Wednesday, July 4, 2012

Soaking the Corporations

PERSONAL INCOME TAX RATES THAT RISE TO THE level of 77 per cent obviously discourage incentives, investment, and production. But no politician raises the point for fear that he will be accused of defending the rich. What is probably an even greater discouragement to new investment and increased production is the present marginal corporation income tax of 52.8 per cent. Yet this gets even less criticism than high personal income taxes. Nobody wants to defend the corporations. They are everybody’s whipping boy. And yet they are the key productive element on which the nation’s income, wealth and economic growth depend.

There was at least some awareness of this until recent years. When the tax on corporation income was first imposed, in 1913, it was at the very cautious rate of 1 per cent. This was also raised very cautiously. Even in World War I the rate was lifted only to 12 per cent. It never got above 15 per cent until 1937. In the midst of World War II it was still only 40 per cent. It did not get to 52 per cent until 1952.

Today such a rate is taken for granted. Yet the people who approve of it, and who suggest maybe it could be a little higher, are the very people who have been complaining most loudly in recent years about the country’s disappointing rate of economic growth.

The steep rate of tax on corporate income gets so little criticism because there is confusion of thought concerning whom it falls on and what are its economic effects. Is the whole tax “absorbed” by the corporation, for instance, or is part or all of it “shifted”?

What happens is somewhat complicated. A corporation is a legal fiction. From an investment standpoint, it consists of its present stockholders. When the tax on corporations is raised above its preceding level, most of the loss falls on existing stockholders in the form of a capital loss—and later of an income loss. If, to simplify, we can imagine a situation in which a corporation were wholly free from taxation, and then suddenly a 50 per cent income tax (assumed to be permanent) were imposed on its future earnings, the price of its shares would tend to fall in the stock market by 50 per cent. The old shareholders would be forced to absorb the loss in capital value and in future income. The new buyers, however, able to buy the stock for half of its former market price, would stand to get the prevailing “normal” return on their capital investment.

Even for the new buyers, however, this would apply only to their original investment. When the corporation management considered any new investment, any corporate expansion, any addition to plant or equipment, it would have to consider the tax. And this would apply, of course, to anybody who thought of launching an entirely new corporation.

The present average tax on all corporations is about 45 per cent. On successful corporations of any size, however, the average rate is close to 52 per cent. Broadly speaking, therefore, when anybody contemplates a new corporate investment, he will not make it unless the investment promises to yield before taxes at least twice as much as the net return he would consider worthwhile. If, for example, he would not consider a new investment worthwhile unless it promised a 10 per cent average annual return on his capital outlay, then it would have to promise a return of 20 per cent on that outlay before taxes.
It is obvious that a corporation income tax in the neighborhood of 50 per cent must drastically reduce the incentive to new investment, and therefore to the consequent increase in jobs, real wages, and economic growth that the politicians are always calling for.

But what is at least as important as reducing the incentive to investment, the present corporate tax reduces the funds available for investment. In 1968, according to estimates of the Department of Commerce, United States corporations earned total profits before taxes of $91.1 billion. Out of this their corporate tax liability was $41.3 billion. This reduced their profits after taxes to $49.8 billion. Out of this sum, in turn, $23.1 billion was paid out in dividends while $26.7 billion was retained in undistributed profits.

This last figure represents the corporations’ own reinvestment of their earnings in working capital, inventories, improvements, new plants and equipment. If there had been no corporate tax, and there had been the same proportionate distribution of profits between dividends and reinvestment, the amount of money reinvested would have been $50.5 billion instead of $26.7 billion—89 per cent, or $23.8 billion, greater. A proportional increase in dividends would have given stockholders about $20 billion more than they actually received. If they reinvest only a fifth of what they receive in dividends, this would make an annual increase in corporate investment in the neighborhood of $25 billion.

Of course certain deductions would have to be made from this figure if we tried to calculate what would be lost from investment by alternate taxes imposed to raise the same revenue. But broadly speaking, the overwhelming bulk of annual government expenditure goes into current consumption rather than in building up the capital formation, the economic strength and wealth-and-income-producing capacity of the country.

A great deal of the complacency about our drastic corporation tax stems from the idea that the tax is somehow “shifted” to others. One common facile assumption is that the corporations just pass the tax along by raising their prices. How they can do this so easily is never explained.
Nor is it prima facie plausible. Every television manufacturer, for instance, must keep his prices competitive with other television manufacturers. Granted, they all pay about the same percentage tax on their net profits. Yet all of them must also keep their prices competitive with those of foreign manufacturers. The same is true of automobile companies and, in fact, of all American companies that either have an export market or must meet competition from imports.

A uniform sales or excise tax (if also imposed on imports) can be passed along uniformly, but not a percentage tax on profits after expenses, because this necessarily means a different tax rate per unit of output on every producer. Its general tendency is to penalize the low-cost efficient producer much more than the high-cost inefficient producer.

There is one reason, however, why over a long period a higher corporate income tax can be passed along in a price rise. This is because the tax may eventually put some manufacturers out of business, prevent others from expanding, and certainly retard the expansion of the rest. It will force those who stay in business to keep decrepit and obsolete machinery much longer than otherwise. It will retard or prevent reduction in costs. It will reduce supply, raise production costs, and make quality and variety poorer than they otherwise would be. The consumers of the country will be more poorly served.
The end result in this case, however, is not so much that the corporate income tax is “shifted” as that an additional burden is placed on the whole country. By discouraging and retarding investment in new machinery and plants, either by existing corporations or by the formation of new corporations, the 52.8 per cent corporation income tax shields existing obsolescent capacity from the competition of the new, more modern and efficient plant and equipment that would otherwise come into existence, or that would come into existence much sooner.

By striking directly at new investment, the present corporate income tax slows down economic growth more directly and surely than does any other tax.

The only study I can at present think of that has adequately explained the devastating effect of the high corporate income tax on investment appeared in a pamphlet by Dr. George Terborgh for the Machinery and Allied Products Institute of Washington in 1959. It left no traceable influence on Congress or the Treasury.

The tax, by hurting business and investment, hurts employment and slows down the increase in productivity and in real wages. In brief, in the long run it hurts most of all the mass of the country’s workers.

Man vs. The Welfare State

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