Corporate Income Tax trial balloons - Office of Naval Contemplation
Dec. 14th, 2011
12:25 pm - Corporate Income Tax trial balloons
I think I've gotten all the feedback I'm going to get on my lists of concerns to address, so it's time for the proposals. These are trial balloons, draft ideas submitted for comment, criticism, and revision.
Option 1: Bond/Salary Parity
Under this proposal, the tax treatment of stock would be altered to mirror the tax treatment of bonds. At the individual level, dividends would be taxed as ordinary income, same as bond interest. Capital gains for both stocks and bonds would also be taxed as ordinary income, rather than at the current reduced rate. At the corporate level, though, dividends would be counted as a deductible business expense, the same way bond interest is, and the same way employee salaries are. The corporate income tax rate would be pegged to the top individual income tax rate.
From the liberal perspective:
- Corporations would be paying full income taxes on their income, and so would their shareholders. If corporations and their shareholders are truly different people, then dividends (like salary, and like bond interest) are an expense to the corp and income to the recipient, and should be treated that way.
- Capital gains would get taxed at the full ordinary income rate, so income from lucky timing of stock sales and purchases would be fully taxed.
- Retained earning of the corporation would be fully taxed, so there's no incentive to retain too much earnings in order to avoid taxation.
- Shareholders would have a strong incentive to induce corps to pay dividends rather than retaining earnings, since shareholders would realize more after-tax income from a given dollar of corporate profit from dividends than from share appreciation due to reinvestment of retained earnings. This would lead to corps tending to be smaller, no bigger than they need to be to operate efficiently. It'd also likely lead to a model where corps pay out most of their profits as dividends, then sell new shares when they want more capital with which to expand; in this model, the need to get explicit approval from investors before expanding would serve as a check on the power of corporate executives and make them more accountable to investors.
- Regardless of tax incidence of the corporate income tax, shareholders would be fully taxed on their own incomes.
- If my expectations are wrong and corps do not in fact shift to a dividend-heavy model (i.e. if they continue to retain most of their earnings and shareholders continue profiting mainly via capital gains), this would be a significant net tax increase on investors.
- Looked at from the sock-puppet mental model of corporations, profits from corporate investment realized via capital gains would be double taxed worse than before, but eliminating double taxation of income realized through dividends would make up for it.
- Stock and bond income would be treated identically, eliminating the tax incentive to over-leverage.
- If corps do shift to a dividend-heavy model, this would be a significant cut to taxes on corporate investment. This shift is most likely to happen in businesses where the tax cut makes the difference between our hypothetical investor buying stock or buying a yacht.
- A downside, from the conservative or libertarian perspective, of the shift would be that the default behavior for investors would now be to consume their dividend income rather than reinvesting it. This is a fairly minor downside, since it's pretty easy for a small individual investor to set up automatic dividend reinvestment, and large-scale investors are likely to actively scrutinize and rebalance their investments and not just go with the default.
- To the extent that corps shift to a dividend-heavy model, middle-income investors would no longer be hit with upper-income effective tax rates (again, applying the sock-puppet model of corporations rather than the morally-separate-person model)
This is an add-on to the above proposal, a significant reform of the corporate income tax. One possible objection to the above model is that if ACME pays Scrooge McDuck a dividend, which he immediately uses to buy newly-issued shares of ACME, that's functionally the same thing as ACME retaining the earnings, but it'd be treated very differently from a tax perspective.
Under the modified proposal, a corporation's taxable income would be all money coming into it from all sources (including newly-raised capital) minus any money it spends on business activities which generates taxable income to the beneficiary of the spending (interest and dividend payments to investors, salary to employees, capital equipment purchases, purchases of raw materials, etc). The only spending that wouldn't count would be consumption-type spending on behalf of executives or other employees, buying them perks and benefits that don't get treated as taxable income at the individual level. This last bit can be very, very tricky to define and enforce, but there's a serviceable attempt at doing so in the individual tax code for deductibility of business expenses for partnerships, S-Corps, and sole proprietorships.
The net effect would be that when a corp issues stocks or bonds to raise new capital, they'd be able to invest it tax-free in expanding operations or funding the burn-phase of a startup (as is the case now), but anything spent on executive perks or simply hoarded as cash reserves would be counted as taxable income. Retained earnings would be treated the same way: spend it on expanding operations, and it's deductible, but hang onto the cash and it's taxable income.
This would lose most of the incentive to shift to a dividend-heavy model, and it would encourage corps to hold less cash as an emergency cushion, but it would encourage more spending by corps on expanding operations, and it'd make the corporate tax code conceptually cleaner. Overall, I'm not sure how I feel about this option.
Option 2: Nerf corporate personhood
A major (probably the major) argument for taxing profits at both the corporate and the individual level seems to a "screw you" directed at the idea of corporate personhood. So what if we get rid of corporate personhood, except as a sock-puppet convenience? Formalize the idea that everything a corporation owns is really owned by its shareholders, and everything it does is really being done by some combination of its shareholders, officers, and employees.
Figuring out exactly what this would look like would be a very complicated process. I suspect in terms of actual legal rights, there'd be little practical difference, as shareholders, officers, and employees would still have property rights, free speech rights, due process rights, etc that would apply.
The big difference would likely be nerfing the concept of limited liability. If a corp loses a lawsuit and can't afford to cover the judgment, under current law the lawsuit's plaintiffs are out of luck, as the corp can declare bankruptcy and there's nobody left to sue. "Piercing the corporate veil" and suing an individual officer, shareholder, or employee for the remainder can be done, but there's a very high legal bar for it. Under this proposal, though, the corporate veil would become much thinner. Any individual employees or officers who commit torts as part of their corporate activities would be individually liable (although the corp could, and probably would, buy liability insurance for its employees as part of its benefits package) for their actions and decisions, and if their pockets aren't deep enough or if individual responsibility couldn't be pinned down, then a portion of the remaining liability could pass through to the corp's officers and shareholders. Pre-1930s, financial corporations used to have the so-called "double liabilty" rule, where if the corp went bankrupt, its shareholders were individually liable for up to the "par value" of their shares in addition to what they'd lost on their investment. Something like that could be reinstated (although par value has fallen into disuse for publicly-traded corporations, so some rule would need to be defined to set a minimum par value).
Tax-wise, every corporation could be an S-Corp, with its shareholders paying taxes directly on their share of the corporation's profits every year. After all, it's legally and conceptually their money, so they should pay the taxes on it.
Option 3: Shift to a Wealth Tax model
One of the big problems with taxing investment income as income is that this is largely a tax on getting rich, not a tax on being rich, since it's quite possible for someone who's already rich to have tons of assets but little or no actual income, but you can't get rich unless you're making money. Another big problem is that if an investor holds his investment forever, his unrealized gains never get taxed.
In this model, the corporate income tax would be abolished, as would all individual taxes on dividends, interest, and capital gains. Instead, each year, anyone who owns financial assets in non-trivial quantities would pay a tax equal to a percentage of the value of those assets. I've done some back-of-the-envelope calculations, and a 1.1-1.2% wealth tax would be roughly revenue-neutral over the next ten years. Conceptually, it's equivalent to taxing an estimated return on investment of 3.3% at the top marginal income tax rate of 35%, regardless of your actual return. The 3.3% is reverse-engineered from the revenue-neutral rate, but it's within the usual range for "risk-free interest rate" (i.e. the typical rate of return for capital before adjusting for risk) estimates used by accountants and economists.
The conceptual justification for only taxing wealth at the individual level, not at both the individual and corporate levels, is that corporations don't actually own their assets; their shareholders do (if you don't believe this to be true, perhaps the proposal could be coupled with Option 2 in order to make it true).
One big benefit of this model is that it's very hard to avoid taxes and it saves a whole raft of problems in deciding what to count as income. No longer could a corporation juggle its books to realize profits in Ireland or the Netherlands. Well, it could, but there'd be no point. So long as the corp's activities are generating shareholder value, no matter how they're juggled, they'd be reflected in the share price, on which all of their US shareholders would pay the wealth tax.
Another benefit would be stabilizing the tax base in recessions. Big corporations tend to take losses at the beginning of a recession, then carry over the tax losses for the next year or two (under the current system, if you have negative profits, you don't pay negative taxes; instead you carry the losses forward and deduct them against next year's income so your total taxes over several years are the correct percentage of your total profit over those years), which guts the corporate income tax base for the duration of the recession. Asset prices tend to go down, too, and investors either hold on through the recession or sell at a loss, so the capital gains tax base is also gutted. The wealth tax base would still go down in recessions, but much less than the current corporate and capital gains tax bases. Rather than the current feast-and-famine tax pattern (where the government has big windfall incomes in boom years (encouraging overspending on the assumption that no, really, this time it's different and the boom will last forever) and massive deficits in recessions), year-to-year tax income would be much smoother and more better-correlated with the fundamental long-term health of the economy.