Tax reform: Are you really a believer?

  • Article by: PAUL GUTTERMAN
  • Updated: May 23, 2013 - 6:55 PM

In any such reform, corporate taxes would have to go.

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Apple CEO Tim Cook, center, flanked by Peter Oppenheimer, Apple's chief financial officer, left, and Phillip A. Bullock, Apple's head of Tax Operations, are sworn in on Capitol Hill in Washington, Tuesday, May 21, 2013, prior to testifying before the Senate Homeland Security and Governmental Affairs Permanent subcommittee.

Photo: J. Scott Applewhite, AP

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Almost everyone, including members of Congress, believes in tax reform ­— in theory. But this week’s congressional grilling of Apple executives over their firm’s avoidance of corporate taxes highlights the reason why major tax reform is a pipe dream. The gulf between theory and practice is unbridgeable.

Let me give you an example to test whether you are a true believer.

According to almost all economists and tax policy wonks, one basic unfairness and inefficiency under the current tax regime is the corporate tax. Any sound tax reform plan should eliminate this tax, since there is no theoretical rationale for it.

Yet this is unthinkable for most people, especially when faced with trying to replace the $287 billion in taxes paid by corporations last year. This represents more than 10 percent of all federal revenue. The lost revenue would have to be made up by taxing individuals in some fashion.

Are you still a believer?

Changes to our tax laws over the years have eliminated any tax benefits of doing business in corporate form. Instead, there is simply a huge reason to avoid being a corporation: double taxation.

Every other way of doing business, whether as a partnership, limited liability company or what is called a Subchapter S corporation, faces only one level of tax. The entity itself, the firm, pays no tax. Rather, any income is flowed through to the owners and taxed there.

There is no sound rationale for treating this one way of doing business differently than any other, particularly when other forms of doing business can be structured to enjoy the same nontax benefits as incorporation.

Indeed, tax law recognizes that all corporations would willingly convert to other forms to conduct business. Consequently, the code specifically provides that all publicly traded business entities will be treated as corporations for tax purposes even if they are something else under state law. Therefore, a huge tax burden exists to conduct business in publicly traded rather than privately held form.

Corporations suffer double taxation because of dividends. The corporation itself pays tax as a separate taxpayer, then shareholders pay tax on the same income when dividends are distributed.

There are three main methods by which we could eliminate this double tax burden on corporations. One would be to simply repeal the corporate tax and treat corporations the same as other entities — a conduit through which shareholders earn and report income. The second method would be to give corporations a deduction for dividends paid. The last method would be to not tax dividends.

Prior to 2004, dividends were taxed as ordinary income, the same as wages and interest income. However, since 2004, most dividends have been taxed at the same (lower) rate as capital gains. This was essentially a compromise between Republicans who wanted to get rid of the double taxation on corporations and Democrats who saw any reduction in corporate tax as a windfall to the rich. While the rate reduction for dividends was temporary when passed, it became permanent as part of this year’s fiscal cliff agreement.

Eliminating the corporate tax would greatly simplify the law. Currently, the United States has the highest marginal corporate rate in the world. Even though there is widespread agreement in Congress that the top marginal rates on corporations should be reduced, that will not simplify the law.

One problem is that certain provisions of corporate taxation favor some types of businesses (such as manufacturing) over others. Another problem is with the way the U.S. taxes international operations, which results in real, effective rates much lower than the statutory rates (see Apple Inc. as Exhibit A). Such complications and inequities would disappear with the elimination of the corporate tax.

Another benefit of eliminating the corporate tax would be that corporations would be forced to distribute a significant amount of cash each year so that shareholders would have the funds to pay the tax on the flow-through of corporate earnings. Currently, there is little incentive to distribute excess funds to shareholders.

But despite its theoretical desirability, the corporate tax is not in danger of elimination. The faceless corporation gathers little sympathy, and many taxpayers would rather increase the corporate tax rather than give up their individual tax benefits — which may have little justification.

For example, limiting the ability to deduct home mortgage interest could easily offset the lost revenue from eliminating the corporate tax. If you are a true believer in tax reform that simplifies the tax system while creating economic benefits, you embrace such a tradeoff.

So, are you a believer or not?

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