December 28, 2017

Integrating Corporate Taxes: An Important Element of Tax Reform

US corporate taxes are a textbook example of what not to do in tax policy. For 2017, the maximum statutory federal corporate tax rate is 35 percent, which is far higher than the average for industrialized countries. The net revenue collected, however, is much less than it could be, partly owing to the estimated $1 trillion in compliance costs and partly owing to an array of carve-outs and tax expenditures. The actual tax rate that a corporation pays can vary widely depending on the form of the business, the industry, the type of financing, and other attributes. The existing corporate tax system distorts investment decisions, hampers economic growth, increases tax collection costs, and lowers net tax revenue. Worse, much of the burden of the corporate income tax falls on workers.

Simplifying corporate taxes through some form of integration, so that tax rates are standardized across business forms and financing methods, could spur investment and facilitate economic growth. The tax rate a business pays should not depend on a business’s form of organization or the mix of capital financing it uses. Corporate tax integration would level the playing field and increase transparency and equity in the tax system.

The Problems of the Current System

The tax system currently treats some corporations and their owners as separate tax entities, resulting in the double taxation of any income that is passed on to shareholders in the form of dividends or capital gains. Publicly traded C corporations are taxed on the profits they earn. Then, when the after-tax profits are distributed to shareholders as dividends or capital gains, the shareholders are taxed again. For 2017, shareholders who are taxed at the top rate receive, on average, less than 44 cents of every dollar of corporate profits. 

Corporations can avoid paying taxes on earnings that they pay as interest on debt, since corporate interest payments are currently tax deductible. This gives corporations an incentive to fund their operations with debt instead of equity, potentially resulting in too much corporate debt. Profits paid as dividends or capital gains are taxed twice—once at the corporate level and again at the individual level. But while interest paid is taxed only once at the tax rate of the lender and is deductible to the borrower, there is no allowable tax deduction for dividends or capital gains. Figure 1 shows a comparison of the proportion taxed at the corporate and individual level in equity versus bond financing.The tax rate an individual pays on capital gains and dividends is lower than the ordinary income tax rate. In part, this is to account for the fact that capital gain and dividend income received by shareholders was first taxed at the corporate level, at a rate of up to 35 percent. Hence, under the 2017 tax rules, if a corporation first pays the maximum statutory tax rate of 35 percent on each $1 of profit, leaving $0.65 to either be distributed as a dividend or realized as a capital gain, then factoring in the individual’s 15 percent tax rate yields a combined tax rate of 44.75 percent. 

Double taxation applies to C corporations but not to partnerships, limited liability companies, or S corporations. Earnings distributed to nonprofit organizations are taxed only once. Because of the extra tax burden on C corporations, fewer firms incorporate, and those that do are disadvantaged compared to businesses structured in some other way.

Although corporate income taxes are paid by the corporation and taxes on dividends and capital gains are paid by shareholders, most of the actual cost or economic burden of those taxes (more than 70 percent) is borne by workers in the form of lower wages. This is because in a global economy where capital is highly mobile, corporations can move business operations and investments to countries with lower tax rates; more capital investment makes workers more productive so they can earn higher wages. Since the United States has the highest statutory corporate income tax rate among industrialized countries, firms have a tax incentive to locate in other countries and invest less in the United States, resulting in US jobs paying less than they otherwise might.

How Integration Works

Integrating corporate taxes involves taxing businesses the same, regardless of how they are structured or how they finance their operations. Integration also involves removing the double taxation of corporate income by ensuring that returns to capital are taxed once and only once. One way this could be done is by eliminating the corporate income tax and taxing dividends and capital gains at ordinary income tax rates. Then taxes paid would be the same whether corporations were financed with equity or debt. With this change, corporate profits paid to tax-exempt organizations, which are now subject to corporate income taxes, would not be taxed at all.

Reducing the corporate income tax rate to zero is not politically feasible. Nevertheless, even if not eliminated, double taxation could be reduced. A lower corporate tax rate is a reduction in double taxation by itself. In addition, allowing corporations to deduct dividends from their tax liability in the same way that they deduct interest would eliminate financing distortions that favor debt over equity purely for tax reasons. If corporations could deduct all dividends paid, tax rates on dividends should be increased to the rate each shareholder pays on ordinary income so that dividend income is treated the same as interest income.

If the corporate income tax rate were lowered but not eliminated and corporations were permitted to deduct dividends from their tax liability, a reduction of the capital gains tax rate could bring the combined tax on retained earnings close to the rate on earnings paid as dividends. Otherwise, double taxation of capital gains income would discourage corporations from retaining some of their earnings. Alternatively, instead of allowing dividends to be deducted from corporate income, the tax rates on both dividends and capital gains could be reduced below ordinary income tax rates. This would mean that the combined percentage paid in taxes from the corporate income tax and individual taxes on capital gains or dividends would be comparable to a shareholder’s marginal tax rate on ordinary income.

The Benefit of Integration

Implementing reduced tax rates on corporate profits and capital gains, and either reducing the rate on dividends or permitting corporations to deduct dividends from their tax liability, would level the playing field between C corporations and pass-through businesses (e.g., partnerships, S corporations, and sole proprietorships). This would enhance the horizontal equity of the US tax system. It would also simplify decisions about incorporation and debt financing. Allowing corporations to deduct dividends from their tax liability would make corporate tax rates more transparent, since the tax rate on profits paid as dividends would be the rate paid by shareholders. Lower rates would also reduce incentives for corporate inversions (US corporations acquiring a foreign company and moving their headquarters outside the United States), increase incentives to invest, and lead to increased wages for domestic workers.