Our Tax Code is Too Complicated. Here's How to Simplify It.

James Livingston, historian and author of a book on consumerism that I didn't like very much, has taken to the op-ed pages of the New York Times to suggest that we ought to get rid of payroll taxes and replace them with corporate income taxes.  It is a festival of bad statistics:

So, by slashing corporate income taxes and forcing a new reliance on payroll taxes to finance government spending, we have redistributed income to the already wealthy and powerful. Our tax system has actually fostered inequality.

The fiscal problem we face is not, then, a lack of revenue sources. We can finance any amount of transfer payments and “entitlements” by taxing corporations’ profits in the same way we tax personal income, using a progressive formula. If necessary, give them a mortgage deduction — they already get something like it in the form of accelerated depreciation allowances on their purchases of capital equipment — but make them pay higher taxes on their income. Do that, and the federal deficit goes away.

The now-familiar objection to a tax increase on corporate profits is that it will discourage private investment and thus dampen job creation. The retort is just as obvious: since when have tax cuts on corporate profits led to increased investment, faster job creation and higher per capita consumption out of rising real wages? It didn’t happen after the Reagan Revolution, it didn’t happen during the Clinton boom of the 1990s, and it sure didn’t happen under George W. Bush.

Nor is it happening now, as corporate profits soar and full-time job creation languishes. American corporations are now sitting on $4.75 trillion in cash, according to the Federal Reserve Bank of St. Louis.

The other well-worn objection to an increase of corporate income taxes is that it would encourage companies to invest and hire overseas, where tax rates are presumably lower. Here, too, the retort is obvious: the tax code already works exactly this way by postponing taxes until profits from investment overseas are repatriated. American companies routinely avoid taxation by moving their idle cash offshore.

In view of these facts, there’s no downside to replacing payroll taxes with increased taxes on corporate profits, wherever they’re made or held. By doing so, we make the tax code more progressive, and mobilize capital that is otherwise inert. In other words, we can lay solid foundations for economic growth simply by going back to the tax principles we used to have. What could be more conservative than that?

It is, for example, true that corporate income taxes were, for a brief moment in the 1950s, about 6% of GDP.  But they'd fallen to 4% by the late 1950s, and 3% by 1970.   Since 1986 they've averaged about 2%--lower during recessions, higher during booms.  Over the last few years they've been very low indeed, but that's because corporations lost so much money in 2008-2009, and the losses carry forward.  We could raise the corporate income tax to 100% and we'd still be taking in relatively little money right now, because 100% of 0 is still 0.  

Moreover, the steady downward drift in the corporate income tax owes less to Ronald Reagan than it does to Dwight D. Eisenhower, and the invention of the Subchapter S Corporation, or S Corp:

Before Congress created S corporations, entrepreneurs had two choices when starting a business. They could form a regular C corporation, enjoy liability protection, but face two layers of federal tax at the corporate and individual level. Or they could choose a partnership or sole proprietorship, enjoy a single layer of taxation at the individual level, but sacrifice the umbrella of liability protection.

Neither choice was optimal for small and family owned businesses. In 1946, the Department of Treasury suggested a third option – merging a single layer of federal tax with comprehensive liability protection.

A few years later, Republican President Dwight Eisenhower found himself under fire from the Democratic Congress for practicing “trickle-down economics” and favoring big corporate interests over the little guy.
At the same time, Republicans and Democrats were increasingly alarmed that too much economic power was being consolidated into the hands of a few wealthy, multinational corporations. This economic centralization was characterized by economists like John Kenneth Galbraith, who saw America’s economic future as a grand balance of power between Big Labor, Big Business, and Big Government. Private enterprise was viewed as a thing of the past.

In response to these concerns, Eisenhower embraced the Treasury proposal and recommended the creation of the small business corporation to Congress. In 1958, led by Democratic Finance Chairman Harry Byrd, Congress acted on Eisenhower’s recommendation, creating subchapter S of the tax code as part of a larger package of miscellaneous tax items. In exchange for enjoying a single layer of tax, entrepreneurs electing S corporation status agreed to the following limitations:

• They were required to be a domestic enterprise
• They were required to have a limited number of shareholders;
• They were limited by who those shareholders could be; and
• They could have just one class of stock.
  

How significant was the creation of subchapter S? Consider that in 1958, the top income tax rate was 52 percent for corporations and 91 percent for individuals. That means dividends paid by a C corporation to a high-income shareholder faced an effective tax rate of 96 percent! Even a shareholder with median family income faced an effective federal tax of more than 60 percent.

To get liability protection, you used to have to pay corporate income tax, even if you were a quite small business.  This added a layer of unnecessary bureaucracy and expense for both the businessman and the government.  Now income from small companies is more likely to be "pass through"--which is to say that it passes through the corporation and straight to the tax return of its owners.  

As this suggests, it isn't that corporate income is going untaxed; it's that income that used to be filed on corporate income tax returns is now filed on personal income tax returns.  Much of the decline in corporate income tax collections since the mid-1950s is an artifact of a change in the IRS recording system, not an actual decrease in the fraction of the tax take that comes out of the profits of some corporation.

It's worth noting that taxing S-Corp income at ordinary income tax rates is highly--more progressive, in fact, than the corporate income tax, which falls equally on Bill Gates, and an elderly widow with a few dozen shares of Microsoft.  Struggling business owners pay a little, while wealthy partners pay a lot.

By contrast, it is not true at all that we could pay for "any amount of transfer payments" by raising corporate income taxes and getting rid of the payroll tax.  Let's say that we could get corporate income taxes back up to 6% of GDP (this would probably take a rate higher than 52%, because of the aforementioned changes in small business taxation).  That's an increase of roughly 4% of GDP over its expected future average.  But transfer payments and entitlements are (depending upon what you count) somewhere between 1/2 and 2/3 of federal budget outlays.  And those outlays are expected to run around 21% of GDP by the end of the decade.  That's a pretty big gap.

Furthermore, though Livingston pooh-poohs the idea, there is a limit on how much in tax you can extract from any group.  It is true that Reagan did not revolutionize the American economy by very modestly lowering the corporate income tax burden.  It does not therefore follow that we can simply take any amount of money from corporations and see no ill results, such as companies relocating abroad, or shifting into smaller, less efficient corporate forms.  Livingston's reasoning is akin to noticing that there's not much difference between a 3-year-old Honda and a 4-year old Toyota--and therefore concluding that you might as well buy a $500 used Gremlin because it makes no difference how much you spend on a car.

Anyway, I've got a better idea: let's get rid of the corporate income tax entirely.

No, really, hear me out.  The corporate income tax is the source of almost all the tax-dodging activity in America.  This activity is extremely expensive, and millions of valuable man-hours are diverted into it.  As well as into writing semi-numerate op-eds about the corporate income tax.

Why not get rid of the tax, and the tax avoidance, by radically simplifying the tax code?  Eliminate the corporate income tax--and then also eliminate the special rates for capital gains and dividends.  Tax all income once, progressively, when it's realized by a person.  

After all, despite the ignorant nattering about "corporate personhood", we can't tax a corporation, and we don't really want to.  A corporation has no independent existence apart from the people who make it up.  What we actually want to do is tax the wealthy and powerful people connected with the corporation: the managers and shareholders.  We already have a very good way to do that, known as the "personal income tax".  

But what's to stop people from creating a corporation to collect their paycheck, and having it buy their house and car, and living high on the hog while paying no taxes at all?

Good question.  Let me ask you a better one: what's stopping people from doing that right now?

There are considerable advantages to having your company pay for your car and house and so forth; the company can deduct those expenses, while you mostly can't.  Yet almost no one does this, even small business owners who could theoretically get away with it.  Why not?  

Because they'd end up in the pokey.  The IRS is well aware of the tax advantages of having your company pay for everything, and as a result, they devote considerable energy to auditing small businesses for just this sort of abuse.  Of course business owners do push the envelope.  But their abuses are mostly of the tamest possible variety, like having their kids do clerical "work" for the company, which pays them their allowance at a much lower tax rate than Mom and Dad enjoy.  On the other hand, almost no business owners have a "corporate house" as their primary residence.  The IRS wouldn't like it.  

In fact, once you eliminate the corporate income tax many of these incentives disappear.  Right now your company likes to sweeten the pot by paying you in tax-deductible fringe benefits, including corporate junkets.  That's because they can deduct it--and you don't have to pay taxes on it.  But if they can't deduct any of it, they'll have more incentive to hold down expenses, and pay out compensation in highly taxable cash.  Which we could then tax progressively, according to the income of the person who's receiving it.  

Of course, for some people, collecting money as efficiently and progressively as possible isn't really the purpose of the corporate income tax.  The purpose is to express our dislike of corporations.  I don't agree with this, but on the other hand, we do have to accept some compromises in order to keep this great democracy of ours running smoothly.  

So here's my proposal: we eliminate the corporate income tax.  We tax all dividends and capital gains as ordinary income.  And then we take a little bit of the money we've saved, and use it to offer tax deductions for banners reading "I Hate Corporations".  The people who want to send that message can hang the banners from their house or car.  The rest of us can get a coffee or some soft serve and finally talk about something else.