So we sailed on through the narrow straits, crying aloud for fear of Scylla on the one hand while divine Charybdis sucked the sea in terribly on the other.
The United States taxes corporate profits twice. Corporations pay one tax, and shareholders pay another when they receive dividends or sell stock. Many commentators have criticized this “double tax,” proposing instead to use only one of these taxes.
For instance, some want to replace the corporate tax with a mark-to-market tax on shareholders.
Other proposals to repeal the corporate tax emerged in the 2016 presidential campaign.
The mirror image is to keep the corporate tax and repeal the shareholder tax. For example, the “comprehensive business income tax” (CBIT), considered in an influential 1992 U.S. Treasury report,
would eliminate the dividend tax and possibly also the capital gains tax.
Although choosing to tax the corporation or its investors may seem like taking money from one pocket or the other, this Essay emphasizes a key difference: Corporate and shareholder taxes prompt different tax planning. Relying on one or the other mitigates some distortions and leaks, while exacerbating others.
At one end of the spectrum, what if Congress repeals the corporate tax and relies only on a (higher) shareholder tax? The good news is that this step eliminates familiar distortions from the corporate tax, such as a firm’s incentive to earn income abroad and to change its tax residence.
But there is bad news as well. Because the shareholder tax is higher, the distortions it causes are more severe. For instance, shareholders have a stronger tax motivation to keep appreciated stock. In addition, tax-exempt and foreign shareholders no longer pay tax (indirectly) through the corporate tax.
As a result, relying only on the shareholder tax is problematic. To deal with these concerns, Congress can move to the other end of the spectrum, repealing the shareholder tax and relying solely on a (higher) corporate tax. But although this step eliminates distortions from the shareholder tax (such as the incentive to hold onto appreciated stock), it exacerbates distortions from the corporate tax (such as the incentive to shift earnings).
Since there are distortions either way, choosing which tax to use is like navigating between Scylla and Charybdis.
In response, this Essay recommends using both corporate and shareholder taxes. The two rates should be coordinated so that they aggregate to the combined rate Congress wants, which ideally would be the same as the rate on pass-through businesses (or, at least, close to it).
The main goal of this Essay, then, is to defend the use of both taxes—in essence, to show “how I learned to love the double tax”
—and to calibrate the balance between them. At first blush, this argument seems counterintuitive. If both taxes are distortive, isn’t it better to get rid of at least one? It seems odd to contend that “each tax is so flawed that we really need them both.” But in fact, this is the case.
Using both taxes has three important advantages. First, if one is avoided, the other still raises some revenue. Second, if the goal is to deter a planning strategy, cutting the rate to zero is an overreaction. When the rate is low enough, paying a tax is cheaper than avoiding it, since tax planning is not free. For example, a firm’s incentive to shift income abroad can be eliminated not only by repealing the corporate tax, as noted above, but also by cutting the rate to 10% or 15% (so it is competitive with the corporate rate in other countries). Third, if one tax is cut instead of repealed, the other can be correspondingly lower, and thus induces less planning. Proposals to use only one tax on business profits typically neglect these advantages of using two.
Even so, using two taxes poses challenges as well. First, although the taxes are supposed to backstop each other, they cannot do so when a planning strategy avoids both.
Second, ensuring that two taxes aggregate to a particular rate is not easy.
This coordination is fairly blunt unless we shore up both taxes, so they are hard to avoid, and also use a sophisticated mechanism like an imputation system, which gives shareholders a credit for tax already paid by the corporation.
Third, using two taxes can increase administrative costs.
Once Congress chooses the combined rate on corporate profits, how should it allocate this burden between corporate and shareholder taxes? Since lower rates discourage planning, the more distortive tax should be lower. The corporate tax is probably more distortive, so it should be cut significantly.
The shareholder tax should be increased to make up the difference (or at least some of it).
How much of the tax burden should be shifted from the corporation to shareholders? Since the answer depends on how distortive each tax is, the analysis changes when reforms ease distortions in one tax or the other. For example, if a reform makes the shareholder tax harder to avoid, even a high shareholder rate does not motivate taxpayers to avoid the tax (since the reform keeps them from doing so). Once the shareholder tax becomes more reliable in this way, the corporate tax does not need to collect as much revenue, so its rate can be cut. In other words, shoring up the shareholder tax allows more of the tax burden to be shifted from corporations to shareholders. At the same time, the mirror image is also true: If a reform makes the corporate tax harder to avoid, this tax collects more revenue with fewer distortions, so the shareholder tax can be cut. Therefore, both taxes should be strengthened with incremental reforms. As each becomes more reliable—and thus collects more revenue with fewer distortions—the other does not have to collect as much revenue. This allows the other tax to use a lower rate, so it becomes less distortive. The bottom line, then, is that reforms ease the tradeoff between collecting tax from corporations, on the one hand, and shareholders, on the other.
In theory, if reforms could eliminate all distortions from one tax—so it could collect as much revenue as is needed without changing taxpayer behavior—the other tax would no longer be necessary. Yet as a practical matter, even fundamental reforms cannot eliminate every distortion; as a result, this Essay shows that these more ambitious reforms also benefit from using two taxes, instead of one.
For instance, repealing the corporate tax and replacing it with a mark-to-market tax on shareholders offers the significant advantage of eliminating the incentive to shift income. But this reform creates a new distortion: Stock in a public firm is taxed less favorably than investments that do not have to be marked to market. Even so, using two taxes can mitigate this distortion. If a modest corporate tax is retained, the shareholder rate can be lower, making stock more competitive with other investments.
Before proceeding to the analysis, six clarifications are in order. First, this Essay focuses on publicly traded businesses, since private firms usually do not pay corporate tax under current law and use other planning strategies that are mostly beyond this Essay’s scope.
Second, this Essay generally assumes that income is the tax base, although some consumption-tax alternatives are discussed briefly as well.
Third, the goal is to maximize national welfare, instead of global welfare.
Fourth, this Essay does not focus on distribution, since the alternatives it compares—corporate and shareholder taxes—both tax capital income, and thus reach high-income taxpayers. Even so, distributional effects can still vary if the incidence of these taxes is different.
Fifth, this Essay focuses on where rates and rules should end up. How the transition should be managed—including whether changes apply only to new firms or new equity (e.g., to avoid windfalls), as well as whether changes should be phased in gradually—is beyond this Essay’s scope. Finally, the focus here is on policy instead of politics, although political constraints are discussed briefly.
This Essay proceeds in four Parts. Part I explains why nominally equivalent corporate and shareholder taxes induce different planning, and it surveys strategies used to avoid a high corporate tax, on the one hand, and a high shareholder tax, on the other. In response to these dueling distortions, Part II recommends using both taxes. Part III considers what the division of labor should be between these two taxes, as well as how to strengthen each with targeted reforms. Part IV extends the analysis to more comprehensive reforms, showing that they also benefit from using two taxes, instead of one.
I. Dueling Distortions: Some Arise Only in Taxing Corporations, While Others Arise Only in Taxing Shareholders
Should tax on businesses be collected from the business itself, its investors, or both? This choice would be unimportant—like taking money from one pocket or the other—if corporate and shareholder taxes were interchangeable. But in fact, these taxes measure income differently. Some planning strategies avoid one tax but not the other. As a result, the choice to tax corporations or shareholders influences which distortions arise, as well as how much revenue is raised.
In principle, there are two ways to deter these planning strategies. One is to tighten up the relevant rules, so the strategies would no longer be effective at reducing the tax bill. Parts III and IV offer examples of how to reform the relevant rules. But unfortunately, these reforms face familiar administrative and political barriers, which have impeded reform so far and may well continue to do so.
Alternatively, a second way to deter planning strategies is to cut (or even repeal) the relevant tax. After all, avoiding a 15% tax offers less tax savings—and thus justifies less effort and expense—than avoiding a 40% tax.
Yet even though cutting one tax eases the distortions it causes, this progress comes at a cost: If Congress makes up the revenue by increasing the other tax, the distortions from this tax become more severe. In other words, changing the mix of rates solves one set of problems but exacerbates another. For instance, a low (or 0%) corporate rate reduces the appeal of strategies to avoid the corporate tax, which are described in section I.B. Yet if the cut in the corporate tax is funded with an increase in the shareholder tax—so, for instance, the corporate tax is 0% and the shareholder tax is 40%—taxpayers would have a correspondingly stronger incentive to avoid shareholder taxes. A key point, moreover, is that they would use different strategies to do so. As a result, the system would confront another set of distortions and challenges, which are canvassed in section I.C.
Because of these dueling distortions, collecting tax from either corporations or shareholders is quite difficult, especially when the rate is high. As a result, relying on only one of these taxes is problematic. Part II shows why it is better to use both taxes, instead of only one. But first, this Part surveys the challenges with each tax to show why it matters whether tax is collected from corporations or shareholders.
A. Corporate or Shareholder Taxes: Why It Matters
The current rules for taxing businesses cause familiar distortions. Corporations are not taxed the same as pass-through entities, and debt is taxed differently than equity.
Not only are the rates different, but the number of taxes is also not the same. In some cases, only the investor is taxed; in others, the entity also pays tax. At first blush, who is billed for a tax seems much less important than the size of this bill. But in fact, the choice to tax corporations or shareholders matters a great deal, since these taxes define income differently. As a result, different planning strategies are used, so the distortions and revenue are not the same.
1. Current Law: Different Tax Burdens and a Different Number of Taxes. — Under current law, two familiar variables influence how large a business’s tax burden is, as well as whether the business or its investors write the check. The first variable is whether the business is taxed as a corporation or a pass-through entity. Businesses taxed as corporations are called “C-corporations.” They are subject to a heavier tax burden, and tax is collected from both the firm and its owners. In the top bracket under current law, the firm pays a 35% corporate tax,
and shareholders pay a 23.8% tax when they receive a dividend or sell stock.
In contrast, pass-through entities are subject to a lower tax burden and are taxed only once. The pass-through entity itself pays no tax. Instead, its owners pay the only tax, using the “personal” rate that applies to salaries, which currently is 39.6% in the top bracket.
As a result, the combined rate for C-corporations (50.5%)
is higher than the rate for pass-through entities (39.6%).
A second variable also affects a business’s tax treatment: whether the firm is capitalized with debt or equity. Under current law, the extra tax burden on C-corporations, described above, arises only for equity and not for debt. When a C-corporation makes interest payments, the revenue funding these payments is taxed only once; the corporation is not taxed, since it can deduct interest payments.
Instead, only investors are taxed (i.e., on the interest payments they receive).
These lenders are taxed at their personal rate, which is 39.6% in the top bracket.
So under current law, corporate equity bears a higher tax burden (50.5%) than corporate debt (39.6%).
Notably, the same tax burden (nominally) applies to both pass-through equity and corporate debt (39.6%), and each is subject to only one tax. This tax is collected from owners in the case of pass-through entities and from lenders in the case of debt owed by C-corporations.
2. Nominal Equivalence of Corporate and Shareholder Taxes. — Of the two differences highlighted above—the rate and the number of taxes—the first initially seems more important. The difference between the 50.5% and 39.6% rates obviously matters. But the choice to collect tax from the firm or its shareholders appears to be less significant, since these taxpayers are related. After all, if a taxpayer has two bank accounts, does it matter if tax is collected from one or the other? Similarly, why should it matter if tax is collected from the owner’s bank account, instead of the business’s bank account?
If this initial impression is correct—so rates are important, but the choice to tax the business or its owners is not—the right solution is to conform the rates. This step, by itself, should eliminate the relevant distortions.
For example, assume Congress wants to tax all business profits at 40% and also uses 40% as the personal rate. (This Essay uses 40% as a recurring example, but this round number is merely illustrative and is not intended as a recommendation.)
In principle, a 40% combined rate can be implemented with a 40% corporate rate and no shareholder tax,
a 40% shareholder tax and no corporate tax,
or a 22.5% rate for both.
Indeed, any of the pairs of rates in the following table seem to raise the same revenue and affect taxpayers in similar ways:
Table 1: Nominally Equivalent Pairs of Corporate and Shareholder Tax Rates: Combined Tax of 40%
||Corporation’s After-Tax Profit on $100 of Earnings
||Dividend Tax if Corporation Distributes After-Tax Profit
||Shareholder’s After-Tax Profit
Since these pairs of rates all yield the same combined 40% rate, they all initially seem equivalent, and thus seem equally able to eliminate the inconsistencies described above. All of these pairs seem to align the 40% personal rate with a 40% combined tax on corporate equity.
In so doing, each rate pair appears to conform the tax on corporate equity with the tax on pass-through equity, as well as the tax on debt.
3. Why Nominally Equivalent Taxes Are Different: Component-Rate Strategies. — But in fact, conforming rates is not enough. Although a 40% corporate rate might seem the same as a 40% shareholder rate, this apparent equivalence is misleading. Even when rates are the same, the tax treatment can still be different, since rates alone do not determine the tax burden. Rather, the definition of income is another key factor, and corporate and shareholder taxes use different definitions under current law. As a result, these taxes have different gaps, so a 40% corporate tax does not have the same effects or collect the same revenue as a 40% shareholder tax. In principle, Congress could conform these definitions of income, but this would require substantial changes in the relevant rules.
Indeed, there are five well-understood differences in these regimes. First, the corporate tax measures a firm’s earnings, while the shareholder tax measures a shareholder’s dividends and capital gains. In the long run, these metrics may well yield the same amount of income, since stock prices—and thus an investor’s capital gains—are supposed to be a forecast of the firm’s future earnings.
But in the short run, these two measures can diverge.
Second, and relatedly, corporate and shareholder taxes do not come due at the same time, since some steps trigger one tax but not the other. For example, assume a shareholder buys stock in a corporation, which then rises in value because the firm buys an asset that appreciates. Sale of the asset triggers corporate tax, while sale of the stock triggers shareholder tax. Taking one of these steps triggers only one tax, not the other.
Third, these taxes have different geographic boundaries. As a result, the shareholder tax sometimes applies when the corporate tax does not, and vice versa. For instance, assume a foreign corporation earns money abroad and distributes it to shareholders who are U.S. citizens. The corporation does not pay tax on this profit (since foreign corporations pay tax only on income earned in the United States),
but U.S. shareholders do pay tax on these dividends (since dividends of U.S. shareholders are taxed, regardless of where the firm earned the profits).
In other words, this profit is taxed at the shareholder level, but not the corporate level.
A fourth difference arises when Congress pursues goals other than raising revenue. For some tax expenditures,
Congress uses the shareholder tax, but not the corporate tax. For other tax expenditures, the opposite is true. For example, Congress enacted the production tax credit to promote green energy.
If a corporation produces electricity with wind turbines, this credit reduces its corporate tax bill. But if the firm distributes profits from wind energy to shareholders, the dividend tax still applies.
Finally, another difference between corporate and shareholder taxes is that taxpayers face different nontax costs (or “frictions”) in avoiding them. For example, to reduce their corporate tax bills, firms can draw on sophisticated legal and financial expertise. In contrast, shareholders who want to avoid the shareholder tax may not have access to the same expertise.
Because corporate and shareholder taxes do not have the same gaps, some planning strategies reduce one tax, but not the other. To describe strategies that avoid only one of these taxes, this Essay uses the term “component-rate” strategies. For instance, holding on to appreciated stock defers only the shareholder tax. As a result, this strategy affects only a component of the overall tax on corporate profits (i.e., the shareholder tax, but not the corporate tax).
In contrast, “combined-rate” strategies avoid both corporate and shareholder taxes. For example, organizing a venture as a nonprofit avoids both taxes.
The same is true of organizing a business as a pass-through entity; the personal rate applies, instead of the corporate or shareholder rate.
4. Allocating the Tax Burden Between Corporations and Shareholders. — To summarize, taxpayers respond differently to corporate and shareholder taxes. So even when these taxes are coordinated to yield a particular combined rate, taxpayers use different planning strategies, depending on whether tax is collected from corporations or shareholders. Yet although the allocation between these taxes is very important for some strategies, it is less important for others. Specifically, this allocation matters more for component-rate strategies (which avoid only one tax) than for combined-rate strategies (which avoid both).
a. Effect of the Allocation on Component-Rate Strategies. — For component-rate strategies, the mix of corporate and shareholder taxes is important for two reasons. First, it influences how much revenue the government loses from these strategies. For instance, holding stock until death avoids the shareholder tax but not the corporate tax.
Therefore, revenue falls to zero if the shareholder tax is 40% (and the corporate tax is 0%), but it is unaffected if the shareholder rate is 0% (and the corporate rate is 40%).
Second, this allocation also affects whether component-rate strategies are cost effective for taxpayers. After all, tax planning is not free. Taxpayers have to pay advisors and modify their behavior. These nontax costs are justified only when they are less than the tax savings. The break-even point varies among taxpayers, since a strategy can be easier for some than others. But in general, some planning is cost effective for avoiding a high tax, but not a low tax.
For instance, if the corporate rate is 40% and the shareholder rate is 0%, taxpayers abandon even the cheapest ways to avoid shareholder tax. But if the shareholder rate is increased to 22.5%, some strategies become cost effective.
If the rate is increased further, additional strategies become appealing.
At the same time, if the corporate rate is cut—to keep the combined rate at 40%—some ways to avoid the corporate tax cease to be cost effective. In other words, the balance between shareholder and corporate taxes influences the viability of strategies targeting one tax or the other.
b. Effect of the Allocation on Combined-Rate Strategies. — Yet although this allocation between shareholder and corporate taxes is quite important for a component-rate strategy (which avoids one tax), it is less important for a combined-rate strategy (which avoids both). In deciding whether to use combined-rate strategies, taxpayers still compare the strategies’ costs and benefits (as taxpayers do with component-rate strategies), but the payoff from combined-rate strategies is different: avoiding both taxes, instead of only one.
For instance, in deciding whether to use a pass-through entity instead of a corporation, taxpayers focus on the aggregate of the corporate and shareholder rates. If the personal rate is 40%, a pass-through entity offers no tax advantage when the corporate rate is 40% and the shareholder rate is 0%. The same is true if the corporate rate is 0% and the shareholder rate is 40%. The key is that the corporate and shareholder rates aggregate to 40%, but the balance between them is less important.
Yet it is an oversimplification to say that the allocation between corporate and shareholder rates is entirely irrelevant to combined-rate strategies. Rather, the balance between these taxes can have second-order effects, as long as a key condition is satisfied: One of the component taxes—that is, either the corporate tax or the shareholder tax—has to be easier to avoid than the other. When this is the case—and Congress allocates more of the combined burden to the easily avoided tax—less combined tax is collected.
For instance, assume the corporate tax is easy to avoid, but the shareholder and personal taxes are not. If the (easy-to-avoid) corporate tax is 40% and the (hard-to-avoid) shareholder tax is 0%, the true burden is less than 40% (since taxpayers will avoid some of this 40% tax). As a result, corporations have an advantage over pass-through entities. But this advantage is eliminated—so the true burden is closer to 40%—if the (easy-to-avoid) corporate rate is 0% and the (hard-to-avoid) shareholder rate is 40%.
The bottom line, then, is that the allocation of tax between corporations and shareholders influences the cost effectiveness of various planning strategies. Changing the mix of rates can deter some strategies, while encouraging others.
B. High Corporate Taxes: Planning Strategies and Other Challenges
As the last section showed, even when corporate and shareholder taxes are coordinated to produce a specific combined rate (e.g., 40%), the allocation between these taxes still matters. It affects how taxpayers respond, as well as how much revenue is raised. To show why the allocation between corporate and shareholder taxes is so important, this section canvasses distortions and challenges that arise with a high corporate tax, but not a high shareholder tax. For instance, if the corporate tax is 40% and the shareholder tax is 0%, how would taxpayers respond? This section surveys a range of planning strategies to avoid this high corporate tax.
1. Shifting Income Abroad. — Perhaps the most important problem that arises with a high corporate rate—but not a high shareholder rate—is the incentive to shift income to other jurisdictions. Earning income abroad—or, at least, treating it as earned abroad—reduces the corporate tax burden of both foreign and U.S. firms, albeit for somewhat different reasons. Foreign corporations generally pay U.S. corporate tax only on U.S. earnings.
Likewise, U.S. firms generally pay current U.S. tax only on U.S. earnings and can defer U.S. tax on foreign earnings.
As a result, the corporate tax consequences change when income is sourced abroad. This incentive to shift income is especially strong because the U.S. corporate rate (35%) is the highest in the Organisation for Economic Cooperation and Development (OECD).
In contrast, Ireland’s rate is 12.5%, and the United Kingdom’s rate is 20%.
In motivating firms to shift their income abroad, high corporate taxes induce two types of distortions. First, firms move assets and jobs abroad, even if they would rather operate in the United States.
As the gap in rates widens, more investment flows to low-tax jurisdictions,
shifting assets to owners with less expertise or fewer synergies with other assets.
Since real activity is harder to shift in some sectors than in others, tax distorts capital allocation across sectors.
Second, income can be shifted not only with changes in real activity but also with familiar planning strategies.
As a result, a great deal of income is shifted abroad,
costing the United States approximately $100 billion of annual revenue
and distorting behavior in a variety of ways.
Managers and advisors invest significant time in shifting income.
In addition, U.S. multinationals keep over $2 trillion of foreign earnings offshore.
To invest it in the United States, they have to pay a 35% repatriation tax or use costly planning to bring it back another way.
Yet although high corporate taxes encourage firms to shift income abroad, high shareholder taxes do not. They are immune to this distortion because, as noted above, the geographic boundary of shareholder taxes is based on where the shareholder lives, not where the firm earns its income.
As a result, shareholders cannot avoid this tax by sourcing income abroad. For example, if a U.S. citizen receives a dividend from a foreign corporation, U.S. shareholder tax is due for this dividend, regardless of whether the firm earned this profit abroad or in the United States.
This difference between corporate and shareholder taxes has become much more important in recent years. It did not loom as large, for instance, when the Treasury and the American Law Institute (ALI) published studies on corporate integration two decades ago.
At the time, the economy was less global, foreign rates were higher, and some tax rules used in income shifting, such as the “check-the-box” rules, were not yet on the books.
Perhaps for these reasons, the Treasury and ALI did not focus on the issue. Indeed, the Treasury proposed to rely on the corporate tax and to repeal the shareholder tax on dividends (and, to an extent, the capital gains tax as well).
Although more plausible in 1992, this proposal is untenable today, as one of its principal architects has emphasized.
2. Inversions. — In addition to encouraging firms to shift income abroad, high corporate taxes induce another familiar distortion: Some firms respond by becoming a foreign firm, instead of a U.S. firm. Changing tax residence allows a firm to pay U.S. tax only on U.S. income, rather than on worldwide income.
Changing tax residence is not especially difficult for corporations. They have to reincorporate abroad or combine with a foreign firm. Yet their headquarters can remain in the United States, along with factories, researchers, and customers. They also can still be listed on a U.S. exchange.
Admittedly, although changing tax residence for a corporation is not hard, it is not entirely without cost. The firm has to pay an exit tax
and also may alienate some customers and investors.
Different corporate law rules apply, so the cost of capital could increase if investor protections are weakened. But these costs are unlikely to deter self-interested managers, since they may benefit personally from having more discretion to pursue self-interested goals. Indeed, they can even blame the tax law for “forcing” them to weaken investor protections.
So although switching tax residence requires some changes in behavior—and thus involves distortions—these costs often are less than the tax savings, at least when the U.S. corporate rate is high. In response, Congress and the Treasury have tried to block this planning strategy with section 7874,
as well as with repeated rounds of regulatory action.
But although these steps raise the cost of this planning strategy, they have not stopped it entirely.
For instance, firms can still combine with foreign firms that are sufficiently large.
Firms also can incorporate abroad initially when they first go into business.
While high corporate taxes induce these distortions, high shareholder taxes are less likely to do so. Admittedly, shareholders enjoy tax advantages in changing tax residence, which roughly parallel those for corporations. Although shareholders still owe U.S. shareholder tax on dividends from U.S. firms, they no longer owe shareholder tax on dividends from foreign firms or, for that matter, on capital gains. Yet although changing residence can offer tax savings to both firms and shareholders, this step is much costlier for shareholders. In addition to owing an “exit” tax,
shareholders have to renounce U.S. citizenship, leave the United States, and forgo the right to come back.
These are major life changes, which are much more daunting than the relatively minor implications of changing a corporation’s residence. As a result, changing tax residence is a distortion that is more likely with high corporate taxes than with high shareholder taxes.
3. Debt. — Along with encouraging firms to shift income and change their tax residence, high corporate taxes prompt another familiar planning strategy: Firms issue more debt. Since interest is deductible, corporations pay no tax on revenue that funds interest payments. Only lenders pay the tax, which they avoid if they are tax exempt or foreign.
When debt finances favorably taxed assets (e.g., those that are eligible for accelerated depreciation), the effective tax rate can be negative.
In addition to reducing revenue, the tax preference for debt causes familiar taxpayer responses. On the positive side of the ledger, debt imposes discipline on managers. If a firm has no debt, managers can choose what to do with the firm’s cash, so they are freer to use it in self-interested ways. But once the firm has debt, managers have less discretion, since they have to pay interest. To avoid this constraint, self-interested managers may shy away from issuing debt, so the tax preference for debt plays a useful role in countering this impulse.
Yet on the negative side of the ledger, debt increases the risk of bankruptcy, which is a costly process. As a result, a tax preference for debt is likely to increase bankruptcy costs.
Alternatively, it can induce costly financial innovation, as hybrid securities are developed that offer a tax deduction but do not increase bankruptcy risk as much.
When firms respond by taking on more insolvency risk, the tax preference for debt can cause another distortion as well: Managers have the incentive to take unwise risks when firms are on the brink of insolvency. Even if a risky initiative is unlikely to pay off, managers “swing for the fences” because they personally share in gains (by avoiding the reputational cost of bankruptcy) but can shift losses to creditors (by reducing their recovery in bankruptcy).
4. Corporate Lock-In. — The high corporate tax distorts managerial behavior in another familiar way: Managers hesitate to sell appreciated assets, since selling them triggers corporate tax on the appreciation.
If the tax is high enough, managers keep unwanted business units, intellectual property, and passive investments. Although managers are supposed to allocate scarce capital to the most promising opportunities, this “lock-in” effect impedes this process by favoring appreciated assets that the firm already owns.
In some cases, managers can use planning strategies to avoid lock-in. In effect, they dispose of appreciated assets tax-free, for instance, with spinoffs or derivative transactions.
When these strategies are available, lock-in no longer impedes the efficient allocation of a firm’s assets. Yet these strategies cause other distortions instead. In addition to paying advisory fees, the firm has to comply with a host of technical requirements, which can affect the structure and economic return.
While high corporate taxes encourage firms to hold onto appreciated assets, high shareholder taxes do not; instead, high shareholder taxes induce a different form of lock-in by encouraging shareholders to keep appreciated stock. These dueling lock-in effects are a quintessential example of why shifting tax from corporations to shareholders alleviates some distortions, while exacerbating others. For example, suppose a corporation has appreciated assets while the firm’s shareholders have appreciated stock. Both the corporation and its shareholders have a tax incentive not to sell. Cutting the corporate rate mitigates the corporation’s lock-in. But if this cut is funded by increasing the shareholder rate, shareholder lock-in is exacerbated.
5. Comparative Advantage of Corporations over Shareholders in Tax Planning. — Another challenge in collecting tax from corporations, instead of from shareholders, is that corporations enjoy greater economies of scale in tax planning than do shareholders. When firms incur advisory fees and other structuring costs, all shareholders share in these costs. In contrast, individual shareholders cannot pool costs in the same way.
Admittedly, this difference should not be overstated, since corporations do not always use their comparative advantage. Managers can be wary of tax planning, since they bear reputational costs when strategies fail but share tax savings with shareholders when strategies succeed. Even so, there are familiar ways to mitigate these agency costs, including legal opinions to protect managers’ reputations, as well as bonuses for lowering the firm’s effective tax rate.
When managers are motivated to engage in tax planning, they focus on corporate taxes instead of on shareholder taxes. Corporate taxes are more likely to affect standard metrics of their performance, such as reported earnings.
Managers also have less control over shareholder taxes, which often turn on shareholder choices (e.g., about when to sell) and vary with each shareholder’s tax bracket.
6. Incidence. — A further challenge with relying on the corporate tax is the uncertainty about who actually pays it. Obviously, the corporation writes the check. But does this payment reduce the investment return of shareholders, lower the salary of employees, or raise the price paid by consumers? If the goal of taxing “rich” corporations is to tax high-income investors—as voters often assume—this goal is not achieved if the burden actually falls on low-income workers.
A key reason why corporate taxes may burden workers is income shifting. If firms respond by shifting real activity overseas, there is less capital in the United States, reducing the productivity and wages of U.S. workers.
Yet this effect will not necessarily arise if firms shift income with planning, instead of moving real activity.
Shifting income also is not a viable strategy—so incidence is not likely to be on workers—when U.S. firms earn rents, are not capital intensive, or cannot easily rely on foreign production. Therefore, it is unclear how much of the corporate tax is borne by investors, as opposed to workers.
Does the same issue arise with a shareholder tax? Although generalizations are hard, there is a reason why shifting the corporate tax to workers could be easier than shifting the shareholder tax: If workers refuse to take a pay cut, managers can avoid this expense by moving the business offshore, which is costly to workers. “If you will not absorb this cost for us,” managers can say, “we will move our operations out of the United States, and you will lose your jobs.” But unlike the corporate tax, the shareholder tax cannot be avoided by moving the business offshore. As noted above, U.S. shareholders are still taxed on dividends and capital gains, even if the underlying profit is earned abroad.
Since this tax cannot be avoided another way—which is even more costly to workers—employees are under less pressure to accept lower pay. For this reason, the incidence of corporate and shareholder taxes could be different. Yet even so, it is hard to know whether this is actually the case.
7. Tailoring the Tax Burden to Individual Circumstances. — Finally, another limitation of corporate taxes is that, unlike shareholder taxes, they use a rate that does not account for the other income of shareholders (or others who bear the tax’s economic burden).
The brackets of a corporate tax are based on the income of the firm, not the income of shareholders (or other stakeholders).
So if a corporation earns enough to be in the top bracket, the same (top) corporate rate applies (indirectly) to all shareholders (and other stakeholders). Retirees with low incomes are treated the same as the CEO.
This blunt approach creates familiar efficiency and distributional concerns. Corporations are treated differently than pass-through businesses, whose owners are taxed at their personal rate, which accounts for other income.
This discontinuity can distort behavior.
In addition, using a rate that fails to account for other income is a flawed way to pursue distributional goals.
C. High Shareholder Taxes: Planning Strategies and Other Challenges
To show why the allocation between corporate and shareholder taxes is important—even when rates are coordinated to produce a specific combined rate (e.g., 40%)—the last section showed that a high corporate tax motivates a range of planning strategies.
For instance, if the corporate tax is 40% and the shareholder tax is 0%, corporations are likely to respond by shifting income abroad, changing their tax residence, issuing more debt, and delaying the sale of appreciated assets.
In response, these planning strategies can be preempted by cutting (or even repealing) the corporate tax. Since taxpayers are less motivated to avoid a low tax, they would have less reason to invest in these strategies or to change their behavior in other ways. But unfortunately, this progress is not free. If the cut in the corporate tax is funded with an increase in the shareholder tax—so the corporate tax is 0% and the shareholder tax is 40%—taxpayers have a correspondingly stronger incentive to avoid shareholder taxes. Instead of using the strategies discussed above, they would use other strategies to avoid the shareholder tax. This section canvasses planning strategies that are appealing when shareholder rates are high and corporate rates are low. The bottom line is that changing the mix of rates eases one set of distortions but exacerbates another.
1. Shareholder Lock-In. — A familiar challenge with relying on shareholder taxes, instead of on corporate taxes, is that shareholders control the timing of an important component: the tax on share appreciation. Unlike corporate income, which is taxed every year, share appreciation is taxed only when stock is sold.
By discouraging sales, a capital gains tax “locks in” shareholders, distorting portfolio choices and encouraging costly hedging transactions. Not only can this tax be delayed, but sometimes it can also be avoided entirely: Shareholders are never taxed on capital gain if they hold appreciated stock until they die
or contribute it to charity.
Obviously, these strategies become more appealing when the shareholder rate increases.
So if the shareholder tax is raised in order to fund a cut in the corporate tax, more shareholders will use these strategies to delay or avoid the capital gains tax.
2. Trapped Earnings. — Like the tax on share appreciation, the tax on dividends can also be delayed. This tax is not due until a dividend is actually paid.
At first blush, delaying the dividend tax may seem advantageous, but delaying this tax actually does not reduce its present value (as long as the rate does not change).
Even so, there is a different tax reason to delay a dividend, which is not prompted by a high shareholder rate, but by a low corporate rate. When the corporate rate is low, firms have a comparative advantage over shareholders in investing money.
For instance, assume the shareholder rate is 40%, the corporate rate is 0%, and the personal rate is 40% (i.e., on pass-through businesses, rents, interest, etc.). Because the corporate rate is 0%, investments grow tax-free inside a corporation. But if the firm distributes earnings, and shareholders do not reinvest them in a corporation, the shareholders’ investments generally are taxed at the 40% personal rate.
So if the pretax return is the same, the investment grows faster inside a corporation. As a result, corporations function like a tax-advantaged account when the corporate rate is lower than the personal rate.
This tax advantage of corporations was widely used when corporate rates were significantly lower than personal rates.
Although this planning receded when this gap narrowed in 1981, it would revive if the gap were to widen.
Unfortunately, this tax preference for retained earnings is likely to exacerbate agency costs. Retained earnings are problematic because managers have unfettered discretion to spend them. In contrast, if profits are distributed to shareholders, managers no longer have capital on hand. To pursue new initiatives, they have to persuade investors to write a check. The need to make a case disciplines managers, discouraging them from proposing self-interested uses of capital.
Since leaving cash in the corporation undermines this discipline, tax rules that encourage firms to keep cash breed agency costs.
This is a problem not only with favoring retained earnings, but also with collecting tax from shareholders instead of corporations: If the check comes from shareholders, the corporation keeps more of its cash, leaving managers in control of more resources.
Shareholder taxes can also affect corporate cash flow in another way. Taxing dividends creates a timing mismatch for shareholders whose stock has not appreciated: Current income from the dividend is offset by future capital loss when they sell stock.
One way to avoid this mismatch, emphasized by Professor David Weisbach, is to accelerate dividends, paying them before stock is sold to a new owner with shares that have not appreciated.
Conversely, another solution is to delay dividends until shares appreciate. Still another (partial) fix is to cut dividends, so the magnitude of this mismatch is reduced.
3. Salary Shifting. — When the shareholder rate is high—or, to be precise, when the corporate rate is low—another planning strategy becomes appealing: Owners who are also employees pay themselves below-market salaries. This strategy is appealing when the personal rate (which governs salaries) is higher than the corporate rate. To implement this strategy, employee-owners leave money inside the corporation, instead of taking it out as salary. There is not much economic significance to leaving money in the corporation, since the employee-owner owns and controls it. But the tax treatment changes: (High-taxed) salary is transformed into (low-taxed) corporate earnings.
This “salary shifting” loses its appeal if the corporate rate is increased to match the personal rate. But unfortunately, raising the corporate rate exacerbates income and residence shifting, as well as the other problems discussed in section I.B. In theory, to avoid all of these distortions, the U.S. corporate rate has to equal both the U.S. personal rate (to deter salary shifting) and foreign corporate rates (to deter income and residence shifting). But this solution is mathematically impossible under current law, since the U.S. personal rate is significantly higher than foreign corporate rates. So once again, we have to pick our poison.
4. Tax-Exempt Shareholders. — Another familiar problem with shareholder taxes is that, unlike corporate taxes, they do not reach tax-exempt shareholders.
For instance, assume that tax-exempt shareholders own a for-profit corporation, which earns $100 million. If the corporate tax is 40% and the shareholder tax is 0%, $40 million of tax is collected. But if these rates are flipped—so the corporate rate is 0% and the shareholder rate is 40%—no tax is collected.
This gap in investor-level taxes is already an issue for debt. Under current law, tax-exempt lenders pay no tax on interest, but corporations can still deduct it.
As a result, the United States collects no tax on revenue servicing this debt. This hole in the tax base would grow if equity were also taxed only (or primarily) at the investor level. Significant revenue is at stake, since less than half of U.S. equities are held by taxable U.S. shareholders; tax-exempt and foreign shareholders own the rest.
This gap in shareholder taxes complicates any effort to fund a corporate tax cut with them.
Obviously, the treatment of tax exempts does not have to be binary. Instead of paying a full tax or no tax at all, they could pay an intermediate amount, as with the (indirect) corporate tax under current law. How much they pay should depend, at least in part, on the reasons for exempting them. Since the rationales vary with the type of tax exempt, the tax could vary too. For example, individual retirement accounts (IRAs) encourage savings, especially for low-income people. So do pension funds, although distribution features less prominently (since there are no income limits).
By contrast, exempting investment income of universities, religious organizations, and cultural institutions is supposed to promote their charitable missions. But another tax preference—the charitable deduction—also advances this goal and is arguably more effective. The deduction rewards charities for attracting support from donors; government money flows only if donors are willing to contribute their own money and thus have “skin in the game.”
In contrast, exempting investment income rewards charities for running a surplus and investing it successfully, which is a less reliable signal of social value.
In fact, nonprofits with investment income are under less pressure to raise new money. They have less need to demonstrate continuing value to donors, especially when investment income is tax-free and thus covers more of their budgets. As a result, the deduction arguably promotes positive externalities more effectively than the exemption does. Yet even if these rules are equally effective, charity can still be subsidized without the exemption, as long as the deduction is available. A cut in one can be offset with enhancements to the other.
5. Foreigner Shareholders. — Like tax exempts, foreigners are taxed indirectly by the corporate tax, but (largely) escape shareholder taxes.
So if shareholder taxes are increased to fund a cut in corporate taxes, foreign shareholders would mostly be exempt from this increased shareholder tax. Under current law, foreigners pay no tax on capital gains.
Although foreigners’ dividends are subject to withholding, treaties often reduce the rate of the withholding tax that applies to these dividends (e.g., from 30% to 15%).
So if foreigners own a U.S. corporation that earns $100 million, $40 million of tax is collected with a 40% corporate tax and a 0% shareholder tax. But no tax is collected if these rates are reversed, as long as shareholders earn capital gains instead of dividends. Like tax exempts, foreigners already avoid both corporate and investor taxes in lending to corporations. This gap would grow if equity were also taxed only (or primarily) at the investor level.
A key question, then, is how much tax foreigners should pay. Taxing them enhances national welfare in three ways. First, it keeps resources in the U.S. economy.
Second, revenue targets can be met with a lower (and less distortive) tax on U.S. firms and shareholders. Third, taxing foreign owners of corporate businesses matches the treatment of noncorporate businesses, whose foreign owners already pay tax on U.S. profits. (The politics are tempting as well, since foreign investors do not vote in the United States.)
Even so, taxing foreign investors has two offsetting costs. First, the United States might attract less foreign investment. Yet a zero rate seems like an overreaction, even though the United States exempts interest for this reason. After all, investing in the United States is appealing,
so foreigners presumably will pay some tax to do so. Second, if the United States raises taxes on foreigners, other jurisdictions might reciprocate with higher taxes on U.S. investors. If Americans claim more foreign tax credits, the United States might not raise (net) revenue.
So far, the focus has been on revenue losses when a corporate tax cut is funded with higher shareholder taxes: Less revenue is collected from foreign and tax-exempt shareholders of U.S. corporations. However, these rate changes offer offsetting revenue gains as well: More is collected when U.S. shareholders invest in foreign firms that earn money abroad.
The corporate tax does not reach foreign profits of foreign firms, but the shareholder tax does. Therefore, cutting the corporate rate and raising the shareholder rate collects more tax on these profits.
6. Administrative Costs. — In addition to the revenue losses from exempt and foreign shareholders, another challenge in taxing shareholders, instead of corporations, is the loss of economies of scale in compliance and collection. Corporations can spread the cost of advice, record-keeping, and other infrastructure across all shareholders. For the government, monitoring the firm is more cost effective than policing (and suing) owners of small blocks of stock.
Even so, these administrative advantages have become less compelling over time. Superior expertise has enabled corporations not only to comply with rules, but also to avoid them, as emphasized above.
At the same time, third-party reporting of dividends and basis has helped the government monitor shareholder compliance more effectively.
7. Tax Expenditures. — Finally, another difference between corporate and shareholder taxes is that shareholder taxes have less influence on managers. In theory, since shareholder taxes affect a shareholder’s return, a manager should try to minimize them. But tax-exempt and foreign investors do not want managers to devote resources to these efforts—since these shareholders would not benefit—and shareholder taxes also have a less immediate impact on reported earnings.
Since managers do not focus on shareholder taxes, tax expenditures have less influence on corporate behavior when included in shareholder taxes, instead of in corporate taxes. Of course, this is a disadvantage only if the relevant tax expenditures are good policy. If they are not, reducing their impact is actually an advantage.
II. Balancing Component-Rate Distortions: Advantages of Using Two Taxes
Part I laid out key challenges in taxing corporations, on the one hand, and shareholders, on the other. Cutting one rate and raising the other fixes some problems while complicating others. What is the right response to these dueling distortions? Obviously, one answer is to fix the relevant rules, so they cannot be gamed. In theory, if all the holes in each tax were plugged, taxpayers would no longer be able to avoid either one. Each tax would measure income in the same (perfectly accurate) way. But although the rules can certainly be improved, and these improvements should be an important priority, it is too optimistic to expect all these planning strategies to be foreclosed. The administrative and political challenges are too formidable. Instead, it is more realistic to expect at least some gaps in each tax to endure.
So if these dueling distortions are likely to be a perennial challenge, what is the right response? Since each tax has significant gaps, one option is to get rid of at least one of these porous taxes, and to do the best we can with the other. But as this Part explains, the opposite is actually a better strategy. Instead of relying on one tax or the other, this Essay’s central recommendation is to use both. Although it may seem counterintuitive, the fact that each tax is flawed is all the more reason why both are needed.
A. Value of Keeping Both Taxes
1. Built-In Redundancy. — There are three reasons to rely on both corporate and shareholder taxes. First, the government gets two bites at the apple. If one tax is not collected, the other still is. For instance, even if corporations avoid the corporate tax by shifting income abroad, shareholders are still taxed on dividends and capital gains. To make a system more reliable, engineers often add a backup.
This built-in redundancy is useful not only for planning strategies already in use, but also for ones that have not been developed yet. Just as the Treasury’s integration study twenty years ago did not worry about income shifting and inversions,
it is not possible to predict what leaks and distortions will arise two decades from now.
Admittedly, built-in redundancy is effective only when two systems have different vulnerabilities. If the two taxes measure income in precisely the same way, there is no advantage in using both taxes instead of only one. Rather, for one tax to work when the other does not, their limitations have to be somewhat uncorrelated. Corporate and shareholder taxes satisfy this condition. As this Essay has emphasized, these taxes define income somewhat differently and thus are avoided with different planning strategies. Admittedly, these disparities are conceptually unsatisfying, since it is not clear why two regimes that measure business profits should yield different answers. But ironically, these disparities facilitate built-in redundancy, which is a meaningful silver lining.
2. Repeal Is an Overreaction. — A second reason to use both taxes is that, if the goal is to cure distortions from a tax, repeal is too drastic a remedy. Instead, cutting the rate is often sufficient. As long as the rate is low enough, paying a tax is cheaper than avoiding it. After all, tax planning is not free. Taxpayers have to hire advisors, incur transaction costs, and change business decisions in ways that otherwise are unappealing. These costs are justified only if they are less than the tax.
Obviously, the magnitude of these costs varies for different strategies. For instance, moving factories abroad might be cost effective when the U.S. corporate rate is 10% higher than in other jurisdictions, but not when it is only 7% higher. Likewise, the threshold for moving patents offshore could be a 7% gap, while the threshold for intercompany debt could be 5%. If this differential narrows to 3%, shifting income may no longer be worth the trouble.
When tax planning has this sort of cost curve, cutting the rate winnows out costlier strategies. As the rate is reduced, fewer strategies remain cost effective. If even the cheapest strategies involve significant costs, rate cuts can meaningfully ease distortions—indeed, almost as effectively as repealing the tax—while still collecting some revenue.
3. Repeal of One Tax Puts More Pressure on the Other. — Third, this revenue is another advantage of using both shareholder and corporate taxes. If one of these taxes is eliminated—instead of merely cut—the surviving tax has to be even higher (assuming the two taxes, in combination, have to meet a revenue target). For instance, assume the goal is to mitigate distortions from both corporate and shareholder lock-in. The severity of corporate lock-in depends on the corporate rate (C), while the magnitude of shareholder lock-in depends on the shareholder rate (S). If tax must be collected either from corporations or shareholders, there is a tradeoff: To ease shareholder lock-in (by cutting S), we have to exacerbate corporate lock-in (by raising C), and vice versa. Cutting one tax more than necessary puts more pressure on the other.
If a 0% rate is used for one, when a 10% rate would be just as effective at eliminating the relevant distortion, the other rate has to be correspondingly higher, and thus more distortive.
B. Challenges in Keeping Both Taxes
1. Combined-Rate Decisions: Irrelevance of Rate Allocation. — To be clear, although using two taxes can ease distortions from component-rate planning (such as corporate and shareholder lock-in), it cannot do so for combined-rate planning. For instance, only the combined rate matters when taxpayers decide to use a corporation instead of a partnership or, for that matter, to save money instead of spending it. For these combined-rate choices, whether tax is collected from corporations or shareholders usually is irrelevant; it matters only in changing the combined rate (e.g., by altering the present value of what is actually collected) or in shifting the incidence of the tax, as noted above.
2. Imperfect or Unstable Coordination. — Moreover, even for component-rate planning, using two taxes is not a panacea. Although relying on both taxes has distinct advantages, a key challenge is that it is not easy to coordinate corporate and shareholder rates so they always aggregate to a particular combined rate. After all, an important rationale for using two taxes is that, if one is avoided, the other is still collected. When this happens, only a portion of the combined tax is collected, rather than the entire amount. This means the combined rate does not apply uniformly to all economic activity. Of course, these disparities are likely to be even greater if the system relies on only one tax, which sometimes can be avoided entirely. But even so, using two taxes is not a complete remedy. It still is necessary to shore up both taxes, so they are actually collected. In addition, the challenge is not just to coordinate rates now, but also over time. This is particularly difficult, since Congress constantly tinkers with tax rates.
Ideally, rates would be coordinated so one adjusts automatically when the other is avoided or changed. Current law does not supply this sort of coordination, but there are various ways to do so. For example, a reduced shareholder rate for dividends could be available only if the firm has paid tax on the distributed profits. Alternatively, dividends could be deductible only if the firm withholds shareholder tax on the distribution. Likewise, shareholders could reduce their tax bills by claiming a credit for tax the corporation already has paid; under this “imputation” system, shareholders would backstop any tax the corporation was supposed to pay. By cutting its tax bill, a corporation would reduce the shareholder’s credit and thus increase the shareholder’s tax liability.
Instead of an automatic adjustment when a taxpayer avoids one of the taxes, a less ambitious approach is an adjustment when Congress changes the rate schedule. For instance, Congress could impose a statutory relationship between corporate, shareholder, and personal rates, so that a change in one automatically triggers adjustments in the others. Obviously, Congress would be free to repeal this formula (or to override it explicitly) when changing rates. Yet if it does not do so, the desired balance is maintained as rates change.
3. Administrative Costs. — Another challenge with using two taxes is that administrative costs are higher.
The government has to administer both taxes, and taxpayers have to comply with them. With one regime, administrative costs are likely to be lower.
This is not a trivial advantage, since these regimes are complex. The corporate tax, in particular, is extraordinarily intricate.
Even so, the administrative savings from repeal may not fully materialize for two reasons. First, if only one tax is used, it will have to be shored up,
and these enhancements are likely to increase compliance and enforcement costs. Second, if taxpayers believe the repealed regime may someday be reinstated, their compliance costs will not go down as much. For instance, if the corporate tax is repealed, would corporations be confident enough in the permanence of this reform to stop tracking their tax basis in assets? In any event, even if a second tax adds administrative costs, this is the price of built-in redundancy and the other advantages of two taxes.
III. Implications for Incremental Reforms
As Part II emphasized, the fact that corporate and shareholder taxes have different gaps allows them to backstop each other.
One tax can still raise some revenue, even when the other is avoided.
In addition, using two taxes allows each one to have a lower rate.
As a result, planning strategies that avoid only one tax become less appealing.
In theory, if all the gaps in one tax are eliminated, the other tax is no longer needed as a backstop. But as a practical matter, even the most ambitious reforms are unlikely to plug all the gaps in one tax (without creating new ones). Part IV argues that even fundamental reforms benefit from using both taxes, instead of only one.
The same is true of more modest reforms that preserve the broad outlines of current law. This Part focuses on modest reforms, which, as this Essay has emphasized, should preserve both taxes.
While the focus here is on policy, politics obviously also plays a role. So in addition to highlighting important policy choices and offering illustrative examples of targeted reforms, this Part also briefly surveys political dynamics that are likely to influence business tax reform.
A. Three Interrelated Choices for Incremental Reform
After deciding to keep both the corporate and shareholder tax, Congress still faces three interrelated choices, which this section considers in turn. First, what should the total tax burden be on corporate profits? Second, how should this combined burden be divided between corporations and shareholders? This allocation should depend on the severity of the component-rate distortions from each tax: The more distortive tax should have a lower rate. Third, what targeted reforms should be used to shore up each tax? Notably, these reforms can influence the second decision—that is, the balance between the shareholder and corporate rates. While the less distortive tax should have the higher rate, the fact that one is less distortive now does not mean it will always be less distortive, since targeted reforms can make a tax less distortive. If one tax is shored up more than the other, its share of the overall tax burden should increase.
1. The Combined Rate on Corporate Profits. — In any event, in using one tax or two, Congress must decide how much to tax corporate profits. In making this choice, Congress should consider a range of familiar issues, including empirical estimates of elasticity, incidence, and distributional impact, as well as the nation’s revenue needs and social-welfare function.
Since these issues are beyond this Essay’s scope, this Essay does not recommend a rate and offers 40% only as an illustrative example.
Even so, in focusing on planning, this Essay’s analysis has four implications for rates. First, the rates on corporate and noncorporate businesses should be comparable, since disparities breed familiar distortions.
Second, corporate and shareholder taxes are inefficient revenue sources. To ease the pressure on these porous regimes, rates should be low. The revenue cost of low rates is less than it may seem, since effective rates are much lower than stated rates under current law.
Therefore, lower stated rates can generate the same revenue, as long as they are actually collected. Third, high rates advance distributional goals only if the incidence of these taxes is on high-income investors, instead of on low- and middle-income employees.
Even then, these inefficient taxes may not pursue distributional goals as effectively as other policy instruments, such as progressive wage taxes. Fourth, Congress should be wary of taxing private businesses at a (much) lower rate than the personal rate. Otherwise, employee owners will convert salary to business profits, treat personal consumption as business expenses, and the like.
2. The Balance Between Corporate and Shareholder Rates. — Once Congress picks the combined rate for corporate profits, it must allocate this burden between corporate and shareholder taxes. For each one, a lower rate would induce fewer distortions. But since these taxes have to aggregate to the combined-rate target (e.g., of 40%), cutting one means increasing the other. If these taxes are equally distortive, the goal should be for both taxes to be as low as possible, so the rates should be the same. Each should be 22.5%, which is the minimum rate for both taxes that aggregates to 40%.
If one is lower than 22.5%, the other has to be higher.
Yet these rates should not necessarily be the same; rather, if one tax is more distortive than the other, its rate should be lower in order to mitigate its (more severe) distortions. If one is slightly more distortive, it should have a modestly lower rate. But if one is significantly more distortive, it should have a much lower rate. If the corporate tax induces more planning—as seems likely, although this empirical question cannot be resolved here—its rate should be lower.
Obviously, this is the opposite of current law (35% for corporations and 23.8% for shareholders).
In any event, instead of 22.5% for both rates, a better split would be 20% for corporations and 25% for shareholders or, for that matter, 15% for corporations and 29.5% for shareholders.
3. Adjustments for Targeted Reforms. — Raising the shareholder rate obviously increases the pressure on this tax. In response, targeted reforms should shore up some of its familiar vulnerabilities. With these changes, Congress could increase the shareholder rate even more.
Likewise, Congress could cut the corporate tax a bit less if targeted reforms plug some of its leaks. More generally, the appropriate balance of rates can shift if targeted reforms address some of the distortions discussed above. These reforms are needed, moreover, to enable the combined rate that is actually collected to come closer to the combined rate on the books.
B. Political Constraints on Reform
While decisions about rates and reforms should be based on rigorous policy analysis, politics inevitably plays a role as well. So before the next two sections offer examples of incremental reforms, this section provides a few observations about political dynamics that are likely both to constrain and shape business tax reform.
Fortunately, both sides of the aisle recognize the need to reduce the corporate rate and reform the rules for multinationals. Nevertheless, support for reform in the abstract does not translate into a consensus for specific proposals, which are vigorously debated.
Reaching a consensus is difficult for four reasons. First, the business community is divided. To fund a corporate rate cut, firms want to repeal tax breaks for others, instead of tax breaks for themselves. For instance, limits on income shifting are more appealing to sectors that cannot shift income anyway, such as retail and real estate.
Similarly, cutting the corporate rate does not benefit pass-through businesses, so they do not want it funded with increases in their taxes, such as repeal of accelerated depreciation. Self-interest also colors the perspective of managers. For instance, since they benefit from retaining earnings, they may resist reforms that encourage distributions.
Second, statutory rates for corporations and shareholders are politically salient. As a result, some Democrats are reluctant to support tax cuts for “rich corporations,” even though the tax burdens workers as well as investors.
Meanwhile, Republicans face a parallel political constraint. Although they want to cut the corporate rate, they are reluctant to pay for it with higher shareholder rates.
Third, although rates are politically salient, gaps and planning strategies are not. The average voter does not have the esoteric knowledge to understand these gaps or to monitor efforts to plug them. Therefore, organized interest groups wield disproportionate influence, which they use to block or water down these reforms.
The result is stated rates that are much higher than effective rates, a combination that has familiar political advantages and policy disadvantages.
Finally, a political downside of cutting the corporate rate is that this tax is invisible to many who bear it.
Shareholders are more likely to focus on taxes they pay than on taxes corporations pay for them. Unsophisticated investors ignore the corporate tax because they do not write the check, while sophisticated investors know that some of this burden is shifted to workers. Meanwhile, workers are even less aware of the corporate tax’s impact on them. As a result, many beneficiaries of this tax cut would not realize they are benefitting and thus would show less gratitude to politicians for supporting it.
Even so, the political payoff would still be substantial if reforms improve the anemic U.S. growth rate. Rising wages, lower unemployment, and booming real estate and stock markets generate good will (and greater job security) for elected officials. To reap these policy and political benefits, political leaders may seek a “grand bargain,” funding a corporate tax cut with base-broadening reforms and higher shareholder rates. But admittedly, the political case for this package is weaker than the policy case, so its prospects are uncertain.
C. Incremental Reforms to Ease Distortions from a High Shareholder Rate and a Low Corporate Rate
Since the corporate tax is probably more distortive than the shareholder tax, Congress should cut the corporate rate and make up the revenue by increasing the shareholder rate, as noted above. But how large should this shift be? If the combined rate is 40%, should the corporate and shareholder rates be 20% and 25%? Or 18% and 25%? Or 15% and 29.5%? Or something else?
As emphasized above, two constraints complicate this shift from corporate to shareholder taxes. First, the shareholder tax also has gaps, which are more likely to be exploited as the shareholder rate increases. Second, a low corporate rate—and, in particular, one that is lower than the personal rate—causes distortions of its own. In response, Congress should consider reforms to ease these distortions. This section gives illustrative examples of how to do so. Of course, even without this shift from corporate to shareholder taxes, these reforms should be considered. Yet this shift in rates lends greater urgency to these reforms.
In offering examples of incremental reforms, this Essay’s goal is not to offer a comprehensive analysis of any specific reform, advocate for a particular reform package, or argue that these reforms are politically plausible. Although the reforms in this section largely preserve current law,
some are more politically plausible than others. Rather, these examples are supposed to provide a more concrete sense of how the shareholder tax can be shored up and also to emphasize the connection between reforms and rates. This sort of reform allows Congress to raise the shareholder rate—and cut the corporate rate—even more.
1. Tax-Free Appreciation: Charitable Contributions and Stepped-Up Basis. — One reform strategy is to block two familiar ways of avoiding the shareholder tax: contributing appreciated stock to charity and holding it until the shareholder dies. Under current law, these steps permanently shelter share appreciation from income tax.
To plug this gap, one option is to tax the holder of the appreciated stock. To do so, a reform could treat bequests and charitable contributions as taxable sales. Another alternative is to limit the charitable deduction to the taxpayer’s basis
and to require heirs to use the donor’s “carryover” basis.
If Congress has the political will to revoke these tax benefits—and, frankly, it is not clear that Congress does—these reforms would make the shareholder tax a more reliable source of revenue, so steeper cuts in the corporate tax would be feasible.
2. Salary Shifting and Trapped Earnings in Private Firms. — Two other familiar planning strategies complicate any effort to make steep cuts in the corporate rate. As noted above, these strategies become appealing when corporate rates are lower than personal rates (which apply to salaries and noncorporate businesses). First, entrepreneurs take below-market salaries, transforming high-taxed salary into low-taxed corporate income.
Second, earnings are retained, compounding at a higher after-tax rate than if they were distributed.
At first blush, these planning strategies seem to create a difficult tradeoff for Congress in setting corporate rates: Although low corporate rates exacerbate these distortions, they ease other distortions—for instance, by reducing the incentive to shift income
or reincorporate abroad.
But this tradeoff in using a low corporate rate is not as stark as it first seems, since these planning strategies appeal to different types of firms: One set of strategies is used by multinationals, while the other is popular with family firms. Specifically, income and residence shifting are plausible for multinationals, but not for small family businesses.
In contrast, salary shifting makes sense for family businesses, but not for multinationals. After all, for salary shifting to be a viable strategy, the employee has to own the business. Otherwise, she is sharing her salary with other owners, something the CEO of a multinational obviously would not do. Likewise, using a corporation as a tax-advantaged savings vehicle is also especially plausible for a family business, since the corporation can function like a family investment account.
Since a low corporate rate deters planning by multinationals, but encourages planning by family businesses, a solution is for Congress to offer the low rate only to multinationals. There are three ways to do this. Since multinationals are almost always public companies, one option is for the C-corporation form—and, therefore, the reduced rate—to be available only to public firms. Private businesses would have to be pass-through entities (e.g., LLCs, partnerships, or S-corporations) and thus would not have access to the reduced corporate rate.
Second, if the C-corporation form were still available to private firms, the rate structure should be adjusted so a higher marginal rate applies to family businesses (to deter salary shifting) than to multinationals (to deter income shifting). To accomplish this, the top personal rate (39.6%) should apply to the first $30 million of income—or another threshold approximating the earnings of successful family businesses—and a lower rate (e.g., 15% or 20%) should apply above that level.
Third, a special tax could be imposed when employees own more than a minimum percentage of a firm.
The profits of these firms could be divided into the return on capital (taxed at the lower corporate rate) and disguised labor income (taxed at the higher personal rate). As Professor Edward Kleinbard has proposed, these returns could be distinguished by applying an assumed rate of return to capital invested in the firm (e.g., measured by tax basis).
An extra tax could apply to profits above this level.
The bottom line, then, is that a corporate-rate cut implemented in one of these three ways can mitigate distortions from a high corporate rate (e.g., income shifting) without exacerbating distortions from a low corporate rate (e.g., salary shifting).
3. Trapped Earnings in Public Firms. — Yet cutting the corporate rate can create distortions not only in private firms, but also in public ones. Specifically, a low rate can discourage public firms from distributing earnings, as noted above.
This is undesirable because the managers of public firms already have familiar agency-cost reasons to hoard cash. By not distributing this cash, managers maintain control over it and can use it in self-interested ways (e.g., for perquisites or pet projects).
Yet targeted reforms can counter this tax incentive to retain earnings so that the corporate rate can be cut without “trapping” earnings in this way. For example, the accumulated earnings tax under current law is supposed to stop retained earnings “beyond the reasonable needs of the business.”
But this test sets a low bar, since the IRS and courts lack the expertise to apply it effectively; reinvesting in the business is sufficient, even if this is not the best use of capital.
Firms can also keep a significant amount of cash on hand.
Another approach, known as a “split rate” system, taxes retained earnings at a higher rate than distributed earnings.
Compared with the accumulated earnings tax, this alternative is easier to administer: Instead of imposing an extra tax only on excess retained earnings—a category that is hard to define—split-rate systems impose an extra cost on all retained earnings.
This differential is desirable, since dividends enhance corporate governance (by allowing investors to control this cash), but are undersupplied for agency-cost reasons (since managers usually prefer to control cash).
As a result, the tax cut is conditioned on a step we want managers to take, instead of ones we do not want to encourage, such as shifting real activity abroad for tax reasons.
4. Tax-Exempt Shareholders. — Under current law, the shareholder tax does not reach tax-exempt shareholders, but the corporate tax does so indirectly. In relying more heavily on shareholder taxes, then, Congress has two choices: It can give up on this revenue, or it can begin taxing tax exempts on dividends and capital gains.
Arguably, tax exempts should also pay tax on interest, so their debt and equity investments are taxed the same way.
In setting the rate for this new shareholder tax on tax exempts, one possibility is to offset the corporate rate cut.
For instance, if the corporate rate falls from 35% to 20%, this 15% of corporate tax can be replaced with an 18.75% shareholder tax.
Politically, the easiest way to justify this new tax on tax exempts is to argue that it replaces the tax they were already paying indirectly.
Yet in principle, the rate should not turn on what tax exempts already pay, but on a policy judgment about the right level. This assessment should account for social benefits of tax exempts, which vary for different types of exempt organizations. A further question is whether exempting investment returns is the most effective way to encourage the good work that nonprofits do (e.g., in providing health care, education, social services, etc.). As noted above, the tax exemption is arguably less effective at supporting this good work than the charitable deduction, which rewards nonprofits that attract donations instead of ones that invest a surplus successfully.
5. Foreigner Shareholders. — Like tax exempts, foreign investors are taxed indirectly by the corporate tax, but they (mostly) avoid the shareholder tax under current law.
Any effort to rely more heavily on shareholder taxes must either forgo this revenue or change the treatment of foreign shareholders.
Changing the rules for foreigners is harder than for tax exempts for two reasons. First, a vast network of tax treaties would have to be renegotiated.
In principle, the United States could override these treaties with legislation, as long as the intent to do so is clear.
But the United States rarely overrides treaties
and has done so mainly to target abuses.
Second, to collect this tax, the United States would need information about the holdings of foreigner shareholders, as well as infrastructure to withhold the tax. Although this infrastructure is already in place for dividends, one would have to be created for capital gains, which is not straightforward.
Assuming a tax on foreign shareholders can be collected, would it enhance national welfare? This revenue would add to the U.S. GDP, while allowing a lower rate to govern U.S. taxpayers. But there are two reasons to tread carefully, as noted above. First, the United States benefits from attracting foreign investors, although a low tax is unlikely to deter them given the unique appeal of the U.S. market. Second, if foreign governments respond by raising their taxes on U.S. investors, U.S. revenue would fall as U.S. taxpayers claim foreign tax credits. Therefore, taxing foreign shareholders enhances U.S. welfare only if the United States can still attract enough foreign investment and raise revenue on a net basis.
D. Incremental Reforms to Ease Distortions from a High Corporate Rate
Since the corporate tax is probably more distortive than the shareholder tax under current law, Congress has good reason to cut the corporate rate and make up the revenue by increasing the shareholder rate, as noted above. But these rate adjustments exacerbate other distortions, and the prior section canvassed various ways to mitigate them.
Of course, instead of cutting the corporate tax, a different strategy is to shore up this tax. If the corporate tax is strengthened, there is less need to cut this tax (or, at least, to cut it as much). If this strategy is successful, there also is less pressure to increase the shareholder tax (or, at least, to increase it as much). This section offers illustrative examples of how to diminish the need for these rate adjustments by strengthening the corporate tax.
Since there is an extensive literature on reforming the corporate tax,
only a few examples are offered here, which preserve the broad contours of current law. Again, the goal is not to advocate for particular reforms. Instead, these examples illustrate how to strengthen the corporate tax with incremental reforms, while showing how difficult this task is. In addition, this discussion emphasizes the connection between reforms and rates: Targeted reforms to strengthen the corporate tax can enable the cut in the corporate rate—and the offsetting increase in the shareholder rate—to be more modest.
1. Interest. — While this Essay recommends using two taxes, debt—unlike equity—is taxed only once under current law. Because firms can deduct interest, lenders pay the only tax on debt-financed revenue.
Using only one tax creates three problems. First, there is no built-in redundancy, so no tax is collected when lenders are foreign or tax exempt. Second, if the goal is to discourage tax planning, cutting this tax could be as effective as eliminating it. In a sense, the interest deduction is a form of repeal. Instead of cutting the corporate tax on debt-financed income, it eliminates this tax entirely. In doing so, the interest deduction is not an effective way to combat corporate tax planning; on the contrary, this deduction is actually an essential ingredient of many planning strategies for avoiding corporate tax.
Third, since no revenue is collected at the corporate level, the investor tax on interest has to be correspondingly higher and thus more distortive.
In response, some of this tax burden should be shifted to corporations. One way of doing so is to offer only a partial deduction for interest. Like travel and entertainment expenses, a portion of interest would be deductible (e.g., 50%). At the same time, Congress could offer an offsetting reduction in the lender’s tax on interest income. For instance, the same fraction of this income could be excluded (e.g., 50%). If the same deduction and exclusion were also applied to dividends, the tax preference for debt would be eliminated, along with the familiar distortions it causes.
Another alternative is to eliminate the interest deduction entirely, while cutting the corporate tax substantially. Broadening the base in this way can help fund the rate cut. At the same time, the treatment of interest and dividends could be conformed at the investor level. For example, if the target combined rate is 40%, the corporate rate could be 15% or 20% (with no interest deduction), while the rate for dividends and interest could be 29.5% or 25%.
2. Income Shifting. — In addition to the debt–equity distinction, another reform priority is to block income shifting. But this problem is excruciatingly difficult to overcome, as long as the United States continues to have a much higher corporate rate than other countries. In fact, the two leading options for international reform would exacerbate this problem, instead of solving it, by offering favorable treatment to foreign earnings: First, a territorial system would tax U.S. multinationals only on U.S. earnings, exempting foreign earnings; second, a minimum tax would tax U.S. multinationals on both their U.S. and foreign earnings, but would apply a reduced rate to foreign earnings.
In theory, income shifting can be blocked with better source rules, which treat income as really earned in the United States, even if taxpayers say otherwise. A virtue of reforming source rules is that they govern both U.S. and foreign firms, so tougher rules do not put U.S. firms at a comparative disadvantage.
But source rules are hard to improve for a familiar reason: Conceptually, the source of income is often unclear.
For instance, profit from a cellphone could be characterized as originating not only from where its technology was invented, but also from where it was manufactured or sold. Since source rules resolve this sort of issue in arbitrary ways, they are easy to manipulate.
Likewise, when value is added in different jurisdictions, the allocation of profit among them is malleable. Multinationals include low-tax affiliates in the production process and allocate disproportionate profits to them.
This internal accounting has little significance—aside from cutting the U.S. tax bill—since the same shareholders own all these affiliates.
In response, a familiar alternative is to ignore this internal accounting. Instead, income can be allocated with a formula based on the location of the firm’s employees, property, and sales.
Yet this sort of formula also can be manipulated in familiar ways, for instance, by moving employees and capital to low-tax jurisdictions.
At first blush, sales may seem harder to manipulate, since firms want to sell their products in the United States.
But firms can still access the U.S. market without (technically) having any U.S. sales: They can sell to an independent distributor in a low-tax jurisdiction, which then sells in the United States. Even if these avoidance strategies are blocked, the formula still has to be coordinated with other jurisdictions to prevent double taxation. This is a tall order, since the OECD opposes formulary apportionment.
Instead of general changes in source rules, narrower reforms can target especially mobile deductions and income, such as interest deductions and intellectual property income. For instance, firms should not be allowed to source interest deductions in the United States—where they offset high-tax income—if the loan generates income in low-tax jurisdictions. A formula can block this strategy, at least to an extent, by allocating interest based on each affiliate’s earnings, assets, and equity.
Likewise, a tech firm’s profits derive largely from intellectual property. Instead of allowing firms to choose where to source these profits, a formula (or other rule) can allocate them based on the location of research or sales.
While this sort of narrow reform can offer some relief, income shifting will continue to be a serious problem as long as the corporate rate in the United States remains uniquely high. Thus, income shifting is a compelling reason to cut the corporate rate, since other reforms are unlikely to solve this problem on their own.
3. Residence Shifting. — In contrast, cutting the corporate rate is not the only effective way to eliminate the appeal of inversions. A territorial system accomplishes this goal by exempting a U.S. firm’s foreign earnings from U.S. tax. Like foreign firms, they pay only foreign tax on foreign operations and can repatriate earnings tax-free. At first blush, a territorial system seems to collect substantially less revenue, but this actually may not be the case, since the effective rate on foreign earnings is already low.
Even so, an important downside of a territorial system, noted above, is that the incentive to shift income persists and could even grow stronger.
However, if the United States continues to tax worldwide income, inversions will remain a challenge, unless Congress cuts the corporate rate substantially. For example, section 7874 blocks some inversions, while allowing others.
Although the Treasury has introduced a series of regulations to tighten up the rules, a truly comprehensive ban on inversions would be overbroad. For instance, if the rule were “once a U.S. firm, always a U.S. firm,” it could deter mergers with foreign firms that are not tax motivated, while also not stopping new businesses from organizing as foreign corporations.
Given these difficulties, current law does not seek to stop all inversions, but to make them incrementally more costly so that the trickle does not become a flood.
This task is more daunting when the corporate rate is 35%, instead of 15% or 20%.
IV. Implications for Fundamental Tax Reform
So far, this Essay has focused on incremental reform, but its core argument also applies to more ambitious reforms: Even when fundamental reforms seem economically comparable, they can induce different planning strategies, which usually are easier to block with two taxes than with one. This Part assesses the vulnerability of five fundamental reforms to the various planning strategies discussed above: first, the comprehensive business income tax; second, the “dual BEIT”; third, mark-to-market accounting or interest charges for shareholders; fourth, imputation; and fifth, corporate cash-flow taxation. While a comprehensive analysis of these proposals would fill several volumes, the modest goal here is to show the relevance of this Essay’s analysis to fundamental reforms.
A. Comprehensive Business Income Tax
One option, which the Treasury called the “comprehensive business income tax” in its 1992 integration report, is to replace current corporate and shareholder taxes with a single entity-level tax.
This proposal repeals the shareholder tax on distributions and possibly also on capital gains.
Similarly, businesses no longer deduct interest, and creditors do not include it.
This proposal offers four advantages. First, aligning the treatment of debt and equity eases an important distortion under current law.
Second, since debt features prominently in many tax-planning strategies, CBIT defangs these strategies. Third, a high entity-level tax eliminates the incentive to retain earnings or recharacterize salary as corporate income. Fourth, if capital gains are not taxed, shareholder lock-in ceases to be an issue.
Although these advantages are significant, they come at a steep cost. A high entity-level tax breeds familiar distortions, including income and residence shifting and corporate lock-in.
CBIT forgoes the advantages of built-in redundancy by collecting tax only once. Moreover, eliminating the shareholder tax, instead of merely cutting it, goes further than necessary to ease shareholder-level distortions.
B. Dual BEIT
An important problem under current law, emphasized above, is that debt and equity are taxed differently. A firm can deduct its cost of capital in issuing debt (since interest is deductible), but not in issuing equity (since dividends are not deductible). In principle, the treatment of debt and equity can be conformed in two different ways: On the one hand, a deduction for the cost of capital can be disallowed for both; on the other hand, this deduction can be allowed for both. The reform discussed in the last section, CBIT, uses the first strategy by repealing the deduction for interest expense. In contrast, another option is to authorize a deduction for equity. Put another way, the current (nondeductible) treatment of equity can be extended to debt (as CBIT does), or the current (deductible) treatment of debt can be extended to equity.
This second approach, which offers corporations a deduction for the cost of equity capital, is a prominent feature of the “dual BEIT.” This proposal’s author, Professor Kleinbard, seeks to tax corporate stock with rules based on current law’s treatment of debt. Every year, a firm would deduct (and investors would include) an amount based on its cost of capital, regardless of whether the firm issues debt or equity.
The amount that the firm deducts (and investors include) is based on what the firm’s cost of capital is assumed to be, and does not necessarily equal the amount the firm pays out in a given year.
Yet like current law’s treatment of interest, this approach has an important disadvantage: Since this assumed yield is taxed only at the shareholder level, not at the corporate level, there is no built-in redundancy. As a result, when investors are foreign or tax exempt, no tax is collected.
In addition to the investor-level tax, the dual BEIT also has an entity-level tax, but its use of two taxes is not consistent with the approach recommended in this Essay. The difference is that Professor Kleinbard divides a business’s return into two components—normal returns and above-normal returns—and uses a separate tax for each: Investors pay the only tax on normal returns, while the entity pays the only tax on above-normal returns. Therefore, the dual BEIT taxes each component of the return once, and only once. In contrast, this Essay recommends collecting some tax at both levels for both types of returns: Normal returns should be taxed at both the entity and investor level, as would above-normal returns. In a sense, Professor Kleinbard is slicing a business’s returns vertically (so each type of return is taxed by different taxes), while this Essay recommends slicing returns horizontally (so each type of return is taxed by both taxes). Therefore, even though the dual BEIT deploys two taxes, the division of labor between them is quite different.
Instead of relying on built-in redundancy and low rates to constrain planning, Professor Kleinbard uses more sophisticated rules to address various distortions. For example, he shows that taxing shareholders based on an assumed yield can mitigate lock-in and reduce an employee-owner’s incentive to recharacterize salary as investment return. While these reforms are promising, they could still be used in a system that taxes the entire return at both levels and thus offers built-in redundancy.
C. Mark-to-Market Accounting or Interest Charges
Another option is to use mark-to-market accounting to strengthen the shareholder tax, as Professors Toder and Viard, as well as others, have proposed.
Taxing gains annually—even when shareholders do not sell—offers two important advantages. First, it mitigates shareholder lock-in. Delaying a sale no longer defers capital gains tax. Likewise, bequests and contributions of appreciated stock no longer avoid this tax entirely (since taxpayers have to pay tax on appreciation every year).
A second advantage, which is less familiar, is that a mark-to-market tax on shareholders counters a firm’s tax incentive to retain earnings. Without this reform, if the corporate rate is lower than the personal rate, firms are more tax efficient investors than shareholders, since profits inside the firm are taxed at the (lower) corporate tax, while profits outside the firm are taxed at the (higher) personal tax. Eventually, profits inside the firm also are taxed at the shareholder rate, but this tax is deferred under current law.
In contrast, this deferral is eliminated under mark-to-market accounting, so investments inside the firm are taxed at both the corporate and shareholder rate.
As a result, these investments lose their tax advantage over investments outside the corporation.
Yet notwithstanding these benefits, a mark-to-market tax poses familiar valuation and liquidity challenges, which are manageable only for publicly traded assets.
Since this reform cannot be used for private businesses, collectibles, or real estate, it creates a tax preference for these investments. Investors may shy away from publicly traded assets, and owners of private firms may hesitate to go public.
To avoid this sort of distortion, the same timing rule has to apply to all investments. Since a mark-to-market rule cannot do so, a different remedy is needed for shareholder lock-in and trapped earnings. As an alternative, economist Harry Grubert and Professor Rosanne Altshuler propose to delay the shareholder tax until stock is sold, as under current law, but to add an interest charge to compensate the government for this delay.
Yet their proposal is less accurate than a mark-to-market rule. Instead of measuring the return each year, it uses (imperfect) assumptions to allocate gains across the relevant years, creating planning opportunities when these assumptions are inaccurate.
This is all the more true when a taxpayer’s bracket changes during these years.
In addition to creating new distortions, mark-to-market accounting and interest charges share two other limitations. First, unlike corporate taxes, they do not reach tax exempts and (mostly) miss foreign shareholders as well. Second, both proposals are likely to encounter political opposition. Rules that impose interest charges under current law are unpopular, as is taxing gains that could prove temporary.
While these proposals may be easier to sell if they applied only to high-net-worth shareholders, as David Miller has proposed,
this limit would introduce another boundary for taxpayers to game.
Therefore, in shoring up the shareholder tax with a mark-to-market rule or interest charges, the goal should not be to eliminate the corporate tax—even though this is what many commentators have suggested—but to cut it.
There are two reasons for this. First, if the corporate tax is repealed, tax exempts would escape tax entirely, and foreigners would (mostly) do so as well, unless the treatment of these taxpayers changes.
Second, collecting some tax from corporations relieves pressure on the shareholder tax. The shareholder rate does not have to increase as much, so shareholder distortions are not as severe (e.g., at the boundary between mark-to-market and realization).
Therefore, even when fundamental reforms strengthen the shareholder tax, two taxes still have advantages over one.
Still another reform option, an imputation system, adheres to this Essay’s core recommendation by collecting tax from both corporations and shareholders. The corporation pays the first tax, and shareholders pay a second tax at their individual marginal rates.
Since shareholders can claim a credit for tax already paid by the corporation, the corporate tax functions as a withholding tax. For instance, if the corporate tax is 35%, a shareholder whose marginal rate is 40% pays an additional 5% of tax, while a shareholder whose marginal rate is 20% receives a 15% refund.
The combined effect is to tax business profits at a shareholder’s individual marginal rate. Since a shareholder’s bracket depends on her other income, using this rate advances distributional goals. Another advantage is that this rate is also used for pass-through entities, as well as for corporate debt. Therefore, as Professor Alvin Warren has emphasized, imputation systems conform the rates for corporations and pass-through businesses, as well as for corporate debt and equity.
If an imputation system is enacted, will it deter the various planning strategies considered in this Essay? Overall, this reform is fairly effective in discouraging these strategies. A key reason is that an imputation system relies on two points of collection, instead of on one. As a result, the corporate tax backstops the shareholder tax. For example, the corporate tax can still reach foreign and tax-exempt shareholders indirectly, as long as they cannot claim a credit for this corporate tax.
Likewise, the shareholder tax can still backstop the corporate tax. For instance, income that is shifted abroad can still be taxed (eventually) at the shareholder level (when shareholders receive a dividend or sell stock); if no corporate tax was paid, shareholders cannot claim a credit.
Arguably, corporate and shareholder taxes backstop each other more effectively in imputation systems than under current law, since these taxes are better coordinated. When a corporation cuts its tax bill, it reduces the credit available to shareholders. As a result, income shifting and other corporate planning becomes less attractive, since it (potentially) increases the shareholder tax.
Some studies suggest that corporations engage in less planning under an imputation system (e.g., in Australia) and ramp up planning when imputation is repealed (e.g., in Europe).
Yet this effect should not be overstated, since corporations still have three reasons to cut their tax bills under imputation systems. First, these efforts still help shareholders who cannot claim a credit for corporate tax and thus do not face higher shareholder taxes when the corporation cuts its tax bill. Since tax-exempt and foreign shareholders are likely to be in this position, they will prefer firms with low effective tax rates. Indeed, activist pension funds and large foreign shareholders will likely lobby firms to ramp up corporate tax planning.
Second, taxable shareholders also have reason to join this chorus. Even though cutting the corporate tax bill reduces imputation credits, these credits are not always needed. Shareholders have other ways to avoid shareholder tax, such as deferring sales or contributing appreciated stock to charity. When these strategies are available, shareholders do not need imputation credits and are happy for the firm to cut its corporate tax bill. After all, even if taxable shareholders do not benefit when the corporation’s effective rate is lower than their (effective) shareholder rate, they do not want the corporation to have a higher effective rate. The corporate tax functions as a withholding tax, and shareholders do not want the firm to withhold tax that they may never owe. For instance, shareholders are taxed currently on dividends but not on retained earnings (as long as they do not sell shares). So shareholders need imputation credits only for dividends and want the firm to minimize the corporate tax on retained earnings.
More generally, an imputation system preserves familiar gaps in corporate and shareholder taxes.
Although it weakens incentives to exploit these gaps in some cases, it maintains them in others.
Third, even when shareholders do not benefit from corporate tax planning, managers still have agency-cost reasons to invest in it: Reporting higher (after-tax) earnings could inflate their equity compensation or bonuses. This incentive is especially pronounced in the United States, where equity compensation is pervasive. So even though evidence suggests that imputation systems have discouraged corporate tax planning in Europe and Australia,
these jurisdictions use equity compensation far less frequently, so the U.S. experience could turn out to be different.
Therefore, it is too optimistic to expect imputation, on its own, to shut down the various planning strategies in this Essay. But imputation still is a valuable step, especially if paired with a lower corporate rate, as well as other reforms to shore up the corporate and shareholder taxes. A key advantage of imputation is that—like current law and unlike some other proposals—it relies on two taxes, instead of on one. Imputation also has the advantage of coordinating these taxes more effectively than current law.
E. Cash-Flow Corporate Taxation
A final alternative, a “cash-flow corporate tax,” is a type of consumption tax. Its defining feature is that capital investments are deducted currently, instead of capitalized. Therefore, this reform avoids the challenge of calibrating depreciation to reflect economic reality (or encourage investment). As in a 401(k) plan, the deduction of investments spares the “normal” (or market-wide) return on capital from tax. Since this return is not taxed anyway, tax planning is not needed to shield it from tax.
But this reform is still supposed to tax above-market returns (for instance, when intellectual property creates market power) as well as disguised labor income (when owners are paid a below-market salary). Therefore, taxpayers still have an incentive to shelter these returns from tax. Although their interest in tax planning is muted, it does not disappear.
Even so, the available planning opportunities depend on how the tax is structured.
A key variable is whether the tax covers economic value produced or consumed in the United States. If the tax applies only when value is produced here (an “origin-based” tax), firms have an incentive to shift income overseas. Admittedly, there is no need to shift normal returns, which are exempt anyway, but shifting above-market returns is advantageous. This is a significant limitation of the “X-tax,”
an origin-based tax endorsed by Professor David Bradford, Robert Carroll, and Professor Viard.
Although they acknowledge this problem,
they rely on current law’s (porous) responses, such as transfer pricing and a tax on repatriated earnings.
Another prominent origin-based proposal, Professors Robert Hall and Alvin Rabushka’s flat tax, shares this limitation.
In contrast, there is no incentive to shift income when a tax applies to goods and services consumed here, regardless of where they are produced (i.e., destination-based taxes). Even if the product is developed abroad, this tax still reaches above-market returns from U.S. sales.
This advantage motivates Professor Alan Auerbach to recommend a destination-based cash-flow corporate tax
and Professor Michael Graetz to favor a destination-based value added tax (VAT).
While immunity from income shifting is a notable advantage—and some commentators argue that destination-based consumption taxes solve all problems with the corporate tax under current law
—these taxes still have familiar limitations. For example, international trade rules may block variations that tax wages separately with progressive rates (such as cash-flow corporate taxes, but not VATs).
Another limitation is that (by design) destination-based taxes do not reach exports. As a result, they collect less revenue from debtor nations like the United States, which have to run trade surpluses in the future to compensate for past trade deficits and thus will have more (untaxed) exports than (taxed) imports.
A further concern is that destination-based taxes can trigger a one-time transfer from the United States to its trading partners, which could be quite large.
Given these distortions and leaks, relying solely on one of these new taxes—without a second tax as a backstop—can be problematic. For instance, an origin-based corporate-cash-flow tax would not reach above-normal returns that are shifted abroad, but a second tax (e.g., on a shareholder’s capital gains and dividends) would reach them. Likewise, a destination-based cash-flow tax would not reach exports, but a second (e.g., shareholder) tax would do so. In this spirit, Professor Auerbach pairs his destination-based corporate tax with the current personal income tax,
while Professor Graetz proposes to use three taxes: a destination-based VAT, a corporate income tax (at a much lower rate), and a personal income tax (for high earners only).
Admittedly, coordinating two taxes can be a challenge. If some activity is subject to only one of them, the combined rate varies for different activity. For instance, if an origin-based cash-flow tax of 20% is paired with a shareholder tax of 25%, only the shareholder tax reaches above-normal returns that are shifted abroad. As a result, the combined rate for this foreign income (25%) is lower than for U.S.-source income (40%). This sort of inconsistency can be conceptually unsatisfying and is also likely to induce distortions. Yet these problems are even worse if the origin-based cash-flow tax stands alone, without a shareholder tax as a backstop. Since foreign income is not taxed at all, the disparity is 40%, instead of 15%. So even though the second tax is not a complete solution, it is still helpful.
To sum up, then, a central challenge in taxing corporate profits is that corporate and shareholder taxes prompt different tax planning. A cut in one tax, which is funded with an offsetting increase in the other, mitigates some distortions and leaks, while exacerbating others. To deal with these dueling distortions, this Essay recommends keeping both a corporate tax and a shareholder tax. If taxpayers are able to avoid one, the other can still collect some tax. Moreover, if the goal is to deter planning that targets only one of these taxes, repealing this tax goes further than necessary. Cutting the rate can also accomplish this goal, while generating at least some revenue.
The two taxes should be coordinated so that, in combination, they equal (or approximate) the rate on noncorporate businesses. The balance of rates under current law also should shift, so the corporate rate is lower than the shareholder rate. In addition, targeted reforms should be considered to shore up both taxes, so the combined rate that is actually collected comes closer to the one on the books.
Although this incremental reform strategy would improve current law significantly, it still leaves problems unsolved. For instance, shareholder lock-in remains a concern, unless Congress charges interest on tax deferral or adopts mark-to-market accounting for publicly traded stock (and derivatives based on it). Likewise, since the coordination between corporate and shareholder rates is likely to be rough, an imputation system can improve it. These more ambitious reforms are appealing, if the political will can be mustered to enact them. But even with more fundamental reforms, there are significant advantages in relying on two taxes, instead of on one alone.