?

Log in

Query on arguments for and against double-taxation of corporate income - Office of Naval Contemplation

Dec. 5th, 2011

04:29 pm - Query on arguments for and against double-taxation of corporate income

Previous Entry Share Next Entry

I'm toying with some ideas for reform proposals for taxation of income from corporate investment, intended to address the common concerns on both sides of the issue. In order to do a proper job of this, I want to make sure I'm not misunderstanding or misrepresenting what these concerns are. I have a fairly high confidence level in my understanding of the common concerns that conservatives and libertarians have on this issue, but I'm somewhat less well qualified to speak for liberals and progressives. But many of you, my dear readers, are liberals or progressives yourselves, so I ask you to double-check my understanding, and to correct my errors and omissions.

To give a bit of background for those who just wandered in, Subchapter C Corporations (*) in the United States pay federal taxes at a marginal rate of about 35% (**) on their profits (***). When shareholders realize income from long-term ownership of stock, either by selling the stock at a profit after holding it for at least a year, or by receiving a dividend payment, they pay an individual tax at a 15% rate. Short term capital gains (selling stock at a profit when you've held it a year or less) are taxed as ordinary income.

(*) C-Corps are what we usually think of as corporations. There are also S-Corps, LLCs, and LLPs, commonly used for "professional practice" businesses (like a doctor's office) and other small businesses, which have their own separate tax codes. There's also "nonprofit" and "not for profit" corporations that don't pay taxes but also aren't supposed to make profits or generate income for their members/shareholders.

(**) There's actually a variable rate structure based on income, but in practice the result is very close to a 35% flat rate for all but the smallest C-Corps.

(***) The corporate income tax code, like the personal income tax code, allows rather a lot of deductions and credits, so a given corp's taxable profits are usually significantly smaller than their GAAP accounting profits. Estimates I've seen for actual effective tax rate (taxes paid divided by accounting profits or economic profits) across all US corporations range roughly from 20-30%, depending on data sources and methodology. 25% is the number I've seen most often.

The marginal corporate income tax rate is the same as the top marginal rate on individual income, and the marginal rate on capital gains and dividends is a bit less than half the top marginal rate on ordinary income. Thus, on the trip from customer->corporation->investor, each dollar is taxed about 1.5 times. In general, those who criticize this system from the left appear to prefer a system where it's taxed twice (once per transfer, or once per economic entity), whereas those who criticize it from the right appear to prefer a system where it's taxed once.

These are the arguments and concerns I've heard most often from the leftward side of the argument, as I understand them:

  1. Corporations and their investors are distinct legal entities (indicated by limited liability, etc), so it makes sense to apply a full tax at each level. A corporation's relationship with its investors should be considered (from a taxation perspective) on an equivalent basis with its relationship with its employees, suppliers, and creditors.

  2. A significant portion of profits from capital gains are due to luck, from correctly timing the chaotic fluctuations of stock prices, not from true productive investment.
    1. At most, the corporate income tax taxes productive investment. Without a capital gains tax, the additional profit from "speculation" won't get taxed.
    2. Income derived from luck is less deserved than income derived from productive activities, and so should be taxed at a higher rate.

  3. If income were to be taxed only at the shareholder level, this would create an incentive to avoid taxation by keeping the money inside the corporation.

  4. Eliminating or significantly reducing either end of corporate investment taxation (or keeping capital gains at a reduced level) would incentivize behavior with negative externalities. A low or zero capital gains tax encourages gambling-like behavior, and a low or zero corporate income tax would encourage businesses to grow artificially large by using retained earnings to expand.

  5. Some portion of the corporate income tax is likely passed forward to customers or backwards to employees and suppliers, rather than upwards to shareholders. As such, only a portion of the corporate income tax should be attributed to shareholders.

  6. Once you have money to invest, you're going to invest it in something, so long as the tax rate isn't very close to or over 100%, so a high marginal rate on investment income is less likely (in the considered assessment of people making this argument) to suppress beneficial economic activity than a high marginal rate on labor income, so from an efficiency perspective taxes on investment income should be higher than taxes on labor income.
And from the right:
  1. Corporate personhood is a legal fiction, fundamentally merely an accounting convenience for a partnership with broad membership that changes often (so the argument goes). A corporation is a sock puppet for its shareholders, not a real separate entity. As such, applying taxes at both levels at a combined rate higher than the single-taxation that's applied to an S-Corp, LLC, LLP, ordinary partnership, or sole proprietorship is akin to making me fill out separate tax returns for my savings account and my checking account.

  2. If a corporation raises additional investment by borrowing rather than by issuing stock, the corp can deduct the interest payments from its corporate income taxes. Thus, the interest payments are taxed only once, as ordinary personal income, whereas dividends are taxed ~1.5 times. This is (so the argument goes) unfair to shareholders relative to bondholders, and it incentivizes corporations to load up on debt, which makes them more vulnerable to unexpected bad times.

  3. The lower after-tax returns on investment become, the more you incentivize potential investors to spend rather than saving, which (so the argument goes) drags down potential economic growth by reducing the supply of private capital.

  4. (Mostly a restatement of the previous point, but taking it further) Capital investment has large positive externalities, by creating jobs, bidding up wages for existing jobs, and providing more, better, and cheaper goods and services for purchase. As such, it should be taxed at a lower marginal rate in order to encourage people to save and invest more.

  5. For the middle class in particular, the combined tax rates on personal investment income and the corporate income tax are unreasonably high relative to taxes on wages. The corporate income tax rate alone, at a 35% marginal rate, is considerably higher than the middle-income brackets for wage income (25% for most taxpayers, if you don't count the payroll tax). The effect is magnified by it being easier for rich people to dodge double-taxation by investing in LLCs, S-Corps, ordinary partnerships, and the like.


The point here is not to debate the relative merits of the arguments and concerns on each side, nor is it to question the correctness of the other side's arguments. I don't even entirely agree with all the arguments I've listed for my own side. Please focus your comments on correcting my substantive misunderstandings and omissions of the arguments and concerns of the side of the issue you are most familiar with and sympathetic to.

Comments:

[User Picture]
From:makellan
Date:December 6th, 2011 01:12 am (UTC)
(Link)
An additional concern from a liberal perspective.

If a corporation is going to enjoy the rights and privileges of a person, then it should be taxed on its income. You mentioned this as an argument from the right, but the argument from the left mostly stems from a dislike of corporate personhood in general. I could go more into that, but it's off topic.

A liberal assessment of your argument 2 would argue for more corporate tax. That is: tax borrowing in some way as to level the playing field rather than reduce the tax on dividends. Also, the tax on dividends isn't a tax on the corporations issuing the stock, but rather on the shareholders buying it so I don't see the incentive to load up on debt. A corp can use money it gains to issue dividends. The corp is taxed on money coming in and the stock holder is taxed on money coming in. The fact that this may or may not be the same money doesn't seem relevant. Look at the entities, not the dollar.

#3 I don't see how reducing the money you get from dividends encourages spending. I agree that it disincentivises investment in corporations, and I agree that that's not something we want, but investors can simply save another way instead of in the stock market.

#4: again, saving has nothing to do with this.

#5: the total corporate income for most businesses would put them above the middle class. If you're going to treat a corp as a person, then you can't really say that it's a middle class person based on the same income scale.

Sorry, I didn't finish your comment before writing my responses. At least my first comment should help.
(Reply) (Thread)
[User Picture]
From:maniakes
Date:December 6th, 2011 02:27 am (UTC)
(Link)
Also, the tax on dividends isn't a tax on the corporations issuing the stock, but rather on the shareholders buying it so I don't see the incentive to load up on debt. A corp can use money it gains to issue dividends. The corp is taxed on money coming in and the stock holder is taxed on money coming in. The fact that this may or may not be the same money doesn't seem relevant. Look at the entities, not the dollar.

The analysis works out the same. Wiley Coyote, CEO and sole shareholder of ACME corporation, is looking to get $100,000 to build a new widget factory that he expects to yield an operating profit of $10,000/year before taxes. As luck would have it, Scrooge McDuck has $100,000 that he's considering investing. In order for it to be worth Scrooge's while to make the investment rather than spending the money on a new yacht, he wants at least a 5% return on investment after taxes.

Under current tax law, if Wiley raises the capital by issuing stock and selling it to Scrooge, ACME will own $3500 in taxes, leaving an after-tax profit of $6500. In order for the stock to be worth Scrooge's while to buy, he'd need to be able to expect a total yield after taxes (consisting of capital gains plus dividends) of $5000. At the current 15% tax rate for dividends and long-term capital gains, that would require a pre-tax total yield of $5,883. If Wiley makes the best possible deal with Scrooge that Scrooge is willing to accept given a realistic appraisal of the stock's likely rate of return, the leaves Wiley, as the owner of the rest of the company's stock, with $617 a year in additional pre-personal-tax improvement in the fundamental value of the company (the rest going to Scrooge, in some combination of dividends and dilution).

If instead Wiley has ACME sell Scrooge a bond, that bond would need to pay Scrooge a pre-tax interest of $7,692 in order to yield $5,000 after Scrooge's marginal personal income tax of 35%, which works out to an interest rate of 7.69%. Again, we assume Wiley drives a very hard bargain with Scrooge, getting the best possible deal form him that Scrooge would be willing to accept. In this case, though, ACME pays Scrooge the interest with pre-tax dollars. ACME's taxable income from the factory, after paying the bond interest, is $2,308, yielding taxable income of $1500, all of which belongs to Wiley as sole shareholder.

From ACME's perspective as an imaginary person, they're $883/year better off selling Scrooge a bond compared to selling them stock. From Wiley's position as ACME's sole existing shareholder, he's $750 better off after paying his own taxes on dividends and capital gains. So Wiley and ACME both have a big incentive to raise the money by borrowing rather than issuing stock.

If Scrooge is in a position to negotiate himself a bigger surplus for the deal, there's still more opportunity for him to do so by lending rather than buying stock. Wiley can and will offer him a higher after-tax rate of return on the bonds than on the stock, and Wiley will still come out better himself (as will ACME, to whatever extent it has an existence independent of its owners and officers).

Now, this is an oversimplified example to illustrate the concept, and there are a lot of possible reasons why Scrooge might prefer to buy stock or Wiley/ACME might prefer to sell it despite the tax disadvantage, but the tax disadvantage will still make Wiley less inclined to sell stock and more inclined to sell bonds than he otherwise would have, and likewise for Scrooge.
(Reply) (Parent) (Thread)
[User Picture]
From:maniakes
Date:December 6th, 2011 06:33 am (UTC)
(Link)
$2,308, yielding taxable income of $1500

Should be "yielding after-tax corporate income of $1500".
(Reply) (Parent) (Thread)
[User Picture]
From:makellan
Date:December 6th, 2011 09:13 pm (UTC)
(Link)
Wiley sells stock to Scrooge: At the end of year, Wiley has $6500 in his pocket. If what Scrooge needs is a guaranteed %5 ($5000) per year starting the first year, then, as you said, the vast majority of that goes to Scrooge as a dividend. Since Scrooge still owns the stock, though, Scrooge ends up with much more than 5K under that scenario so he must presumably count some value of that stock against his 5%. Assuming that the stock rose in value to cover some of the 5K, that part of Wiley's profit doesn't have to go to pay Scrooge.

I'm not familiar enough with the stock market to know how much stock value increases with a known and steady profit, and there are many more variables, but Wiley isn't paying Scrooge as much of his profit as your example requires.

In addition, Scrooge being able to demand such repayment sounds much more like a loan than buying stock.

None of this refutes your original point, but it lessens the impact.
(Reply) (Parent) (Thread)
[User Picture]
From:maniakes
Date:December 7th, 2011 02:14 am (UTC)
(Link)
At the end of year, Wiley has $6500 in his pocket.

No, ACME has $6500 in their bank account. Wiley and Scrooge own ACME between them (remember, now that Scrooge has bought into ACME, ACME is a joint sock puppet for the two of them, no longer merely a sock puppet for Wiley alone). In order for the money to get into Wiley's pocket, either he has to sell shares and pay capital gains taxes on them, or ACME has to pay out a dividend, which Wiley and Scrooge split (according to how many shares each of them own), and each of them must pay dividend taxes on the proceeds.

In addition, Scrooge being able to demand such repayment sounds much more like a loan than buying stock.

That's a product of me artificially simplifying the situation to both make the math easy and make the comparison as apples-to-apples as possible.

The standard theory of stock pricing they taught us at business school is that both stocks and bonds are priced as risk-adjusted discounted future cash flows. That is, given your "discount factor" or "time preference" (i.e. how much you value a dollar a year from tomorrow vs. a dollar tomorrow), you calculate the present value of what the money you expect to get down the road (interest and principle payments for a bond, or dividend payments and eventual sale or liquidation of a stock), adjusted for the chance that things might turn out better or worse than you'd expect. The main difference between the two is the degree and type of uncertainty, which I abstracted away in my example.

Scrooge's yield on the stock is the combination of dividends and capital gains, not just the dividends. In either case, it's coming out of Wiley's pockets: any growth in the real fundamental value of the stock comes either from the factory that's just been built (which is the $6500/year figure, for ACME's post-corp-tax profits) or from the Scrooge partaking in the growth of the value of ACME's other operations. In the latter case, that's growth that Wiley would otherwise have had for himself that has instead been sold to Scrooge, and should be counted against Wiley's residual profits from the stock.
(Reply) (Parent) (Thread)
[User Picture]
From:makellan
Date:December 9th, 2011 07:06 pm (UTC)
(Link)
Good point. The $6500 is the profit that is sitting in ACME's bank account at the end of the year.

If Wiley wants some of that money, he has options. If he wants it for himself, he can take it as salary and pay income tax or take it as dividends and pay capital gains tax. If he chooses dividends, then he must necessarily pay Scrooge some money as well since Scrooge owns some of the stock. If Wiley wants to reinvest some of that money back into the business, he doesn't take any tax hit since the money already belongs to ACME and can be used for operating expenses, expansion, etc. without special penalty. I say "special" because this ignores sales tax for buying equipment, payroll tax for paying people, etc.

Scrooge is only going to get capital gains if he sells some stock. That will lower his income the following year. I assume that you're looking at this from the perspective of Scrooge eventually paying capital gains tax on profits that are made this year when he sells the fully appreciated stock in 10 years. That lowers Scrooge's tax burden and only gives him "paper profits" in the short run.
(Reply) (Parent) (Thread)
[User Picture]
From:maniakes
Date:December 9th, 2011 10:24 pm (UTC)
(Link)
If he wants it for himself, he can take it as salary and pay income tax or ...

That's an interesting scenario, for two reasons. If he takes a higher salary as CEO, he as an individual pays taxes on it as ordinary income, but salaries count as a business expense for corporate income tax, so his increased salary is deducted from ACME's taxable profits. Theoretically, he could raise his salary by $10,000 (absorbing all of the profits from the new factory), not just $6500, since ACME's paying the salary with pre-tax money. So if Wiley's marginal personal tax rate is 35%, then all $6500 would wind up in Wiley's pocket.

He's limited in his ability to do this, though, since as CEO he is an employee of the shareholders, and has a fiduciary duty to act in the collective interest of the shareholders. Raising his salary is in Wiley's interest, but it's not in Scrooge's interests, and Scrooge is a shareholder, too.

If Scrooge is now the majority shareholder, he can protect his interests by firing Wiley and hiring a different CEO, or he can simply refuse to approve Wiley's salary increases (executive compensation is almost always subject to review by the Board of Directors, and can sometimes be directly reviewed directly in shareholder elections). In a different hypothetical, where there were other shareholders other than Scrooge and Wiley, it's likely the other shareholders would share Scrooge's concerns, although depending on the number of shareholders it might be difficult for them to coordinate action.

If Wiley is the majority shareholder, Scrooge can't just fire him or have the Board veto his salary increase, but Scrooge instead has the option of suing Wiley for fiduciary misconduct: Wiley's duty of care to his shareholders is legally enforceable through the courts.

In either case, the risk of Wiley doing so gives Scrooge a reason to prefer bonds over stocks, since Wiley has less of an opportunity to screw Scrooge over with the former. Wiley's reputation for honesty and Scrooge's confidence in his ability to exercise appropriate remedies to protect himself if Wiley does try to screw him will affect how big this risk is and how much of a price difference it'd take to convince Scrooge to accept it.

In practice, Wiley could probably get away with overpaying himself a little bit, but Scrooge's potential remedies should serve to keep Wiley moderate in his dishonesty.

I assume that you're looking at this from the perspective of Scrooge eventually paying capital gains tax on profits that are made this year when he sells the fully appreciated stock in 10 years.

That is correct, for varying values of "10 years". Scrooge chooses when to sell the stock and realize his gains, and whenever he does so (as long as it's at least a year so he qualifies for the long-term capital gains tax rate), he pays taxes on whatever his realized gains are.
(Reply) (Parent) (Thread)
[User Picture]
From:maniakes
Date:December 6th, 2011 02:27 am (UTC)
(Link)
3, 4. Consider a hypothetical where I have a choice between buying a share of stock, buying a bond, or making a deposit in a savings account. But for unequal tax treatment, my most profitable option would be to buy a share of stock. If I buy the bond instead, I'll be making less of a return on my investment than if I'd been able to buy the stock without double taxation. Not as much less if I didn't have the option to avoid the tax by shifting my investment, but still less of a return, which reduces my incentive to save by at least a little bit.

The decision to save or to spend is generally modeled economically as a choice between having $X to spend today vs having $Y to spend next Tuesday, where Y is the risk-adjusted expected value, after taxes and transaction costs, of the investment at maturity (assumed to be next Tuesday for illustrative purposes). The lower Y gets, the less attractive the choice becomes, and the less often people should be expected to choose it.

The effect is compounded if we run with your early suggestion of abolishing deductibility of bond interest, which would lower the rate of return on one of the major alternative forms of investment.

Back to our earlier example, if you raise bond taxes to parity with stocks, and if Scrooge's time preference were 6% a year rather than 5%, he'd buy the yacht he had his eye on, he'll tell Wiley to go fly a kite, and (assuming either he's the only source of capital or that he's a representative example of the capital market) the widget factory won't get built.

5. As you note, your counterargument is predicated on corporate personhood being real on a moral level. On a practical level (regardless of the moral question), if corporate income taxes were reduced, corporations would make more profits after taxes, allowing them to pay more dividends or increase their value by having more retained earnings available to expand.

To get off-topic somewhat, the sides of corporate personhood debate often seems to be talking past one another. The standard conservative/libertarian argument is that corporations are like Soylent Green: they're not people, but they're made of people. A corporation has no rights in and of itself, being merely a name associated with a bundle of deals and contracts and understandings, but the shareholders, officers, and employees of a corporation are (generally speaking) real people with real rights, and those rights continue to exist when they're wearing their hats as shareholders, officers, and employees of that corporation.

To elaborate on your first point, distaste for corporate personhood in general as a motivation for taxing corporate investment, in what ways would you imagine the world looking differently without the concept of corporate personhood?
(Reply) (Parent) (Thread)
[User Picture]
From:makellan
Date:December 6th, 2011 09:42 pm (UTC)
(Link)
Why would buying a share of stock be, sans taxation, necessarily the most profitable?

You keep saying double taxation, but it still seems like single taxation to me. As a stock holder, your personal income is taxed once when you sell stock or receive dividends. As a company, your income is taxed when you receive it from the sale of goods or services or stock.

5. Conservatives of many stripes often argue for less taxes with the logic that companies would be able to "pay more dividends or increase their value by having more retained earnings available to expand". While this is true in theory, it has been proven an incredibly unreliable method to increase dividends or actually expand operations. While the money is available for such things, the lack of trickling in the "trickle down effect" keeps most of that money is the personal coffers of the top employees.
(Reply) (Parent) (Thread)
[User Picture]
From:maniakes
Date:December 7th, 2011 02:00 am (UTC)
(Link)
Why would buying a share of stock be, sans taxation, necessarily the most profitable?

It isn't, necessarily. But generally, when someone does buy a share of stock, it's because in their best estimation, that's the most profitable investment available (after adjusting for risk, time profile, etc). People who think bonds are the better investments tend to buy bonds, not stocks.

If I were going to buy stock but for different tax treatment, and I instead invest in something else in order to dodge the tax, then my expected profits from the investment have been lowered.

You keep saying double taxation, but it still seems like single taxation to me. As a stock holder, your personal income is taxed once when you sell stock or receive dividends. As a company, your income is taxed when you receive it from the sale of goods or services or stock.

Noted. I'm using the terminology to explain my position, and it reflects my assessment of the situation. Consider it a shorthand for "taxing both corporate profits and individual profits from corporate investment".

While this is true in theory, it has been proven an incredibly unreliable method to increase dividends or actually expand operations. While the money is available for such things, the lack of trickling in the "trickle down effect" keeps most of that money is the personal coffers of the top employees.

Are you sure? That doesn't strike me as conceptually likely, nor does it gibe with the empirical evidence I've seen.

While top-level executives at big firms are often extremely highly-paid in absolute terms per individual, it's still a very small slice of the pie, about 1% of revenue and 3% of total profits for CEOs of Fortune 500 companies. When CEOs are super-rich, it's usually mostly due to owning a big chunk of the company as co-founders or very early investors rather than due to their salaries as CEO.

http://www.forbes.com/2009/04/22/compensation-chief-executive-salary-leadership-best-boss-09-ceo-intro.html

When the 2003 tax cut changed the tax treatment of dividends from ordinary-income rates to the capital-gains rate, a lot of companies actually did increase dividends. Microsoft, for instance, had never paid out dividends before, but started shortly after the tax change went into effect and has paid out dividends ever since, and they weren't the only company to do so.
(Reply) (Parent) (Thread)
[User Picture]
From:maniakes
Date:December 6th, 2011 02:53 am (UTC)
(Link)
Also, more closely related to the original intent of the thread, what do you mean by distaste for corporate personhood as a justification for taxing both corporate income and dividends + capital gains, beyond the first point I listed under the leftward arguments?
(Reply) (Parent) (Thread)
[User Picture]
From:makellan
Date:December 6th, 2011 09:49 pm (UTC)
(Link)
After rereading it a couple of times, I completely agree with your statement of liberal point #1. The second sentence muddied my understanding a bit at first. Income earners are taxed based on their income level. A liberal assessment of Corporations, whether as a person or not, has them pay a marginal tax rate based on that income, regardless of income source.
Stock holders pay such taxes on income that they receive, either from the sale of stocks or the dividends the company chooses to pay out.

If corporations are going to be allowed to engage in the political process as a "person", this gives the decision-makers at the company much more power than just about any individual in the political process. That's off topic, however so we'll discuss it later.
(Reply) (Parent) (Thread)
[User Picture]
From:maniakes
Date:December 7th, 2011 02:18 am (UTC)
(Link)
What I was trying to get at with the second sentence is that given the premise of the first sentence, a shareholder is simply someone who has a particular business relationship with the corporation, the same way an employee or a bondholder is a different person with a particular relationship with the corporation.
(Reply) (Parent) (Thread)
From:(Anonymous)
Date:December 6th, 2011 02:29 am (UTC)

The Luck Factor

(Link)
I have heard the luck argument before, but was surprised that you brought it up because I thought it was an aberrant argument of just one person. I just don't understand this argument or where it is coming from. No objective assessment of corporate profits can attribute any but the tiniest fraction of earnings as being derived from randomness.

--
David Johnson
(Reply) (Thread)
[User Picture]
From:maniakes
Date:December 6th, 2011 02:45 am (UTC)

Re: The Luck Factor

(Link)
I've heard it several times from a variety of sources, although this may be skewed based on me mentally aggregating it with the closely related "speculators" argument. I phrases it more in terms of luck than in terms of speculation, since if the luck argument isn't implicit in the speculators argument, then I don't understand the speculators argument and need to have it explained to me by someone who understands and sympathizes with it.

If I understand it as it was intended, it applies specifically to the capital gains side, as the luck factor seems to be primarily regarding short-term chaotic fluctuations in stock price and how well you time when you buy and when you sell. I consider this a dominant factor only for short-term trading (which is already addressed by taxing short-term capital gains as ordinary income), but there seem to be a lot of people who disagree with me on that, and the point of the exercise is for me to try to understand and address the concerns of people who significantly disagree with me on the general question: coming up with a reform proposal that would make me happy is easy, but coming up with one that I like that also addresses most of the concerns on the leftward half-ish of the political landscape is both quite a bit trickier and (if it's possible) quite a bit more valuable.
(Reply) (Parent) (Thread)