A few issues with U.S. corporate tax policy

We know that the U.S. federal government collects revenue from individuals in a manner both arbitrary and opaque. Its taxation of companies is even less transparent and more distortive.

Some get handsomely subsidized for doing what they would do anyway, while others get penalized for being in an unfavored industry.

Just to make matters worse, the current system makes us more vulnerable to financial crises than we otherwise would be.

First, some perspective. This chart shows the effective federal tax rate on corporate profits since 1947:

I calculated this by combining the Corporate Profits After Tax data from the NIPA tables with the OMB’s data on the revenue collected by the corporate profit tax. The sum of these two series ought to equal total pre-tax profits (roughly), so from there it is easy to calculate the average effective tax rate. As you can see, this rate is at its lowest in over six decades. This does not jive with claims that U.S. corporate taxes are uniquely burdensome.

Yet those who claim the rate is too high have a point. While the average effective rate is quite low relative to history, the official rate of 35% is the second-highest in the industrialized world. Moreover, the low average rate masks the incredible variation in effective tax rates faced by U.S. businesses. Consider the difference between CVS, which paid more than 38% of its profits in taxes, and General Electric, which gets paid by the government to do things it already does.

Since investors care about after-tax profits more than pre-tax profits, the result is that GE has to pay less to raise equity than CVS. GE is therefore getting a subsidy partly paid by middle-class taxpayers and partly paid by companies like CVS. Hardly seems fair, does it?

These differences exist because the corporate tax code, like the individual code, is riddled with deductions carved out by special interests. The result is an implicit industrial policy that favors certain types of companies over others. The New York Times measured the average effective corporate tax rates in the U.S. for different industries to determine the winners and losers. This was what they found:

Besides having the lowest effective corporate tax rates in the United States, what else do American biotech, internet, pharmaceutical, and software companies have in common? They are among the most profitable in the world and they crush their foreign competitors.

One way to read this is that industrial policy works: throwing enough money at companies will ensure their outperformance relative to those that are not the recipients of taxpayer largesse.

The other is that this is a colossal waste of taxpayer money. Google makes great products and is clearly run by geniuses—why do they need enormous subsidies paid for by the middle class?

There is a second major problem with the U.S. corporate tax code: it increases the fragility of the financial system. For some reason, companies can deduct their interest payments to creditors from their taxable income but not their dividend payments to shareholders. The result is that it is much cheaper for a firm to raise funds by issuing debt than by issuing equity.

Why should we care?

When revenues fall, a company that is mostly financed by debt will find that it has a lot less cash available for things like paying employees because it is legally obligated to prioritize interest payments. On the other hand, a firm mostly financed by equity can ride out the storm by temporarily suspending dividend payments.

Moreover, if a company misses a debt payment it falls into bankruptcy. This immediately forces large losses on banks, pension funds, and regular savers.

Banks will try to offset the loss by contracting their balance sheets and calling in loans. That forces companies and households to come up with cash a lot sooner than they had planned. Either they have to postpone spending that was previously scheduled or they also fall into bankruptcy, unleashing a self-reinforcing chain of defaults.

Households will try to offset the loss by raising their savings rate. This reduces their spending and thus the revenues for all companies that have not yet gone bankrupt, which makes further bankruptcies more likely. This hits the people who own and work at those companies, not to mention these firms’ suppliers. The downward spiral could go on for a long time before hitting bottom.

All in all, debt seems far more dangerous than equity. Yet we encourage firms to borrow rather than issue shares. Odd, no?

Putting these pieces together, it is not clear why we tax corporations at all. They are nothing more than legal structures created for the benefit of their owners. It would be far simpler to tax the owners directly rather than the corporation. Not only would this be simpler and fairer, it would remove the distortions that benefit some firms over others while threatening financial stability. Good luck getting that through Congress.

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About Matthew C. Klein
I write about the economy and financial markets for Bloomberg View. Before that I wrote for The Economist on a fellowship provided by the Marjorie Deane Financial Journalism Foundation. I have worked at the world's largest hedge fund and read every FOMC transcript since May, 1987.

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