A Trade-In for the Corporate-Income Tax: Echoes

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By Joseph J. Thorndike

Taxes wear out. Like a new car, they start out fresh and shiny (if lacking that new-car smell). After a few years, things start to go wrong. Eventually, as failures become more frequent and repairs less durable, the time arrives for a trade-in.

We have reached that point with the corporate-income tax. With more than 100 years under its belt, it had a pretty good run. Over the years, it raised a lot of money, regulated some unsavory business practices and helped make the tax system more progressive.

But it also distorted business decisions, discouraged investment and encouraged a lot of tax avoidance (both by companies and individuals). As business has gone global, these problems have gotten worse.

The decay of the corporate-income tax shouldn’t come as a surprise. Other taxes have followed a similar trajectory, from promising innovation to functional tool to doddering anachronism.

Case in point: the general property tax. Once upon a time, U.S. states relied heavily on property taxes that, at least in theory, applied to all forms of wealth. These were not the same property taxes we know and loathe today, levied on real estate and some personal assets.

Rather, they were assessed on all forms of property: tangible and intangible. If successful, such a tax would ensure that the farmer’s land would get the same treatment as the investor’s stock portfolio.

Unfortunately, the tax wasn't successful. It's not easy to see a stock portfolio, while land and buildings are hard to hide. As a result, the tax often burdened landowners heavily and investors lightly.

As historian Ajay Mehrotra of Indiana University has noted, the inexorable rise of finance capitalism in the 1880s and 1890s exacerbated such problems. By century’s end, calls to abandon the tax were deafening. Economist Edwin R.A. Seligman offered a particularly scathing indictment, using rhetoric to make a Tea Partier blush.

“It puts a premium on dishonesty and debauches the public conscience,” Seligman wrote of the property tax. “It reduces deception to a system and makes a science of knavery; it presses hardest on those least able to pay; it imposes double taxation on one man and grants entire immunity to the next. In short, the general property tax is so flagrantly inequitable that its retention can be explained only through ignorance or inertia. It is the cause of such crying injustice that its alteration or its abolition must become the battle cry of every statesman and reformer.”

Lawmakers listened, and soon abandoned efforts to tax intangible property. But to keep things fair, they introduced new taxes on individual and corporate income.

Federal lawmakers followed their state counterparts and embraced income taxes as a way to make the system more progressive. They also used the corporate tax to regulate various business practices, such as ownership structures and earnings distribution. And of course, they used it to raise money.

For almost as long as the corporate-income tax has been on the books, critics have derided it as a “double tax,” since earnings are also levied at the individual level. They have also challenged one of its leading justifications: that it makes the overall system more progressive. In fact, the tax probably falls most heavily on the owners of capital, as its defenders insist. But some significant part of its total burden is almost certainly borne by workers in the form of lower wages.

More recently, critics have insisted that the corporate tax also makes the U.S. less competitive. Our marginal rates, topping out at 35 percent, are among the highest in the world, making it harder for U.S. companies to operate in a global marketplace. Supporters of the tax counter that average rates are actually much closer to the international norm. But defending a tax on the grounds that it’s easily avoided seems less than compelling.

The corporate tax has been wearing out for some time. Its contribution to total federal revenue has declined to just 8.9 percent in 2010, from a postwar high of 30.5 percent in 1953. As a share of gross domestic product, it has fallen to 1.3 percent in 2010 from 6.1 percent in 1952.

Current proposals for the repatriation of overseas profits (which remain untaxed as long as they stay offshore) are just another sign that the corporate tax is nearing the end of its useful life. If gutting a tax every three or four years is the only way to keep it functional, then what does that tell us about the tax itself?

So what’s the best way to get rid of it? The U.S., with its dire fiscal outlook, is in no position to simply repeal the levy. Clearly, some sort of replacement is necessary.

Luckily, one is available. A federal value-added tax could finance a gradual retirement of the corporate-income tax. Initially, even a modest VAT could be used to dramatically reduce marginal rates. According to estimates from the Tax Policy Center, a think tank based in Washington, a broad-based 5 percent VAT could pay for a reduction in the top corporate rate to 7.4 percent. Eventually, lawmakers could repeal the tax entirely.

Such a swap isn't without problems. Among other things, it would almost certainly make the tax system less progressive, since the VAT falls most heavily on the poor. But the new VAT could be designed to ameliorate this effect, either by exempting certain necessities or by creating a refundable credit.

One thing is certain: Doing nothing about the corporate-income tax simply isn't an option. Hobbled by tax shelters, capital mobility and international competition, it is showing its age. Sooner or later, it's destined for the scrapheap.

We might as well start shopping for a replacement.

(Joseph J. Thorndike, a contributor to the Echoes blog, is the director of the Tax History Project at Tax Analysts and a visiting scholar in history at the University of Virginia. The opinions expressed are his own.)

To contact the writer of this blog post: Joseph J. Thorndike at jthorndike@thorndike.com.

To contact the editor responsible for this blog post: Timothy Lavin at tlavin1@bloomberg.net.

-0- Sep/30/2011 14:12 GMT