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Corporate Tax Laws Put Obama in a Bind

5 years ago
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Much has been made of the fact that the U.S. corporate tax rate is exceptionally high -- 50 percent higher than the average rate in other industrialized countries. But not much has been said about why the U.S. collects so little of this potential revenue or about the implications of failing to do so. Recently economists have begun to focus on this trend.

More than 40 percent of all corporations had losses at some point between 1982 and 2005, reported Peter Merrill of PricewaterhouseCoopers during a recent meeting on corporate tax reform at the Tax Policy Center in Washington. And when they post losses, they don't pay corporate income tax. The Congressional Budget Office notes in its monthly budget outlook that the dramatic fall in corporate profits, combined with tax breaks designed to offset the burden of the economic recession, will drive corporate tax revenues down by more than 50 percent this year, to just $139 billion.

However, even if corporations were not chalking up losses, the federal government would still face a shrinking tax base due to changes in the organizational structure of U.S. businesses.

Like many countries, the United States subjects businesses that incorporate to two levels of taxes -- first at the corporate level, when the income is earned, and second at the individual level, when the company pays dividends to shareholders.

But the government doesn't impose corporate income taxes on partnerships, S-corporations (corporations with a small number of shareholders) and other "pass through" entities, such as regulated investment companies and real estate investment trusts. Instead, the U.S. taxes only the owners or partners on their share of taxable income that the entity has "passed through." Put simply, corporate income is subject to two levels of tax, non-corporate income is subject to just one.

Since companies can essentially choose their form of taxation, largely through relatively permissive federal and state tax laws, it's no wonder that the U.S. has one of the largest shares of income earned in non-corporate form. As the Treasury Department reported, "sixty-six percent of the U.S. businesses reporting profits of $1 million or more were not incorporated."

So, despite having the second highest corporate income tax rate in the industrialized world, the U.S. collects among the least amount of revenue from its businesses. Profitable companies have an incentive to organize in a tax-favored form, while unprofitable companies have an incentive to remain in corporate form where they may one day offset future profits with today's losses.

What do these trends imply for President Obama's tax policy?

This continued erosion of the corporate income tax base -- corporate tax revenues only make up about 12 cents of every dollar of federal tax revenue -- means that an already small tax base is becoming even smaller. And as the corporate tax base shrinks, the president will then face some very tough policy choices to meet growing spending demands. Although he has promised not to raise taxes on most individuals, the decline in tax revenue due to ongoing corporate losses and the shift to pass-through entities means that the president may have no choice but to raise taxes in other areas.

This option is sure to be highly unpopular -- and seen as a losing tax policy.

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