This week, Senator Orrin Hatch (R-UT) announced that he is working on a plan to eliminate the double taxation of corporate income, according to Politico Pro. He hasn’t released any details, but he said he is thinking about allowing corporations to deduct the dividends they pay to shareholders. There are many benefits of corporate integration: it equalizes the treatment of debt and equity financed investment, it lowers the cost of capital, and moves towards treating all business forms equally. However, as Hatch puts his plan together, there are a few challenges he will face.
Under current law, corporations are not able to deduct from their taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. For both individuals and corporations, taxable income differs from—and is less than—gross income. the dividends they pay to shareholders. This results in the double-taxation of equity financed investment. Suppose a corporation earns $100 in profit. It needs to pay the corporate income tax of $39.10 (a federal and state rate of 39.1 percent), which leaves the corporation with $60.90 in after-taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. profits. When the corporation distributes these earnings as a dividend, the income is taxed again at the individual level. The shareholder then pays $17.47 in income taxes (a federal and state rate of 28.7 percent). In total, the $100 of corporate profits face a combined marginal tax rate of 56.6 percent.
|
Table 1. The Integrated Corporate Tax Rate in the Current U.S. Tax System |
|
|
Corporate Profits |
$100.00 |
|
Corporate Income Tax @ 39.1% |
$39.10 |
|
Distributed Dividends |
$60.90 |
|
Dividend Income Tax @ 28.7% |
$17.47 |
|
Total After-Tax Income |
$43.43 |
|
Total Tax Rate |
56.57% |
Not only does the double tax on equity investment increase the cost of capital, it creates economic distortions. The most obvious one is the distortion towards debt-financed investments. Under current law, corporations are able to deduct interest payments they make to lenders against their taxable income. Thus, profits derived from the debt-financed investment do not face a corporate level tax on the portion of the profit that is paid back in interest. The lender then receives the interest as income and needs to pay tax on it. The debt financed project only nets a single layer of tax at the debt holder’s level. As a result, businesses may be more likely to finance projects with debt due to the tax differential.
In addition, the double tax on corporate income also gives companies the incentive to reincorporate as a pass-through entity, such as an S-corporation or partnership, or never incorporate as a C-corporation. Pass-through businesses do not face the same double-tax on their profits. This may be one of the reasons why we have seen such growth in the pass-through sector over the last thirty years.
If corporations were able to deduct dividends, as Hatch suggested, it would significantly reduce the overall tax burden on corporate investment, would lead to greater investment, and a larger economy in the long run. It would also reduce the incentive to debt-finance or reorganize to avoid the second layer of taxation.
However, corporate integration through a dividend deduction comes with a few challenges that Hatch will need to consider. (This list is not exhaustive).
First, corporate integration will reduce revenue even when accounting for the economic growth it will provide. A deduction for dividends effectively eliminates the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax. from dividends distributed to shareholders. Given that the corporate income tax is 35 percent, this could be a significant cut. And even after the reduction in the cost of capital increases the size of the economy, boosting wages and investment, this proposal will still likely net a revenue loss. While revenue neutrality isn’t a necessity, it could reduce support for it if it isn’t paired with other policies that reduce spending or raise taxes elsewhere.
Second, some capital income could escape taxation completely with a dividend deduction system. Many shareholders in the United States are tax-exempt organizations such as college endowments. These non-profits do not pay tax on dividends received. If corporations were able to deduct dividends, there will be no tax at the corporate level and then no tax when tax-exempt organization receive the dividend. Alternative systems such as a credit-imputation system, or dividend exemption system avoids this by placing most of the tax at the entity level and making the adjustment for double taxation at the individual level. These systems are used in other developed countries such as Australia, New Zealand, and Estonia. The taxation of foreign shareholders face a similar challenge.
Third, a dividend deduction doesn’t address the high entity level tax. With integration, the overall tax on corporate income will decline. However, the tax levied directly on corporate profits will remain at 35 percent, which is the highest in the industrialized world and third highest in the entire world. A high entity level tax comes with its own complications such as the incentive to profit shift into lower tax jurisdictions.
Lastly, corporate income would still face a second layer of tax on retained earnings, or earnings that are not distributed as dividends. The same double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. occurs if the corporation retains its after-tax earnings, rather than distribute them as dividends. When corporate earnings are retained, the value of the stock increases to reflect an increase in assets held by the corporation. Shareholders that decide to sell their stock will realize a capital gain and pay tax on that gain. The integrated corporate tax rate through capital gains in the United States is also 56.6 percent.
Double-taxation of corporate income is one of the biggest weaknesses of the U.S. tax code. Hatch’s plan to integrate the corporate and individual income tax systems would be a huge improvement over current law. However, the way you integrate the system matters and there are challenges in designing the policy.
More on corporate integration here.
Share this article