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
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:
- 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.
- 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.
- At most, the corporate income tax taxes productive investment. Without a capital gains tax, the additional profit from "speculation" won't get taxed.
- Income derived from luck is less deserved than income derived from productive activities, and so should be taxed at a higher rate.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- (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.
- 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.