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
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  1. John Penfold Member
    John Penfold
    @IWalton

    ShellGamer:Well yes, probably a number of accounting difficulties would have to be overcome and would bring new sets of incentives that have to be sorted out.   But why wouldn’t it be the same as paying a dividend to those who hold the shares as of the x dividend date.  So if you own it you get that quarters dividends but also become liable for an appropriate tax liability. The equivalent would be to pay all profits as dividends sorted out as it is now but with some last quarter adjustment for profits and tax liabilities.   The point is to put shareholders back in charge and management more accountable to them, end double taxation and the fiction of corporate profits taxes.  Profits belong to shareholders, although ownership has gotten complicated as have profits I suppose.    Why is it so expensive to track?  If the profits belong to owners wouldn’t it be in management and owners interests to migrate toward simpler systems to accommodate simpler tax liability rules?

    • #31
  2. Ekosj Member
    Ekosj
    @Ekosj

    As the owner of a small corporation, here is the thing … In a very important sense, corporations aren’t real … They are a legal construct. My little corporation occupies a modest black binder. The contents are the legal documents that constitute EKOSJ incorporated. The binder IS the corporation. Go ahead tax it. Assess fines and penalties against it. Threaten it with jail if you like. It does not care. It is a binder filled with paper!!! It cannot pay anything. Only flesh and blood people can pay taxes.

    They can SAY they are taxing corporations. But they aren’t. The binder can’t pay. And they know it. When EKOSJ incorporated gets taxed …. I PAY. They are really trying to tax ME, the owner of the corporation. But they are too gutless to come out and say so. Because the owners of corporate America are, for the most part, either entrepreneurs like myself, or firemen and police officers, teachers and healthcare workers, truckers and longshoremen and other regular working people who own stock through their pension funds or IRAs or 401ks. Its not very politically correct to say ‘Lets tax the cops and teachers and truck drivers’. But every time the cry goes up to ‘Tax the corporations!’ Thats exactly who gets hit. They might own shares of GM or FORD or APPLE, but the only difference, from a legal perspective, between my little corporation and FORD is that FORD’s binder is a heck of a lot thicker. Thats it. Only the owners can pay. So lets at least be honest and up front about it. Say what you mean.

    ‘Tax the business owners, whomever and wherever they are.’

    But be prepared to answer questions about geese and golden eggs.

    • #32
  3. Tuck Inactive
    Tuck
    @Tuck

    Ekosj:…So lets at least be honest and up front about it. Say what you mean.

    ‘Tax the business owners, whomever and wherever they are.’

    But be prepared to answer questions about geese and golden eggs.

    Indeed. Very well put.

    • #33
  4. iWe Coolidge
    iWe
    @iWe

    ShellGamer:

    iWe:As a CEO whose companies are headquartered overseas, I have reallyenjoyed 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 feecollectors 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.

    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?

    Not really, no.

    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.

    We are not doing serious buybacks yet. But there is value to having an asset that has appreciated – it can be leveraged, for example.

    Additionally, giving the shareholder control over their own tax timing is a very big deal for many of them. There are just more options this way.

    • #34
  5. iWe Coolidge
    iWe
    @iWe

    Big Green: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

    Because we are in a non-tax treaty country, dividends would be taxed differently. It is a big loser for US taxpayers at least now.

    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.

    More than “a bit” – it gives the shareholder complete discretion about when to sell any or all of their holdings, and have the taxes then.

    • #35
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