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 Richmans' Trade and Taxes Blog

End the Corporate Income Tax; Integrate the Corporate and Personal Income Taxes
Raymond Richman, 3/12/2014

This paper is an attempt to decide the best way to tax the owners of corporations. First is to tax the corporation on the basis of its earned income and capital gains, which is the present treatment.  Dividends that shareholders receive are included in their personal income subject to the personal income tax. Second is to tax corporate income as partnership income is taxed, namely shareholders would include their share of the earnings of the corporation in their personal income subject to the personal income tax, which is the way we tax income from partnerships and other limited liability companies. Third is to tax corporations not on their earnings but on the market value of the outstanding shares of each corporation at the end of the year.  Each has its advantages and disadvantages but of the three alternatives, the present Corporate Income Tax is the worst.

The Corporate Income Tax, as it exists at present, violates most of the principles of taxation developed by economists over the past two centuries. Those principles are:

1. Equal treatment of equals. Persons of equal taxable capacity should bear the same burden of the tax. Taxing corporate income at the same rate, e.g., 25%, taxes the low income shareholder at the same high rate as the most wealthy.

2. Progressivity. The burden of a tax should fall with greater weight on persons with greater taxable capacity than on those with lesser taxable capacity. They should never be lest than proportional to income.

3. Economic effects. The negative economic effects of a tax should be minimized.

4. Benefit Principle. Where the proceeds of a tax are spent for a service provided a specific taxpayer or class of taxpayers, the taxpayer should bear the full burden of the tax.

5. Economy of administration. The cost of administering a tax should be a small proportion of the amount collected.

A major defect of the corporate income tax is that it burdens shareholders with modest personal incomes at the same rate as multi-millionaires. Those dependent on retirement accounts and pensions who are subject to personal income tax rates of twenty percent are in effect taxed at 35 percent. To make the effects even worse, capital gains and dividends, the primary source of income of millionaires are taxed at reduced rates of personal income tax, 15% in 2012, 20 % in 2013. This was the principal reason Warren Buffett’s secretary paid a higher rate of tax in 2012 than he did. Note that Warren Buffett suggested making the personal income tax more progressive; he did not recommend taxing capital gains and dividends at ordinary rates.

Another defect of the corporate income tax is that much of the burden is passed on   to consumers and passed backward to employees. How much, economists are unsure. To the extent that corporations would not invest unless their rate of profit is at least 1.25 the rate of unincorporated enterprises, capital investment in the corporate sector is reduced. It may be that in perfectly competitive markets, e.g., agricultural products and commodities, little of the burden can be passed on to consumers. But in most markets, the corporation has some monopoly power, enabling it to raise prices and pass some, sometimes most, of the burden of the tax on to consumers. The higher the degree of monopoly, the more likely that the burden is passed on to consumers of the product. In any case, economists are unsure of how the burden is distributed among shareholders, consumers, investors in general, and employees

With regard to equal treatment, the corporate income tax places the same burden on taxpayers of lower income shareholders as it does on the most wealthy. To make the matter worse, Congress, convinced that corporate income was taxed twice, once at the corporate level of 35% and again taxing earnings paid out as dividends under the personal income tax, with those in the top bracket paying 39.6%, provided that dividends would be taxed at a lower maximum rate. In 2012, the maximum rate on dividend income was 15%. For the year 2013, the maximum rate of tax on corporate dividends received by the taxpayer became 20%. The trouble with these limits is that they benefit the wealthy and those of modest incomes not at all. It would be much better to exempt a given proportion of dividend income from personal income taxation.

Taxing the earnings of corporation as the personal income to its shareholders would apply the progressive rates of the personal income tax to corporate earnings. This is the treatment accorded partnership earnings. Its advantage is that unlike the corporate income tax, the tax is not a cost of doing business. Therefore, it would not disadvantage corporations that do business abroad. A corporate income tax enables the wealthy to avoid high rates of the personal income tax. They do this by retaining and reinvesting earnings and paying little in dividends. When they want to benefit their shareholders, they use buy-backs which converts, in effect, ordinary income in the form of dividends into income in the form of capital gains.  Because of lower rates of tax on capital gains, both corporate buy-backs and corporate dividends are minimized converting ordinary income into capital gains. By postponing the distribution of income to shareholders, the value of shares grow and the reinvested earnings generated accrued capital gains which, when distributed, are taxed at a lower rates than dividends.

The advantages of taxing corporations on the basis of the capitalized value of their shares include its beneficial economics effects. The basis of the tax is the market value easily calculated for every listed corporation. Unlisted corporations would receive the partnership treatment; earnings would be taxable under the personal income tax.The tax on the market value of corporations encourages corporations to use their capital more wisely. Wasting money no longer reduces its tax liability. Under an income tax, the government shares part of the cost of the waste in lower revenues, e.g., corporate jets! Its real advantage though is the economy of administering the tax, the lower cost of administration means a smaller Internal Revenue Service.

The burden of the tax, so far as shareholders are concerned, would be proportional to one’s wealth. Considering how the present treatment enables the wealthy to accumulate wealth by postponing taxes -- it is the principal reason we have so many millionaires and billionaires – the tax is most likely to do most to level the distribution of income after tax and any other market policy.

The recent abuses by the IRS, employing delaying tactics to frustrate applications of political opponents of the current administration, suggests the need to reduce the power of the Bureau of Internal revenue. At the very least, it ought to be separated from the Department of Treasury and independent of administration control. Giving it departmental status is not the solution since the Secretary of Internal Revenue would still be subject to political pressure from whatever administration is in power. Congress could create an independent Internal Revenue Authority, reporting directly to the Congress.

In sum, the Corporate Income Tax is the worst way to tax corporations. Treating corporate earnings as personal income – the partnership treatment – or taxing the capital value of the corporation’s outstanding share are infinitely better. Both would tax the wealthy more effectively than they are taxed at present. No longer would Warren Buffett be able to state that his narginal rate is less than his secretary’s.