Editor’s note: The following is an edited transcript of remarks delivered by Viard at the Tax Council Policy Institute’s 15th Annual Tax Policy & Practice Symposium on February 19, 2014.
Let me begin by laying out the key features of the corporate and individual income tax systems from a domestic perspective. Although the features are familiar, I think it’s useful to review them because they give rise to the various distortions that the current system features. And that will help us think about the extent to which integration can or cannot address those distortions.
We have a firm-level tax imposed on C corporations on a tax-accounting measure of those profits. We also, in our nonintegrated system, have individual taxes imposed on stockholders’ dividends and capital gains, although at reduced rates. We defer the tax on capital gains until realization, which makes the effective tax rate lower than on dividends, even though they’re taxed at the same statutory tax rate.
The current system is filled with numerous distortions, and I will list only some of them. I’m not going to try to determine which are due to the firm-level tax and which are due to the individual-level tax, because many of them arise from the interaction of the two taxes.
The tax system penalizes some kinds of capital relative to others because of differences in how cost recovery is treated. For example, most intangible investments are expensed, equipment receives mildly favorable tax treatment, structures are treated a bit less favorably than equipment, and inventory even less favorably. There’s also a penalty on equity relative to debt, which is very important. We have good evidence from many studies over the years that the decision between the two financing methods is somewhat sensitive to the differences in tax treatment. One complication is that the debt-equity distortion may alter some of the conclusions about which kinds of capital are tax-favored because some kinds can be more easily debt-financed than others.
Dividend payout conjoined with the issuance of new equity is penalized relative to the reinvestment of the corporation’s earnings, because capital gains bear a lower effective tax rate than dividends. That penalty is smaller now than it has been in the past because the difference now arises solely from the deferral of tax on capital gains. In the past, it’s been a bigger distortion when dividends were taxed at a higher statutory rate than capital gains. Of course, there’s also a penalty on the sale of appreciated stock, which we like to call the lock-in effect.
There’s also a penalty on investment by C corporations relative to investment by flow-through firms. And, there’s a related distortion that is often overlooked. Some people don’t even view it as a distortion, but, in economic terms, that’s what it is. The current system penalizes the ownership of C corporations by tax-exempts. That is, aside from the impact on the size of the C corporation sector relative to the flow-through sector, there’s also a change in the ownership allocation. We have a corporate tax imposed at the firm level that applies regardless of the identity of the stockholder. But, the relief we offer to offset that tax is a reduction of the dividend and capital gains tax rates, which benefits individual shareholders, but not tax-exempt shareholders. That distortion has received some attention in the economic literature over the years, maybe not as much as it should have, but it has not been addressed properly in a lot of the policy debate.
All of these distortions would hold even in a closed economy. Now, let me discuss the open economy. The U.S. tax system penalizes investment in the United States relative to investment abroad. Many people, when discussing this distortion, seem to focus solely on the incentives facing U.S.-chartered firms, but that is only part of the story. A crucial part of the landscape is that foreign-chartered firms do not pay U.S. tax on their income abroad. So the U.S. tax system gives them an incentive to invest abroad rather than here. Our tax system also gives U.S.-chartered firms an incentive to invest abroad, but to a lesser extent. U.S.- chartered firms ostensibly pay U.S. tax on their worldwide income but deferral and the foreign tax credit reduce the tax burden on the income they earn abroad.
It’s very important to realize that this distortion against investment in the United States also affects foreign-chartered firms. If the distortion applied only to U.S.-chartered firms, then the solution would be easier. We could tax those firms’ overseas income the same as their domestic income. But, doing that would aggravate another distortion, the one penalizing investment through U.S.-chartered firms relative to investment through foreign-chartered firms, because only U.S.-chartered firms are taxed on income abroad. Reform proposals that change the treatment of U.S. firms’ overseas income to ease one of the distortions tend to worsen the other distortion.
So, can integration alleviate these distortions? In general, yes, it can address many of them. The effects really depend on how it’s designed. There are a lot of different integration proposals. Like Hank, I’m not sure exactly what the term “integration” is supposed to encompass or whether it’s actually the right term to describe all of the reforms that could be looked at.
But, a lot of issues that are sometimes viewed as details really end up being important when we evaluate these plans. The treatment of cross-border transactions is certainly crucial. Are we trying to tax the corporate income that accrues to American stockholders? Are we trying to tax the income that is earned through U.S.-chartered corporations? Are we trying to tax the income earned in the United States? Different integration plans give very different answers on that, depending upon whether foreign shareholders qualify for integration benefits and whether foreign-chartered corporations are subject to the tax regime and how foreign income and foreign taxes are treated.
Another issue is the treatment of tax-exempt stockholders. Integration plans can reduce or eliminate the bias against corporate equity ownership by tax-exempts, but not all plans do that. There’s a common, but puzzling, perception that tax-exempts should still be taxed on their income from corporate stock under integration, even though they don’t pay tax on their interest and other income. It’s important to realize that if you treat corporate equity income and interest income differently for tax-exempts, you perpetuate the ownership distortion that I mentioned earlier. Of course, you can also change the treatment of interest income received by tax-exempts.
There’s another key question. If there’s a single tax on corporate income, on what base is that tax imposed? One possible tax base is corporate profits, still computed at the firm level using accounting-type concepts. That base can be taxed at the firm level or it can be allocated to the stockholders to be taxed there. A different tax base arises if we remove the corporate tax burden, either in whole or in part (through something like a dividend-paid deduction), with the main tax imposed at the shareholder level on dividends and realized capital gains. Finally, another possibility is to impose the tax at the shareholder level, but apply it to accrued capital gains rather than realized gains.
Revenue and distribution are always the big challenges to lots of grand plans and that’s certainly true in this case.
The corporate tax is not a central part of the Federal Government’s finances, but it is far from trivial. The Congressional Budget Office’s most recent numbers say that, under the current-law baseline, corporate tax revenue will be two percent of GDP over the upcoming decade, which is certainly not a tiny sum.
So, if you eliminate the corporate income tax or negate it in some fashion, you are looking at pretty sizable revenue hole. How can you off-set that? Well, the imagination is the limit, as long as you’re not constrained by political reality. So, I’m going to mention some conceivable options here, without claiming that all of them are politically feasible.
It’s logically possible to finance corporate tax integration through entitlement cuts. Or, you could use a carbon tax or other energy tax. You could go with a VAT. Individual income tax base broadening is an attractive option. It may not be politically easy, but it is perhaps less politically difficult than some of the other options. A progressive consumption tax would, of course, be my favorite. Bob Carroll and I have written about it, but it’s not on the immediate political agenda.
Distributional issues also pose a challenge. Distributional tables are certainly taken very seriously in political debate. I think they should be taken seriously, although they probably should not be used quite as mechanically as they sometimes are. We have to confront the reality that many of these revenue-raising options are less progressive than the corporate income tax.
That would certainly have been true under the traditional, or naive, view that the corporate income tax falls solely on shareholders or on owners of capital in general. Now, that’s not a correct way of thinking about the corporate tax because part of the burden falls on labor in an open economy, although there’s a lot of uncertainty about the size of labor’s burden. Economic theory pretty strongly indicates that, if you impose a tax on corporate investment in the United States there will be less investment in the United States. There will be a smaller capital stock, which means that labor will be less productive and the market-clearing level of real wages will fall.
Different estimates emerge as to what share of the corporate tax burden might fall on labor. An upper bound, from a theoretical perspective, is probably around 70 or 75 percent, which would apply if the United States was a perfectly open economy and some other assumptions held. The United States is not perfectly open, so labor’s share of the burden may be significantly smaller than that, but it is probably still substantial. The statistical studies trying to bring empirical evidence to bear on this have a wide range of results, with some really huge estimates, and it’s hard to know how to sift through those. It’s very interesting that most of them do find some burden on labor and are therefore broadly consistent with economic theory.
Now, we do have distributional analyses being done. In the government, we’ve got CBO, Treasury, and the Joint Tax Committee. In the private sector, we’ve got the Urban-Brookings Tax Policy Center. It’s interesting that all of them are now putting part of the corporate tax burden on labor. And it’s all in the range of 18 to 25 percent. I think a case could be made that the true share might be higher, but it’s hard to know for sure. In any case, they recognize that some of the burden is on labor. So, we need to keep that in mind as we think about some of these options for replacing corporate tax revenue.
Nevertheless, many of these options continue to be less progressive than the corporate tax, even if we measure the corporate tax incidence in a realistic way. Let’s consider proposals to replace the corporate income tax with a VAT, an option that is frequently discussed because it offers some economic gains. In 2007, Treasury found a long-run output gain of two to 2.5 percent from this option. (Part of the increase in long-run output is offset by reducing consumption in the short run, so the actual efficiency gain would be smaller than two to 2.5 percent.) The price of the efficiency gain, though, is a reduction in progressivity, which would be a political drawback and a policy objection. You need to do an apples-to-apples comparison, so if you allocate the corporate income tax to sources of income, you should also allocate the VAT to income sources, which makes more sense than allocating it to consumers. In other words, you should treat the VAT as a proportional tax on wages and business cash flow. If there’s no low-income relief, then labor would bear more than 80 percent of the burden of the VAT, which would surely be more than labor’s share of the burden of the corporate income tax. So, there would be some reduction in progressivity. Other revenue replacement options would avoid the VAT’s reduction in progressivity, but would probably have smaller efficiency gains.
Just as a side note, it seems to be obligatory that, if you’re proposing a VAT to replace the corporate income tax, then you have to label your VAT as a business tax. You have to call it a business transfer tax or a business consumption tax or maybe even work the word “income” into the name somehow. But whatever you call it, a VAT is a VAT. Now, a VAT may be good or it may be bad. But avoiding the V word doesn’t really change the economics, one way or the other.
I want to mention the option of replacing the corporate income tax with a shareholder-level tax. I think that, in a global economy, the shareholder level rather than the firm level is the right place to impose the single layer of tax. As long as we have firm-level taxation, we cannot escape the tradeoff between penalizing investment through U.S.-chartered firms relative to foreign-chartered firms and penalizing investment in the United States relative to investment abroad. If we try to maximize national well-being, which I think is the right perspective because it’s consistent with the mission of the United States government and the rest of its policies, then we don’t want either of those penalties. And, more broadly, we don’t want to keep trying to define the source of a corporation’s income, which is very tricky, or trying to define the residence of a corporation, which is essentially meaningless.
Instead, we should simply impose tax based on the residence of the stockholder. In other words, we should tax American stockholders on their income from corporations, regardless of where the corporation is chartered or where it’s operating. We should not tax foreigners on their income from corporate shares, except potentially as a bargaining chip for treaty negotiations on dividend withholding taxes.
So, I think shareholder-level taxation would have a lot of advantages. But, to make it work, you have to prevent the tax-free accumulation of earnings within the corporate form. Now, you could layer all kinds of anti-avoidance rules onto the system to try to do that. But the right solution is to go to the accrual method. That’s really quite administrable for publicly traded shares—it doesn’t pose any valuation problems or any serious liquidity problems. There’s obviously a lot of public resistance to accrual taxation based on the idea that somehow it’s unnatural to tax gains that haven’t been realized. But, that’s almost the inverse of reality. Realization is a highly artificial concept, as we’ve seen with things like the constructive realization rules, the various restrictions on deducting realized losses, and the basis allocation rules. So, let’s replace that artificial concept, which is exploited in a lot of tax shelter schemes, with an accrual tax base.
Now, a lot of issues would need to be addressed. Transition is always a big issue. There are also questions about how to treat tax-exempt shareholders, whether tax preferences should flow through to shareholders, and what to do about volatility.
Eric Toder at the Urban Institute and I are working on a report exploring this option and also the option of expanded international cooperation on defining the source of income. We expect that the Peter G. Peterson Foundation, which is funding our work, will release the report this spring.
Accrual taxation at the shareholder level would actually be more progressive than the corporate income tax for two reasons. First, the burden wouldn’t be shifted to labor, at least not to nearly the same extent. Second, the tax rate would vary based on the bracket of the shareholder. So, a dollar-for-dollar equal-revenue replacement of the corporate tax with shareholder-level accrual taxation would increase progressivity. The complication, though, is that it wouldn’t actually be an equal–revenue replacement. If you eliminated the corporate income tax entirely, accrual-level taxation at today’s ordinary income rates would replace only part of that revenue loss. So, to ensure that you really were maintaining progressivity, you’d have to be careful in specifying where you make up that revenue. But if you found some moderately progressive mechanism to replace that missing revenue, then you certainly could maintain progressivity. For example, you might do income tax base broadening, focused on high-income tax preferences.
Eric Toder and Alan D. Viard, Major Surgery Needed: A Call for Structural Reform of the U.S. Corporate Income Tax, report funded by the Peter G. Peterson Foundation, April 2014, available online at http://www.aei.org/papers/economics/fiscal-policy/taxes/viard-toder-major-surgery-needed-a-call-for-structural-reform-of-the-us-corporate-income-tax/.