The Corporate Income Tax: Mend It, Don’t End It

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By Josh Barro

In today’s New York Daily News, Luigi Zingales, a Bloomberg View contributor, describes a proposal for corporate tax reform. While his plan has definite upsides, it's ultimately unappealing.

It’s true that the corporate tax doesn’t work very well. But capital gains and dividend taxes also have a lot of problems -- problems that would become more acute under Zingales’ proposal.

Broadly, Zingales proposes to sharply cut corporate income tax rates while raising the tax rates on capital gains and dividends to match the tax rates on labor. All of these are taxes on the profits of corporations, and since the corporate income tax is fraught with problems -- corporations can do a lot to avoid taxes with clever accounting, and lobby effectively for tax preferences -- he says it’s best to cut it and rely more on the capital gains tax. Such a reform would also eliminate the bad optics that come from taxing capital gains at a lower rate than wages.

The first fact to note is that taxpayers have a lot of control over when they pay capital gains taxes, which can be deferred until the stockholder actually sells the stock. Corporate profits, meanwhile, are subject to income tax in the year in which they are earned.

In some cases, governments are indifferent to tax deferral -- taxpayers can pay now or pay later, effectively with interest, and the government just borrows to cover the gap. But there are several ways that taxpayers gain (and governments lose) due to capital gains tax deferral. A taxpayer can hold stock until he dies, bequeath his stock, and then his heir will have to pay tax only on gains since the date of the bequest, not the date of purchase. Tax is never paid on any gains in value during the deceased shareholder’s life. Or a taxpayer may simply hold stock until capital gains tax rates go down.

For these reasons, the option to defer capital gains tax means a lot of lost revenue for the government. And if the capital gains tax rate goes from 15 percent to 35 percent, as Zingales proposes, taxpayers will have much stronger incentive to use smart deferral strategies that deny the government revenue.

Another problem: A lot of stocks are held by non-taxable entities, such as charities, foundations, pension funds, and IRA and 401(k) accounts. These entities only get a partial tax preference -- while they pay no capital gains or dividend tax, the corporations they own shares in do pay corporate income tax before distributing profits. Shifting away from corporate income tax toward capital gains tax would increase the value of these entities’ tax preferences, meaning more revenue loss.

A bigger tax preference for retirement accounts and charities might or might not be good policy (and my inclination is that it’s not). At any rate, it’s something we should create for explicit reasons, not incidentally to other tax reform.

Yes, Zingales’s proposal could be modified to address some of these issues. But those moves would be politically difficult, and still would not address the fact that taxpayers could defer capital gains while awaiting a favorable shift in the tax policy winds.

That's why it's better to broaden the corporate tax base and lower rates, but not shift away from corporate tax toward individual tax. Ideally, we should abolish the capital gains tax altogether. I wrote last fall about the merits of the Bradford X-Tax, which uses a corporate tax component to build a tax system that is effectively a progressive VAT.

In addition to his proposed tax shift, Zingales says we should tax corporations on their profits before interest expense, allowing an even lower rate. This is a good idea. Unlike much of Zingales’s plan, however, this reform would likely be quite difficult to sell politically. It wouldn’t raise the tax burden overall, but it would cut taxes on low-leverage firms and raise taxes on high-leverage ones. Industries that lend themselves to high leverage, such as banking, would likely fight hard against the reform.

That’s a fight worth having -- the deduction for interest expense encourages firms to finance themselves with debt instead of equity, which increases the risk of bankruptcy -- but it will involve taking on the same corporate interests that fill the corporate tax code with loopholes and preferences.

Ultimately, there’s no way to make tax on corporate profits work without taking actions that are against the interests of one corporate lobby or another. But giving up corporate tax in favor of capital gains tax only trades one set of tax policy problems for another. As difficult as it will be, the United States needs to fix its corporate income tax, not give up on it.

Josh Barro is a contributor to the Ticker and a fiscal-policy analyst based in New York.


-0- Jun/12/2012 16:43 GMT