The effective incidence of corporation tax

Who would be worse off if the rate of corporation tax was raised? Some argue that the tax falls on “business”, but any reduction in the value of a business due to tax must ultimately be borne by an individual. So would it be the shareholders, or would they be able to pass on the tax to others?

Economic theory makes a remarkable proposition about who bears corporation tax. It says that in a small open economy, with mobile capital, the owners of capital cannot bear the burden of the tax. The reason is that any investor can allocate his investments around the world, and will not be prepared to accept a lower post-tax rate of return in one country than is available elsewhere. Any tax in that country must therefore increase the pre-tax rate of return, leaving the post-tax rate of return equal to that available elsewhere. But if this is true, then the owners of capital will not bear the tax levied on capital located within a country. Instead, the tax must be passed onto immobile factors – such as the labour force or other supplies – or in prices.

Until recently, this important proposition had not been subject to rigorous empirical testing. We test this using firm-level accounting data from France, Italy, Spain, and the UK. Specifically, we test whether the average wage rate paid by a firm is affected by the firm’s tax liability.

Our results are consistent with economic theory. We find that in the short-run a £1 increase in tax tends to reduce wages by around 50 pence. But in the longer-run, wages fall by £1. In short, our results support economic theory in suggesting that employees tend to bear the corporation tax burden.

“The incidence of corporate income tax”, Wiji Arulampalam, Michael Devereux and Giorgia Maffini, Working Paper No. 07/07. It has also been published as a working paper of the European Tax Policy Forum.