A Radically Progressive Idea: Abolish Corporate Income Taxes

The inequities in actual income taxes paid among corporations, large stockholders and wage earners have been a preoccupation among progressives, particularly during the presidential campaigns of Elizabeth Warren and Bernie Sanders. These income tax inequities are partly (although not entirely) responsible for the growing income and wealth inequalities in the United States. Solutions proposed by candidate Warren included a “Real Corporate Profits Tax” and an “Ultra-Millionaire Tax.” Although Warren is spot-on regarding the underlying problem of corporate taxation, perhaps there is a simpler solution: Eliminate corporate income taxes entirely.

First, it’s important to understand the counter-intuitive reason why taxes on individual wages can be so much higher than corporate and investor income taxes: corporate earnings have always been taxed twice in the US. As an accounting student in the 1980s, one of the most important things we studied was how to minimize this double taxation paid by the corporation and its stockholders, which could far exceed the individual tax rates on the same earnings. 

Here is a simple example of what’s referred to as the double taxation problem. Let’s imagine that we have a Californian investor who makes more than $200,000 a year and owns stock in a California business which produces $1,000 earnings for his share of equity, before taxes. The marginal corporate Federal and State income tax rate in California is 28%, so $1,000 in corporate earnings after taxes is $720. If the corporation pays out 100% of those after-tax earnings as dividends, our California investor must how pay an individual marginal Federal rate of 35% and a California marginal rate of 9% – for a total of 44% taxes on the $720 payout. So now, after paying individual income taxes, our investor has $403. If our same investor had earned $1,000 in additional wages over $200,000, he would pay combined 44% taxes on that income, leaving him with $560 net income. Thus the impact of double taxation on $1,000 of business earnings results in $157 (15,7%) additional taxes paid versus wages. 

Politicians over the years have continuously modified Federal and State Tax codes to “fix” this double taxation problem and encourage investors. These tax law changes have created an absurd labyrinth of laws, including a long list of different business types, unique definitions regarding a plethora income and expense categories that exist only for tax purposes, and capital gain tax rates for both individuals and businesses. (See www.irs.gov/businesses for the US Federal Taxes code….and good luck!)

So considering those tax laws, if instead of paying out their after-tax earnings as dividends, our hypothetical business kept the $720 after tax income as retained earnings and then the investor sold his equity in the business for a capital gain of $720, he would pay a 20% Federal Capital Gains Tax on that income and a 9% ordinary income tax rate in California. Now our investor’s effective personal tax rate would be 29%, which would net him an additional $108 ($511-$403) or 10.8% of his $1,000 share of corporate earnings. If the business’s accountants were really clever, they might be able to find enough tax deductions and special treatments (such as accelerated depreciation) to have zero profits for tax purposes, regardless of what their GAAP (Generally Accepted Accounting Principles) financial statements show. When the company pays zero dollars in income tax and all of that $1,000 in GAAP income stays in the business, the stock market (or other investors) recognizes the additional value created in the company – so now our investor’s shares are worth an additional $1,000. When our investor sells his shares, he realizes $1,000 in capital gains. In California, his $1,000 of capital gains would be taxed at 29%, leaving him with $710 in after tax income. So by realizing the exact same $1,000 share of business earnings as tax-sheltered earnings and capital gains, our investor has an after-tax return of $710, rather than the same $1,000 income as wages ($560 return), as retained earnings in the corporation ($511) or, heaven forbid, earnings paid out as dividends ($403).

Nearly all of the tax and income inequities between wage earners and holders of capital are the result of similar efforts to minimize the overall tax burden on the same business earnings. Thus, the corporate tax code is the reason why corporations have two sets of books that don’t match – one set is meant to show the “real” state of the business, while the other exists only for minimizing corporate taxes. The tax code is why a company can report $1 billion in profits to Wall Street, but pay zero corporate income taxes – because they are paying no taxes on that second set of books. It is why corporations almost never pay out dividends anymore, because the marginal tax rates for investors are so much higher than if a company keeps the money and the investor sells his investment for a capital gain. It is why there is an overwhelming preference for corporations to buy back stock rather than paying out dividends – so that all earnings are turned into capital gains for stockholders. It is why corporations typically “grow” by acquiring other companies, because by investing their after-tax earnings in other businesses, it increases the value of the investment and allows investors to pay capital gains taxes when selling their shares. It is why corporations move parts of (or all of) their businesses to foreign countries, such as Ireland: in order to minimize corporate income taxes. It is also why they “keep” any earnings in that foreign country: to avoid US taxes. 

What if, instead of trying to “fix” the code yet again, we eliminated all corporate income taxes and passed through business earnings to individual investors as ordinary income? As part of this change, we could eliminate all corporate income tax reporting and, instead, companies would have to keep only one set of books that adhere to Generally Accepted Accounting Principles and report their net income to investors on a per-share basis. By requiring investors to pay tax on their investment income when it was earned and also pay taxes (as ordinary income) for any increase in value of their investments when they sold their shares, we could eliminate all capital gain tax treatments. Finally, we could require all compensation for executives and board members to be made in cash rather than stock options or stock grants, so that their income is taxed as wages in the current year. If executives and board members want to invest in their companies, they can do that after they pay taxes on their income. 

What would this do? How would it help address the inequities in taxes? 

First, and most importantly for our example investor, all income, regardless of its source would be taxed as ordinary income at the individual level. Period. Thus, there would not be four or more possible tax burdens on the exact same income. Warren Buffet and his secretary would have the same marginal tax rates for their respective incomes, and Mr. Buffet would now pay much more in taxes than his secretary. 

Second, note that this proposal is incredibly easy to implement with today’s technologies. Third, by removing the second set of accounting numbers for tax purposes, companies would only have one set of books that reflected their business – which is what financial accounting is supposed to do! Fourth, since all investment income would be treated as ordinary income when it’s earned – this would create incentives for firms to pay out at least some portion of their earnings to cover the taxes paid by their investors on that income. Fifth, because there would be no tax incentive to retain earnings, firms would only retain earnings to invest them in net positive activities or business that would increase earnings long-term; otherwise, they would pay out those earnings to allow their investors to invest the money themselves (or otherwise spend it). Sixth, since investors would pay taxes on their income regardless of where it was earned, it would remove incentives to move companies overseas or “park” earned income overseas. By removing all corporate income taxes, the US would become the most attractive country to locate a business – at least until the other OECD countries adopted the same tax policies. Seventh, this would also put all US citizens on the same graduated tax structure. For the “little old lady” with a fixed income and modest stock investments, she would only pay the marginal tax on her investment income relative to her overall (presumably low) income, whereas millionaires would pay the marginal rates based on their significantly higher incomes. Finally, for the purposes of this proposal, there would be one other positive outcome – the simplification of Federal and State Income Tax codes for individuals. The taxing of all income as ordinary income would eliminate the bevy of capital gain, investment and other tax categories currently addressed in the individual tax codes. Instead, all income would be ordinary income to individuals. Period. 

Gary F. Gebhardt, CPA (Ohio, non-practicing), MBA, PhD, is a business school professor at HEC Montréal.

Doing Capitalism Right

It is frustrating when people criticize capitalism as a economic system, because usually what they are really criticizing is the economic system that currently exists in the United States of America. Spoiler alert: the current economic system in America is hardly capitalism. It’s more like a mix of cronyism and feudalism, with a veneer of capitalism used to justify the system. In this post, I’ll focus on what briefly describing what capitalism done right looks like. I will go into more depth, as well as criticisms of current societal, market, organizational and individual practices in subsequent posts.

So what does “Doing Capitalism Right” look like?

The ideal of capitalism is some combination of those highlighted in the works of Max Weber and Adam Smith discussed in my earlier post:

An economic system that encourages the contributions of individuals to society in a way the maximizes the collective good of everyone by allocating resources and talents to those activities and outcomes that are most valued by individuals and society. The way that this is accomplished is by rewarding those who do a better job of meeting the needs and wants of individuals and society through the market mechanism.

It really is that simple. But as both Smith and Weber observed, the system doesn’t work correctly when the focus is on maximizing the wealth of those in power at the expense of individuals and society.

Market Focused Management as the Embodiment of Capitalism

In Marketing (as a practice and an ideal), we discuss three different assumptions that underly organizational cultures and how those organizations operate.

Production orientation

The focus here is on creating stuff as efficiently and effectively as possible and selling it for as much money as possible. It’s all about the innovator and producer. It’s a bit like the old saying, “Build a better mousetrap and the world will beat a path to your door.”

Sales Orientation

The focus here is on selling, selling, selling for as much as the market will bear. If we sell enough – for enough – we will make lots of money. (Unfortunately, what most people incorrectly refer to as marketing.)

Market Orientation

A market orientation is an externally focused culture in which the preoccupation of the organization is “How do we make money by improving the lives of others?” The organization starts by understanding the context of customers (consumers or other organizations), as well as the context of potential channels and partners to serve those customers, and then develops solutions (value propositions) accordingly. Key to those solutions is that they make the channels/partners and customers better off than they would be without the solution. That might include a comparable solution at a lower cost to the customer or a solution that makes the customer better off at a price that is equal to or lower than the value of that improvement. (I published a book and an award-winning article that explain how to create a greater market orientation, in case you’re interested.)

I thought that this post was about capitalism….

Well, yes, it is. The point of this post is that the philosophy underlying capitalism is about making all of us, as consumers, better off over time. The people and organizations that are more successful at realizing the ideal of making people better off make more money than other people and organizations. This is an empirical fact that has been documented across a bevy of management and marketing studies.

Note that within capitalism, the “producers” are also consumers and many consumers also work for producers, so the notion that consumers are better off also includes that assumption that the system provides work and income for those same consumers. Providing goods and services to consumers who cannot buy them because they don’t have employment is not a functioning system.

When capitalism works correctly, everyone is better off over time. That is the ideal that capitalism promises. That is the ideal as described by Adam Smith and Max Weber. Unfortunately, that is not the situation in which America finds itself today. In future posts, I’ll be offering thoughts about how we can return to those ideals in practice, rather than rhetoric.

Why “Recapturing the Spirit of Capitalism?”

The name of this blog is inspired by the Sociologist Max Weber’s 1930 work “The Protestant Ethic and the Spirit of Capitalism,” in which he argues that the Protestant work ethic played a key role in the growth and success of capitalism in the West – and the United States in particular. The following quote largely captures Weber’s thesis that the notion of “a calling” to serve one’s fellow man through the capitalistic system largely explains its success among Protestant cultures.

Labour in the service of a rational organization for the provision of humanity with material goods has without a doubt always appeared to representatives of the capitalistic spirit as one of the most important purposes of their life-work. It is only necessary, for instance, to read [Benjamin] Franklin’s account of his efforts in the service of civic improvements in Philadelphia clearly to apprehend this obvious truth. And the joy and pride of having given employment to numerous people, of having had a part in the economic progress of his home town in the sense referring to figures of population and volume of trade which capitalism associated with the word, all these things obviously are part of the specific and undoubtedly idealistic satisfactions in life to modern men of business. (Weber, pages 36-7)

At the end of the book he notes how this foundation of “callings” and “idealistic satisfactions” in serving fellow citizens was disappearing. And he offers a fairly chilling assessment regarding the future of capitalism:

The Puritan wanted to work in a calling; we are first to do so. For when asceticism was carried out of monastic cells into everyday life, and began to dominate worldly morality, it did its part in building the tremendous cosmos of the modern economic order. This order is now bound to the technical and economic conditions of mating production which today determine the lives of all the individuals who are born into this mechanism, not only those directly concerned with economic acquisition, with irresistible force. Perhaps it will so determine them until the last ton of fossilized coal is burnt. In [theologian] Baxter’s view the care for external goods should only live on the shoulders of the “saint like a light cloak, which can be thrown aside at any moment.” But fate decreed that the cloak should become an iron cage.Since asceticism undertook to remodel the world and to work out its ideals in the world, material goods have gained an increasing and finally an inexorable power over the lives of men as at no previous period in history. Today the spirit of religious asceticism – whether finally, who knows? – has escaped from the cage. But victorious capitalism, since it rests on mechanical foundations, needs its support no longer. The rosy blush of its laughing heir, the Enlightenment, seems also to be irretrievably fading, and the idea of duty in one’s calling prowls about in our lives like the ghost of dead religious beliefs. Where the fulfilment of the calling cannot directly be related to the highest spiritual and cultural values, or the, on the other hand, it need not be felt simply as economic compulsion, the individual generally abandons the attempt to justify it at all. In the field of its highest development, in the United States, the pursuit of wealth, stripped of its religious and ethical meaning, tens to become associated with purely mundane passions, which often actually give it the character of sport.

No one knows who will live in this cage in the future, or whether at the end of this tremendous development entirely new prophets will rise, or there will be a great rebirth of old ideas and ideals, or, if neither, mechanized petrification, embellished with a sort of convulsive self-importance. For of the last stage of this cultural development, it might well be truly said: “Specialists without spirit, sensualists without heart; this nullity imagines that it has attained a level of civilization never before achieved.” (Weber, pages 123-4)

And that disappearance of a raison d’être that ties individuals’ work to helping fellow citizens is responsible for most (if not all) of the negative effects of capitalism seen today. Essentially, capitalism has become a religion of its own, where people have faith that it “works” and is “the best,” without understanding or questioning the assumptions and limitations underlying capitalism. One example is the assumption that by focusing solely on maximizing shareholder value, companies will provide the maximum value for all stakeholders, including employees and customers, due to the “magic of capitalism.” I’ll call bullshit on that article of faith in a subsequent post.

Since I am a business school professor (in marketing, no less!), this may seem to be heresy. But, in fact, it is an effort to highlight the historical underpinnings of much of what falls within “business” today to help people understand and consider those assumptions and theories when “doing capitalism.” And it’s not heretical. Adam Smith, arguably the father of modern capitalism, wrote in his 1776 book “An Inquiry into the Nature and Causes of the Wealth of Nations,”

Consumption is the sole end and purpose of all production; and the interest of the producer ought to be attended to, only so far as it may be necessary for promoting that of the consumer. The maxim is so perfectly self-evident, that it would be absurd to attempt to prove it. But in the mercantile system, the interest of the consumer is almost constantly sacrificed to that of the producer; and it seems to consider production, and not consumption, as the ultimate end and object of all industry and commerce. (Smith, page 715)

Therein lies my primary motivation for this blog. To bring us back to these roots of capitalism to understand why it is or isn’t working out as planned – and ideally to offer solutions on how to optimize our societies, institutions and organizations to “Recapture the Spirit of Capitalism.”