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 Richmans' Trade and Taxes Blog

How the Corporate Income Tax Contributes to Income Inequality
Raymond Richman, 1/28/2014

The growing number of millionaires and billionaires and the increase in the inequality of income has been raised as a political issue by Pres. Obama. But his policies and those of his “liberal" constituencies have helped exacerbate income inequality. One of the reasons there are so many millionaires and billionaires is the corporate income tax, which turns out on analysis to exclude corporate income from any tax at all.  As the readers of this site are aware, we have been campaigning for the integration of the corporate and personal income taxes, essentially to treat corporations as we treat partnerships. Partners report their share of partnership profits as personal income. There is no separate partnership income tax as there is for corporations.

Not only is the corporate income tax a very bad tax from an economic point of view, economists are not even in agreement that the shareholders bear the burden of the tax. Some believe that the tax is passed on to consumers and that little if any of the burden of the tax is borne by shareholders. To make matters worse, corporations that export are disadvantaged compared to those that produce for the domestic market. In international markets, the likelihood of passing the tax on to consumers is practically nil because their competitors may pay little or no corporate income tax. Value-added and sales taxes may be rebated to exporters but income taxes cannot be rebated under international law.  

The income tax on corporations in the U.S. came about as the result of anti-corporate and anti-trust fervor that gripped radical activists in the late 19^th and early 20^th centuries. Congress, then as now, appeased this voting segment without considering its unintended consequences. 

The U.S. corporate income tax violates nearly every criterion of a good tax. It violates the principle that persons with equal incomes and in equal circumstances should bear an equal burden. Shareholders of modest incomes pay the same rate of corporate income tax as the most wealthy. It causes corporations to engage in uneconomic practices, including relying too heavily on debt financing and too little on equity financing. It encourages corporations to buy-back their shares, a process by which corporate ordinary income is converted ordinary income into capital gains, taxed at a lower rate. It encourages the wealthy shareholders to get the corporations whose shares they own to retain earnings and pay little or no dividends that would subject them to high personal income tax rates. No wonder that Warren Buffett reported that his personal income tax rate was lower than that of his secretary!

The wealthy as a result of the exclusion of undistributed corporate earnings are permitted accumulate huge fortunes essentially free of tax.  If the corporate and personal income taxes were integrated, there would be many fewer millionaires and billionaires. Corporate income should be taxed as the personal income of the shareholders just as partnership income is taxed. Corporate income taxes can be levied as they are at present but shareholders will treat the income as payment at the source subject to the personal income tax and they would be credited with the income taxes paid on their behalf by the corporations. We simply integrate the corporate income tax with the personal income tax.

Some of the implications of the proposed integration is that there would no longer be any reason for corporations to avoid paying dividends, to buy back (disinvest!) their shares, or even to tax capital gains. Warren Buffett’s tax rate would be substantially higher than his secretary’s!