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How to Think About the Corporate Income Tax

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Tuesday, 26 August 2014 07:06

My friend Jared Bernstein had a piece in the NYT warning against plans to eliminate the corporate income tax. He argues that the corporate income is paid primarily by owners of capital, who in turn are primarily wealthy people. Therefore, if we eliminate the corporate income tax we will be giving a big tax break to the wealthy.

This is largely true. Eliminating the corporate income tax without some major increases in the personal tax rates for high income people would be a big gift to the wealthy. And as much as we would all like to help our favorite billionaires, they are probably not the ones most in need of a hand at the moment.

But the story on elimination may be a bit brighter than Jared implies. First, it is important to remember that not all of the corporate income tax comes out of corporate profits. Due to feedback effects (less investment), some portion will come out of wages. The model used by the Tax Policy Center of the Urban Institute and Brookings Institution put the split at 80 percent profits and 20 percent wages. This means that if we lose $100 billion in corporate income taxes we are effectively losing $80 billion in revenue from rich people.

But even this is somewhat of an overstatement. If companies had $80 billion in additional after-tax profits, then they would pay roughly half of this out in dividends, or $40 billion. If we assume for simplicity that all of this is paid to high end individuals, then we will tax back 20 percent of this amount or $8 billion. (Dividends are taxed at roughly half of the rate of normal income. This would presumably change if we eliminated the corporate income tax.) This means the net loss of revenue from rich people is $72 billion.

Now let's consider the tax evasion industry that is created by the corporate income tax. The corporate income tax use to raise close to 4.0 percent of GDP. In recent years it has been less than 2.0 percent even though corporate profits are at a record high as a share of income. Part of the drop is explained by a drop in the top tax rate from 50 percent to 35 percent. However most of this decline is explained by more effective forms of tax avoidance or evasion. (Avoidance is legal.)

The question is, how much will a company pay to avoid paying $100 in income taxes? The answer is up to $99.99. There are a lot of companies that are paying lots of money to avoid paying corporate income taxes. It is likely that a very substantial portion of that lost 2.0 percentage points of GDP in corporate income taxes ($350 billion a year in today's economy) is instead being paid to the income tax avoidance industry (a.k.a. the financial sector).

To take one important example, much of the bread and butter of the private equity industry is bringing creative tax schemes to smaller businesses that lacked the expertise to do it themselves. To personalize this some, think of Mitt Romney. Much of the story of his wealth was the corporate income tax. By devising clever schemes that allowed businesses his firm took over to escape the tax, he was able to resell these businesses at an enormous profit. In this way, the corporate income tax is not just a way of taking money from rich people, it is also a way to give money to rich people by creating enormous profit opportunities in altogether unproductive areas of the economy.

And Mitt Romney's wealth has direct ramifications for the rest of us. Suppose Mitt Romney spends a big chunk of his wealth building a big new house. In the context of a depressed economy, any spending is good for growth and jobs, so his consumption is a net plus just like anyone else's consumption. However as we start to get to the point where the inflation hawks are bringing enough pressure to bear on the Fed to force it to raise interest rates and slow the economy, Romney's construction project will effectively be crowding out other spending. The Fed will be raising rates sooner than it otherwise would have because of the riches Romney accumulated from designing ways to avoid the corporate income tax.

If we assume that roughly half of the drop in corporate income tax is now income for the tax avoidance industry, then this means that we are giving them 1.0 percent of GDP to raise 1.15 percent of GDP (0.72*1.6 percent of GDP raised in corporate income taxes) in taxes from rich people.

In this fuller context, the corporate income tax is a much more questionable proposition. It seems very plausible that we could design a system that will raise as much money from the rich with an increase in personal tax rates, while at the same time destroying the tax avoidance industry.

 

 

Comments (11)Add Comment
Bernstein's argument is better in one respect
written by Dennis, August 26, 2014 9:00
I am favorably disposed to getting rid of the corporate tax in return for equal treatment of capital income and wages, along with higher personal rates at the top. That would be killer tax code simplification. (On the downside(?), it would worsen the glut in the market for attorneys.)

However, how do you address Bernstein's point that much income that is now being treated as pass-through to persons would instead be sheltered in non-taxable corporate profits? You'd open up a whole new category of loopholes, which would require some pretty careful tax code writing to avoid.
destroying the tax avoidance industry
written by BenBen7, August 26, 2014 9:06
In regards to the below comment- I'm pretty sure it wouldn't destroy the tax avoidance industry- just refocus its efforts from helping corporations avoid taxes to entirely focusing on helping the rich avoid personal income taxes
"raise as much money from the rich with an increase in personal tax rates, while at the same time destroying the tax avoidance industry"
Shierholz
written by Peter K., August 26, 2014 9:29
Good news?

http://blogs.wsj.com/economics/2014/08/25/labor-department-picks-epis-heidi-shierholz-as-new-chief-economist/
New York Sun
written by Peter K., August 26, 2014 10:02
wants to back to the social democratic era of high tax rates and strong unions as it looks back fondly on the 1947 and 1971 era:

http://www.nysun.com/editorials/mystery-of-jackson-hole/88816/

Creating a new tax avoidance industry
written by Tom B, August 26, 2014 11:39
As a neophyte to economics I always thoroughly enjoy reading Dean's columns. I certainly can support giving the financial industry less money from decreasing the amount they make counseling corporate clients on tax avoidance; however, I don't understand why the rich (with higher personal incomes due to the elimination of corporate tax) wouldn't just create a bigger market for the personal tax avoidance industry? Would this be a case of cutting off one head and another grows right back?
why does neither Bernstein nor Baker credit Lester Thurow?
written by David, August 26, 2014 12:18
I've asked this before here on this site. Thurow made a thought-provoking case back in the '80s in The Zero Sum Society that bypassing corporate entities and taxing earnings whether distributed or undistributed back to the shareholder just like a partnership or S corp (or now, an LLC) would be significantly fairer and eliminate many distortions in our system. Eliminates double taxation of corporations. Eliminates bias toward debt. Focuses attention on which taxpayers are and ought be exempt from income taxation. Should a (c)(3) pay taxes on earnings in corporations whose shares it holds in endowment? a (c)(4) or (c)(6)? -- we can have that debate. And Thurow didn't even know about what was coming in Citizens United. Another benefit of bypassing the corporate layer of taxation is underlining the point that corporations are not natural persons, have no rights of expression, and so on -- damn it, we don't even tax them. Go back to the future.
...
written by Bill, August 26, 2014 2:10
I'm with you 100%.
Regarding the personal income tax, it makes little sense that the highest MTR takes effect at about $450,000 in annual income. We could have an MTR of 41% starting at $1 million per year, 43% starting at $3mm, 45% at $5mm and so on up to say 60% on incomes over $20,000,000.
...
written by BillB, August 26, 2014 2:50
Jared said: "If income generated and retained by incorporated businesses should become tax-free, then guess what type of income everybody will suddenly start making? "

You can take care of the retained earnings problem by treating all corporations just like S-corps. The tax obligation for retained earnings are passed through to the shareholders, whether an actual dividend distribution takes place or not. There would be no tax-free income.

Jared said: "To see the relative efficiency of the current arrangement, think about alternative ways of designing a system to tax undistributed corporate profits. What if I held shares for a day? A week? Suppose dividends were paid out that week?"

The market already handles this situation easily for normal quarterly dividends. Why would retained earnings be any different? Currently a shareholder can choose to buy or sell before the ex-div date, but on the ex-div date, the price of the stock is adjusted by exactly the amount of the dividend. In fact the exchanges automatically adjust the price of any outstanding limit order that are held over night on the ex-div date. Whether you choose to accept the dividend or not by buying right before or right after the ex-div date is financially neutral and already handled by the market.

For normal dividends currently you have the choice of buying before the dividend and accepting the dividend but seeing your share price decline by exactly the same amount or you can buy after the dividend at the cheaper price but you miss the dividend. The market handles this perfectly, The two are financially identical.

For non-distributed earnings, you could offer the exact equivalent trade off. If you buy before the ex-div date, non-dividend earnings are distributed as additional shares and subject to ordinary income taxation. You have the choice of buying before the dividend date and getting the new shares but their price declines by exactly the amount of the distribution. Or you could buy after the dividend date, in which case you get cheaper, diluted shares, but you miss the share distribution. The two are financially equivalent. The market can handle this case just as easily as it has handled normal dividend distributions for over a century.

A share distribution for retained earnings and a dividend distribution would be taxed identically.

...
written by BillB, August 26, 2014 3:02
Note that the description I made above about distributions is exactly the way mutual funds work now. If you opt to have your distributions reinvested, then your dividends received are automatically converted into new shares. But you still pay income taxes on the distribution even though you simply have more shares.

For retained earnings you just skip the intermediate step of dividend distribution and the income is automatically converted into new shares. You are taxed on the retained earnings just as you are for new shares via reinvestment currently.

The market and the tax system handle these cases already.
I doubt we will see any change
written by ifthethunderdontgetya™³²®©, August 26, 2014 4:08
.
That won't make the rich even richer.

That's 'our' country. We just live here, the 1% own it.

http://shoqvalue.com/george-carlin-on-the-american-dream-with-transcript/

Forget the politicians. They are irrelevant. The politicians are put there to give you the idea that you have freedom of choice. You don't. You have no choice! You have OWNERS! They OWN YOU. They own everything. They own all the important land. They own and control the corporations. They’ve long since bought, and paid for the Senate, the Congress, the state houses, the city halls, they got the judges in their back pockets and they own all the big media companies, so they control just about all of the news and information you get to hear. They got you by the balls.

~
...
written by Jay, August 26, 2014 4:51
I don't understand why the term corporate tax rate is used. It frames income taxation as if there is a separate tax rate that is prohibitively higher than ordinary income taxation. It is income taxation and corporations are more likely to take advantage of deductions, credits, and various other tax minimization practices. I don't think most people understand marginal tax rates and that it is income tax not some special hyper inflated tax rate for corporations.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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