Should We Cut Corporate Taxes By Raising Rates on Investors?

By :: March 29th, 2011

While there seems to be growing agreement in Washington that the U.S. needs to cut its tax rate on corporations, there is (surprise) no consensus at all on how to pay for this. One way: Raise taxes on capital gains and dividends.   

This idea was one element of the broad tax reforms proposed last year by the chairs of President Obama’s deficit reduction commission, Alan Simpson and Erskine Bowles, and by the Bipartisan Policy Center’s deficit panel, chaired by Alice Rivlin and Pete Domenici. Both panels relied in part on analysis in a paper by my Tax Policy Center colleagues Eric Toder, Ben Harris, and Rosanne Altshuler.  The plan has so far received little attention. It deserves more.

The plan would tax dividends and long-term capital gains at ordinary income rates, with a maximum rate on gains of 28 percent--compared to 15 percent today--and use the revenue to cut corporate tax rates. Those of you with long memories may remember these investment rates were the law back in 1997.

Eric, Ben, and Rosanne figure the revenue this idea would generate would allow Congress to cut the corporate rate from 35 percent to about 26 percent, assuming corporations and investors do not change behavior (by, say, reducing dividend payments). Since they almost certainly will adjust, a redesign would probably buy less of a rate cut. At a roundtable last Friday sponsored by Tax Analysts, Congressional Research Service economist Jane Gravelle suggested it might get rates down to just 30 or 31 percent. Still, that ain’t nothing.

Here’s a bit of background to help explain what this is all about: Economists believe that all income should be taxed once but only once. By that standard, the current taxation of corporations is a mess. In theory, corporate income is double-taxed—once at the firm level and again when income is distributed to shareholders through dividends or capital gains. In reality, some is taxed repeatedly while some is not taxed at all.

To avoid this, many economists have argued for a fully integrated system where corporate income is paid either entirely at the business level or fully by shareholders. In fact, the vast majority of U.S. firms already do this by organizing themselves as pass-through entities such as S corporations and partnerships. In this model, owners pay tax on their individual returns but their business is not taxed at all.  

Matters are much more complicated for other corporations, however. Some profits are double-taxed. But others are never taxed at the business level, largely thanks to the ability of multinationals to shift income to low-tax countries and deductible expenses to the U.S. Worse, in that environment, high corporate rates discourage investment in the U.S.

Similarly, foreign investors and tax-exempt shareholders (such as pensions) pay no tax on a big chunk of corporate profits. Another slug of capital gains goes untaxed because investors die and their unrealized gains pass tax-free to their heirs.

The challenge in this environment is to figure out how to reduce the corporate rate so it is competitive with the rest of the world, make sure that profits are somehow taxed, and not increase the deficit by tens of billions of dollars annually.  The Congressional Budget Office figures that over the next decade corporations will pay about $400 billion-a-year in income taxes.

That brings us to the option of raising taxes on investors. Shifting some taxes on corporate profits from firms to shareholders has some obvious advantages. The biggest may be that it would reduce those disincentives for companies to invest at home. A tax on shareholders is based on where they live, rather than where their profits are earned. Thus, a lower corporate tax and a higher shareholder tax may, on balance, help keep investment in the U.S.

The TPC paper also figures it would be more progressive than the current regime. Since some share of corporate taxes is paid by workers (just how much is a matter of theological debate among economists), lowering the corporate rate would raise their after-tax earnings. At the same time, TPC figures 70 percent of the higher individual investment taxes would be paid by the top one percent of earners.

There are lots of issues to sort out with such a shift. But it is certainly worth considering.

11Comments

  1. Michael Bindner  ::  6:46 pm on March 29th, 2011:

    I promise you, because it raises money on his donor base, Grover Norquist and those he controls will hate this idea, although I whole heartedly agree with taxing dividends at normal rates.

    Some economists believe in taxing income only once, but we all don’t. The best plan to do so is the proposal to enact a business receipts tax – essentially a VAT with both credits and surtaxes – as proposed by Lawrence B. Lindsey.

    I also have a business receipts tax, which does not show up on receipts and is not zero rated at the border, as well as a VAT, which does both show up and is zero rated. Both plans for a business receipts tax would totally replace the business income tax, as well as passing taxes through to the individual taxes of owners.

    I also retain a separate busienss surtaxes because for high income tax payers, it may be better to report inheritance income, dividend income and salary to the employer – rather than to report everything to every income source so that the appropriate rates can be paid.

    I can sympathize with TPC on having the Bipartisan Policy Center options ignorned – however both Lawrence B. Lindsey and I would likely say that this is simply Karma. Spend more time analyzing both the Fiscal Commission recommendations and those of other analysts – like for example Michael Bindner and Lawrence B. Lindsey – and you might find that more attention is paid to your offerings.

    You might also find that you like someone else’s plan better.

  2. Sid F  ::  7:40 pm on March 29th, 2011:

    Interesting proposal, although like Mr. Bindner I seriously doubt that all economists believe income should be taxed only once, in fact as a member of the Economics Profession I don’t think there is anything that all economists believe.

    This sentence is key, “The challenge in this environment is to figure out how to reduce the corporate rate so it is competitive with the rest of the world, make sure that profits are somehow taxed, and not increase the deficit by tens of billions of dollars annually”

    and like Mr. Bindner I also have a plan, basically a Modest Proposal. It is this.

    The corporate tax rate in the U. S. should be lowered to 10%. The deductions allowed would be zero. While I think the benefits of such a plan are obvious, let me set them out.

    1. Immediately the U. S. would have the lowest statutory corporate tax rate in the western world. In lists of corporate tax rates, the U. S. would be at the top (bottom?) ahead of even Ireland.

    2. Corporations, who apparently focus solely on the statutory tax rates, would invest heavily in the U. S. Jobs and productivity would dramatically increase.

    3. We would have gained the goal of simplification, eliminating the “mess” identified in the Post. The Corporate Tax Return would be four lines.

    Line 1.Revenues:
    Line 2. Deductions: (This would be zero, and the zero could be printed on the form thus making things even simpler).
    Line 3. Taxable Income: Line 1 minus line 2
    Line 4. Tax: Line 3 x 10 %

    4. The corporate tax department could be eliminated, in fact the return could be prepared by a single intern. No computer or even a calculator needed.

    5. The IRS could eliminate almost all of its corporate tax compliance resources.

    6. Since the tax rate would be going down and revenues going up, at long last Conservatives would have a real world example to point to in order to uphold their position that you raise revenues by lowering tax rates.

    Unlike the political problems pointed out in Mr. Bindner’s first sentence, this program should have the support of all, since it lowers tax rates as supported by Republicans and increases revenues as supported by Democrats. In the race to the bottom, the U. S. wins!

    (Please note, before this gets withdrawn to “Under Review by Moderator”, this is satire. It is satirizing the fact that while corporations focus on effective tax rates, analysts and politicians focus on statutory tax rates. GE, Google and others like them I am sure have not qualms with the U. S. corporate tax rates. Just thought I needed to explain that.)

  3. TaxVox » Should We Cut Corporate Taxes By Raising Rates on Investors? « Double Taxes  ::  2:38 am on March 30th, 2011:

    […] from: TaxVox » Should We Cut Corporate Taxes By Raising Rates on Investors? Comments […]

  4. Matt Lykken  ::  11:27 pm on March 30th, 2011:

    They would have much more impressive results – a rate of zero – if they used the right mechanism, i.e. a dividends-paid deduction coupled with two things that can only be implemented with a dividends-paid deduction, namely switching from foreign tax credits to a foreign tax deduction and limiting the relief or imposing a withholding tax for dividends to foreign investors. See http://www.sharedeconomicgrowth.org for details and the three-page bill that would do it. While changing to a foreign tax deduction for corporations may seem controversial, it is effectively equivalent to switching to territorial taxation, which the UK and Japan recently did without any flap. Leaving foreign investors with the same benefit they have today, either by denying the deduction for dividends paid to them and allowing their dividends to be limited accordingly or by imposing a straight withholding tax, would be perfectly fair. With that and taxing dividends and capital gains and ordinary rates, you would need to impose an extra AGI tax of between 2.5% and 7.3% on incomes over $500,000 (putting those folks just part way into the same boat as regular working people who pay employment taxes, and leaving them with very acceptable marginal rates)to be revenue neutral on a static basis. In practice, this would be strongly revenue positive for four reasons. (1) This does not count the increased revenues that would flow from the fact that corporations could now bring home their stranded foreign cash and pay it out to shareholders who would be taxed on it. (2) This counts dividends paid to IRAs, 401ks, annuities, etc. as non-taxable, when in fact this income (which would increase by about 53% under the proposal) would largely be taxed as the beneficiaries retire. (3) The dividends-paid proposal would take the fun out of tax shelters and government giveaways, replacing them with nice, clean 1099 income. (4) The proposal would increase the efficiency of the economy and give market power back to middle class workers as companies moved valuable operations to the U.S., leading to additional taxable individual income. The authors are correct that we should shift taxation to the right level, but we need to do it through the right mechanism, and do it properly.

  5. Matt Lykken  ::  12:29 am on March 31st, 2011:

    Sorry, I should clarify that “While changing to a foreign tax deduction for corporations may seem controversial, it is effectively equivalent to switching to territorial taxation, which the UK and Japan recently did without any flap” assumes that the dividends-paid deduction is enacted at the same time. That results in an effective corporate-level exemption on the income, just as territorial taxation does, and so should satisfy our treaty obligations despite being coupled with a mechanism to pick the tax up currently at the individual level. That is just a timing issue.

  6. Brian Dell  ::  12:14 pm on March 31st, 2011:

    “Economists believe that all income should be taxed once but only once.”

    I don’t believe this is true. First of all, many economists believe that spending should be taxed, not income. Secondly, I don’t think most economists have a problem with double taxation if the double taxation ensures that the tax system does not preference a particular form of business… while I was working at Canada’s ministry of Finance we had a problem with incorporated businesses reorganizing into flow-through trusts. Although dividends from corporations were taxed lighter than income from flow-through entities (which is taxed as ordinary income), the zero tax rate at the business level created an overall tax advantage for changing the form of business to an income trust. So we introduced a tax on these trusts to level the playing field. I argued that perhaps the playing field should remain unlevel, because moving money out of the business to external investors will ensure more frequent “re-pricing” or efficient allocation of the economy’s capital stock as those investors circulated this money back in via capital markets, but the consensus was that the information asymmetry problem inherent in arm’s length capital market transactions ended up leaving less money being available to the businesses that are in a position to invest in property, plant, and equipment. The legacy background was that these trusts were common for mature industries that threw off cash but had few growth opportunities. So double taxation made the system BETTER in this view.

    It’s true that an alternative would have been to reduce the corporate rate to zero. But I think the consensus would be better described as economists advising their home jurisdictions to lower corporate taxes to the lowest, most competitive rate (with associated loss of revenue made up for in higher consumption taxes) than simply recommending a zero rate of corporate tax.

  7. Ralph H  ::  2:55 pm on April 1st, 2011:

    Here’s a suggestion. Why not restructure the corporate tax to capture a fair share of their overall business representing the market or facilities in the US. For example, if Google really pays les than 2% tax, lets redo the law to close the loophole. Although I feel they are morally wrong, you can not blame them for utilizing a loophole. You MUST BLAME the government. The laws have to be framed to equitably tax corporations: a large multinational company should not be able to be taxed at a very low rate while a small domestic company pays the top rate (or a large domestic –ie Wallmart– pays at the statutory rate.

    To sum up my point, lets first ensure the effective taxation is equitable through legislation then hopefully we can optimize the rates (lower). Only the Government and the legislature can do this.

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