TABLE 5.-Reduction in differential against net corporate earnings and stockholder income due to relief provisions of the Internal Revenue Code of 19541 [Estimated from 1950 data. Weighted average of joint and separate returns]

1 Exclusion of $50 for separate and $100 for joint returns plus tax credit of 4 percent of dividends in excess of excluded amount. • Denotes increase in differentials in favor of net corporate earnings and stockholders.

How can the unequal taxation of stockholders be remedied?

The relief provisions of the Internal Revenue Code of 1954 are imperfect even when evaluated strictly with reference to distributed earnings. They are even less satisfactory when account is taken of retained earnings. How then can stockholders be equitably taxed?

If we think of a change in tax procedure for stockholders alone, there is only one way to bring their income tax liability in line with that of other taxpayers. It is this: Abolish the corporate tax and tax currently as part of personal income each stockholder's pro rata share of corporate profits.20 This would be a clean-cut and direct solution and would achieve equality in tax burdens whether earnings were distributed or saved. It is its bearing on the tax equity attaching to retained earnings that distinguishes the "partnership" method from all other procedures. For it is only by full and current imputation that corporate earnings, whether distributed or not, will be related to the personal income tax paying capacity of the stockholder. And it is this that is necessary for equalizing their tax liability and that of other income taxpayers.21 It is not surprising, therefore, that the sug

20 In fact, a "corporate" levy can be maintained. The crucial requirement is that it be taken into account in reckoning the stockholder's personal income tax. That is to say, if the personal income tax base were defined to include all corporate earnings-paid out as dividends, retained by corporations, or tax withheld by the Federal Government at the corporate level-the corporate tax would be a withholding appendage to the personal tax. Stockholders would, besides including it and the rest of corporate profits in their personal income, be permitted to deduct their share of the corporate tax from their personal income tax liability.

Two specific features of the "partnership" method should be mentioned: (1) Losses as well as profits would be imputed to stockholders; (2) the basis of their stock for capital gains tax purposes would be raised by the excess of each year's imputations over dividends.

gestion that we treat stockholders like partners keeps recurring. Yet there is a strong feeling, even among many of its proponents (or people who would otherwise favor it), that the "partnership" method is subject to a number of disabilities so severe as to preclude its use or limit its application to small corporations with simple capital structures. It has been agreed that it can't be done because of insuperable administrative difficulties; that it shouldn't be done because of its undesirable economic effects; and that instituting it would involve so much revenue loss for the Treasury that under any conceivable circumstances it would be out of the question.22 The question of the "partnership” method's undesirable economic effects will not be examined here. This would be one more instance of the conflict between equity considerations and economic effects frequently found in taxation. There are no objective principles for reconciling them or for assessing their relative importance. Nor will we pay much attention to the administrative difficulties that attach to it. The consensus has been that these administrative difficulties could be very great, perhaps insuperable. Among the considerations raised in this connection have been

(1) The uncertainty that characterizes common stockholders' claims to earnings in a given year in the presence of accumulated preferred requirements or income bonds or the possibility that retentions of a given year are looked on in part as a cushion in future years for the support of the claims of prior obligations;

(2) It may be impossible, or at least extremely difficult, to evaluate stockholder pro rata shares of earnings when shares are owned by other companies, for then, even in the simplest casesX holding shares of Y, Y holding shares of Z, and Z holding shares of X-imputation would require simultaneous equations;

(3) Innumerable special complexities have been cited: The need to reopen personal returns after corporate audit; the special problem posed by corporations in receivership; the difficulties connected with the fact that millions of stockholders, many of them imperfect recordkeepers at best, would have to revise their capital gains basis each year to the extent that what they were taxed on exceeded what was paid out to them, etc.23

These are all weighty objections, and there is no intention to minimize them. On the other hand, it could be that not as much thought and ingenuity have been devoted to solving or simplifying these problems because of a feeling that it would be of no use to do so because the corporation income tax looms so large in the Federal revenue structure that we simply cannot afford to give it up.

It is recognized, of course, that were the "partnership" method adopted there would be some offset to this lost corporate tax revenue via increased personal income tax collections. But the general im

22 An additional criticism, viz, that it doesn't need to be instituted because stockholders' and all other taxpayers' tax liabilities have been equalized through the operation of market forces is not limited to the "partnership" method, but is common to all suggested changes in our present procedure, including the dividend exclusion and tax credit instituted in 1954. More will be said about this below.

23 There is not much merit in another criticism that is sometimes made of the "partnership" method-that it would mean taxing people on income they have not received. Presumably, sale of some shares at the enhanced price due to retention would enable payment of taxes. And if retentions do not show up in higher stock prices, then stockholders should not acquiesce to management's actions, or could express their opposition by selling their stock.

pression is that the offset would be "slight." Estimates I have made for the years 1944-52 indicate, on the contrary, that there would be a considerable degree of recoupment of the forgone corporate tax revenue. Over these years, the estimates showed net revenue losses running at from -2 to 35 percent of the corporate tax liability actually levied in a given year. A reasonable guess for the current revenue loss would be toward the upper limit of this range. So we can say that about two-thirds of the lost corporate tax revenue would be recouped through the personal income tax.24 This would mean a revenue loss-currently associated with a change to the "partnership" method of about $8 billion. This, I think, places the "partnership" method in a new light, at least in terms or revenue feasibility. One way to put it is this: Were Federal revenue needs to develop in such a way that a cut of one-third in corporate tax rates could be seriously contemplated, we could also, at least as far as the revenue is concerned, afford to abolish the corporation income tax entirely, substituting in its stead the prompt and full taxation of corporate earnings to stockholders as part of their personal income. Or to put the "partnership” method in perspective against other possible changes in stockholder taxation, we note that it could cost the Treasury very little more (and might even cost less) to tax all corporate earnings equitably in relation to other income than merely to remove completely the overtaxation of distributed earnings. (The revenue cost of this latter change has been discussed above.)

What we have said about the "partnership" method-i.e., that it is the only device by which the tax liabilities on stockholders' distributed and undistributed earnings can be made equal to that on other sources of income-is true if we think about changes in the tax structure that would apply only to stockholders. However, there is another possibility, this one a change in the tax structure that would apply for all taxpayers, but particularly for stockholders, that would also equalize stockholders' taxes with those of other taxpayers. If capital gains were to be taxed in full as personal income as accrued over a given period, whether realized through actual sale of assets or not (and capital losses, of course, permitted as deductions in full), then the corporate tax could be abolished, dividends would be included in personal income, and so would any capital gains attributable to retained earnings (as well as capital gains or losses for any other reason).

Ideally, under such a proposal, stockholders (and other asset owners) should value their assets frequently and be liable for tax on the change in these valuations over short periods, say a year or two. Otherwise, they would enjoy an interest-free loan of the deferred tax liability,25 and an averaging period longer than that open to other

24 This all has reference to the revenue loss in a given year. Some additional loss, much slighter, would show up over the long pull because of smaller capital gains tax collections due to revisions in basis on the score of imputations in excess of dividend payments. See "The Income Tax Burden on Stockholders," ch. 6.

25 This follows from our preoccupation with tax equity. If, however, there is a desire to encourage saving and investment and it is felt appropriate to use the tax system to this end, deferral of the taxpayer's reckoning with the Government for his capital gains tax would be a positive incentive. Henry Simons has put the case this way in arguing for full taxation of capital gains and deductibility of losses, but not until sale, gift, or death. The Government says to the owner of a business: "Leave your earnings in the business if you so desire. I won't tax you, while you live, on any earnings reinvested. In fairness to other taxpayers, you and I must have a final and comprehensive reckoning

taxpayers. But some students of the subject hold that as a rough, but reasonably good expedient, it would be sufficient to tax the gains (or allow the losses) at sale, gift or death, with some averaging permitted to prevent unduly high surtaxes applying in the year of actual or constructive realization.26 Such a procedure, too, would provide a more subtle measure of income generated by corporate activity than would be used under the "partnership" method. For, by using dividends plus the difference between market valuations at two points in time rather than the change in book value over this period to measure the income generated by a corporation for its stockholders, account is taken not only of retained earnings, but also the valuation the market places on their use and of the host of other considerations that enter into the expectations of future earnings (or dividends, or some combination of the two) which determines the price of stock.27 ing capital gains in full would require averaging of income, for the bunching of gains in particular years would otherwise mean an undue tax penalty and the concentration of losses in a given year would push their deduction far down the marginal rate schedule.28 All in all, this type of tax treatment for capital gains would seem to involve as severe a set of changes in current tax procedures and problems in administration as taxing corporate earnings under the "partnership” method.

Tax

To achieve completely equal taxation for stockholders' share of corporate earnings, either by the "partnership" method or full taxation of capital gains-would require a major overhaul of our tax structure, and because of the numerous difficulties associated with either of these changes (administrative as noted above and perhaps also constitutional) the likelihood of their being adopted at this time is not great.

sometime (after you are gone or, if you get indolent with age, when you retire from ownership participation in the enterprise). Pending that time, however, you may, as it were, borrow from me without interest what you would pay additionally under partnership procedure or the annual reappraisal scheme. Besides, if you lose the accrued taxes which I'm temporarily forgoing along with the rest of your reinvested earnings, I'll take the loss myself." (Henry C. Simons, "Federal Tax Reform," University of Chicago Press, 1950, p. 49.)

26 Cf. Carl S. Shoup, "The Dividend Exclusion and Credit in the Revenue Code of 1954," National Tax Journal, March 1955, p. 146.

For partnerships while annual imputations are related to accounting statements of income, there is an ultimate adjustment based on some other valuation, e.g., when a partner sells out or at his death.

Shoup, op. cit.

On the other hand the more modest goal of removing the overtaxation of distributed earnings (or any fraction thereof) could be accomplished by adopting either of two simple procedures.20 One

It should be emphasized once more that they would still leave most stockholders overtaxed on their share of retained earnings but some those with higher incomes-would be undertaxed. There would still be the pressure to avoid personal surtaxes via corporate savings and to convert regular income into preferentially taxed capital gains, with all the absurdities, uneconomic use of resources, that this might lead to. With simple arithmetic it is easy to conjure up a parade of examples, and while on this level they remain just numerical examples, where self-advantage beckons, behavior cannot be far behind.

1. As to the equality of tax burdens, consider the following illustrative data, all based on a corporate rate of 50 percent, i.e., $2 of earnings are required for each dollar of net corporate saving.

NOTE.-Capital gains are assumed to be long-term and ceiling rate limitation of 25 percent (50 percent of the 50 percent included in income) is used where applicable. Line (a) gives the corporate tax borne on $2 of earnings no matter what the stockholder's marginal rate of personal income tax may be. Line (b) shows how much this $2 would have been taxed as personal income. The difference between the two, line (c), can be considered a simple measure of the "extra" burden on the stockholder's share of retained earnings. It ranges from 50 percent for those persons or institutions not subject to tax to minus 40 percent (a tax saving of 40 percent) for stockholders in the highest marginal rate bracket. That this is a disparate and unequal experience requires no elaboration. Line (e) incorporates a greater degree of realism into the example by assuming that retained earnings would raise stock prices equivalently, and that capital gains tax would be paid on these increases in value. The picture is essentially unchanged-lines (f) and (g)-except, of course, the "extra" burdens are higher for all personal income taxpayers. Line (h) takes account of the possibility that retentions may not show up in a like amount of stock price increase, it assumes an increase in stock prices only half as great as the amount of undistributed profits after tax. In effect, it says retained earnings bear three taxes: A corporate tax; a tax "levied" by corporate directors since at one point in time stockholders could have been given, say a dollar, but with this dollar retained by the corporation, they can realize only a 50-cent increase in the value of their holdings; and, finally, a capital gains tax on the gain they do realize. (All these examples take no account of the possibility open to stockholders of passing capital gains tax free at death.) "Extra" burdens are, of course, higher under this assumption (lines (i) and (j)) But it is interesting to note that even with this 50 percent attrition in capital gains reflection of corporate saving, a stockholder in the highest marginal rate bracket remains "undertaxed." The conclusion simply is that the present tax treatment of stockholders' shares of retained earnings involves very unequal tax liabilities for stockholders-most are "overtaxed," those in the highest tax brackets are "undertaxed."