Eliminate the Corporate Tax, and Capital Gains Special Treatment

In all the talk (and little action) on tax reform, repeated voices have been lamenting how U.S. corporate taxes appear to be the highest in the developed world both on paper and in reality (the actual average rate usually being far below the stated 35 percent). While almost all parties acknowledge the anti-growth aspects of the current corporate tax system, at least a good number of those who will need to support tax reform hate to give away any tax revenue. The best possible compromise would be to eliminate all federal corporate income taxes while simultaneously ending the preferential treatment of capital gains and dividend income.

Dividends are payments made by corporations to their shareholders. Dividends must be paid with after-tax income under U.S. tax law. Thus, the corporation first pays a tax of up to 35 percent, then the shareholders pays personal income taxes on those already-taxed dividends. Usually that will be another 15 percent although a few high earners will have to pay 20 percent. That means, in essence, that the federal government collects as much as 45-48 percent in taxes on dividends.

That is far higher than the top personal income tax rate of 39.6 percent and falls on people with much lower incomes who happen to own some dividend-paying stocks.

Similarly, capital gains (profits from investments) are taxed at lower rates than regular, "earned" income. As long as the investment was held for at least one year, these earnings are taxed at 15 percent for 99 percent of us and 20 percent if you are in the top 1 percent. Meanwhile, a married couple making around $100,000 per year can easily reach the 25 percent bracket on their regular income.

The idea of lower taxes on capital gains and dividends is to encourage investment and business formation; in other words, to encourage the creation of jobs. However, taxing different sorts of personal income at different rates based on the source of the income is only one way to accomplish this. Another, perfectly reasonable approach would be to remove all income taxes from businesses.

While most dividends and capital gains would face higher tax rates of 25 to 39.6 percent, they would be larger to begin with thanks to the elimination of corporate taxes. After all, if your dividend gets 35 percent larger, but then you pay an extra 10 or 20 percent in taxes, you are still ahead of the game. Similarly, investments that no longer face taxes will be more valuable so pre-tax capital gains will be larger before facing a higher, one-time tax.

James Pethokoukis recently laid out a case for elimination of corporate taxes on the basis of its pro-growth and pro-jobs impacts. He hypothesizes that tax revenue might drop initially, but then should rise as companies respond to the lack of taxes by expanding their suddenly more profitable operations.

In actuality the impact of such a change on total tax collections is rather ambiguous. If corporations paid 35 percent now, this change would cause the government to collect fewer taxes. The Government Accountability Office last year estimated that corporations pay an average tax rate of 12.6 percent. If that is the correct figure, then the tax reform I am proposing here might be pretty close to revenue neutral. One important factor is that corporations currently utilize accounting tricks to hide profits from taxes, while individuals have a harder time employing tax shelters. Overall, I suspect the revenue effect is not overwhelming in the medium-term.

President Obama is currently upset about the reported rash of corporate inversions in which American companies buy a foreign firm in order to move their tax headquarters out of the U.S. and save money on taxes. He wants to do something to stop this, either through a change in law or his ever-threatened executive actions. However, corporate lawyers and accountants are quite smart and eliminating all the loopholes would be nearly impossible. Much simpler would be to eliminate the incentive to move profits overseas.

If corporate taxes were eliminated in favor of higher taxes on the personal income that results from corporate activity, the flow of companies out of the U.S. would actually reverse as foreign companies would now see the U.S. as the low-tax location for business expansion. If they structured things correctly, they could probably avoid the U.S. personal income taxes, too. What would we gain? All the jobs (plus the taxes on all the Americans hired to work in these new businesses).

Dividends and capital gains are taxed lower than regular wage income currently, mostly based on the fact that the money was already taxed once through a business. Eliminating corporate taxes would allow simplification of the personal income tax code (one rate for all income types), would encourage businesses to expand, and would make the U.S. an attractive location for foreign investment and the jobs that go with it. If we want to talk tax reform, that would be a good place to start.