How do corporate tax cuts affect earnings across the wage distribution?
Core argument: A 1% reduction in marginal tax rates under the 2005 Domestic Production Activities Deduction raised average earnings by 1.1%, with the largest gains at the top of the within-firm earnings distribution.
The 2005 U.S. corporate tax cut, specifically the Domestic Production Activities Deduction (DPAD), significantly impacted wage distribution within firms, with notable effects on smaller firms. A 1% reduction in marginal tax rates led to a 1.1% increase in average earnings, with the most substantial gains at the top of the earnings distribution. For small firms, semi-elasticities at the 95th and 99th percentiles were 4.4 and 5.7, respectively, compared to 2.2 for large firms at the 99th percentile. This suggests that smaller firms experienced larger wage gains, likely due to less monopsony power and greater employee bargaining power. While overall employment remained unchanged, small firms saw an increase in employee numbers, contrasting with declines in large firms. The DPAD also spurred capital investment in large firms, indicating a shift towards capital-labor substitution. These findings highlight the tax cut's role in widening income disparities and its varied impact across firm sizes.
Ed Comment: "Not clear what time frame they used. My guess is a short one. Very profitable firms have sustainable competitive advantages. That’s why they are more profitable. If we lower the tax rate, they and their leaders will capture some of the value in the short run. But the prospect of excess returns is the very thing the incents innovation. Without excess returns, competitors are highly incented to wait until their competitors take the risks and suffer the failures needed to create innovation. So the correct time frame for tax analysis has to be very long, much longer than anyone’s Ceteris paribus data. And the link between tax rates and R&D, which we saw recently, and here capex and tax rates, both harbingers of the future, are not encouraging that we can enjoy a free lunch in the long run. The notion of a progressive corporate tax rate that looks at returns above the cost of capital is intriguing in theory but hard to imagine how it would work in practice. This harkens back to my debate with Jan Eeckout. We can’t look at the one lucky success and tax their excess returns, if we want innovation to pay. If we want a logical tax system, we have to look at the returns of the one lucky firm divided by the cost of the entire pool of failure, or said differently, we have to discount a successful firm’s profits by its ex-ante probability of success. Good luck with that! Otherwise we are taxing the very thing we would like to avoid taxing—excess returns to innovations that are large enough to make a difference to our growth. Moreover, those are the very firms that expose our most productive workers to the technological frontier, which is critical increase the probability of producing successful innovation. And we have to treat international competitors differently, if they can’t pass their higher tax rates on to customers when competitors have lower rates in other countries."
Steve Comment: Time Frame Is 2005-2017 (Repealed By TCJA)