Friday, November 12, 2010

Corporate Income Tax

On October 28 Kevin Drum put up a post up titled Kill the Corporate Income Tax which seemed to me to be quite wrong. His main point was that it would reduce the incidence of lobbying because most lobbying is directed at corporate tax issues. This makes no sense to me, it would rather simply push lobbying toward ending regulations an or other mechanisms by which the Federal Government can direct favorable treatment toward corporations.

Beyond that, it seems to me that the corporate income tax is an eminently sensible tax which should certainly be preserved. To bring the issue into clearer focus a commenter posted links to two articles describing why the corporate income tax should be abolished. One of these articles comes from Beardsley Ruml the Chairman of the Federal Reserve Bank of New York and was printed in 1946. The other comes from William Vickery in 1996, a list of 15 fallacies in economics.

So my task now is the supremely arrogant one of explaining why I think they are wrong.

Chairman Ruml lists three reasons why the corporate income tax is a bad idea, the first of which is

1. The money which is taken from the corporation in taxes must come in one of three ways. It must come from the people, in the higher prices they pay for the things they buy; from the corporation's own employees in wages that are lower than they otherwise would be; or from the corporation's stockholders, in lower rate of return on their investment. No matter from which sources it comes, or in what proportion, this tax is harmful to production, to purchasing power, and to investment.

He further explains the problem as follows

Let us examine these three bad effects of the tax on corporation profits more closely. The first effect we observed was that the corporation income tax results in either higher prices, lower wages, reduced return on investment, or all three in combination. When the corporation income tax was first imposed it may have been believed by some that an impersonal levy could be placed on the profits of a soulless corporation, a levy which would be neither a sales tax, a tax on wages, or a double tax on the stockholder. Obviously, this is impossible in any real sense. A corporation is nothing but a method of doing business which is embodied in words inscribed on a piece of paper. The tax must be paid by one or more of the people who are parties at interest in the business, either as customer, as employee, or as stockholder.

My problem starts with the sentence “A corporation is nothing but a method of doing business which is embodied in words inscribed on a piece of paper.” It is true that a business may be organized as a corporation or it can forgo incorporation and run as a private business. But the state ob being incorporated must either add value to the business or it will leave the value unchanged or decreased. If it is the latter than any corporate income tax can only cause business to do without incorporation. However, the assumption here is that this leaves the value of the business unchanged so this imposes no cost on anyone. if, on the other hand, the state of incorporation increases the value of the business that the tax may be paid out of that increase in the value of the business.

Let us assume, for example, that a given business is operating unincorporated and generates a profit of $1 million. It then incorporates adds value to the business raising its profit to $2 million per year. Assume also that it must pay the full 35% corporate income tax which reduces its incorporated profit to $1.3 million. This is still $300,000 more that it had prior to incorporation. This kind of tax “burden” most people would be willing to endure. As far as the Chairman's options as to who has to pay for this tax, the business described above could increase the amount of dividends paid to investors by $50,000, increase wages paid to employees by $50,000 and reduce prices paid by consumers by $50,000 and still be $150,000 richer. Now, of course, it is possible to claim that all the value added by the status of incorporation should be given to the business and the failure to give this value away is forcing one of the three to “pay” the tax. But this seems to be equivalent to claiming that any time the government could provide a subsidy to some business and does not, the government is forcing the business to “pay”. This is hardly consistent with standard economics, particularly as argued by conservatives.

Consider too that the value added by incorporation does not come for free. For a number of businesses there exist some low probability events that would be extremely costly, perhaps ruinous, for investors under ordinary liability laws. Consider something like a chemical plant which could catch fire and destroy most of a town. If the owners of such a business are fully liable. then the cost of the damage done could certainly be greater than the total assets of the owners, in which case such an accident would ruin them. Under those conditions getting people to invest in such a business is very difficult and the amount of capital that can be raised to run it is limited. And where the capital invested is limited the returns on that investment are limited. Incorporation was invented to produce a state of limited liability to protect the investors against such a disaster. It functions essentially as an insurance polity against investment loss. The amount that an individual invests then is the deductable, all other costs in the event of disaster are paid for by someone else. Incorporation does not, however, eliminate the risk. The possibility of disaster remains, it just is not the investors who will pay (at least they will pay no more than the amount they invested, even if the damage done exceeds that amount to any extent whatsoever.) So if the investors are not taking the risk who does? That would be, in the example I cited, the people living near the plant whose property may be destroyed by such an accident.

If this seems abstract, consider the concrete case of an offshore oil exploration platform in the Gulf Cost. Since being incorporated the value of British Petroleum has been vastly enhanced by the fact that its investors are protected against investment loss in the event of a catastrophic accident. Being incorporated the business is able to raise far more capital than it otherwise would be able to do, and with that additional capital it can earn far more revenue. But that enhancement of the value of BP did not come from nowhere. It was made possible because the residents living around the Gulf Cost have been taking on some of the risk related to the oil exploration and extraction which is the source of BP’s revenue. Indeed, not only have they taken on some of the risk, they have recently had to pay a price in lost business, lost property, adverse health effects and the like due to the spill that took place earlier this year. In order for businesses to gain the revenue they do as a result of incorporation then other people, most of whom are not owners of the business, are taking on some of the risk, risk that involves very real costs to these people. If some of the revenue gained through this process is spent on things of value to those people on whom this risk is thrust, that is in no way a burden on the business gaining the benefit.

In short the nature of the corporate income tax is a matter of simple trade. People take on risk to enhance the revenue of a business which pays them some (but by no means all) of the additional revenue and both parties are better off. It is the opponents of the tax who are advocating a policy at odds with trade. They are calling for the government to spread risk from a business to people in the larger community solely to benefit the business and the modern conservative form of this policy is to adamantly opposed to those who take the risk gaining any benefit thereby. The transfer of the risk should be a one way street from the general population to the privileged owner of the business.

Now it is true, as argued by Ruml and Vickery, that with the corporate income tax in place the incorporated business will be able to either pay higher wages to its workers, charge lower prices or pay a higher return to investors (or some combination of the three) when compared to what that business would do in the absence of the tax. What is ignored in their argument is that it is equally true that if the tax is collected and the money spent on education, transportation, health care and the like, the sorts of things upon which the people who absorb the risks discussed above would have the have the money spent, will also result in higher wages spent paid to employees involved in these activities, higher returns paid to investors and an increase the value of the labor and capital employed by people touched by the improvements to education, transportation and the like. I am not aware of any good reason to think that the largest gains in wages, investment or prices would occur if we provide this service of sharing risk and give it away for free, nor do either of these men offer any such reason.

To summarize, the corporate income tax, in my view, is a simple matter of commerce between a general population and the practitioners of certain businesses. It is a service the population provides through the government which increases the revenue earned by the business. In return, and in complete adherence to the basic principals of market economics, the business pays the government for the service and the government spends the money on things which are needed to continue providing the service and on things which are of value to the owners of the business, which in the case of a government are the citizens of that government. This sort of trade is perfectly good and indeed is the basis of a country’s prosperity. Providing such services, or any services, for free, however, is potentially ruinous.

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