The current tax system taxes corporate income twice: It is taxed once at the corporate level, generally at a tax rate of 35 percent;[REF] it is then taxed again when the income is paid as dividends to shareholders or as a capital gain when the corporate stock is sold.[REF] This double taxation of corporate income has a pronounced negative economic impact, particularly on wages. It distorts the economy and harms productivity.
Congress should end the double taxation of corporate income—meaning that Congress should “integrate” the individual and corporate income tax.[REF] In the context of an income tax, this integration could be accomplished in three basic ways:
- Impose no entity-level tax;
- Impose no tax on shareholders with respect to dividends or capital gains on corporate stock; or
- Provide shareholders with credit for entity-level tax paid.
Senate Finance Committee Chairman Orrin Hatch (R–UT) has often discussed integrating the corporate and individual income tax. At a May 2016 hearing he said: “A better, more efficient system would be one that integrated the taxation of corporate and individual income.”[REF] In January 2017, Senator Mike Lee (R–UT) called for abolishing the corporate income tax and taxing capital gains and dividends as ordinary income.[REF] Economists at the Brookings Institution and the American Enterprise Institute have released an integration proposal.[REF] In 2014, former Treasury official and Columbia law professor Michael Graetz and Harvard law professor Alvin C. Warrant Jr. re-released their 1998 book on integration.[REF] Many foreign countries have fully or partially integrated tax systems.[REF]
Who Pays the Corporate Tax
Who bears the actual economic burden of the corporate income tax is an open question.[REF] One thing is certain: It cannot be corporations. A corporation is a legal fiction, and legal fictions do not pay taxes—people pay taxes. The corporate tax could be borne by corporate shareholders in the form of lower returns;[REF] owners of all capital (again in the form of lower returns);[REF] corporate customers in the form of higher prices;[REF] or employees (in the form of lower wages).[REF] It is, almost certainly, some combination of these.[REF] The economics profession has changed its thinking on this issue several times over the past four decades, but the latest consensus is that workers probably bear more than half of the burden of the corporate income tax because capital is highly mobile.[REF] Labor’s share of the corporate tax burden is potentially as high as three-quarters.[REF] Nevertheless, government estimators continue to assume that the primary incidence of the corporate tax is on those that own capital.[REF]
The corporate income tax is perhaps the most economically destructive tax that the federal government imposes.[REF] American Enterprise Institute scholars Alex Brill and Kevin Hassett find that a corporate tax rate higher than 26 percent (including state or provincial corporate tax rates) results in a loss of tax revenue.[REF] In other words, they find that the corporate tax results in so much reduced economic output, or in U.S. and foreign corporations moving so much economic activity out of the U.S., that imposing a tax higher than 26 percent reduces rather than increases federal revenue.[REF] Because U.S. state corporate taxes on average are about 4 percent, this would imply that reducing the federal corporate tax rate to 22 percent would actually increase revenues.[REF] Other studies find that reducing the U.S. corporate tax rate[REF] or eliminating the corporate tax altogether[REF] would have a pronounced positive economic impact. This is because a lower corporate tax rate will lead to higher investment, higher productivity, higher real wages, and both foreign and domestic businesses choosing to locate headquarters and production facilities in the U.S.
Debt and Equity Capital
Firms need capital to operate. That capital can be equity capital from the sale of stock or debt capital from borrowing.[REF] In each case, the investors who provide the capital must be compensated for it. The tax treatment of equity and debt finance differs markedly.[REF] When a firm borrows from a lender or issues bonds, it pays interest. The tax code treats interest as a tax-deductible expense. The interest is then taxable to the recipient. When a firm issues stock, it pays dividends to shareholders. Dividends are not treated as an expense and are not tax deductible. Thus, the compensation to investors providing equity capital is taxed both at the corporate level and again when received by the investor.[REF] For a given pre-tax payment to capital providers, debt is a less costly means of finance because interest payments reduce the firm’s tax bill while payments to shareholders do not. This distorts capital markets and encourages firms to rely more heavily on debt finance than they would in the absence of the disparate tax treatment. This higher degree of leverage makes it more likely that firms will fail since interest payments are obligatory while dividends may be suspended if profits decline.[REF]
Properly structured integration of the corporate and individual income tax would eliminate the double taxation of corporate income, eliminate the disparate tax treatment of debt and equity finance, and eliminate the tax-rate differential between regular “C corporations” and pass-through entities.[REF] The current tax system already has elements of an integrated tax system.
In the context of an income tax, there are three basic ways to accomplish integration:
- Impose no entity-level tax;
- Provide shareholders with credit for entity-level tax paid;
- Impose no tax on shareholders with respect to dividends or capital gains on corporate stock.[REF]
1. Impose No Entity-Level Tax. One approach to integrating the personal and individual income tax is to impose no tax at the corporate level. Under current law, closely held businesses typically do not pay tax at the entity level. The entity reports its income and shareholders or partners pay tax on their share of the entity’s income (whether or not the individual owners actually received a payment from the business). This is called pass-through treatment. Electing corporations may elect past-through treatment under Subchapter S of the Internal Revenue Code.[REF] S corporations may not have more than 100 shareholders, non-resident alien shareholders, or more than one class of stock. In general, only individuals may be S corporation shareholders. Partnerships are subject to a different, more flexible, set of rules under subchapter K.[REF] Limited-liability companies (LLCs) are generally treated as partnerships for tax purposes. Publicly traded partnerships are treated as regular C corporations, and are subject to entity-level tax.[REF]
This type of pass-through treatment is appropriate for closely held businesses where ownership interests change hands infrequently. For publicly traded companies, it raises serious administrative problems. A given ownership interest could change hands many times over the course of a taxable year, and allocating income among those who owned the shares or other interest during the year poses both administrative and fairness issues. Either the income would have to be allocated in proportion to the duration for which the interest was held, or, potentially unfairly, the income and tax liability would be allocated to the year-end holder even though the tax liability would be unknown until well after the year ended.
Alternatively, a consumed income or cash-flow-type consumption tax would allow a deduction for capital contributions to a business entity, and payments from the company (whether dividends, distributions, or return of capital) would be taxable.[REF] The tax base in a cash-flow tax is receipts less outlays.[REF] For example, unlike with the income tax, capital and inventory acquisition expenses would be deductible when incurred. In a national retail sales tax, no entity-level tax would be imposed, either.
2. Shareholder Credit (or Imputation) Method. An alternative approach is to provide shareholders a tax credit for their proportionate share of corporate tax paid at the entity level. This is called the shareholder credit, or shareholder imputation, method of integration. It has been adopted in a number of major foreign countries.[REF]
3. Dividend Exemption and Deduction. Entity-level taxation paired with the exemption of dividends from taxation at the individual level, or allowing corporations a deduction for dividends paid, substantially reduces the double taxation of corporate income. To the extent that a corporation retained earnings instead of paying all earnings out as dividends, some degree of double taxation would remain. Current law has a reduced level of taxation for “qualified dividends” and, therefore, partially adopts this approach.[REF] Similarly, under current law, some intercorporate dividends are eligible for a full, or partial, dividends-received deduction (DRD), which is functionally equivalent to a shareholder exclusion or exemption.[REF]
Consumption Taxes with Business-Level Taxation
The simplest way to eliminate the problem of double taxation at the corporate level is to abolish the income tax and replace it with a tax on consumption. Such a tax could be applied at the point of consumption, such as a national sales tax or a value-added tax, or could be administered through the current system by allowing deductions for savings and investments. Tax reform proponents have proposed four different types of consumption taxes: (1) a national retail sales tax, (2) the Hall–Rabushka flat tax, (3) a business flat tax, or (4) a consumed-income, or cash-flow, tax.[REF] Each type of consumption tax effectively integrates the corporate and individual tax, but each handles integration differently. In a national retail sales tax, businesses are not subject to tax but withhold and remit taxes on their sales to consumers. In a business flat tax,[REF] all businesses are subject to one level of tax on the goods and services that they sell less their purchases from other businesses. There would be no additional tax on the businesses owners when profits are distributed to them. In fact, all financial transactions would be disregarded in a business flat tax; only the sale and purchase of real goods and services would be relevant to the tax due. In the Hall–Rabushka flat tax, there would also be no additional tax on the businesses owners when profits are distributed to owners and financial transactions are disregarded. In a consumed-income, or cash-flow, tax, there would be, in principle, no tax on reinvested earnings. Only income spent on consumption would be taxed.[REF]
The House GOP Better Way plan[REF] is a substantial move toward establishing a consumption base for taxation,[REF] and similar in many respects to the Hall–Rabushka flat tax.[REF] It substantially reduces the double taxation of corporate income by reducing the C corporation tax rate from 35 percent to 20 percent, and by reducing the tax rate on dividends and capital gains from as high as 43.4 percent to 16.5 percent. It does not, however, entirely eliminate double taxation. Under the Better Way plan, pass-through entities would continue to pay tax only at the individual level, at a reduced tax rate of 25 percent.
Tax Base Issues
There are two competing concepts about how to define income for tax purposes. One, the Haig–Simons (or comprehensive) definition of income, defines income as consumption plus changes in net worth.[REF] The other, the Fisher–Ture definition of income, defines income as gross receipts less outlays made in order to earn future income.[REF] The double taxation of corporate income is inconsistent with either definition of income since it includes corporate income in the tax base twice.[REF] Because the double taxation of corporate income taxes corporate income more heavily than other forms of income, the current tax system also violates principles of horizontal and, for that matter, so-called vertical, equity.[REF]
In an income tax, the issue of the proper corporate tax base cannot be entirely avoided. For example, even if no entity-level tax is imposed, the amount of income attributed to shareholders or partners is a function of the choice of entity-level tax base. Rules governing capital cost recovery, inventory accounting, the inclusion or exclusion of foreign source income, financial intermediation, and so on, must be provided in order to determine the amount of entity-level income that will be attributed to shareholders. Similarly, with a shareholder-credit method, the tax base at the entity level must be determined to assess the entity-level tax for which shareholders are credited. Even a dividends-paid deduction or exclusion must determine the earnings of a corporation to determine whether the payment to the shareholder is a dividend or a return of capital.[REF]
There are, however, two consumption-tax plans that do not require the determination of corporate income. Corporate income would be irrelevant under a national retail sales tax. It could also be irrelevant under a true consumed-income, or cash-flow, tax that was structured as an individual tax only and treated all investments in a business entity (including corporations) as deductible, and all distributions from businesses (including dividends and capital withdrawals) as taxable.
Integration raises a number of important international tax issues.[REF] These fall into two basic categories. First, how to treat international transactions for purposes of calculating the entity-level tax base. Second, how to tax foreign shareholders of U.S. corporations (or U.S. branches of foreign corporations).[REF] These issues are complicated by the fact that the traditional focus of the corporate income tax is on the source of the income, while the traditional focus of the individual income tax is on the residence of the taxpayer.[REF] Residence and source principle-income taxation do not lead to the same tax base decision in an international context. Furthermore, taxation on the basis of consumption leads to different results than income taxation.
In an integrated system, policymakers would still need to decide whether a tax system was territorial or worldwide, destination principle or origin principle, and whether foreign investors would be subject to withholding, or other, taxes on their U.S. source income. The tax treatment of foreign investors in U.S. companies arises in different ways in different tax plans. If there is no entity-level tax, should foreign shareholders of U.S. corporations be subject to some tax on the dividends or other distributions paid to them? If there were no withholding tax, they would effectively not be subject to any tax on U.S. source corporate income. In case of an entity-level tax, should foreigners be afforded any credit for the U.S. entity-level tax paid or provided the exclusion that U.S. shareholders would receive? If there is a dividends-paid deduction, should the corporation receive a deduction for dividends paid to foreigners? If so, should there be a withholding tax on those dividends paid? There is also the issue of whether the tax treaty network that dramatically reduces withholding rates on dividends should be rethought in an integrated system. The resolution of these issues will have very large revenue effects given the magnitude of international capital flows and transnational investments. Foreigners hold about one-quarter of U.S. stocks.[REF] Although they are often substantially simpler, consumption taxes also have international issues that need to be addressed.
Tax-Exempt Organizations and Qualified Accounts
Under current law, taxable shareholders only account for about one-quarter of corporate-share ownership.[REF] Tax-exempt organizations hold corporate stock. Qualified accounts (such as Individual Retirement Accounts, 401(k) plans, and employer-sponsored defined-benefit retirement plans) hold about 37 percent of all corporate stock.[REF] Investments held in life insurance contracts are tax deferred. Thus, the tax treatment of dividends and other distributions from businesses to tax-exempt institutions or tax-deferred accounts is of major importance. The current corporate tax imposes a significant tax burden on the investment made by these institutions or accounts that would be eliminated should the corporate-level tax be repealed. Unless some form of withholding tax on dividends paid to tax-exempt organizations and qualified accounts were instituted, a large portion of corporate income would not be taxed currently and, in some cases, would never be taxed. However, it is not appropriate to tax qualified accounts’ income until withdrawn for consumption purposes in a consumption tax.
The current tax system double taxes corporate income. This double taxation has a pronounced negative economic impact, particularly on wages. It distorts the economy and harms productivity. The double taxation of corporate income is also inconsistent with competing concepts of proper income taxation. Congress should eliminate the double taxation of corporate income. There are three means of eliminating this double taxation in the context of an income tax. Alternatively, Congress could eliminate the double taxation of corporate income by replacing the income tax with a consumption tax.
Although there are a wide variety of secondary issues that must be resolved in order for an integrated system to work properly, solutions exist and integrated systems function well in many other countries. Furthermore, since nearly three-quarters of corporate shares are held by tax-exempt organizations, foreigners, or qualified accounts, these decisions can have substantial revenue effects.
—David R. Burton is a Senior Fellow in Economic Policy, in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom, at The Heritage Foundation.