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Unintended Consequences of Cutting Corporate Tax Rates
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.
Published in Domestic Policy, Economics, General, Politics
Interesting point. I wonder how other countries handle having low corporate tax rates.
Let’s start with the purpose of a tax system under our social compact. Our Constitution authorizes the Federal government exactly three purposes for spending: paying the national debt, paying for the national defense, and paying for the general Welfare. I’m one of those who hew firmly to the general Welfare not merely being limited to, but being completely defined by the next 16 clauses of Art I, Sect 8.
Thus, our tax code need only raise funds for those limited purposes. In particular, our tax code cannot be used (even though it is…) for social engineering.
That takes me to my tax code end game: a low (I say 10%) flat tax on all individual income, regardless of source or type, with no deductions, credits, subsidies, etc, that everyone pays. And a zero tax on businesses–which we individuals pay a large chunk of, anyway, in the form of higher prices so the business can recoup some of that cost center. Not taxing (or subsidizing) business at all takes government completely out of the business of influencing business into either debt or share sales as a means of raising money; the business is free to make that choice solely on sound business and economic reasoning. The loss of subsidy transfers, deductions, etc also takes government out of influencing business at all. And it leaves the retained profits freely in business hands for business to use for business–not government–purposes.
Will that low tax on individuals and even lower tax on business lead to the use of business structures by individuals as tax shelters? Maybe. Probably.
So what? It’s not the government’s money. The government’s desire for our money in no way gives it a claim on it.
Bush’s tax plan certainly is not my end game. But it’s what’s possible doable in the interim, and I don’t have the impression that it’s his desired end point, either. As an interim step, Bush’s plan is sound. As an interim step, so is Rubio’s. That’s the thing, too. None of this can be taken as a final stage. Do the intermediate step. Observe and collect data on empirical outcomes. Use those data to adjust the intermediate and also to take the next step. We’re not going to get to a useful end game in one step. Obamacare and Dodd-Frank, regardless of whether those laws are any good or not, should have taught us the foolishness of trying that.
The observe, collect data, and adjust also applies to my end game–which cannot be an endgame. If there really is a too large move of individuals and families structuring themselves as businesses so that Federal revenues fall too low even for the legitimate uses, then an adjustment will be needed.
Eric Hines
Many have value added taxes. Another shell to make it harder for voters to tell what they’re really paying for government.
Thanks, I understand that other countries have VAT to make up for lost revenue. I meant that I wonder how other countries handle your specific point which I took to be the ease with which some people might be able to construct shell corporations to take advantage of low corporate tax rates.
Very nice post.
Eric,
I’m in full-throated agreement with nearly everything you wrote. But I think you’re missing an element of the social compact.
Our money is ours; the government isn’t entitled to it. But we have a mutual obligation to contribute to lawful expenditures. To pick a non-controversial example, national defense is a true public good–it protects all of us, whether we want it to or not. We must pay for it collectively.
True tax shelters allow some citizens to shirk their obligation. They enjoy the same protection at a lower cost than citizens who cannot take advantage of the shelter.
Unlawful (as in unconstitutional) federal expenditures are a problem. It’s very tempting to say “Well then I just won’t pay for them” and use tax shelters as a means of avoidance. But this doesn’t stop the expenditures, it just increases the deficit. Which simply shifts the injustice to the next generation.
So as we take interim steps, it’s important to step in the right direction. In my view, for the reasons stated, creating tax shelters is a step in the wrong direction.
As to what is doable, why is cutting the corporate tax rate more doable than making dividends deductible? Arguing about the comparative corporate tax rates of different countries buys into the narrative that corporations are taxpayers. Allowing full deductions for dividends would allow corporations to cut the effective corporate tax rate to zero by distributing their earnings.
I must admit I don’t really know. But in the debate in the U.S. seems to always focus on competitive rates for public corporations. I’m not sure policy makers consider the impact on the much larger number of closely held corporations.
True tax shelters allow some citizens to shirk their obligation.
I’m not missing this point of our social compact obligations, I’m deliberately eliding it. Tax shirkers always will be among us; there comes a point, though, where chasing the marginal shirker (the next one, not the one who’s only doing it a little bit) isn’t worth the gain from catching him. I don’t think, at that low rate, tax avoidance will be a big enough problem to worry about from a revenue collection perspective. That’s the collect empirical data and adjust part.
…why is cutting the corporate tax rate more doable than making dividends deductible?
It may not be. My view is that dividends are perceived as the vehicle of the rich, while the stereotypical widows and orphans who truly benefit from them are ignored today. From that, I think cutting corporate tax rates is more politically possible than untaxing dividends. The fact that dividends currently are taxed twice has been a long-standing beef, and for all that time, the argument against untaxing–on either side–dividends would be an unacceptable tax break for the rich. By all means, have that debate in townhalls and on the floors of Congress, though. My point about doing the interim thing is simply to not blow up something that, in the main, is an improvement just because one aspect of the thing isn’t palatable. Two steps forward and one step back is a step forward.
Allowing full deductions for dividends would allow corporations to cut the effective corporate tax rate to zero by distributing their earnings.
Dividend distributions as corporate tax shelters. Hmm…. [g] The whole idea of a flat tax with no deductions is to have a flat tax with no deductions. No gerrymandering for this or that government-determined social engineering purpose.
Eric Hines
The European countries (also using VAT to increase revenues over that collected via their lower-than-ours tax rates) also openly object to tax rate competition among the nations. Look at the unconscionable pressure the EU is applying to Ireland to try to force it to raise its “unfairly” low rate so as to not undercut the mainland.
Eric Hines
Interesting post but, like many others, you don’t quite get the issues right.
1. Almost every other developed country in the world has a corporate tax rate that is lower than individual rates (certainly the individual rates at the top end of the progressive structure). The problem you are concerned about here does not run rampant in those countries. Further, at a corporate tax rate say of, 25%, relatively few people could even take advantage of the lower corporate rate with creative structuring because their marginal rates would be below that amount.
2. Repurchasing stock does not increase the value of the remaining shares in and of itself. So many people make this statement and it is completely false. Total equity value of the company goes down by the exact amount of the shares repurchased so price per share remains constant. In this respect, it has the exact same impact of dividends.
3. The reason companies are sitting on $2 trillion of cash isn’t because of the double taxation of dividends (although it does play a small role). It is because of the idiotic international tax system US companies are subjected to. The vast, vast majority of that cash is sitting overseas because companies are not going to pay the enormous incremental tax to repatriate back to the US. This is true irrespective of the potential uses of the repatriated cash.
This paints with too broad a brush. Repurchasing stock increases stock prices in the short run (measured in days after the stock purchase plan has played out) from the increased demand for a dwindling supply. Book value only gets factored into stock share market pricing over the intermediate- to longer-term.
It’s similar with dividend-paying stocks, although it’s more obvious with preferred stocks. The price of a dividend-paying stock rises through the quarter (usually quarterly) as the unpaid dividend gets factored into the share price. The day after the dividend is paid out, the share’s price falls by roughly the dividend payment, then begins rising again for the new cycle.
Eric Hines
Further, this is a perfect example of the inability of our current political system to make positive incremental changes in the current environment. Republicans do a very poor job of articulating the issues and Democrats simply demagogue about “wealthy” corporations. The solutions are very simple.
1. Move away from current global international tax system to a territorial system just like the system in place for all those other “greedy” market fundamentalist countries – Canada, Germany, UK, Spain, Italy, Australia and France….FRANCE!!
2. Lower corporate rate to 20-25% or, I do like your idea of making dividends deductible in some form or fashion (although there are a lot of challenges here in regards to multinationals operating in the US). As you are entirely correct that corporations are not necessarily the tax payer, they tend to be the tax collector. That said, I don’t think full deductibility of dividends is politically viable in current environment where reducing the corporate rate is somewhat. Would have the benefits of reducing incentives to create certain capital structures as you note.
The bigger issue here is our crazy international system. It actually reduces revenue to the government (although my goal is not to increase it) and makes the US a relatively less attractive place to invest.
You are almost entirely wrong here. Further, I never mentioned one thing about book value…as it is entirely irrelevant. You are correct that increased demand on the buy side as a result of a repurchase program could cause share price to go up slightly in the very short term but that ignores how most repurchase programs are executed. They are executed over a period of several months taking into consideration total float and size so as not to disturb the price.
Also, you have the dividend piece correct but don’t logically extend that to the share repurchase piece. If a company repurchases $100 worth of shares, total equity value decreases by $100 (just like a dividend). Share count decreases by equivalent value….hence no change in share price.
Big Green,
I winced right after I posted it, as it also buys into corporations being tax payers.
The notion of stockholders being the rich is a legacy of the Great Depression. In the 21st Century, stockholders are CALPERs, 401(k) plans and IRAs, foundations and charities, and retirees. Renewing the debate over double taxation of dividend provides an opportunity to update the paradigm and allow the middle class to see that their paying these taxes.
I knew what you meant; I just couldn’t pass up the straight line.
The advantage for me for going after corporate tax rates rather than focusing on dividend taxing is that the argument over dividend double taxing has been a long argument with little progress. It’s time, say I, to take a different argument–corporate tax rates–which, as a side effect, will take dividend taxing along.
Eric Hines
Shell –
1. This is a fair point and admittedly my views on this are more anecdotal rather than from specific knowledge of the law and/or data. I travel to Europe quite often on business and engage in political/economic discussions frequently. I have never heard of this being a significant issue. I understand that proves nothing but it is my experience. I also, highly doubt that those European countries would have such a tax system in place if people were indeed able to shelter income taxes through corporate forms. I do think this is a legit concern of yours though.
2. Will address this one in a separate post. For some reason people get confused by buybacks.
3. As of the of of Q2 this year, publicly traded US corporations had about $1.7 trillion in balance sheet cash based on the data I have access to (Bloomberg). Most estimates peg $1.1-1.2 trillion of it held overseas. Almost all of this would be subject to tax upon repatriation. So only about $500-600 billion is held in the US. Given that not all balance sheet cash is true “excess”, $500-600 billion held in the US (and only about 40% of the total) does not seem high at all in my experience. Further, the currency in which the cash is held says nothing about whether or not it will be taxed upon repatriation.
On share buybacks….
I worked at a publicly traded company in finance, was then an investment banker and now work in private equity. Bankers talk about share buybacks as increasing shareholder value but it is mostly nonsense. It does not create shareholder value in isolation but it can in certain circumstances if you believe that the existing share price is meaningfully undervalued.
Now in regards to P/E, this is the usual go to when talking about value creation. Train of thought is…fewer shares means higher EPS and if multiple is held constant, the share price will increase. This is total bunk…full stop. Excess balance sheet cash gets accounted for in equity value too, equity value it is not just a multiple slapped onto earnings. Assume a company has 100 shares outstanding, $1.00 EPS, $150 excess cash and trades at a 15x P/E multiple. Total equity value is $1,500 and shares trade at $15 each. However, $150 of the $1,500 total equity value derives from the $150 excess cash. Let’s say we use the cash to repurchase shares. We can repurchase 10 shares (assuming no friction). Shares outstanding is now 90 and total equity value is $1,350. Each share is still worth $15. However, the P/E multiple has decreased slightly – $15 share price divided by $1.11 EPS, so about a 13.6 P/E now. This decrease is because excess cash is now exactly $0.
I’ve never understood why all limited liability corporations aren’t just treated as partnerships (No C corporations, just S corporations). It would make so many problems go away besides the current (highly fictional) corporate tax code. Stocks no longer serve as simple, clever, and generally unrecognized tax shelters. Mitt Romney no longer has to fret that he’s being taxed at an unjustly favorable rate. Double taxation on capital gains and dividends goes to the ash heap of history. Potential mischief with retained earnings no longer requires activist investors having to squabble with the Larry Fink, Herself, and whoever else with their dresses up over their heads about “short-termism,” whatever the hell that really means.
I’m sure there’s a good reason other than blinding stupidity; I just have never heard what it is.
Eric, where does the Constitution authorize payment for general welfare? I’ve not heard that interpretation before.
From the first clause of Art I, Sect 8: …to pay the Debts and provide for the common Defence and general Welfare of the United States….
That’s the importance of my qualifying position in my first comment: …the general Welfare not merely being limited to, but being completely defined by the next 16 clauses of Art I, Sect 8.
Eric Hines
In contrast to “general Welfare” being whatever President Obama thinks is good for the country. This being Chief Justice Robert’s interpretation.
SParker,
I think the answer lies, to some extent, on practical issues. There are two general approaches to taxing income from business organizations.
The second approach can work if there isn’t too much turnover in ownership. If changes in relative shareholdings are the exceptions, then it’s easy to divide tax results among the owners on regular basis.
Tracing becomes difficult when ownership changes on a regular basis, particularly if records of beneficial owners are buried under layers of intermediaries. For public corporations (at least), where ownership shares trade every day, it’s easier to collect taxes at the organizational level.
It’s not impossible to use the second method for a public company. I’ve dealt with publicly traded master limited partnerships since the mid-80s, which do trace to underlying partnership units. But it’s difficult and expensive.
Allowing dividends to be deducted simplifies the tracing problem by having the tax obligation follow the cash. Cash distributions always make their way to the beneficial owner, who can pay the taxes on the distributed income.
I don’t know that I’ve ever met a CFO who didn’t believe his company’s shares (and thus his options) were “meaningfully undervalued.” Their logic may be wrong, but that doesn’t make their intent more noble.
I was puzzling on the fact that, if successful, the buy-back would increase P as well as EPS, so the ratio might remain the same or decrease. So the ultimate (or even immediate) impact on share price would be indeterminate.
I agree with you that most of the folks in the C-Suite believe there stock is undervalued. However, that isn’t germane to whether or not the mechanics of share repurchases in isolation result in a higher stock price. Further, the reason the repurchase of “undervalued” shares increases shareholder value is because you are effectively buying out the other shareholders at a discount not because of some “shell-game” that increases EPS.
Intrinsic value of equities are indeterminate in a sense…the “efficient market” assumption obviously is that the current price does reflect intrinsic value. The key in understanding share repurchase net effect of zero though is understanding that underlying excess cash is reflected in the price at which shares are repurchased. When my team does these types of analysis, we always look at the “cash neutral” P/E ratio to understand the true multiple at which EPS is being capitalized.
As a CEO whose companies are headquartered overseas, I have really enjoyed this discussion.
For our part, we have always preferred share buybacks to dividends… Cleaner, simpler, lower taxes.
But then again, we don’t mind having a thinly traded stock, and we don’t exist to pay fee collectors on the dividend or share issuance road. And I could not care less about the short term; increasing long term shareholder value (which, sooner or later, calibrates to book value) is my job.
Agree with almost all of this, but there is an easier fix and one that distorts less, raises more revenue per tax rate, will make shareholder return to paying attention to management, ( why they don’t is a long story about confiscatory taxes and the transformation of boardroom cultures), and reduces wealth sheltering effects of stock ownership. Simply treat corporate profits as the income of the holder of record.
I applaud you for your long term shareholder value focus. Just one thing on the dividend vs. repurchase debate though. In the US qualified dividends and long-term capital gains tax rates are virtually identical across the tax code now so one isn’t favored over the other. Also, I believe that short-term capital gains and unqualified dividends are taxed the same now as well. Therefore, shareholders shouldn’t care which form it comes in other than that they can control the timing a bit with capital gains as they can always choose not to sell where they don’t have this flexibility on dividends obviously.
Clearly only applies to US domiciled shareholders (not sure if this is the case for your companies as you said they are headquartered overseas) but I believe that most other countries where there is pervasive equity ownership have the same, or very similar, system in place.
See #23. Cede & Co., the nominee of the Depository Trust Company, is the holder of record of nearly all publicly traded stock in the U.S. But I understand you mean to look down the chain of intermediary to the ultimate owner.
The problem is “profits as of when.” Many shareholders don’t own shares for an entire year. Should company’s estimate daily profits? Should annual profits be pro rated by your holding period? Or should whoever happens to own shares at year end pay all the taxes?
The securities holding system is design to pass information downstream (company to DTC to intermediaries to owners), not upstream. Companies cannot tell who owned how many shares on any day, so they could not tell who was a shareholder when profits were earned. So the company could not keep track of who earned a share of the profits and send them tax report.
You don’t have an issue with the fact that the only way your shareholders can generate income from their investment is by selling it? I realize some companies (perhaps yours) are growing or developing and need to plow earnings back into the business. But they wouldn’t have spare cash for buy-backs.