February 22, 2007

Companies’ Fair Share: Zero Percent

(The following article originally appeared in the February 20, 2007 edition of TCSDaily.com.)

Conventional wisdom on taxes these days is that good taxes are progressive taxes. The more we earn, the higher our tax rate should be. And for nearly a century that logic has been etched into federal tax law, with progressive income tax rates rising along with Americans’ rising incomes.

The usual justification for those graduated rates isn’t that they raise more money. It’s that they’re “fair.” And what do we mean by that?

Ask an economist and she’ll tell you there are two basic approaches to tax fairness. One is “benefits received” which says taxes are fair if those who use the most government pay the most taxes. The other is “ability to pay” which says to forget how much government we use—people who make more money should pay more tax.

In today’s policy world, ability to pay wears the pants. And although adherence to that principle doesn’t require that tax rates be graduated—even a flat 20-percent tax means rich pay more dollars than poor—in practice ability to pay is the ethical centerpiece of America’s progressive income tax, currently with rates from 10 percent to 35 percent based on incomes.

So here’s a question. If graduated tax rates on people are fair, are they also fair for corporations?

I hope you’re sitting down, because the improbable answer is that they’re not fair.

Even if we enthusiastically embrace progressive income taxes on people, progressive taxes on corporations don’t follow at all. In fact, it turns out today’s steeply graduated corporate tax rates—eight brackets ranging from 15 percent to 39 percent—are unfair to a large number of low-income workers and consumers. And once you see why, you might find yourself whispering among friends that maybe, just maybe, the fairest corporate tax rate of all is zero percent.

Let’s start with a simple example. Imagine two companies. One is a start-up that makes high-tech satellites. Like most start-ups, it’s well-financed but earns no profits. It has rich customers, highly-paid employees, and very rich venture-capitalist shareholders.

Now consider a second company. It’s a large big-box retailer. Like most big companies, it earns handsome profits. Most of its thousands of employees earn low wages, and so do its customers. Its stock is publicly traded, and shares are mostly held by mutual funds feeding 401(k) retirement plans of workers, many of whom fall in the middle of the nation’s income distribution.

Question: which of these two companies should pay a higher corporate tax rate, given their ability to pay?

At first this seems easy. The one with higher profits should pay higher rates. But look closer. What do you mean by the company’s ability to pay?

Every freshman economics class teaches companies can’t bear taxes, only people can. Companies are just legal fictions that shove off taxes onto customers, employees and shareholders. The firm itself pays nothing. And so the age-old notion that we should hammer rich companies because “they can afford it” is really based on a simple misunderstanding.

Personally, I blame lawmakers for the mix-up. They notoriously preach the gospel of “tax companies, not people” with campaign promises to shift taxes from families onto businesses. But business taxes are just a tricky way of dumping tax burdens back onto different people. So in the world of corporate taxes, the right measure of ability to pay isn’t the profits of the Fortune 500. It’s our own pocketbooks.

Back in our two-company example, one earns zero profits but has well-paid workers, rich shareholders and wealthy customers. The other earns huge profits but has low-wage workers, poor customers and middle-income shareholders. How can a progressive corporate tax be fairly applied here? What’s the logic in taxing poor folks who work and shop at profitable companies with a 39 percent rate, while rewarding wealthy employees and customers of unprofitable start-ups with a 15 percent rate?

Yet that’s what our current tax code does. And that leads to our take-away point. Those buildings downtown don’t pay taxes, we do. So progressive corporate tax rates that treat companies like people aren’t just silly, they’re unfair. And unfair in an especially capricious way that should infuriate people who really care about tax fairness.

If you can understand this simple argument, congratulations are in order. You understand something an army of Washington lawyers, economists and lawmakers who continually wring their hands about “companies not paying their fair share” do not. As if companies ever paid a dime. As if the only thing keeping Americans tethered to the yoke of taxation are those darn buildings, desks and cubicle dividers that won’t pay their share of the tax bill.

Sam Walton was rich. But the poor families who bought jeans at Wal-Mart this morning aren’t. Why soak them for shopping at a profitable company? Why not tax the Waltons directly, and forget the rococo con game of corporate taxes altogether?

Andrew Chamberlain is an economist at the Tax Foundation in Washington, D.C.