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Carl S. Shoup, Columbia University The Federal income tax does not profess to strike different types of income at differing rates. In this respect it contrasts with many foreign income taxes. Yet one kind of income is in fact treated quite differently from all others, under the Federal income tax: income derived from corporations. The corporation itself pays corporate income tax on its profits, and the stockholder pays personal income tax on his dividends and his capital gains. This combination of taxes sometimes results in a higher rate of tax on income from corporate activity than on salary or proprietorship or partnership income. Sometimes, the net result is a lower rate of tax on corporation-derived income.

These conclusions assume that the corporation income tax is not shifted. To the extent that it is shifted, either forward in prices to consumers, or backward in lower wages, interest, or rents, the corporation income tax becomes a regressive and capricious tax. We do not know what the facts are. My own guess would be that an appreciable part of the tax is shifted, but that for the most part it remains a tax on the corporate stockholders. To facilitate isolating the chief points at issue, the present analysis is built on an assumption that none of the tax is shifted.

The rate of income tax that rests on corporate profits is the sum of three distinct tax rates, which are applied to varying proportions of the corporation's pretax profit. There are first the rates of the corporate income tax itself, 30 percent on the first $25,000, and 52 percent on the remainder. Second, dividends paid are taxable to the individual stockholder, at rates that depend on the size of the stockholder's total income from all sources; and a small exclusion and a small credit against tax are granted. Third, the special low rates allowed for long-term capital gains, 25 percent at the highest, apply of course to gain realized from sale of the stock eventually by the individual stockholder. One of the factors making for capital gains is the retention of earnings within the corporation, since the corporation thereby grows in size and each share of stock tends to increase in value. At least this is so if the retained earnings are put to fruitful use, not held idle or dissipated in mistaken investment. Thus large retained earnings, under expert corporate management, tend to produce capital gains for the stockholders. If an individual'investor realizes such a gain by sale of his shares of stock, or upon liquidation of the corporation, he pays income tax at the favorable capital-gains rate, on this realized increment in value, in place of having paid, annually, a tax on dividends at the regular income tax rates, as would have occurred if the management had decided to pay out all earnings each year in dividends. Moreover, if the investor holds his shares of stock until death, those to whom the stock is passed on may use, as the basis for

computing capital gain or loss when they dispose of the stock, the value of the stock as of the date it was transferred to them upon

death of the former owner. In this case, no one ever pays any individual income tax on the gain in the value of the stock that accrued before death. In effect, in this instance, that part of its profits that the corporation has retained escapes individual income taxation entirely.

Clearly, it is not a simple matter to compare the income tax on dividends with the income tax on a salary or on profits of an unincorporated enterprise. The net result of all this complexity is approximately as follows.

Stockholders who own shares in corporations that pay out practically all of their profits in dividends suffer a substantial extra tax, relative to what they would pay on salary income, or income from partnerships or individual businesses. The rate of this “extra tax” is higher, the lower the taxpayer's income, because the corporate rate stays at 52 percent, hence exceeds the personal income tax rates by more and more, the lower the personal income.

A stockholder who owns shares in "growth corporations," which usually retain most of their profits, enjoys a substantial tax reduction compared with salary taxation, provided he has a high income. He gets this advantage if his total income puts him in a bracket rate higher than the 52 percent rate of the corporation income tax, provided that he can hold his stock until death and thus can allow his successors to get a new high basis. If, on the contrary, the investor realizes his gain before death and pays a 25 percent tax, a tax advantage for corporate-derived income exists only for the individual who falls in a bracket higher than 64 percent. However, in each of these cases, the advantage really takes hold at somewhat lower bracket levels, in view of the interest saving that arises from the ability to postpone capital gains tax until time of realization, in place of paying year by year, as one must on a salary or on profits of an unincorporated enterprise.

High-income investors presumably have a sizable proportion of their stock investments in growth corporations. Moderate-income and low-income investors probably, on the average, allocate a larger proportion of their stock investment to current-yield corporations that pay out most of their earnings in dividends. To the extent that this is so, the present tax system grants tax favoritism to stock investment by high-income taxpayers, and penalizes stock investment by moderate-income or low-income taxpayers. As to all investors, considered as one group, we do not have enough statistical information to hazard a guess as to whether corporate investment is favored or penalized by the present tax system, relative to salary or unincorporated-enterprise income. A promising start on obtaining such information has been made by Dr. Holland in his “The Income Tax Burden on Stockholders and his forthcoming study, “Dividends Under the Personal Income Tax." The difficulty persists, however, that a reasonably representative picture cannot be obtained from any one set of assumptions about (a) degree to which retained corporate earnings are translated into enhancement of share values, (6) length of time elapsed before realization of capital gain, assuming that realization occurs before death, and (c) extent to which capital gains are not realized until after the property has passed at death and has thus acquired a new

basis for computing gain or loss. To carry out statistical studies under each of a number of different sets of such assumptions is costly. Moreover, there would still be the problem of ascertaining how frequently, in a relative sense, each set of assumptions was matched in real life.

Taxation of intercorporate dividends is historically linked with the treatment accorded consolidated returns, and cannot be settled in isolation from that latter issue. In any event, we may note that the relation between rates of tax on dividends and on capital gains is just the opposite, for corporations owning shares in other corporations, from what we find for the individual investor in corporate shares. Dividends paid to a corporation are taxed, in effect, at 7.8 percent (or 4.5 percent), while on its long-term capital gains a corporation pays 25 percent. As to tax rates alone, therefore, abstracting from the advantages gained by postponing realization indefinitely, a corporation should not invest in growth stocks.

A comprehensive reshaping of the income tax that would produce a satisfactory treatment of dividend income thus involves issues well beyond the scope of the present paper, especially capital gains and the taxation of undistributed profits. Whatever the solution, it will need to limit somewhat the stockholder's present freedom to postpone indefinitely, and in many cases to escape entirely, taxable realization of accrued capital gains. Meanwhile, a few ground rules may be suggested.

1. If the tax on corporate-derived income were raised to the level that the tax law says salaries and partnership and proprietorship incomes must pay, the result might be deemed excessive discouragement to investment in the very high brackets of income. If that is so, the indicated remedy is to lower the top bracket rates for all forms of income, instead of permitting complicated detours around the rates for some types of income.

2. If extra taxation on corporate-derived income is to be reduced, the tax relief must be channeled to those who invest in corporations that distribute most of their profits, since that is where the extra taxation lies.

3. If investment is to be stimulated, the particular kind of formula used to give tax relief becomes important. Some relief formulae are ineffective, from this point of view. Although they reduce extra taxation, they give no stimulus to investment. An example is the exclusion of a flat amount of dividends: for example, the present $50 exclusion. Exclusion of a flat amount has little or no impact on the margin of a taxpayer's activity. Let us consider, for instance, a married couple with a taxable income of $15,000, including an appreciable amount in dividends, who are debating whether to invest another $10,000 in order to gain another $500 dividend income. They will pay 30 percent personal income tax on that extra $500. Raising the present exclusion from $50 to $100 would leave the marginal rate on the prospective additional $500 unchanged. Not until more than $4,000 of dividends were excluded would the marginal rate be lowered, hence the inducement to invest on this score be increased. Thus an exclusion of, say, the first $1,000 of dividends, while reducing

1 See Shoup, "The Dividend Exclusion and Credit in the Revenue Code of 1954," National Tax Journal, March 1955, pp. 145-146.

extra taxation of corporate income, would offer almost no incentive to additional investment. If the tax relief is to promote investment, it should take effect at the margin of the taxpayer's income.

4. Whatever the relief granted, it should be of a type that commands enough support in Congress so that it will not be in continual danger of repeal. If the relief seems to be constantly in peril, the result is tax relief, but no incentive to invest. For example: Whatever modest incentive effect the present 4 percent credit may have had has been effectively extinguished by recent debates over possible repeal of this measure, which was enacted only in 1954. Investors look to future taxes, over a considerable period of years. Thus a tax relief measure, even though it operates at the margin of the taxpayer's activity, may last for decades without stimulating investment.

5. A step-by-step relief program, a little relief now with more promised later, should not be undertaken unless it is clear from the start that the formula employed will continue to be acceptable as it is intensified or expanded. The present 4-percent credit is faulty in this respect. A 4-percent credit means little; a 15-percent or a 25percent credit granted to all dividend recipients would put dividends actually on a tax-preferred basis relative to all other types of income, for taxpayers in high brackets. If the 4-percent credit were raised to 25 percent, then, even if a corporation distributed 100 percent of its posttax profits, a corporate shareholder would have a tax advantage (over salary or unincorporated enterprise income) if his total income reached the 76-percent bracket or higher. On the other hand, even a 25-percent credit would remove only a small part of the extra tax on the low-income corporate investor. An investor in that same kind of corporation, if he is in the 20-percent bracket, needs an 87-percent credit against his tax (87 percent of the dividend), not a 4-percent or 25-percent credit, if his share in the corporation's income is to be taxed no more than salaries or partnership or proprietorship incomes. These facts suggest that the credit percentage might be varied, being made high for the low income taxpayer, and stepped down as the bracket rate increases. Under the extreme assumption that none of the 52 percent corporation tax is shifted to consumers or others, and ignoring the initial 30-percent rate, the formula tells us that those taxpayers in the 22-percent bracket, would be allowed a credit of 84.5 percent; those in the 26-percent bracket, a credit of 80 percent; and

These percentages are valid, strictly, only if the corporation is distributing 100 percent of its after-tax profits in dividends, and only if the dividend income is all taxed at the marginal rate. In practice, no such extreme set of percentages could be justified; but the principle of varying the credit with the individual taxpayer's income, and perhaps also, roughly, with the percentage of profit that is habitually distributed by the corporation, may be worth exploration.

6. The present corporate tax has no doubt been discounted in large part. Those who have purchased stock in recent years have done so with the thought that the tax rate would probably continue to be about 52 percent, and with little expectation that tax relief to eliminate extra taxation would be given. By the same token, they have pur

so on.

a Arguments for repeal of the exclusion and credit were offered by Senators Paul Douglas and Eugene J. McCarthy, in “Corporate and Excise Tax Rates Extension," hearing, Committee on Finance, on H.R. 7523, June 23, 1959, pp. 63, 103-107. The Senate voted on June 25, 1959, to repeal the 4 percent credit. Wall Street Journal, June 26, 1959.

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