To get a good tax system we must: (1) know the cost and effects of each tax, (2) know who pays which taxes, and (3) decide which groups will contribute how much of the total.
We first explored estate taxes. They turned out to be cheap to collect, hard to evade and have low impact on economic activity Now corporate income taxes. They are costly to collect, quite easy to avoid or evade, and fraught with competitive issues. We noted earlier that estate taxes paid by the heirs of those who built the asset are the most unpopular of all. That suggests we hold the peculiar belief that those who earn money should be taxed while those who inherit what others earned should not. The Walmart heirs, for example, own more than the bottom 40% of America. Is that what we want?
In general, we want corporations to pay more income taxes while we pay less. Taxes are taken directly out of what we earn, so they are highly noticeable. It feels unfair that a significant amount of our earnings is taken away but corporate income taxes do not feel unfair because we feel corporations could afford more. When we hear that some pay none at all, it feels outrageously unfair. It also feels unfair that while we are taxed on gross income, businesses are taxed only on profits.
Who in fact does pay corporate income taxes; customers, workers or owners,? It can’t be customers because prices are set by the market and the market is supplied not just by corporations but also sole proprietorships, partnerships and S-corporations that pay individual income tax. That means corporations can’t raise prices to cover their taxes. So, is it workers or owners? When corporate income tax was introduced in 1909 it reduced profits, i.e. was paid by shareholders. Later, it was paid in part by workers getting lower wages. Treasury Department economists reckon 82% now falls on owners and 18% on labor.
Note that tax on the income of non-incorporated businesses is paid entirely by the owners and, as I noted in Business Tax, around two thirds of US businesses reporting profits of $1 million or more are not incorporated.
How much tax do corporations pay? The top rate in the US at 39.1% (35% at the federal level) is the highest in the world. The effective rate, what they actually pay, is less clear. The Tax Foundation summarizing 13 studies reports rates ranging from 23% to 34.9%. The US rates are among the five highest for all countries analyzed. Another analysis found 30 Fortune 500 companies had paid no federal corporate income taxes at all for the 2008-2010 period and there was recent outrage that, by accounting for them overseas, Apple avoided taxes on $74 billion in profits over the last four years. Less noticed is that Apple’s 14% effective tax rate is much higher than Ford’s 3%, Amazon’s 6%, Boeing’s 7% and Verizon’s 9%, and is in the same range as IBM 15% and Google 17%. That is half the 29.1% average rate for 2007-2012. This magnificent chart shows all the numbers.
Why such different rates? Chiefly because US corporations can delay paying income taxes on overseas profits until they are brought back into the US. $1.7T of profits is currently estimated to be offshore. Corporations like Apple locate intellectual property and/or manufacturing in countries with low tax rates. When an Apple product is sold in the US, Apple pays its patent-holding Irish subsidiary a royalty that reduces the profit Apple shows in the US and transfers it to low-tax Ireland. Apple borrows in the US, deducts the interest here, and uses the funds to pay dividends to shareholders and establish manufacturing overseas. PepsiCo relocated concentrate manufacturing from New York to Ireland. Over half their soda sold worldwide is now based on concentrate manufactured there. Coca-Cola opened a plant in Singapore to produce concentrate for 18B cans of soda a year. The soda industry as a result paid not the 29% average tax rate but 19%. But retailers, who among other things sell soda, cannot relocate offshore so most of them paid between 35% and 40%. Even Wal-Mart paid 31%.
The closer you look, the more complicated corporate taxes become. Large multinational corporations have great flexibility in where they locate production, incur costs and realize profits. They can borrow in one country and take the interest deduction there, locate production facilities and employ workers in another country, and realize profits in a third country. A change in taxes on overseas profits impacts only multinationals, a change in depreciation allowances mainly affects manufacturing companies, but many multinationals are manufacturers. The existing tax code encourages moving jobs overseas.
How important is this? The Joint Committee on Taxation estimates a bill introduced this February by Senator Sanders (I-Vt.), a member of the Senate Budget Committee, would yield more than $590B over the next decade. US corporations would pay US taxes on all profits when and wherever earned. “At a time when we have a $16.5 trillion national debt and an unsustainable federal deficit; at a time when roughly one-quarter of the largest corporations in America are paying no federal income taxes; and at a time when corporate profits are at an all-time high, it is past time for corporate America to contribute significantly to deficit reduction”, Sanders said.
By closing the gap between companies that now pay different rates, the bill would also result in the market, not the tax code, playing a bigger role in determining companies’ success and failure.
Is that the only alternative? Wouldn’t it price our corporations out of the global market or commit us to cut our corporate tax rate in a global race to the bottom where all countries keep cutting? Taxes based on where customers are located is another option. The state of California moved to a sales-based system last year because the States already are in a race to the bottom. Maine, where I live, is considering a substantial cut in business taxes for this reason. In California’s scheme, a company that gets 20% of its sales in California pays California taxes on 20% of its worldwide profits at the state’s corporate tax rate. It makes no difference where the firm has offices or where its employees work.
The US could move to a similar system, though if we were the only nation that did, companies could be taxed twice. Presumably, there would be changes to our existing tax treaties with countries that require non-US companies to pay tax here while US companies pay tax there.
But could it be there is no system in a global economy that’s fair for multinational vs domestic corporations, small vs large ones, corporations vs non-incorporated, advanced vs developing economies, and so on. Should we just end corporate income tax? As I noted in Business Tax, it has long been falling as a % of GDP and as we saw above, it is paid mostly by shareholders. Since they tend to be wealthier than average, that results in greater income inequality. It would at least be clearer if we simply decided what rates of tax those with higher and lower incomes should pay.
What to do about corporate income tax? Eliminate deferral of the tax on profits held overseas and other exemptions while cutting our tax rate? Switch to taxing worldwide profits based on the US percentage of worldwide sales? Eliminate corporate income tax? Or what? That decision must be made along with decisions about personal income and other taxes, each forming part of a better overall tax system.
The research for this series of posts is proving a lot more interesting than I expected. We value working for success but want to abolish estate taxes. What we call “payroll taxes” are not taxes but savings and insurance. Corporate income tax is paid chiefly by wealthy people, distorts competition and cuts personal income by encouraging jobs to be moved overseas. What will we discover next?
A naive question: What would be the result of eliminating corporate tax, and taxing dividends and capital gains at the same rate as wages? I would think it would be an incentive to allocate more of the corporate profit towards R&D and capital improvements, and a disincentive to short term buying and selling. And would the loss of government revenue from corporate tax be offset by the increase from dividends and capital gains taxed at a higher rate? I’ve never understood why corporate profits are taxed as if the corporation were a person, then taxed again when distributed as dividends, but then it’s never been a subject I’ve studied in depth.
That’s not one naive question but a deep and thorny collection. Eliminating corporate income tax would make less difference than I imagined. We already do not tax two thirds of all US businesses that report more than $1M of profits. The tax we collect from the remaining one third is only about 1% of GDP.
I will explore the impact of taxing different sources of personal income at different rates in a later post. It’s always said, for example, that we need to encourage investment by taxing capital gains at a lower rate. I’ll try to figure out how the behavior of those with capital to invest would change if there was not a lower rate for long term gains.
I’m not sure if it will end up as part of this series but I also want to explore the short term nature of executive incentives. Some executives (e.g., Steve Jobs) are motivated for the long term, many (e.g. Chainsaw Al Dunlap) are not. Why the difference?
The same argument of “investment is encouraged by a lower rate of capital gains” was given to me by someone at work. I’m not sure I agree. If all roads to income had the same grade, wouldn’t the incentive be to choose the road most interesting, not the one perceived to get you rich quick? Isn’t there too much absentee investing, i.e. investors who know nothing about what it is in which they invest, other than the monetary return? I draw a parallel to absentee landlords, who have nothing to do with the maintenance of their buildings, and are only interested in collecting rents with the lowest possible expense outlays. As long as you can walk away before it all crumbles, but what do you leave behind?
My conclusion in the post I promised is different from what I expected, all income should be taxed at the same rates: http://martinsidwell.com/personal-income-tax-and-fairness/
Martin, I appreciate your efforts to clarify the issues around taxation and our economy. I’ve been mulling over how best to treat corporate taxation and regulation myself, but it seems the more I look into it the less sure I am of how best to deal with it. In an age of globalization, the complexity and amorphous nature of mega-corporations and their international relationships are tied up with many other things. With the corporation’s ability to create shell entities and a multinational presence, they can bypass regulations and reduce or eliminate taxes. It’s like trying to pin down an amoeba.
For instance, many American insurance corporations have been creating dummy re-insurance entities, in countries with lax regulations, that purport to guarantee some portion of their obligations, but in fact have little or no assets to cover these obligations. This maneuver clears the books of the insurance company to spend more of what should be their reserves on stock market speculation or inordinately exorbitant executive salaries and bonuses. Another example is Apple’s recently reported tax ploy using a loophole that capitalizes on the difference between U.S. and Irish rules regarding tax residency to avoid paying corporate income taxes.
On the one hand, it would seem that since corporations benefit from our county’s infrastructure and economic environment they should contribute to maintaining and building that beneficial environment through taxes and adherence to regulations. In addition, corporations and businesses should be held accountable for environmental damage caused by their production of goods. They should be required to take steps to reduce such damage or clean up the resulting damage, or be heavily fined if they are recalcitrant about cleaning up the environment they polluted.
On the other hand, taxes, regulations, and regulatory fines may act as a disincentive to corporations basing their operations in our country. In addition, taxes and regulatory fines on a corporation will be passed down to the consumer, assuming the consumer needs or wants the product badly enough, which negatively affects middle and lower income people more than upper income folks.
However, on the 3rd hand, it seems reasonable that consumers should pay in some way for the full cost of producing, distributing and ultimately safely disposing of products they use including the costs of rectifying environmental damage caused by production of these products. Adding these costs into a product may make it less competitive, but forces the consumer to appreciate the true cost of products they use.
So, I do think corporate entities should be taxed as their fair share of maintaining and building the economic infrastructure they employ. Perhaps their share of the tax burden could be reduced by increasing the burden on other tax-paying entities. I can think of three possibilities: instituting a financial transaction tax on stock market trades, treating capital gains for individuals as ordinary income, and adding new marginal income tax rates for individuals to perhaps 50% at the $2 million level, 70% at the $10 million level, and 90% at the $50 million level. As far as the “double taxation” argument against taxing businesses and the dividends paid to stockholders, corporate taxes are a cost of doing business. Dividends paid to shareholders should be paid from after-tax profits and should be taxed as ordinary income to the payee.
The problem of eliminating some of the off-shore tax avoidance strategies mentioned above and counteracting the disincentive to corporations basing their operations in our country is another question. Perhaps a well thought out system of tariffs would help, but that is fodder for some later essay.
Thank you very much for your encouragement, John, and for your thought-provoking comments. Several points you raise are likely to provoke separate and maybe even series of posts, for example about the impacts of globalization and what, among other things, it means for tariffs.
I don’t know that I’ll get to it, but I should research FASB (Financial Accounting Standards Board). The issue of overseas reinsurance entities that purport to cover obligations but in fact have insufficient assets seems fixable with better standards. Accounting standards differ from country to country and I’m guessing they’re all falling behind on maintaining transparency in a rapidly globalizing economy.
I will do more thinking as I force myself to an overall conclusion about a better tax structure but I’m no longer certain corporate income tax makes sense. As noted above, a high percentage of large US businesses are not incorporated. Taxes on their profits are paid by their owners. Maybe it should be the same for all businesses. I’m leaning toward the idea that it’s better to tax only biological people.
The environmental damage issue is an example of an externality. It falls primarily on others, not the one who creates the cost. Externalities are a feature of capitalism (where feature=bug). Legislation could make some of what are now external costs fall instead on their creators, e.g., a carbon tax would be a highly effective way not just to shift but greatly reduce that environmental cost, but externalities in general are the mirror image of infrastructure. Some external costs and some infrastructure investments are just too large to be funded privately. They must be born by the overall public.
I don’t see how to make consumers pay the full cost of what they buy. Environmental and worker protection laws in the USA, for example, are much more stringent than countries where much of what we consume is manufactured. The folks of those countries are paying those costs. This is where the Fair Trade movement is coming from but it’s a much bigger issue.
I wanted to finish my post about personal income tax before responding to your last set of points. I came to the same conclusion about capital gains and marginal rates although the research I examined suggests a lower top rate than you suggest. The financial transaction tax feels like a good idea but I should really go back to the overall topic of financialization.