Corporate Taxes and the Earnings Distribution: Effects of the Domestic Production Activities Deduction
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The 2005 U.S. corporate tax cut, particularly the Domestic Production Activities Deduction (DPAD), significantly impacted wage distribution. A 1% cut in marginal tax rates increased average earnings by 1.1%, with small firms seeing higher gains at the top of the earnings distribution.
"...This paper investigates how corporate tax changes affect workers’ earnings. We use a dataset of U.S. worker-level W-2 filings matched with corporate tax returns and study the implementation of the Domestic Production Activities Deduction (DPAD). We find the DPAD tax rate reduction has a substantial effect on the distribution of annual wage earnings within a firm. Earnings of workers at the top of their firm’s earnings distribution rise relative to those at the bottom of the distribution. We estimate a semi-elasticity of average earnings of 1.1 with respect to the DPAD marginal tax rate reduction, while the semi-elasticity of median earnings is notably smaller—0.5. Furthermore, we estimate a semi-elasticity of 1.3 at the 95th percentile of workers’ earnings and 2.7 at the 99th percentile. This trend of larger semi-elasticities at the top of the earnings distribution is especially pronounced for small firms. Looking at overall employment effects, we see no change overall, but the number of employees rises at small firms and declines at large firms. In contrast, we find that capital investment rises for large firms, suggesting that the DPAD also resulted in domestic capital labor substitution for large corporations. Our paper has significant implications for assessing the progressivity of the U.S. tax code and for analyzing the effect of corporate tax policy changes on the U.S. income distribution....We find the DPAD tax reduction resulted in a substantial increase in mean earnings at the firm level and that earnings gains were particularly concentrated at the top of the earnings distribution within firms. Our results suggest that a one percentage point reduction in marginal tax rates due to the DPAD led to a 1.1 percent increase in average earnings at the firm level. We find a much smaller impact, however, on median earnings within a firm, with an estimated semi-elasticity that is less than half the size of the average effect. Looking more broadly across the within-firm earnings distribution, we find semi-elasticities of earnings that are statistically indistinguishable from 0 at the very bottom of the earnings distribution—the 1st percentile through the 10th percentile. At the 25th percentile, we observe a statistically significant semi-elasticity of 0.4, which rises slightly at the median and the 75th percentiles, to 0.5 and 0.6, respectively. Earnings at the top of the distribution are notably more responsive: we find a semi-elasticity of 0.9 at the 90th percentile and of 1.3 at the 95th percentile. Earnings are the most responsive at the very top of the distribution; at the 99th percentile, we observe a semi-elasticity of 2.7—more than double that of mean earnings. As a result of rising earnings at the top of the distribution, we find the tax reduction leads to a widening of the within-firm earnings distribution overall. A one percentage point tax rate reduction due to the DPAD leads to a 1.1 percent increase in the ratio of earnings paid to the 95th percentile of workers compared to the 5th percentile. The change is even more pronounced at the higher end. A one percentage point rate reduction leads to a 2.8 percent increase in the 99th-to-1st percentile earnings ratio....We also examine the DPAD’s effect on overall firm employment and investment. We find no effect of the DPAD tax reduction on firm employment but find that the number of employees rises at small firms and declines at large firms. Our estimates of investment responses are consistent with capital-labor substitution for large firms, with investment increasing substantially in the highest two quintiles of firm size. But we find no investment effect of the tax cut for small firms...."
The core evidence"... We find the DPAD tax reduction resulted in a substantial increase in mean earnings at the firm level and that earnings gains were particularly concentrated at the top of the earnings distribution within firms. Our results suggest that a one percentage point reduction in marginal tax rates due to the DPAD led to a 1.1 percent increase in average earnings at the firm level. We find a much smaller impact, however, on median earnings within a firm, with an estimated semi-elasticity that is less than half the size of the average effect. Looking more broadly across the within-firm earnings distribution, we find semi-elasticities of earnings that are statistically indistinguishable from 0 at the very bottom of the earnings distribution—the 1st percentile through the 10th percentile. At the 25th percentile, we observe a statistically significant semi-elasticity of 0.4, which rises slightly at the median and the 75th percentiles, to 0.5 and 0.6, respectively. Earnings at the top of the distribution are notably more responsive: we find a semi-elasticity of 0.9 at the 90th percentile and of 1.3 at the 95thpercentile. Earnings are the most responsive at the very top of the distribution; at the 99thpercentile, we observe a semi-elasticity of 2.7—more than double that of mean earnings. As a result of rising earnings at the top of the distribution, we find the tax reduction leads to a widening of the within-firm earnings distribution overall. A one percentage point tax rate reduction due to the DPAD leads to a 1.1 percent increase in the ratio of earnings paid to the 95th percentile of workers compared to the 5th percentile. The change is even more pronounced at the higher end. A one percentage point rate reduction leads to a 2.8 percent increase in the 99th-to-1st percentile earnings ratio….”
Christine Dobridge, Paul Landefeld, and Jacob Mortenson, "Corporate Taxes and the Earnings Distribution: Effects of the Domestic Production Activities Deduction," Federal Reserve Board, December 2021, https://www.federalreserve.gov/econres/feds/corporate-taxes-and-the-earnings-distribution-effects-of-the-domestic-production-activities-deduction.htm
Size of firms, "... Generally, these results suggest that the DPAD had larger effects on the widening of the earnings distribution for the smallest firms by employment size than for the largest firms. Small firms exhibit positive and significant semi-elasticity estimates, and the estimates are strongest at the upper end of the earnings distribution. The semi-elasticities for small firms are statistically discernible from zero at the 25th, 50th, 75th, 90th, 95th, and 99th percentiles, with magnitudes that increase substantially at the very top of the distribution. The semi-elasticities in the upper portion of the distribution are also notably larger for small firms than for larger firms. The point estimate for the median percentile of small firms is a semi-elasticity of 1.8, for example, which rises to 4.4 and 5.7 percent, respectively, for the 95th and 99th percentiles. In contrast, for the largest firms, semi-elasticity estimates are considerably smaller overall. The point estimate for the semielasticity of the earnings for the median worker is 0.03, for example, and not statistically different from zero. Estimates increase the most at the very top of the earnings distribution for the largest firms, with a 2.2 semi-elasticity of earnings estimate for workers in the 99th percentile (though still less than half the magnitude of the 5.7 estimate at the 99th percentile for the smallest firms). Interestingly, for the largest firms, we observe statistically significant earnings increases at the very bottom of the earnings distribution—the 1st, 5th, and 10th percentiles—in addition to the top of the distribution, and the magnitude of the effect is similar to that for workers in higher earnings percentiles of these large firms. For workers in the 5th and 10th percentiles of the largest firms, for example, the semi-elasticity point estimates are 0.9, similar to the point estimates of 0.7 and 0.9 for the 90th and 95th percentile. The largest firms are the only firms for which we observe earnings increases due to the DPAD at the very bottom of the distribution. For firms in the middle of the employment distribution (the 2nd through 4th quintiles), we observe a statistically significant increase in earnings only at the 99th percentile for the third and fourth employment quintiles, and also at the 75th percentile for the third employment quintile.20 Finding larger effects for small firms is consistent with employees having more bargaining power at those firms but is also consistent with small firms having less monopsony power than large firms to set earnings. We further investigate the bargaining power and monopsony theories by studying effects of the DPAD on earnings for publicly traded firms and multinational firms in our sample. Large, public firms and multinational firms operating in global markets may also be expected to have greater local wage-setting power and workers in these firms may have less bargaining power as well. Semi-elasticities specific to publicly held firms for select earnings percentiles are presented in Table VI, column (3) and shown in Figure IV.B. Multinational firm results are in Table VI, column (4). Semi-elasticities for the full earnings distribution for public and multinational firms are given in Appendix Table A3. For publicly held firms, we find little effect of the DPAD on workers’ earnings. The largestpoint estimate is for the 99th percentile of the within-firm earnings distribution and implies a semielasticity of about 2.2. This result lends some support for Ohrn’s (2021) finding that top executives of publicly traded firms capture a substantial fraction of the DPAD and bonus depreciation tax reductions, but that there are no effects elsewhere in the earnings distribution for public firms. Widening of the within-firm earnings distribution, therefore, only occurs when comparing the very top of the distribution to the very bottom; the ratio of the 99th percentile earnings to the 1st percentile earnings rises by 2.2 percent as a result of the DPAD (Table VI)...."
Who gains, "...To investigate whether earnings increases are flowing to firm owners, we examine a sample of firms (half of whom are in our main sample) who reveal their owners in Schedule G of their corporate tax return.23 These data are available starting in 2011. We match these firm owners to W-2s issued by the company and determine where in the firm earnings distribution these owners lie for firms with employee counts in the first quintile of our main sample (about 50 employees or less). The location of owners in the within-firm earnings distribution is shown in Figure V. This figure demonstrates that owners comprise more than 50 percent of the workers above the 99th percentile at these firms and around 25 percent of the workers between the 95th and 99th percentiles (i.e., more than 75 percent of workers in this sample of firms are in the top 5 percent of their withinfirm distributions). This result provides suggestive evidence that earnings gains among these small firms are accruing to firm owners and that some of the corporate tax cut benefits are accruing to capital and not labor...."
Employment, Net Investment, and Total Earnings Effects
"...We report results for employment in column (1) of Table VII, Panel A, and we find an aggregate firm employment effect that is indistinguishable from zero. Column (2) presents the results for net investment as a share of installed capital and finds a point estimate of 0.008, implying that a one
percentage point reduction in the tax rate leads to 0.8 percentage point increase in net investment as a share of installed capital.26 Because the calculation of net investment requires an extra year of data and therefore the sample of firms is smaller, column (3) reproduces the estimates from column (1) with the smaller, common sample as well. We see that the employment effect remains statistically insignificant if a somewhat larger magnitude in the common sample...."
"...Figure VI.B shows the response of net investment as a share of installed capital to the DPAD rate cut. We find that the investment response is generally concentrated among the largest firms, with an increase in net investment as a share of capital of about 0.8 and 1.4 for every 1 percentage point decline in the tax rate due to the DPAD, for firms in the 4th and 5th quintiles by employment size, respectively.28 Of note, the combination of results in Figures VI.A and VI.B are consistent with evidence from Lester (2018), who uses a sample of large, publicly traded firms and finds that total employment declined among firms using the DPAD while investment increased. Lester suggests that this is consistent with capital-labor substitution among these firms...."
"..Similarly to the largest firms in our sample, we also observe some decline in terms of total employment for publicly traded firms and for firms that payout to shareholders (our proxy for firms less likely to be financially constrained)—declines of 1.6 percent and 1.2 percent, respectively (Table VII). In contrast, we do not observe a statistically significant responses in terms of total employment among multinationals or firms that do not payout to shareholders. But we find that all of these subsets of companies have statistically significant and sizeable investment responses (1.6 percent, 1.1 percent, 0.7 percent, 1.0 percent for publicly traded, multinational, no payout and payout firms, respectively). Of note, the results for payout and non-payout firms taken together do not provide consistent evidence of financial constraints driving firm investment or employment responses to the tax cut; if looser financial constraints due to the DPAD were the primary mechanism driving our results, we would expect to see an investment increase in the “no payout” firms only...."
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)