February 6, 2014

The tax reform effort may face significant headwinds, but the debate over who pays what continues, with the business community doing a good job of articulating just how much they pay in taxes and entities like the Congressional Budget Office, well, not.

Embedded in yesterday’s economic update is a section entitled “Corporate Income Taxes” that includes a chart showing the effective tax rate of the domestic profits of C corporations declining over time.  The effective corporate tax rate was in the 30s during the 1970s, in the 20s during the 1980s and 1990s, but now is down in the teens.

On its face, this chart would support the case that the corporate tax base is eroding and needs to be fixed.  But does it?

Not exactly.  As our friends at the Tax Foundation observe, the measure of “corporate” profits used to create the chart include both C corporation and S corporation profits, but only C corporation taxes.  In other words, the inclusion of S corporation profits has the effect of artificially reducing the measured tax burden on C corporations.  Here’s the Tax Foundation:

The main difference between the CBO and IRS numbers is that the CBO has included the pass-through businesses in their measure of profits, even though those businesses are not subject to corporate taxes but rather pay under the individual tax code. Particularly, the CBO is using as their corporate tax base measure domestic economic profits from the BEA, which includes both C and S corporations, even though S corporations are pass-through entities not subject to the corporate tax. This matters more and more, as S corporations have been growing relative to C corporations for over 20 years. It is now the case that about 30 percent of the profits measure used by CBO and BEA is due to S corporations. Hence, any calculation of the average corporate tax rate based on these numbers will be about one-third too low. 

So the C corporation number in the CBO report is incorrectly low because it includes pass-through profits but not pass-through taxes.

Why is this of concern?  Aside from the fact that it violates the basic virtue of using numbers accurately so we have a clear picture of what’s really going on in the economy, left unchallenged the report just lends fuel to the argument that the C corporation tax base is “eroding” and that Congress needs to take steps, like forcing large S corporations into C corporation taxation, in order to fix it.

To the contrary, as our effective rate study made clear, pass-through businesses pay lots of business taxes.  In fact, at 32 percent, S corporations pay the highest effective rate of any business type.  Moreover, as the Tax Foundation notes, an increasing share of business income shifted from the C corporation world to the pass-through world over the past thirty years, so much of the decline in the average tax rate shown in the chart above can be attributed not to a loss in taxes, but rather to a shift in collections from one tax code to another.  The government is still collecting those taxes and at the same time; it just shows up in another accounting column.

Perhaps the CBO can make that clear next time?