Mitigating the Potential Inequity of Reducing Corporate Rates

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Abstract

Since the statutory marginal U.S. income tax rate on corporate income is higher than the marginal rate imposed by all of our trading partners except Japan, there have been a number of proposals to reduce the U.S. marginal corporate rate. At the same time, it seems likely that the top individual rate will be increased. However, a differential between marginal corporate and individual rates could reduce the overall rate of tax on corporate distributions and enable higher-income taxpayers to shelter their income from services or investments. This paper suggests that we can mitigate these problems if the lower corporate rate is denied to income from services or passive investments and if there is always a second tax on distributed income. The latter requires reducing the step-up in basis at death and the deduction for charitable contributions by the amount of undistributed earnings to prevent taxpayers from permanently escaping tax on earnings retained in the corporation. Nonetheless lower corporate rates allow reinvested corporate profits to earn a permanent higher rate of return. Setting the combined individual and corporate rates on corporate distributions higher than the top individual rate offsets this advantage and also reduces the risk that corporations will be used to shelter income.

Introduction

The statutory marginal U.S. income tax rate on corporate income is higher than the marginal rate imposed by all of our trading partners except Japan. This higher rate of tax is said to hurt the ability of the United States to attract foreign investment. In response, there have been a number of proposals to reduce the U.S. marginal corporate rate. At the same time, it seems likely that the top individual rate will be increased.

If the corporate rate is lower than the top individual rate, as was the case prior to 1986, corporations may again be used to shelter high-income individuals from high individual rates. Currently, the top corporate rate of 35 percent is the same as the top individual rate, and there is an additional tax of 15 percent if corporate income is distributed to shareholders. This brings the combined burden on distributed corporate income up to 44.75 percent. Therefore, the ability to shelter income in a corporation in order to reduce the overall tax burden is limited. Accordingly, it is ordinarily optimal for a closely held business to choose an entity that allows business income to be passed-through directly to the owners. In that case, there would be no corporate-level tax and the top marginal rate would be 35 percent,5 the highest individual rate. However, if the corporate rate is reduced, closely held business might again choose to be subject to the corporate tax. In these circumstances, taxpayer efforts to minimize taxes, through choice of entity, the timing and manner of distributions, and the use of debt or equity, could reintroduce a number of complexities in the law that are largely avoided today as far as closely held business is concerned.

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