Part two can be read here.
Furthermore, high corporate tax rates are negatively correlated with economic growth. That is to say, higher corporate tax rates, ceteris paribus, are negatively correlated with economic growth. The leading empirical research in the area of growth and corporate taxation estimates that cutting U.S. corporate taxes by 10 percentage points could increase annual growth by a little over one percentage point. (See Young Lee & Roger H. Gordon, Tax Structure and Economic Growth, 89 Journal of Public Economics 1027-1043 (2005)). This estimate may seem trite, but an additional 1% growth compounding year-over-year would lead to an enormous increase in the standard of living of everyone in the United States. Projected out over twenty years, the difference between 2% growth and an accelerated rate of 3% is the difference between an increase in GDP of $8 trillion versus an increase of $13 trillion. An additional $5 trillion, when reduced to per-capita terms, would mean that on average every household in the United States would be better off to the tune of over $16,000.
Additionally, another — less salient, but no less important — problem exists alongside the fact that high corporate taxes lead to slower growth and reduced economic activity: complicated corporate accounting and the imperfect observability of the use of internal resources makes it very difficult to target a corporate income tax at pure economic profits. This point is as complicated as it is esoteric, but it is safe to say that the very fact that a) large corporations have been so successful at using accounting techniques and tax strategies to avoid high domestic rates, and b) the economic substance of a particular transaction may be too specific to the particular business conditions faced to be determined by an outside observer, makes it extremely difficult to be sure that the entity-level corporate income tax is being levied on pure economic profits.
Finally, in our current system, both profit and loss and debt and equity are treated asymmetrically. The problem with treating profit and loss asymmetrically is that tax incentives, rather than purely business decisions, change the relative profitability of mutually exclusive investments. The relative profitability of a business decision may come down exclusively to tax policy. For example, consider two different investment projects with different probabilities of success. Project A has a probability of success pA = 0.5, while Project B has a probability of success of pB = 0.64. Returns are (200, -10) for Project A and (180, -50) for Project B. Therefore, expected returns are 95 to Project A and 97.2 for Project B. With no corporate tax interaction, Project B will be chosen. However, if the corporate tax rate exceeds 14%, then a rational investor would choose Project A instead. Assume, for example, that the corporate tax rate for this hypothetical is 20%. In such a case, the expected return after taxes of Project A is 75, and the expected return after taxes for Project B is 74.16. Therefore, Project A is chosen, even though from a pure business perspective Project B was the better option.
The only way to achieve total neutrality with respect to the entity-level corporate tax’s effect on business decision-making is to subsidize losses at a unitary rate of the same value as it taxes profits — a kind of “loss insurance,” fully funded either through unemployment insurance-type taxes on corporations or through direct government expenditures out of the general fund. The institution of such a program would almost certainly be disastrous. In essence, the program would make every corporation in the United States that pays the corporate income tax “too big to fail.”
Logically, the same is true of the current regime’s differing treatment of debt and equity finance. The fact that interest payments on debt are deductible but dividend payments are not subsidies debt finance at the expense of equities. There are undoubtedly many cases where debt financing is superior from an economic perspective; however, the current regime subsidizes debt when many companies are already over-leveraged.
But What to Replace it With?
The contemporary model of taxing corporate income in the United States is as antiquated as it is inefficient. That being said, if the United States were to eliminate the corporate income tax the question will (and should) inevitably be asked: “What will you replace it with?” One may be tempted to answer with the great Thomas Sowell’s retort that one should not ask, “[w]hen you put out a fire, what do you replace it with?” However, whether revenue neutrality is a primary goal or not, the elimination of the entity-level corporate income tax must be followed by at least some reform of tangential tax regimes.
When the corporate tax is eliminated, should dividends and capital gains rates remain the same? Probably not. This conclusion is drawn not only from a desire to make up for revenue shortfalls that would inevitably occur if corporate incomes were no longer taxed at the entity level, but also from the notion that because profits from distributions and the sale of appreciated capital assets are income earned by individuals, absent double taxation, they should be taxed at the same rate as any other income. Generally, abstracting away from the manifold administrative and logistical difficulties with implementing such a regime, the ideal tax system would treat all individual income the same, from whatever source derived.
This goal is made easier to attain with the inclusion of the policy assumption that has been repeated so many times and bears inclusion one last time: only individuals (and not abstract corporate entities) can really earn income. Granted, a corporate entity has its own accounts, and those accounts are typically managed by more than one person. However, the incidence of any taxes levied on that income can only fall on one of three groups of persons: 1) shareholders; 2) employees; or, 3) customers. We have noted that only individuals can actually pay a tax, even one levied on the abstract entity of a corporation, and it is prudent to note additionally that only individuals can earn income.
After all, in addition to the fact that only individuals can bear the incidence of taxation of corporate entities, so too can only individuals receive that money which is so taxed. The incidence of benefit from any income made by a corporation is enjoyed by either:
- Shareholders, in the form of distribution of profits;
- Workers, in the form of wages; or,
- Customers, in the form of lower prices or ostensibly better products financed by reinvesting corporate earnings into research and development or capital accumulation.
The answer, then, is as simple as it is non-specific: tax individuals on the income they earn, rather than the pass through from which the earnings are distributed.
The modern entity-level corporate income tax is inefficient, anachronistic, and distortionary of economic and business decisions. There are many problems associated with reform — administrative, logistical, and political problems, as well as economic difficulties associated with one-time distortions of current business conditions. However, reforming the system in a way similar to the ways described above is necessary, regardless of and difficulties that may arise as a result.
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