One of the biggest issues with today’s 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. code is that a lot of economic activity is taxed more than once. The most obvious instance is with corporate income.
Corporate income is taxed at the entity level then again at the shareholder level. This is due to the fact that the tax system treats shareholders and the corporation as separate entities. Even if the United States lowered its 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. rate to 25 percent, the combined tax on corporate income would be high.
Under our current system of double-taxation, a corporation that earns $100 needs to pay the corporate income tax (for this example let’s assume a 25 percent corporate tax rate). The after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. ($75) is then passed to shareholders and taxed again. The result is a 46.53% tax burden on corporate income.
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Current Tax System, with a 25% Corporate Tax Rate |
|
|
Corporate Profits |
$ 100.00 |
|
Corporate Income Tax @ 25% |
$ 25.00 |
|
Distributed Dividends |
$ 75.00 |
|
Dividend Income Tax @ 28.7% |
$ 21.53 |
|
Total After-Tax Return |
$ 53.48 |
|
Total Tax Rate |
46.53% |
One solution to this problem of double-taxation is to integrate the corporate and individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source of tax revenue in the U.S. systems. Integration simply makes the tax code recognize that corporations and shareholders are one taxpayer, not two. The goal is to make sure that corporate income is ultimately taxed at the marginal tax rateThe marginal tax rate is the amount of additional tax paid for every additional dollar earned as income. The average tax rate is the total tax paid divided by total income earned. A 10 percent marginal tax rate means that 10 cents of every next dollar earned would be taken as tax. faced by its shareholders and that the tax burden on corporate investment is reduced.
There are two ways to integrate the tax system: a credit imputation and a dividend deduction.
Assume that in both these cases, the corporate income tax is lowered to 25 percent, while dividend income is taxed at the ordinary top marginal income tax rate of 39.6 percent.
Credit Imputation
Credit imputation is a system by which the corporation and the shareholder both pay part of the corporate income tax, but the shareholder is given a credit to offset the taxes already paid by the corporation.
When the corporation earns the $100 and pays the corporate income tax, it passes along the $75 after-tax dividend. The shareholder then needs to add back, or gross up, the taxes the corporation already paid and then apply the individual income tax of 39.6 percent. The shareholder then receives a credit for the amount the corporation already paid ($25). In total, the shareholder and the corporation pay an effective rate of 39.6 percent ($25 from the corporation, $14.60 from the shareholder).
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Credit Imputation Method |
|
|
Corporate Profits |
$ 100.00 |
|
Corporate Income Tax @ 25% |
$ 25.00 |
|
Distributed Dividends |
$ 75.00 |
|
Grossed-Up Dividends |
$ 100.00 |
|
Dividend Income Tax @ 39.6% |
$ 39.60 |
|
Credit for Corporate Taxes Paid |
$ (25.00) |
|
Net Shareholder Tax |
$ 14.60 |
|
Total After-Tax Return |
$ 60.40 |
|
Total Tax Rate |
39.6% |
Dividend Deduction
The second way to integrate the corporate and individual income tax is the dividend deduction. In this system, corporations are given a deduction against corporate 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. for dividends they pay out to shareholders.
The corporation earns the $100. If the corporation distributes all $100 to its shareholders, it deducts it all from taxable income. With $0 in taxable income, the tax bill will be $0 for the corporation. When the shareholder receives the dividend (which is equal to pre-tax profits), it is taxed at the top rate of 39.6% on all $100. In the end, the total tax rate on corporate income is 39.6 percent.
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Dividend Deduction Method |
|
|
Corporate Profits |
$ 100.00 |
|
Distributed Dividends |
$ 100.00 |
|
Corporate Income Tax @ 25% |
$ 0 |
|
Dividend Income Tax @ 39.6% |
$ 39.60 |
|
Total After-Tax Return |
$ 60.40 |
|
Total Tax Rate |
39.6% |
Although both methods lead to identical results, what people see differs and that will undoubted paint their perception of the two systems.
Under the credit system, high income individuals get tax credits, which reduces the effective tax rate of the shareholder. This could affect the perceived progressivity of the individual income system.
In contrast, the dividend imputation system maintains the perceived progressivity of the individual income tax. The trade-off, however, is that it makes it seem as though corporations are paying less due to their dividend deduction.
Integration Makes Taxes More Transparent and can lower the Tax Burden on Corporate Investment
Although these systems have a trade-off in perception, both of them have clear advantages in the context of tax reform.
Both of these systems reduce the need for differential tax rates on dividend income. Dividend income can be treated like ordinary income in the individual tax code.
These systems are both transparent. As a shareholder you either pay your share of the corporate income tax with full knowledge of what the corporation already paid on your behalf, or you pay the full burden of the corporate income tax when the full pre-tax dividend is passed to you.
Most importantly, however, the total tax burden on corporate income can be reduced through integration. This will have meaningful benefits for investment and the economy as a whole, which is the end goal of any serious tax reform proposal.
Coincidentally, Michael J. Graetz and Alvin C. Warren have an article about corporate tax integration in Tax Notes today. Read that here.
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