On Oct. 19, the Institute on Taxation and Economic Policy (ITEP), a union-backed organization affiliated with Citizens for Tax Justice, issued a new study showing that a number of large corporations paid no federal income taxes in at least one year between 1996 and 1998. It further charged that the overall federal tax burden on corporations is falling at a time when corporate profits are rising. The implication is that something fishy is going on and that Congress should move to restrict corporate tax shelters that are keeping big corporations from paying their "fair share" of taxes.
Before discussing the details of corporate taxation, it is important to understand that the corporate income tax is per se a double tax. When a corporation makes profits, it pays 35 percent of those profits directly to the federal government. But when it pays the remaining 65 percent out to the owners of the corporation (i.e., the shareholders) in the form of dividends, they are taxed again on exactly the same profits that have already been taxed. With the top federal individual tax rate at 39.6 percent, this means that the total federal take on corporate profits can be more than 60 percent.
There is virtual unanimity among economists and tax theorists that the corporate income tax should be abolished, with all corporate profits taxed only at the shareholder level. For example, the late William Vickrey, winner of the 1996 Nobel Prize in economics, called for abolishing the corporate income tax in his presidential address to the American Economic Association in 1993. He said the tax is "the most serious hurdle in the way of private capital formation" and "inflicts a double whammy on the economy." It causes "inefficient allocation of investment," encourages "thin equity and resulting bankruptcies," and "lubricates takeovers and mergers of dubious intrinsic merit."
Indeed, support for abolition of the corporate income tax crosses political and ideological boundaries. In 1977, the ultra-liberal Americans for Democratic Action passed a resolution at its national convention saying "the corporate income tax should be abolished." This view was seconded by the New York Times in an editorial on Sept. 11, 1977, entitled, "Abolish the Corporate Income Tax." More recently, Prof. Joseph Bankman of Stanford, whose work is often cited favorably by those seeking to restrict corporate tax shelters, listed abolition of the corporate income tax as his No. 1 tax reform.
Having established that the corporate income tax is illegitimate in the first place, let us turn now to some recent issues in corporate taxation.
First, there is no downward trend in federal corporate tax receipts. In fiscal year 2000, which ended on Sept. 30, corporate taxes were up 12.6 percent, while the gross domestic product was up just 6 percent. Since 1992, corporate tax receipts have more than doubled, while GDP has risen only 70 percent. Over the same period, corporate taxes have risen from 9.2 percent of total receipts to 10.3 percent, and from 1.6 percent to 2.1 percent of GDP.
Second, corporations pay vast amounts of taxes to state and local governments, they pay half of all payroll taxes, and those that operate in other countries pay large amounts of taxes in those countries. In 1997, U.S. corporations paid at least $350 billion in taxes over and above the $184 billion paid to the federal government that year, according to the Internal Revenue Service.
In the March testimony before the Senate Finance Committee, Kenneth Kies of the PricewaterhouseCoopers accounting firm made several additional points about factors affecting corporate profits and tax receipts lately.
First, he notes that the ITEP analysis compares taxes to reported profits. But profits reported on company annual reports, the principal source of ITEP's data, can legitimately differ sharply from taxable income reported on tax returns. A major difference is profits earned by foreign subsidiaries of U.S. corporations. These are part of a company's reported profits, but not necessarily part of its taxable income, because such profits are taxed by the U.S. only when repatriated. Those profits are, however, fully taxed in the countries in which they were earned.
Second, the tax treatment of stock options distorts the relationship between book income and taxable income. That is because stock options are not considered a cost to the corporation for financial accounting purposes, but usually can be deducted for tax purposes. This is reasonable because stock options increasingly are just substitutes for wages, a valid business expense. Of course, these options are fully taxed at the individual level when exercised.
Finally, Mr. Kies notes that increased depreciation expenses are a major factor lowering taxable income for many corporations. Under the law, businesses are allowed to write off a portion of their capital expenditures each year. Since they have been greatly increasing such investment in recent years, their depreciation write-offs are also rising. Nonresidential fixed investment by U.S. businesses has more than doubled since 1993, rising from 10.3 percent of GDP to 14.2 percent.
More investment is clearly a good thing, especially investment in computers, a growing share of business investment. But computers, unlike older types of capital equipment, have shorter useful lives because they become obsolete very quickly. This means they are written off faster, giving businesses a bigger write-off. It would make no sense to restrict this write-off in order to raise corporate taxes because computers are fueling economic growth and higher productivity. It would be a classic case of killing the golden goose.
In conclusion, the ITEP analysis is deeply flawed. Instead of raising taxes on corporations, we should be cutting them. For example, instead of forcing businesses to write off capital equipment over many years, they should be allowed an immediate full deduction for such investments. That will increase investment, raise productivity and improve the standard of living for all Americans.