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Jeb!’s tax plan provides a good opportunity to explain why cutting corporate tax rates below individual tax rates will only worsen problems with the existing tax structure.
We tend to think of large multinationals, or at least publicly-traded corporations, as the paradigm corporate taxpayers. But according to the 2012 IRS Corporate Income Tax Report, 86 percent of Form 1120 filers (commonly known as C Corps) had assets of less than $1 million. (I used the data in Figure F, to separate out the S Corp returns.)
I started practicing law just before the 1986 Tax Reforms. At that time, the top corporate rate was much lower than the top individual rate. I still remember attending a seminar where we were instructed that it was malpractice per se not to incorporate a business. Because the corporate rate was lower, every corporation was a tax shelter. As salaries are deductible, you could take what you needed from the corporation’s net income without double taxation, while having the net savings taxed at a lower rate.
I like savings as well as the next conservative, but there is no reason to limit tax breaks for savings to those who can run their income through a corporation. The original justification for taxing corporations was to prevent them from being used as tax shelters, and to my mind, this remains the only appropriate objective of corporate taxes.
Jeb!’s plan would magnify the problem by removing the deduction for interest. Taxation of dividends (which produces double taxation, at both the corporate and individual level) already encourages corporations (particularly the 14 percent with assets above a million) to hold cash. My friend Tony Carfang, at Treasury Strategies, estimates that US corporations hold nearly $2 trillion in cash. Corporate executives can justify this because paying out the cash as dividends would be the most tax inefficient use of the money.
Before continuing, let me emphasize my moral objections to the current treatment of dividends. That cash already belongs to the shareholders. Distributing property to its owners should not be a taxable event. It also limits the shareholder’s choice about what should be done with the money. If the shareholder wants to leave it in to grow the company, he can elect to reinvest the dividend. But he might elect to spend it, lend it or invest in another company. Such choices are foreclosed by tax incentives for corporations to hold cash.
If you don’t want the tax system to encourage debt (the rationale for Jeb!’s proposal to eliminate interest deductions), the correct reform is to allow corporations fully to deduct their dividends, just like interest. This would equalize the after-tax returns from equity and debt. Moreover, if you’re looking to reach 4 percent growth, just imagine the effects of injecting a trillion or so of the cash currently sitting idly in corporations into the economy.
The irony is that the current system contributes (I suspect significantly) to the income inequality that liberals constantly decry. Retaining cash increases the value of a company’s stock, and of the stock options universally used to compensate the directors and officers of public companies. The use of cash for stock buy-back programs (in order to distribute cash to some shareholders at lower capital gains rates) further increases the price of the stock and of the executives’ options. Undistributed cash becomes the executives’ bank for doing deals that generally increase the stock price of the acquired company (with a disproportionate impact on the executives who cash out and receive their golden parachutes).
Getting us to focus on corporations, rather than their shareholders, is a classic tax shell game. (I had to say it). I realize the national and international scope of modern business makes it difficult to devise a fair corporate tax system. But it can only help to bear in mind that the corporation is simply a proxy for its owners, and that any taxes it pays are paid on behalf of the owners. From this perspective, I don’t see any reason for the tax system to create incentives to incorporate or not to incorporate a business. To the extent practical, incorporate, and unincorporated business should be taxed equally, Jeb!’s plan would lead us in the opposite direction.