Site Meter

Sunday, January 18, 2004

Random thoughts on the corporate income tax.

Why do we have a corporate income tax at all ? There is a debate as to whether it would be better to eliminate double taxation of dividends or to expense investment. The corporate income tax is the combination of double taxation of dividends and taxation of reinvested profits. If there is a debate as to which part of it is more aweful, why not just eliminate it ?

pro forma disclaimer
[I understand perfectly well that a huge tax proposal is a terrible idea here and now (meaning here on planet earth and so long as human nature is human nature). Also I know that there is a huge literature on the topic which I should read and haven't.]

I think that we have a corporate income tax because people think of corporations as very rich individuals. The argument that owners of small businesses are richer on average than shareholders of large corporations has never convinced ordinary people.

There is a theoretical public finance argument (Diamond and Mirrlees) that the corportate income tax rate should be 1-epsilon. The proof is mathematically correct, of course, but it assumes that corporations are profit maximizing machines. That is, it is assumed that executive compensation is like any other cost. To apply the result to the real world, it is necessary to decide what corporations really maximize.

I am going to imagine starting almost fresh. We want to take money from corporations. Is there a series of arguments that leads us to taxing profits plus wages and salaries of employees up to a ceiling as opposed to something else ? Notice I have snuck FICA in with the corporate income tax.

The corporation has a cash flow from sales. A tax on sales would be very silly because the merger of two corporations eliminates sales from one to the other and we don't want corporations to merge for tax reasons. The closest thing to a tax on all cash flow which makes any sense is a value added tax.

Replacing the corporate income tax with a value added tax would be a bad idea. The value added tax creates an incentive to reduce the scale of production. This is not at all what we want. In particular people want jobs. We like it when corporations hire someone and payi him his marginal product. This has 0 effect on profits and increases value added. It should not be punished by the tax system. Some of us value equality and think that executives are way overpaid. OK so how about a tax on value added and a subsidy on employment ? That is tax value added and give back $Wbar per employee where wbar is total aggregate wage and salary income divided by the number of employees. This means an incentive to hire someone and pay him less than the average wage and a disincentive to pay more. OK OK I got greedy and asked for a huge progressive shift.

Of course this is still no good. It no longer penalizes employment but it penalizes investment (as does the corporate income tax). I think a good modification is to subsidize investment in mechanical equipment not including transportation equipment. This is an existing NIPA category so it is currently measured. Certainly once tax treatment of mechanical equipment, transportation equipment and structures are totally different, there will be creative redefinition.

Hve I gotten back to the corporate income tax ? Well no, there is symmetric treatment of debt and equity. There is no deduction (for tax purposes) of the cost of stock options. The indirect tax on employment has become wildly progressive instead of being regressive as is the current payroll tax.

Let's see two changes.
a) the corporation raises genius execs salary from 1 million to 2 million. With the current system, other things equal (including genius' work effort) this reduces tax liabilities. Whith the proposal it has no effect. Do we want to take less money from corporations because they raised someone's salary from huge to immense ?
b) The corporation is a monopoly and it has chosen the price to maximize profits. Thus it maximizes after tax profits. If it cuts production increases and sales and costs increase equally. This has 0 effect on profits and corporate income tax liabilities. It increases the payroll and thus increases payroll tax liabilities. Thus it is punished. Under the plan there should be no effect on tax liabilities. Do we want to punish monopolies for cutting prices ?

No comments: