07 December 2017

H.R. 1 Is Budget Busting And Handles Corporate Taxation Badly

While no 497 page tax bill is completely devoid of good ideas, on the whole, both the House and Senate versions of H.R. 1 which are now being hashed out in committee, are very bad bills. In this post, I'll focus on three problems with it (there are many more): the fact that it reduces revenues, the fact that it mishandles C corporation taxation, and the fact that it mishandles pass through entity taxation.

The two current versions of H.R. 1 reduce federal revenues by about $1,400 billion to $1,500 billion over ten years. 

Even with the most optimistic estimates of increased tax collections due to economic growth, it still increases the deficit by at least $1,000 billion.

There are public purposes of existential importance, like fending off a foreign invasion or fighting a civil war, which could very well be worth some combination of spending cuts and increased deficits elsewhere. 

But, reducing the tax burden on, for example, profitable, predominantly publicly held, frequently multinational corporations, slashing taxes on the repatriation of tax free foreign assets, and on heirs in families with net worths in excess of $11 million per couple (at least half of which is income that never has been and never will be subject to income tax of any kind), does not justify spending cuts or deficit spending of this magnitude.

Overall, the United States has some of the lowest combined tax rates in the OECD. Only Japan (where a lot of services provided by government are provided by employers as fringe benefits) and developing and third world countries is there less taxation than the U.S. relative to the size of the economy. High overall levels of taxation are not a problem with the U.S. economy.

There are problems with how we tax C corporations (overwhelmingly publicly held companies), but the solution of H.R. 1 is not the right one.

Graduated Corporate Tax Rates Make No Sense

One problem is that graduated tax rates do not now, and never had, made sense for corporations, since corporate income tells you nothing about the total income of its shareholders (upon which progressive tax rates are justified on the theory that increased income had diminishing marginal utility). A corporation with $50,000 income could be owned by a pauper or a billionaire.

Corporate tax rates should be a single flat rate and already are in the case of Personal Service Corporations established by doctors and lawyers for their practices, for example.

Double Taxation At The Corporate And Shareholder Levels Is A Problem, But H.R. 1 Is Not The Solution

Another problem is that it imposes double taxation, once at 35% at the corporate level, and another 20% for the highest income shareholders and 15% for most other shareholders with under $467,000 of income in the case of a married couple filing jointly and $415,000 for single shareholders (and more in the case of short term capital gains or "unqualified dividends") at the shareholder level at capital gains or "qualified dividends", for a combined top rate of 48% on corporate income that is realized at the shareholder level (44.75% for shareholders with under $467,000 of income for a married couple filing jointly). This compares to a top shareholder income tax rate of 39.6% on the ordinary income of individuals, trusts and estate.

The proposed reduction in the top corporate tax rate to 20% under both version of H.R. 1 brings the combined corporate and shareholder rates to 36% for shareholders in the 20% capital gains tax bracket and 32% for shareholders in the 15% capital gains tax bracket. 

The H.R. 1 Rate Is Too Low

The H.R. 1 rate of 20% is (unjustifiably) lower than ordinary income tax rates even when combined corporate and shareholder level taxes are considered. 

Parity for the combined rate would be reached at approximately a flat 25% corporate tax rate, which would be 40% combined for those in the 20% capital gains tax bracket (v. a 39.6% top personal income tax rate on ordinary income), and 36.25% for those in the 15% capital gains tax bracket.

There is no good reason to tax income at a lower combined rate because it was earned in a C corporation rather than a pass through entity or as wage or salary or other forms of investment income (e.g. interest on debt).

H.R. 1 Increases The Incentive To Retain Earnings To Defer Or Eliminate Shareholder Level Taxes

This encourages corporations to retain earnings or pay out earnings as executive compensation, rather than distributing it as dividends to shareholders, because that defers shareholder taxation indefinitely for shareholders who do not sell their shares and instead, either hold their shares until death (at which point all taxes accrued on untaxed capital gains in the shares are forgiven and not taxed to either the decedent or to the decedent's heirs at death or at any time in the future) or transfer them during life by gift (which does not trigger capital gains taxation but does not result in the abatement of taxes accrued on untaxed capital gains either).

Note also that a lack of dividends or capital gains does not mean that shareholders are denied an ability to use their stock wealth to finance consumption, because they can still take out margin loans against the stock without trigger capital gains taxation in most circumstances (so long as they don't default on the loans).

A strong tax incentive for corporations to retain earnings or to pay out earnings as executive compensation is also a problem because it means that shareholders don't have an opportunity to shift funds from the corporation that earned them (which may not be the use of the funds with the highest likely returns going forward) to some other investment that brings higher returns, leading to economic inefficiency and reduced productivity in the economy.

The concerns about tax deferral and inefficiency are present even when corporate and individual tax rate are fully integrated, to some extent, any time that retained earnings are taxed more lightly than distributed earnings.

A Higher Corporate Level Tax Rate Combined With Corporate and Shareholder Level Integration Is The Right Solution

The solution is to integrate taxes at the corporation and the individual level, not to reduce corporate level income taxes. Corporate income should be taxed at a tax rate equal to the top tax rate paid by its shareholders, and in practice, at the top individual income tax rate of 39.6%.

There are a several ways to integrate corporate and personal income taxes. Two of the most attractive are as follows:

Corporate Tax Integration With A Dividend Withholding Tax Model

One is to treat corporate income taxes as withholding tax from future dividends, with dividend payments distributed with a taxable amount equal to the actual cash distributed grossed up to reflect the fact that the cash distribution is net of a 39.6% withholding tax, and then to give shareholders a 39.6% withholding tax credit just as you would for wages.

This model works fine at the federal level, but doesn't extrapolate well to the state level, where there is not identity between the states where withholding tax credits are earned, and the states where shareholders pay their taxes. Also, if non-resident alien shareholders and charities are not allowed to benefit from refunds of the withholding tax, it prevents corporate earnings from going completely untaxed at that point because they have tax exempt owners.

Corporate Tax Integration With A Dividends Paid Deduction Model

An alternative means of integration, which isn't quite as mathematically perfect, but is simpler, is more easily generalized to state and local income taxation, and is already used for complex trusts (i.e. trusts that can choose between retaining and distributing their income from year to year), is to give corporations a deduction from corporate income for dividends paid just as they do for interest. 

This could be subject to a withholding tax when made to non-resident alien shareholders to prevent this U.S. source corporate income from escaping taxation entirely if distributed.

The Benefits Of Corporate Tax Integration

Either approach ends the inefficient economic bias in favor of physical or financial capital over human capital.

Either approach ends the ability to defer income taxation, in part, indefinitely by retaining earnings and not selling stock.

Either approach ends the macroeconomically inefficient bias in favor of retaining earnings.

Either of these corporate tax integration approaches also ends a strong bias in the tax code in favor of debt over equity financing of publicly held corporations, which is very transparent in the case of a deduction for dividends paid, and is present, although far less obviously, in the case of a dividend withholding concept corporate tax regime.

Either of these corporate tax integration approaches would greatly simplify corporate tax law, which contains a variety of complex, yet ineffectual, means of encouraging companies not to retain earnings.

The real drive behind the persistent pressure to lower tax rates on capital gains and dividends has been to reduce the compared corporate and shareholder tax rates relative to the single rate that applies to ordinary income. And, another plus of integrating corporate taxation at the corporate and shareholder levels is that it would take a lot of the pressure of the desire to have an irrational preference for capital gains in the tax code, which inefficiently prefers income from physical and financial capital over income from human capital.

Pass through taxation isn't broken and shouldn't be fixed.

Pass through taxation, which is employed by almost all closely held companies in the United States, (except small and medium sized closely held C corporations which pay all income for which corporate taxes can't be eliminated with tax credits or for which tax rates can't be reduced with lower graduated tax rates applicable to small C corporations, in compensation to owner-shareholders, and foreign owned C corporations which don't pay U.S. income taxes on their dividends and capital gains), is exactly what it should be from a tax policy perspective. Owners of passthrough entities are taxes in the same amount they would have been if they did their share of the entity's business themselves.

Tax breaks for the self-employed relative to wage and salary earners have no rational basis, and also ignore the fact that wage and salary earners almost always report all of their income and pay tax on it as they go through withholding, while self-employed pass through entity owners already routinely underreport their revenues, inappropriate take expenses which are not allowed by law, and often don't pay their taxes on time.

Tax breaks for the self-employed also inappropriately favor physical and financial capital relative to human capital.

The tax breaks for pass through entities in H.R. 1 are simply a give away to self-employed entity owners who are much more affluent than the general public, particularly in the House bill which provides a tax break only to entity owners taxed at marginal rates above 25%.

The pass through entity tax breaks in H.R. 1 take a system that isn't broke and breaks it in favor of the affluent.

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