The genius of our ruling class is that it has kept a majority of the people from ever questioning the inequity of a system where most people drudge along, paying heavy taxes for which they get nothing in return.[337]
Gore Vidal
The unified theory of macroeconomic failure identifies several taxes as causing negative externalities that interfere with economic efficiency, misallocate resources, promote inequality, increase instability, and hinder economic growth. Moreover, the large share of taxes in GDP amplifies their negative externalities. The efficiency of corporate taxation is particularly critical because it directly affects the largest productive sector in the economy.[338] No country can realize its full economic potential if its corporate taxes frustrate economic efficiency. Hence, the corporate sector deserves special attention. To the extent that similar negative externalities plague the corporate tax code of rest of the world, then reducing such externalities in any country holds the promise of improving its economic efficiency and growth prospects relative to the rest of the world for as long as other countries do not adopt similar reforms.
Tax Bias, Indebtedness, and Other Inefficiencies
The unified theory of macroeconomic failure identified debt and amplified cyclicality as two daunting negative externalities facing Western economies. Both externalities are attributable to a flawed tax system, which provides tax incentives for pervasive indebtedness and, consequently, amplified cyclicality. Resolving those negative externalities requires understanding their cause.
The principle of tax neutrality is important for maintaining economic efficiency. In general, taxes should not distort economic behavior by influencing, for example, the choice of financing, unless there is a compelling economic reason to do so. Unfortunately, several taxes violate this principle by providing incentives for using debt instead of equity financing and investing, such as:
1. Corporate income tax
2. Personal income tax
3. Tax-exempt municipal bonds
4. Dividend withholding tax
Economists have rarely voiced concern about the lack of tax neutrality with respect to interest. For example, the prominent economic scholar Friedrich von Hayek was an avid supporter of Pareto optimality and a keen student of economic cycles, yet he did not criticize the debt bias of the tax system or its role in economic instability.[339] His silence on the subject is puzzling given that he spent a lifetime advocating economic efficiency and studying economic cycles. If political ideology was not the reason behind his silence but rather that he simply did not detect the negative consequences of this tax bias, then this leaves us to speculate what his position might have been had he been aware of the problem.
The degree of interest bias in corporate income tax is directly proportional to the corporate income tax rate; the higher the tax rate, the greater the tax advantage of debt financing. Around the turn of the 20th century, the top corporate income tax rate in many industrialized countries was no more than 15 percent. However, the enormous costs of two world wars compelled many Western countries to increase their corporate income tax rate to more than 50 percent, making the after-tax cost of equity financing punitive, while the tax deductibility of interest provided a phenomenal tax advantage for debt financing. As a result, to recover their previously higher after-tax rates of return on equity, many corporations resorted to increasing their use of debt.
Indebted corporations must meet all the terms and conditions of their indenture at all times; these terms, besides demanding timely interest and principal payments, often entail the maintenance of liquidity and solvency ratios, cross-default clauses, negative pledges, and other conditions.[340] Violation of these terms can trigger an event of default and, hence, represent incremental risks to corporations, especially during recessions. Moreover, violations give lenders an opportunity to renegotiate debt terms to gain greater advantage, another tacit cost of debt.
The effect of interest tax deductibility is uneven across sectors, with its strongest negative impact falling on sectors with a natural tendency for wide cyclical fluctuations, particularly capital-intensive sectors with a high operating leverage. Several strategic sectors fall in this category, including the automotive, airline, and steel industries. Even without borrowing, the presence of debt in the economy magnifies cyclical fluctuations for these industries, increasing their business risk. Superimposed on this debt environment are inept monetary policies that exaggerate cyclicality and the chronic overvaluation of the dollar. Hence, many such companies go under during business downturns. For example, the steel industry practically became extinct in Cleveland, Ohio, after one such recession; foreign industrialists bought the idle plants for a song, dismantled them, and shipped them overseas, thereby providing fiercer competition to the unfortunate residual US steel producers.
Tax neutrality requires comparable treatment of interest and dividends. Thus, the German federal government permits dividends deduction from corporate income tax and refunds to shareholders the corporate income tax corresponding to the cash dividends they receive. Still, even complete tax neutrality between equity and debt is not economically efficient because debt is a negative externality.
Keynes argued that uncertainty increases economic instability and raises the normal rate of unemployment.[341] This rationale also implies that greater uncertainty curtails the capacity of corporations for business risk-taking, slows economic growth, and raises the rate of “normal” unemployment.
More generally, we would expect high indebtedness to be associated with the following:
1. Greater uncertainty
2. Higher interest rates
3. Currency overvaluation
4. Mounting trade and budget deficits
5. Industrial erosion
6. Falling industrial investment
7. Higher unemployment
8. Slower economic growth
In the case of the US economy, all of the above consequences have materialized over the past three-and-a-half decades, save one: high interest rates. Chapter 10 pointed to the role of the Federal Reserve in subverting a market-determined interest rate, which explains the present low interest rate environment despite heavy indebtedness. This makes the chronic dollar overvaluation, despite low interest rates and huge trade deficits, an economic anomaly that deserves further exposition.
The standard supply-and-demand framework cannot explain the inconsistency of a persistent overvalued dollar despite large trade deficits and low interest rates because this glitch is rooted in game theory. The problem of dollar overvaluation is, primarily, self-inflicted. Following the 1973 oil crisis, the United States insisted that the Organization of Oil Exporting Countries (OPEC price its oil exports in dollars, artificially boosting the demand for the dollar and contributing to its overvaluation. The United States also persuaded several oil-exporting countries to invest their large trade surpluses in dollar-denominated assets, adding to the chronic dollar overvaluation. Furthermore, the United States has sought to maintain the dollar as the primary international trading and reserve currency, which, with the phenomenal growth of international trade, has steadily increased the demand for the dollar and sustained its overvaluation.
Finally, the principal exporters of industrial products to the United States, like China, Japan, and South Korea, have supported the dollar overvaluation by investing a substantial part of their trade surpluses in dollar-denominated debt despite the meager interest rates. From these countries’ perspective, accepting a low interest rate is rational because an overvalued dollar preserves their trading advantage. This is not unlike the strategy employed by a company that cuts its prices and accepts a lower profit in the short term to drive some of its competitors out of business, thereby increasing its long-term market share and ultimate profit potential.
These factors have reduced the interest elasticity of the dollar exchange rate, which explains the inconsistency of dollar overvaluation with low interest rates and large trade deficits. The overvaluation, in turn, has contributed to perpetuating the huge US trade deficits, reducing US international competitiveness, and eroding the US industrial base. The dollar overvaluation also explains the lack of inflation in the United States despite an explosive growth in the monetary base.[342]
Since the dollar exchange rate is no longer sensitive to the rate of interest, correcting the chronic dollar overvaluation and the associated US trade deficit requires a gradual reversal of the aforementioned policies that caused the overvaluation in the first place, such as the insistence on pricing oil and investing the oil surpluses in dollars.
In addition, improving economic efficiency requires reversing the present corporate tax discrimination in favor of debt by making dividends tax deductible, instead of interest. This would lower the after-tax cost of equity while raising that of debt, thereby encouraging equity and discouraging debt financing. Consequently, corporate financial risk would fall, resulting in a fall in corporate bankruptcies and job losses, shallower recessions, greater capacity for business risk-taking, faster economic growth, and potentially saving the government tens of billions of dollars during recessions. Still, while these measures are steps in the right direction, they are not sufficient for reversing the US economic decline. What is required is a whole battery of additional measures to improve US economic efficiency, with a redesigned corporate tax as a cornerstone, thereby permitting the United States to steal a march on its international competitors.
Employers’ Social Security Tax Contribution
An employer and an employee must each pay social security tax at 7.65 percent of an employee’s income, bringing the total to 15.3 percent, while the self-employed must pay the full 15.3 percent, a stiff penalty for self-employment. The 7.65 percent tax rate is the total of two separate taxes, 6.2 percent required by the Federal Insurance Contribution Act (FICA) and a payroll tax at 1.45 percent. The latter has no salary ceiling. FICA, on the other hand, only applies to the social security wage base, which in 2014 was set at $117,000, exempting salaries in excess. The social security tax also has a mélange of exemptions regarding minor sources of income.[343]
The benefits that the social security tax provides are essential but inadequate. However, it is a very regressive tax because it exempts incomes exceeding a ceiling under FICA instead of exempting meager incomes. Moreover, some analysts warn that the social security system is underfunded because as the longevity increases, the number of beneficiaries will increase and the outgoings will exceed the revenue.
The most serious criticism of the social security tax is that by taxing labor it discriminates against labor and employment, falling most heavily on labor-intensive industries and lightly on capital-intensive ones. It also results in major misallocation of resources because it favors the substitution of labor with capital. This was probably a minor concern when the original legislation was passed in the 1930s. In recent decades, however, robotics and artificial intelligence have been displacing labor in car manufacturing, bank ATMs, and barcode-readers at retail checkouts, to name a few, and the testing of driverless trucks is underway. This systematic displacement of labor by capital is likely to increase dramatically over time.
Given rising chronic unemployment and falling real wages, the social security tax discrimination against labor is an acute negative externality: imposing a social security tax on labor while depreciation of capital investment shelters capital from taxation, only accelerates and accentuates these problems. The process of increasing automation is unstoppable, but a slower transition would give the economy and labor more time to adjust through improved education and learning new skills to compete better in the face of this onslaught of new technology. From the perspective of business too, robots do not represent customers, hence, an orderly transition is in everybody’s interest. Indeed, there is a case for taxing automation to increase employment during this transition phase because unemployment is a negative externality.
It is economically more efficient in terms of resource allocation to stop discriminating against labor by incorporating employers’ share of the social security tax within a general tax on the corporate sector that does not specifically target labor. The section “Computation of a Corporate Capital Tax Rate” to follow explores such tax integration. A capital tax would also decrease the cost of compliance because employers would only need to inform the Treasury about their employees and their salaries once a year.
Erosion of the Corporate Income Tax Base
The corporate income tax base is suffering rapid erosion as more corporations discover that engaging in global trade provides a legal means of tax avoidance, at a time when there are record budget deficits on both sides of the Atlantic. Lower effective corporate income tax rates have been achievable by simply shifting corporate profits from a high to a low tax jurisdiction, and there is no shortage of tax havens worldwide.
Let us illustrate how this works using two examples. Assume an American company manufactures electronic products in Southeast Asia for export to North America and Europe. It acts as a manufacturer, intermediary, and seller in different tax jurisdictions. To minimize its global corporate income tax liability, it needs to lower its reported profit where the tax is high and increase it where the tax is lowest. This requires minimizing its profit in the manufacturing domicile by minimizing its inter-company export price to a tax haven. It then jacks up its re-export price from the tax haven to the final destinations, thereby minimizing its reported profits in the high-tax jurisdictions. Thus, US corporations have been reportedly accumulating hundreds of billions of profits in tax havens, which will remain untaxed until repatriated to the United States, if ever.
The second example is that of a US company that exports coffee beans from a tax haven to its large chain of cafes in the UK. The UK tax authorities complained to the company that its corporate income tax liability was too low. The coffee exporter responded promptly by reducing its export price to the British market, thereby increasing its profits and taxable income there. This illustrates how some corporations are in effect setting their own tax rates.
The same rationale applies to foreign corporations that have US manufacturing plants because they can inflate the prices of their imported parts and components, thereby reducing their US corporate income tax liability.
Domestic corporations with overseas subsidiaries and foreign corporations with US manufacturing plants are enjoying a significant tax advantage over US companies without overseas subsidiaries. Hence, US corporations are paying corporate income tax at widely varying rates. This has contributed to the deindustrialization of the United States because domestic industrial producers pay a higher effective corporate income tax rate than those that move their plants abroad. Furthermore, it is less economical or uneconomical for smaller companies, the most important source of job creation in the US, to engage effective but costly tax experts to cut their tax liabilities.
In theory, governments can use transfer pricing for goods that cross borders to assess corporate income tax; in practice, this can be highly arbitrary. Moreover, with the mushrooming of corporations that are involved in international trade and the extensive bag of tricks available to multinational corporations, including relocating their domiciles, transfer pricing is not a satisfactory tax remedy.
Pricing Public Goods for the Corporate Sector[344]
Corporations enjoy the benefits of public goods, including defense of their property against foreign invaders, a legal system that protects their property rights and a police force that enforces such rights, an education system that provides them with skilled labor, a health system for their workers and customers, and a transportation system for their customers, workers, and products. These and many more public goods are essential for the proper functioning of a modern corporate sector and taxes are the price of such public goods. A rational and fair corporate tax prices public goods in proportion to the benefits that corporations derive from them.
Naturally, larger corporations derive bigger benefits from public goods than smaller ones by virtue of their size. Hence, corporate size is a logical tax base for pricing public goods` to the corporate sector. This raises the question of what is the most appropriate measure of corporate size between six identifiable measures: sales volume, number of staff, income, total assets, shareholders’ equity (net worth), and capital (shareholders’ equity + debt).
Sales volume is an unsatisfactory measure of size because it overstates the size of some small corporations with huge sales volumes but little value added, as in the wholesale trade, while vertically integrated corporations have high value added per dollar of sales and, thus, sales tend to understate their true size.
Number of staff is also inappropriate because some very large corporations use high capital intensity and automation, and scant labor. Besides, a tax based on the size of the labor force discriminates against employment and encourages the substitution of labor with capital, a self-defeating measure under conditions of chronically high unemployment and low wages. Such a tax would also place an excess burden on labor-intensive industries such as fast food, retailing, and agriculture, while corporate giants in capital-intensive industries like oil refining, chemicals, and automated steel production would substantially escape the tax.
Income is another poor indicator of corporate size because certain small companies are highly profitable while some large ones are only marginally so. Moreover, corporate profits fluctuate widely over the business cycle, while corporate size remains relatively stable. In addition, corporate income tax suffers from several defects, like the erosion of its tax base, as discussed in the previous section.
This leaves three measures: total assets, shareholders’ equity (net worth), and capital (shareholders’ equity + debt). The three have similarities. However, total assets would overstate the real size of some industries like retail and wholesale trades because these carry relatively large inventories and accounts receivable, which would overburden them with excessive taxation along with their customers, given the potential for tax shifting.
Shareholders’ equity is also not an ideal proxy because some industries, such as utilities, have historically employed a lot of debt. Hence, shareholders’ equity on its own seriously understates their true size.
Finally, capital (shareholders’ equity + debt) is a compelling indicator of size because it is based on the size of long-term corporate resources, regardless of its composition in terms of equity or debt. A capital tax is also preferable to a tax on shareholders’ equity because the latter would encourage the replacement of equity with borrowing to lower the tax bill, thereby inheriting a key defect of the present corporate income tax. Accordingly, capital would seem to be the most robust indicator of corporate size and a logical tax base for pricing public goods to the corporate sector.
The Relative Economic Efficiency of a Corporate Capital Tax
Before declaring a corporate capital tax a suitable replacement for corporate income tax, one needs to assess its relative economic efficiency and its effect on the corporate sector. Table 17.1 presents the tax consequences of a corporate income tax versus a corporate capital tax on two purposely very similar corporations: A and B.
Table 17.1 begins by listing the assumptions regarding companies A and B. They have identical shareholders’ equity, number of shares, and price-earnings multiples (PE), and, for simplicity, both are debt free. They only differ in their profitability: Company A has a 16 percent pretax rate of return on equity compared to 8 percent for Company B.
Also, for ease of comparability, the rates for the two taxes—corporate income and corporate capital taxes—are revenue-neutral such that both taxes generate the same total tax revenue; however, the incidence of the two taxes on each company varies considerably, as illustrated in Cases I & II in Table 17.1.
Case I illustrates the imposition of a 40 percent corporate income tax; it taxes Company A twice as heavily as it taxes Company B because Company A is twice as profitable.[345]
Case II illustrates the imposition of a 4.8 percent corporate capital tax that generates the same total tax revenue as the corporate income tax. In this case, both companies pay the same amount of tax because they have equal shareholders’ equity given that both have no debt.[346]
Table 17.1 demonstrates the economic irrationality of the corporate income tax, because by using profitability as its tax base, it taxes corporate efficiency. Indeed, under the corporate income tax the more efficient a company is, the greater is its tax penalty, while an inefficient company earning no profit or incurring losses completely escapes the tax, permitting corporate free riders to enjoy the benefits of public goods without paying for them.
The following compares the economic effects of using a corporate income tax with those of a corporate capital tax:
1. A corporate income tax is economically irrational on two counts. It is a poor proxy for the public goods consumed by corporations and it penalizes efficiency, falling most heavily on the highest rates of return in the economy, hence, it is economically irrational. By contrast, a corporate capital tax is economically rational because it taxes permanent corporate resources, a proxy for the public goods consumed by a corporation, without penalizing efficiency.[347] Indeed, a corporate capital tax favors efficiency and penalizes inefficiency by acting like a corporate income tax that varies inversely with profitability, falling as a percentage of income as profitability increases and rising as profitability falls.
2. The losers under a corporate income tax are the shareholders of the most profitable companies, their employees, suppliers, customers, and the national economy because it is a penalty on collective efficiency.
3. Since a corporate income tax favors inefficient companies, it misallocates resources and, therefore, entails a larger excess burden than a corporate capital tax.
4. Switching from a corporate income tax to a corporate capital tax raises the after-tax rate of return (marginal efficiency of capital in Keynesian terminology) of above-average profitability (i.e. efficient) companies and lowers it for below-average profitability (i.e. inefficient) companies.
5. The tax switch also increases the number of viable investment opportunities, thereby inducing a higher level of investment.
6. It also increases the after-tax resources available to efficient companies and decreases them for inefficient ones.
7. A corporate income tax blurs the distinction in the profitability of companies, rendering capital markets less efficient, whereas corporate capital tax accentuates this distinction, rendering capital markets more efficient. Even with the PE ratios of the two companies remaining constant, as assumed in Table 17.1, the tax switch raises the stock prices of efficient companies and lowers it for inefficient ones. Thus, the signals to the capital market become sharper, improving capital market efficiency and capital allocation. More likely, the PEs of efficient companies will expand while those of inefficient ones will shrink because the growth of the former will accelerate relative to the latter, making capital markets even more efficient by further increasing the capital availability to efficient companies and reducing it to inefficient ones.
8. The simultaneous rise in the after-tax profitability of investment opportunities available to efficient enterprises, coupled with the rise in their after-tax resources and their increased availability of funds through the capital markets, tends to increase the level of investment in the economy, accelerating economic growth.
9. Unlike corporate income tax, eliminating the tax deductibility of interest would tend to shrink corporate indebtedness and the financial risk in the economy, thereby dampening economic cycles, increasing the capacity of the corporate sector for business risk-taking and achieving faster economic growth.
10. To the extent that a corporate capital tax results in faster economic growth and lower unemployment, it would increase tax revenue and diminish certain budget expenditures such as unemployment benefits. Where a budget surplus results and in the absence of any urgent spending programs, including national debt repayment, it is possible to cut the corporate capital tax rate with further positive ramifications for the economy.
11. The burden of a corporate capital tax falls most heavily on poorly utilized corporate resources, inducing enterprises to ration their idle and excessive assets by paying off their debts, reducing their capital, increasing their dividends, and generally shrinking their bloated balance sheets to minimize their corporate capital tax bill. A corporate capital tax would also encourage enterprises to improve their capital efficiency by becoming more specialized, focusing on their most profitable core operations, and spinning off nonessential businesses as independent entities or selling them to third parties. The net effect on the economy would be greater resource dynamism and improved resource allocation, releasing low-productivity resources to other parties that can better utilize them. Thus, a corporate capital tax is an effective antidote to corporate resource hoarding by fostering a more efficient use of society’s scarce resources and limiting the negative impact of the liquidity trap during recessions.
12. To the extent that a country adopts a corporate capital tax while other countries retain corporate income taxes, there would be a tendency, over time, for highly profitable investments to migrate to the corporate capital tax domicile and for low-profitability investments to migrate to the corporate income tax domicile, both motivated by the desire to minimize their tax bills. Thus, a corporate capital tax would attract the most profitable and efficient use of capital, while a corporate income tax would attract the least efficient. A country that adopts a corporate capital tax instead of a corporate income tax would likely enjoy significant favorable long-term effects on its growth, employment, and tax revenue.
In 1997, Don Fullerton and Gilbert E. Metcalf estimated the excess burden of the corporate income tax at 35 percent due to its inefficiency.[348] In other words, a corporate income tax creates large economic distortions and dislocations. The total economic distortion is likely higher still because Fullerton and Metcalf did not explicitly address all the potential inefficiencies of corporate income tax.
In conclusion, a corporate capital tax would likely accelerate economic growth with benefits accruing to corporate shareholders, labor, customers, and the public purse. It is especially suited for stimulating the mature economies of the West, where economic growth is languishing and deficits and chronic unemployment are high.
The Incidence of a Corporate Capital Tax
Tax incidence is concerned with who ultimately bears the tax burden: consumers, workers, or shareholders, or a combination of these in varying degrees. In theory, a company would likely attempt to shift its tax burden, at least partially, away from its shareholders. It shifts the tax forward to its customers by raising the price of its products and services or backward to its suppliers and labor by reducing the prices it pays for their inputs.
Tax incidence is a function of the elasticities of demand and supply. The more elastic the demand for a company’s products and services, the less it can shift the tax forward. Similarly, the more elastic the supply of its inputs, the less it is able to shift the tax backward, including to its own labor force. On the other hand, the more inelastic the demand for a company’s products and the supply of its inputs, including labor (by limiting pay raises), the easier it is for a company to shift the tax forward and backward, respectively. However, one should also keep in mind that elasticity increases over time as competitive substitutes become available to consumers and suppliers (including labor) find alternative buyers. Hence, because it tends to change over time, the analysis of tax incidence is most relevant for the short-term.
In the case of a corporate capital tax replacing a corporate income tax, we can draw certain tentative conclusions a priori. To the extent that the tax bill increases for low-profitability companies, presumably with less pricing power, they would be less able to shift the tax forward. However, they might be able to shift it backward, in part or in full. Hence, there is a reasonable expectation that the shareholders of low-profitability companies, and possibly their suppliers (including labor), would bear a larger share of the tax burden rather than their customers.
By contrast, the adoption of a corporate capital tax would lower the tax liability of high-profitability companies relative to corporate income tax. However, to the extent that such companies have significant pricing power, it is possible they would be less inclined to pass the tax reduction to their consumers by lowering their prices. Hence, the profitability of such companies would likely improve further, at least in the short term, with further favorable repercussions on economic growth.
Effect on Corporate Indebtedness
The tax base of the corporate capital tax is shareholders’ equity plus debt. Hence, it carries no corporate tax incentive to replace equity with debt. Furthermore, it favors neither interest nor dividends, because neither enters into the calculation of the tax liability. Thus, a corporate capital tax is tax-neutral with respect to debt versus equity.
Some public finance textbooks and articles mistakenly praise the so-called “automatic stabilization” of corporate income tax. The term refers to the variability in corporate income tax revenue over the economic cycle, falling during recessions when corporate profits fall and peaking at the height of expansions when profits peak. This analysis arrives at the wrong conclusion because it takes a secondary effect, tax revenue, as the only effect while overlooking the larger, primary, but opposite effect. Indeed, corporate income tax, through the tax deductibility of interest, encourages corporate indebtedness and therefore induces greater cyclicality, dwarfing any marginal advantage of a cyclical rise and fall in tax revenue.
In the case of corporate capital tax, to the extent that the value of the assets of a company rises and falls over a cycle and with it the market valuation of its capital (shareholders’ equity plus debt), this provides some automatic stabilization through a corresponding rise and fall in the tax bill. This occurs without encouraging indebtedness, and therefore, without inducing amplified cyclicality.
In any case, it is easy enough to give a corporate capital tax additional automatic stabilization features, if required. For example, giving corporations the option to make prepayments against their future corporate capital tax liability (up to two or three years in advance) would provide such a counter cyclicality feature. This is especially helpful to the highly cyclical sectors such as the extractive, petrochemical, transportation, and high-capital-intensity industries generally. Indeed, a case can be made for making such tax prepayment a requirement for such industries to partially shield them from the impact of a downturn.
To encourage corporations to use this option, the tax prepayment could be treated, fully or partially, as an expense instead of a prepaid expense, thereby slightly reducing the corporate capital tax base and with it the tax bill. Implementing this option would tend to increase tax collections during boom times and lower it during contractions, providing an additional source of automatic stabilization without the negative consequences associated with increased indebtedness under a corporate income tax. A wide exercise of this option by corporations would entail a reduction in tax revenue, which would require a corresponding adjustment to the tax rate to ensure that this option is revenue neutral over a business cycle.
Today, inflation seems like a distant memory, but the huge rate of expansion in the money supply, along with other factors, could bring it back, swiftly. Inflation distorts various taxes in different ways. In the absence of replacement cost accounting, inflation increases the replacement cost of assets such as inventories, equipment, plants, and buildings above their historical cost, the cost basis for computing depreciation and income, thereby automatically raising the effective marginal corporate income tax rate as inflation rises.
This problem is most acute in the case of long-lived assets such as buildings, plants, and equipment because, over several years, the cumulative effect of inflation results in a large discrepancy between historical and replacement costs. The overstatement of taxable income raises the effective corporate income tax rate without any constitutional authorization. Hence, under inflationary conditions, the effective corporate income tax becomes arbitrary. Sometimes governments secretly welcome this effect because it raises additional tax revenue by stealth.
Economically, this stealthy income tax hike under inflationary conditions lowers the corporate real after-tax rate of return, discourages investment, curtails increases in supply, and inhibits growth. It also discriminates against investing in long-lived high-capital-intensity assets because these are riskier. Generally, inflation adds to the general risk in the economy and lowers the real after-tax rate of return on investments.
In the case of a corporate capital tax, inflation has the opposite effect because the book value of corporate assets tends to understate their replacement cost, thereby reducing the effective corporate capital tax and increasing real return. This effect tends to curb a government’s incentive to perpetuate inflation. On the other hand, periodic asset revaluations could update the current value of long-lived corporate assets, particularly buildings and lands, albeit, with a time lag.
Corporate Capital Tax Avoidance
Regardless of the form of corporate taxation, a growing tendency among companies is to relocate their domicile to minimize their tax burden. Some economists have argued that the solution to this is reducing corporate tax rates generally. This opinion has some validity in exceptionally high tax-rate environments. Nevertheless, the existing competition among tax jurisdictions for lowering their tax rates to attract more companies is a loser’s game. The ultimate outcome is a tax rate that is too low to pay for the cost of a satisfactory level of public goods in major economies, although it might be more than adequate for tax havens and quasi tax havens that provide small quantities of public goods. The immediate solution to this problem is to ban the relocation of corporate domiciles. The long-term solution is global tax harmonization as proposed by Professor Piketty.
The other concern is about the pricing of international inputs. Under a corporate income tax, an international manufacturer with a domestic manufacturing facility is motivated to overstate the cost of international inputs to siphon more of the profits tax free to a lower tax jurisdiction. Under a corporate capital tax, there is no such enticement. Instead, the tax-minimization strategy becomes to streamline the capital invested, reducing the domestic plant as far as possible to an assembly operation that requires smaller capital. In the absence of international tax synchronization and tariffs, maintaining vertical industrial integration would have to fall on a fair exchange rate that stops the subsidization of imported inputs and curtails excessive international sourcing.
Computation of a Corporate Capital Tax Rate
What should the rate be for a corporate capital tax? If the initial target is to maintain the current corporate tax revenue, then the calculation of the rate of a flat corporate capital tax is straightforward, as follows:
Corporate Capital Tax Rate= (∑Current Corporate Tax Revenue)[349] / (∑Corporate Shareholders’ Equity + ∑Corporate Debt)
The term “∑Current Corporate Tax Revenue” ought to include all current direct corporate taxes. For example, a previous section titled “Employers’ Social Security Tax Contribution” proposed integrating employers’ share of social security tax contributions with the primary corporate tax. This implies the following:
∑Current Corporate Tax Revenue= ∑Corporate Income Tax Revenue + ∑Employers’ Social Security Tax Contributions + ∑Other Corporate Tax Revenue
The term “∑Other Corporate Tax Revenue” represents: all other corporate taxes, including those that only apply in some jurisdictions, such as a possible corporate wealth tax or a corporate capital gains tax, as the case may be. However, it should not be interpreted literally to include government charges, fees, or taxes limited to specific activities, companies, or sectors, such as licensing fees, a pollution tax, and the like.
Adapting a corporate capital tax to permit tax credits for foreign corporate income tax while maintaining the same overall tax revenue, is also relatively simple, as follows:
Corporate Capital Tax Rate = (∑Current Corporate Tax Revenue + ∑International Tax Credits) / (∑Corporate Shareholders’ Equity + ∑Corporate Debt)
The above calculation provides a means for giving international tax credits to corporations up to a ceiling represented by their corporate capital tax on their international corporate capital tax base (International Shareholders’ Equity + International Corporate Debt).
Finally, to encourage the formation of small businesses, it would be wise to exempt the first $1 million or more of corporate capital from the tax. Hence, the tax rate computation would be as follows:
Corporate Capital Tax Rate = (∑Current Corporate Tax Revenue + ∑International Tax Credits) / (∑Corporate Shareholders’ Equity + ∑Corporate Debt - ∑Corporate Exemptions of $1 Million per Company)
Naturally, to avoid double or multiple counting of a corporate capital tax, it needs to be synchronized for companies with large ownership stakes in affiliates and subsidiaries by crediting them with the tax levied on their ownership stakes in such affiliates and subsidiaries. This approach should not affect the tax revenue generated by a corporate capital tax because it merely eliminates the multiple counting of the same capital. The corporate income tax has adopted an approximately similar methodology.
One transitory problem deserves consideration. In recent years, many enterprises have resorted to buying back their own stock at prices that far exceed their book value per share. This practice has artificially decreased corporate net worth, sometimes to zero or even a negative amount, which results in substantially escaping a corporate capital tax.[350] One way to overcome this problem is to treat the average premiums per share paid over book value for stock buy-backs during the past twenty-five years as an intangible asset per share that needs to be added to the current book value per share of existing shares, thereby augmenting shareholders’ equity for purposes of calculating the taxable amount. Alternatively, such corporations could elect at the time of the adoption of a corporate capital tax to use the excess of the market value of their shares over their book value as the proxy for such intangible assets. The intangible assets would be amortized over, say, twenty-five years to give corporations sufficient time to increase their shareholders’ equity, the major component of the tax base, to a reasonable level. Incidentally, this measure would encourage future pro-rata share redemptions at book value, which would be fair because all shareholders, both large and small, would enjoy similar treatment. It would also encourage increasing dividend payouts.
Corporate Capital Tax Collection and Compliance
One measure of the efficiency of a tax is its cost of collection as a percentage of the total tax revenue it generates. The cost of tax collection incurred by the Treasury as well as the cost of compliance incurred by corporations is an economic waste that is best minimized. The simpler the tax code, the lower the cost of tax collection, permitting the Treasury to retain more of the revenue it collects while reducing the cost of compliance for corporations too and vice versa. The corporate income tax code is extremely complex, and its complexity continues to surge as special interests lobby to amend it to cut their tax bills. It is especially burdensome to small and midsize corporations, the source of most of the economic growth and job creation. Finally, a complex tax code, by providing multiple opportunities for inserting tax loopholes and exemptions, makes taxation less transparent, unfair, and undemocratic.
Income, a flow concept, makes estimating corporate pretax income costlier and much more intricate than assessing a corporate capital tax, a stock concept. Corporate income is defined as total corporate revenue (sales plus other sources of revenue such as fees, royalties, interest, etc.) less total corporate expenses (salaries, wages, raw materials, power, light, fuel, maintenance, depreciation, amortization, depletion, advertising, fees, bad debts, travel, communications, interest expense, miscellaneous expenses, etc.). Within a single tax year, billions of revenue and expense items go into the determination of a large corporation’s taxable income, an overwhelming task. By comparison, the determination of its net corporate asset values and liabilities is a vastly simpler task, only requiring the identification of corporate assets and liabilities and their book values or prices, as the case may be. Thus, the cost of collecting and complying with a corporate capital tax should be a small fraction of the corresponding cost of a corporate income tax, resulting in significant cost savings to both the government and the corporate sector. The assessment of a corporate capital tax could be once a year, semiannually or quarterly. The first option is the simplest and the least costly.
Charities, Charitable Foundations, and Charitable Assets
The definition of charitable assets ought to be restricted to assets that are dedicated to charitable activities. Thus, free or low-cost shelters for the deprived that cover its reasonable operating costs and earn no profit represent charitable assets. Similarly, a hospital, school, or university that charges no more than its reasonable operating cost, without realizing a surplus, holds charitable assets and is properly exempt from a corporate capital tax. On the other hand, charities and foundations that realize surplus revenue over reasonable costs can either increase their subsidy to needy recipients or pay a pro rata corporate capital tax on a portion of their assets that is earning a surplus. The tax would discourage abuse of the charitable label by taxing assets that are not fully dedicated to charitable service and ensuring efficient use of societal resources by charging partial charities a fair share of the cost of public goods. Prime examples of abuse are universities that charge exorbitant fees to their students and earn significant surpluses while claiming to be charitable, whereas they ought to have their capital resources taxed like any other profit-seeking enterprise.
The United States currently imposes a 30 percent tax on dividends while exempting interest. It is one of the many irrational biases against equity in the present tax system. In this case, tax neutrality is achievable by either imposing an equivalent withholding tax on interest or eliminating the tax for both.
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In conclusion, the economic advantages of replacing a corporate income tax` with a corporate capital tax are numerous and significant, yet a corporate capital tax is unjustifiably unpopular, even if it is revenue neutral compared to a corporate income tax. The underlying reasons are definitely not economic but a result of enthusiastic corporate lobbying by the less efficient corporations and a lack of sufficient lobbying by the efficient ones.