Why End Corporate Taxes

I recently posted that I had come to the conclusion that we should do away entirely with the Corporate income tax and only tax corporate earnings at the stockholder level.

Today, I am explaining some of the reasons why I have have taken that position.

We want company managers to succeed – to create efficient companies that innovate, develop products that make life easier/better, and thereby improve society and our standard of living.  We largely depend on the free market to guide companies in accomplishing these goals – going back to Adam Smith’s “invisible hand” to push companies to allocate their resources to the highest and best use.  This is pretty basic economic theory, and underlies the capitalist system.

However, every aspect of the Corporate Tax Code creates incentives for company managers.  Many of them are intentional – for example, the tax code has a litany of incentives to encourage domestic oil production.  Similarly, we have tax incentives for fuel-efficient vehicles, for easing access for the disabled, to encourage higher education, etc.  Presumably, every one of these tax incentives made sense to the Congress that passed them and the President that signed them into law.  Every one of them, however, distorts the workings of the market to allocate resources efficiently.

The very fact that the expenses of a business are deductible distorts the decisions of the company’s management – if a company pays taxes at the 35% corporate rate for federal income taxes and 10% for state income taxes, it will only end up reducing its net income by 55 cents for every dollar of expense that it incurs.  The state and federal governments will incur the other 45 cents through reduction of the tax bill.  That can lead the company to over-spend and be less efficient than it needs to be.  And the more profitable the company, the more it focuses on reducing taxes rather than creating new efficiencies.

I see this every day in my venture capital practice.  When a company is a brand-new start up, it is almost always unprofitable.  It is not paying taxes anyway, so it has no incentive to reduce its tax bill.  These companies are the most efficient engines I have ever seen.  They get every bit of value out of every penny.  My grandmother would say that they squeeze a penny it so hard that Abe Lincoln’s eyes water.

After companies are profitable and have burned through their net operating losses, they begin to pay taxes.  Invariably, they calculate tax savings into all of their strategic planning (as they should in the current system).  And that calculation leads them to spend more than they would without taking tax savings into account – marginal projects that would have been rejected become marginal projects that are accepted.

If, on the other hand, the tax system were changed so that corporations paid no tax, with the lost revenues for government offset by stockholders paying a higher tax on dividends and capital gains, companies would invest in projects that produced the most profit, without the distortions created by the tax code.  The companies would generate higher profits, resulting in either higher dividend pay-outs or increasing stock prices.  Since stockholders would reap the benefits of both higher dividends and increasing stock prices, stockholders would end up better off even at higher tax rates.

Finally, such a system would be much simpler to administer for the government and be much less burdensome for companies and individuals.  Just the efficiencies gained through administration would save huge sums of wasted resources throughout society – with those resources allocated to productive work rather than tax compliance.

Better for government, better for companies, better for stockholders, better for citizens.

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2 responses to “Why End Corporate Taxes”

  1. Anonymous says :

    When I responded last week to the author’s post, I assumed that he opted for a system that taxed shareholders currently on corporate earnings. Now, I however realize the author is advocating not for flowthrough taxes like a partnership, but rather that corporations are never taxed and shareholders are only taxed upon distribution. Although this may be administratively simpler, it will lead to even more tax avoidance and less dividends for shareholders. Under such a system, boards now will have an incentive to hold onto the company’s cash indefinitely. Further, shareholders would prefer this activity in many situations as well because they would be able to defer the payment of tax on the earnings of the company indefinitely.

    Effectively, creating such a system would be EXACTLY like the issue that arises in the international context with locked-out capital. In the previous article, the author explained how multinational enterprises are able to structure there international operations in such a way as to pay zero taxes on the foreign earnings. And because there has been no income taxes paid on these earnings, there are no foreign tax credits to offset the earnings. Because there is a tax of 35% on the distribution of those earnings back to the United States (repatriation), the company has an incentive to keep the money in the foreign subsidiaries rather than pay the full bill of repatriation. What has resulted is that capital earned in foreign markets by US based multinationals like Apple, Google, Cisco and the like is that they have hoards of cash stuck overseas being put to inefficient uses. This problem has been referred to as capital lock-out. See Kleinbard, Stateless Income, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1791769.

    By changing the tax system to never tax at the corporate level and only shareholders upon distribution will lead to a similar capital lock-out distortion. The corporation would be analogous to the foreign subsidiary in the international problem. Both do not pay any taxes on income earned for one reason or another and are able to control when it will make distributions to its shareholders (parent). And the shareholder would be analogous to the domestic parent in the international problem. Both are only taxed whenever the distribution is made to them at a high rate of tax. The shareholder/parent does not want to have to pay this tax when the money is finally distributed. They would rather have the corporation/foreign sub keep the cash and avoid paying tax indefinitely.

    The result would be inefficient use of capital, lower tax revenues for tax authorities, and less distributions to shareholders.

    • Graham Burnette says :

      I commend you for your well-reasoned reply to my post. Thank you for the thoughtful comments. If not for empirical evidence, I might well be swayed to your position. However, I think we have recent evidence to the contrary.

      Over the past five years, many tech companies have amassed huge amounts of cash reserves. The company that had built the largest amount is Apple. As the pile of cash grew larger and larger, voices calling for return of at least a portion of that cash to stockholders became louder and louder – and Greenlight Capital’s David Einhorn even filed a lawsuit to try to unlock a portion of the value. While those calls grew louder and stronger, the Apple stock price was dropping from a high of over $700 per share to less than $400 per share. Then, on April 23, 2013, Apple announced that it was more than doubling its capital return program – and the stock steadily rose from under to $400 per share to near $450 per share.

      I do not believe that Apple’s decision was influenced in any way by the fact that stockholders receiving the dividends would pay taxes on them, or any stockholders selling into the stock buy-back program would pay taxes on the gains they received from selling the stock. But state and federal tax authorities certainly will be collecting more taxes after Apple’s doubling of the capital return program than they were receiving before that doubling.

      This is evidence to me that the market works to push corporate management toward efficient capital allocation. Apple seemingly had no plans to use a huge amount of cash to advance its business, and the stock market collectively punished the company – depressing its stock to a P/E far below the average in the S&P 500. The company reacted, and the stock market collectively rewarded the company. I believe that we can expect such market forces to lead corporate management to distribute profits to stockholders so that stockholders can invest it where they will – and so that the profits can be taxed at the stockholder level.

      Further, I expect general stock prices to rise without a corporate income tax, and that will result in many stockholders selling stock at a significant gain to capture and use those gains – agin resulting in taxation at the stockholder level.

      So, I believe that the empirical evidence shows us that my proposal would result in more efficient use of capital, more distributions to stockholders, and more revenues to tax authorities.

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