One of the interesting things about the Bush administration is its willingness to press far-reaching initiatives on several fronts simultaneously. Thus, at the same time it is pushing a major tax cut, it is also pursuing Social Security reform and an overhaul of energy policy. Consequently, it should come as no surprise that the administration has already started work on its next major effort: fundamental restructuring of the tax system.
Over the weekend, Treasury Secretary Paul O’Neill hinted at where the administration may be going, in an interview with London’s Financial Times newspaper. He called the current tax system “an abomination” requiring changes to its “very structure.” President Bush, he said, “is also intrigued about the possibility of fixing this mess.”
O’Neill offered few details, but he did say that he favors abolition of the corporate income tax, which has been a goal of tax reformers on both the left and right for decades. If this one thing could be done, it would do more to improve the Tax Code and the competitiveness of American businesses than any other single action Congress could take.
It is important to understand that the corporate income tax is per se a double tax. When an individual owns his own business and makes a profit, he, the owner, simply reports it on his individual tax return and pays whatever taxes he owes. Business profits in this case are taxed just once. But if this businessman decides to incorporate, he will find that his business profits are taxed separately at the corporate level and again at the individual level. He first pays as much as 35 percent of his profits in corporate taxes, and when he takes the remaining profits, as owner of the business, the same profits are taxed all over again at rates up to 39.6 percent.
Thus we see that in the first case, a business owner may be taxed up to 39.6 percent, the top federal income tax rate, but in the second case may pay as much as 60 percent, when the corporate income tax is included. The Tax Code alleviates this problem to some degree by allowing small businesses to organize as “Subchapter S” corporations. But this option is not available to large companies, meaning that almost everyone who owns a share of common stock is being taxed twice.
The double taxation of corporate profits has a number of consequences. First, by taxing this form of income more heavily than others, such as wages and interest, it discourages saving and investment. Less saving and investment translates directly into fewer jobs and lower wages. For this reason, many economists believe that the ultimate burden of the corporate income tax actually falls on workers, not shareholders.
Second, the corporate income tax fosters undesirable business practices. For example, it encourages corporations to finance growth by going into debt, rather than issuing new equity. This is advantageous because interest payments are tax deductible, whereas dividends are not. The result is that corporations are much more highly leveraged today than in the past, which makes them more vulnerable to bankruptcy during economic downturns.
Double taxation also discourages the payment of dividends. Instead, it makes more sense for corporations retain their earnings or buy back shares. This theoretically leads to a rise in the stock price, allowing shareholders to take their profits in the form of lower-taxed capital gains. However, this doesn’t always work. Nor does it suit the needs of all investors, many of whom, such as the elderly, prefer to invest for income rather than capital gains.
Finally, the corporate income tax acts as a kind of veil between a corporation’s owners — the shareholders — and its managers. It allows the latter to abuse their positions at times through excessive compensation, extravagant expenses and making investment decisions more to benefit themselves than the shareholders. Managers are able to get away with such behavior partly because the corporate income tax blinds shareholders from clearly seeing that corporate waste and inefficiency comes out of their pockets. As long as the waste is tax deductible, they figure that it is coming at Uncle Sam’s expense rather than theirs.
More than 50 years ago, the great economist H.C. Simons listed abolition of the corporate income tax as his No. 1 tax improvement. In his book “Federal Tax Reform” (1950), he writes: “There should be no levies on business or concerns as such. The impact of taxes should be kept as far away as possible from the concern or enterprise, and from the sphere in which operating and investment decisions are made.”
In 1977, Americans for Democratic Action, a left-wing group, called for abolition of the corporate income tax, saying it was unfair for low-income shareholders to, in effect, be taxed at the same rate as rich shareholders. That same year, The New York Times echoed the ADA recommendation, as did the late Bill Simon, Gerald Ford’s Treasury Secretary.
During the 1976 campaign, Jimmy Carter hinted at proposing elimination of the corporate tax, saying that all income should be taxed the same. His Treasury Secretary, Michael Blumenthal, worked on such a proposal but never put it forward.
In 1983, Ronald Reagan strongly denounced the corporate income tax. He asked, “When are we all going to have the courage to point out that, in our tax structure, the corporate tax is very hard to justify?” Reagan said that corporate profits should be attributed directly to shareholders and taxed only at that level. He said his administration was looking at the problem, but ultimately it did not try to fix it in the Tax Reform Act of 1986.
Nicholas Brady, O’Neill’s predecessor in the elder Bush’s administration, at least went so far as to issue a specific plan for integrating the corporate and individual income taxes, but he didn’t put it out until December 1992. With Bill Clinton just days away from taking office, hardly anyone took notice.
O’Neill is in good company if he makes abolition of the corporate income tax his top tax reform priority. The ground is already well plowed.