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Tax Stock Returns: If Biden Really Wants to Close Corporate Income Tax Loopholes

Photograph by Nathaniel St. Clair

President Biden has indicated that he wants to raise much of the money to cover the cost of his infrastructure program by raising the corporate income tax. The amount of money raised through the corporate income tax plummeted following the Trump tax cut in 2017. In non-recession years it had been averaging close to 2.0 percent of GDP. It had plummeted to just 1.0 percent of GDP in 2018 and 1.1 percent of GDP in 20019.

If we could get the corporate income tax back to 2.0 percent of GDP, it would add over $200 billion a year to government revenue. Over the ten-year budget planning horizon, this would add more than the projected $2.3 trillion projected cost of President Biden’s infrastructure program. This would be real money.

There are two issues with the corporate income tax, the nominal tax rate and the portion of the targeted tax that is actually collected. Corporations never pay taxes at a rate that is close to the nominal rate. Prior to the Trump tax cut, the nominal tax rate was 35 percent. Actual tax collections were around 21 percent of corporate profits, on average.

Both fell further after the Trump tax cut in 2017. The tax cut lowered the nominal rate to 21 percent. Part of the rationale for this tax cut was that it was supposed to eliminate many of the loopholes that had previously created the large gap between the nominal tax rate and the actual rate, so that we would actually be collecting close to the 21 percent nominal rate.

That didn’t happen, the effective tax rate on corporate profits averaged less 13.0 percent in 2018 and 2019. We lowered the tax rate and left in the loopholes.

Part of this story is that a substantial share of corporate profits is actually earned abroad, for example on sales by subsidiaries in Germany, to German companies or individuals. These profits are generally subject to taxes by other countries and therefore we would not expect to see substantial U.S. tax revenue raised on these foreign profits.

But that is a small part of the story of the gap between the nominal tax rate and the effective tax rate. Corporations use a wide variety of loopholes to avoid paying taxes on their profits. Tax gaming can be a very lucrative line of work for lawyers and accountants. Changing the tax code in a way that actually does eliminate opportunities for avoidance and evasion would both raise more revenue and reduce the amount of resources being wasted in legal fees and accounting.

A Simple Alternative – Taxing Stock Returns

Taxing stock returns is better than taxing corporate profits for the simple reason that it is completely transparent. Stock returns are the rise in the value of a company’s stock, plus whatever it paid out in dividends over the course of a year. It requires no complex calculations of depreciation or other issues, it can be calculated with a normal spreadsheet.

To take a simple example, if a company’s stock is worth $10 billion at the start of the year and $10.5 billion at the end of the year, then it would be taxed on this $500 million increase in the value of its shares. If it paid out $300 million in dividends, then it would also be taxed on this $300 million, for total stock returns of $800 million. If we apply a 25 percent corporate tax rate, then the company owes $200 million in taxes. All of the information needed for this calculation is fully public and could be calculated in seconds.

There is the small complication that most of our major companies are now multinationals, which means that they earn profits in more than one country. This does not need to be major complication, we can simply allocate returns according to sales.

If 60 percent of their sales are in the United States, then they will be taxed based on 60 percent of their stock returns. This means that actually having large sales in Germany, Japan, and other major markets will lower their U.S. tax liability. Having a post office box in the Cayman Islands, or in other tax havens, will not do them any good.

In addition to being simple, having stock returns as the basis for the corporate income tax also means that companies can’t cheat the I.R.S. unless they also cheat their shareholders. The I.R.S. gets 25 percent of whatever their shareholders got: full stop.

There will still be a problem with private companies, with no publicly traded shares. These companies will still have to be taxed based on their profits. However, the vast majority of profits are earned by publicly traded companies, so this switch to having stock returns as the basis for the corporate income tax will deal with the vast majority of potential tax avoidance/evasion.

Also, by making the tax collection from publicly traded companies a simple spreadsheet calculation, this switch would free up I.R.S. resources to more carefully monitor privately traded companies. It would also be reasonable to structure the tax code so as to have a modest penalty on privately traded companies, to give them incentive to go public.

Furthermore, the route of having stock returns as the basis for their corporate income tax should actually be a desirable switch for private companies that are not actively engaged in tax avoidance or evasion. Most companies have substantial fees associated with hiring tax lawyers and accountants. A simple tax structure, with no loopholes, will save them these fees. That should be an additional reason for private companies to go public, and also make the decision not to go public a huge warning flag for the I.R.S.

The Purpose of Taxing: Reducing Demand in the Economy

As our Modern Monetary Theory friends remind us, the purpose of taxes for a country that prints its own currency is to reduce demand in the economy, thereby preventing inflation. Corporate income taxes have this effect indirectly, by reducing the money going to shareholders. If shareholders have less income, they will consume less.[1] This frees up resources for spending in other areas, like President Biden’s investment and recovery package. (There is a small impact of taxes on investment, but we need not spend much time worrying about this.)

The switch from having corporate profits to stock returns as a basis for the corporate income tax will also reduce demand by reducing the need for accountants, lawyers, and others engaged in the tax avoidance/evasion industry. This secondary effect will likely free up tens of billions annually, that would be otherwise spent complying with, avoiding, and enforcing the tax code. These savings may be in the range of 5-10 percent of the money raised through the corporate income tax. Also, since there are big payoffs in the tax avoidance/evasion industry, this switch will eliminate one important source of inequality in the economy.[2]

Let’s Make Tax Reform Real

If the Biden administration wants to do a serious overhaul of the tax code, to both raise more money and make it fairer, it is difficult to imagine a better way to go than switching the basis for the corporate income tax from profits to stock returns. It will be a huge step towards simplicity and transparency. This is exactly what we should want in our tax code.

Note.

[1] There also is a wealth effect. Higher corporate taxes lead to lower stock prices, other things equal. Insofar as stockholders spend out of their wealth, a reduction in stock prices should mean they consume less.

[2] Michael Moore’s movie, Capitalism: A Love Story, featured a fascinating segment on “dead peasant insurance policies.” These are life insurance policies that large companies like Walmart take out on their front-line workers, like cashiers. Generally, the workers never know about the policies. The company, not the worker’s family collects when a worker dies. Moore pointed to these policies as an example of the perversity of American capitalism. But, apart from their morbid nature, the real story of dead peasant policies is that someone undoubtedly got very rich from this scheme for smoothing corporate profits and tax liability. There would be many fewer opportunities for great fortunes with a tax system based on stock returns.

Dean Baker is the senior economist at the Center for Economic and Policy Research in Washington, DC. 

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