Wednesday, November 06, 2013

Why do we have the corporate tax?

I was recently discussing my forthcoming international tax book with some people when I got a question from an economist who observed that almost no one in public economics is interested in these topics (corporate or international taxation) and almost no one writes about them - it's just a tiny niche area.  The economist challenged me to justify writing about it, when we don't even know why we have the corporate tax.

The "why" question, of course, is meant to be normative, not historical or a question of political economy.  If I am proposing that the taxation of multinational companies' income by a given country should follow approaches A, B, and C, rather than X, Y, and Z, then I am in the normative realm, and a convincing descriptive explanation of why we in fact have corporate and international taxation would not be on point for the normative question, though perhaps illuminating it indirectly - for example, in terms of the set of feasible policies.

Before I turn to the question asked, however, a couple of preliminary observations.  First, I myself certainly have a foot in the art for art's sake camp - I think that interesting theoretical work that clarifies our understanding either of the world, or even just of ideas for their own sake, is great.  But it is certainly comical, and not in a good way, to hear that the vast majority of people in public economics have zero interest in these topics that are in fact quite important in our world, not to mention interesting once you get sufficiently far inside to see what the issues are.  None of those people who do the other stuff have any obligation to work on corporate and international tax issues just because they are important.  And also, lots of different things are important.  But the element of sniffy disdain for dirty reality, concerning central institutions that have large empirical effects, doesn't reflect well on the field as a whole.

Let me also tease out another subtext to the question.  Economists who don't spend any time talking to lawyers may naturally think that the lawyers are too unmoored from having an underlying policy framework to even realize that they have to ask themselves the question of why we have a corporate tax, in order to frame policy claims.  Indeed, in some cases economists may talk to lawyers and find that this appears to be the case.  But as it happens, I do discuss the fundamental underlying why questions at length in my book, and the policy prescriptions do derive from this discussion.  Moreover, the implicit characterization is in general an unfair stereotype, and seems to ignore the value of collaboration across disciplines.

OK, let's start with the fact that we have an income tax.  Obviously one could ask why at that stage as well, but here there is a big literature and people pretty much know what it's all about.  For distributional reasons, or rather based on trading off distributional and efficiency concerns, there's a widespread consensus for having at least a progressive consumption tax.  All you're doing when you make it an income tax is also taxing saving, a.k.a. taxing future consumption at a higher rate than current consumption.  There are arguments on both sides of that, but in the abstract the two instruments are potentially not all that far off each other.

Once you have an income tax, why would you tax "corporate" income?  But equally, why wouldn't you tax it?  Let's approach it from another direction.  Suppose the question were: Should the income tax reach income that is paid into escrow?  That is not a hard question.  If you are taxing income, and have reasons for wanting it to be comprehensive, why wouldn't you tax it just because it was paid into escrow?

How is corporate income different from other income?  Both earned by people, albeit in the corporate case via ownership in a legal entity that is taxed separately from the owners.  The main particular problems posed by the corporate tax are threefold:

First, we don't know who the underlying people are.  Now, this is not quite the same as the question of corporate tax incidence.  If you think the incidence of the corporate tax is shifted from shareholders to, say, workers, the same may hold for business income that is earned by individuals directly, rather than through corporate entities. (Note: A recent Joint Committee on Taxation suggests that the incidence might actually tend to differ in these two cases, but that addresses the underlying question rather than ignoring it.)  Given, however, that the corporate income tax is levied at the entity level, we don't even know who the owners are.  For example, to what extent, in a given case, are they U.S. individuals or foreign individuals?  And suppose that, at the shareholder level, you have tax-exempt entities, with unknown individuals (who aren't the "owners" in a straightforward way) standing behind them.  A reasonable starting point might be to think that, for each of these groups, we would want to (if we could) tax income earned inside a corporate entity the same way (whatever that might be) as that earned outside.

Second, we don't know what type of income it is.  For example, to what extent is it labor income?  Obviously, this can also be a problem with taxing individuals directly, if one wants to tax labor income differently than say, pure returns to waiting or the risk element (bringing us back to the income vs. consumption tax debate).  But with corporations, while it's often mistakenly assumed that we're not dealing with labor income since this would be paid out to workers via arm's length salaries, in fact there is the whole issue of the owner-employee.  This is a very big issue these days in the U.S. corporate tax.  So one reason for having a corporate income tax - though it falls well short of telling us what the instrument should look like - is that it includes significant labor income of one group of U.S. individuals (owner-employees) who aim to profit through share appreciation.

Third, we don't know what to make of the at least hypothetical second level of tax.  In theory, corporate distributions are taxable to shareholders, but it's very hard to generalize about the extent to which this happens (and matters) in practice.  There actually are income tax revenues from dividends, and from capital gains upon the sale of corporate shares, but there is also, under current U.S. law, not just the prospect of deferring the tax for a long time but of permanently escaping it, due to the step-up in basis for appreciated assets at death.

I expressly discuss this in chapter 5 of my book.  For example, when people say, as many do, that the U.S. should lower the corporate tax rate to, say, 25 percent, they are actually proposing a blended tax rate for lots of things that are actually different, and that we should want to tax differently.  For example, insofar as U.S. individuals are earning labor income through a corporate entity, underpaying themselves because they benefit from stock appreciation, there is no reason for a lower corporate rate at all (except insofar as they would face the second level of tax, which of course they can avoid by paying themselves deductible arm's length salaries).  But, as my book explains, when foreign individuals invest in the U.S. or through a U.S. corporation, there are circumstances in which the U.S. is best-off charging a tax rate of zero (i.e., where it has no market power and those individuals will be able to demand the global after-tax rate of return whether they invest in the U.S. or not).

It's in the nature of entity-level corporate taxation that we end up applying one rate to all this different stuff that we would want to tax differently.  (Of course, the dilemma can be narrowed a bit in various dimensions - for example, through "dual corporate income taxes" that attempt to tease out the labor income element.)  What to do given the underlying dilemma is the sort of question that one really needs both lawyers' institutional understanding and an advanced grasp of economics to address meaningfully.  But the fact that it is a messy question should not induce intelligent people to think that it is best ignored.

1 comment:

Ramu said...

Good Thoughts on Corporate taxation, Thanks for sharing. Capita Malta