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Abolish the Corporate Income Tax

J: President Trump has proposed reducing the top corporate income tax rate from the current 35 percent to 15 percent. He would also eliminate the current deduction for interest paid.

In order to avoid being unfair to owners of small businesses (LLCs, subchapter S, partnerships and sole proprietorships) that pass through their business income to their personal taxes, he would use the same 15 percent rate. While there is no chance that Congress will do that, it does suggest a dramatic tax reform that could be both revenue-neutral and strongly boost growth.

During my graduate school days, we had to pick two major fields of economics for our studies in addition to the two full years of economic theory courses that were required. My choices were econometrics (a fairly new field then) and public finance.

The acknowledged top public finance authority at the time was Professor Richard Musgrave at the University of Michigan. One of his top students was a Polish immigrant named Marian Krzyzaniak, who wrote a book called The Shifting of the Corporation Income Tax, which amazingly enough went through 18 editions.

This book fascinated me as it combined both of my chosen fields. My analysis of the book led to my first professional presentation, which was being a discussant for Professor Krzyzaniak’s presentation of his work at the Southern Economic Association meeting in Atlanta. Since then, there have been hundreds of studies of the shifting and incidence of the corporate income tax. One done for the US Treasury by Professor William Gentry of Williams College is a good summary. [L: But he digresses…. J]

All the studies come to essentially the same conclusion as Professor Krzyzaniak and my independent testing of his original work. This is not really surprising because when you tax a corporation, one of three things can happen:

  1. The return on capital is reduced because dividends go down or capital gains are less.

  2. Employees are paid less.

  3. Prices go up to offset the tax burden.

The first one is unlikely because there is pressure on all leaders of publicly traded companies to keep earnings and dividends as high as possible. The second one is unlikely because corporations feel pressure to keep wages high enough to attract or keep productive employees. That leaves raising prices. Adding insult to injury, a negative side effect of this is that corporations tend to raise prices more than necessary to offset the tax burden.

This is what Professor Krzyzaniak proved. It also makes sense. There are considerable influences on incidence from international trade, but they tend to impact wages (reducing them) more than prices. [L: I’m pretty sure the word “incidence” is a jargon word here and I don’t even want to get into translating it today. If you understand this paragraph, good for you!]

Many countries have lowered their corporate income tax rates over the last 35 years. All developed countries except Japan now have lower rates that the US.

We could avoid all these distortions caused by the corporate income tax by abolishing it and integrating corporate earnings with personal income. Then the owners of companies would be taxed on retained earnings at whatever their personal income tax rates are, just as the owners of noncorporate businesses are now.

L: This means that all owners of any business that is considered a corporation under US law will pay personal income taxes on the earnings (profits) their business makes, proportional to their level of ownership. So, an example: Ms K owns 10 percent of ABC Company. The company makes $50,000 in profit in 2017. Ms K will report $5,000 as income on her personal income tax filing. Easy peasy.

J: The May 29 article in The Wall Street Journal says that each one percentage point in the corporate income tax rate would cut federal tax revenues by $100 billion over a decade. Thus, eliminating the tax would cost $3.5 trillion over a decade or $350 billion a year.

Corporate income taxes brought in $299.6 billion in FY 2016. That was a big drop from $343.8 billion in FY 2015 and the record $370.2 billion in FY 2007.

Personal income tax revenues were a record $1,546.1 billion in FY 2016. It is likely that all corporate profits on a pass-through-basis would raise more money (or at least as much given that equity ownership is concentrated in the top half of the income distribution.

The economy would also reap enormous benefits from corporations having no need to work to minimize their tax burdens. There would be some employment shifts from this, but they should not be very large when looking at the entire US employment levels.

L: Besides, who is going to feel sorry about corporate tax attorneys and accountants losing their jobs? (OK, that’s not nice but you know you were thinking it!)

J: Of course, this proposal is too simple and straightforward to ever get through Congress. You can easily imagine, though, how wonderful it would be if the US took this giant leap for economic efficiency and tax simplification.

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