A simple change in what is taxed would raise more money
The Inflation Reduction Act includes a remarkable innovation. Redemptions of shares will be taxed at the rate of 1%. It’s a huge deal, not only because it taxes money that often went untaxed at the individual level, but it’s a distance from basing corporate tax on profits, which can be easily manipulated, to tax returns to shareholders.
It is time for a major and simple overhaul of the corporate tax system. The main problem with the current system is that it focuses on the wrong target. Instead of taxing corporate profits, we should be taxing stock returns for investors.
To the extent that corporations spend large sums of money to avoid paying taxes, the purpose of corporation tax is compromised.
The big problem here is that corporate profits are not a well-defined concept. A thousand problems arise in determining profit, all of which depend to a large extent on the judgment of accountants. Capital depreciation is the most obvious problem, but there are many others.
What is visible, what is not
While profits are something we cannot see, returns to shareholders can be easily seen. It is simply the increase in market capitalization plus the money paid out in dividends. This information is readily available on dozens of financial websites.
Before explaining how this alternative would work, it’s worth going through a bit of recent history.
Democrats in Congress have been unanimous in opposing the Tax Cuts and Jobs Act (TCJA) that Republicans pushed through Congress in 2017. However, there is one aspect of this tax cut law. taxes that almost all Democratic economists would support: lowering the corporate tax rate in exchange for limiting tax deductions.
Prior to the 2017 tax cut, the corporate tax rate was 35%. However, few companies have paid anything close to this rate. Actual tax revenue generally represented around 20-22% of corporate profits.
While the nominal tax rate of 35% placed the United States at the top of the OECD countries, our effective tax rate was slightly below the median.
Trump’s failed tax promise
It makes no sense to have a high tax rate that is easily avoided or evaded. It just encourages companies to spend large sums of money to game the system. This game is a complete waste from an economic point of view. We have many highly skilled people who spend their time finding ways to play tax tricks rather than doing something that is economically productive. This is why almost all economists would prefer to have a lower tax rate actually collected.
Unfortunately, the TCJA that Trump signed into law did not deliver on that promise. Although he cut the nominal tax rate sharply, from 35% to 21%, companies still manage to avoid paying taxes. In 2019, the overall effective tax rate was only 13.3%, which is not even close to the posted rate.
While the Trump administration probably has little interest in reducing tax evasion and evasion, taxing stock returns gives us a surefire way to accomplish that reform. We simply apply the tax rate we are targeting to the returns shareholders receive in a given year.
Tax shelter industry
Nor is there anything companies can do to hide their stock returns unless they want to rip off their shareholders on top of ripping off the government. If we want to have a 25% corporate income tax, for example, we can simply tax shareholder returns at a rate of 25%, and we know exactly what we will get. (We could allow averaging, say over five-year periods, to smooth out tax payments.)
In addition to making corporate income tax more collectible, shifting the tax base from reported profits to shareholder income will drastically reduce the size of the tax shelter industry. Today, businesses spend tens of billions of dollars every year to hire lawyers and accountants to reduce their tax burden.
These tax avoidance expenses are a total waste of resources and undermine the purpose of the corporate income tax. As the modern monetary theory team reminds us, the purpose of taxes at the national level is to reduce demand in the economy. To the extent that corporations spend large sums of money to avoid paying taxes, the purpose of corporation tax is compromised.
The tax avoidance industry is also a major source of inequality. Creative tax lawyers and accountants can earn huge salaries by developing innovative tax dodges. We can put many of these people out of business by basing corporate income tax on stock market returns, which are completely transparent.
Conjuration of numbers
The imposition of stock buybacks in the Inflation Reduction Act is a small but important step in this direction.
This shows that we don’t have to use profits as the basis for corporation tax. Once it has been in place for a few years, and we have a chance to see how effective it is in generating revenue, we may be able to shift the base of the rest of the income tax from companies to the stock market returns that we can all see, rather than the income statements that accountants talk about.