Winning the Tax Game: Tax Stock Returns

September 28, 2021

President Biden efforts to raise taxes on corporations and the wealthy has been getting seriously bogged down in recent weeks. More conservative Democrats have objected to the 28 percent corporate tax rate he proposed. Others seem to have nixed plans for raising the estate tax by making the capital gains held by large estates taxable. And, the Republicans working on the bipartisan infrastructure package were adamantly opposed to increasing the resources available to the I.R.S. so that it could better crack down on tax cheats.

Sometimes, when a particular game is not going well, the best way to turn things around is to change the game. Congress can still do this. The way to do this is to change the basis for the corporate income tax from profits to stock returns.

The key advantage to this switch is that profit is not a well-defined concept. The money that companies pay for things like wages or electricity are treated as expenses that are subtracted directly from income when calculating profits. However, the money they spend building a factory or setting up a new computer system is treated as an investment, which must be depreciated over a number of years.

Determining which spending falls into each category, and the number of years over which an item should be depreciated, are topics that can employ tens of thousands of accountants, tax lawyers, and lobbyists. And, this is just one of the ambiguities in calculating profit.

By contrast, stock returns are very well defined. It’s just a matter of adding up the dividends a company paid out and the amount that its stock price went up over the course of the tax year.  The I.R.S. can get this information from any number of business websites. It then just applies, say a 25 percent tax rate, and it can calculate the tax liability of every publicly traded company on a single spreadsheet. It doesn’t get much simpler than that.

There is an issue that stock prices are more volatile than profits. That one can be easily dealt with by making the basis for the tax an average of stock returns for the prior three or five years. We’re still on the same spreadsheet.

There are companies, like Tesla, that have seen extraordinary runups in stock price that are completely out of line with their profits. These companies would face a substantial increase in their tax liability even if they averaged returns over the prior three or five years.

There is a simple and obvious answer for companies that find themselves in this situation: issue more shares of stock. Of course, these companies will not want to see their stock diluted by additional shares, but that’s life. No one likes paying taxes.   

Most of our major corporations are multinational, which means their profits come in part from other countries. This is also a huge problem under the current tax code. The obvious solution is to allocate stock returns in proportion to sales. If 60 percent of their sales are in the United States, then we tax 60 percent of their stock returns. We’re still on a single spreadsheet.

There is the issue of companies that are privately held, without publicly traded shares. These companies would still have to be taxed based on their profits. But that is not a major problem for this system.

The overwhelming majority of profits are earned by publicly traded companies, so if we have a simple formula for determining their tax liability, we’ve largely solved the problem. Furthermore, we can structure the tax code to give companies an incentive to go public, for example by having a slightly lower tax rate for publicly traded companies.

For companies that are not looking to game the tax system, making stock returns the basis for the income tax should already offer a large benefit in terms of savings on accounting costs. They would not have to keep careful records to send to the I.R.S. at tax time. They just need to calculate their stock returns and send a check.

This simplicity alone should be a big enough advantage to encourage many privately traded companies to go public. Constructing the choice this way also is helpful to the I.R.S. Companies that choose to remain private when they could otherwise save compliance costs by going public are in effect telling the I.R.S. that they are looking to game the system.

The enormous savings on oversight for the I.R.S. on the corporate side should also make it much easier to police individual returns. If Republicans in Congress won’t directly give the I.R.S. additional funds for cracking down on tax cheats, the Democrats can provide the resources indirectly by making the corporate side more efficient.

In short, making stock returns the basis for the corporate income tax is a game where everyone but the tax cheats win. 


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