This past Friday, two prominent 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. economists released a detailed and thoughtful tax reform proposal, calling for a major overhaul of the U.S. 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. . In a report titled “A Proposal to Reform the Taxation of Corporate Income,” Eric Toder of the Tax Policy Center and Alan Viard of the American Enterprise Institute propose lowering the corporate income tax rate to 15 percent, along with several other promising reform ideas.
Perhaps the most interesting aspect of the new report is that just two years ago, Toder and Viard were calling for the corporate income tax to be eliminated completely. In an 2014 report titled “Major Surgery Needed: A Call for Structural Reform of the U.S. Corporate Income Tax,” Toder and Viard argued that the U.S. would be better off eliminating the corporate income tax and increasing shareholder-level taxes on dividends and capital gains.
What caused Toder and Viard to switch their position on the U.S. corporate income tax? Last Friday’s report contains a paragraph that may reveal how their thinking has shifted:
The disincentive for foreigners to invest in the United States could be completely removed by eliminating the corporate income tax… That would be the optimal policy if the United States were a small economy, with no unique attributes, that provided rents to foreign investors. In that case, the United States would not be able to raise any revenue from foreign investors by imposing a tax on them, as the investors could completely shift the tax to American workers by demanding a higher pretax return. Because the United States has unique attributes as an investment location, however, investors do not regard equity investments in the United States as perfect substitutes for investment in other countries. As a result, foreign investors in US equity cannot fully shift the tax to Americans. It is therefore in the United States’ national interest to impose a low-rate tax on these foreign investors to extract some rents from them. We believe that 15 percent is a reasonable tax rate to achieve this goal.
This is a pretty complex line of reasoning, so let’s unpack it.
A Simple Case Against Corporate Income Taxes
Toder and Viard begin by arguing that, under certain assumptions, the corporate income tax is entirely counterproductive. Specifically, if corporations are able to easily shift their investments from high-tax countries to low-tax countries, then countries stand to gain nothing from levying higher corporate income taxes.
To illustrate this point with a specific example: imagine a corporation with significant investments in the United States. The U.S. government decides to impose a 35 percent corporate income tax on the corporation’s earnings. The corporation in question could react to the new corporate tax in two ways.
First, perhaps the corporation would simply pay the 35 percent tax, without making any changes to how it runs its business. Under this scenario, the corporation would see lower after-tax profits and would distribute fewer dividends to shareholders. In this case, the burden of the corporate income tax would fall entirely on the corporation’s shareholders.
However, in a globalized economy, the corporation might pursue a different course of action: it might respond to the 35 percent U.S. corporate tax by reducing its investments in the United States and increasing its investments in other countries. Specifically, we might expect a corporation to keep reducing its investments in the U.S. until it ends up with the same return-on-investment that it had before the tax was introduced.
In this second scenario, none of the burden of the corporate income tax would fall on the corporation’s shareholders, in the long run – because the shareholders would be earning exactly the same return-on-investment. Instead, the burden of the corporate tax would fall mainly on American workers, by the corporation conducting less business and creating fewer jobs in the U.S.
Most economists believe that the second scenario is more likely, and that the majority of the burden of the corporate income tax falls on workers. In one survey of public finance economists, the median respondent thought that only 40 percent of the corporate income tax burden is borne by shareholders.
This is a powerful case against the corporate income tax: while some of our politicians say “corporations and the wealthy” in one breath, there’s actually good reason to believe that the bulk of the corporate income tax burden falls on workers, rather than wealthy investors.
A Nuanced Case for Retaining a Corporate Income Tax
However, Toder and Viard point out that the case outlined above – that the corporate income tax does not fall on shareholders – rests on a central assumption: that corporations are able to easily shift their investments from one country to another. However, this assumption does not always hold in the real world.
As the two economists point out, “The United States has unique attributes as an investment location”: there are certain investments that can only be made in the United States, due to our especially strong business climate and our highly-educated workforce. As a result, corporations may be reluctant to shift their investments out of the United States, and may end up passing a portion of the corporate income tax on to their shareholders.
If some of the burden of the corporate income tax falls on shareholders, then Toder and Viard argue that the United States should keep its corporate income tax, in order to impose taxes on foreign shareholders of corporations that do business in the U.S. Because these shareholders live outside the borders of the U.S., one of the only ways for the federal government to raise revenue from them is through a corporate income tax.
However, Toder and Viard do not think that the corporate income tax is an appropriate vehicle to tax U.S. shareholders of corporations that do business in the U.S. This is because the federal government already can tax U.S. shareholders through the 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. , on their dividend income, and their capital gains. In fact, the two economists design their corporate tax so that almost none of the burden of the tax falls on U.S. individual shareholders, by using a credit imputation system.
To summarize, Toder and Viard argue that a portion of the corporate income tax does indeed fall on shareholders. So, their tax reform proposal retains a 15 percent corporate income tax, which is designed to raise revenue from foreign shareholders but not from U.S. shareholders.
The full Toder-Viard proposal can be found here, and I encourage you to check it out.
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