Taxation of Corporate Profits

By Bob Gerecke

On March 24, 2011, the New York Times reported that General Electric paid no taxes on its $14.2 billion in profits, more than a third of which it earned here in the U.S. In fact, it received over $3 billion from the IRS.

Many other huge businesses successfully game the tax system to pay little or no taxes, although few do so as successfully as G.E. This gives the huge companies a competitive advantage over smaller businesses that have a smaller tax department to invent tax avoidance strategies or have fewer foreign operations to which they can shift their profits. It encourages the big ones to invest outside our country and discourages them from bringing their foreign profits into the US. It provides an incentive for them to issue bonds instead of dividend-paying shares of stock, because they can deduct bond interest but not stock dividends; bonds are debt, and the existence of this debt increases the risk of bankruptcy during a recession. And by enabling them to avoid taxes on real profits, it decreases the government’s ability to provide services and shifts the tax burden to the rest of us.

Meanwhile, wealthy investors – who, unlike us working people, hold their corporate shares outside of an IRA, 401K, 403B or other retirement plan – pay a lower tax rate on their profits than the rest of us do on our profits and even on our salaries, because of the myth that their profits have already been taxed at the corporate level. In addition, the wealthy can avoid tax on their profits during their lifetimes, because (unlike the middle class) they don’t need to cash out all or most of their investments to fund their retirement. They are thus able to gift or bequeath their wealth to their heirs largely tax-free. This ability to escape taxes on most of their investments further lowers their effective tax rate far below that of the middle class.

It is an outrage that income derived from wealth is taxed less than income derived from work done by the people who produce our goods and services. This also concentrates our country’s wealth, which damages our economy in two ways: it weakens the ability of consumers to spend money and thereby to create jobs, and it provides an excess of investment capital, which generates speculation leading to bubbles and crashes. It also concentrates political influence and is already destroying our democratic republic, making it instead a plutocratic republic. Finally, it undermines morality and ethics by tempting many to seek great wealth for themselves at the expense of others.

Because of these consequences of the corporate tax system, I'm increasingly convinced that it's better to eliminate the corporate tax and instead to tax wealthy shareholders progressively and promptly. Here’s a proposal to accomplish that.

First of all, the corporate tax should be abolished completely.

Secondly, capital gains and dividends should be taxed at the same rates as the earnings and retirement income of working people – employees, the self-employed and small business owners – or even at a higher rate, rather than at a lower rate as is done now.

Thirdly, in addition to taxing such investment income at an appropriate rate, our government should tax a shareholder’s profits – for those shares not held in a retirement plan -- not only when the shares are sold but also, for shares still held at the end of the tax year, by valuing them on the last day, and by requiring that the gain or loss in value be reported for tax purposes. That gain or loss in value should be calculated from the end of the prior year or from the purchase date, whichever is later.

Shares held in retirement plans (such as a pension, IRA, 401k or 403b) should be exempted from this end-of-year taxation. After all, these plans are supposed to be tax-deferred, i.e., taxed only upon withdrawal. In this way, the middle class will not have to report income until withdrawals are made and will be taxed only on the value of the withdrawal, just as is done now. They will not have to sell shares and make a withdrawal from their plan – or take money out of their budget -- in order to pay a tax bill, and the value of their shares will not be reduced by a tax debt incurred before they sell them to make a withdrawal. For them, nothing will change.

By taxing the appreciation of shares held outside of retirement plans, this system will inhibit the accumulation of great wealth tax-free by those – primarily persons with inherited wealth or very high incomes -- who have invested far more than the maximum allowed in retirement plans. Under the present system, they can completely avoid taxes on their profits. They can let all or most of their investments grow indefinitely, because they have so much income that they don’t need to cash out investments in order to cover their living expenses. They can then pass millions of dollars worth of investments directly to their heirs free of estate tax and indirectly to their heirs through various trusts.

To ensure that the upper middle class saver is not forced to sell shares to pay the tax, the allowable annual contributions to an IRA can be increased retroactively, allowing transfer of currently-held shares into the plan. The profits when these shares are kept or sold will then be tax-deferred until withdrawals are made in retirement, as if they had been originally purchased in a retirement plan. This will differentiate between the middle class and the truly wealthy.

Accumulation of wealth by the middle class will not be penalized or discouraged, but concentration of wealth in the hands of the economic elite will be more difficult, and taxation will be fairer. Both of these are ethically and socially desirable and necessary to preserve our democracy.

A corporation’s incentive to boost earnings and cash flow will remain. The incentive to game the tax system will be obsolete. Loopholes at the corporate level will cease to exist. It won't matter whether the profits are from one type of business activity or another, and whether they are made in the US or overseas. In fact, it won't even matter whether the corporation is domiciled in the US or in another country; the US shareholder will be taxed in any case on the appreciation in value of his shares – whether he sells them or not -- and on any dividends received, as long as the shares are held outside of a retirement plan.

Shares held in IRAs, 401Ks and other tax-deferred retirement plans will still defer the tax; this is what these accounts are supposed to do, whereas under the present system their shares are taxed annually at the corporate level, which is not deferred, if the corporation actually pays taxes.

This should be a progressive tax, i.e., high-income shareholders should pay a higher ordinary income tax rate on their share of the company's profits than lower-income shareholders will. This will be unlike the present corporate tax system, in which the small investor's shares are taxed at the same corporate rate as those held by the wealthy investor. Even worse, under existing tax law, capital gains and dividends from shares held by middle-class working people -- usually in a IRA or other retirement plan -- are eventually taxed at the higher ordinary income rate than those held by the upper class -- usually outside of such a plan -- which are taxed at the lower capital gains rate. Multi-billionaire investor Warren Buffett should no longer pay a lower tax rate than his middle-class secretary.

It will prevent the wealthy from escaping taxes on their profits by holding their shares until death and then passing them to their heirs tax-free. Middle-class working people can't do that, because they need to cash in their shares in order to produce income during retirement. The wealthy will no longer be able to increase their fortunes by leaps and bounds by not paying taxes on their gains. This will reduce or even reverse the growing inequality in income and wealth.

Corporations will no longer have a corporate tax incentive to issue bonds instead of dividend-paying shares, because they will no longer be in the position of being allowed a tax deduction on bond interest but not on dividends. This will in some cases reduce corporate borrowing and therefore the riskiness and volatility of stock shares. With less debt, fewer corporations will fail during recessions.

Corporations will no longer have to spend money on tax specialists or on lobbying for tax benefits, nor will they distort operations in order to avoid taxes. They will be more efficient. In addition, by not having to pay taxes, those companies which are now paying them will be more profitable and will have more cash flow to re-invest in the business or to pay dividends. Small. medium-sized and merely large businesses will no longer have the competitive disadvantage of being unable to game the tax laws the way that huge businesses like G.E. do. Those that now dutifully pay U.S. taxes will no longer be at a disadvantage to foreign corporations domiciled in countries which have little or no corporate tax. The vast majority of U.S. businesses will benefit.

So will the vast majority of Americans who invest in them, who work for them or who are dependents of those who do, because businesses which are more efficient and more successful will generate more profits and hire more employees, and because businesses which are not tax-penalized for investing and profiting in the U.S. will be more likely to do so. Companies will no longer have a tax incentive to keep their foreign profits out of our country and invest them elsewhere.

Congress can set the progressive personal tax rates on corporate share sales, appreciation and dividends, and the retroactive increase in allowable IRA contributions, to ensure that the resulting revenue increases, decreases or is neutral to the amount of revenue which the government now collects from the combination of corporate and investor income taxes. Because of the growing national debt, higher revenue is a desirable alternative, especially if it occurs at the expense of the wealthiest investors: they have been cornering the benefits of our economic and political system, they therefore can well afford to pay accordingly, and they have an obligation in fairness to do so. Even many of the wealthy agree with this and have formed a group to lobby patriotically for higher taxes on themselves.