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Corporate Income Tax trial balloons - Office of Naval Contemplation

Dec. 14th, 2011

12:25 pm - Corporate Income Tax trial balloons

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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:

  1. 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.

  2. 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.

  3. Retained earning of the corporation would be fully taxed, so there's no incentive to retain too much earnings in order to avoid taxation.

  4. 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.

  5. Regardless of tax incidence of the corporate income tax, shareholders would be fully taxed on their own incomes.

  6. 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.
And from the conservative/libertarian perspective:
  1. 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.

  2. Stock and bond income would be treated identically, eliminating the tax incentive to over-leverage.

  3. 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.

  4. 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.

  5. 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)
Option 1b: Tax Corporations on a Modified Cash-Flow Basis

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.

Comments:

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From:rdmasters
Date:December 14th, 2011 09:21 pm (UTC)
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A lot of food for thought there...
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From:makellan
Date:December 16th, 2011 12:45 am (UTC)
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Responding one at a time.
I very much like Option 1. The only thing I'd change is the corporate tax rate being pegged to the highest income rate unless we increase the highest income rate to account for very high ($>1M) incomes.

1b: There are some complicated mental gymnastics for someone new to a good deal of this.

2: My strongest objections to personhood revolve around free speech and the difficulty and inequality of punishment for transgressions. On the free speech front, an individual is limited by his personal finances (ignoring his potential willingness to take on loans) to make his statement. Corporations have, in general, more capital at their disposal. This allows them to have a louder voice in politics than the individuals making up the company. Conversely, there is a difficulty in punishment. If I break the law, I can be fined, go to jail, or be killed. Corporate persons can realistically expect only one of those punishments to be possible. Individual officers may go to jail to punish the hand inside the sock puppet, but the puppet can not go to jail.
That said, it has little to do with how a corporation is taxed. I don't like the idea of taxing shareholders' unrealized profits. If I buy a share of Ares at $10 and, due to good profits, the price rises to $20, I have to pay taxes out of pocket for a profit of $10 that isn't in my wallet. Conversely, if I buy my share at $20 and it goes down to $10, do I get a tax credit or deduction for the loss? Would that count as some type of business loss even though I'm not a business unto myself?

3: What a very interesting idea. I like most of it, but I have some questions.
How you add up and calculate corporate assets would be very interesting indeed. I see a "normal" company wealth like so: profit + assets (cash + investments + real estate + inventory + machines and desks and such) - losses - debt - business expenses (rent, payroll, dividends, etc).
A simplistic example may help me see what we're talking about:
Let's say Ares ends up with $10,000 in wealth sitting around at the end of the year. I own 1% of the shares and the entire value of the company is assumed to be the exact value of all of the shares combined. I now pay $110 = 1.1% of 1% of $10,000. All the shareholders combined pay $1,100.

I see an interesting loophole. Assuming that you take the measurement at the moment of the end of the fiscal year, would there not be an incentive to take out a $10,000 loan for a day to make sure everyone pays no tax because at that moment, the company would be worth nothing? The loan is paid back with some trivial interest the next day and no one pays anything.

Interesting note: Local provisions such as Prop 13 would become huge tax shelters for the companies owning land that would normally go up in value, but that's already a problem.
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From:maniakes
Date:December 16th, 2011 02:20 am (UTC)
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2. Do your objections to corporate political speech also apply to non-business corporations (e.g. political advocacy nonprofits like the NRA and the ACLU, or labor unions), or do you a distinction between business corporations and non-business corporations that mitigates your objections in the latter case?

Do you believe that free expression and freedom of the press should apply to a for-profit corporation whose primary business is news reporting or book publishing?

I'm proposing taxing individuals based on their slice of the corporation's profits, not based on their personal unrealized capital gains. The way S-Corps work under current law (which is what I'm basing this on) is that they calculate their taxable profits for the year like a regular C-Corp, but instead of paying taxes directly, they send a statement to each shareholder saying something like:

Total taxable profits in 2011: $100,000
Number of shares outstanding: 1,000
Taxable profits per share: $100
You own: 20 shares
Your taxable profits: $2,000

You then add $2000 to your taxable income in your personal income tax return. The wikipedia article has some more detailed examples.

For a large, publicly traded corporation, the problem of needing to pay taxes on unrealized profits is a real issue, but there are ways to work around it. For current S-Corps, the usual solution is that the corps are generally set up with internal rules requiring them to pay out dividends large enough to cover shareholders' tax burdens.

Another way to do it would be to require corps to withhold 35% (or whatever the top bracket is) of their taxable incomes. Then, I as a shareholder would get a statement saying my taxable income via the company's profits is $2000, from which $700 has already been pre-paid by the company towards my taxes. Since I'm only in the 28% tax bracket, I only owe $560 in taxes, so after filing my tax return I get a $140 refund.

For the capital gains tax under current law, yes, if you sell stock at a loss you can deduct the loss from your personal income. The only caveats are that if you sold a different stock for a gain or you have dividend income, it deducts from that income first before deducting your ordinary income, and that you can't deduct more than $3000/year from your ordinary income (any excess carries over to next year's tax return).

3. This proposal is inspired by the Dutch Flat Tax on Savings and Investment. Rather than trying to add up the values of all of Ares's tangible and intangible assets, instead you use the stock price (valuing ownership of 1% of Aries at the price people are willing to pay for it). So if Ares is trading for $20/share and I own 1000 shares, I pay 1.1% of $20,000. I'm not sure if the Dutch system uses average daily value, or Dec 31 balance, or what, but presumably they've thought of the major practical issues and abuses and tried to find some way of dealing with them. I'll continue to poke around to see if I can find some more detailed information.

If we do use the book-value method you're thinking of rather than the market-value method I was thinking of, I don't think the instant-debt loophole would work. When Ares takes out the loan, their debts would go up by $10,000, but they'd also have $10,000 extra in the bank, so their net worth would still be the same as it was before. The only way to actually lower their net worth would be to give the borrowed money away, which would defeat the purpose.
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From:maniakes
Date:December 16th, 2011 08:46 pm (UTC)
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More on #3:

It looks like the Dutch wealth tax uses the average of the market value on Jan 1 and the market value on Dec 31.

Another way I though of to do it, that'd be pretty hard to game:
1. The year you sell a share, it's valued at the price you sold it for.
2. The year you buy a share (unless you sell it the same year), it's valued at the price you paid for it.
3. If you held a share all year, or if you sold stock in the same company and then bought it back in a relatively short time-window, it's valued at the median price it traded for over the course of the year (your broker gets the number from the stock exchange and puts it on your annual tax statement).
4. If you sell a share, then buy it back within a fairly short time window, apply something like the current wash sale rule used for capital gains taxes to prevent someone from using rules 1 and 2 to lock in a low tax basis when the stock's temporarily tanking.

Back to the book value method of valuation you'd been thinking of (rather than the market valuation method I've been thinking of), for publicly traded corps it'd be pretty easy to implement, as they're already required to track and publish the value of their assets as part of their annual reports to investors. There's a metric shitton of nitpicky rules on how to do this, but in general the rule is that an asset is valued at what you paid for it, minus an adjustment (called "depreciation") for things wearing out, based on the estimated usable life of the asset. There are rules for the usable life of different categories of assets, intended to make the system hard to game. So if a computer has a usable life of 3 years and it cost the company $2400, then the first year it's valued at $2400, the second year it's valued at $1600, and the third year it's valued at $800.

The big problem with book value accounting for wealth tax purposes is that it doesn't reflect the value of intangible assets (for example, reputation, established customer relationships, and what's called "organizational capital" (things like having an internal structure and corporate culture that enables the employees to get things done as a team)), and it's hard to capture the value of assets the company's built up on its own (for example, a software company's code base). Financial accounting usually doesn't even bother trying (just report the value of objectively-priceable tangible assets and let investors figure out the rest on their own), and while managerial accounting (a separate branch of accounting that focuses on qualtifying things to help managers make good decisions) does have methods for this, the methods are too subjective and game-able to make sense for tax accounting.

One possibility would be to mix the proposals: Aries pays a wealth tax based on the book value of their assets, and Aries's investors pay a wealth tax based on the market value of their shares, minus their slice of Aries's book value, on the assumption that the difference is investors' collected estimates of the value of whatever of Aries's assets that weren't captured by the book value method. Conceptually, this would be basing the tax incidence on a mental model that Aries owns the desks, buildings, computers, equipment, etc, while Aries's shareholders own Aries itself (the intangible value of the company, its reputation, and its established business relationships).
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From:cakoluchiam
Date:January 1st, 2012 02:58 am (UTC)
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Could you clarify how you see the premise leading to 1b working out?

My impression is as follows:
Option A: ACME keeps the 10,000$ profits issuing no dividends and is taxed at the highest rate (say 50%) this year, starting the new year with 5,000$ cash reserves to expand the company with no tax liability the following year.

Option B: ACME pays all 10,000$ "profits" as dividends, each shareholder being taxed at their income bracket (say, average 30%), and all shareholders (intelligently?) reinvest in the company, offering the company 7,000$ cash to expand the company, but counting (50%?) against profits the following year.

So, the choice appears to be between A:"Pay 5,000$ now" or B:"Pay 3,000$ now and 3,500$ later", which seems to be a classic example of the choice of investment... the difference between the corporate tax rate and the average reinvesting shareholder tax rate will make the choice for the company by determining the opportunity cost of those 2,000$ over the next year.

...which might also make companies try to appeal more to investors in the lower economic classes so they can get more money back in reinvestments... which is good, right?

Am I missing something?
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From:maniakes
Date:January 1st, 2012 03:42 am (UTC)
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Two things you're missing:

1. The top corporate income tax rate is 35%, not 50%, and
2. Investors realize the benefit of expansion funded by retained earnings as capital gains, taxed at 15% under current law, or at individual income tax rates under proposal 1 or 1b.

So, the choice becomes:

A. ACME pays $3500 in corp income tax now. At some point in the future, ACME's share holders sell their shares and pay capital gains on their profits. The expected net present value of the profit would be roughly the same as the retained earnings, so 30% of $6500, or $1950.

B. ACME's shareholders pay $3000 now, and reinvest the remaining $7000, on which AMCE pays $2450.

It's now a choice between A. $3500 now and $1950 later, or B. $3000 now and $2450 later.

The choice depends on the effective individual income tax rate, though. If it's the top rate of 35%, A and B work out exactly the same. But the lower the individual rate is relative to the personal marginal tax rate of ACME's average investor, the better A looks relative to B, which is what I'm trying to avoid. It also looks like counting incoming investments as taxable income restores the double-taxation problem I'm trying to avoid. All in all, I think proposal 1b needs some work. Thank you for the feedback.
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From:cakoluchiam
Date:January 1st, 2012 05:25 pm (UTC)
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Again to clarify:

A: ACME pays $3,500 now, Shareholders pay $1,950 later on capital gains
B: Shareholders pay $3,000 now, ACME pays $2,450 later (with no capital gains since the reinvestment will dilute the stock pool)

?
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From:maniakes
Date:January 2nd, 2012 07:47 am (UTC)
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Yes.
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