INSIGHT: The Simple Fix For Corporate Income Tax—Tax Stock Returns

August 14, 2020

Bloomberg Tax

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It is time for a major and simple overhaul of the corporate income tax system. The main problem with the current system is that it is focused on the wrong target. Instead of taxing corporate profits, we should be taxing stock returns. Before explaining how this alternative would work, it is worth going through some recent history.

Democrats in Congress were unanimous in opposing the Tax Cut and Jobs Act (TCJA) the Republicans pushed through Congress in 2017. However, there is one aspect to the tax cut that nearly all Democratic economists would favor: the idea of lowering the corporate tax rate in exchange for limiting deductions.

Prior to the 2017 tax cut, the corporate income tax rate was 35%, however few companies paid anything close to this rate. Actual tax collections were typically around 20%-22% of corporate profits. While the 35% nominal tax rate put the U.S. at the top of OECD countries, our effective tax rate was slightly below the median.

It makes little sense to have a high tax rate that is easily avoided or evaded. This simply encourages companies to spend large amounts of money gaming the system. This gaming is a complete waste from an economic perspective. We have many highly skilled people spending their time finding ways to play tax tricks rather than doing something that is economically productive. This is why almost all economists would prefer to have a lower tax rate that is actually collected.

Unfortunately, the TCJA did not deliver on this promise. While it did sharply lower the nominal tax rate, from 35% to 21%, companies are still finding it easy to avoid paying taxes. In 2019, the effective tax rate was just 13.3%. The TCJA reduced the effective corporate tax rate by roughly 40%.

Although the Trump administration probably had little interest in actually cutting down on tax avoidance and evasion, the taxation of stock returns gives us a surefire way to accomplish this trick. We simply apply whatever tax rate we are targeting to the returns that shareholders receive in a given year.

Let’s say we have a tax rate of 25%. Suppose a company’s stock has a market value of $100 billion on Jan. 1 and $105 billion on Jan. 1 of the following year, and that it pays out $3 billion in dividends over the course of the year. This means the returns to shareholders have been $8 billion over the year, which would make its tax bill $2 billion (25% of $8 billion).

This calculation is about as simple as it gets. It requires no complex accounting and leaves no room for companies to rip-off the Internal Revenue Service unless they are also ripping off their shareholders, in which case the government will have some powerful allies in collecting the taxes owed.

There will be some complications due to the fact that most major companies now operate in multiple countries. This of course, is a major problem for the current tax code as well. The logical solution is to prorate the tax rate based on sales over some prior period. If 60% of the company’s sales, on average, have been in the U.S. over the last five years then 60% of its stock returns in the current year will be subject to this stock returns tax.

There is also the issue that stock returns are erratic. This can be dealt with through averaging, where taxes are based on the last four or five years of returns. The formula remains simple and can be calculated on any spreadsheet.

There is the obvious point that basing a corporate income tax on stock returns is not feasible for privately traded companies. This is true, but it doesn’t undermine the advantages of this switch. Publicly traded companies earn the vast majority of corporate profits. If determining their tax liability can be reduced to a simple calculation based on stock returns, the IRS will free up an enormous amount of staff for monitoring privately traded companies.

This simplified treatment will also give privately traded companies a large incentive to become publicly traded. Any company that was not actively looking to rip off the IRS could save itself a substantial sum in accounting fees by becoming a publicly traded company and determining its taxes based on a simple calculation.

States can also opt to go this route of taxation based on stock returns. This will substantially reduce the burden states now face in monitoring corporate income tax collections. States would have a targeted tax rate which they can then apply to the share of sales that occurs within the state. This would both be good policy for any state choosing to go this route and an example that could be picked up by other states and the federal government.

The basic story here is that by switching the focus from corporate profits to stock returns we can both make sure that the corporate income tax is collectible and radically reduce the resources required to administer the process. This is what tax reform should be about.

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