Is it better to have more corporations?

by  Tyler Cowen in

A reduction in the corporate income tax burden encourages adoption of the C corporation legal form, which reduces capital constraints on firms. Improved capital reallocation increases overall productive efficiency in the economy and therefore expands the labor market. Relative to the benchmark economy, a corporate income tax cut can reduce the non-employment rate by up to 7 percent.

That is from the new AEJ: Macroeconomics, by Daphne Chen, Shi Qi, and Don Schlagenhauf.

Comments

Ray Lopez

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A good book on corporations is The Corporation by the Washington bureau Economist chief, Google his name, Tom Standish(?) slow internet here in PH. Basically, the corporation allows for 'irresponsible' behavior that proprietorships don't allow, since there's limited liability. Hence the East Indian companies of the UK/Netherlands and the like. It's like having liberal (easy) bankruptcy laws, same effect. The downside is corporations are rapacious, and 'mission statements' only put a patina of PR respectability on them. I personally favor fewer corporations and more accountability; I also don't like deposit insurance (moral hazard) and of course am in favor of strong IP laws and government sponsored prizes. With my system, you'd have more investment and less consumption, but the flip side is you'd have less "Madison Avenue" style consumerism.

Bonus trivia: lots of American yard sales have stuff being sold and thrown out that's never been used, still in the original box, what does that say about US consumerism? Speaking as somebody living in the Third World where you never see anything thrown out (well, also, in the provinces there's no trash pickup, you have to burn your stuff yourself, but still). Even cardboard, plastic bottles, anything metal is recycled. Trash is treasure in PH (especially Manila).

Mulp

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The overwhelming source of funding for the bad mortgages given to those without income to service the mortgage and that fueled inflating housing prices far about cost to build and thus quickly underwater mortgages were entirely not deposit insured UNTIL THE BANK RUN BEGAN ON THE SHADOW DEPOSITORY INSTITUTIONS.

Then FDIC insurance was extended to shadow bank depositors stopping the bank runs within 48 hours.

The irony is the money fund that paved the way for non-FDIC demand deposits, backed by Milton Friedman as safer than regulated depository banks, was the first to file for bankruptcy protection in 2008, with a week of the start of the bank run.

Given bankruptcy is a government bailout designed to redistribute wealth from those who had it to those who lost it, Reserve Primary Fund got a government bailout that protected it's founders and operators from liability after losing depositor money. In the end, the loss was 0.9%, but if they had held out a few weeks longer, and bought FDIC insurance, it would still be operating, and depositors would have earned several percent annually since 2008.

McMike

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Indeed, deposit insurance was not the moral hazard, it worked more or less fine for three human generations.

The no-strings government/fed bailouts and legal forbearance regarding the elite is the moral hazard to worry about.

Rebarbativsky

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I think your first sentence adequately refutes your argument: "...(slow Internet here in PH)." Without limited liability there wouldn't be *any* Internet in PH, or anywhere else.

Rebarbativsky

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Sorry, that was a response to Ray Lopez, not to Mulp. Hard to track the response threads here!

Ray Lopez

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@Rebarbativsky - you're referring to fibre optic buildouts of course, and the 'overexpansion' in the early 00s, which only now is being filled. You have a point. They have at least one undersea cable to the Philippines, from Japan I think. But PH internet is awful, I think they are not maintaining their transmission towers and/or routers. Everything here is not maintained.

Ray Lopez

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I agree with you Mulp, and McMike. I'm reading now the 2008 David Wessel book on the Great Recession, "In Fed We Trust", it's pretty good, much to my surprise (I thought I'd be sick of it). Apparently a negotiation stance by H. Paulson, "We don't do bailouts" prior to the Lehman bankruptcy, which was meant not to be taken too literally, was leaked to the press in Sept 2008 by two noxious PR aides (both of them did not have their career negatively impacted either), Jim Wilkinson and Michele Davis, and this tied Paulson's hands when it came time to rescue Lehman (which Paulson despised but was prepared to bail out). The UK financial agency FSA also refused to clear Barclays to buy Lehman without a shareholder vote (as Barclays wanted to do, without a vote). Ironically, three days later the Fed/Treasury ended up bailing out AIG for three times the amount of Lehman. I would have liked to have seen no bailouts whatsoever, Andrew Mellon style, but I agree Lehman should have been saved if you're going to go down the road of bailouts. As Congressman Barney Frank quipped, "Free Market Day" lasted exactly one day (September 14, 2008, when Lehman went bankrupt but no other big institution was allowed to afterwards). Also TARP was not $450B/700B as implied by Wessel, but more like $2T over 2008-2010 or so, since that's the size of the Fed balance sheet when they took over a lot of junk paper like MBS on their books (also they took more safe government bonds, it's hard to tell what percent is junk, I think the Fed is deliberately opaque on that topic).

People don't realize that only rising asset prices since 2008 has 'saved' the Fed from having to issue, Japan style, even more "quantitative easing" (printing money to buy assets).

Bonus trivia: they had an "Operation Twist" in 1961! Wikipedia dat!

McMike

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Not sure partnerships restrain behavior much when at scale. Look at the big accounting firms.

And most of the abusive vehicles for accounting fraud, money laundering etc, these days are partnerships of some form

McMike

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Also, oil & gas companies are notorious for using partnerships to extract early profits and then bankrupt the hole. Leaving the taxpayers to clean up the mess.

Ray Lopez

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Nobody denies partnerships can be sleazy and take on risk, but less so than corporations. I think Goldman Sachs was a partnership until the mid 1990s, and I'm sure they were sleazy back then too.

John

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Back in the 80s they created LLPs limited liability partnerships. As a result accounting firms (Arthur Andersen etc) moves to an LLP structure so their partners no longer had unlimited personal liability they were just liable for the amount invested in the firm.

McMike

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Yes, important distinction. LLPs, LLCs....

Does anyone except very small businesses still use pure partnerships?

dearieme

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I'm thinking of starting a corporation myself. Our UK rate of corporation tax is 19%, purportedly on its way down to 17%.

The corporation will have two Directors, several shareholders, but no employees. Employing people brings an insupportable amount of hassle.

rayward

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When I studied taxation the C corp was the preferred choice of business organization, not so much because of its efficiency but because there weren't any good alternatives. Pass through entities were limited (S corporations could have only 15 shareholders at the time and, besides, were always at risk of losing S corp status if a non-qualified shareholder became a shareholder). General partnerships weren't a good option because of the unlimited liability. Limited partnerships weren't a good option because it needed a general partner with significant assets or the IRS would treat it as an association taxable as a C corp. Then the IRS opened the floodgates, allowing entities to choose whatever tax treatment they preferred, whether as a pass through entity (such as a partnership) or a C corp. This resulted in an explosion in the number of limited liability companies, the pass through entity of choice (most LLCs choose partnership treatment for tax purposes). Pass through treatment may be "tax efficient" but I will add my support for this paper that the C corp is the "economic efficient" form of business organization. Why? Let me count the ways. First, public ownership is incompatible with pass through tax treatment, thus creating the dilemma of choosing tax efficiency or economic efficiency. Second, C corps are more likely to create their own legacy, whereas pass through entities are more likely to come and go with their creators. Third, by their nature, C corps grow within, whereas pass through entities don't (as earnings are distributed to equity owners for whatever purpose they may choose). Sure, C corps can buy their own stock (which, unfortunately, is how most used the corporate tax cut windfall) rather than invest in productive capital, but it's not as likely as a pass through entity distributing most or all of its earnings to equity owners (there is some tax inefficiencies to stock buy backs). I could go on, but I won't. I will mention that tax experts in C corps look forward to getting reacquainted with the consolidated return regulations. And you think the human genome is complex. [I suspect that Cowen would disagree, since he prefers "disruption", the kind of disruption inherent in a form of business organization in which the earnings are distributed to the owners for reinvestment in something new rather than used to preserve a business (the C corp business) whose best days may have passed.]

rayward

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I should add that whatever incentive to use the C corp form of business organization as the result of the corporate tax cut was at least partially (mostly?) undermined by the 20% deduction for earnings of a pass through entity. Indeed, the laughter you hear are all those tax lawyers and accountants planning exploitation of the deduction. Tax and economic efficiency are not top priorities with the current crew controlling government, insolvency maybe, but not efficiency.

ohwilleke

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There are benefits for C corporations, but mostly not the ones you identify. The down sides of closely held businesses are generic to the tax form chosen for the most part. One of the big benefits of a C corporation is comparative anonymity for shareholders (the IRS doesn't get information about shareholders who don't have capital gains and don't receive dividends), and the fact that shareholders are only taxed when they actually receive distributions eliminating the phantom income problem which can be used to squeeze minority shareholders.

Axa

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Lowering the corporate tax reduces the capital constraints of business.

So, it seems like a tool that could be used during the next financial crisis. Or, are (some) firms today suffering from capital constraints that stunt growth?

And more importantly, are capital constraints endogenous or exogenous? If some business leader takes bad investment decisions which end in losses and reduced access to credit/higher capital costs, should this business be saved by lower tax?

john

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Given the SC ruling that corporations are simply people now, why make any tax distinction between any corporation or person? Just imagine the stimulus and wealth building that could occur if every household could enjoy the same benefit as corporations are given?

For instance, if every home owner were able to depreciate the house they need to access in order to show up to work rested, clean and ready to be productive, how fast would household wealth for the lower socio-economic rungs increase compared to what occurs today?

Dave Smith

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I don't understand all the nuance of these laws, but wouldn't the homeowner have to pay taxes on the "income" they received from selling the depreciated house?

McMike

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I have some experience in the construction industry; heavy equipment is very attractive early on what with accelerated depreciation. But when you want to get rid of it, that can be a problem. This is one reason why you see so much unused heavy iron sitting around rusting.

There are of course ways to minimize, usually involving value of trade-ins.

Homeowners do get to depreciate their houses, in a sense, by deducting mortgage interest. And since gain on sale is exempt, this in the end works out sort of the same way in the end.

john

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Yes, they would. But just like corporate capital investment the depreciation allows them to recoup their payments via reducing the tax burden from ordinary income. In short the normal home owner is treated the same as all the corporate RE investors that are flipping homes, renting all the foreclosed homes they bought up or operating apartment complexes--or even hotel and motel or other commercial RE operations (mall, industrial parks...).

Moreover that would shift the tax burden for the these homeowners from income to capital gains taxed -- just like corporations enjoy when they depreciate a $100M complex, depreciate to 0 and then sell for $10M (or whatever they get).

Granted corporations the fail don't build wealth but in general corporations are incredible tools for for amassing wealth.

@McMike -- the mortgage interest is similar to corporate interest deductions but that is not the same as depreciation and that deduction from income. So why does the home owner have to wait until the sale to recoup the investment while corporations get to use accelerated depreciation tricks?

Josh

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House gains are already treated like capital gains, and that is only if you are above the limit where you pay nothing. Interest deduction reduces ordinary income as soon as you pay interest, i.e. as soon as you buy the house with a loan. And C corps are subject to double taxation, as when the money is paid to investors, there is another level of dividend tax.

Roger Zimmerman

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"Given the SC ruling that corporations are simply people now ...."

Sorry, but to what ruling are you referring? Can you cite some text from a majority opinion please?

Mulp

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Given a high growth corporation like say Amazon or Tesla pays 100% of revenue to current and past direct and indirect workers, thus paying zero in business profits taxes no matter the rate, on what basis does lower tax rates increase employment For such firm's?

Would eliminating the business profit tax allow Tesla to have even larger operating losses from building even bigger factories that result in even bigger depreciation expenses to swamp the direct labor costs of making cars?

Elon will do everything in his power to keep Tesla losing money for another decade or two, building ever more gigafactories for batteries, cars, trucks, solar panels, roofs. Then, like Bezos, the profit would be barely positive, with all revenue paid to workers.

Milton Friedman argued for cutting business profit taxes to cut business investment, to cut employment, to cut wages and benefits, and pay high profits to shareholders. He argued the high tax rates created incentives for business managers to grow production beyond what was needed, creating a society that consumed and wasted too much. After all, paying ever more workers ever more in income resulting in excessive demand for bigger houses, more cars, boats, vacation homes, etc, things that were seldom used because workers were spending all their time working.

McMike

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Any conversation about top-line tax rates rather than effective tax rates is already doomed

Josh

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The new tax law offers tax breaks to S Corps so that they receive equal benefits to C Corps and will mitigate any switching of firms.

ohwilleke

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The empirical evidence simply does not bear out the theoretical predictions about job growth in papers like these. One niche where the C corporation rate cut is a huge boon, however, is in marijuana dispensaries, which the ability to reduce entity level tax rates dramatically reduces the bite of IRC 280E relative to pass through entities, in addition to reducing tax uncertainty and tax risk.

ohwilleke

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Another big problem with this analysis is that almost all entities that pay meaningful corporate tax are C corporations already because they have to be because they are publicly held and publicly held corporations are the lion's share of the economy. All of the shift from C corporations to S corporations happens in the closely held company sector and a change is the tax classification of a closely held company has little or not impact on its ability to raise capital.

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