Taxing Corporations

Lately I see arguments everywhere about corporate taxes; arguments that go on and on with nothing close to a resolution. So I thought I’d see if I could make things a little clearer.

One argument that my fellow libertarian-conservatives like to make is, “Corporations don’t pay taxes–people do.” The truth of this is not clear to many people, however, and I don’t blame them for their skepticism. After all, it’s pretty obvious that many types of businesses find it advantageous to organize as C-corporations rather than S-corporations or limited partnerships or sole proprietorships. Basically, standard corporate structure–which allows widespread ownership of equity shares–is a really good way to finance big firms. And to say that incorporation is “really good” is the same thing as saying “more profitable” than the alternative form of ownership. And as long as it’s better than the alternative even after taxes, then it ought to be taxable. Seems pretty reasonable, no?

Well, we’ve got to trace out the sequence of responses that a corporate tax triggers.

To the extent that corporations’ profits are lower because of the tax on them, their dividend payouts fall. This means that individual investors shift away from common stocks toward other types of assets:  in particular, corporate and government bonds. This drives down the yields on those assets, which means that part of the effect of the corporate tax is to reduce the rates of return on all types of assets. This movement of investors away from corporate ownership continues until the after-tax returns on all types of investments return to the relative levels that prevailed before the corporate tax was imposed. In short:  all types of savings are affected equally by corporate taxation.

So now we’re left to ask if this is a sensible way to tax saving. The answer is…not really. The reason is this: Since corporations and non-corporations tend to dominate in very different types of businesses, a tax that reduces the size of the corporate sector shifts workers as well as capital out of the activities that corporations specialize in. While those displaced workers eventually find work in the noncorporate sector, they may find that their wages are lower than before under this condition: they (and the workers in the corporate sector) wind up working with less capital.

The long-run impact of a corporate income tax on workers depends largely on the long-run response of savers and investors to the lower return to saving and investing. The more they reduce their saving, the worse things will be for workers. In the extreme case, when capital simply goes abroad, workers end up bearing the full burden of the corporate income tax. In cases like that, this tax is a disaster, because people won’t understand that wages are lower than they’d be without this tax.

The biggest problem with the corporate income tax is that it’s so very difficult to trace out all its effects. One of its clear effects is especially annoying to me: the proliferation of “luxury boxes” at sports stadiums. Those things are a way to offer tax-deductible compensation to executives, and therefore would be gone in a heartbeat if there were no corporate tax–thereby freeing up lots of space for seating for us ordinary folks.

If you want to tax saving and investment, then just go ahead and tax it by taxing personal income. Tax dividends and interest and capital gains at the same rate. That rate needn’t be the same as the tax rate on labor, but it probably shouldn’t be higher and it’s probably better all around if it’s lower. The more readily investment in the US will decline in response to taxes on the income it generates, the lower the tax on it should be. But don’t impose a surcharge on one type of investment income–from corporations–because that will distort the pattern of production throughout the economy, with subtle effects that are hard to figure out.

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