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Understanding the Budget Debate Part 3: Business Taxes

Editor's Note: This is the third in a five-part series of articles on the federal budget. In the first one, we examined deficits and the mounting federal debt, and in the second we looked at government revenues and individual taxes. This article focuses on business taxes, particularly corporate taxes.

Corporate income taxes account for only about 9% of the tax revenues collected by the federal government as Exhibit 1 illustrates.

exhibit
      1That may seem like a small number since corporations are generally viewed as behemoths that make lots of money. Some are, of course. But there just aren't enough of them to account for a bigger share of federal tax receipts.

Given the modest role corporations play in funding the federal government, one might be tempted to dismiss the controversy over how heavily corporations should be taxed. But corporate taxes have significant consequences for our economy beyond their direct contribution to the federal budget.

They are important to job growth, for example, and to the decisions companies make about where to locate their operations and investors make about where to deploy their capital.

They impact individuals as well. Although they are paid directly by corporations, corporate income taxes are actually borne by others: their customers, who pay higher prices; their employees, who receive lower wages; and their investors, who earn lower returns on their investment portfolios.

In many ways, corporate income taxes are hidden taxes on individuals. In its final report, dated January 2012, President Obama's Jobs Council noted that, "A growing body of research also shows that in a world of mobile capital, workers bear a rising share of the burden of the corporate income tax in the form of reduced employment opportunities and lower wages."

New tax proposals by Congress and the president have the intention of lowering corporate taxes in order to make U.S. companies more competitive globally.

Tax rates vary depending upon the form of the business

There are two broad categories of business organization: (1) C corporations – which are usually referred to simply as corporations – and (2) pass-through entities, the most common forms of which are S corporations, partnerships and limited liability companies (LLCs).

A critical difference between these two categories is how they are taxed. C corporations pay taxes on earnings before they pay dividends to shareholders, and then shareholders pay taxes on the dividends.

Pass-through entities do not pay taxes themselves. The income is taxed only on the personal returns of their owners (the income is passed through).

So, if you were setting up a new business, which form would you prefer? One important consideration is the tax burden. Due to the double taxation, the maximum corporate tax on a C corporation dividend distribution would be 53.34%.

By contrast, for a pass-through entity, such as an S corporation or a partnership, the maximum rate paid by an individual would be the 39.6%, plus a 3.8% net investment income tax, for a total maximum tax rate of 43.4%.

exhibit
      2Considering the large difference in the tax burden between a C corporation and a pass-through entity, it should come as no surprise that the number of pass-through entities has been steadily growing while the number of C corporations has been flat to declining – as Exhibit 2 illustrates.

Small business & job growth

Although the number of C corporations is much smaller than pass-through entities, pass-through businesses tend to be much smaller.

A third category is sole proprietorships, which are individuals without any legal business structure. Sole proprietorships are even smaller on average, but there is a very large number of them – roughly three times the number of pass-through entities.

Government data shows that virtually all net job growth in the economy comes from small businesses, mainly pass-through entities and sole proprietorships, the profits of which are taxed on individual tax returns. This creates concern about individual tax rates and their effect on job creators.

Existing corporate tax rates make US less competitive globally

Two features of the U.S. corporate tax structure make the U.S. globally uncompetitive: (1) the rates are higher than any Organization for Economic Cooperation and Development (OECD) country and (2) the U.S. taxes U.S. multinational companies on overseas profits when those profits are brought into the U.S.

Most other OECD countries apply a territorial system, which means that profits are only taxed in the country where they are earned. The U.S. structure encourages multinational corporations to leave profits overseas and expand their operations in lower tax countries.

Under the U.S. tax law, companies are taxed on overseas earnings, but the law allows them to put off paying taxes on those offshore earnings as long as they don't bring those earnings to the U.S.

As a result, U.S. companies have been reluctant to bring those earnings into the U.S., avoiding taxes on an estimated $2.6 trillion* in offshore income.

The high tax rates have encouraged large U.S. companies to change their country of domicile to reduce their taxes. For instance, Medtronic changed its country of domicile to Ireland in 2014.

New tax proposals being considered by Congress and the president are designed to lower corporate taxes, particularly on overseas profits. The proposed new law could reduce the tax rate on overseas corporate earnings from 35% to 10%, which could encourage companies to bring their profits home.

The remittent of those funds, even if they are taxed at the lower 10% rate, would likely unleash a multibillion dollar infusion for the U.S. Treasury.

Erskine Bowles, co-chairman of President Obama's debt committee, recommended that the U.S. reduce corporate tax rates and adopt a territorial tax system to make the U.S. more globally competitive and encourage investment and job growth in the U.S.

Summary

  1. While corporations may seem large, they represent a relatively small share of U.S. gross domestic product and federal tax revenue.
  2. Taxes on C corporations are hidden taxes on individuals.
  3. Because of double taxation – once on corporate earnings and then on dividends – the combined tax rate for C corporations is higher than on pass-through businesses even though the current 15% to 20% tax rates on dividends have the appearance of being low.
  4. The number of C corporations has been flat to declining for three decades while the number of businesses formed as pass-through entities has increased significantly.
  5. The U.S. has the highest corporate tax rates among developed countries.
  6. High corporate tax rates discourage investment in the U.S. and encourage U.S. multinational companies to move out of the U.S.
  7. Many politicians on both sides of the aisle believe that the U.S. should lower corporate tax rates and adopt a territorial tax system in order to encourage investment and job growth in the U.S.

 

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