Berk: Kill Business Profit Tax; Dock Investors Instead

The corporate income tax, part of the U.S. tax code since 1909, is a failure on all counts. It isn’t raising much money. It isn’t creating socially desirable incentives, and it isn’t immune from manipulation. We should get rid of it in favor of more efficient levies on capital.

There are two commonly held myths about corporate taxes. First, that they bring in a lot of money. They don’t. Last year, only 8.9 percent ofgovernment revenue came from such sources. Second, that companies pay the tax. They don’t; only people pay taxes. The corporate tax is extracted from persons associated with a business: investors, employees and customers. Government revenue from these people has been dropping steadily since the peak of almost 30 percent in the 1950s.

One reason why the corporate contribution is low is the tax break for debt. Companies’ payments to debt holders are deductible, while dividends for equity holders aren’t. This imbalance was written into law a century ago, when corporate-tax rates were so low that the disparity didn’t seem to matter. As those levies have climbed, corporations have become eager to take on leverage and thus lower their payments to the Internal Revenue Service.

We witnessed the consequences of this policy in 2008. Corporations, especially banks, opted to issue too much debt, ultimately imposing huge costs on society. One might argue that the leverage subsidy could be better eliminated by simply removing the exemption for debt payments. But that solution is unlikely to succeed, given corporations’ immense lobbying power in Washington.

Creating Loopholes

This brings up a second reason to eliminate the tax. For individuals acting alone, it is effectively impossible to bend the tax code to our will. We can’t afford to hire lobbyists to argue for tailored exemptions for us. We aren’t likely to channel campaign contributions to politicians who can create loopholes just for us, or to ask top accounting firms to reinterpret the tax code to our advantage.

Such ploys are so expensive that it’s cheaper to pay what is due. But if we were taxed as a group, the equation would change. Then we could share tax avoidance costs. If the group were large enough, it would become beneficial for us to engage in tax avoidance.

From a tax perspective, a corporation is a large collection of individuals sharing the costs of avoidance. General Electric Co. (GE), for example, posted $14.2 billion in profits last year but reported paying only $1.1 billion in taxes, an average rate of just 7.4 percent. Corporations strive mightily to pay much less than the statutory 35 percent tax rate on their profits -- a socially wasteful activity.

Meanwhile, the corporate tax’s mischief keeps increasing. Because the levy distorts corporate incentives, it imposes a significant indirect burden on individuals. Workers bear large costs because, by subsidizing leverage, more firms go bankrupt, thereby undermining job security. The rest of us are forced to pay when these over-leveraged firms are deemed too big to fail and must be funded by large government bailouts.

Most importantly, our political process is compromised by the tax-avoidance strategies that corporations adopt. It is hard to understand why we, as a society, are prepared to incur these additional costs for a tax that raises less than 9 percent of government revenue. Surely we are better off eliminating the tax altogether and replacing it with a direct one on individuals.

Taxing Dividends

The obvious alternative would be additional taxes on investment income. Dividends could be taxed at regular rates for individuals, rather than the current 15 percent, which is low by historical standards. The capital-gains rate could be increased, too, from its current maximum of 15 percent on long- term profits.

Greater reliance on investor taxes would be simpler, more equitable, more efficient and more easily enforced. These changes could be implemented without adding to the true load that investors already shoulder. If investors are currently paying most of the corporate tax anyway, increased investment taxes merely offset what was previously paid as corporate taxes.

For society as a whole, efficiency gains would arise as corporations shake free of perverse incentives to spend time and money on tax avoidance. Managerial talent could be redeployed more productively. GE’s shareholders would no longer need to finance the world’s best tax-law firm. Businesses could concentrate on product innovation and profit expansion, creating more lasting value.

(Jonathan Berk is the A.P. Giannini professor of finance in the Graduate School of Business atStanford University.)

To contact the writer of this article: Jonathan Berk at berk@gsb.stanford.edu