Published January 12, 2017
Illustration by Michael Austin
Reform of the corporate income tax is shaping up as a priority for the new Congress. To no one’s surprise, Republicans are pushing for big cuts in the corporate tax rate. And while most observers assume conservatives and progressives will be at loggerheads over those cuts, that is not inevitable. Indeed, there is a strong progressive case for sharply lowering the corporate income tax rate — or abolishing it altogether.
On its face, corporate tax reform is dividing Washington in all the usual ways. President-elect Trump has proposed lowering the top bracket from its current 35 percent to 15 percent, offsetting some of the revenue loss by eliminating many tax preferences. For their part, House Republicans have proposed a 20 percent top rate, also eliminating some important deductions and preferences.
Meanwhile in the Senate, many Democrats, who retain the power to filibuster tax reform legislation, are digging in their heels against the corporate rate cuts, with progressive superstar Elizabeth Warren leading the charge. In a recent New York Times op-ed, she wrote, “Congress should increase the share of government revenue generated from taxes on big corporations — permanently.” In the 1950s, she points out, the corporate tax accounted for more than 30 percent of federal revenue, compared to less than 10 percent today.
She is right on the numbers but wrong that the glory days of the corporate tax are worth recapturing. Here’s why.
The corporate tax is not a tax on corporations
Although corporations bear the legal obligation to fork over the tax, they cannot bear the economic burden because they are not real people — a point progressives are quick to agree with in the contexts of campaign contributions, free speech and criminal liability in fraud and antitrust. More to the point here, the economic burden of the tax (the incidence of the tax, as economists put it) must ultimately fall on corporate stakeholders — principally shareholders and workers.
But figuring out just how that economic burden is divided has proven to be an intellectually challenging and politically polarizing exercise, as a report available from the Urban Institute and Brookings Tax Policy Center details. Economists trying to do the numbers face not only the usual difficulties of identifying the right data and constructing the right econometric model to test alternative theories but some unique problems, too.
The earliest estimates for the United States, made in the early 1960s at the dawn of the era of globalization, concluded that the burden rested almost entirely on shareholders. As the economy became more open to trade and financial flows, however, the assumptions that drove this conclusion became questionable.
Capital can move across national borders much more easily than labor. Thus, if one country imposes a higher corporate tax rate than others, investors will be inclined to decamp but workers will largely stay put. That means less investment per worker in the higher tax country and therefore lower labor productivity and wages. This downward pressure on wages effectively shifts part of the burden of the tax to workers. And, of course, this effect is especially relevant to the United States, which has the highest statutory corporate tax rate of any major economy.
Now, influential studies cited in the aforementioned report from the Tax Policy Center conclude that workers bear as much as 70 percent of the burden — some think even more. But that’s not how harder line progressives read the evidence. The Tax Justice Network, in a report titled “Ten Reasons to Defend the Corporate Tax,” points to work by the Congressional Budget Office, which uses 25 percent for its estimate of labor’s share.
There’s a way to reconcile the two views. The degree to which the corporate tax is shifted to workers seems to depend on the time horizon. Because the global pattern of investment responds fairly slowly to financial incentives, in the short run an increase in the corporate tax rate is likely to be absorbed almost entirely by shareholders. However, the shift of the burden to workers, if and when capital flees, persists once it becomes established.
The time lag is important because, while economists tend to focus on the long run, politicians and CEOs, with their eyes on the next election and the next quarter’s earnings report, tend to focus on the short run. The Tax Justice Foundation notes that corporate executives typically behave as if tax burdens fall on shareholders. “Would they spend so much time and energy finding clever ways to dodge tax,” the report asks, “if they believed that taxes didn’t fall ultimately on their shareholders, to whom they are accountable?”
But it’s the long run that should interest policymakers. And the reality that a significant part of the burden of the tax is probably borne by workers should give pause to progressives, even if no one can pin down the time frame with much confidence. It would be far better to identify an alternative tax that distorts economic incentives less (as conservatives claim is priority one) yet is certain to be borne by shareholders. Fortunately, just such an alternative is available.
While economists tend to focus on the long run, politicians and CEOs, with their eyes on the next election and the next quarter’s earnings report, tend to focus on the short run. But it’s the long run that should interest policymakers.
The right way to tax shareholders (if you really do want to tax them)
Pause for a moment for a digression — albeit a relevant digression — on the issue of “double taxation.” Double taxation occurs when corporate profits are taxed once when earned by the company itself, and again, as individual income, when they are paid out as dividends or realized as capital gains. The U.S. tax code imposes a high rate of tax at the corporate level and then mitigates the double levy by taxing the dividend and capital gains income of individual shareholders at preferential rates — about half that charged on “ordinary” income.
In contrast, other advanced countries not only tax corporate profits at a lower combined rate but also collect relatively less at the corporate level and relatively more at the individual level. If the United States matched their lower corporate rates it would sharply decrease incentives to invest abroad, reducing the long-run incidence of the tax on labor. Making up the lost revenue by raising individual income taxes on dividends and capital gains would reinforce this distributive impact.
One of the Tax Justice Foundation’s talking points in favor of retaining the corporate tax does reflect a legitimate concern, however. Unless reform is done right, it could open the door to a new kind of tax shelter:
If the corporate rate is zero or very low, then people — and here we are talking mostly about wealthy individuals — could leave their earnings inside the corporation and defer paying personal income tax on them indefinitely until the corporation pays them a dividend at a date of their choosing, or perhaps never. Those corporate profits will not be effectively taxed over that period.
A plan jointly advanced by Eric Toder of the liberal-leaning Urban Institute and Alan Viard of the conservative American Enterprise Institute addresses this problem directly. Any reduction of the corporate tax, they argue, should be offset by an “accrual” or “mark-to-market” tax, at the full ordinary rate, on shareholder income. Mark-to-market income would be calculated as the sum of dividends paid and the change in the market value of shares during the year. Gains and losses would be smoothed to reflect share-price volatility by allowing deductions for losses in one year to offset profits in a previous year. Shareholders would pay tax on the earnings of the corporations they owned whether or not they were paid out as dividends and whether or not they sold the stock and realized capital gains.
Corporate tax reform, even if revenue-neutral, would spur growth
Conservatives regularly claim that cutting corporate taxes would spur growth, but progressives tend to be skeptical. In part, that’s because the conservative argument too often invokes an evidence-free trickle-down effect in which lower taxes lead to more investment or more consumption by the rich that stimulates the economy. But the case for the reform discussed above in no way depends on trickle-down. It would, indeed, increase after-tax income of corporations but, under mark-to-market accounting, it would increase taxable personal income of (largely wealthy) shareholders by the same amount.
Such a revenue-neutral reduction in corporate taxes would still spur growth, however, because of the potential to reduce incentives that chew up resources unproductively. Consider a hypothetical example. Suppose that, if your corporation paid taxes at the full statutory rate, it would owe $35 million in tax on $100 million in profit, for a net income of $65 million. By changing your product line, moving your corporate headquarters to Ireland or, who knows, Borneo and using more tax-deductible debt instead of equity financing, suppose you can cut your taxes to $10 million. Suppose, too, that these tax avoidance measures would cut pre-tax profit by $20 million. The government loses $25 million in revenue. But the corporation ends up $5 million ahead — which is why the avoidance scheme was in the stockholders’ interest in the first place.
The tax system is not a “zero-sum game” in which the government’s loss is the taxpayer's gain.
The example may be hypothetical, but it illustrates a very real fact that the tax system is not a “zero-sum game” in which the government’s loss is the taxpayer’s gain. We can't be sure what corporations would do if didn’t have incentives to waste energy and resources to avoid taxation. They might expand; they might pass cost savings along to consumers through lower prices; they might bring jobs back home that they had previously sent offshore for tax reasons. Or they might just pay higher dividends, thereby increasing taxable personal income. Any way you slice it, though, the potential for win-win gains from deemphasizing the role of the corporation as tax collector ought to be central to the way progressives think about reform.
The bottom line
Pardon my inclination to repetition, but I find progressives’ enthusiasm for the corporate income tax long overdue for a makeover. Even in the most optimistic of scenarios, too much of the tax’s burden spills onto workers — especially since the growth-enhancing and more equitable alternative is staring us in the face.
To be sure, none of this means that progressives should simply sign off on GOP reform plans, which do cut the top corporate rate but don’t try to recoup the lost revenue from the personal income of affluent shareholders. As a result, the House reform would add $1.7 trillion to the deficit over 10 years, while the Trump plan would add $2.6 trillion.
Those prospective revenue losses should give Senate Democrats modest bargaining power since some Senate conservatives have repeatedly expressed the view that tax reform should be revenue-neutral. A compromise that sharply cut the top rate for the corporate tax while reducing tax preferences for dividends and capital gains should make everyone happy — with the exception of the current beneficiaries of those preferences. Even if immediate compromise turns out to be impossible, progressives should begin to rethink the way they would tax business income if they could. I think the starting point should be something along the lines of the Toder-Viard scheme — not a return to a high-rate corporate tax that encourages waste and does nobody-knows-what to the distribution of income.