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Decoding the U.S. Corporate Tax | Introduction

Decoding the U.S. Corporate Tax Cover

As Mark Twain once said, people always talk about the weather, but they never do anything about it. Among policymakers and experts on taxation, the same has frequently been true of corporate taxation. The U.S. corporate tax has been around since 1909—longer than the current individual income tax—and continues to be an important institution, raising well over $300 billion per year. Continually studied by lawyers and economists alike, and frequently singled out as urgently needing reform or even abolition, it has nonetheless trundled along through the decades, only rarely changing significantly.

But just as human activity may finally be affecting the weather in an era of global warming, so the corporate tax could soon be headed in new directions. Here the main precipitating forces, in lieu of rising carbon dioxide levels, are globalization and rising worldwide capital mobility, along with financial innovation in designing the instruments that are traded in capital markets. These trends have the potential to transform such fundamental elements in the functioning of the corporate tax as how much revenue it raises, whom it burdens, and to what extent it burdens anyone at all. They therefore do not merely invite, but may end up necessitating, a major rethinking of how (and if) the U.S. corporate tax operates.

Even if something needs to be done, however, just what should be done remains keenly disputed. As much as the corporate tax has been studied, in many respects both experts and the public still poorly understand how it truly operates on the ground.

The following observations illustrate the public and expert confusion and dissensus, along with the political pressures that may make corporate tax law changes hard to avoid:

(1) Corporate integration, a tax reform idea that would eliminate the existing double tax on corporate income at both the entity and shareholder levels, is widely supported by academics across the ideological spectrum. Yet it has so little public support that President George W. Bush, at his political high-water mark in 2003, working with a generally complaisant Republican Congress, could not get it fully enacted. Not only did Congress merely reduce, not eliminate, the shareholder-level tax on dividends received, but it provided that this tax reduction for shareholders would expire after 2010, potentially bringing the old system back in full force, and in the interim creating substantial uncertainty among investors and corporate actors regarding what to expect in 2011 and beyond.

(2) The scheduled 2011 "sunset" of the rate cut for dividends guarantees continued active political consideration in Congress of what the corporate tax regime should look like. However, political equipoise is unlikely to be reached any time soon, even if the rate cut is either extended or allowed to expire. Republicans tend to be committed to some form of permanent corporate tax relief (relative to the full double tax), while Democrats tend to oppose it, and neither side appears interested in reaching a stable compromise. Thus, continued instability seems highly likely even once the sunset problem is resolved.

(3) There has recently been movement on both sides of the aisle in Congress to lower U.S. corporate tax rates, and thus to make them significantly lower than the top individual tax rate. Corporate tax rates have generally been declining across the world, reflecting international tax competition that the United States may increasingly have to heed. Top individual rates face considerably less competitive pressure, so long as wealthy people are reluctant to leave the United States just for tax reasons. However, a large gap between corporate and individual rates is a potential tax-planning bonanza for taxpayers that can shift their income into a corporate entity and avoid the second level of tax. It also raises serious questions about fitting a lower corporate rate into an overall system that may still be intended to distribute tax burdens progressively.

(4) Proponents of double taxation of corporate income and tougher corporate tax enforcement often think of the corporate tax system as a way of increasing the tax system’s progressivity by burdening shareholders (or investors generally) that are relatively wealthy. Those on the other side of political debates concerning the corporate tax often appear to agree that it does this, and to merely have a different policy preference regarding whether progressivity is good or bad. However, there are serious and unresolved empirical questions about how the corporate tax affects progressivity. Increased worldwide capital mobility suggests that workers, rather than investors, may principally bear the burden of the corporate tax, but this remains empirically uncertain (although supported by several recent studies).

(5) When not focused on progressivity, political arguments about the corporate tax often center on the question of how tax burdens should be divided between the individual and corporate sectors. On its face, this is nonsense (unless it is shorthand for something else, such as progressivity or different sectors of the economy), given that only flesh and blood individuals, as opposed to legal entities that exist only on paper, can actually bear tax burdens. The main reason why, at least at present, the United States actually needs a corporate-level tax has nothing directly to do either with progressivity or with the proper division of burdens between the supposed individual and corporate sectors. Rather, it is because the U.S. system employs an income tax, rather than a consumption tax. The former involves taxing savings (most conveniently, on a current basis), whereas the latter waits until people actually spend the money they have earned. Thus, in an income-tax environment, failing to impose taxes at the corporate level would turn all corporations (as defined for tax purposes) into special tax-free savings accounts. In a consumption-tax environment, by contrast, we could simply wait for corporate earnings to be withdrawn by investors and consumed, without effectively turning corporations into tax shelters.

(6) Economists seeking to model the corporate tax, so that they can understand its distributional or other effects, face the challenge that it offers them an ill-posed problem. What the corporate tax system actually does is unclear, since its true content depends on how a set of highly formalistic line-drawing exercises—for example, defining corporate versus noncorporate entities for tax purposes, or distinguishing between debt and equity—end up being resolved in practice. I call the various legal distinctions on which corporate taxation is built "pillars of sand," because they continually threaten to crumble unless reinforced.

A common solution to the economists’ modeling problem is to make a simplifying assumption that everyone knows is not entirely true. An example would be assuming either (1) that the debt and equity labels for financial instruments are purely elective without regard to investors’ actual economic relationships, or (2) that the labels embody a clean binary division between two radically different flavors with distinct constituencies, like chocolate and vanilla ice cream. Neither assumption is entirely true, but which one the models adopt as the superior proxy for the truth can radically affect conclusions. For example, if the debt-equity choice is purely elective, the perceived double tax problem can flip over into a concern about whether the corporate tax unduly benefits, rather than unduly burdening, the choice to do business through a corporate entity.

(7) Actual corporate behavior is not well understood. So simple a question as why companies pay dividends, rather than retaining the funds or repurchasing shares of their own stock, continues to be hard to answer. And much observed managerial behavior, such as the obsession with boosting reported financial earnings even if investors can still get the bad news by reading the financial reports’ footnotes, is difficult to square with the assumptions of rational behavior and market efficiency that often are so powerful in economic analysis.

(8) Business interests argue, with increasing support from recent economic research, that globalization makes it ever more important, as a matter of U.S. national welfare, to increase U.S. multinational firms’ competitiveness in overseas markets. But advocates disagree about whether U.S. national self-interest is better served by making sure that these firms, when considering outbound investment, face tax rates that are (1) no higher than those of their foreign competitors, or (2) no lower than those that they would face upon investing at home. One cannot do both at the same time when countries’ tax rates differ.

* * * * *

Against this background of complexity and confusion, this book has the following aims. First, it lays out the main policy issues raised by the corporate tax and shows how their analysis is affected by adopting different assumptions about the underlying mysteries concerning what the system really is and does. As we will see, while virtually no reasonable assumptions could lead to the conclusion that the current system actually makes sense, it is hard to say which of its distortionary rules most needs addressing. The harm caused by double taxation, for example, might be either great or small, depending on which assumptions one adopts about how the tax operates. In the international realm, while there is widespread consensus that the current rules for taxing U.S. multinationals on their outbound investment are extremely inefficient, the contours of an optimal regime (even among politically feasible alternatives) remain disputed due to the lack of a properly comprehensive framework for analyzing the issues.

Second, this book considers where corporate taxation is headed given three important trends. The first of these is ongoing financial innovation, which makes the system’s building blocks, such as the debt-equity distinction, ever more fragile and manipulable. The second trend is rising worldwide capital mobility. The third trend is rising political instability in U.S. tax policy resulting from the sharp partisan divide and from long-term budgetary shortfalls that will eventually require significant tax increases. Expectations about future tax policy turn out to be very important in shaping the incentive effects of corporate taxation today.

Finally, this book analyzes the implications of the underlying analysis and trends for corporate tax reform. In particular, it argues that corporate integration may not be worth doing, unless, contrary to the design choice in the 2003 Bush administration effort, the distinction between debt and equity is eliminated. Keeping the distinction would increasingly permit investors, as predicted 30 years ago by economist Merton Miller, to effectively elect to pay tax either at the corporate rate (by holding equity) or at their own individual rates (by holding debt), whichever is lower. With substantial tax-exempt players from around the world participating in the marketplace, taxing U.S. corporate income even once may increasingly become problematic unless this effective election is eliminated by treating debt and equity the same.

Given the difficulty of proper corporate integration and the risk that it would fail to become a stable regime, this book argues that corporate tax-reform efforts might fruitfully emphasize taking other directions. Three possibilities in particular are (1) lowering the U.S. corporate tax rate for reasons of international competitiveness, (2) radically simplifying the U.S. international tax rules without greatly changing the level of taxation, and (3) addressing corporate executives’ well-known proclivity for simultaneously understating corporate income to the Internal Revenue Service in their tax returns and overstating it to investors in published financial statements.

The remainder of this book proceeds as follows. Part One, "Basics," reviews what the corporate tax is, why each of its key elements exists, and what economic distortions these elements, working in tandem, create. Part Two, "Economic Theory Meets the Corporate Tax," reviews several dueling pairs of economic models that support radically divergent views of how the corporate tax affects the creation and distribution of national economic wealth. Part Three explores the international dimension in U.S. corporate tax policy which, if anything, involves greater disagreement and confusion than the domestic dimension. Finally, Part Four, "Where Is the Corporate Tax Headed?" examines possible directions for legal change. It starts by examining leading approaches to corporate integration and their desirability given underlying economic and political trends and the pillars of sand. It then turns to the alternative reform directions described above, and concludes by asking what is likely to happen—a question that depends as much on whether the U.S. political system can still function effectively, in an era of pervasive partisanship and sound-bite-driven policymaking, as it does on anything lying within the current parameters of the corporate tax.

 

Decoding the U.S. Corporate Tax, by Daniel N. Shaviro, is available from the Urban Institute Press (ISBN 978-0-87766-757-5, paper, 220 pages, $26.50).

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