The effects of business and payroll taxes on firms and workers: evidence from linked employer-employee data

While the average rate of corporation tax amongst OECD countries was close to 50 percent in the early 1980's, it had fallen to below 25 percent by 2015. Moreover, competition to attract inward investment through cuts in business and payroll taxes is likely to intensify in the near future. In the UK, Prime Minister Theresa May has suggested that Britain is to have the lowest corporate tax rate among the world's 20 largest economies, and in the US, President Donald Trump is seeking a dramatic reduction in the rate of corporation tax to around 15 percent.

Advocates of a reduction in business or payroll taxes argue that it will lead to an increase in firm profits and thereby affect firms' location decisions and hence employment levels. Opponents, on the other hand, claim that such taxes are shifted either onto workers' wages or consumer prices, and hence will not alter firms' location decisions. Even if tax reductions have a positive effect on employment, governments might face a trade-off between job creation and tax revenues; while business and payroll taxes may indirectly boost tax revenues through increased employment and wages, they directly reduce tax revenues. Unless the indirect positive effects dominate the direct negative effects, tax reductions will result in a decrease in tax revenues and public spending. Therefore, a thorough understanding of the overall effects on employment, wages and tax revenues of cutting taxes levied on businesses is crucial for governments to make informed policy choices.

This project aims to improve our understanding of firms' adjustments in response to changes in two types of taxes levied on firms: business taxes (levied on profits) and payroll taxes. Employing rare and detailed administrative data linking firms and workers and following them over a prolonged period of time, we will analyse the causal effects of changes in business and payroll taxes on firm adjustments, including the demand for labour (hiring and firing), wages, investments, product price setting, firm entry and exit. Furthermore, we will look at whether workers respond by migrating. Based on our thorough understanding of the responses of firms and workers, we will simulate the overall effects of business and payroll tax changes on tax revenues, taking into account both the direct and indirect effects.

A particular strength of our analysis, besides using unusually rich longitudinal administrative data on firms and workers, is the proposed research designs. We exploit policy changes induced by national-level regulations that generated tax changes of different magnitudes across local labour markets. These changes were unrelated to local economic conditions, and our research designs hence allow us to separate out the causal effects of tax changes from confounding factors.

The scientific output of the proposed research is aimed at publication in top academic journals, and we expect our contributions to significantly advance the academic debate on business and payroll taxation, firm behaviour and labour market outcomes of workers. Moreover, a thorough understanding of the overall effects on employment and tax revenues of cutting business and payroll taxes is crucial for governments to make informed policy choices. We expect the results from our proposed research to have direct policy relevance to governments, the business community as well as to central banks, and international institutions such as the EU, Organisation for Economic Co-operation and Development (OECD), the World Bank, The International Monetary Fund (IMF) and NGO's.

Besides its intellectual merit, the results from our proposed research have immediate policy relevance. Knowledge on how taxes levied on firms impact on workers, firms, the productivity of local labour markets and overall tax revenues is crucial for informed policy making in the UK and elsewhere. From the onset of the project period we aim to build links and contacts with potential beneficiaries and users of the research. Potential beneficiaries include:

1) The Academic Community: The scientific output of the proposed research is aimed at publication in top academic journals, and we expect our contributions to significantly advance the academic debate on business and payroll taxation, firm behaviour and labour market outcomes of workers. Our results can further serve as an empirical basis for the development of theoretical models of the firm side of the labour market in fields of Economics such as Macroeconomics, Public Economics, Industrial Organisation and Business Economics.

2) Governments, Organisations, NGO's and the Broader Policy Community: Output from the proposed research will be beneficial for policy makers in the UK and elsewhere. The research questions addressed in this project are particularly timely, with corporate taxation high on the political agenda in the aftermath of Brexit. Moreover, central banks and international institutions such as the EU, the Organisation for Economic Co-operation and Development (OECD), the World Bank, The International Monetary Fund (IMF), and NGO's may employ our findings to make economic predictions about the economy, and to advise countries on the conduct of macroeconomic policy.

3) Businesses and Workers: The findings of the proposed research are likely to be of significant interest to the business community as well as to worker unions. Knowledge on how different types of firms (e.g., by size and industry) respond to tax changes is of importance to entrepreneurs planning to start a business, and to existing firms that need to take into account the responses of their competitors and business partners when planning their own actions.

4) The General Public: The consequences of tax changes for different types of workers and firms, as well as their overall welfare implications is of utmost interest to the general public. Our research will answer several questions of immediate policy relevance to the general public: How do the politicians' proposals of cutting corporate taxes affect workers' wages and employment? And how do the effects differ across workers with different levels of education or firms operating in different sectors?