The New Corporate Minimum Tax In Congress’ Climate Legislation Is A Bad Idea

Last weekend, Senate Democrats passed one of the largest pieces of climate change legislation in U.S. history. A vote is likely in the House of Representatives, perhaps as early as Friday. For those concerned about climate change, this legislation would be a big deal, assuming it is signed into law. However, there remain some details to be hammered out, and some of the tax provisions in particular are concerning. Moreover, these provisions seem at odds with the legislation’s overall goal of investing in the environment and reducing unnecessary carbon-emitting consumption.

As currently written, the somewhat misleadingly named Inflation Reduction Act would require firms to pay a new corporate minimum tax to ensure that the largest, most profitable businesses in America don’t come away paying $0 in taxes in particular years. It would work by having companies with over $1 billion in income calculate taxes two ways. They’d pay a 15% minimum tax on earnings reported to shareholders if their traditional tax payment works out lower than that.

Right now, prospects are looking good for the legislation. On the Senate side, a deal has been worked out between senators like Joe Manchin, Kyrsten Sinema, and Democratic Party leadership. The more boisterous Democratic-controlled House of Representatives also seems to be mostly on board.

The new tax is largely a response to a few companies avoiding paying some federal taxes in certain years. We’ve all seen newspapers trumpet headlines like, “No Federal Taxes for Dozens of Big, Profitable Companies.” These stories, which describe how companies like AmazonAMZN
, NikeNKE
or FedExFDX
purportedly pay no federal income taxes, tend to make people’s blood boil, and so it has long been a priority of Democratic politicians to make sure this ceases to occur.

The reason companies can pay so little federal income taxes (they do pay other taxes, of course) is because they reinvest profits back into things like research and development, property, plants, and equipment. According to several popular economic theories, this is actually good news, because society may be underinvesting in these things relative to what would be optimal. Therefore, taxes on investments can be counterproductive if they discourage these activities.

One economic theory backing up the idea that society might want to subsidize (rather than tax) investment is known as the Arrow-Lind principle, named after Kenneth Arrow and Robert Lind. Economist Tyler Cowen of George Mason University recently pointed to it in a blog post, arguing the principle casts doubt on the new corporate minimum tax.

The Arrow-Lind principle states that risks individuals face can be diversified away as they are spread across a large group. The implication is society as a whole should be less risk averse than particular individuals are, which would imply that risk-averse investors often pass up investments that society would want to take on, because society can diversify away the risks while individuals cannot.

The Arrow-Lind principle has some problems, though its implications for investment may still be correct. To see why, consider a simple case involving two people. John lives in a flood zone and Sally does not. If John bears the risk of a potential flood to his house alone, it’s easy to see why it could potentially ruin him. If Sally says she will contribute to paying the cost of a flood if it occurs, the potential cost to John has fallen. Spread the costs across enough people and the cost to each one of a flood occurring is virtually nothing.

In this way, socializing risks makes them more affordable for individuals to bear. But note that the risk in our example—the chance of a flood wrecking John’s house—is independent of how any insurance program is set up. Society as a whole can’t eliminate the risk just by spreading the costs; risk in this case can only be reduced if John moves or some system is set up to divert water. The cost doesn’t change depending on who pays for it.

In short, insurance makes risks easier for some to bear from a financial standpoint, but it doesn’t eliminate risk for society and it may even encourage risk taking if individuals don’t bear the costs of their own actions. This causes one to question the idea that society should view an investment as less risky than an individual would (and by extension to question the Arrow-Lind principle).

To be fair, I don’t believe Cowen endorses the Arrow-Lind principle. I think he’s pointing out an implication of a popular theory. Furthermore, the rather intuitive idea that society often consumes too much and invests too little is usually right. Individuals tend to consume most of their wealth over the course of their lives, while society would benefit from that wealth continuing to be reinvested, thereby growing the economy. Individual incentives aren’t aligned with the social interest when it comes to deciding how much to invest, since individuals won’t be around to enjoy the benefits.

Given this, let’s return to the climate and tax legislation. The underlying philosophy behind the new corporate tax provision seems to be that avoiding paying taxes because a company invests is problematic. But several economic theories suggest reducing investment by raising taxes could harm welfare. Perhaps taxing investment is simply the fair thing to do. But if fairness is more important than welfare, it would seem our definition of fairness needs some revision.

There are other problems with the Inflation Reduction Act. For one, it probably won’t reduce inflation. Another problem is some of the environmental benefits could prove illusory. Subsidies for electric cars could run into problems with “Made in America” provisions or supply chain issues, like there not being enough lithium available for the batteries in the envisioned fleet of electric vehicles.

If politicians really believe more taxes on investment are a good idea, they should be arguing society consumes too little and explain why that is the case. Yet much of their climate agenda seems aimed at the opposite—at reducing society’s carbon-emitting consumption and boosting investments in renewable energy. Perhaps there is a philosophic system that reconciles these seemingly opposing views. But given the hurried nature of the legislation, I worry that economics is being left on the sidelines in the debate over the Inflation Reduction Act, and that Americans will be worse off for it.