1. The US has the highest statutory corporate tax rates among developed countries
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The US corporate income tax is broken. Our tax rate is the highest in the developed world, yet we collect less corporate tax revenue as a share of gross domestic product than many of our trading partners. The tax discourages firms from investing in the US. It also enables multinationals to avoid tax by shifting profits to low-tax countries.
The US can impose corporate tax only on income companies earn within our borders and income of companies legally based in the US. US tax law defines a company's residence as the place where its charter was issued. But that legal home may not be where many of the company's investments, employees, customers and shareholders are located.
The current tax system:
And there’s more: Intangible assets such as patents, and brand name, and reputation contribute to profits throughout the world no matter where they are located. Multinational companies can avoid tax by shifting their intangible assets and their profits to low-tax countries.
Double Taxation: Congress adopted the corporate income tax in 1909. Publicly-traded companies and other C corporations1 pay corporate income tax on their profits, which include dividends paid to shareholders. Their shareholders also pay tax (at preferential rates) on dividends1 and capital gains1 from these companies.
Pass-through businesses:1 Sole proprietorships and partnerships taxed only at the owner/investor level under the individual income tax and do not pay corporate income tax.
New company structures: Congress and the IRS have started moving away from double taxation. Over the past 55 years, they have extended pass-through treatment to more businesses that have the same limited-liability benefits as corporations. In 1958, Congress allowed small corporations to receive pass-through treatment as S corporations.1 In the 1990s, the IRS allowed limited liability companies (LLCs) and limited liability partnerships (LLPs) to be taxed as partnerships and Treasury enacted “check the box” rules that made it easy for firms that are not publicly traded to choose to be taxed as pass-through businesses.
Most publicly-traded companies, however, are still C corporations that are subject to double taxation.
1 See bullet #6 below for definitions of terms
Corporate equity-financed investments are taxed at a higher rate than debt-financed and pass-through companies. Corporations financed by debt pay lower effective tax rates than those financed by equity because they can deduct interest expenses. This unequal tax treatment encourages corporations to raise their debt levels, increasing their financial vulnerability.
Below are two companies. They are both located in the same city in the US, and they both have the same operating profit, but have different financing.
Note: The example assumes that the investment receives no corporate tax preferences and that all after-tax profits are paid out as dividends.
Congress is entertaining several tax reform proposals. These proposals would expand some perverse incentives while trying to minimize others.
Eric Toder and Alan D. Viard - A Joint Publication of the American Enterprise Institute and the Tax Policy Center (2016)https://www.aei.org/wp-content/uploads/2016/06/A-proposal-to-reform-the-taxation-of-corporate-income.pdf
Pages 4-11 describe and critique the current corporate income tax system and the proposals under consideration in Congress. Pages 12-45 describe the details of the authors' proposal. Pages 46-63 present the expected benefits of the proposed changes to the corporate income tax.
Conference participants: Eric Toder, Alan D. Viard, David Wessel, Martin A. Sullivan, Pamela Olson - Conference co-sponsored by Urban-Brookings Tax Policy Center and American Enterprise Institute (2014)https://www.youtube.com/watch?v=Bugm6cpuirI
Toder and Viard present their proposal (and an alternative proposal on international coordination) at a conference co-sponsored by the Tax Policy Center and AEI. Pamela Olson of PricewaterhouseCoopers and Martin A. Sullivan of Tax Analysts comment on the proposal. David Wessel of the Brookings Institution moderates.
Eric Toder and Alan D. Viard - Market Watch (2014)http://www.marketwatch.com/story/tweaking-corporate-tax-system-doesnt-go-far-enough-2014-08-05
The authors describe their proposal and why we need it in an op-ed in Market Watch. Upon its release in April 2014, the proposal received widespread media attention. It drew another round of publicity that summer with a wave of corporate inversions sending US companies abroad, prompting the authors to write this article.
Joseph Dodge - NYU Tax Law Review (1995)Dodge Mark-to-Market and Pass-Through.pdf
In this 1995 article, Professor Joseph Dodge, a leading tax expert, advanced a proposal to replace the corporate income tax with shareholder taxation. Although some of the details are different, his proposal followed the same broad approach as this proposal.
Organization for Economic Co-Operation and Development - (2015)http://stats.oecd.org//Index.aspx?QueryId=58204
The OECD tax database provides information on corporate income taxes that are levied in the 34 OECD member countries. The table shows 'basic' (non-targeted) central, sub-central and combined (statutory) corporate income tax rates. Where a progressive (opposed to flat) rate structure applies, the top marginal rate is shown.
URBAN INSTITUTE, founded in 1968 to understand the problems facing America’s cities and assess the programs of the War on Poverty, brings decades of objective analysis and expertise to policy debates — to open minds, shape decisions, and offer solutions through economic and social policy research. It is regarded as one of the preeminent think tanks in the US. Along with BROOKINGS INSTITUTE, another preeminent think tank, the Urban Institute sponsors the URBAN-BROOKINGS TAX POLICY CENTER.
AMERICAN ENTERPRISE INSTITUTE is committed to expanding liberty, increasing individual opportunity and strengthening free enterprise through research and education on government, politics, economics and social welfare. It is regarded as one of the preeminent think tanks in the US.
As these organizations do not take institutional positions, this proposal reflects the views of the individual authors.
Funding for the research of Toder and Viard has been provided by The Peter G. Peterson Foundation, which focuses on America's fiscal challenges, and The Laura and John Arnold Foundation, which focuses on criminal justice, education, and public accountability.
Alan D. Viard is a resident scholar at the American Enterprise Institute (AEI), where he studies federal tax and budget policy.
Prior to joining AEI, Viard was a senior economist at the Federal Reserve Bank of Dallas and an assistant professor of economics at Ohio State University. He served as a visiting scholar at the US Department of the Treasury’s Office of Tax Analysis, a senior economist at the White House’s Council of Economic Advisers, and a staff economist at the Joint Committee on Taxation of the US Congress. While at AEI, Viard taught public finance at Georgetown University’s Public Policy Institute.
Earlier in his career, he was a visiting scholar in Japan at Osaka University’s Institute of Social and Economic Research.
A prolific writer, Viard is a frequent contributor to AEI’s “On the Margin” column in Tax Notes and was nominated for Tax Notes’ 2009 Tax Person of the Year. He has testified before Congress, and his work has been featured in a wide range of publications, including Room for Debate in The New York Times, TheAtlantic.com, Bloomberg, NPR’s Planet Money, and The Hill. Viard is the coauthor of “Progressive Consumption Taxation: The X Tax Revisited” (2012) and “The Real Tax Burden: Beyond Dollars and Cents” (2011), and the editor of “Tax Policy Lessons from the 2000s” (2009).
A native of Kansas, Viard received his BA in economics from Yale and his PhD in economics from Harvard. He completed the first year of the JD program at the University of Chicago Law School, where he qualified for law review and was awarded the Joseph Henry Beale prize for legal research and writing.
This reduction would occur over a ten-year period (see recommendation #7 below).
American shareholders of publicly-traded companies would be taxed on their dividends and capital gains at full ordinary income tax rates, up to 39.6%, rather than today's 20% top capital gains tax rate. This tax increase would be introduced over a ten-year period. The 3.8% net-investment-income tax would also continue to apply to dividends and capital gains.
Capital gains taxes would be imposed on an accrual basis:
To prevent double taxation, American shareholders would receive a tax credit for their share of the US income taxes paid by the US firms whose stock they own. However, foreign shareholders, nonprofit organizations, and tax-preferred retirement plans would not receive the credit because they generally don't pay a second level of tax on their dividends.
Gains and losses on non-publicly-traded businesses, land, and other assets without established market prices on organized exchanges would continue to be taxed only when the assets are sold and would still receive the preferential capital gains tax rate. However, previously untaxed gains on these assets would be taxable (at the preferential rates) when the owner dies.
Because the stock market is volatile, shareholders might have large accrued gains in some years and large accrued losses in other years. To make tax payments less volatile and limit the need for shareholders to sell shares to pay tax in years with big gains, the gains and losses would be smoothed. In each year, 20% of the gain or loss would be taxed or deducted and the other 80% would be placed in a pool of unrecognized gains and losses. In each year, 20% of the balance in the pool, in addition to 20% of the new gains and losses, would be taxed or deducted.
So, if a shareholder had a $100 gain one year, $20 would be taxed in that year and $80 would be placed in the pool. In the next year, $16 of the $80 would be taxed (because 20% of the pool balance would be taxed). In the following year, $12.80 of the remaining $64 would be taxed, and so on. Gains and losses would therefore be smoothed over many years. It would not be necessary, however, to keep track of all the past years, as a single number (the pool balance) would be the only information needed.
The smoothing would apply to dividends and capital gains and losses on corporate stock, whether or not the stock was sold. The shareholder credit for corporate tax paid at the company level, which was discussed in Recommendation 2, would also be smoothed.
Capital gains accruing after a privately held company went public would be taxed as they accrue under the proposal’s general rules (including the credit for corporate taxes paid at the company level and the application of geometric smoothing). However, special rules would apply to the gains that had accrued before the company went public, but that had not yet been taxed because the owners had not sold their ownership stakes. Three-quarters of those previously accrued gains would be exempt from tax and the remaining one-quarter would be included in the owners’ taxable income over a ten-year period. These rules would ensure that companies did not face an undue tax penalty for going public. For further details about this provision, please see pages 23-25 of “A Proposal to Reform the Taxation of Corporate Income” (see full reference below).
The first $500 ($1,000 for couples) of dividends and accrued capital gains would be exempt from tax each year. As a result, small shareholders would not have to deal with accrual taxation, the shareholder credit, and the geometric smoothing system. This exemption would remove a large number of shareholders from the capital gains tax system with relatively little revenue loss.
Once the reform took effect, shareholders of publicly-traded companies would pay tax on accrued annual gains and deduct accrued annual losses.
Over a ten-year period, the individual income tax rate on dividends and newly-accrued capital gains would be increased to the ordinary individual income tax rate. Over the same period, the corporate income tax rate would be reduced to 15%.
The chart below shows the corporate income tax rate and the top individual income tax rate on dividends and newly-accrued capital gains. The 3.8% net-investment-income tax (not shown below) would also still apply to dividends and capital gains. The chart assumes that the reform is enacted in 2016 and starts to take effect in 2018.
The following rules would apply to capital gains that had been accrued before January 1, 2018, but that had not been taxed (because the shares had not been sold). The first $10,000 of these previously accrued gains would not be taxed. Three-quarters of the gains above that threshold would also not be taxed. The remainder – one-quarter of the gains above the threshold amount – would be included in taxable income, spread over the ten-year period from 2018 through 2027. This treatment of previously accrued gains would, on average, roughly approximate the treatment they would have received under previous law, under which they would have been taxed at preferential rates if and when they were realized through the sale of the shares.
Other transition rules would also apply to a variety of specialized circumstances.
For further details about the transition rules, please see pages 38-42 of “A Proposal to Reform the Taxation of Corporate Income.”
The US tax system would no longer provide significant incentives for companies to move their corporate charters abroad. The shareholder tax would not depend on where the corporation was chartered and the corporate tax would be much lower. The tax incentive for inversions would be greatly diminished. US companies would face little or no tax on overseas income, after applying credit for foreign income against their 15% US tax.
With our current tax system, both US and foreign companies are taxed on profits earned in the United States, with less tax, or no tax, on profits earned abroad. The current corporate tax discourages both types of companies from investing in the United States. Reducing the corporate income tax rate to 15% would greatly reduce that effect. Capital would flow into the US, boosting US job creation, productivity, wages and standard of living. By keeping a 15% corporate income tax, we'd ensure that foreign shareholders pay some U.S. tax when they invest here, but the rate would be low enough that it wouldn't drive their money out of our economy. The size of the gain would depend on several factors, including how other countries reacted to the US reform.
Because the United States would have a much lower corporate tax rate, both foreign and US companies would book additional profits in the United States rather than abroad. The tax on those additional profits would offset part of the revenue loss from the corporate tax rate cut. State governments with corporate income taxes would also receive additional revenue from taxing those increased profits.
Publicly-traded equity-financed and debt-financed companies would receive equal tax treatment. Companies would be free to choose the best capital structure for their businesses without worrying about tax consequences.
Compared to today's system, the tax treatment of publicly-traded and non-publicly-traded businesses would be more similar than under current law (for American owners.) Neither type of business would be subject to double taxation:
The charts below show the taxes that would be paid by the two companies (described in background point 4) under the reform plan.
Note for Equity-Financed Investment: The shareholder credit for corporate taxes would be approximately $15, the amount of corporate tax paid. The shareholder would pay the 43.4% tax on approximately $100, the $85 dividend plus the $15 corporate tax. So, the shareholder’s net tax would be approximately $28 (the $43 tax minus the $15 credit).
Although the corporate income tax rate would be much lower than the top individual tax rate (15% compared with 43.4%), corporate profits could not be sheltered from full-rate tax by being reinvested and shareholders delaying selling their stock. Reinvested profits would show up in accrued capital gains, which would be taxed each year at the ordinary income tax rate, even if shareholders held onto their stocks for an extended period.
The Urban-Brookings Tax Policy Center estimates that the top 1% of households would pay slightly more taxes than under current law and that all other income groups would pay slightly less. This occurs because the higher shareholder taxes fall almost entirely on upper income individuals with investment income, while a portion of the corporate tax cut will raise workers’ wages by increasing investment in the US, thereby raising capital per worker and labor productivity.
The Urban-Brookings Tax Policy Center estimates the plan would be approximately revenue neutral in the long run; it may even raise revenue if the taxes collected on the additional profits that are likely to be booked into the US in response to a reduced corporate tax rate are counted.
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