01 January 2008

A Market Capitalization Tax?

The corporate income tax is largely a tax on the privilege of operating as a publicly held entity. Privately held entities can, and routinely do, avoid all entity level tax. Fewer than 5% of all U.S. corporations (about 150,000) and fewer than 1% of all businesses pay any entity level income taxes after tax credits, and the vast majority of that tax is paid by publicly held corporations. Yet, little effort is made to formally link this privilege to the tax. The corporate tax laws are the same for family businesses that can easily avoid it by paying employee-owners bonuses at year end, as they are for the Fortune 500 companies of the nation.

The corporate income tax, while it generates substantial revenues, is also easy to reduce through tax planning, and involves massive compliance costs for both corporations and the government. It also creates a myriad of distorting economic incentives, some intended, some contradictory and many of which are mere historical curiosities or legislative drafting accidents. For example, current corporate tax laws encourage corporations that do business in the United States to shift as much of their income as possible abroad, to favor debt over equity in a way that increases systemic risk of business failure in the U.S. economy, and subsidizes unprofitable for profit business entities through the net operating loss deduction.

The bright folks at Tax Analysts (via the Tax Profs blog) have proposed a radical, revenue neutral alternative: a quarterly tax of 0.2% of the market capitalization of entities with publicly held securities, both debt and equity (actually a 0.17% quarterly tax would be revenue neutral and 0.2% would represent a modest tax increase).

Determining the amount due would be a trivial exercise that would require only stock and bond price quotations, and SEC filings on outstanding stock and bond issues, the proponents suggest a "drop dead date" but an average valuation for every trading day could serve just as well with more stable results. Under this system, for example, a company with a market capitalization of $100 billion dollars ($50 million in outstanding publicly held stock and $50 million in outstanding publicly held bonds) would owe about $800 million a year in tax.

The notion is that market capitalization is the most accurate available way to determine value and that market value, to the level of rough justice necessary for a workable tax law, reflects long term profitability, and hence reflects ability to pay. Yet, the marginal tax rate on increased profitability would approach zero. Also, this avoids the politically embarassing situation in which corporate giants with an ample ability to pay owe no tax at all, a surprisingly common situation in the current regime.

This is essentially the same methodology we use to tax real estate, which, like publicly traded securities, is succeptible to easy valuation to a rough justice extent, based upon a huge volume of arms length transactions.

The big picture point that they get, that so many analysts in the field do not, is the taxes are primarily about raising money to conduct government, not directing the economy. If we can secure revenue from corporations in a way that is indifferent to the economic organization of their day to day operations, so much the better.

This proposal is also an excellent idea for use in a developing economy where corruption and limited governmental resources make implementation of an elaborate U.S. style corporate income tax impracticable.

The proposal would also eliminate the argument that tax breaks for income from capital gains and dividends are necessary to compensate for corporate entity level "double taxation" of profits on top of shareholder level taxes.

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