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Real Income Tax Reform Is Taxing Corporate Earnings As Personal Income
Although tax reforms have been proposed by all candidates for President in the primaries, they all fall far short of what most economists would propose. It is not tax reform to impose a flat tax as Sen. Cruz and others have proposed or to eliminate the estate tax as a number of Republicans have recommended. The proposals would simply eliminate all progressivity from the tax system. The personal income tax and the estate tax are the only taxes that reduce income inequality and wealth inequality in a free market system. It is not tax reform to propose a value-added tax as Pres. Obama once briefly suggested and his rival Romney said he was considering it. The VA tax, widely used in the Euro community and promoted by the IMF for every country in the world is not appropriate for countries with a federal system of government. It is a sales tax and nearly every one of the States in the U.S. imposes a sales tax. Sales taxes should be left to the States.
Real reform must call for abolition of the corporate income tax and taxing corporate earnings as personal income under the personal income tax. None of the candidates for President have proposed doing so. Instead they propose reforms that are not real reforms at all.
Hillary Clinton proposes raising the top personal income tax rate to 43.6 percent, leaving the corporate income tax unchanged. Donald Trump would lower the maximum corporate income tax rate to 15 percent, lower personal income tax rates, and establish only three brackets. He would change the personal income tax by exempting family income less than $50,000 and reduce the maximum rate to 25%. In addition, he would eliminate the estate tax.
Trump proposes three brackets, Hillary eight. The number of brackets has no effect on simplifying the calculation of the tax. A small number of brackets does nothing to simplify anything for the taxpayer. It is calculating one’s income that is complex given that the income tax code runs to hundreds of pages. Once one has calculated one’s taxable income, calculating one’s tax liability is a matter of multiplying two numbers regardless of the number of brackets. The larger the number of brackets the more gradual is the change in rate as income increases. Reducing the number of brackets does not simplify the calculation of tax liability at all. The fewer the number of brackets, the larger is the range of income and number of taxpayers in each bracket. Each person in the bracket is taxed at the same rate. Those in the lower part of the bracket pay the same rate as those in the highest part. If there were a larger number of brackets, they would benefit and those in the upper part of the bracket would be paying the same rate as they were when brackets were wider. The fewer the number of brackets, the worse it is for those in the lower part of the bracket. Reducing the number of brackets is not income tax reform at all.
The federal tax system does need reform. The most important reform is the elimination of the corporate income tax entirely and taxing corporate earnings as personal income under the personal income tax just as partnerships and individual proprietorships are taxed. There are good reasons to eliminate the corporate income tax and to tax corporate earnings as personal income. To do so would increase the progressivity of the tax system, increase the equity of the tax system, and would have beneficial economic effects as shown in what follows.
The corporation is an artificial entity and the burden of the corporate tax must be borne by living persons. Economists are divided on the question of how much of the burden of the tax is really borne by shareholders. Some of the burden is shifted forward onto customers of the corporation, the return to investors generally is reduced somewhat by the tax, and labor bears some of the burden indirectly in the form of lower wages generally. Be that as it may, the dominant view is that the burden of the corporate income tax is more or less fully borne by shareholders but the burden varies from industry to industry. The basic case was made by Professors John Craig, Univ. of British Columbia, Arnold Harberger of the University of Chicago, and Peter Mieszkowski of Yale University who concluded that “capital bears approximately the full burden of the tax”, approving an earlier article by Prof. Harberger that the burden of the tax is on capital used in the corporate sector and that the range of the burden was between “90 and 100 per cent”. Some argue that the degree of shifting depends on the industry and the degree of competition the firm faces from non-taxed sources. Prof. Harberger argued in a separate article that manufacturers who compete with international competitors must bear the full burden. In any case, there is no reason to tax corporate income differently than we tax the income of partnerships and individual proprietorships.
As far as interpersonal equity is concerned, the corporate income tax applies the same rate to middle class and working class households as it does to millionaire and billionaire owners of corporate stock. As a result, the corporate income tax imposes an inequitable burden on middle class and working class households. As John Steele Gordon, historian, wrote in an opinion piece in 2011:
The other pernicious consequence of the separate corporate and personal income taxes has been a field day for demagogues and the misguided to claim that the rich are not paying their "fair share." Warren Buffett recently claimed that he had paid only $6.9 million in taxes last year. But Berkshire Hathaway, of which Mr. Buffett owns 30%, paid $5.6 billion in corporate income taxes. Were Berkshire Hathaway a Subchapter S corporation and exempt from corporate income taxes, Mr. Buffett's personal tax bill would have been 231 times higher, at $1.6 billion.
The earnings on corporate stock owned by workers’ retirement plans and middle income households are taxed at the same rate of tax as millionaire shareholders. Most corporations pay the maximum rate of 35%. Shareholders in the 10 to 25% brackets of the personal income tax are thus taxed at 35% under the corporate income tax. When corporate earnings are taxed under the personal income tax and they are taxed at personal income tax rates, retirement plans would grow much faster and middle and lower income households would save hugely on their income tax burden.
Why are corporations treated differently than partnerships and individual proprietorships. The corporate income tax came into being as a result of popular dislike at the time of large corporations which were believed to enjoy monopolistic power. Since Prof. Edward Chamberlin wrote his Monopolistic Competition, economists have recognized that all businesses have some degree of monopoly power ranging from nearly100 percent for producers of products covered by patents to nearly zero for some agricultural products.
A reason often given for taxing corporations separately is that corporate shareholders enjoy limited liability for the debts of the corporation. But surely this fact does not justify high rates of tax or even taxing them at all. In any case, it is no longer the case that only corporations enjoy limited lability. Most states give partnerships and individual proprietorships the right to enjoy similar limited liability.
Corporations that export or desire to export some of their production are severely handicapped by the corporate income tax whose rate is one of the highest in the world. They have to compete against businesses that pay no tax or substantially lower tax rates. Moreover, these differences encourage U.S. businesses to move all or part of their factories to foreign countries where the tax rates are so much lower and where they can take advantage of lower labor costs as well. Under the trade agreements negotiated by the U.S. tariffs, the signatories cannot impose any new tariffs on individual products. This provision gave a significant incentive to businesses to move their factories abroad to the detriment of manufacturing and manufacturing workers.
As for progressivity, the rich pay most the personal income tax. Those with adjusted gross incomes over $250,000 paid more than half, 51.6 percent, in 2014, those with incomes between $200,000 and $250,0000 paid 5.9 percent, those with incomes between $100,000 and $200,000 paid 21.9 percent. Thus those with incomes over $100,000 paid 79.4 percent of personal income. If corporate earnings were taxed under the personal income tax, the percent of taxes paid by those in the upper bracket would increase substantially. The wealthiest top one percent own over 35% of corporate wealth, the top 10 percent nearly 45%. The next thirty percent, representing the middle class, owns 15 percent. They would be in the 15 to 20 percent income tax bracket but are paying 35%. Even the lowest 40 percent who own about 2.5% and are mostly in the 10 percent personal income tax bracket pay the 35% corporate income tax rate.
The ownership of corporations is highly concentrated. What is surprising about the unequal distribution of stock market wealth is not that it is highly concentrated but that the bottom eighty percent owns as much as 8.9 percent of total stock market wealth. This means that they were taxed at up to 35% on their corporate earnings, some of it in their IRAs and other pension funds.
The individual income tax does need reform. The regulations run to hundreds of pages with a myriad of provisions that benefit special interest groups. Some needed reforms include 1) a limit on the amount that can be taken as charitable deductions, 2) a limit of the depreciation allowance to investment in tangible assets, 3) a requirement that buyers of depreciable assets take as the basis for depreciation the sellers’ depreciated value of the asset, and 4) the elimination of tax credits. If the government wants to subsidize a firm or industry it should show up in government expenditures in the interest of transparency so that taxpayers know how much the subsidy is costing. When the subsidy is in the form of a tax credit, it does not show up in the budget at all.)
How would the new tax work? Instead of paying corporate income tax, corporations would withhold the corporate income tax that their shareholders owe. They would do so at the maximum personal income tax rate, currently 39.6%. Shareholders would be credited with the withheld earnings against their personal income tax liability. So if they are in a lower tax bracket than 39.6%, they would receive a tax credit for the difference. Where an IRA or other pension plan is the owner of corporate stock, it would be treated as being liable for the tax on the corporate profits. He or she would get a tax credit that would be more than enough to pay that liability. Foreigners would pay America’s 39.6% tax rate. Americans who own shares in foreign companies would be liable to pay tax on the income per share earned by those corporations.
Integrating the corporate and personal income tax would bring in more revenue thus enabling lower personal income tax rates. Eliminating the corporate income tax entirely and taxing corporate earnings under the personal income tax would increase progressivity and be more equitable.
Comment by jacob wallace , 10/32/2016:
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