New CBO Report Shows Declining Share of C Corporations

The Congressional Budget Office (CBO) this week released its latest Budget and Economic Outlook, a document that includes projections about the U.S. economy and fiscal situation over the next decade. One interesting prediction highlighted in the report was the CBO’s belief that corporate income tax revenues, as a percentage of GDP, would fall over the next decade.

The corporate income tax system is the third largest source of federal revenues, behind only the individual income tax and the payroll tax. However, the CBO projects it to become less and less important, as a source of revenue as time goes on.

One key reason for this change? The declining share of businesses using the traditional C corporation structure and the rising share of businesses using the pass-through structure. (For more on this tax structure, where taxes are paid by the owners of the business rather than at the entity level, see an overview here.)

This trend is one of two corporate strategies the CBO mentions as reducing corporate income tax receipts. (The other strategy is profit shifting, which also makes it difficult to raise revenue at the high U.S. rate.)

As the CBO puts it:

One such strategy is to decrease the share of business activity that occurs in C corporations (which are taxed under the corporate income tax) while increasing the share that occurs in pass-through entities, such as S corporations (which are taxed directly under the individual income tax rather than the corporate tax, increasing individual income tax receipts).

We have highlighted this issue since report a year ago. The central problem is that the United States has relatively reasonable individual income tax rates, but the highest corporate income tax rate in the developed world. But it’s not just this: a C corporation pays both the high corporate income taxes and the individual income taxes.

This is remarkably thoughtless policy. Some businesses (but not all businesses, just those with a disfavored legal structure) pay a 35% rate at the entity level, followed by taxes of up to 23.8% at the shareholder level. Others, like partnerships and sole proprietorships, have taxes paid by their owners commensurate with their owners’ income in a single layer of taxation. Of course nobody wants to be a C corporation.

The answer to this problem would be a system of corporate integration, where all businesses end up having a pass-through structure. Senator Orrin Hatch (R-UT) is currently looking into such a system.

In any case, in the near term, expect corporations to continue to restructure themselves as partnerships and other kinds of pass-through entities over the near future.