CORPORATION INCOME TAX RATES

Richard Goode,1 the Brookings Institution, Washington, D.C.

The proper level of corporate tax rates depends on the total amount of revenue that the Federal Government needs to raise and on the proportion of the total that may appropriately be obtained from the corporation income tax. In this paper I shall confine myself to the second of these two questions and consider the place of the corporation income tax, relative to other taxes, in the Federal revenue system.

Taxes on corporate profits have been an important source of Federal revenue since World War I. In the late 1920's and early 1930's the corporation income tax accounted for almost one-third of total receipts. The proportion of Federal revenue from this source fell sharply during the depressed years of the 1930's but rose quickly during World War II with increases in corporate income tax rates, the imposition of an excess profits tax, and the expansion of economic activity. Corporate taxes yielded about one-third of total receipts during the war years, almost the same fraction as in the late 1920's and early 1930's. After the war, corporate tax rates and yields fell but increased again in response to the Korean emergency. For the current fiscal year the official estimates place revenues from the corporate income tax at a record level but equal to a smaller fraction of total receipts than in many previous years.

Until the middle of World War II corporation income and profits taxes yielded more than the individual income tax in nearly every year. As a result of the drastic reduction of personal exemptions, the increase in rates all along the line, and the adoption of withholding, the yield of the individual income tax then surpassed that of the corporate taxes. The individual tax has continued to hold its lead. In the postwar period receipts from corporate taxes have usually ranged from about one-half to two-thirds of receipts from the individual income tax.

Corporate taxes have been an elastic and highly productive source of revenue. Rates have been adjusted to changing needs. Corporation profits, which are the base of the tax, have been highly responsive to the secular growth of national production as well as to cyclical fluctuations in activity.

ATTITUDES TOWARD THE CORPORATE TAX

Despite the important role in the revenue system that the corporation income tax has filled for many years, it has been a highly controversial measure. No other major tax has been so severely and persistently criticized. The attacks have not been confined to complaints that rates are high or that the tax has certain technical defects but

1 The opinions expressed are my own and should not be construed as expressing the views of the officers, the staff, or the trustees of the Brookings Institution.

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have extended to charges that the corporation income tax is fundamentally unfair and especially injurious to the economy.

The criticisms of the corporation income tax continue, but my impression is that they have somewhat abated during the past decade. Proposals for drastic revision of the corporate tax structure and for deemphasis of this revenue source are less common than they were a few years ago. The corporation income tax seems to be better accepted by the business community. Its academic critics are less numerous and less outspoken.

One reason for the wider acceptance of the corporation income tax in recent years is no doubt the relatively satisfactory economic history of the postwar period. Among the economic forecasts which have so far turned out to be too pessimistic must be included those that visualized high corporation income taxes as an insuperable obstacle to high levels of investment and business activity. In the decade 1949-58 corporate profits after taxes represented 6.5 percent of national income-approximately the same percentage as the average for 1936-37 and 1939, the 3 best years of the 1930's, and substantially less than the figure of 9.5 percent for 1929. Gross private domestic investment equaled 15 percent of gross national product in 1949-58, compared with 11 percent in 1936-37 and 1939 and 15.5 percent in 1929. Corporations have been able to finance their heavy investment outlays in the postwar period out of retained profits and new security sales as well as depreciation and amortization accruals. The boom in stock prices has shown that investors have been willing to accept rates of return on shares that are modest by historical standards. In these circumstances, it has been difficult to make a convincing case for the opinion that the corporation income tax is seriously detrimental to the economic system. Heavy Government expenditures for defense and other purposes have contributed to the maintenance of activity in the past decade but at the same time have presented a continuing demand for revenue which has been partly responsible for the wider acceptance of the corporation income tax. Another factor that may have contributed to the acquiescence in the continued imposition of the corporation income tax at high rates is the uncertainty about who actually bears the tax. In the absence of a consensus on this point, it has been possible for different persons to accept the tax for quite different reasons. Many business spokesmen believe that the corporation income tax is largely shifted to consumers, whereas spokesmen for labor usually seem to believe that the tax rests mainly on corporations and their stockholders. Some neutral observers are of the opinion that the corporate tax has been largely absorbed into the cost-price structure and suggest that it would be unwise to disturb these accommodations unnecessarily. This is a complex subject, and I shall not attempt to go into it here. I wish merely to assert that, although it is reasonable to believe that the economic effects of the corporation income tax are widely dispersed, I have seen no evidence that in my judgment makes necessary the discard of the traditional conclusion that the major immediate and direct impact of the tax is on profits. If this is so, any substantial reduction of the tax would first be reflected mainly in an increase of profits after taxes. Any major effect on prices or wages that might occur would come about gradually as a result of the in

crease in profits and consequent modifications of methods of doing business and changes in the level of investment and activity in the economy as a whole and in different industries. In view of the uncertainty of the ultimate nature of the adjustments to a large change in the corporation income tax, it seems justifiable to give great weight to the apparent short-run change. This approach is commonly followed with respect to other taxes.

Another consideration that has influenced thinking about the corporation income tax in recent years is the view that the tax has served as a stimulus to corporate expenditures for research and development, institutional advertising, contributions for public purposes, and fringe benefits for executives. Expenditures for these purposes are deductible, within limits, from taxable income, and the Treasury bears 52 percent of their cost. This arrangement in effect creates a 48-cent dollar which management may be more willing to devote to certain marginal purposes than it would be to spend 100-cent dollars for such purposes. Many economists would regard such an outcome as objectionable on the grounds that it distorts business decisions and impairs the efficiency of the market mechanism as a guide to the allocation of economic resources. Other commentators and I suspect that this group includes many persons who influence public opinion more than the typical economist does take a different view. They feel that some of the expenditures which may be fostered by high corporation taxes have desirable consequences such as promoting technological development, supporting the communications industry, providing public amenities, and offering incentives for executives.

There must be something to the idea that a high corporation tax promotes certain kinds of marginal expenditures, although it is easy to exaggerate this influence. As usually presented, the argument is seriously incomplete. Emphasis is placed on the fact that the Government absorbs part of the costs of the outlays but attention is not called to the fact that the Government will also absorb an equal fraction of any increment to profits which may result from the expenditures. In this respect, the tax leaves undisturbed the relationship between costs and possible returns and hence offers no profit incentive for undertaking expenditures that would have been unattractive with a lower tax rate. As between two types of expenditure which promise to return more than their cost, however, the tax may encourage firms to prefer that which can be immediately deducted from taxable income as compared with that which must be capitalized and written off over a period of years. For example, a high rate of corporate tax may induce some firms to increase research expenditures, which may be currently deducted (Internal Revenue Code, sec. 174), relative to investments in plant and equipment, which must be capitalized. Because a larger fraction of the initial outlay is covered by a reduction in current taxpayments, the currently deductible expenditure can be financed with less sacrifice of liquidity and is less likely to require the firm to raise external funds. A high tax may also encourage certain expenditures by making managers more willing to approve outlays that have litle direct relation to the firm's profit prospects and shareholders more ready to accept such behavior on the part of management.

Despite its wider acceptance, the corporation income tax is still more subject to challenge than the individual income tax. There is a large body of opinion holding that an important objective of tax reform should be the adoption of measures looking toward the elimination of the corporation income tax as an independent revenue source. Those who take this view usually recommend some plan designed to integrate corporation and individual income taxes. Most such plans. call for reduction or elimination of the corporation tax on the distributed portion of profits in order to eliminate the so-called double taxation of dividend income. It is usually conceded that a tax on retained profits would be appropriate at the corporate level. The challenge to the corporation tax is thus more fundamental than that to the individual tax, which ordinarily takes the form of suggestions for refinement of the base or modifications of the rates. In considering the future role of the corporation income tax it is necessary to give thought not merely to the base and proper rates of the tax but to the advisability of continuing the tax in its present form.

REASONS FOR RETAINING THE CORPORATE TAX

Several years ago, after an intensive study of the corporation income tax, I expressed the opinion that it was our second best tax, second only to the individual income tax in acceptability as well as in yield.2 Although the course of economic events has differed in certain important. respects from that which I then foresaw, I still believe that the corporation income tax ranks second only to the the individual income tax and I see little prospect of our being able to reduce greatly our reliance on it. Without attempting a detailed appraisal of the corporation income tax I should like to mention some of the reasons why I think that it merits an important place in the Federal revenue system.

First, it is reasonable in my opinion to treat corporations as taxable subjects, separate and distinct from their shareholders. The separate identity of corporations and their shareholders is a legal prínciple which is accepted in other economic relations and which has been embodied in the Federal income tax for half a century. For large public corporations the separate-entity principle corresponds more closely to economic reality than the alternative view that these organizations are essentially similar to partnerships. For private corporations the separate-entity doctrine is less realistic, but these corporations and their shareholders may now elect to be taxed as partnerships.

Second, in its impact on shareholders the corporation income tax is, broadly speaking, a progressive element in the revenue system. Although stock ownership is now more widely dispersed than in the past, dividend income is still more highly concentrated than any other major share of national income. On the average, dividends are a much more important source of income for families in high-income groups

Richard Goode, "The Corporation Income Tax" (New York: John Wiley & Sons, Inc., 1951), p. 217.

than for those in the low- and middle-income groups. A large fraction of total dividend income is received by those in high income groups. For example, in 1956 only 5.3 percent of individuals who filed tax returns had adjusted gross incomes of $10,000 or more. They reported three-fourths of all dividends shown on tax returns compared with one-fifth of all income. Dividends represented about 12 percent of total income of this group but only about 1 percent of income of those below $10,000. In 1956 individuals with incomes of $100,000 or more, who numbered less than one-tenth of 1 percent of all those who filed returns, received about one-fifth of all reported dividends, and about 40 percent of their income consisted of dividends. Above an adjusted gross income of about $6,000, dividends increased steadily as a percentage of income in successive income classes. Below that level, however, reported dividends, although only a small fraction of total income, were a higher percentage of income in the lowest brackets than in somewhat higher brackets. The figures probably reflect in part the existence of a sizable group of retired persons and others with low incomes but considerable stockholdings and in part temporary declines in the incomes of persons who are normally in higher brackets. The statistics must be viewed with some reserve because of the apparent prevalence of underreporting of dividends on tax returns.*

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The corporate tax adds less to the progressivity of the tax system as a whole than might be suggested by statistics on the distribution of dividends among income classes. Any additional dividends received by shareholders owing to a lower corporate tax would be subject to the progressive rates of the individual income tax. This factor greatly reduces but does not eliminate the potential progressivity of that part of the corporate tax which falls on dividends. The offsetting effect of the individual income tax is much weaker with respect to capital gains of shareholders which are associated with undistributed profits. As a progressive tax the corporate tax is much less powerful and refined that the individual income tax. In the lowest income classes the corporate tax on distributed profits may be regressive or proportional, and in higher income classes the progressivity of the corporate tax is reflected in aggregate figures which conceal wide differences between individuals in the same income bracket. The corporate tax, however, should not be judged by too strict a standard. The excise and payroll taxes, which still account for about one-fourth of total Federal receipts, are regressive and also unequal in their

3 U.S. Treasury Department, Internal Revenue Service, Statistics of Income, Individual Income Tax Returns for 1956, pp. 4, 20.

Daniel M. Holland, "Dividend Underreporting on Tax Returns," Journal of Finance, vol. XIII (May 1958), pp. 238-260. Holland's estimates for 1948, based on the audit control program for that year, indicate that dividend underreporting was greater in the two broad income classes "under $7,000" and "$7,000 to $25,000" than in higher income classes but do not offer a breakdown into narrower income classes at the bottom of the scale. It may be significant that in 1956 dividends were considerably larger relative to total income on nontaxable returns in the lowest income classes than on taxable returns. 5 This fraction relates to total receipts from the public (Budget for the Fiscal Year 1960, p. 930). Figures on budget receipts tend to minimize the fiscal importance of the excises and payroll taxes because budget receipts are shown net of transfers to the Federal old-age and survivors insurance trust fund, the railroad retirement account, and the highway trust fund.