Introduction
A corporate income tax is a levy placed on the profit of a firm to raise taxes. If we examine this at the federal level, this links to the level of federal tax across all states. Statistics of this level are usually reported annually and may change year to year dependent on government decisions. Unemployment is defined as a situation where people are willing, able and available to find work but are unable to find work. This can be expressed as a percentage of the labor force, whereby it is known as the unemployment rate. Both the unemployment rate and the corporate tax rate in the United States have fluctuated in recent years and based on economic theory are inherently linked. This investigation will attempt to answer the question “To what extent do current American federal corporate income tax policies affect the unemployment rate in the United States?”
High unemployment rates have historically been linked to higher incidences of crime and social unrest. Therefore, it is important to limit the number of unemployed and understand the reasons for which unemployment rates fluctuate and the driving forces behind high versus low unemployment rates. Given that corporate income tax rates can be set and changed by the government, if indeed they are linked to unemployment, this may be a significant method to control unemployment rates. Currently, both the unemployment rate and corporate tax rate are relatively low, which may be significant when answering the research question.
To answer the research question, statistics were taken from national databases so that tax rates and unemployment rates could be compared from year to year and used to predict future effects of tax rate manipulation upon unemployment levels.
Background of Federal Corporate Income Tax Rates
A corporation is a legal entity that is separate and distinct from its owners. In order to be imposed with corporate income tax, businesses must be defined as corporations under US federal law. Corporate income tax can be set at the federal, state and local levels. Corporations imposed with this tax can either be domestic or foreign with economic activity occurring within the United States. The income of a corporation that is taxed may include all profits of the corporation accounting for deductions such as “certain necessary and ordinary business expenditures…[like] employee salaries, health benefits, tuition reimbursement, and bonuses.” In the United States of America, corporate income tax is a progressive tax. A progressive tax takes a higher percentage of tax from people with higher incomes. Thus, the higher the corporate income, the higher the tax rate for the corporation. This can be illustrated in the table below which shows the federal corporate income tax rate brackets in the United States in 2015.
Taxable income ($)
Tax rate[27]
0 to 50,000
15%
50,000 to 75,000
$7,500 + 25% Of the amount over 50,000
75,000 to 100,000
$13,750 + 34% Of the amount over 75,000
100,000 to 335,000
$22,250 + 39% Of the amount over 100,000
335,000 to 10,000,000
$113,900 + 34% Of the amount over 335,000
10,000,000 to 15,000,000
$3,400,000 + 35% Of the amount over 10,000,000
15,000,000 to 18,333,333
$5,150,000 + 38% Of the amount over 15,000,000
18,333,333 and up
35%
In this investigation, only the highest level of corporate income tax will be analyzed.
Background of Unemployment Rates
Data about unemployment rates are collected by the Bureau of Labor Statistics of the US Department of Labor. These statistics are released monthly by conducting a survey called the “Current Population Survey.” This survey is not taken by the entire population, but instead by only around 110,000 people per month. Thus, the data represents a sample of the population and attempts to account for variance in geographical location within states. The survey consists of questions about the individuals’ labor force activities or lack thereof. Information such as age, gender, race, and education is also collected. Each month, one- quarter of the individuals that are being sampled are changed so that “no household is interviewed for more than four consecutive months. After a household is interviewed for four consecutive months, it leaves the sample for eight months, and then is again interviewed for the same four calendar months a year later before leaving the sample for good.” The results of the survey are entered into a computer system which determines whether the individual can be classified as unemployed.
There are inherent difficulties that occur upon measuring unemployment. For example, there is the case of hidden unemployment. This is when the unemployment rate is overstated due to individuals claiming an untruthful employment status in order to continue receiving transfer payments. Transfer payments are a one-way payment to a person for which no money, good or service is given or exchanged. There is also underemployment, which is where individuals may be employed but not at the level they desire. For example, they may work part time instead of full time, or work in a low skilled job even though they are more highly qualified. The unemployment rate also ignores disparities such as those between age, gender, ethnicity, and geographical location. Thus, during this investigation, when examining the unemployment rate, these problems must be considered.
Unemployment comes in various forms. Frictional unemployment is when people are in between jobs and is not harmful to long-term economic growth. Structural unemployment is when people are out of a job because their skills are no longer required and can be harmful to long-term economic growth. Seasonal unemployment is when people are out a job because their workplace only operates seasonally. This type of unemployment is not as relevant to this investigation as the main source of data will be the annual unemployment rate, which is averaged for all of the months. Cyclical unemployment occurs due to weak demand for various goods and services. It is characterized by firms decreasing their output and firing workers. This is the main type of unemployment affected by the manipulation of corporate tax rates.
Economic Theory Behind Federal Corporate Income Tax Policies
Changing the rate of federal corporate income tax could have effects on both aggregate demand and aggregate supply. Aggregate demand is an economic measurement of the sum of all final goods and services produced in an economy expressed as the total amount of money exchanged for those goods and services. It is composed of consumption, investment, government spending, and net exports. Corporate income tax rate indirectly affects investment. Higher corporate tax rates mean that firms have less money available to invest in capital, thus lowering the investment component of aggregate demand. The money lost through having higher tax rates could be passed onto consumers in the form of higher prices. In this way, the consumption component of aggregate demand may also decrease. The high corporate tax could lead to lower wages for workers, thus decreased worker income which may result in lower consumption. The inward shift of aggregate demand can be illustrated in the diagram below.
Aggregate supply is the total supply of goods and services produced within an economy at a given overall price level in a given time period. The aggregate supply curve can be shifted by changes in the quantity or quality of the factors of production within an economy. High corporate tax rates will discourage firms to invest in improving the quality or quantity of their capital, thus shifting the aggregate supply curve inward. In addition, high corporate tax rates will discourage foreign firms from investing in the United States. If corporate taxes were lowered, then foreign direct investment, or the net transfer of funds to purchase and acquire physical capital such as factories and machines, would increase, and this money could be used by domestic firms to increase the quantity of labor and capital. Higher corporate tax can sometimes result in an uncertainty for firms, thus they may choose to invest less, and hire a reduced number of workers, therefore shifting the aggregate supply curve inwards. An inward shift of the aggregate supply curve can be illustrated in the diagram below.
Economic Theory Behind Unemployment
Unemployment can be shown on a macroeconomic graph by changes in real output resulting from shifts in the aggregate supply or aggregate demand curves. Cyclical unemployment occurs when there is a decrease in aggregate demand. This is represented by an inward shift of the aggregate demand curve and a reduction in real output.
A decrease in aggregate demand can be observed at an individual firm’s level. If demand decreases but wages remain the same, then there will be an increase in unemployment from Q1 to Q2.
The natural rate of unemployment is linked to shifts in the aggregate supply curve. Natural unemployment is the minimum unemployment rate resulting from real or voluntary economic forces. This is unemployment existing when the economy is on the vertical portion of the aggregate supply curve and can be illustrated in the diagram below.
At wage rate 1, there is a disparity between the supply of labor (S) and the labor force (LF). This is because there are individuals unwilling to work at this wage rate. As the wage rate increases, the supply of labor and labor force converge because there are more individuals willing to work for higher wages.
Linking Together Corporate Tax Policies and Unemployment
First of all, as discussed above, corporate tax policies may lead to an inward shift of the Aggregate Demand curve. An inward shift of the Aggregate Demand curve will have an effect on Cyclical Unemployment. As Aggregate Demand decreases, there is less overall demand in the economy for all labor, thus Cyclical Unemployment will increase.
The y-axis on the graphs above represents real output in the economy. Real output and employment are linked due to the idea that if an economy is to grow and real output is to increase, then employment must also increase, as the size of the labor force will be greater to maintain a high level of productivity so growth can occur. Okun’s law analyzes the relationship between economic growth and employment levels. It states that “When unemployment falls by one percent, GNP rises by three percent.” This law only applies to the economy of the United States. Therefore, in order to decrease unemployment, economic growth must occur “at a pace above its potential.”
As noted above, lower corporate tax policies may increase Aggregate Supply due to an increase in investment that will improve the quality and quantity of the factors of production. An increase in aggregate supply will lead to an increase in real output and thus economic growth and a lower unemployment rate. However, with the advent of new technologies, automated machines may replace workers, thus increasing the unemployment rate.
One of the main reasons why countries lower corporate tax rates are to attract foreign direct investment. Countries such as Ireland have lowered corporate tax rates to as much as 12.5% in order to maximize foreign direct investment. If corporate tax rates are lowered, foreign firms will be more inclined to move their businesses to the country with these lower tax rates. Many multinational corporations, or firms with facilities and other assets in at least one country other than its home country, such as Apple, locate their businesses in countries with low corporate tax rates to avoid paying taxes in their home country. If foreign direct investment increases, then more jobs will be available in these firms for domestic workers. Moreover, increased foreign direct investment will increase real gross domestic product, which is an inflation-adjusted measure that reflects the value of all goods and services produced by an economy in a given year, could be followed by the positive multiplier effect. The multiplier effect occurs when there is an injection into the circular flow of income, which will lead to an increase in spending, which will increase aggregate demand and thus firms will continue to invest and unemployment will decrease. However, lowering corporate tax rates alone may not necessarily make a difference to unemployment rates. There are a large number of alternative factors that will affect foreign direct investment in a country. For example, if the United States of America has a highly educated workforce and access to capital, then even higher corporate tax rates may not deter foreign countries from locating within the United States of America. Also, even if foreign direct investment does occur, this may not affect unemployment rates, as workers may relocate from other countries to work in these firms and thus no new jobs will be created.
Conversely, high corporate tax rates lead to US companies locating their firms abroad which also moves jobs overseas. US corporations officially hold $21 trillion in profits offshore, much of it in tax havens, that have not yet been taxed here. The US does have a repatriation tax on foreign source income. However, many large corporations avoid this by storing profits in tax havens such as Switzerland and Barbados. In spite of corporate tax rates decreasing over the past thirty years, US direct investment has nearly doubled, growing from fourteen percent to twenty-five percent of GDP, meaning that lowering corporate tax rates do not necessarily encourage firms to maintain locations domestically. Though there is fear that US companies locating abroad will move large numbers of jobs overseas, it has been shown that although seven tax havens are responsible for 50% of all American MNC foreign profits, they only account for 5% of foreign employment.
Corporate income taxes and unemployment are also related through the means of wages. If corporate income taxes are raised, then firms have less money to spend on wages, so may either lower worker wages or lay off workers. Since wages are generally “sticky downwards”, meaning that they are unlikely to decrease, it is more probable that workers will lose their jobs, thus unemployment increases. However, this argument may be unfounded because loopholes and deductions enable many companies to pay less than the statutory rate, thus they may not need to lay off their workers. For example, General Electric, Boeing, Verizon and 23 other profitable Fortune 500 firms paid no federal income taxes from 2008-2012, while 288 of these Fortune 500 firms paid an average effective federal tax rate of just 19.4%.
Arguments Against Lowering Corporate Tax Rates to Decrease Unemployment
Although economic theory may suggest that lower corporate tax rates should encourage increases in employment, there are substantial flaws in this argument. Firstly, although US statutory corporate tax rates are higher than many other countries in the Organization for Economic Cooperation and Development (OECD), effective tax rates are actually nearly equal to the effective tax rates of other OECD countries. The average effective tax rate is the total of taxes paid by corporations divided by corporate profits. This is because there are many loopholes in the American tax system that allow multinational corporations to avoid paying the full tax rate set by the government. As a share of GDP, corporate tax revenues have fallen from 5.9% in 1952 to 1.9% in 2015. This drop, in spite of current large corporate profits, highlights the extent to which corporations are exploiting loopholes in the American tax system. This means that the argument stating that corporate tax rates must be lowered to stimulate economic growth by aligning their tax rates with other OECD countries is unfounded.
Earlier in this investigation, it was stated that employment may be increased through increased consumption, which would lead to an increase in aggregate demand. Boosting consumption through a decrease in tax rate depends on the marginal propensity of households affected by the tax cut to consume. The marginal propensity to consume is the proportion of an aggregate raise in pay that a consumer spends on the consumption of goods and services as opposed to saving it. In general, higher income households have lower marginal propensities to consume than lower income households. Therefore, it follows that tax cuts should be made on taxes that burden low-income households. Corporate taxes generally place a greater burden on higher income households. The Congressional Budget Office (CBO) states that 75% of incidence of corporate income tax falls upon capital owners such as business owners, shareholders, and partners. Therefore, a change in corporate tax rate will have a greater effect on high-income households who are less likely to increase their consumption. Thus, aggregate demand may not necessarily increase to a great extent and employment may not rise.
Another argument in favor of lowering corporate tax rates contends that it may reduce a trade deficit, which in turn would increase aggregate demand and therefore employment. The theory behind this is that the lower tax rates would reduce the costs of production for a firm, which would be passed on in the form of lower-priced output, therefore making US products more competitive on the world market. However, only a very small portion of American goods are tradable. Thus, even if tradable goods saw their prices reduced, this would not have a great effect on total aggregate demand and employment. Moreover, the price of firms’ output is not necessarily linked to the tax rate, as they may choose to maintain their original prices.
One of the main reasons for lowering corporate taxes is the thought that firms will be able to hire a larger number of workers. However, corporations may not spend the extra money gained through lower taxes on hiring and instead choose to hold on to the increased profits or distribute the profits to shareholders and other executives.
Lowering corporate tax rates in America will dramatically decrease government revenue, which in turn will decrease government spending, a component of AD which could be used to lower unemployment. When Ireland decreased their corporate tax rate, this argument was minor, as there were so few companies already set up there that every company choosing to relocate to Ireland was an increase in the Irish government’s revenue. In the case of the United States, there are already a very large number of companies existing, so to decrease taxes would mean a huge loss of revenue from these corporations and potentially very little gain from those who may choose to relocate to the States. Furthermore to this point, many companies have already chosen to locate in the US despite high taxes. This may be a result of extremely high after-tax corporate profits and low interest rates. This may suggest that attempting to increase FDI to increase employment may not be the ideal solution.
Current and Historical Tax Policy and Unemployment Data
Through analysis of current and historical data relating to unemployment rates and corporate tax rates, it can be seen that links occur between the two.
As can be seen from the graphs above, looking at the general trends over the past five years, corporate income tax rates have decreased as has the unemployment rate. Currently, the top corporate income tax rate in the United States is at 35 percent, while the unemployment rate is at 4.7 percent, both of which are lower than in previous years. From 1947 to 2010, there was a positive association between gross domestic product and corporate tax rates. Since gross domestic product and unemployment are linked according to Okun’s law, this suggests that employment rates are also positively associated with corporate tax rates. Looking back further, the average five-year unemployment rate decreased from 1987 to 1991 after the United States lowered its top corporate income tax rate. President Obama’s top economic advisory task force links lowering the statutory corporate income tax rate with economic expansion, investment, and job growth.
However, although the United States has the highest corporate income tax rate of all the countries in the OECD, they actually have a lower unemployment rate than most countries in the OECD. This is supported by the fact that the American economy added 15 million jobs in five years immediately following a large federal corporate income tax increase in 1993. Moreover, a “tax holiday” in 2004 which temporarily lowered the corporate income tax rate for companies that brought back cash stored overseas resulted in companies cutting jobs. This shows that lower corporate income tax rates do not necessarily result in decreased unemployment. Companies paying the highest tax rates still create many jobs in the United States. For example, 22 of the 30 profitable Fortune 500 companies that paid the highest tax rates from 2008-2012 created almost 200,000 jobs in this time. Therefore, the link between high tax rates and unemployment is dubious. Historically, federal corporate income tax rates were actually the highest in US history when the unemployment rates were the lowest in US history. This occurred in 1953 when the top federal corporate income tax rate was 92 percent and unemployment was 2.5 percent. However, this period immediately followed World War II and was marked by an escalation in tensions between the United States and the Soviet Union. Generally speaking, in times of war, economic growth will occur, as more labor is needed to facilitate wartime production. Another piece of evidence that may suggest a lack of relationship between unemployment rates and corporate tax rates is the fact that corporate profits in the United States are the highest they have been in sixty-one years, yet the federal unemployment rate is higher than most of the developed world. High corporate tax profits are a result of low corporate tax policies, therefore the fact that, even though the United States has high corporate profits, it also has high unemployment, would suggest that corporate tax policies may not affect unemployment to a great extent.
Conclusion
Economic theory strongly suggests that lowering corporate tax rates would decrease unemployment and that there is a clear link between the two. There is also statistical evidence that could indicate this idea, such as the trend of decreasing corporate tax rates and decreasing unemployment rates over recent years. However, there is also compelling historical evidence showing that high corporate tax rates have also led to low unemployment rates, as well as many arguments that refute the economic theory behind decreased corporate tax rates and unemployment. When facing lower corporate tax rates, businesses may decide to increase consumption or by investing. It is reasonable to assume that most businesses will strike a balance by utilizing both strategies, as full employment in the US economy is rare, yet businesses wish to expand their profits. Taking all of this into account, it seems reasonable to conclude that current American federal corporate income tax policies have affected unemployment in the United States to a moderate extent, as we also must take into account external factors such as the Great Recession technological advances and the propensity of foreign firms to continue to invest in the United States despite its high tax rate. It could be argued that a limitation of the scope of this investigation is that it only focused on the top corporate tax rates. Most small businesses in the United States do not qualify to be taxed at these rates; thus if the lower corporate tax bracket rates were adjusted, this would likely have a significant effect on these businesses as they employ the majority of workers. Furthermore, it is important to note that there is a limitation to the data used in this investigation, as advances in technology have made data collection, especially within the realm of unemployment rate calculation, more accurate than in prior years.