill always had a personal services contract with the University of Kansas, and he got a salary from Kansas as being their basketball coach.

So think what you would do. You take 90 percent of your income and you have it paid to the LLC, which is a pass-through firm. Under the Kansas tax plan, what happened? That income goes to a firm and is not taxable. So 90 percent of his income, because he’s shuffling it through an LLC, was tax free. He paid taxes as he should on his salary as a basketball coach. So that didn’t create a lot of jobs.

Now, he took advantage of the new law, but it’s not like he planned it. It was an opportunity. We would all take advantage of this.

Karen: That brings us to the topic of the recent corporate tax cut in the Tax Cuts and Jobs Act. What can you tell us about this tax cut?

Don: Well, if you think about it, our optimal or close to optimal tax rate is 10 percent, which is a little lower than the Trump tax plan, which went from 36.5 percent, approximately, to 21 percent. So there’s a little difference.

Now, what can we say about the Trump tax plan and our model? We're working on that right now. But here’s the key difference. Everything we’ve talked about, whether it be Kansas or our model, have dealt an environment which is revenue neutral. The current tax plan is not revenue neutral. It’s deficit enhancing.

Now, so the question is, what are the benefits of the tax plan? What you really have to separate are the stimulus coming from not having revenue neutrality and the tax cut. There are two things going on, so it’s hard to see which effect is causing what, and we need a model to kind of sort that out. So that’s what we're looking at now. But it might be that you get a double boost of employment and growth, or you may eventually lose it when you have to pay for that. That’s the kind of things we're thinking about now.

Karen: OK. And what does your research say about the likely effectiveness of this tax cut?

Don: Well, I mean, we forget about separating deficits-financed tax cuts from just a tax cut that’s not deficit-financed. I mean, it’s pretty obvious that this tax cut has generated employment, has generated growth in the economy.

Karen: And finally, what should our listeners take away from this discussion? Or what would you want them to know about this issue?

Don: Well, I think the answer is that you want to think about what the optimal tax rate is for corporations. Obviously, our corporate tax rate was much higher than other corporate tax rates, but we’ve got to be careful. The legislative tax rate may not be the tax rate they pay. But given that fact, probably a lower corporate income tax was called for. We have to worry about how you finance it. And we didn’t finance it. We just ran deficits, are running deficits right now.

Karen: OK. Well, thank you, Don, for your insight on this timely topic of corporate income taxes. You can find more of Don’s research online at stlouisfed.org. And thank you, listeners, for tuning into the latest Timely Topics podcast. You can find more of our podcasts at stlouisfed.org/timely-topics. Thank you for joining us.