VSP's 501(c)(4) Exemption Revoked

No one disputes that VSP (for Vision Service Plan), which is basically a major insurance company specializing in vision services that also provides on the order of 40,000 sets of eyeglasses on a charitable basis each year has no shareholders in the traditional corporate sense. Likewise, VSP doesn't claim that charitable income tax deduction that comes with 501(c)(3) status. It has claimed since 1960, a tax exemption under 501(c)(4), more commonly applied to civic membership organizations, originally optometrists. But, this wasn't enough for VSP to hold onto to its 501(c)(4) tax exempt status which was revoked this year. Even if a corporation is organized as a non-profit under state law, it can't receive a tax exemption without fitting into one of the numerous different categories of non-profit organizations out there.

The vast majority of its services are provided on a fee for service basis. It pays high salaries to its senior executives and big commissions to its major brokers based upon sales generated, and has for-profit like incentives for its employees to cut costs. VSP also accumulates large surpluses by charging more for its services than it costs to provide those services.

In practical effect, this ruling means that a little more than a third of VSP's accumulated earnings each year, after payment of all expenses including executive compensation, will have to be turned over to the federal government to pay federal corporate income taxes. Given the availability of a charitable deduction for for profit corporations, this means that VSP actually has a stronger tax incentive to be charitable and to control fees for its members as a for profit corporation, than it did as a non-profit corporation.

Also ironically, the current tax code contains no strong incentive "for profit" corporations that are not closely held pay dividends to shareholders, despite the paper tigers of the accumulated income tax and personal holding company tax. Special tax rates applicable to the dividends received by individual shareholders from corporations identical to the capital gains tax rates paid by those shareholders gaining from the sale of shares in corporations make the tax code largely neutral, beyond two taxes aimed at accumulated income, between dividends and capital gains.

Debt financing of for profit corporations is also favored over equity financing of for profit corporations under the current tax code in almost all economically important circumstances, and the likely repeal of favorable rates of taxation on dividends received by individuals in the next administration will favor retention of earnings over distribution of dividends in large "for profit" corporations.

In practice, the vast majority of corporations subject to corporate income taxes measured by revenues, profits or assets, for example, are publicly held corporations. The overwhelming majority closely held companies never pay corporate income taxes in the absence of a tax planning goof. Medium sized privately held companies can likewise often greatly reduce their corporate income tax burden with fairly simple tax planning.

It is time to square tax law incentives with non-tax law objectives. The taxation of publicly held corporations should be designed to favor equity financing (which makes the economy more stable) and to favor dividend distributions (which subjects publicly held corporation investment decisions to market discipline) over the accumulation of income, while discouraging high executive compensation when it doesn't produce shareholder value. The taxation of non-profits should reward non-profits that focus on the greater good or the good of their members, while creating natural incentives that discourage use of non-profit resources for narrow gain or purposeless or unnecessary accumulation of income, while similarly discouraging self-dealing fat compensation packages by senior executives.

The theoretical basis for transforming the incentives already exists. Indeed, doing so is basically a multiple choice question, there are a small finite number of big picture to go about doing it. There are technical issues that would have to be vetted carefully, because the devil is in the details in tax law, but the broad economic principals involved in crafting these kinds of reforms are well established.

The main distinction between U.S. tax law and tax law in countries with better corporate tax incentives is that U.S. tax law reform has to be sensitive to the fact that in American federalism. In the U.S. individual state tax systems are largely independent of the federal system, something that is hard to force states to due differently, because state constitutions make fiscal reforms in many states, including Colorado, difficult. For reasons that aren't obvious until you try to start drafting concrete proposals, American public finance federalism makes the "dividend withholding credit" model used in much of the world and in many academic proposals to implement some of these incentives much more awkward to implement here than it is elsewhere. In contrast, American federalism favors approaches that tinker with definitions of corporate adjusted gross income and individual adjusted gross income, which are touchstones of state income taxation in most states that have income taxes, even though this may not secure theoretical perfect parity between debt and equity, and between capital gains and dividend income.