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March|April 2005
The Corporate Tax Is Dying! By Maya MacGuineas
The Secret Posse By Geoffrey Klingsporn

The Corporate Tax Is Dying!

Time to (carefully) bid it farewell.

By Maya MacGuineas

THE CORPORATE INCOME TAX HAS ALWAYS HAD ENEMIES. Introduced in 1909 as an effort to close the country's worst budget gap since the Civil War, economists and capitalists almost immediately began to argue that it was inefficient and slowed down business. More recently, Presidents Reagan and Carter, as well as conservative economist Milton Friedman and liberal economist Lester Thurow, have all recommended that the country scrap it. In May 2001, then-Treasury Secretary Paul O'Neill called the tax system of the United States an "abomination" and proposed the abolition of the corporate income tax.

Efforts to repeal it, however, haven't gone far. Taxpayers have long been more frustrated by the taxes they must each pay personally, such as property and individual income taxes. The corporate income tax just doesn't sting the way writing a check on April 15 does.

But there is a long list of shortcomings associated with corporate taxes. Many companies pay more for their accountants' time than they do in taxes, and the Congressional Budget Office has estimated that because of the many inefficiencies the corporate tax creates, it drains as much from the economy as it actually collects. These facts, combined with the country's increased recognition of the incentives that drive American companies abroad, mean that the corporate income tax finally seems to be on its way out.

THE CORPORATE TAX ENTERED A WORLD without commercial airplanes, much less e-mail. At the time, if a company set up its headquarters in Chicago, its top executives likely couldn't even get to Bermuda. Now a Chicago company can relocate its entire headquarters there with limited effort. This ease of mobility has brought global competition, and companies can leave countries that aren't friendly places to do business.

Unfortunately, however, American corporate tax rates are higher than those imposed by most of our trading partners, and that disadvantage takes its toll. Meanwhile, lower corporate tax rates connect to higher growth. Ireland's recent economic success, where per capital GDP went from well below European Union averages to well above, is attributed in part to the country's reducing its top corporate tax rates from over 40 percent to 12.5 percent.

U.S. corporate earnings are also subject to double taxation. If Microsoft makes a dollar, the federal government takes a cut before the profit can be passed on to Bill Gates, other employees, or other shareholders—at which point the government takes another cut. From the shareholders' perspective, as partial owners of the corporation, they bear part of the first round of taxes on corporate income, and they bear the second on income received through dividends. Whether you view these taxes as distinct or as duplication, it would be more efficient if the government took a single bigger bite at one point.

Compounding the problem is that in order to reduce the problem of double taxation, many of our trading partners have gone further to integrate their individual and corporate income taxes than we have. For example, Germany exempts 50 percent of dividend income from the income tax, and Greece has eliminated it entirely. Though a measure to reduce the U.S. tax rate on dividend income was recently made law, the change is only a temporary one.

Companies incorporated in the United States face still another challenge. The U.S. tax system is a worldwide system, meaning that the federal government taxes the income of U.S. companies no matter where it is earned. If a company is headquartered in Hartford and has manufacturing plants in Mexico City and Guangzhou, money the company earns abroad is taxed as if it were earned here. Most other industrialized countries use territorial systems where companies pay taxes only on what they earn domestically. This gives companies an incentive to structure themselves as subsidiaries of foreign corporations in low- or no-tax countries. Although companies that choose this course of action risk being denounced as Benedict Arnolds, the tax savings still seems compelling to many of them.

Rather than engaging in a fundamental debate about the corporate income tax, Congress has often addressed aspects of it and tried to plug corporate tax holes by reducing tax rates or providing additional deductions to companies. But even on the rare occasions when these efforts prove successful, a new leak has invariably been sprung somewhere else. Consider the 2004 corporate tax bill. The World Trade Organization determined that part of the U.S. tax system had to be changed to comply with international law and to prevent what the WTO considered to be the illegal subsidization of American goods. Attempts to keep any company or industry from being overly burdened in the process led to a bill with a hodgepodge of tax breaks for tackle box producers, NASCAR track owners, and barge operators.

IT MAY SEEM INAPPROPRIATE TO FLOAT THE IDEA of getting rid of the tax at a time when corporate America's reputation has dropped precipitously. The Enron scandal, United Airlines's pilfering of its employees' pension fund, and the Tyco collapse make it unlikely that Congress would find much support for giving American businesses a free tax pass. They are already getting a pretty good deal, it would seem, given that the percentage of federal revenues coming from corporate taxes has dropped from one third during WWII, and over a quarter during the 1950s, to only 9 percent today.

With large budget deficits also projected to last ad infinitum, politicians who want to maintain old spending programs or develop new ones have to offset the costs—which makes it even more unlikely that the Congress will now go for eliminating the corporate tax. It has political support, it is administratively feasible, and it has been a part of the American tax system for decades.

But, as the old-but-valid economics adage goes, corporations don't pay taxes, people do. While corporate CFOs may write the checks, the real burden—or, in economic parlance, the incidence of the corporate tax—falls elsewhere. Corporations are merely legal entities structured to pass along profits to their owners and investors. Taxes are just another cost of doing business, one that is also passed along, just as when the price of one of the inputs increases for a company. If the cost of cocoa were to go up, that would be compensated for with some combination of responses—an increase in the price of Hershey's Kisses, a few Hershey's employees losing wages, or a decline in the quarterly dividend of shareholders. The same thing would happen if Hershey's had to pay higher taxes. The cost to consumers would be hidden, but that doesn't reduce the costs to those who bear them.

IT'S SAFE TO BET THAT THE CORPORATE TAX will contribute far less revenue to the bottom line of the U.S. government in the next decade than in the last one. That trend is well underway and, if the corporate tax rate doesn't change, companies will continue to have a big incentive to leave the country, reducing what they pay to the U.S. government as a result.

But there are still a few reasons why we should be careful in eliminating the corporate tax. First of all, current budget deficits leave no room for further tax cuts. With federal revenues as a share of GDP at their lowest level of the past five decades, tax increases would be far more appropriate. If Congress is to reduce or eliminate the corporate tax, then the move needs to be accompanied by a way of increasing revenue, like broadening the income tax base or introducing what is known as a consumption tax. While many consumption taxes are highly regressive, a "progressive consumption tax" with tax rates levied on spending would be both efficient and fair.

Second, the corporate tax is relatively progressive, since much of it is passed on to shareholders, who tend to be well off. Reducing or eliminating the tax out of economic good sense should not have the undesirable effect of shifting the overall tax burden away from the wealthiest to those on the lower end of the income spectrum. With inequality growing, the tax system should be made more progressive, not less.

Finally, eliminating the corporate tax could allow individuals to incorporate and avoid income taxes. It might be hard to imagine your next door neighbor going to the trouble, but for professional athletes and movie stars, corporations created as tax shelters could spring up with abundance. That the corporate tax serves as a backstop against sheltering income is probably the strongest reason today for keeping the tax. At the very least, it argues for keeping the move toward extinction a gradual and managed one.

But arguments for working carefully to eliminate the tax are different from arguments that we should keep it, and there are few of those. The longstanding arguments against the tax—for example its inefficiency and complexity—are still there. And now they've been joined by the argument that the tax, in an age of globalization, is driving companies out of the country. All of that combined means that it's finally time to rid the country of a bad economic policy that has been around for nearly 100 years.

Maya MacGuineas is the director of the Fiscal Policy Program at the New America Foundation.

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