The United States’ 39% marginal corporate tax rate (35% federal and 4% average state and local) is the third highest in the world. It is the highest of the 34 industrialized nation members of the OECD – and it compares poorly with Europe’s average tax rate of 24%.
Because of loopholes, deductions, loss carry-forwards, etc., few, if any, companies pay the full 39% rate. Nevertheless, our statutory rate is higher than almost anywhere in the world.
President Trump has proposed lowering the Corporate Tax Rate from 35% to 20%. That’s a good idea – but it doesn’t go far enough. The Corporate Tax Rate should really be lowered to zero.
If this sounds a bit off, stay with me – I promise it will make more sense.
But first, a basic question.
Who actually pays corporate taxes?
Hint: it isn’t the corporations.
Corporations are actually just tax collectors – legal entities that serve to collect taxes on behalf of the corporation’s owners.
The true taxpayers are the company’s shareholders – and labor – not corporations.
Shareholders’ dividends and capital gains (taxable items to the shareholder) are reduced by taxes collected by the corporation. If the corporation did not collect this tax on “behalf” of the shareholder, these extra dollars would flow through to shareholders in the form of increased profits and dividends, reinvestment in the business (which generates additional profits) and share repurchases.
These increased cash flows to shareholders would then be taxed at the shareholder level.
If this argument is not sitting well, consider this example. A corporation could, in theory, give year-end bonuses to its workers such that the amount exactly equaled the corporation’s taxable income. After the payment to workers, the corporation has zero taxable income. Shareholders pay no tax (they received no profits) nor does the corporation. But workers now have a significantly increased tax bill – and in all likelihood are taxed at a higher overall rate than the corporation would have been.
The corporation merely serves as the vehicle or conduit – the legal structure – for tax payments.
What about customers and labor – do they shoulder some of the corporate tax bill through higher prices for goods or lower wages?
There is some debate about these two groups.
Customers probably don’t pay much, if any, in corporate tax as it is very hard to pass this cost through. The ultimate price of the corporation’s end product or service is determined by market forces. And corporations have many differing competitors – including sole proprietorships and foreign corporations with differing tax structures. Market competition determines the final selling price – not taxes.
The amount of corporate taxation that labor bears is less clear – the arguments center around the availability and flexibility of capital – the ability to shift production to lower cost areas, etc. The Tax Policy Center has concluded – fairly close to Treasury estimates – that labor bears about 25% of the corporate tax burden. Other estimates have labor bearing as much as 70% of the cost.
I believe the true cost borne by labor is probably closer to the 70% number.
The reason for my belief lies in the mobility of capital. Money is far more fungible and easily moved then labor. If returns are higher abroad due to lower foreign tax rates, investors will quickly move capital to those places. Labor has a more difficult time taking advantage of higher wages elsewhere.
When corporations are burdened with a higher tax rate, their return on capital falls making them less attractive for investment. In order to attract capital, companies are forced to reduce costs in an attempt to boost returns. And, in general, labor is the largest cost component for most corporations, making it a prime target for cost cutting.
Think of it in simple terms. If corporations were hit with a tax hike tomorrow, which group could more quickly adjust. Investors who could quickly sell and redeploy their capital overseas – or labor with their families and homes? The matter becomes a bit more complicated in real terms because if such a tax was enacted, share prices would be impacted immediately, but hopefully you get my point.
Why are tax rates different at the corporate level versus the shareholder level?
At the heart of the matter, the tax rate is lower for capital gains and dividends paid to shareholders to reduce the impact of double-taxation – profits used to pay dividends have already been taxed at the corporate tax rate. The capital gains and dividend tax rates are arbitrary but the intent has been to pick a number that was not so high as to completely discourage investment into companies by investors.
The answer to this question may surprise some – in 2015 the federal government collected about $340 billion in corporate taxes or 11% of total tax receipts. This compares to the approximately $1.5 trillion in individual taxes and $1.1 trillion in payroll taxes. The amount paid in corporate taxes is not as large as many intuitively expect.
How are corporate taxes from international operations handled?
Corporations have a mandate to maximize profits. Managing their business in a manner that minimizes taxes is the correct approach for any CEO, but the effort to do so creates further problems. One effort that has a received a lot of national attention is the process known as Inversion.
Simply described, inversion is a strategy whereby a U.S. corporation merges with a foreign company and then reincorporates, as part of that merger, in the foreign company’s nation. If the tax rate is lower in the foreign country, the newly formed corporation pays less in taxes than it would have if the company had stayed domiciled in America.
While the CEO is often the one demonized, he is not the one to blame. Legally minimizing one’s tax burden is something we all do and is part of the duty of any CEO. The fault lies with the flawed tax structure of the U.S. as it encourages this activity.
There is another problem with our corporate tax code. The United States has a “worldwide” tax code – U.S. corporations are statutorily taxed at 35% (less taxes paid to foreign governments) no matter where their profits are made. Most other nations use a “territorial” tax system whereby companies are taxed by the country where economic activity takes place. This territorial system is far better suited to the multi-national landscape companies operate in today.
Under a territorial system, a multi-national company pays taxes to each of the nations it does business in according to the amount of economic activity done in the nation’s borders and the particular nation’s tax rate. This has the obvious advantage of placing all companies operating within a given nation on the same economic footing from a tax burden perspective.
A further twist exists as part of our worldwide tax code. Corporate profits are not actually taxed until they are repatriated to the U.S. This incentivizes companies to keep cash from offshore operations in the place it was generated – offshore. Estimates vary but there appears to be at least $2.5 Trillion in cash profits residing overseas. This is a staggering level of capital that could be going toward economic investment, production and growth domestically instead of boosting the capital availability and growth of other nations.
Our corporate tax structure creates countless unnecessary complexities and conflicts with our individual tax code. Do away with that structure – even if shareholder taxes are adjusted in a manner that was revenue neutral to the Treasury – and you have gained massive economic efficiencies – in addition to providing instant solutions to the problems listed above.
Some other reasons to abolish the corporate tax:
Removal of political gamesmanship – An entire lobbying force working to get tax breaks for corporations is gone overnight. Gone too are the incentives for politicians to grant their constituencies favors via the tax code. Kill the corporate tax code and you immediately remove a big motivation for corporate money being involved in the political arena – along with special interests.
Legal & Tax Departments – Tax compliance and tax strategy related departments would be rendered obsolete and would result in the saving of literally billions of dollars and countless man-hours. Tax lawyers and consultants would need to find another avenue for work. And smaller businesses would be placed on a more equal footing.
Tax status – there would be no need for non-profit distinction and the associated gamesmanship – by corporations and the IRS.
The entire tax system would be vastly simpler.
Any corporate tax burden borne by labor is removed.
The increased level of investment by corporations – along with higher dividends – would re-invigorate our entire economy
Corporations would run their companies based on underlying economics without the distorting influence of tax strategy behavior. Corporate CEOs would focus on what are now pre-tax profits.
Foreign investment would flood back into the United States.
The International tax problems and distortions noted earlier would disappear.
The $2.5 trillion in U.S. corporate cash could be repatriated for use domestically.
Lowering – or removing – the corporate tax does not mean that taxation of corporate income is avoided. Instead, taxes are now paid at the individual versus corporate level. Corporations could stop focusing on tax strategies and could instead place their full focus on generating profits.
And Labor would see their corporate tax burden lifted.
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