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How to Reduce Inequality of Income and Wealth
Raymond Richman, 2/11/2014

The inequality of income has been raised as a political issue but neither the Democrats nor the Republicans have proposed anything resembling a reasonable policy to reduce it. The Dems would raise the rates of the personal income tax and increase entitlements while the Republicans argue that lower taxes would create more equality by helping achieving full employment. Both are partly right. But both overlook the fact that much of the income of the very wealthy is not really taxed at all. You would not suspect that the principal reason there are so many millionaires and billionaires is, believe it or not, the Corporate Income Tax.

And the solution is simple, treat corporate income as we treat partnership income. Partners report their share of partnership profits as personal income. There is no separate partnership income tax as there is for corporations. Corporate shareholders should report their share of corporate profits as personal income. Small corporations, so-called S corporations are now permitted to elect to have their earnings treated as the personal income of their shareholders. What we propose is that shareholders of all corporations treat their shares of corporate income as personal income for tax purposes.

Many of the wealthy have earned their wealth by invention, productive work, and investing wisely, men like Warren Buffett and George Soros. Neither inherited  his  enormous wealth, for example. But our country’s tax policies have enabled both to become richer than they would otherwise have been. Warren Buffett, who derives almost all of his income from corporate dividends and capital gains, both taxed at a  maximum rate of 15 percent, announced that in 2012, his average and marginal rate of tax was lower than that of his secretary. If he had included as personal income his share of the earnings of the corporations whose stock he owned, tens of millions of dollars, his average and marginal rate of tax would have been close to the maximum personal rate of 39.6 percent and his wealth would not have grown so rapidly. He did not mention the fact that the corporations whose stock he owned paid millions in corporate income tax, perhaps because he knew that most of the  burden of the corporate income tax was really borne by consumers, not the shareholders.  How much of the burden corporations in different industries are able to shift to their customers is a matter on which economists are not agreed but there is little doubt among economists that the total is substantial.

The income tax on corporations in the U.S. was brought about by the anti-corporate and anti-trust fervor that gripped radical activists in the late 19th and early 20th centuries. Economists at that time gave little thought to the incidence of corporate income tax and its economic effects. As is often the case, those who pretend to be the spokesmen for the common man often turn out to be, as a result of the foolish policies they espouse, the common man’s worst enemies.

The World Bank reported that the total market value of US corporations in 2012 amounted to $16.7 trillion. The wealthiest 1 percent of Americans own roughly one-third of the value of all shares. The wealthiest 5 percent hold more than two-thirds of the value of all shares; the remaining 95 percent own less than one-third. So if much of the income derived from corporate share ownership escapes taxation inequality is exacerbated.

Economists have long known but kept it a secret that much of the corporate income tax is not even paid by shareholders but is shifted forward and paid by consumers.  All private businesses have some degree of monopoly power, ranging from product differentiation caused by advertising and location to oligopoly and pure monopolies based on patents. Economists call this market system monopolistic competition. They are able to charge more than they would be able to under a system of perfect competition, closely approached only in the cases of homogeneous products and commodities.

Income inequality has always existed but has been increasing since the recession began in 2008. That is to be expected since 23 percent of the labor force is unemployed, working part-time involuntarily, or have stopped looking for jobs. It was also reported recently that the rate of increase in productivity of those employed, to which wages are intimately related, has fallen below its historical rate which means that even the employed are not doing well. As a result, the standard of living of the average American worker has declined. The trend can be expected to continue. During the same period, the wealthy fared well. The stock market has boomed since 2009, exceeding its 2007 level and the prices of other assets such as real estate have risen as a result of the large expansion of the money supply (euphemistically called quantitative easing) by the Federal Reserve System.

The corporate income tax has been justified by the “fact” that it is an entity separate and distinct from its shareholders. Its basis is the fact that corporate shareholders are numerous and their liability is limited to the capital they have advanced. But this is also true of limited liability partnerships and limited liability proprietorships which are legal in most states. Yet the income of partnerships and proprietorships is treated as the personal income of their owners under the personal income tax. There is no good reason why the income of corporations should not receive the same treatment.

The total market capital value of corporations is about ten times their expected stream of future net income. That is to be expected since capital value is simply the discounted value of expected future yields. That is why capital gains that are consumed and not rolled over should be taxed as ordinary income as I argued in the book, Trading Away Our Future (2008).

Treating corporate income as the personal income of shareholders would go a long way to reducing the degree of inequality. There will still be substantial inequality but the wealthy cannot take their wealth with them and there is the federal estate tax to help equalize wealth when they die. Although they consume more during their lifetimes, it should be remembered that income is subject to the law of diminishing marginal value. They may spend a hundred or a thousand times more than the median income household does in a year, but they have to watch their calories, sleep in one room, and watch one football game at a time. Brewster of Brewster’s Millions fame had difficult spending a million dollars during the single year allotted to him. Some inequality is a small price to pay for a dynamic private economy.

There are other reasons for integrating the corporate and personal income taxes. 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. IRAs and pension funds of those with 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 into capital gains, taxed at a lower rate. It encourages the wealthy shareholders to get the corporations whose shares they own to retain earnings increasing the value of outstanding shares. If corporate income had been taxed as personal income, there would be many fewer millionaires and billionaires.

To administer the proposed change, corporate income taxes can be levied as they are at present but shareholders will treat the taxes paid by the corporations on their behalf as a credit to their personal income tax liability. One would expect corporation to pay dividends more or less equal to the increased personal income tax liability of their shareholders, leaving plenty of undistributed earnings for capital appreciation.

Some of the intended effects of the proposed integration is that there would no longer be any reason for corporations to avoid paying dividends and to buy back their shares, Warren Buffett’s tax rate would be substantially higher than his secretary’s!

  

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    Wikipedia:

  • [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]

    Journal of Economic Literature:

  • [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....

    Atlantic Economic Journal:

  • In Trading Away Our Future   Richman ... advocates the immediate adoption of a set of public policy proposal designed to reduce the trade deficit and increase domestic savings.... the set of public policy proposals is a wake-up call... [February 17, 2009 review by T.H. Cate]