Friday, May 07, 2010

What is the double taxation of corporate income?

Financial reform is on a lot of peoples' minds these days, but the simple truth is you can't have real financial reform without some important reforms to taxation in this country. Last week I responded to some posts suggesting that the taxation of capital gains should be eliminated. I responded with my argument that capital gains ought to be taxed at the same rate as ordinary income.

It was fun to see some of the reaction. I think James Young's head exploded. What James failed to notice was my caveat at the end of my post saying that it was necessary that we address the problem of the double taxation of corporate income. The preferential tax rate given to long term capital gains combined with the double taxation of corporate income has done more than any other single factor to distort our financial sector, wreck our economy, and foster the unequal distribution of wealth. But before I get to an explanation of the reforms I think are necessary, I need to explain the concept of double taxation.

So what is the "double taxation of corporate income"? Lots of people toss the term "double taxation" around without knowing what it means. Most of those people are simply ignorant and don't know what they are talking about. A handful know better, but are deliberately trying to distort the debate so as to win preferential treatment for those whom they are paid to represent.

The double taxation of corporate income is a term of art used by tax professionals to describe what happens when a C corporation earns income and then distributes that income to its shareholders in the form of dividends. Let's take a look at an example.

The ACME Corporation is a C corporation. Let's say that after taking all applicable deductions and credits the ACME Corporation has net taxable income of $100,000. The federal corporate income tax is 34%, so ACME owes $34,000 to the federal government. ACME cuts a check and sends it to the U.S. Treasury along with its corporate tax return. ACME now has $66,000 left.

Now let's say that ACME has two shareholders--Mrs. Smith and Mrs. Jones--and each owns 50% of the company's stock. ACME's shareholders require the corporation to distribute all of its after tax income to the shareholders. Mrs. Smith is quite wealthy and pays taxes at an effective rate of 38.6%, the top rate for individuals. Mrs. Jones is less affluent and pays income taxes at an effective rate of 28%. Congress lowered the tax on dividends to 15% for those in tax brackets above 25% and to 5% for those in brackets below 25% (as Vivian Paige kindly reminded me). Both Smith and Jones will pay 15% additional tax on their dividends; a total of $4,950 each.

Now let's add up all those taxes: $34,000 in corporate income taxes, $4,950 in personal income taxes from Smith, and $4,950 in personal incomes taxes from Jones: a total of $43,900. That means a combined effective rate of tax on the original $100,000 of nearly 44%. That's a pretty high rate of taxation, especially when you compare it to the 15% rate paid on long term capital gains. Think about it: if Smith and Jones could restructure the way they receive income so that it is in the form of a long term capital gain, they could avoid 29% in taxes.

The long term capital gains rate and the double taxation of distributed corporate earnings work together to exercise an extremely perverse and destructive effect on our economy. Together they work to discourage real productivity and the creation of real value and work to encourage speculation. Why would anyone want to own a share of stock in a corporation that earned money when nearly a half of that money will be taken in taxes and when you can speculate in stocks and only pay 15%?

Next time we'll talk a little more about stock speculation and how companies manipulate their stock prices to encourage speculation and take advantage of the long term capital gains rate.


vjp said...

Except you missed the fact that qualified dividends are also taxed at a preferential rate. In your example, both Mrs. Smith and Mrs. Jones would pay 15% on their dividends - or $4,950 each. If either of them were in a marginal tax bracket of 25% or lower, the tax paid would be 5%.

Not to say that double taxation doesn't occur - because, obviously, it does - just that the change in the law to treat dividends the same as capital gains has mitigated the effect.

J.C. Wilmore said...

You are, of course correct. I'll have to fix my math.