Tax Analysts Blog

Splashing Cold Water in the Face of Corporate Tax Reform

Posted on Sep 22, 2017

I recently pondered whether the widely anticipated federal tax reform effort would include a corporate integration proposal from the Senate Finance Committee. That post presented the rationale for eliminating – or at least minimizing – the double taxation of corporate profits. It also outlined how a hypothetical partial dividends paid deduction might be structured. That framework would allow corporations to significantly reduce their effective tax rate to the extent they pay out dividends. Presumably that’s a better economic incentive than, say, indulging in related-party debt – which is how multinationals currently drive down their taxes.

But hold on.

The foundational bedrock of any corporate integration plan is that double taxation is an actual thing. That is, the U.S. tax system hits business profits at both the entity and shareholder levels, and in so doing creates various market distortions. That notion must be correct, right? After all, it’s been part of the economic orthodoxy for more than 100 years. We’re talking Tax Policy 101, or so you’d think.

Enter a recent economic study from Len Burman, Kimberly Clausing, and Lydia Austin, which prods us to reconsider our basic understanding of double taxation. (Burman is Institute Fellow at the Urban Institute, Clausing is the Thormund A. Miller and Walter Mintz Professor of Economics at Reed College, and Austin is a research assistant at the Urban-Brookings Tax Policy Center.) You can read their paper here.

The new report asks a simple question: Is U.S. corporate income actually double-taxed? The authors build upon the conclusions of a similar report released in 2016 from Steven Rosenthal and Austin. That paper found that the taxable share of U.S. corporate stock had fallen from 80 percent in 1965 to a mere 24 percent in 2015. The explanation for the sharp decline lies in the proportion of shares held by tax-exempt retirement accounts or by foreigners, who generally escape U.S. tax on dividends.

Rosenthal and Austin relied on data from the Federal Reserve flow of funds estimates. The Burman-Clausing-Austin study validated the earlier findings while relying on alternative data; they also tried to address concerns about the earlier paper’s computational method. They concluded that 32 percent of U.S. corporate stock is held by taxable entities. Admittedly, that’s higher than the earlier findings, but the overall message is the same. Boatloads of shareholders are outside the reach of the U.S. tax net –a major obstacle for integration.

One way to reach exempt shareholders is through a withholding tax on dividends, but that solution raises its own set of problems. In the case of retirement accounts, any attempt at withholding would immediately be labeled a tax on people’s ability to put away money for old age. That’s not the kind of thing likely to win over hearts and minds. And in the case of foreign shareholders, you’d have a treaty problem. A main purpose of the U.S. tax treaty network is to reduce statutory withholding on cross-border income streams, including dividends. A withholding tax on dividends paid to foreign shareholders would be an obvious treaty override. It could trigger retaliatory responses from foreign governments aimed at U.S. shareholders with overseas investments, which would wreak havoc on the financial sector.

This is a conundrum for advocates of corporate integration. As Columbia Law School professor Michael Graetz recently said during his congressional testimony on tax reform, “If you withhold on foreign shareholders, you have a treaty problem; if you don’t withhold on foreign shareholders, you’re giving them a tax cut relative to other shareholders.” Nobody said tax reform was easy.

The implications are bad for a dividends paid deduction proposal, even a partial one. The gist is that Congress should think twice about shifting the tax burden on business profits away from the entity level and onto the backs of shareholders. Yet that kind of shift is exactly what a dividends paid deduction proposal would do.

 

 

Read Comments (7)

Mike55Sep 26, 2017

This was a good pair of articles on an interesting (and perhaps highly relevant, guess we'll find out tomorrow!) topic.

I find the question of whether corporate profits are "double" taxed irrelevant. The point is that corporate profits are subject to an extra layer of tax relative to all other types of business income. You can say corporate profits are taxed once and other types of business income never, or instead that corporate profits are taxed twice and other types of business income once. To me this is just semantics.* The point is that corporate profits are subject to an extra layer of tax, and that extra layer of tax incentivizes actions that would not otherwise occur.

Personally I find it hard to feel strongly about integration either way, because it's difficult to intuitively know the costs/benefits. The real world consequence of integration would be to reduce the amount stock buy-backs and debt funded distributions that occur. Whether or not that's a good thing, and if so how good, is beyond my knowledge.

*If we wanted to be precise, I suppose we'd say corporate dividends are immediately taxable 32% of the time, and either deferred (U.S. retirement accounts) or subject to a reduced rate (foreign equity) 68% of the time.

Edmund DantesSep 26, 2017

Hold on there, Bucko. Retirement accounts are fully taxable, the tax is merely deferred. At some point all the dividends in my IRA will be hit by the income tax--hopefully decades in the future, but they will be taxed. It is very wrong to lump those funds in with those of the tax exempt entities. The dividends collected by the Harvard endowment truly do escape the tax net. Why anyone thinks that this is fair or just is a mystery to me, but that's a separate topic.

An analysis of who pays the corporate tax needs to separate out the tax-deferred retirement accounts from the tax-free endowments and charities. I'm going to assert without much proof that at least 60% of corporate dividends do face an income tax eventually, so there really is significant double taxation. Unless you are wealthy enough to worry about estate taxes, in which case it is triple taxation. My assertion is based upon the fact that retirement accounts hold some $25 trillion, the lion's share in equities, according to the Investment Company Institute. I'm guessing that is roughly equal to amount held in taxable accounts. I'd be happy to see better evidence.

Travis RechSep 28, 2017

"At some point all the dividends in my IRA will be hit by the income tax--hopefully decades in the future, but they will be taxed."

Whats the old adage? 'A tax deferred for 20 years is a tax avoided'? Something like that some fancy economist once said.

Jose LopezSep 29, 2017

Not only do dividends avoid taxation, but they accumulate interest. Although the benefits depend on what kind of IRA you have, the deferral of taxation is a huge windfall for savers. Not to mention corporations hardly pay the statutory rate. Any corporate integration should be limited to corporations which pay their fair share of taxes to the US government. And since about 25-35% of dividends go untaxed, with qualified dividends also obtaining a preferential rate, double taxation concerns are mininal. There are also instances of not even single taxation, from stateless income. And it’s hard to see an issue of triple taxation through estate taxes, as the massive exemption of the tax impacts only a few of the wealthiest families.

Elliott J DubinSep 29, 2017

Edmund:

You are correct-- the dividends are allowed to accumulate free of tax. However, there is no interest paid to the IRS or state tax agencies on the deferred taxation.

Mike55Oct 2, 2017

In the context of this discussion, I don't think it really matters what one thinks of how we tax retirement accounts, pensions, foreign investors, university endowments, etc. Those are all special regimes that supersede the normal operation of the tax law. Each has its pros/cons to be debated, but their existence in no way undermines (or supports) the argument for integration.

Imagine your retirement account makes two investments, "A" and "B." Investment A is in a massive natural gas deposit investment fund (generally such funds would are organized as a flow-through, which in turn purchases interests in MLPs). Investment B is made in shares of an equally massive utility that provides natural gas directly to consumers (generally such consumer-facing utilities are organized as public C-Corps). Investment A is taxed once, following a long period of deferral. Investment B is taxed immediately, then the remainder is taxed again following a long period of deferral.

Integration proposals are built on the premise that A and B should be taxed the same. I get that many folks think both A and B are taxed too lightly under current law. But that's NOT what integration is about. It's instead about closing down the tax disparity between A and B, so the scarce resources that your retirement account represents are allocated efficiently between the two. And if you're a progressive type just who wants to soak the rich no need to worry: you can do so just as easily with integration as you can under the existing regime (you'd want the new withholding tax that goes with integration to be high, and only provide a credit to low/middle income folks).

I personally don't have strong feeling regarding whether A and B should be taxed the same. The point though is that we should judge integration based on its own merits, which have nothing at all to do with whether we tax investment heavily enough under current law.

Paula N. SingerSep 28, 2017

Tax reformers shouldn't lose sight of the fact that corporate integration would encourage doing business in corporate form rather than using pass-through entities - S Corps, partnerships and LLCs. This would result in a reduction in the complexity and number of tax return filings and huge total cost savings for business taxpayers, business owners and tax administrations at all levels - federal, state and local.

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