Reforming a Corporate Tax Code That Double Taxes

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Senator Orrin Hatch, chairman of the Senate Finance Committee, is focusing on an important aspect of the agenda for corporate tax reform -- -- allowing U.S. corporations to receive a deduction for dividends paid to their shareholders. That deduction would eliminate double taxation of corporate profits distributed as dividends; instead, these profits would be taxed only to shareholders, not at both the shareholder and corporate levels.

Although Senator Hatch has not disclosed the details of his proposal, a corporate deduction for dividends paid has several advantages. But such a proposal would raise financial and political challenges that would have to be addressed.

Here is a simple example. Under current law, if a firm organized as a corporation had $100 in net income, it would pay 35 percent in federal taxes-- leaving it $65 in corporate income. Then, if the corporation distributed this $65 as dividends to its shareholders, they would pay roughly 20 percent in taxes on these dividends -- leaving it with $52.

By contrast, if such a corporation received a dividends-paid deduction, it could distribute all $100 of its net income as dividends to its shareholders directly and pay no corporate tax on such distributed income. Then its shareholders would pay the taxes on these dividends at the applicable rate -- currently about 20 percent of the $100, leaving them with $80 of income.

However, if Congress passed the dividends deduction for corporations and kept the 20 percent tax rate on dividends for shareholders, the combination would result in a big revenue loss for Treasury. In response, some politicians would push for revenue neutrality -- offsetting those revenue losses with tax increases and/or spending cuts. Both would run into stiff political resistance.

One logical approach would be to increase the 20 percent tax rate on dividends, which is much lower than the top rate on ordinary income (39.6 percent). The lower rate on dividends has been justified mainly because those profits have already been taxed at the corporate level before being distributed as dividends. But that justification would no longer apply if corporations could deduct their dividends.

A dividends-paid deduction also raises thorny issues for pension plans and other tax exempt investors. The goal of the proposed deduction is to tax corporate profits only once. But corporate profits would not be taxed at all if distributed as deductible dividends to tax-exempt shareholders. To address this problem, the proposed deduction would likely include a requirement that corporations withhold a certain percentage of dividends before being paid to tax-exempt shareholders.

Similarly, most foreign shareholders of U.S. corporations reside in countries with U.S. tax treaties that reduce their taxes on US dividends to 5-15 percent. These treaties were signed when profits were taxed at the corporate level before being distributed as dividends. Under the proposal, by contrast, dividends would not be taxed at the corporate level. Therefore, U.S. corporations would likely be required to withhold a higher percentage of dividends before being paid to foreign shareholders.

Despite these issues in implementing a dividends-paid deduction, the plan would have several significant advantages. Most importantly, the deduction should eliminate the current tax bias to finance corporate projects by borrowing money instead of selling stock. Under current law, interest paid by corporations on loans is fully deductible, while dividends paid by corporations are not deductible.

This tax bias favoring debt over equity strongly encourages corporations to increase their leverage -- the ratio of debt to equity. Highly leveraged corporations create greater risks of bankruptcy and financial crises. Moreover, this tax bias impedes raising capital by modern companies based primarily on intellectual capital, rather than hard assets like buildings that typically serve as collateral for loans.

If businesses distribute a substantial portion of their profits to their owners, the dividends-paid deduction would dampen the incentive of businesses to avoid the corporate form in favor of pass-throughs such as partnerships, Limited Liability Corporations (LLCs) and S corporations. All of these pass-throughs tax business profits only once at the owner level, rather than twice at the both entity and owner levels.

Over the last few decades, there has been a sharp shift to doing business as a pass-through and avoiding corporate tax. In 1980, corporations filed 17 percent of all business tax returns; in 2008, this dropped to 6 percent. In 1980, corporations earned 75 percent of all net income of businesses; in 2008, this dropped to 48 percent.

Similarly, if businesses distribute a substantial portion of their profits to their owners, the dividends-paid deduction would in practice lower the average U.S. corporate tax rate below 35 percent, which is almost the highest corporate tax rate in the industrialized world. For example, the corporate tax rate is 20 percent in the UK and 12.5 percent in Ireland.

Because of these large differences in country tax rates, some U.S. corporations have become UK or Irish companies through complex transactions called inversions. Thus, by lowering the effective tax rate on U.S. corporations, the dividends-paid deduction may help discourage other U.S. corporations from inverting.

In short, the dividends-paid deduction would be a good start toward reforming corporate taxes. Nevertheless, to get the deduction passed, Senator Hatch would have to deal skillfully with a series of difficult issues.


Pozen is the former chairman of MFS Investment Management, and a senior lecturer at the MIT Sloan School of Management. 

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