The federal government relies less and less on the corporate income tax with each passing year. As corporate tax receipts fall, some policymakers (including the president) have looked to plug holes in international tax rules, arguing that multinationals are taking advantage of leaky transfer pricing rules to legally lower their tax burden. Others have proposed scrapping the corporate tax and replacing it with a consumption tax or something similar. But a recent study argues that focusing on corporate tax revenues misses the point and that overall, federal taxes on businesses have not fallen that much.
The U.S. corporate tax is 2 percent of GDP. The OECD average is 3 percent. In 1979 those numbers were reversed, according to the Tax Foundation -- the U.S. number was 2.8 percent, while the OECD was at 2.2 percent. The Tax Foundation points out, however, that one overlooked reason for falling corporate taxes is that more and more U.S. businesses are organizing as passthroughs and are subject to individual income taxation. More than 50 percent of businesses in the United States are organized as passthroughs, the foundation says. From 1980 to 2012, noncorporate business income grew 400 percent, from $360 billion to $1.6 trillion. Corporate income grew at a much slower rate, rising only 100 percent (from $763 billion to $1.7 trillion). Using the Tax Foundation’s numbers, it is easy to see that total U.S. taxes on business as a percentage of GDP is twice the corporate number, or close to 4 percent. That, of course, is higher than the OECD’s average of 3 percent. The foundation’s implicit conclusion is that lawmakers shouldn’t be looking to raise more revenue from business in the future.
The Tax Foundation is right about the importance of passthroughs, and confronting this problem is one of the legislative challenges facing any lawmakers who want to reform the tax system, even (perhaps especially) those who only want to focus on the corporate or business side. Fewer and fewer C corporations are being formed. There is no reason for that trend to stop unless the rules are changed. With the check-the-box regime and the advent of LLCs, almost all of the legal advantages of corporation entities can be had by passthroughs. And usually the tax rules for corporations are far less advantageous because of the problem of double taxation. There is a reason that House Ways and Means Committee Chair Dave Camp dedicated so much effort to proposed reforms to partnerships and S corporations in his initial drafts and then in his comprehensive proposal in February. The Obama administration has even suggested moving some large passthroughs to corporate tax rules, although it hasn’t issued a formal proposal.
The Tax Foundation’s report isn’t complete. It fails to provide an OECD average level of business tax (other nations have passthrough entities as well). It criticizes observers who try to use corporate income tax rates as a substitute for overall business tax rates, but then compares U.S. business taxes to the OECD corporate average. Passthroughs aren’t quite as developed in Europe as in the United States (and they haven’t grown at nearly the same rate), but the partnership form does exist overseas and should be accounted for. It also isn’t clear from the foundation’s numbers how much potential corporate tax has merely been shifted from the corporate to the individual tax regime and how much has been lost to transfer pricing abuse or other loopholes (in other words, how much corporate tax isn’t being collected that probably should be, versus how much is being collected from passthroughs instead).
The foundation does emphasize an important point: Congress must consider passthroughs when discussing business tax reform. You can’t complain about high U.S. corporate tax rates or declining corporate tax revenues without looking at how the shift to passthrough entities is affecting the U.S. tax system. Passthrough reform is just as critical as corporate reform, even if it doesn’t receive nearly as much attention in congressional speeches or front-page news stories.