The Corporate Double Taxation Problem
The U.S. has about 1.4 million entities taxed as C-corporations, as of 2020 (the most recent year for which full tax statistics are available) of which only 644,000 had tax taxable income and only about 433,000 had any net tax liability. Thus, almost a million C-corporations are small, closely held entities that pay bonuses to management annually calculated to eliminate any corporate level tax liability after any available corporate tax credits. But C-corporations that pay significant corporate income taxes in at least some years are economically extremely important as they include all publicly held corporations and many large, privately held businesses in the U.S. For example, in 2020, corporations has $33,400 billion of gross revenues and owned $124,500 billion of assets.
One of the widely acknowledged issues with U.S. federal income taxation of corporate earnings is the double taxation of C-corporation income. U.S. C-corporations pay tax once when income is earned at the corporate level at a rate that is currently a flat 21%. Then, when dividends are distributed to shareholders, shareholders are taxed on their dividend income but C-corporations don't receive a deduction for this payment.
This double taxation issue has been an important driver of the preference for pass through entity taxation in the U.S., and it creates a strong tax incentive for U.S. corporations to retain rather than distribute their income. And, since U.S. corporate income tax rates have generally been lower the the maximum U.S. individual income tax rate, it creates a tax preference for C-corporations that retain their income due to deferral of income taxation at the shareholder level.
It also creates a strong tax incentive for C-corporations to finance their operations with debt rather than equity, which from a macroeconomic perspective causes C-corporations, mostly publicly held companies, to have excessively high debt to equity ratios, which makes the U.S. economy more vulnerable to business failures, and less robust, in recessions.
The favorable tax rates for corporate income, capital gains income, and "qualified dividends" in U.S. tax are also rough justice attempts to mitigate the double taxation of corporate income.
Options To End Corporate Double Taxation In the U.S.
There are various ways to end the double taxation of C-corporation income.
1. One could exempt dividend income from taxation, but that would distort how progressive marginal income tax rates for individuals work and would create a perception of unfairness. This would also continue to preference for debt over equity in corporate finance with the macroeconomic costs that come with it. And, it would be unfair to people who would be taxed on capital gains income from stock but not on dividend income from stock.
2. One could exempt corporate income from taxation. But this would create a massive tax incentive for corporations to retain income indefinitely. This would also massively favor equity investment over debt investments and would lead to a surge in preferred stock replacing corporate bonds.
3. One could replace federal corporation income taxes as a withholding tax on ultimate dividend payments for which shareholders receive a tax credit when receiving dividends. This is the most common approach in developed country economies that works quite well there, even though it retains some of the bias for debt financing over equity financing. But in the U.S., in light of federalism considerations, where there is no coordination in corporate taxation between federal corporate income taxes and state corporate incomes taxes, with some states not having these taxes at all, and other states having significant ones, this is difficult to implement gracefully.
4. One could have some sort of simplified pass-through taxation regime similar to what is done now with mutual funds, real estate investment trusts, and publicly traded partnerships. This would be close to neutral at the macroeconomic level between debt and equity financing. Pass-through taxation is predominant for U.S. closely held entities, many millions of which are taxed this way, mostly through limited liability companies, limited liability partnerships, limited liability limited partnerships, limited partnerships, and S-corporations. As of 2020, there were 4.9 million corporations taxed on a pass-through basis (primarily S-corporations, REITs and RICs), another 4.3 million entities taxed as partnerships, and 2.8 million single person limited liability companies taxed as sole proprietorships, for a total of 12 million entities using pass-through taxation regimes (a figure that ignores trusts and estates which have another form of pass-through taxation). But this is administratively very complex and it causes tax audits of the pass-through entities to impact far more people. It is also less fair, as the amount of taxable income allocated in this system to shareholders may not exactly match the amount distributed to them creating "phantom income" in some cases, and windfalls in others. The phantom income problem is particularly problematic in entities where substantial corporate profits are retained for future operations, rather than being distributed.
5. One could continue the imperfect status quo of mitigating the harm caused by corporate double taxation by taxing some combination of corporate income, capital gains from the sale of corporation shares, and dividends from corporation at reduced income tax rates, doing rough justice in terms of equity between total tax rates on shareholder received income from corporations and income from other sources, but presenting the problems discussed above.
6. One could allow a deduction for corporate taxable income for dividends paid. This is already done, in full and in part, depending upon ownership percentages, for dividends paid by C-corporations to other C-corporations that own a significant part of their stock. It has the virtues of being simple, being easy to administer, being easy to integrate between varied state and federal corporate tax systems, almost perfectly eliminating double taxation of corporate income, and ending the preference at the corporate level for equity financing over debt financing. This is the model I explore below, considering its viability in terms of tax rates, which I conclude are very viable. With the appropriate corporate tax rates, it also basically eliminated an incentive to retain earnings in order to defer income tax liabilities.
The Federal Tax Revenue Impacts Of A Corporate Dividends Paid Deduction
U.S. C-corporations paid $374 billion of corporate income taxes in 2020 at a flat corporate income tax rate of 21% from $2,700 billion of corporate net income, reduced by $193 billion of corporate tax credits.
U.S. taxpayers received $328 billion of ordinary dividends and $248 billion of qualified dividends from C-corporations in 2020, for a total of $576 billion.
So, U.S. C-corporations paid 21.3% of their taxable income to shareholder as dividends in 2020 (this isn't quite right, because it excludes dividends from C-corporation to other C-corporations, many of which are partially or fully income tax free, and includes dividend income from foreign corporations that are subject to U.S. corporate income taxes, but neither of those amounts are material).
If dividends paid were deductible from the income of C-corporations, total C-corporation income in 2020 would have been $2,124 billion. So, a revenue neutral transition from non-deductible corporate dividends to deductible corporate dividend payments would require a flat 26.7% corporate tax rate.
If C-corporations were taxed at a flat 41% corporate tax rate (slightly more than the 40.8% of federal taxes due at the highest marginal income tax rate plus the Obamacare tax on investment income), but were allowed to deduct corporate dividend payments and take all existing corporate tax credits, corporations would have paid $678 billion in federal income taxes in 2020 (an increase of $304 billion per year). This would be equivalent to a 32.3% flat corporate income tax rate without a deduction for dividends paid by corporations but with all existing corporate tax credits. A 41% federal corporate tax rate with a dividend paid deduction would be an 81% in federal corporate income tax revenue from current record low corporate tax rates (although this is moderately overstated because corporate tax credits would grow significantly with higher corporate tax rates, although it would still be at least a 31% increase).
The increased federal corporate income tax revenues in this scenario would be partially offset by reduced state corporate income tax revenues due to the reduction in the state corporate income tax base, unless states decided to disallow the dividend paid deduction for state corporate income tax purposes.
This would also make a variety of anti-evasion and double taxation mitigation provisions of the tax code obsolete. These would include the accumulated earnings tax, the personal holding company tax, the separate dividend paid deduction for dividends paid by C-corporations to certain other C-corporations, the special tax rates applicable to qualified dividends, and the special tax rates applicable to capital gains in C-corporation stock.
These changes (except the special rate applicable to capital gains and qualified dividends) would have a negligible federal tax revenue impact. The end of the tax treatment of capital gains would increase federal tax revenues by $162 billion, and the end of favorable taxation of qualified dividend would increase federal tax revenues by about $84 billion.
In all, these reforms would increase federal income tax revenues by about $550 billion a year, which would be a roughly 11% increase in federal tax revenues, more than two-thirds of which would be paid mostly by those in the top 1% and more than three-quarters of which would be paid by those in the top 10% of income earners.
This would reduce the federal budget deficit by more than 46%, which would also tend to reduce interest rates in the U.S. economy, including interest rates of home mortgages.
Bottom line:
An increase of the federal income tax rate on corporate income from 21% to 41%, accompanied by a deduction for dividends paid, the end of favorable tax treatment for capital gains and qualified dividends, and the elimination of other tax code provisions whose purposes are made obsolete by this change, is a good idea.
This would be a viable and sensible tax reform that would be more fair, would be less prone to loopholes and tax planning reductions, would raise modestly more federal revenue in line with historic norms for revenue from corporate income taxes, and would make the U.S. economy more robust from a macroeconomic perspective. It would also reduce tax complexity, be easier to administer, make audits simpler for entities currently taxed on a pass-through basis, and be transaction driven. It would achieve great benefits without radical changes to the overall income tax system in a politically palatable manner.
Other Desirable Reforms In Entity Taxation
* Dividends paid by U.S. corporations to people not otherwise subject to U.S. income taxation should be subject to a final 41% foreign dividend payment tax collected by the entity paying the dividends. This is lost federal tax revenue that could be easily curtailed under the existing tax regime, and is especially important in a corporate dividends paid deduction regime.
* Pass-through taxation should be greatly curtailed. Entities with limited liability should be taxed as C-corporations. Limited partnerships with some unlimited liability general partners and some limited liability limited partners, should be taxed as a general partnership of the general partnership and a C-corporation consisting of the limited partners. S-corporation taxation should be abolished. This would greatly reduce the administrative complexity of the tax system, and would make it much simpler for small businesses to craft their organizational documents, to prepare and file tax returns, and to deal with tax audits. It also removes a huge exception to limited liability for entity income related tax liabilities. State laws causing transferees of limited liability company membership interests to lose their voting rights and right to information about the company and arguably the right to bring derivative actions, which were adopted to gain partnership taxation tax treatment (now obsolete for that purpose) should also be repealed. A fringe benefit of curtailing pass-through entity taxation is that it would greatly increase the privacy of entity owners, particularly in entities that did not distribute dividends to their owners.
* Investments in publicly held, marketable securities and commodities should be taxed annually on a mark-to-market basis, on that the theory that gains that could easily be realized shall be deemed to be realized for tax purposes.
* The proceeds of loans secured by unmarketable or liquid capital assets, such as closely held entity shares, would be taxable as ordinary income when received, and deductible as an ordinary expense when repayments of principal were made by the borrower, to prevent circumvention of capital gains taxations that are de facto realized.
* Equity investments in unmarketable closely held entities should be deemed to be sold at fair market value at death and taxed at that time, rather than receiving a tax free step up in basis, unless a carryover basis election is filed by the executor of the decedent's estate disclosing the carryover basis and representing that the asset is eligible for the election.
This package of additional reforms would raise something on the order of $50 billion of federal tax revenues each year, which combined with the primary package, would increase federal tax revenues by about $600 billion a year, and would reduce the federal budget deficit by 50%.
