Corporate Taxation and Capital Taxation

by on November 2, 2017 at 7:37 am in Current Affairs, Economics | Permalink

In the debate over corporate taxation it’s often assumed that corporate taxes are equivalent to taxes on capital. But corporations are only a minority of firms. Most of the firms in the pass-through sector are small partnerships but by no means are all pass-through firms small. Indeed, corporate profits are less than half of all business profits as shown by the following graph from the Tax Foundation.

What this means is that a cut in the income tax is also a cut in the capital tax. Indeed, a cut in the top marginal income tax rate is a bigger cut in capital taxation than a cut in the top corporate tax rate. (Unfortunately, it now looks like the top marginal rate on income won’t be cut.)

Since pass through businesses can be large, some people have suggested that these businesses should be taxed like corporations. That would be a mistake. An ideal tax system should be neutral as to organizational form. So, if anything, corporate taxation should be moved more in the direction of pass-through taxation.

Hat tip: Lunch with Steve Pearlstein, Bryan Caplan and Tyler.

1 clockwork_prior November 2, 2017 at 7:54 am

‘An ideal tax system should be neutral as to organizational form.’

I’m confident that everyone associated with a 501(c)3 not-for-profit organization will support this enthusiastically, especially if they are involved in bridging the gap between academic research and public policy problems

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2 Alan Goldhammer November 2, 2017 at 8:11 am

“I’m confident that everyone associated with a 501(c)3 not-for-profit organization will support this enthusiastically, especially if they are involved in bridging the gap between academic research and public policy problems”

ROFL!!! I always think of these organization as a form of ‘money laundering’ for half baked ideas.

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3 Troll Me November 2, 2017 at 12:34 pm

A lot of half baked ideas go around in private enterprise as well, but reporting requirements are different so basically we never find out about most of those.

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4 Troll Me November 2, 2017 at 12:41 pm

Non-for-profit activities are substantively different from for-profit activities. That is not a question of mere “organizational form” of organizations with fundamentally similar objectives (earn profits).

Without wanting to promote excessive tinkering in tax codes, the basic notion of promoting that which is to be promoted and deterring that which is to be deterred may apply. For example, you would not tax soup kitchens and tobacco at the same rate – if that means that the adminstrator’s income is higher for each input dollar, that’s simply because every dollar goes further when the tax system provides subsidies to the activity, and not because there’s is anything especially devious.

Now, if you have a case to report where there is money laundering or where charitable status is obviously fraudulent, that’s a matter to report to the IRS and I don’t see what relevance it has for such broad theoretical and practical considerations discussed in this forum.

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5 Curious Fella November 2, 2017 at 12:55 pm

Why should an ideal tax system be neutral to organizational form? Aren’t there benefits to providing businesses with the trade off between liability shields and higher taxes? For example, some corporations in riskier sectors (eg finance, energy, certain product development) may want an increased liability shield and are willing to pay higher taxes for such protection, whereas other sectors may want the opposite (like a small service based company without many customers. The higher taxes can be used to (theoretically) offset the risk of the higher liability shield (eg, the US government could use such revenue in response to large scale environmental disasters), whereas the lower taxes and higher liability can incentivize growth of small businesses and can promote competition.

There are obviously many considerations to account for, but to say an ideal tax system should be neutral to organizational structure seems like a blanket statement without much explanation or reasoning.

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6 Troll Me November 2, 2017 at 1:19 pm

It’s related to a view that exists in economics that taxes should not be distortionary because that leads to higher GDP outcomes than when taxes are distortionary.

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7 Cyrus November 2, 2017 at 2:27 pm

In practice, there’s little trade off here. Passthrough taxation entities can have effective liability firewalls in most jurisdictions.

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8 mulp November 2, 2017 at 1:45 pm

Are you calling for converting business profit taxes to a VAT?

Or don’t you get that not-for-profit means no profit to tax?

Or do you file income taxes for your kids based on the income they get from your gifts of goods and services to feed, house, educate them?

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9 clockwork_prior November 2, 2017 at 4:13 pm

‘Or don’t you get that not-for-profit means no profit to tax?’

By definition, of course. Nonetheless, anyone with any familiarity with (many, though not all) non-profits quickly recognizes that the ‘no profit’ part is a convenient way to indulge in wanton excess as long as the money lasts.

I was not actually joking in the sense that ‘non-profit’ is often merely a shorter spelling of the word ‘tax avoidance.’ And as a note – non-profits are most certainly allowed to earn a profit, it is simply called by another name in their case.

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10 Harun November 2, 2017 at 3:17 pm

Actually, yes, that’s a good idea.

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11 Alan Gunn November 2, 2017 at 8:07 am

Pass-through taxation is extraordinarily complex, especially when the partnership in question has different kinds of income (capital gains, foreign-source income, etc). As a practical matter, the only way to have a tax system that is neutral as to organizational form is to impose an entity-level tax. Don’t believe this? Look at the Treasury Regulations under §704 of the Internal Revenue Code. Of for that matter, any other partnership-tax regulations.

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12 rayward November 2, 2017 at 8:35 am

Back when I was a tax lawyer, my colleagues and I would joke that subchapter K (the partnership tax provisions) makes the income tax optional (and makes the estate tax optional too).

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13 Dick the Butcher November 2, 2017 at 8:49 am

Sir, Did you have much experience with Subchapter S corporation elections?

Economists and attorneys (too few accountants, too) don’t “muck around” in the intricacies (micro or “zen,” if you will) of owners’ equity and debt financing.

The IRC spawned more criminals than did any other government act. .

Before the IRC, the only native American criminal class was congress.

Before Baseball, tax avoidance was the National Pastime.

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14 Ray Lopez November 2, 2017 at 11:47 am

My S-chapter, which I set up on my own, was simple to do, and I can earn up to $101,300 for 2016 tax-free while working overseas. Since my work overseas is done with US clients via the internet, in countries that don’t tax electronic transactions for services (Greece, Philippines), I effectively don’t pay tax on my first $100k. Not bad work if you can get it. Coupled with my DC real estate, I’m well on my way to getting into the top 1% in wealth, on my own (minimum net worth requirements: $9 million).

Bonus trivia: what’s up with the idea to limit 401(k) funding? I don’t need to do it, since like I say my income is tax free, but I remember when I was in the USA I could put away something like $20k/year. I think it’s the Republican’s plan to ‘broaden the base’ but it seems ‘anti-savings’. Better to eliminate the mortgage tax deduction.

PS–let’s face it, tax laws are written by and for the rich. Seriously. The rich would argue only they add value, since only they have the capital to do so. Do you know why my family votes Republican (I don’t always). Because they’re in the 1%. They support Trump, lol, despite him being a foul racist who uses and abuses Greeks as fall guys (the tool George Papadopoulos, not to be confused with the GR junta leader George Papadopoulos) And most of you reading this would also do the same. The Selfish Gene theme. In a way, you can say the 1% believes in Ricardian Equivalence and future unfunded liabilities to the middle class that will be likely reneged, with a vengeance.

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15 mulp November 2, 2017 at 2:09 pm

The Republicans are just moving tax revenue to the present from a decade or two in the future for the IRA contribution tax deferral cap.

Basically they are moving several hundred billion in deficits out of the ten year window and then counting on the CBO to rule tax cuts do not increase the deficit after 2028 when these tax cuts expire.

The GOP blames Obama for the explosion in the permanent deficit because he got Democrats in the Senate to cast the required votes needed to make the half billion annual Bush-Cheney tax cuts deficits permanent. This is another GOP half trillion annual deficit tax cut that becomes the biggest tax hike ever in 2028, unless Congress votes to make the bigger deficits permanent.

The GOP says they are going to kill 10-20% of jobs to balance the budget in order to create jobs, but they can’t figure out how to make the math work: they don’t want to make flyover country into North Africa filled with refugee camps. Characteristics include resource pillage and plunder with profits going elsewhere, big Chinese corporations farming the land with food and profit going elsewhere, increasing unemployment and poverty and homelessness.

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16 Vivian Darkbloom November 2, 2017 at 2:29 pm

“The Republicans are just moving tax revenue to the present from a decade or two in the future for the IRA contribution tax deferral cap.”

Here’s the text of the bill:

https://www.scribd.com/document/363306066/Tax-Cuts-and-Jobs-Act#download&from_embed

For the benefit of everyone, please point out the section of that bill which changes the IRA rules and does to the budget what you claim it does.

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17 Harun November 2, 2017 at 3:24 pm

You should be careful. I don’t think that if you are receiving US payments to a US pass-through that it would be considered “foreign income” for the exclusion.

You really should be using a foreign business entity for this.

It is nice though when you make money, say in the USA, and then a normal, territorial tax country says “this is not our business.” This is how the US should work.

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18 Vivian Darkbloom November 2, 2017 at 4:34 pm

The source of personal services income for purposes of IRC Section 911 is where the services are performed. See, IRC Section 862(a)(3). Ray’s got other problems with his scenario, but ignorance is often bliss.

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19 rayward November 2, 2017 at 8:24 am

That pass-through entities now earn more net income than C corporations is a reflection of reliance on (1) rising asset prices and (2) market anomalies to accumulate wealth rather than investment in productive capital. Is that a good thing? Ken Griffin, the founder of the hedge fund Citadel (a pass-through entity), has donated $125 million to the economics department at the Univ. of Chicago (he attended Harvard not Chicago). https://www.nytimes.com/2017/11/01/business/dealbook/endowment-griffin-university-of-chicago.html The NYT writer points out the irony of Mr. Griffin, who has accumulated vast wealth as the result of market inefficiencies (i.e., anomalies), would make such a large donation to a school known for an almost religious belief in efficient markets. [I will mention that Richard Thaler is a professor in the business school not in the economics department.] Indeed, according to the efficient-markets hypothesis, it’s impossible for Griffin to have accumulate such vast wealth, so how did he do it? Of course, Griffin has greatly benefited from the “carried interest” income tax loophole (the 20% in market appreciation of his hedge fund that is paid to Griffin).

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20 John Thacker November 2, 2017 at 4:15 pm

It’s more a reflection of businesses that in the past would have organized as C corps being able to and choosing to organized as pass throughs. For that reason, it could be reversed if the corporate rate were decreased but not the individual (or special pass-through rate).

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21 Vivian Darkbloom November 2, 2017 at 8:57 am

The move toward pass-thru’s (LLC’s, partnerships, S-Corps) can be attributed to:

1. The disparity between the combined corporate/shareholder-level taxes versus individual tax rates. This is not only due to the lower marginal rate on ordinary income at the individual level–it also includes the fact that C corporations do not currently enjoy a preferred (lower) rate on capital gains.

2. Prior to 1996, LLC’s generally could not be treated as pass-thru’s. “Entities” were classified according to a five-factor “Kintner test”, which made it challenging, but fun, to create foreign pass-thru’s under US tax law. After 1996, the entity classification rules permitted a taxpayer to elect corporate/pass-thru status for LLC’s (including single-member LLC’s) and many foreign entities (e.g., the Dutch BV). Those regulations were a watershed.

3. The growing popularity of S-corporations due, in part, to the fact that the number of shareholders allowed was increased gradually from 10 shareholders from the inception of this form of business in 1958, to 100 today.

4. The phenomenon of hedge funds and private equity funds which generally are formed as pass-thru’s. A lot of this has to do with regulatory issues confronted by publicly-traded corporations under Sarbanes-Oxley, SEC rules, etc., but not by privately raised capital.

….

“(Unfortunately, it now looks like the top marginal rate on income won’t be cut.)”

I thought Trump proposed a top rate of 25 percent on certain partnership income. If this is correct, the top marginal rate on ordinary income in this regard may not be as important as Alex thinks.

“Since pass through businesses can be large, some people have suggested that these businesses should be taxed like corporations. That would be a mistake. An ideal tax system should be neutral as to organizational form. So, if anything, corporate taxation should be moved more in the direction of pass-through taxation.”

Yes, yes and yes. But, it would be a mistake, I think, to create a new differential by lowering the rate of tax on certain partnership income if that would be lower than the combined corporate/shareholder-level taxes. It would also be more complicated.

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22 John Thacker November 2, 2017 at 4:17 pm

But, it would be a mistake, I think, to create a new differential by lowering the rate of tax on certain partnership income if that would be lower than the combined corporate/shareholder-level taxes.

Indeed, and some of Trump’s inclinations have certainly gone too far in that direction. The actual proposal appears to contain both a pass-through rate and some complicated mechanisms to attempt it from being gamed (missing from, say, the Kansas attempts).

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23 Gideon Magnus November 2, 2017 at 9:35 am

This is true if businesses taxed as pass-throughs cannot deduct all their expenses immediately. With immediate expensing of investments (i.e. a cash-flow tax) the (expected present value of the) tax burden is zero, and the sole purpose of taxing corporations is to mitigate people misclassifying labor income as capital income.

Under pretty much any tax system the government needs to ensure that companies do not treat private consumption as business expenses. But with a cash-flow tax it can focus exclusively on this, and will not be burdened with the next-to-impossible task of disentangling labor from capital income. For example, with a cash-flow tax there wouldn’t be a carried interest loophole for hedge fund managers.

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24 John Hall November 2, 2017 at 9:51 am

What about foreign investors? There shouldn’t be an incentive for foreign ownership over domestic ownership.

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25 John Thacker November 2, 2017 at 4:19 pm

That was the beauty of the DBCFT, combining the advantages that Gideon Magnus mentioned of a cash flow tax with shifting the corporate taxation essentially onto consumption. (A move that made even more sense with other countries moving more to VATs, thus making it the more neutral option.)

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26 byomtov November 2, 2017 at 10:59 am

(Unfortunately, it now looks like the top marginal rate on income won’t be cut.)

Why is that unfortunate?

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27 mulp November 2, 2017 at 2:19 pm

The GOP has been promising free lunch government and economic growth for decades and Trump has doubled the promised free lunches, so what better time to deliver endless free lunches.

Unfortunately TANSTAAFL.

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28 byomtov November 2, 2017 at 11:03 am

Look.

This tax cut is about one thing – cutting taxes on wealthy people.

It is a political action, and ought to be evaluated as such. All the fine-grained economic analysis misses the point.

You want to cut taxes to help the middle class? Cut some of the rates other than the top rate. Despite the magic that the term “marginal” conjures up there is nothing special about the top marginal rate.

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29 Troll Me November 2, 2017 at 12:29 pm

There would have to be a withheld tax on any dividends paid out to foreign shareholders (and if the objective is to attract foreign investment, which does not appear highly relevant here, this should not be at the level of system-wide tax code).

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30 mulp November 2, 2017 at 2:32 pm

Almost all corporate profits are in share price increases, not dividends, price inflation based on greater monopoly power or market dominance.

Amazon not only has no taxable profit, it pays no dividends, which isn’t surprising given it pays so much to exponentially increasing workers.

Contrary to the implied arguments by the GOP and conservatives, the Federal government does not tax revenue paid to US workers, even revenue brought into the US from tax havens overseas.

The trillions parked outside the US are used as collateral for debt inside the US to NOT PAY WORKERS, which would be taxed. Ie, the overseas profits would be brought back to buy competitors and the fire US workers to boost profits with lower labor costs and higher prices.

Only Jeff Bezos and Elon Musk use every penny the can get their hands on to build new productive capital assets in the US.

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31 sean November 2, 2017 at 1:08 pm

Most of my friends are in the top 1%. Everyone I’m talking to sees this as a tax hike. I think it depends on what part of the 1% you are in.

If you are high-income, high tax state, high property value state, then this is a huge tax hike.

If your finances are closer to Donald Trump with a lot of pass-thru income or trust fund set then this looks like a nice tax cut.

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32 ohwilleke November 2, 2017 at 2:28 pm

“(Unfortunately, it now looks like the top marginal rate on income won’t be cut.)”

There is really absolutely no empirical data to show that cutting the top marginal rate when you aren’t close to a Laffer curve peak is good for the economy. Indeed, the limited available empirical data points to just the opposite.

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