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How the Corporate Income Tax Creates Billionaires and Punishes the Middle Class
The U.S. corporate income tax violates nearly every criterion of a good tax. It is expensive to administer and to comply with. It violates the principle that persons with equal incomes and circumstances should bear an equal burden. It causes corporations to engage in uneconomic practices, including relying too heavily on debt financing and too little on equity financing. It encourages corporations to buy-back their shares instead of paying dividends. It encourages the corporation’s principal shareholders to retain earnings and pay little or no dividends that would be subject to high personal income tax rates. Corporate earnings are taxed twice, once by the tax on corporate earnings and again by the personal income tax when paid out in dividends. Because the rates of tax differ widely among countries, the high rates of the U.S. tax puts American corporations at a competitive disadvantage in foreign trade. And, importantly, the corporate income tax is not as progressive as it is believed to be and may not be progressive at all. In fact, it worsens the distribution of income; probably the principal reason we have so many billionaires.
In effect, the corporate income tax enables the controlling shareholders to reinvest their corporate income free of personal income tax. And it may even be free of corporate income tax! Economists widely believe that the tax is passed forward to consumers or backward to employees; they reason that corporate investors must at the margin earn the same return as unincorporated businesses or they would not invest in corporations which are subject to a corporation income tax.
Prof. Arnold Harberger, an eminent economist, argues that corporations that sell their products domestically are able to pass the tax forward to consumers or backward to their employees but corporations that export much of what they produce cannot pass the tax forward to consumers because of international competition. But corporations with earnings abroad have an advantage in that they pay no tax until their foreign earnings are repatriated so they can reinvest their earnings abroad without paying any personal income tax.
Corporate shares are widely believed to be owned preponderantly by the wealthy. This may be true but pension funds, whose beneficiaries are workers, and mutual funds that are widely held by the middle class, own a substantial portion of corporate wealth. Many of the beneficiaries are in brackets below the basic rate of the corporate income tax. Their earning are thus taxed at the high rate of corporate tax and taxed again when they receive the pensions and dividends.
What distinguishes corporations from partnerships and proprietorships is the limited liability of corporate shareholders. But partnerships have in fact achieved limited liability for its investors by laws that permit limited liability partners and relaxed rules about who the general partners may be. Limited liability partners’ shares are traded on the major exchanges just as corporate shares are traded. One notices in the news these days the taking of corporations private; one of the reasons, perhaps the main reason, is to avoid the corporate income tax.
Why are corporations taxed differently than partnerships? The answer is to be found in the anti-big business and the anti-trust movement of the late 1890s and early 1900s. Even corporations that were not trusts or “combinations in restraint of trade” came to be viewed as a threat to consumers when in fact they created an economy having the highest standard of living by increasing the demand for workers with the resulting increase in average wages. Whatever the reason for the anti-corporate bias, a corporate income was enacted and a separate personal income tax was enacted as soon as the 16th Amendment to the Constitution was adopted.
It was not the British experience. Britain’s Income and Property Tax Acts which date from before the Tudors, re-enacted under the reign of William and Mary in the last decade of the 17th century, and re-enacted under William Pitt in 1803, integrated the corporate and personal income tax. Corporations paid the standard rate of income tax and households were credited with those payments on the dividends they received. When the Income and Property Tax was re-enacted in 1862, its provisions were almost identical to the earlier Income and Property Taxes. The British taxed corporations until the end of WWII as part of the personal income tax not as an entity separate from its owners but as taxation at the source of personal income derived from corporations. Corporations paid the basic rate of income taxation on their earnings and shareholders were credited with the basic rate of income tax on income earned by the corporation. (That lunacy is contagious is illustrated by the fact that after labor took power in the 1940s, the British imitated the worst characteristics of the U.S. income tax system including high rates (up to 98%), imposing a separate corporate income tax, and imposing a capital gains tax separate from the income tax.)
Except for its high cost of compliance, the personal income tax gets high ratings from economists. However, economists have called attention to some negative economic effects, for example seeking and finding ways to avoid high rates of tax. Because capital gains are taxed at lower rates than ordinary income, corporations, instead of paying dividends, buy back outstanding shares which, other things equal, raises the prices of the outstanding shares enabling shareholders to realize lower-taxed capital gains. This is the principal cause of corporations buying back their shares to raise the price of the remaining outstanding shares instead of simply paying dividends which are normally taxed at standard rates. But as we have shown elsewhere this can be easily corrected by appropriate treatment of capital gains, by, for example, un-taxing capital gains that are rolled over, i.e., reinvested (the treatment accorded to homes) and taxing consumed gains at the same rates as ordinary income.
Progressive income taxes do little to equalize incomes. Progressive expenditures like free public education, Medicaid, food stamps, public libraries, public parks and recreational facilities, welfare, public safety, public entertainment, et .al. are the great equalizers of income.
While the progressive personal income tax is highly regarded by economists, their acceptance of the corporate income tax is hard to justify. It violates almost all of the principles of taxation. As is typical of democracies, bad laws which have a constituency are never repealed.
But there is also an equity argument against the corporate income tax. The corporation is an association of individuals, its shareholders. Those who do business as a partnership are taxed on their individual shares of the partnership as personal income. The partnership is not taxed as such. The partners must declare under the personal income tax their share of the partnership’s net income. While the corporation can be used as a device to lower the tax burdens on the upper-income shareholders simply by retaining earnings or by converting earnings into capital gains as we’ve shown, partnerships cannot be used to play such games. High income partners pay high personal income taxes on their partnership income and low income partners pay lower rates of personal income tax on their income from partnerships.
The corporation is an association of individuals, its shareholders. So is a partnership .Those who do business as a partnership are taxed on their partnership earnings as personal income. The partnership is not taxed as such. The partners must declare under the personal income tax their share of the partnership’s net income. While the corporation can be used as a device to lower the tax burdens on the upper-income shareholders simply by retaining earnings or by converting earnings into capital gains as we’ve shown, partnerships cannot be used to play such gains. High income partners pay high personal income tax on their partnership income and low income partners pay lower rates of personal income tax on their income from partnerships. It is time to tax corporate earnings as the personal income of the corporation’s shareholders.
Comment by Ted Frank, 10/26/2013:
I have argued for years that the corporate income tax should be abolished because it is mainly paid by the consumers (the only REAL taxpayers) of the corporations' products or services, passed on to them because the corporate income tax is a category of costs of doing business just like wages and overhead. This argument should be made relentlessly because politicians obscure this fact from low-information (even high-information) voters when arguing that corprations should "pay their fair share" of the country's total tax burden. Most voters, however, buy into the notion that if corporations paid more, individual taxpayers could pay less. Howver, individuals are the only ones who truly pay ALL taxes imposed by government, the varied methods of taxation merely taking different routes to the taxing entities. Apart from abolishing the corporate income tax, a discussion needs to be had on the fairest and most efficient (from a cost of collection standpoint) taxes governments should use to raise needed revenue. Then, of course, the more philosophical question is what functions government should actually be engaged in (Constitutionally?) requiring revenue for its implementation?
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