Tax Romney, not Corporations

You may already know, but Mitt Romney only had to pay about a 15 percent personal income tax rate over the last two years. As we search around for someone to blame for this situation—after all, many taxpayers who made far less paid a far larger percentage to Uncle Sam—we might lay part of our outrage at the feet of the corporate income tax. And while blaming it, let’s end it.

Romney had a tax rate of 15 percent because, apparently, most of his total income for those two years came in the form of capital gains and corporate dividends, both of which are taxed at this lower rate (compared to the top rate for wage income, 35 percent). Leaving aside the issue of capital gains taxes (which involves separate pros and cons), dividends are given a lower rate exclusively to avoid “double taxation,” when the Feds take a bit off the top from the corporation, then a bit more from the individual taxpayer. For illustrative purposes, let’s follow the money from an investor’s pocket and back if there were high taxes on both corporations and personal dividends.

A man named Willard invests $10 million in Company A. This company, in the year 2011, has a profit of $20 million. It decides to pay out 100 percent of its profits in dividends to the 20 million outstanding shares (to make the math simple). Willard owns 1 million shares, so would receive $1 million in dividends. But Company A must pay a 35 percent corporate income tax on its profit, so it would have 35 percent less to give to each shareholder. Willard would then receive only $650,000 in dividends after corporate taxes. Since Willard is in the top income bracket, the federal government would then take another 35 percent, leaving him with $422,500 after personal income taxes. Willard would suffer a tax loss of 57.75 percent of the income from this corporate investment.

One can see why this could be a problem. If investors stand to lose almost 60 percent of the value they would have realized from corporate dividends, they will be less likely to invest in corporations. New businesses would have trouble finding the capital to get started while fewer corporations would be able to expand and hire. Hence, double taxation would be an economic depressant. To avoid this result, dividends are taxed at a low rate of 15 percent. The result is that people like Romney end up only paying 15 percent on their income from dividends, and that strikes many wage-earners as unfair (“His $1,000 from dividends is worth just as much as my $1,000 in wages; why does he get a break and not me?”) But as long as the corporate income tax remains, any increase in the dividends rate will de-incentivize investment.

So why not just end the corporate income tax? There are many reasons to do so besides avoiding double taxation—reasons that Republicans and Democrats can support.

Reason #1: Our current Corporate Income Tax is uncompetitive.

Our top federal corporate income tax (CIT) rate of 35 percent is the second highest in the world, behind only Japan. The average top rate of other industrialized nations is 25 percent, the rate of China. Simply put, this harms all domestic businesses, making them spend money on taxes that could go toward expansion and job creation. It increases the cost of doing business in America, causing firms to relocate elsewhere. Lowering—and even better, eliminating—the CIT would provide a significant economic boost to our slow economy.

Reason #2: The Corporate Income Tax punishes Labor

We might be forgiven for thinking that the CIT is a good way to ensure that “rich” corporations pay their fair share in a society that gives them special benefits, such as limited liability. But we would be wrong.

Studies show that rather than taxing the vast bank accounts of the corporate world and trimming beefy corporations down to size, the CIT is ultimately a tax on labor. The corporations pass the tax burden onto their employees by lowering their wages. In 2006, William C. Randolph of the Congressional Budget Office estimated that “domestic labor bears slightly more than 70 percent of the burden” of the CIT. A research study at Oxford University concluded that “a substantial part of the corporation income tax is passed on to the labor force in the form of lower wages.” In this sense, the CIT is regressive. Those who have less income (workers) eventually bear more of the tax costs. This works against the tax code’s commitment to a kind of social fairness, where those who benefit more pay more and those who benefit less pay less.

Reason #3: The Corporate Income Tax has been rigged by Big Business, and probably always will be.

Besides being (in practice) a regressive tax that burdens labor with its costs, the CIT also causes an unfair and distorted business environment as big corporations work to avoid taxes and create loopholes in the system. As President Obama himself noted in last year’s State of the Union address, “Over the years a parade of lobbyists has rigged the tax code to benefit particular companies and industries. Those with accountants or lawyers to work the system can end up paying no taxes at all. But all the rest are hit with one of the highest corporate tax rates in the world. It makes no sense, and it has to change.” The President was right: recent studies have shown this exact trend, highlighting outrageous tax avoidance by big corporations.

A study released last November by Citizens for Tax Justice and the Institute on Taxation and Economic Policy noted that the effective tax rate (after deductions and other loopholes) of the 280 largest and most profitable U.S. corporations for the past two years (2009 and 2010) “averaged only 17.3 percent, less than half of the statutory 35 percent rate.” In fact, thirty companies—including Pepco Holdings, General Electric, Verizon, Wells Fargo—had a tax rate of zero or less (meaning, the government paid them, in subsidies and the like, more than they paid the government). Eventually, smaller corporations suffer in the competitive marketplace because they can’t afford such high-priced tax lawyers and lobbyists. Different industries are also subject to different tax burdens, which further distort the fairness and predictability of the market. For example, U.S. retailers and construction firms generally pay around 30 percent effective rate on income taxes, but financial services companies pay only 20 percent and mining pays only 6 percent.

This topsy-turvy world of tax avoidance and special tax advantages, with GE paying less income tax in total than your local hardware store, is as outrageous as it is predictable. The corporate form allows for vast concentrations of capital, which then have an interest in avoiding taxes. A report released only weeks ago estimates that 280 profitable Fortune 500 corporations spent $2 billion on federal lobbying from 2008–2010. During this time, these same companies received $223 billion in tax rebates and credits. With this kind of money at stake for the biggest corporations, lobbyists and lawyers and politicians get very busy. We can expect that a corporate income tax will always be a feeding frenzy for the largest corporations, which have all the time and, almost literally, all the money in the world. (These 280 companies had profits during this time period of $1.3 trillion in U.S. profits, more than the entire yearly GDP of South Korea.) If we end the CIT, smaller businesses might have more of a chance to compete on the merits rather than on the tax bill.

Why support the Corporate Income Tax in the first place?

The CIT still has its supporters who offer three main arguments in favor of it. First, some argue that it is easier to tax a corporation than an individual, and so the corporate tax provides an important and relatively simple source of income for the federal government. The CIT eliminates some transaction costs since it helps fund the government with larger tax payments from fewer taxpayers. Furthermore, they insist, it is easier to obtain financial information from corporations because they are required to keep documents, which eases enforcement of the tax rules. But as noted before, if corporations are potential taxpayers because they have a lot of money, then they also have the most resources to avoid paying taxes. When the biggest corporations pay an average effective tax rate of around half of the stated tax rate, and when a significant number pay nothing at all, the wealth of corporations begins to be more of a problem than an opportunity for the taxing authorities.

Second, some believe that a corporate tax is justified by the benefit conferred on corporations for limited liability. Corporations get a benefit from society, the argument goes, so they must pay for it. But this more theoretical line of reasoning fails to convince: corporations themselves are merely fictional persons. The idea that they should “pay their fair share” in society is wrong, for the simple reason that if a corporation is taxed, it is not the corporation that bears the burden (nothing “burdens” a corporation, because corporations don’t have feelings, suffer loss, or deal with hardship) but instead some real person, often a worker, who has less income than he or she previously had. It is laudable to try to make the rich owners of capital in the corporate world contribute a just amount for the maintenance of the system that benefits them, but in headlong pursuit of this goal the CIT ends up shearing the wrong sheep.

Third, corporate taxes are defended as a necessary backstop to a personal income tax. As Uwe Reinhardt of Princeton has written, “If the profits of corporations were not taxed, the corporate form of enterprise would become one more major tax shelter through which wealthy people could shield their income from taxation. That probably is the main reason why abolishing the corporate tax has never had any political traction, in the United States or abroad.” The specter of the income-shifting wealthy individual who takes advantage of tax-free corporations to shelter himself from “paying his fair share” is certainly a politically salient one. But is it so dangerous that it requires a CIT with all its economic distortions and secondary effects?

Probably not. The IRS is quite adept at fighting back against tax avoidance. Megan McArdle of The Atlantic writes:

While owners of corporations do manage to chisel at the margins, the smart ones don’t funnel their whole personal budget through the firm, because doing so is a sure route to an audit and a hefty fine. [Without the CIT] there’s no reason to worry about wholesale abuses of the system, because the IRS is already reasonably adept about ferreting these out.

In other words, the U.S. need not fear rampant individual income tax avoidance if the CIT is eliminated. With the funds freed from the losing battle of corporate tax enforcement and added to individual tax enforcement, our tax authorities will be better equipped to enforce these rules. If wealthy individuals still find ways to use corporations as tax shelters, additional rules can be passed to help prevent them as needed. We might establish some sort of cap on retained earnings, or tax corporate earnings directly to the stockholder on something like a pass-through basis. Proper enforcement and good rules can keep the tax dodgers at bay, without the unique distortions and unfairness of the CIT.

Imagine politics without a Corporate Income Tax.

We can expect many good things from the elimination of the CIT, starting with the removal of a huge amount of special interest money from politics. Without the CIT there would be a much smaller financial incentive for corporations to lobby for special tax rules and tax breaks. Moreover, the elimination of the CIT would allow a simplification of the personal tax code by taxing dividends like the normal income they obviously are. It would make our tax environment the most business friendly in the world. It would prevent big businesses from gaining a tax advantage over smaller ones. It would ease the financial burden on labor, whose wages are depressed by the CIT. You can almost hear the rallying cry at the first joint Occupy Wall Street/ Tea Party Rally: “Tax Romney’s Dividends – End the Corporate Income Tax!”