A Tax System That Promotes Prosperity

When you don’t ask the right questions, your chances of reaching the right answers are not very good. That is why this year’s showdown over tax rates is going to leave businesses burdened with counterproductive taxes, no matter who wins in November.

The only thing we are really debating is how heavy that counterproductive burden will be. This is unfortunate. A more intelligently designed tax system could help build the more productive, forward-looking economy that both parties, and most voters, say they want.

Democrats argue that we must protect “the middle class” from the threat of tax increases, but should allow rates to rise for “the rich.” Republicans counter that, among the Democrats’ “rich” are small business owners, who would have to cut payrolls if their tax rates went up. But, not to be so easily defeated in the war of semantics, Democrats raise the point that the category Republicans refer to as “small businesses” actually includes many big businesses as well.

This discussion may be politically useful, but it is economically meaningless. Taxes are ultimately borne by human beings, not by some magical entity called “business.” Businesses, large and small, are just the way we organize commercial activity.

Right now, our tax system claims a large share of profits that might otherwise be reinvested in businesses, which slows economic growth and hurts employment. Our system places an especially large burden on the profits of publicly traded corporations. It is as though we want to discourage companies from tapping into the public’s savings to foster more growth, or to discourage the public from investing in large enterprises. Neither makes any sense.

If we were truly trying to develop a more rational tax system, we would overhaul the way all business profits – and possibly all income – are taxed. We would tax consumption and leave income alone. Or we would tax only spendable income, such as wages, dividends and other profit distributions, and leave reinvested gains (whether from business profits or personal capital gains) untaxed. In either case, the idea would be to grow the country’s supply of wealth and limit its consumption of that wealth.

When most people think of “big business,” they are thinking of publicly traded corporations, which are owned by shareholders. Corporations are subject to the corporate income tax, which currently has a top rate of 35 percent.

If profits are reinvested in a corporation, the only tax that has to be paid is the corporate income tax. However, if the profits are distributed to shareholders, in the form of dividends, they are taxed again. Before 2003, dividends were taxed in the same way as any other “ordinary” income received by individuals. Since then, however, dividends have been taxed at the lower rate for capital gains. This has substantially decreased the total percentage of profits that go toward taxes.

Suppose a corporation earned $100, either in 2000 or in 2003, and wanted to distribute the money to shareholders. In 2000, the corporation would first pay 35 percent for the corporate income tax, bringing the amount left for dividends to $65. Then the shareholders that received the dividends would have to pay personal income tax, at a maximum rate of around 40 percent. If all the shareholders were in the top income bracket, they would pay a combined total of $26 in taxes on the $65 in dividends. Of the original $100, $61 would have gone to the federal government, before even considering state and local taxes.

In 2003, the corporation would still have to start out by paying the corporate income tax, which remained at 35 percent. But then, instead of paying the ordinary income tax rates, the shareholders would only have to pay the capital gains rate. That year, the maximum capital gains rate was lowered to 15 percent. In the end, $44.75 of the original $100 would go to the federal government.

When Republicans talk about the “small businesses” that would be harmed by higher personal income tax rates, they are not referring to ordinary corporations, like those discussed above, but to non-public companies known as pass-through entities. These include partnerships, S Corporations, and limited liability companies (LLCs).

Pass-through entities are not subject to the corporate income tax. Instead, their owners report the companies’ income on their personal tax returns and pay the applicable personal income tax rates. This is why taxes aimed at “the rich” also affect these types of businesses. (Not all privately held corporations are pass-through entities, so some do pay corporate income tax, but these days the tax is paid primarily by publicly traded businesses.)

Suppose Palisades Hudson Financial Group, which is an LLC, earns $100. The owner, in this case me, reports the income. I pay $35 in federal income tax (at the current top individual rate). Since I have already reported the income, there is no further tax, whether I decide to reinvest the money in the business or take a distribution. I can use the profits to put down a security deposit for a new office in another city, or I can withdraw the money to buy a new flat screen TV for myself. Either way, the total federal income tax I pay is 35 percent.

Even though shareholders in corporations can now pay the lower capital gains tax rate on dividends, the total federal income tax that must be paid to get profits to business owners is lower for non-public pass-through companies than for corporations. This explains, in part, why some large but non-publicly-traded companies are organized as pass-through entities rather than public corporations. Several high-profile companies, including Bechtel Group Inc., Kohlberg Kravis Roberts & Co. and PricewaterhouseCoopers, fall into this category. These companies’ partners and shareholders would benefit from lower personal tax rates, just as a husband and wife running their own clothing store would.

Pointing to these large pass-through entities, Democrats argue that Republicans’ appeals on behalf of small businesses are nothing but a ruse. Republicans, meanwhile, claim that those big-name companies are just a few extreme examples, and that, for the most part, the businesses that would suffer from higher personal income tax rates are small ones. “The bottom line is that Washington Democrats’ tax hike would hit 750,000 small businesses across the U.S.,” Michael Steel, a spokesman for House Republican leader John Boehner, told The Wall Street Journal.

But economic progress depends on encouraging businesses of all sizes to grow.

Publicly traded companies are the backbone of the financial markets, one of this country’s greatest economic strengths. The markets allow businesses to raise capital efficiently and make it possible for individuals, pension funds and investment firms to freely and cheaply buy and sell stakes in companies. This easy flow of money is what propels an economy forward. However, the double taxation that comes with going public, along with considerable regulatory overhead, discourages companies from taking advantage of this opportunity to grow.

It is not hard to imagine a system of taxation that would prompt businesses to reinvest their money: Stop taking away the money companies want to reinvest. For public corporations, this would mean eliminating the corporate income tax and collecting tax only on dividends paid to shareholders. For pass-through companies, it would mean taxing business profits at the point when an owner withdraws them, rather than at the point when they are earned.

An alternative approach would be to drop the income tax altogether and switch to a consumption-based value-added tax. Either way, businesses would have more money to buy new equipment and hire new employees. They would be better able to compete with foreign rivals, many of which are located in countries where corporate income taxes are very low or nonexistent. And it wouldn’t matter nearly so much which businesses were considered “small” and which were considered “big,” or whether the owners of the small businesses were also “the rich.”

The problem is that if government revenue doesn’t come from the big bad corporations, it has to come from human beings: those creatures that think about these things and vote, and who can pick up the phone to complain to someone when they feel overtaxed. It’s much easier for politicians to pretend that, when they get money from “corporations” and “big business,” human beings aren’t involved.

As the debate over taxes continues, we’re likely to hear a lot more rhetoric, but not much in the way of substantive ideas to make our tax system promote prosperity rather than impede it.

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