POMERLEAU: A progressive corporate income tax doesn’t make a lot of sense

By Kyle Pomerleau

The House version of the budget reconciliation bill includes a provision to raise the corporate income tax rate from 21 percent to 26.5 percent and reintroduce a progressive rate schedule. Under the proposal, the amount of corporate income tax imposed would be 18 percent of taxable income under $400,000, 21 percent of taxable income between $400,000 and $5 million, and 26.5 percent of taxable income above $5 million. This proposal allows lawmakers to argue that they are reintroducing progressivity into the corporate income tax, only a few years after the Tax Cuts and Jobs Act eliminated it. A progressive corporate income tax, however, makes little sense.

Progressive tax schedules conform to the principle of “vertical equity,” which states that high-income individuals should face a greater tax burden than low-income individuals. For example, the individual income tax rate schedule is progressive. Its statutory tax rate schedule features higher brackets, from 10 percent to 37 percent, for higher-income taxpayers. As a result, a taxpayer’s average effective tax rate rises as taxable income increases.

The concept of vertical equity does not translate well to entity-level taxes like the corporate income tax. Corporations are legal entities, and any taxes levied on corporations will ultimately fall on people (some combination of shareholders and workers). A company’s level of profits can have little relationship to the well-being of its owners. A very large corporation may be owned by thousands of individual shareholders — some of which are high-income households, others are low-income retirees. In contrast, a small corporation may have a single owner that earns more than half a million dollars a year.

To illustrate why progressivity for entity-level taxes is meaningless, consider two hypothetical taxpayers: One is a doctor that owns a medical practice organized as a traditional c-corporation; the other is a retiree that lives, in part, off dividend income from corporate equities. Both taxpayers are owners of corporations, and both ultimately bear the burden of the corporate income tax. However, since the corporations owned by our hypothetical taxpayers each earn a different level of profits, each will face a different tax burden at the entity level.

The retiree with lower income ends up facing a higher corporate tax rate than the doctor. The doctor, as a sole owner, receives all the profits from his practice. If the practice has taxable profits of $400,000, it will face an 18 percent corporate tax rate. The retiree, in contrast, receives dividend income from being a part-owner of publicly traded corporations earning multi-billion-dollar profits in a single year. Under the corporate income tax proposal assembled by the House, those profits would face the 26.5 percent tax rate at the margin.

If progressivity for corporate profits is the goal, lawmakers should consider integrating the corporate and individual income tax. Under certain versions of corporate integration, dividends that shareholders receive would be grossed up for corporate taxes already paid and taxed as ordinary income, currently between 10 percent and 37 percent. Shareholders would then receive a tax credit for corporate taxes paid. As a result, their net tax would be based entirely on the individual income tax schedule. Under this system, the tax rate would correspond directly with the wellbeing of the shareholder, regardless of the size of the corporation.

As long as lawmakers are considering changes to the corporate tax rate, they should stick with a flat rate.

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