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.