Remember the pass-through mantra for tax reform? All business income should be taxed once, it should be taxed at the same top rate, and then we should leave it alone! Well, that mantra was on display Tuesday when a panel of tax experts explored the benefits and costs of corporate integration. Here’s Dr. Michael Graetz:
“In the 1990s, principally because of its administrative advantages, the Treasury Department recommended taxing business income once—at the business level. This form of integration was advanced by President George W. Bush in 2003, but Congress instead simply lowered shareholders’ income tax rates on dividends. That approach is no longer apt today. Locating the income tax at the shareholder level would be more progressive and, given the mobility of business capital and operations, makes much more sense in today’s global economy.”
And Prof. Bret Wells:
“From a tax policy perspective, I think this committee needs to say ‘we need to preserve one level of efficient tax on active business income.’ Having that taxed at the shareholder level assures individual progressivity. That’s a wonderful goal. And if we take the distortions out of who the owner is, whether that’s a foreign-based multinational, or a pension, or others, that creates the tax symmetry that I think the system needs…Corporate integration absolutely is the vehicle to get us there. Whether it is the dividends-paid deduction regime, or other forms of integration. But I think it is absolutely a wonderful first step.”
Amen to that. But corporate integration is not just about reducing layers of tax – it’s also about restoring economic efficiency. The current corporate code distorts decision-making, hurts job creation, and limits investment. Again, here’s Prof. Wells:
“By having a corporate integration regime, the company would get a deduction currently and there would be an offsetting withholding tax, and that would ensure that the company makes the most efficient decision as to what to do with that income. There would not be a double-tax cost. The decision of what to distribute to shareholders or to invest in the business would be solely one based upon the right economics for that company.”
The hearing also did an excellent job of highlighting some of the political challenges of integration, including the loss of relative tax benefits for 401k’s, charities, and insurance products. Not that the tax on those entities goes up under integration – it remains unchanged. The tax on investments they compete with, however, will be reduced, so they could lose some of their comparative advantage. This is a key political challenge the Committee will have to overcome if they are going to move forward on integration. Here, Mr. Wells again did a great job of framing the argument:
“From my perspective, this is not a disadvantage to anyone. When you take a distortion away from a group of taxable shareholders, and you make them not suffer a double tax, then those that are benefited because the other person is suffering a double tax—an inefficient tax system—could say ‘that’s a relative disadvantage to me.’ But what I think this committee ought to understand, and what I think the corporate inversion phenomenon is getting us to understand, is if we allow one group the opportunity to erode the corporate tax base as a subsidy, whether that’s an inbound earnings stripping advantage, whether it’s that particular technique, then what’s going to be the result of that is that they will be the source of market inefficiency going forward.”
So there you have it – at a hearing on corporate integration, two of the key witnesses repeated the refrain the Main Street Business community has been singing for five years — tax business income once, tax it at reasonable rates, and then leave it alone! That’s the reason we cheer corporate integration efforts and look forward to reviewing the details of the Finance Committee plan when they are released.
Tax Policy Center: Only About One Quarter of C Corp Stock is Owned by Taxable Shareholders
Last fall, we reviewed two studies from Treasury and CRS on the effective tax rates of different business entities. The full reviews can be read here and here, but one of our key observations was how wildly different the estimates for how much the second layer of tax on corporate income adds to effective tax burdens.
You’ll recall that Treasury estimated dividend and capital gains taxes on C corporation shareholders adds about 9 percentage points to the corporate effective rate. As we pointed out, Treasury made some very interesting assumptions to get there.
CRS appears to agree with us on that matter. Their estimate for shareholder level taxes is about one-fourth of Treasury’s, or just 2.3 percentage points. CRS lists the lower rates on capital gains and dividends, tax exempt shareholders, and capital gains that are passed on as part of an estate as the primary reasons for the lower estimate.
Seems like a disagreement that large might be worth more study, no? Now the Tax Policy Center has released a paper that does just that. One of the keys to identifying the second layer of tax is estimating the percentage of corporate shareholders who are taxable. This week, writing in Tax Notes, Steven Rosenthal and Lydia Austin suggest that past estimations have vastly overstated that percentage:
After adjusting the data in several important respects, we estimated that taxable accounts held only 24.2 percent of C corporation equity in taxable accounts in 2015. Our exercise revealed that the share of U.S. stocks held by taxable accounts declined sharply over the last 50 years, by more than two-thirds.
As they explain, past estimates of the percentage of taxable C corp shareholders—including Treasury’s paper from last fall, which used a 2004 paper from James Poterba to determine the second layer of tax—used as much as twice this amount.
The Fed reported that in 2015, households directly owned 37.3 percent of corporate equity. Households owned another 13 percent indirectly through mutual funds (and more through ETFs and CEFs). In total, the Fed reported that households owned more than 50.3 percent of the value of outstanding U.S. stock.
The economics literature generally uses the Fed’s figures for household ownership, including both direct and indirect holdings, as a measure of equities held in taxable accounts. James M. Poterba added stock owned directly by the household sector with stock beneficially held through mutual funds — and estimated that the taxable household share of corporate equity was 57.2 percent in 2003. In so doing, Poterba counted stock owned by IRAs and nonprofits in his taxable sector.
If Treasury is doubling the amount of taxable shareholders in C corps, it stands to reason that they are also doubling the effective tax that second layer imposes on corporations. So their estimates would be off by at least a factor of two. That’s a huge discrepancy, and one that Treasury and others should thoroughly address when weighing in on business tax reform.