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Real Tax Reform; Tax Corporations As Partnerships
Raymond Richman, 8/23/2013

The U.S. corporate income tax violates nearly every criterion of a good tax. It is expensive to administer and to comply with. It is not as progressive as it is believed to be. Indeed, by retaining earnings and avoiding paying dividends, wealthy shareholders avoid the high tax rates of the personal income tax.  It violates the principle that persons with equal incomes and circumstances should bear an equal tax burden. It causes corporations to engage in a number of uneconomic practices.  Earnings are taxed twice once as corporate earnings and again under the personal income tax when, as, and if they are paid out in dividends. The personal income tax on dividends amounts to taxing the same income twice. Workers who pay into pension funds are not only taxed twice but the corporate tax date for most workers is higher than their personal income tax rate and they are taxed again when the pension is received and personal income tax has to be paid. It encourages corporations to engage in debt financing rather than to raise equity capital. It encourages corporations to buy back their stock instead of paying dividends, as a means of converting dividend income into capital gains. It encourages moving factories overseas, encourages imports and discourages exports costing millions of jobs. It discourages the payment of dividends and favors corporate practices such a stock buy-backs which convert ordinary income into lower-taxed capital gains.

It is believed to be progressive because corporate ownership is distributed unequally. But the incidence of the tax is in doubt. Prof. Harberger, an eminent economist, argues that corporations that export much of what they produce cannot pass the tax forward to consumers because of international competition. But corporations that sell their products domestically may be able to pass the tax forward to consumers or backward to their employees.

The corporation is in effect a partnership of shareholders. If partnerships are not subject to the corporate income tax, corporations on average must earn a return equal to the average return of partnerships plus the corporate rate of return on net income. One notices in the news these days the taking of corporations private; one of the reasons, perhaps the main reason is to avoid the corporate income tax.

Why are corporations taxed differently than partnerships? The answer is to be found in the antitrust movement of the late 1890s and early 1900s. Corporations that were not trusts or “combinations in restraint of trade” came to be viewed as a threat to consumers when in fact they created an economy having the highest standard of living by increasing the demand for workers with the resulting increase in average wages. Whatever the reason for the anti-corporate bias, a corporate income tax was enacted and a separate personal income tax was enacted as soon as the 16th Amendment to the Constitution was adopted.

This was not the British experience. Britain’s Income and Property Tax Acts which date from before the Tudors, re-enacted under the reign of William and Mary in the last decade of the 17th century, and re-enacted under William Pitt in 1803, integrated the corporate and personal income tax. Corporations paid the standard rate of income tax and households were credited with those payments on the dividends they received. When the Income and Property Tax was re-enacted in 1862, its provisions were almost identical to the earlier Income and Property Taxes. The British taxed corporations until the end of WWII as part of the personal income tax not as an entity separate from its owners but as taxation at the source of personal income derived from corporations. Corporations paid the basic rate of income taxation on their earnings and shareholders were credited with the basic rate of income tax on income earned by the corporation. (That lunacy is contagious is illustrated by the fact that after labor took power in the 1940s, the British imitated the worst characteristics of the U.S. income tax system including high rates (up to 98%), imposing a separate corporate income tax, and imposing a capital gains tax separate from the income tax.)

Except for its high cost of compliance, the personal income tax gets high ratings from economists. However, economists have called attention to some negative economic effects, for example seeking and finding ways to avoid high rates of tax. Because capital gains are taxed at lower rates than ordinary income, corporations, instead of paying dividends, buy back outstanding shares which, other things equal, raises the prices of the outstanding shares enabling shareholders to realize lower-taxed capital gains. This is the principal cause of corporations buying back their shares to raise the price of the remaining outstanding shares instead of simply paying dividends which are normally taxed at standard rates. But as we have shown elsewhere this can be easily corrected by appropriate treatment of capital gains. For example, untaxing capital gains that are rolled over, i.e., reinvested (the treatment accorded to homes) and taxing consumed gains at the same rates as ordinary income.

Progressive income taxes do little to equalize incomes. Progressive expenditures like free public education, Medicaid, food stamps, public libraries, public parks and recreational facilities, welfare, public safety, public entertainment, et .al. are the great equalizers of income.

While the progressive personal income tax is highly regarded by economists, their acceptance of the corporate income tax is hard to justify. It violates almost all of the principles of taxation.  As is typical of democracies, bad laws which have a constituency are never repealed..

Then there is the problems of double taxation and the problem of utilizing the corporation as a device to escape the high rates of personal income taxation. Corporations pay income tax on their earnings and then their earnings distributed as dividends are taxed as the personal income of their shareholders. The millionaires who control most corporations are reluctant to pay dividends which would be subject to high rates of personal income tax. So instead of paying dividends, they accumulate earnings without paying dividends. Share prices rise and the owners sell shares realizing capital gains which are taxed at much lower rates than dividend income..

But there is also an equity argument against the corporate income tax. The corporation is an association of individuals, its shareholders. Those who do business as a partnership are taxed on their individual shares of the partnership as personal income. The partnership is not taxed as such. The partners must declare under the personal income tax their share of the partnership’s net income. While the corporation can be used as a device to lower the tax burdens on the upper-income shareholders simply by retaining earnings or by converting earnings into capital gains as we’ve shown, partnerships cannot be used to play such games. High income partners pay high personal income taxes on their partnership income and low income partners pay lower rates of personal income tax on their income from partnerships.    

The corporation is an association of individuals, its shareholders. So is a partnership .Those who do business as a partnership are taxed on their individual shares of the partnership as personal income. The partnership is not taxed as such. The partners must declare under the personal income tax their share of the partnership’s net income. While the corporation can be used as a device to lower the tax burdens on the upper-income shareholders simply by retaining earnings or by converting earnings into capital gains as we’ve shown, partnerships cannot be used to play such games. High income partners pay high personal income tax on their partnership income and low income partners pay lower rates of personal income tax on their income from partnerships.    

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  • [An] extensive argument for balanced trade, and a program to achieve balanced trade is presented in Trading Away Our Future, by Raymond Richman, Howard Richman and Jesse Richman. “A minimum standard for ensuring that trade does benefit all is that trade should be relatively in balance.” [Balanced Trade entry]

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  • [Trading Away Our Future] Examines the costs and benefits of U.S. trade and tax policies. Discusses why trade deficits matter; root of the trade deficit; the “ostrich” and “eagles” attitudes; how to balance trade; taxation of capital gains; the real estate tax; the corporate income tax; solving the low savings problem; how to protect one’s assets; and a program for a strong America....

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