Is the U.S.-Based Corporation An Endangered Species?
America's businesses are tired of waiting for tax reform, and in response they're voting with their feet - physically and metaphorically. This do-it-yourself tax reform will continue until Congress lowers the corporate tax rate, repeals our arcane worldwide tax system, and ends the double tax bias against schedule C-corporations.
Getting all the attention these days are the handful of U.S. multinational corporations that are actually voting with their feet by moving their official headquarters abroad to escape U.S. tax on their foreign income, a practice known as "inverting." Less noticed, however, is the fact that over the past two decades thousands of businesses have quietly adopted "pass-through" forms - such as partnerships, LLCs, REITs, RICs, and schedule S corporations - to escape the double taxation of the schedule C-corporation.
As a result, the traditional C-corporation is on the path to becoming an endangered species. According to latest IRS figures, there were 1.65 million C-corporations in 2011. This is the lowest number since 1974 and nearly 1 million fewer since the Tax Reform Act of 1986. (See chart.)
By contrast, the number of non-C-corporation entities has exploded since 1986. The number of schedule S-corporations (which are taxed like partnerships) has grown from 826,000 to nearly 4.2 million in 2011.
Meanwhile, the number of partnerships and LLCs have nearly doubled, from 1.7 million to almost 3.6 million. The growth in the number of sole proprietorships has been equally impressive. In fact, there is now more net income reported on the individual 1040s of pass-through owners' than on the 1120 tax returns of C-corporations.
An interesting consequence of the shift of business income from corporate to individual income tax returns is that it has exaggerated the apparent rise in income inequality since 1986, alarming egalitarians like Thomas Piketty. It turns out that the income was there all along, belonging to the same business owners, only now it appears as personal income instead of corporate income.
For many entrepreneurs and small business owners, the main reason for avoiding C-corporation status is the double taxation of the corporate form, made worse recently by the increase in the top tax rate on capital gains and dividends. C-corporation income is first subject to the corporate tax, and then is taxed again as dividends or capital gains (due in part to reinvested earnings) at the shareholder level. "Pass-through" income is passed-through to the partners and shareholders to be taxed once.
Rather than celebrate the growth of these entrepreneurial business forms, aggrieved lawmakers are wringing their hands over the "erosion" of the corporate tax base. The Obama administration and some in Congress have threatened to extend the double taxation of C-corporations to large pass-throughs to claw back the revenue of which they feel deprived. The likely effect will be to make large pass-throughs as endangered as traditional C-corporations.
As for businesses that invert, they too are demonstrating that tax rates matter. U.S.-based multinationals who can reorganize to avoid the punishing U.S. corporate tax rate are doing so to the extent that the law allows. Globally, the nearly 40 percent combined federal-state corporate tax rate is the third highest of 163 countries, behind only Chad and the United Arab Emirates. If the U.S. had the third highest electricity costs in the world our firms would be doing their best avoid that too.
Not only is our corporate tax rate too high, but the U.S. imposes that rate not only on domestic income, but also on the non-U.S. income of U.S.-headquartered businesses if the income is brought back to the United States. Only six other developed OECD countries do the same to their businesses. The rest have so-called territorial tax systems and do not tax the earnings of their companies in other countries.
Inverting firms still pay tax to the U.S. on their U.S. earnings like any other company. They only save the additional tax the U.S. imposes on repatriated foreign earnings, on top of taxes paid to foreign governments. This is an additional tax that U.S. businesses' foreign competitors need not pay. That added tax may be the difference between thriving and failing in foreign markets, and between expanding and contracting U.S. production if firms need access to their foreign profits to reinvest here.
One of the guiding tenets of tax policy is the benefit principle, which requires a tax be linked to the benefits received. But what service does Washington provide the foreign operations of U.S. multinational businesses that would justify a U.S. tax on their foreign earnings? It is the foreign governments that charter companies operating abroad, maintain order and rule of law there, defend property rights, and create foreign infrastructure used by those businesses. Where does the U.S. add value? Does it protect the firms against foreign seizures or defaults? Ask McDonald's about its Moscow sales figures last month.
While Washington condemns inversions, it has actively encouraged foreign firms to buy American firms. The Bush Treasury begged Barclays to bail out Lehman Brothers at the onset of the financial crisis, but Barclays waited until the bankruptcy to pick up selected assets. The Obama Administration had no qualms when Delphi was shopped to Britain during its reorganization, and had no trouble with Fiat's purchase of Chrysler, even though the combined firm will be headquartered in the Netherlands.
Our experiences with inversions and a shrinking corporate sector is eerily similar to what Great Britain suffered less than a decade ago - and we would do well to mimic their solution. Britain had a high corporate tax rate and a global tax system. As other European countries cut their corporate tax rates, Britain saw some of its leading firms move to Ireland or the continent. In response, Britain cut its corporate tax rate and adopted a territorial tax in line with or better than its neighbors. Now, their corporate sector is rebounding and U.S. firms are fleeing to Britain. The number of U.K. corporations is now more than triple what it was in 1986, exceeding one million in 2012, and climbing. It may soon surpass the U.S. level.
Lawmakers are quick to play the patriotism card, but it is the patriotic duty of the U.S. Government to make the United States an excellent low-cost place in which to produce goods and services to sell here and abroad, and a good place in which to work and hire, invest, organize and manage global companies, do R&D, and park intellectual property. To that end, Congress should enact a uniform low rate business tax that is the same for all business types, with one, not two, layers of tax. A reformed corporate income tax should apply to U.S. earnings only, and it should apply to revenues less all costs, including the expensing of capital outlays.
Congress and the President should trust the people who elected them to be smart enough to seize the economic opportunities that real business tax reform would provide. Other governments do. Washington should take a lesson from the competition.
