How the U.S. could kill the corporate tax

The idea of abolishing corporate taxes sounds like a radical one: I've received dozens of angry e-mails after bringing it up in a recent column. In the U.S., however, the process of phasing out corporate tax started in earnest 30 years ago, and though it's unfinished, it has worked reasonably well. Politically charged though it would be, the U.S. would benefit from bringing it to the logical conclusion, and other countries could profit from its example.

In a recent paper, Conor Clarke of Yale Law School and Columbia University economist Wojciech Kopczuk traced the evolution of business income and its taxation in the U.S. since the 1950s. They recorded a gradual shift from corporate to individual taxation.

In working out how to tax business income, a government faces a dilemma. If it stresses individual income for taxation, it encourages people to keep their earnings inside firms and receive consumption-related benefits through them (which are often also taxed as benefits). If it stresses corporate levies, corporations do all they can to avoid it, setting up complicated structures and schemes.

There is a third path that avoids these problems — treating more business income as pass-through and taxing it as it accrues to individuals. That creates the "invidious task of allocating firm-level income in large, complex entities to many dispersed owners," as Clarke and Kopczuk put it. The U.S. has gradually chosen this headache over the others by introducing pass-through S-corporations in 1958 and then allowing more use of them by increasing the number of shareholders they could have. The 1986 tax reform also raised the corporate tax rate above the top-bracket individual tax rate, encouraging owners to switch to the pass-through form. As a result, the share of business income subject to corporate taxation dropped steeply in the U.S. while it grew or remained stable in some other major economies.

The pass-through revolution hasn't significantly changed U.S. tax revenue as a share of economic output. According to the Organization for Economic Cooperation and Development, since 1965, that share has fluctuated between 23.5 percent and 28 percent, keeping closer to the high end of the range in recent years. Keeping the corporate tax essentially just for publicly traded firms with lots of shareholders, which couldn't change into S-corporations, didn't cut into the U.S. government's revenue.

But what if the U.S. government decided to complete the revolution and treat all businesses as pass-through entities?

The classic way to get money out of a corporation is to pay dividends. A relatively small share of dividend income shows up on income tax returns.

There is, however, a variable in this equation that such an approach would change significantly: retained earnings. S-corporations retain far less profit than C-corporations, Clarke and Kopczuk show. There is a reason for C-corporations' higher profit retention rate. They have learned to avoid corporate tax on that income in myriad ways. Taxes on dividends are harder to dodge.

Abolishing the corporate tax without a compensatory mechanism would expand the U.S. fiscal deficit by 2.6 percent of gross domestic product. In my column that suggested getting rid of the tax, I mentioned the possibility of making up for the budget shortfall by raising consumption taxes. Many of my correspondents disagreed. One problem is the temptation of the shadow economy. With that approach, the "with or without invoice" question might become the rule, as a former government official from Latin America wrote. Indeed, sales and value-added taxes are commonly avoided in many countries. Greece is a prime example of where that could lead.

But if previous U.S. experience is any guide, it may not even be necessary to raise consumption taxes to claw back the revenue lost with the abolition of corporate tax. The fiscal gap might be closed just by taxing today's retained profits at individual tax rates, the way it works for S-corporations, rather than letting companies salt away the cash with no other purpose than tax optimization.

Clarke and Kopczuk argue in their paper that the retained earnings of C-corporations, which are not counted toward individuals' taxable income, skew income inequality data. That money is someone's income, if only because it increases the value of the companies that retain the profits. Because of that, it's fair, not just potentially lucrative for the government, to attribute the profits to shareholders and tax it as their personal income.

There would probably be technical difficulties involved in applying S-corporation rules to big public companies — but they wouldn't be greater than those involved in taxing dividends or capital gains.