Why We Should Eliminate the Corporate Income Tax

The FT has a piece today on the administration's plans to lower the corporate income tax rate in exchange for simplification--getting rid of a bunch of deductions.  This is a decent plan--and not just because it's the Full Employment for Policy Pundits Act of 2011--but this seems like a good time to once again charge into the fray and argue that we ought to just eliminate the damn thing altogether.

I can practically hear my more leftish readers grinding their teeth as they prepare to unload a wagonful of vitriol, but my objectives here are as much liberal as they are conservative.  The corporate income tax is an extraordinarily clumsy vehicle for the social purposes it is supposed to serve--it doesn't raise that much revenue, and it doesn't necessarily fall most heavily on the rich.  There are better ways to serve its progressive goals, at least as I see them--to reallocate income from capital to labor, and from rich to poor.

Why do I say this?  Well, I've been over all this before, many times, but for new readers, it's worth rehearsing the arguments:

You can't tax a corporation; you can only tax a person  For all the talk about corporate personhood, ultimately, all the income in a corporation ultimate ends up in the hands of some person: shareholders, employees, suppliers.  Ultimately, we're not interested in the accumulation of money and power in "Ford Motor Company"; we're interested in the managers and shareholders who benefit from that accumulation.

The incidence of "corporate" taxes is not necessarily progressive.  The "employer half" of the payroll tax, for example, is thought by most economists to fall pretty much entirely on the worker; corporations compensate for the extra cost by lowering the wages they offer.  Taxes on corporate profits are exactly the same for middle class families who have some shares in a 401(k), and multi-millionaire heiresses.

The corporate income tax encourages firms to use debt finance, rather than equity.  Debt finance makes companies riskier.  But because payments on debt are tax deductible, and dividends are not, companies have a strong incentive to use debt rather than equity finance. The deductibility of debt payments also lowers the required rate of return for new projects, possibly encouraging companies to invest in marginal ideas that aren't really worth it.  Without the corporate income tax giving them a 35% reduction on their interest payments, they might think twice.

You can't eliminate all the loopholes  I know what you're thinking:  why don't we end the deductibility of corporate debt payments?  Because that would put industrial firms with heavy capital costs at a massive disadvantage (there are other reasons to use debt, like the ability to match the duration of the financing to the lifespan of the asset).  More to the point, you could easily end up in a situation where tax bills were pushing companies into insolvency. Consider a big industrial firm with $1 million in EBIT (Earnings Before Interest and Taxes) during normal times, and $500,000 in interest payments.  Now say a really horrible recession dramatically lowers their income--to say $400,000.  They're actually burning $100,000 in cash a year--but they'd nonetheless have a tax bill of nearly $150,000 on their "profits".  Hello, receivership.

Some loopholes really are simply egregious giveaways to particular industries, but more often they're just disagreements over what constitutes a legitimate expense.  If you refuse to let businesses deduct too many legitimate expenses, you'll put a lot of firms into the red.

The corporate income tax encourages firms to waste resources on tax avoidance  In general, taxes are most efficient when they fall on those who have the most difficulty avoiding them.  Big corporations can and do spend an enormous amount of money and human effort transforming their income into more tax-preferred forms--deferring it, moving it, swapping it with entities that have different tax rules, and so forth.  We spend an enormous amount of energy trying to make rules to stop them.  It would be a lot easier to get rid of the thing entirely and focus on getting the money from people, who can't afford quite such large squads of tax attorneys.  This would also correct an obvious flaw in the corporate tax code: it's easier for big companies to afford pricey tax lawyers--and pricey lobbyists to get them special tax breaks.

Moreover, as I hinted above, the rules governing corporations are complicated for a reason--what constitutes an expense is as much art as science, and varies from industry to industry.  (The blizzard of tax rules governing something like a small mining operation make me quite dizzy.)  The rules governing people can be quite a bit simpler, because the basic operating costs of being a human being are pretty standard from person to person.

I mean, you may think that a large screen television and an annual trip to Tuscany are among life's necessities, but you're not going to get very far arguing that with the IRS.  On the other hand, luxury junkets for the sales force may in fact help a corporation to generate more income than they otherwise would.  All in all, it's a lot simpler to take the money from people.

If we get rid of the corporate income tax, we could eliminate the special treatment for dividends and capital gains.  The reason we currently have the special rates is to offset the "double taxation" of corporate profits.  You can quibble with the term, but the fact remains that a 35% corporate income tax combined with, say, a 43% marginal income tax rate (once we add in the special Medicare surcharges), would be a hell of a disincentive for the very wealthy to invest; you're talking about lowering the projected return on an investment by almost 3/4. There's little question that this would be bad--there's a reason that not even Sweden attempts to levy those sorts of taxes on capital.  But if we get rid of the corporate income tax, we can simply roll capital income into ordinary income--which means that we'll be taxing corporate income more progressively.  The taxes on corporate profits will fall most heavily on wealthy people.

There are already substantial disincentives to shelter your income in a corporation  Every time I suggest this, I get a lot of people arguing that people would simply funnel all their expenses through a corporation, and avoid paying income taxes.  These people are unaware that there are already substantial reasons to do this now, because corporations can deduct all sorts of things that people can't--rent, cars, utilities, non-mortgage interest payments, and so forth.  So why don't people do this?

Because the IRS won't let them, that's why.  While owners of corporations do manage to chisel at the margins, the smart ones don't funnel their whole personal budget through the firm, because doing so is a sure route to an audit and a hefty fine.  You can argue that we need to beef up the rules, and maybe we do.  But there's no reason to worry about wholesale abuses of the system, because the IRS is already reasonably adept about ferreting these out.

The corporate income tax doesn't raise that much money  It's not nothing--about $300 billion. But we could recoup a whole lot of that simply by taxing dividends and capital gains as ordinary income, and perhaps tweaking top rates.  That might be a bargain conservatives would go for.

Without the corporate income tax, a lot of the incentive for lobbying would go away  Not all of it, by any means--I am not trying to paint some halcyon future here.  But an enormous amount of effort goes into lobbying for tax laws, and politicians often reward favored constituent businesses with little sweetheart fillips to the tax code. Conversely, apparently neutral changes to the tax code often turn out to be excellent ways to hamstring your competition, particularly small businesses who cannot afford a huge tax department.

Want to get corporate money out of politics?  Want to erode the power of the Chamber of Commerce?  Take away one of their primary motives to get involved.

I don't say this will persuade everyone.  But I hope that liberals will at least consider that there might be a better way than the corporate income tax to achieve their goals.