that there would be some smarter people in the Senate. In the recent minimum wage bill some braniac stuck in a provision that would make punitive damages assessed against insurers no longer able to be deductible under the corporate income tax. This idea is likely that the insurers shouldn’t get a tax deduction for purposeful harmful actions. At some level I understand that, but we all know that punitive damages are can be awarded in an arbitrary and capricious (but at the same time perfectly legal) manner. Thus, to the extent that punitive damages are random— they are like a tax. So the question is who really bears the cost of the punitive damages?
We have several choices:
- Insurance company managers—they do not bear the costs directly. While their salary might be somewhat sensitive to firm earnings it is not likely sensitive enough. Further, if there is a competitive labor market good managers will be able to go to other industries without this tax penalty and suffer no loss of compensation. Thus, insurers will have to make offers to protect managers against this type of salary effect if they want to keep them managing insurers.
- Lower level insurance company employees—their salary generally does not depend directly upon earnings, so this law has little effect.
- Insurance company shareholders —all insurance shareholders might be expected to see an expected reduction in rates of return due to the imposition of this tax law, but they are also likely to leave the sector seeking higher returns elsewhere. The insurer knows this and won’t be able to lower returns to shareholders without penalty as it is operating in a competitive market for capital. Thus, shareholders will not pay for these punitive damages in terms of lower returns.
- Insurance company customers—they will pay almost the entire amount of non deductible punitive damages in terms of higher premiums. The company has to cover its costs and the only person left to pay is the policy owners. Since all insurance companies are in the same situation, then all policy owners will pay higher premiums to cover the non tax deductibility of the premium punitive damages.
So if the Senate thinks it is punishing insurers, it really is punishing policy holders. This is a simple application of the incidence of a tax and it falls on customers when capital and labor markets are competitive.
I wonder which Mississippi law maker has it in for the insurance industry consumer?
Update: Ted Frank points out that this bill is not just directed against insurers, but all taxpayers. (I didn’t realize that when I was reading about it in the insurance press.) I there apologize for my reference to legislators who may have a biased view of the insurance industry. Since the bill applies to all corporations, it will more likely have an effect on all capital owners as it now is a direct tax on capital invested in US tax paying corporations. This means that investment will be reduced here (i.e. it will shifted to non US tax payers) and economic activity will decline on the margin.
My analysis is based on a static Harberger model of corporate income taxation. However, Greg Mankiw (cached link as the original seems broken) talks about a recent CBO study that employed more state of the art techniques. He summarizes the CBO report ..
The analysis shows how the domestic owners of capital can escape most of the corporate income tax burden when capital is reallocated abroad in response to the tax. But, as in Bradford (1978), capital owners worldwide cannot escape the tax. Reallocation of capital abroad drives down the personal return to investment so that capital owners worldwide bear approximately the full burden of the domestic corporate income tax. Foreign workers benefit because an increased foreign stock of capital raises their productivity and their wages. Domestic workers lose because their productivity falls and they cannot emigrate to take advantage of higher foreign wages. …
Burdens are measured in a numerical example by substituting factor shares and output shares that are reasonable for the U.S. economy. Given those values, domestic labor bears slightly more than 70 percent of the burden of the corporate income tax. The domestic owners of capital bear slightly more than 30 percent of the burden. Domestic landowners receive a small benefit. At the same time, the foreign owners of capital bear slightly more than 70 percent of the burden, but their burden is exactly offset by the benefits received by foreign workers and landowners. To the extent that capital is less mobile internationally, domestic labor’s burden would be lower and domestic capital’s burden would be higher.
Anyway you cut it-it doesn’t enhance US economic activity. It may hurt capital owners, it may hurt customers, and it may hurt workers. It doesn’t benefit anyone — except as Ted states—trial lawyers.