How Corporate Integration Increases Transparency and Eliminates Double-Taxation

November 10, 2014

One of the biggest issues with today’s tax 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 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 income ($75) is then passed to shareholders and taxed again. The result is a 46.53% tax burden on corporate income.

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 tax 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 rate 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).

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 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.

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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