Increase Competitiveness and Progressivity by Taxing Individuals Instead of Corporations

A recent proposal by two noted tax experts—“Shifting the Burden of Taxation from the Corporate to the Individual Level and Getting the Corporate Tax Rate Down to 15 Percent” by Harry Grubert of the Office of Tax Analysis in the Department of the Treasury and Rosanne Altshuler of Rutgers University—promises to lower the federal corporate tax rate to 15 percent. Much of the revenue loss would be made up by eliminating lower individual taxes on capital gains and dividends. The proposal solves many of the political problems plaguing corporate tax reform and deserves serious consideration.

There is wide agreement that the U.S. corporate tax laws need broad reform. Over the past decade or so, nations have become increasingly aggressive in competing for the business tax base generated by multinational companies and fast-growing start-ups. This competition includes lowering statutory tax rates, and providing incentives for investment through policies like innovation boxes and research credits. As a result, the U.S. tax rate of 35 percent is now the highest statutory rate among Organization for Economic Cooperation and Development countries, in many cases 20 percentage points higher than U.S. competitors. These rates strongly deter foreign companies from investing in America. They also encourage domestic companies to escape taxation by shifting income abroad or moving overseas.

But the problem is not just the statutory rate, it’s the effective rate, which is over 27 percent. As a result, even if even if Congress eliminated all corporate tax expenditures except the research and experimentation tax credit and used the money to pay for reducing the corporate rate, not only would the effective rate remain unchanged, but, according to Grubert and Altshuler, the statutory rate would still remain above 31 percent. Eliminating individual tax expenditures like the exclusion for employer paid insurance or the deduction for mortgage interest would raise much more money, but the political difficulty of changing these tax breaks makes it likely that reform will initially be limited to the corporate side.

Instead, Grubert and Altshuler propose increasing the country’s competiveness without increasing the federal debt or touching popular individual tax breaks. The proposal does not necessarily reflect the views of the Treasury.

Their proposal would reduce the statutory corporate rate to 15 percent. At this rate the United States would be highly competitive with the rest of the world. They would pay for it largely by taxing all dividends and capital gains as ordinary income. However, this might result in corporations accumulating excess profits so that shareholders could let their wealth build up without paying individual taxes as they accrue. In order to prevent this, Grubert and Altshuler would subject the tax earned on capital gains to interest. If a shareholder sold his stock after 10 years, any stock appreciation would be allocated to each of the 10 years assuming a constant rate of return and the tax for each year would be calculated. Investors would owe interest (approximately 5 percent) on whatever taxes had been deferred. Finally, the proposal also calls for a maximum dividend rate, perhaps based on an average of past profits, to prevent companies from avoiding interest by making a massive dividend just prior to an anticipated sale of stock. It would also tax all accumulated capital gains upon the death of a shareholder.

By confining individual tax increases to dividends and capital gains, the Grubert-Altshuler proposal leaves the main individual tax breaks intact for Congress to deal with if and when it reforms the individual side of the tax code.

The proposal deserves serious consideration. ITIF has already advocated transferring a greater share of the tax burden onto individuals because they are less responsive to marginal tax rates and because doing so would reduce the incentive to shift profits and investment overseas. The Grubert-Altshuler proposal does this in a nice way that would have several macroeconomic benefits.

First, by dramatically lowering the tax on domestic corporate earnings, the proposal would significantly reduce a company’s incentive to shift profits abroad or to invest overseas rather than in the United States. Even better, it would make the country more attractive as a destination for inward foreign investment. The authors recognize that other countries are actively competing for the U.S. tax base. Lowering the statutory tax to 15 percent would reduce economic distortions by lowering the deadweight burden of the current system and dramatically reducing the incentive to shift profits overseas. To further limit profit shifting, the paper proposes a 15 percent minimum tax on foreign earnings. The authors seem to favor imposing the minimum by country rather than in the aggregate.

The authors also argue that their proposal increases the progressivity of the tax system. Most of the higher taxes on dividends and capital gains will be paid by households at the very top of the income scale. Although other workers also own stock, most of this is in retirement accounts and pensions that are not subject to income tax. In contrast, because most corporate markets are competitive, many of the savings to companies from lower corporate taxes will flow back to consumers in the form of lower prices and to workers as higher wages. The increased U.S. competitiveness (both from an expansion of U.S. companies here at home and more foreign inward investment) will also benefit workers.

One problem with the proposal is that it would raise taxes on owners of pass-through entities without any compensating benefit. Opposition from owners of partnerships, Subchapter S corporations, and sole-proprietorships currently jeopardizes progress on corporate reform. ITIF has argued that these businesses would still enjoy a competitive advantage over corporations since they remain taxed only at the individual level whereas corporations are taxed twice (once on earnings and a second time on dividend payments or capital gains to shareholders). More importantly, few of these businesses face international competition from low-tax nations so we do not have to worry about them going abroad.

Corporate reform does not seem to be a priority for the Obama administration. Nevertheless, a bipartisan consensus is slowly forming in Congress that the corporate tax rate is too high, especially when it is applied to foreign earnings. The leaders of both tax committees seem dedicated to moving legislation forward in the next administration. Ideas such as the Grubert-Altshuler proposal are likely to make their job a lot easier.