Does Lowering the Corporate Tax Rate Spur Economic Growth?
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Policy Economics Mar 5, 2018

Does Low­er­ing the Cor­po­rate Tax Rate Spur Eco­nom­ic Growth?

Results of a new study have impli­ca­tions for the recent U.S. tax overhaul.

Yevgenia Nayberg

Based on the research of

Nir Jaimovich

Sergio Rebelo

When Repub­li­cans passed a major reduc­tion of the cor­po­rate income tax rate in Decem­ber 2017, they tout­ed it as a way to spur eco­nom­ic growth. Yet crit­ics balked at the idea that cor­po­ra­tions would invest in jobs or boost wages. The ques­tion that under­lies this debate is: Just how much can low­er cor­po­rate tax­es improve the econ­o­my as a whole?

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As it turns out, Kellogg’s Ser­gio Rebe­lo recent­ly con­duct­ed research address­ing just this ques­tion. Rebe­lo and his coau­thor Nir Jaimovich from the Uni­ver­si­ty of Zurich con­clude that cut­ting the cor­po­rate tax rate can, indeed, spur growth — but only if the cur­rent rate is excep­tion­al­ly high. 

This con­clu­sion may be good news for pro­po­nents of the U.S. cor­po­rate tax cut. At 35 per­cent, the U.S. had the high­est cor­po­rate tax rate in the world before the new law low­ered the rate to 21 per­cent. But since many com­pa­nies had found ways to get around pay­ing the full 35 per­cent, Rebe­lo says the over­all eco­nom­ic impact may be less dramatic. 

Resolv­ing a Tax Puzzle 

Jaimovich and Rebe­lo began their analy­sis by try­ing to resolve a puz­zle about the rela­tion between tax rates and eco­nom­ic performance.

On the one hand, his­to­ry shows no real link between tax rates and eco­nom­ic growth. The econ­o­my of the Unit­ed States, for exam­ple, has grown at a steady rate since 1870 (an aver­age of about 3 per­cent per year) — despite ups and downs in the cor­po­rate income tax rate. 

If tax­es made a huge dif­fer­ence, we should see their impact in U.S. data, and we don’t real­ly see it,” Rebe­lo says. 

On the oth­er hand, it is clear that the equiv­a­lent of extreme­ly high tax­es, what Rebe­lo calls implic­it tax­es,” puts a major damper on growth. In com­mu­nist Chi­na, implic­it tax­a­tion came in the form of abol­ish­ing prop­er­ty rights. When Chi­na in 1979 restored indi­vid­u­als’ incen­tive to invest, growth picked up dra­mat­i­cal­ly. The same hap­pened in India dur­ing and after its 20th-cen­tu­ry exper­i­ment with socialism.

What is clear from the data is that it is the actu­al tax rate that affects growth, not the change from the pre­vi­ous rate. 

How is it pos­si­ble that, in gen­er­al, fluc­tu­at­ing tax rates don’t seem to mat­ter for growth, yet extreme lev­els of tax­a­tion mat­ter a lot? 

The Extra­or­di­nary Entrepreneur

To rec­on­cile these con­flict­ing obser­va­tions, the researchers designed an eco­nom­ic mod­el where the effects of tax­a­tion on growth are nonlinear. 

What that means,” Rebe­lo explains, is that a small tax rate change has a small impact, but a large tax rate change has a dis­pro­por­tion­ate­ly large impact.”

The key to this mod­el is the assump­tion that entre­pre­neur­ial abil­i­ty fol­lows a Pare­to dis­tri­b­u­tion — the sta­tis­ti­cal pat­tern pop­u­lar­ly known as the 8020 rule, where­by a small num­ber of indi­vid­u­als cre­ate a huge pro­por­tion of the outcomes. 

A few com­pa­nies account for most of the growth in the econ­o­my,” Rebe­lo notes. An obvi­ous exam­ple is Apple with Steve Jobs as its dri­ving entre­pre­neur­ial force. 

Plen­ty of ordi­nary entre­pre­neurs start com­pa­nies, too, and the econ­o­my cer­tain­ly needs peo­ple to open small busi­ness­es like restau­rants and laun­dro­mats. But none of these run-of-the-mill busi­ness­es cre­ate the kind of growth that Apple has gen­er­at­ed. Whether they suc­ceed or fail, typ­i­cal entre­pre­neurs are sim­ply not as inno­v­a­tive and pro­duc­tive as extra­or­di­nary entrepreneurs. 

Both types of entre­pre­neurs, the typ­i­cal and the extra­or­di­nary, respond to tax incen­tives: as cor­po­rate tax rates rise, becom­ing an entre­pre­neur (and pay­ing a high­er tax for it) becomes less attrac­tive than get­ting a reg­u­lar job. But the two types of entre­pre­neurs respond dif­fer­ent­ly to tax incentives. 

Small increas­es to the cor­po­rate tax rate may affect a typ­i­cal entrepreneur’s deci­sions but will not deter some­one like Steve Jobs, Rebe­lo explains. 

His com­pa­ny was so prof­itable that there was no way that he was going to say, Well, if you raise cor­po­rate income tax­es, I’m going to do some­thing else.’” 

Sim­i­lar­ly, if you low­er cor­po­rate tax­es a lit­tle, more peo­ple might start busi­ness­es. But a typ­i­cal firm that reacts to this change,” Rebe­lo says, is gen­er­al­ly not very impor­tant for the economy.” 

The sit­u­a­tion is dif­fer­ent when cor­po­rate tax­es are very high. 

When tax rates are high, we are crowd­ing out firms that might be impor­tant con­trib­u­tors to the growth process,” Rebe­lo says. You might start affect­ing whether Steve Jobs becomes an entre­pre­neur or not.” 

How High Is Too High? 

The notion that low cor­po­rate tax rates have neg­li­gi­ble effects on growth can be deceiv­ing, Rebe­lo says, cre­at­ing the impres­sion that you can raise tax­es with impunity. 

Pol­i­cy­mak­ers might say, well, we raised tax rates from 10 per­cent to 15 per­cent, and we didn’t see the econ­o­my slow down,” Rebe­lo says, so they might think that rais­ing them to 30 will have no impact, either. But the more you raise them, the big­ger the effect, because then you’re crowd­ing out more pro­duc­tive entrepreneurs.” 

By dis­cour­ag­ing these super­stars from start­ing busi­ness­es, you lose out on the cre­ation of a large num­ber of jobs. The more you do that, the more you slow down the econ­o­my,” he says. 

So how high a cor­po­rate tax is too high? 

Unfor­tu­nate­ly, there just isn’t enough data to pin down a spe­cif­ic tip­ping point, Rebe­lo explains. What is clear from the data is that it is the actu­al tax rate that affects growth, not the change from the pre­vi­ous rate. For exam­ple, going from 10 to 5 per­cent is a huge change in pro­por­tion­al terms (a 50 per­cent cut!), while a change from 35 to 30 is much small­er, per­cent­age-wise. Yet in the researchers’ mod­el, the lat­ter tax cut would have a much big­ger impact on the economy. 

What dri­ves the effect of a tax cut are the entre­pre­neurs we are encour­ag­ing,” he says. When the tax rate is 35 per­cent, there might be a lot of peo­ple who want to set up their busi­ness, but instead get a reg­u­lar job. If we low­er tax­es rel­a­tive to that, that might bring them in, and they might be quite pro­duc­tive. Now sup­pose that tax rates are 10 per­cent. Basi­cal­ly, every­body who’s a pro­duc­tive entre­pre­neur has already set up shop. If we low­er the tax rate from 10 per­cent to 5 per­cent, who are we going to bring in? We’ve already exhaust­ed the pool of entre­pre­neur­ial talent.” 

Vot­ers Weigh In 

It is no acci­dent that extreme­ly high tax rates, the equiv­a­lent of what Chi­na or India once had, do not arise in well-func­tion­ing democ­ra­cies. That is because in the Jaimovich – Rebe­lo mod­el, vot­ers who are work­ers under­stand that high cor­po­rate tax­es are a dou­ble-edged sword. 

Clear­ly, work­ers see the upside of tax­ing cor­po­ra­tions: these tax­es gen­er­ate rev­enue that can be redis­trib­uted to every­one in the econ­o­my. Work­ers also under­stand, how­ev­er, that if you have very pun­ish­ing tax rates, the econ­o­my will slow down, low­er­ing wage growth,” Rebe­lo says. Even if many work­ers want­ed to impose high cor­po­rate tax­es, the argu­ment goes, a rival polit­i­cal par­ty would rise up to low­er the tax burden. 

The new tax law seems like a case in point. But will it pro­pel eco­nom­ic growth? 

Yes, says Rebe­lo — though not as much as the change in tax rate might sug­gest. He notes that when the U.S. tax rate was 35 per­cent, large multi­na­tion­al com­pa­nies found ways to shel­ter their earn­ings and low­er their effec­tive tax rate. For these com­pa­nies, low­er­ing the statu­to­ry rate may not feel like that much of a change. For com­pa­nies that are actu­al­ly pay­ing the statu­to­ry rate, which includes sev­er­al large com­pa­nies includ­ed in the S&P 500, the new tax does add incen­tives to invest in new projects or new markets. 

Don’t expect the effects on growth to be trans­for­ma­tion­al,” Rebe­lo con­cludes, but you might expect an extra boost to the economy.” 

Featured Faculty

Sergio Rebelo

Tokai Bank Distinguished Professor of International Finance

About the Writer

Marina Krakovsky, author of The Middleman Economy (Palgrave Macmillan), writes and speaks about ideas in the social sciences.

About the Research

Jaimovich, Nir, and Sergio Rebelo. 2017. “Non-linear Effects of Taxation on Growth.” Journal of Political Economy. 125 No. 1 (February): 265-291.

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