My friend Jared Bernstein had a piece in the NYT warning against plans to eliminate the corporate income tax. He argues that the corporate income is paid primarily by owners of capital, who in turn are primarily wealthy people. Therefore, if we eliminate the corporate income tax we will be giving a big tax break to the wealthy.
This is largely true. Eliminating the corporate income tax without some major increases in the personal tax rates for high income people would be a big gift to the wealthy. And as much as we would all like to help our favorite billionaires, they are probably not the ones most in need of a hand at the moment.
But the story on elimination may be a bit brighter than Jared implies. First, it is important to remember that not all of the corporate income tax comes out of corporate profits. Due to feedback effects (less investment), some portion will come out of wages. The model used by the Tax Policy Center of the Urban Institute and Brookings Institution put the split at 80 percent profits and 20 percent wages. This means that if we lose $100 billion in corporate income taxes we are effectively losing $80 billion in revenue from rich people.
But even this is somewhat of an overstatement. If companies had $80 billion in additional after-tax profits, then they would pay roughly half of this out in dividends, or $40 billion. If we assume for simplicity that all of this is paid to high end individuals, then we will tax back 20 percent of this amount or $8 billion. (Dividends are taxed at roughly half of the rate of normal income. This would presumably change if we eliminated the corporate income tax.) This means the net loss of revenue from rich people is $72 billion.
Now let's consider the tax evasion industry that is created by the corporate income tax. The corporate income tax use to raise close to 4.0 percent of GDP. In recent years it has been less than 2.0 percent even though corporate profits are at a record high as a share of income. Part of the drop is explained by a drop in the top tax rate from 50 percent to 35 percent. However most of this decline is explained by more effective forms of tax avoidance or evasion. (Avoidance is legal.)
The question is, how much will a company pay to avoid paying $100 in income taxes? The answer is up to $99.99. There are a lot of companies that are paying lots of money to avoid paying corporate income taxes. It is likely that a very substantial portion of that lost 2.0 percentage points of GDP in corporate income taxes ($350 billion a year in today's economy) is instead being paid to the income tax avoidance industry (a.k.a. the financial sector).
To take one important example, much of the bread and butter of the private equity industry is bringing creative tax schemes to smaller businesses that lacked the expertise to do it themselves. To personalize this some, think of Mitt Romney. Much of the story of his wealth was the corporate income tax. By devising clever schemes that allowed businesses his firm took over to escape the tax, he was able to resell these businesses at an enormous profit. In this way, the corporate income tax is not just a way of taking money from rich people, it is also a way to give money to rich people by creating enormous profit opportunities in altogether unproductive areas of the economy.
And Mitt Romney's wealth has direct ramifications for the rest of us. Suppose Mitt Romney spends a big chunk of his wealth building a big new house. In the context of a depressed economy, any spending is good for growth and jobs, so his consumption is a net plus just like anyone else's consumption. However as we start to get to the point where the inflation hawks are bringing enough pressure to bear on the Fed to force it to raise interest rates and slow the economy, Romney's construction project will effectively be crowding out other spending. The Fed will be raising rates sooner than it otherwise would have because of the riches Romney accumulated from designing ways to avoid the corporate income tax.
If we assume that roughly half of the drop in corporate income tax is now income for the tax avoidance industry, then this means that we are giving them 1.0 percent of GDP to raise 1.15 percent of GDP (0.72*1.6 percent of GDP raised in corporate income taxes) in taxes from rich people.
In this fuller context, the corporate income tax is a much more questionable proposition. It seems very plausible that we could design a system that will raise as much money from the rich with an increase in personal tax rates, while at the same time destroying the tax avoidance industry.