An examination of the problems surrounding the current corporate tax system, including a detailed look at several reform proposals from the Treasury Department.Corporations - Taxation ; Income tax

Jeffrey J. Hallman

Joseph G. Haubrich

English

Research Papers in Economics

October 1, 1992
eCONOMIG
GOMMeNTORY
Federal Reserve Bank of Cleveland
Integrating Business and
Personal Income Taxes
by Jeffrey J. Hallman and Joseph G. Haubrich
"To tax and to please, no more than to
love and be wise, is not given to men."
/dmund Burke's comment rings no
less true today than it did in 1774. One
need only observe political candidates'
perennial attempts to tar their opponents
with the "tax and spend" brush to know
that Burke had gotten it right more than
two centuries ago.
The Treasury Department brought the
issue of corporate income taxes into
the political forum early this year by
releasing a detailed study of several
proposals to "integrate," or merge, the
corporate and individual income
taxes. Many Americans cling to the
naive view that higher corporate taxes
mean lower personal taxes. Ironically,
the problem is just the opposite: As
business taxes go up, individuals ul-
timately pay more.
This article first examines the problems
surrounding the current corporate tax
system and then looks at how these
concerns are addressed in five specific
reform proposals: 1) abolishing the cor-
porate income tax altogether, 2) treat-
ing corporations like partnerships, with
all net income and losses passed on to
shareholders and handled like ordinary
income, 3) allocating all net income to
shareholders, but not net losses, 4) ex-
cluding dividend payments from
shareholders' taxable income, and
5) continuing to tax corporations, but
allowing shareholders to deduct both
dividend and interest payments.
• The Present System
Congress enacted the corporate income
tax in 1909 as an excise tax on the
privilege of using the corporate form.
The presumption was that people
would be willing to pay for the right to
create a legally separate entity that
provided them with limited liability.
Like "sin" taxes on alcohol and tobac-
co, the corporate tax has dual effects.
That is, it raises revenue while discour-
aging use of the taxed item. In the case
of business taxes, this means that the
corporate form is discouraged relative
to other types of business organization,
such as sole proprietorship, partnership,
or limited partnership.
Today, the federal government taxes
corporate income at a 34 percent mar-
ginal rate. Shareholders then pay an
individual tax of 15, 28, or 31 percent
on dividends received, and on any
appreciation of their shares at the point
of sale. Thus, income earned at the
corporate level is subject to double
taxation. (Although tax-exempt institu-
tions such as pension funds hold a large
share of corporate equity and bonds,
Though most Americans support
reforming federal tax laws to en-
courage growth, there is no consensus
on the best way to approach the issue.
President Bush's proposal to reduce
the capital gains tax has grabbed
most of the headlines over the last
several years, relegating other pos-
sibilities to the back pages. This
Economic Commentary takes a look
at reforming the corporate income
tax, an idea raised by Presidents
Carter and Reagan and the subject
of a recent study by the Treasury
Department.
ISSN 0428-1276the ultimate recipients of most of the
earnings generated by these organiza-
tions do pay taxes.) In an effort to in-
crease investors' returns, corporations
endeavor to circumvent double taxation
by finding and exploiting legal loop-
holes and timing options that reduce
their own taxable income. Combined
with lower business tax rates and dwin-
dling profits, tax avoidance schemes
have made corporate taxes a less impor-
tant source of federal revenue, even
though the corporate share of gross
domestic product (GDP) has increased.
Between 1955 and passage of the Tax
Reform Act in 1986, real corporate
profits and income tax receipts zig-
zagged downward despite the nation's
economic growth (see figure 1). In con-
stant (1982) dollars, corporate taxes
fell from an average of $85 billion year-
ly in the 1950s to $56 billion between
1980 and 1986.
3 As a fraction of the
government's total tax receipts, this rep-
resents a drop of more than half, from
above 20 percent to below 10 percent.
• Why Reform?
Given the transition costs associated
with tax reform, any new proposal must
be justified in terms of both equity and
efficiency. Evaluating a tax means bal-
ancing a complex range of issues, since
every tax has its own set of disadvan-
tages, including financial distortions and
collection costs. We believe that the
correct test is whether the overall econ-
omy gains from a revenue-neutral tax
reform (that is, one that keeps total rev-
enue constant). Looking at the issue from
this perspective avoids having to factor
in spending cuts or deficit reductions.
By this standard, the corporate income
tax is an expensive way to raise reve-
nue. Beyond its direct costs (collection
and enforcement), it also has high in-
direct costs that affect not only how
corporations raise investment funds, but
also how they distribute the proceeds.
We know that the direct costs of ad-
ministering the corporate tax are im-
mense — U.S. companies devote more
FIGURE 1 PRE-TAX CORPORATE PROFITS
Percentage of corporate GDP
25f
20"
1960 1965 1970 1975 1980
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
1985 1990
than 500 million hours a year to filling
out tax forms. However, because
economists are unable to pinpoint the
paperwork burden of the alternatives,
direct comparisons are difficult. Even
harder to quantify and contrast are the
indirect costs of tax avoidance, includ-
ing lawyers and accountants hired to
exploit the existing law, lobbyists hired
to change the law, and campaign con-
tributions aimed at making sure things
go businesses' way on Capitol Hill.
The case against the corporate income
tax rests on the financial distortions it
causes. The current law favors noncor-
porate enterprises over corporations,
debt over equity, and retained earnings
over dividends, effects that can under-
cut the health and productivity of the
entire economy. One major disadvan-
tage of the tilt toward noncorporate
business is that the corporate form is
uniquely suited to undertaking large,
risky projects (aeronautical and phar-
maceutical research and development
are good examples). Incorporation al-
lows for limited liability, unlimited life,
smooth transferability of ownership,
and easy subdivision of risk, factors
that allow corporations to become much
larger than partnerships/ Thus, to the
extent that business taxes discourage
incorporation, large and risky projects
will not be pursued.
Corporations have three ways of financ-
ing new investment: selling bonds
(debt), selling stocks (equity), or retain-
ing earnings. In any effort to balance
the costs and benefits of these alterna-
tives, the corporate income tax is a
major consideration. Currently, firms
can deduct interest payments, but not
dividends, from their taxable income.
Thus, a person holding bonds gets
taxed only once on that income, while
someone holding stock is taxed twice.
Taxpayers even benefit if the firm
retains its earnings. Then, stock prices
rise and profits show up as a capital
gain, which is taxed at a lower rate
than ordinary income (28 percent ver-
sus 31 percent). Cutting the capital
gains tax rate, another reform proposal
currently on the table, would increase
this bias against dividends.
• The Alternatives
Do the disadvantages of corporate taxa-
tion really matter, once taxes are raised
enough to compensate for the lost reve-
nue? This question has both a short and
a long answer. The short answer is yes,
because the corporate income tax has
inherent problems that make it worse
than any likely alternative. Taxing busi-
ness income not only discourages work
effort and investment, as any income
tax does, but also encourages debt
accumulation and the other distortions
discussed above.The long answer, which we can only
touch on here, is that this question
demands a quantitative response that
balances the gains of corporate tax
reform against the losses from a higher
tax rate somewhere else. The Treasury
study does an admirable job of address-
ing this issue. Using three quantitative
models that raise the tax rates on capi-
tal income to offset any losses from
reform, the report finds that integrating
business and income taxes would shift
capital to the corporate sector, reduce
corporate borrowing, boost dividend
payments, and increase GDP by $3 bil-
lion to $30 billion.
6
Below, we qualitatively evaluate five
reform proposals (an initial benchmark
and the four alternatives discussed at
length in the Treasury study) based on
how they would reduce both tax avoid-
ance costs and the financial distortions
caused by corporate taxation. We also
look at how Treasury revenue would be
affected.
Abolishing the corporate income tax.
This proposal clearly eliminates double
taxation and so removes the biases
against equity, dividends, and the corpo-
rate form. It also erases both direct and
indirect compliance and avoidance costs
at the corporate level. Unfortunately, the
plan has a fatal flaw: It promotes cor-
porations as a tax dodge. Individual tax-
payers could self-incorporate, declare
their income as profits, and avoid the
personal income tax altogether. A further
drawback is that Treasury revenue is
reduced by the full amount of the tax,
almost $ 100 billion per year.
Pure conduit approach. This plan
treats corporations like partnerships in
that it allocates all net income and losses
to shareholders, who must report these
payments as ordinary income. To ensure
neutrality between firms' retaining earn-
ings or paying them out as dividends,
shareholder capital gains (and losses) are
calculated as the difference between the
sale price and the purchase price, less
the change in book value. This is known
as the share basis adjustment.
Incentives to disguise income at the
corporate level are reduced, since such
hidden funds would eventually result
in a taxable capital gain to the share-
holder. Moreover, neutrality between
the corporate and noncorporate organi-
zational forms and between debt and
equity finance is restored. The plan
also reduces the costs of tax avoidance
(but not of direct compliance) and
lowers tax revenues, since it eliminates
double taxation of dividends while al-
lowing firms to pass losses on to their
shareholders. Because the personal tax
rate (especially the lower brackets) is
below the corporate rate, Treasury
revenue is reduced.
Modified conduit approach. Here, net
income is allocated to shareholders, but
net losses are not. Corporations still
pay taxes, but shareholders receive a
nonrefundable tax credit for their share
of the tax paid. Capital gains are ad-
justed on a share basis.
Economically, this plan is similar to the
pure conduit approach, especially if
companies can carry losses forward as
an offset against future income. Politi-
cally, however, it is one step behind,
since collecting taxes from corporations
rather than shareholders means that
many wealthy people will pay little or
no individual income tax.
Dividend exclusion. Under this ap-
proach, individuals do not have to pay
taxes on dividend income. This re-
duces, but does not eliminate, debt-
versus-equity and corporate-versus-
noncorporate distortions, since firms
can still deduct interest. It also cuts into
Treasury revenues and introduces a
new bias against retained earnings. If
corporate managers have better infor-
mation about certain investment oppor-
tunities than do their shareholders, total
investment funds drop off.
The comprehensive business income
tax (CBIT). Here, corporations are
still taxed, but shareholders are entitled
to deduct both dividend and interest
payments from their tax bills. CBIT
would apply to all but the smallest busi-
nesses and makes no distinctions based
on organizational form.
All investment returns are treated iden-
tically under this plan, whether financed
by debt or equity or produced by a cor-
poration or partnership. Like the con-
duit and dividend exclusion plans,
CBIT requires a share basis adjustment
to prevent a bias against retained earn-
ings. The comprehensive nature of this
tax, coupled with its reduced financial
distortions, means that Treasury reve-
nues would actually increase.
• Conclusion
All five of the reform proposals dis-
cussed here have the virtue of reducing
the financial distortions caused by the
current corporate tax system. None of
them is as simple as its proponents
claim, however, since each requires a
share basis adjustment to avoid biasing
the system away from retained earnings.
The proposals requiring all taxes to be
paid at the corporate level (modified
conduit, CBIT, and dividend exclusion)
would result in the highly publicized
spectacle of extremely rich individuals
paying no direct taxes to the Internal
Revenue Service — a daunting politi-
cal obstacle. The CBIT has the addi-
tional problem of a 10-year phase-in
period due to the substantial disloca-
tions it would cause (eliminating the
deductions for interest and dividend
payments would require extensive
changes in the tax code). Thus, even if
this proposal is adopted, its chances of
surviving the implementation period
are questionable.
Our preference is for a modified con-
duit approach with a twist on the
Treasury's proposal: We believe that
taxes should be paid at the shareholder
rather than the corporate level. This
would do the best job of minimizing
distortions on all fronts, avoid the long,
uncertain adjustment period associatedwith the CBIT, and eliminate the reve-
nue and administrative problems con-
nected with passing losses on to share-
holders. Not insignificantly, it would
also preclude the politically untenable
situation in which wealthy individuals
pay no personal income tax at all.
Edmund Burke was right: Taxes will
never please. Evidence suggests, how-
ever, that integrating the corporate and
personal income taxes can lower costs,
boost investment, and reduce unneces-
sary risk.
• Footnotes
1. See the U.S. Treasury Department's
report to Congress entitled "Integration and
Individual and Corporate Tax Systems:
Taxing Business Income Once," January
1992.
2. Tax timing options and other offsets can
reduce, but rarely eliminate, the individual
income tax on dividends.
3. See U.S. Treasury report (footnote 1),
p. 156.
4. Looking at direct and indirect costs em-
phasizes the efficiency criterion. Equity is-
sues are harder to decipher, since they depend
on who pays the tax, as well as on its inci-
dence. Economists are unsure about how
much of the corporate tax is borne by share-
holders and how much is passed on to
workers and customers.
5. General Motors, the largest U.S. corpora-
tion, had sales of $124 billion in 1991, while
Exxon, number two, was at $103 billion. By
contrast, the sales figures for the two biggest
partnerships, the University of California
research labs, hospitals, and bookstores and
Star Enterprises (an oil company) were $10
billion and $8 billion, respectively.
6. The models differ only in movement of
production between the corporate and non-
corporate sectors and in whether individuals
can shift their investment in housing and
durable goods in response to changes in the
tax code.
Jeffrey J. Hatlman is an economist at the
Federal Reserve Board of Governors,
Washington, D.C., and Joseph G. Haubrich
is an economic advisor at the Federal
Reserve Bank of Cleveland.
The views stated herein are those of the
authors and not necessarily those of the
Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Federal Reserve Bank of Cleveland
Research Department
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Integrating business and personal income taxes

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