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The Cactus Tax Proposal, Part 3: Corporate Tax Rates

‘d like to give my thoughts on corporate income taxes. A favorite idea on the right is that taxes on corporations should be eliminated. The reasoning is this: because the corporation pays taxes on income when it makes a profit, and the shareholders pay taxes on that income once it is distributed to them, essentially we have double taxation. In this post, I am going to argue that tax rates on corporations should at a minimum be kept where they are, if not raised. My arguments are based on fairness and the concept of moral hazard.

Taxes are fees for services, the price we pay for a civilized society, according to Oliver Wendell Holmes. These services include access to the physical and social infrastructure of the United States, use of the legal system, and even protection from the Canadian hordes.

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All of these services cost money. Many of them exist for the benefit of corporations and nobody else. For instance, there’s a whole body of law associated with corporations alone – it doesn’t directly affect you or me in any way. And corporations have legal rights separate from their owners. As an extreme example, consider that even if you just purchased 100% of the shares of a company, hostile managers could still have you arrested for trespassing if you show up at HQ before the next shareholder meeting.

So… the corporation is not its shareholders. (Yes, there are some types of corporations that are pass-throughs, but they are treated as such by the tax code anyway.) It has separate needs, and separate rights under the law. It receives services from the government separately. It should pay for those services.

How much? Well, it receives essentially the same services from the government as a person does. Sure, there are differences around the edges. As I noted, there are areas of the law that deal only with corporations, just as there are areas of the law that deal only with people. But when it comes to the big services, the expensive ones – national defense, protection of assets, etc. – the corporations use those services as much, if not more, than the rest of us.

Which means that corporations should pay taxes the way people pay taxes. At the same rates for the same level of income.

And now to the second part of this post, to note that, if anything, shareholders are getting a bargain with this “dual layer of taxation” we keep getting told about. And yes, I own a few shares here and there. I also own a small LLC, and am in negotiations with some partners to form another one. So this is not “class envy” speaking.

What I’ve learned about corporations is simple: there’s nothing that is done inside a corporation that can’t done without corporations. Sure, there are a number of economic theories about the benefits of creating a company dating back long before Ronald Coase’s seminal paper, but there is only one benefit to creating a corporation rather than a company: its the ability to reduce one’s risks. But that reduction of one’s risks is not a true reduction – its actually exporting one’s risks onto everyone else and forcing them to share in those risks.

Think of it this way: if you engage in whatever line of business, you assume any and all liabilities for that. If you can find someone to loan you $100 million to buy mortgage backed securities on a leveraged basis, and home prices collapse, you now find yourself owing well more than $100 million. On the other hand, if you buy shares of a corporation that has found someone to loan it $100 million to buy mortgage backed securities leveraged to the hilt, your maximum possible losses equal the amount you spent on buying those shares. What happens to the extra few hundred million in losses? They don’t just go away – they are absorbed by society. Society pays for those losses.

That ability, that right to export your liabilities onto society, onto everyone else, clearly has a tremendous value to individuals, and as a result, it should have a cost associated with it. That cost should also be very, very high to reduce the moral hazard associated with such behavior.

As we saw with the Bear Stearns, to name one recent a recent example, clearly the price being paid is not high enough to prevent a moral hazard when you’re dealing with the unscrupulous and the kool-aid drinkers. After all, it turns out that corporations also have other benefit over flesh and bone human beings – if a corporation gets big enough, the government and the Fed seem to feel that the shareholders shouldn’t even risk losing the entire amount they invested in the company, much less assume the negative value associated with those investments.

Eliminating the corporate income tax would not only be unfair, given the services corporations consume, it would also make moral hazard much, much more likely and much, much more common.

Previous installments to the Cactus Tax Proposal:
Part 1: What Matters More than Anything Else
Part 2: Charities

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The Cactus Tax Proposal, Part 2: Eliminate Tax Deductions for Charity

This post is about taxes. But people find taxes to be a boring subject, so let me begin by noting a few points that at first may seem like they have nothing to do with taxes:

1. In recent weeks, there’s been no small amount of criticism toward Obama over his choice of Church, given that the minister has voiced some opinions which are offensive to many people. Similarly, McCain has sought support from and campaigned with a preacher who is well-known for having beliefs that are offensive to many people.

2. The John and Cindy McCain Foundation seems to be dedicated to a single purpose: improving the quality of McCain’s kids education and their career prospects. Similarly, folks on the right could tell you about the Clinton’s foundation.

Now Obama and McCain, and Clinton and anyone else for that matter, are welcome to associate with whoever they want. But what I find interesting is that the government is in the business of encouraging some forms of offensive behavior, or at least, offensive behavior by some people. For example, the government specifically encourages the two preachers referenced in item 1 above. How? Well, as any good conservative will tell you, if cut the marginal tax rate on an activity, you get more of it, and if you raise the marginal tax rate on an activity, you get less of it. Donations to the organizations run by either of the two preachers are tax deductible, and thus, we are being given an incentive to make those donations rather than spend the money in other ways. This is especially true if the donation also effectively entitles you to benefits that under other circumstances would have to be paid for in non-deductible ways.

Additionally, as the second case shows, many acts of charity are not truly acts of charity. If I donate money to an organization, and in exchange, they slap my name on the side of a building, and have a dinner in my honor, is it really charity? Or is such behavior merely seeking adulation, and an opportunity to attend yet another event on the social season schedule?

FWIW, here’s what I do in my spare time: I feed feral cats. That means time and expenses (food, vet bills). I’ve never so much as written any of that off. I know other people with the same hobby, and they too aren’t writing any of it off. Ditto many folks who feed homeless people.

So here’s what I can conclude about charitable donations… Much of what constitutes charity, according to the tax code, is little more than self-serving activity, whether tax avoidance schemes or methods of self-aggrandizement. Much of it constitutes encouraging behavior that is offensive to some, or even many other people. Such activities will take place whether they are encouraged or not – why should they receive the government’s imprimatur, especially since much (most?) actually charitable behavior isn’t getting that benefit?

Eliminating charitable write-offs would eliminate these problems. But they’d also do something else. As I noted in the first post in this series, for a tax scheme to work any better than the current mess, people need to believe its fair and applies to everyone. Getting rid of loopholes of any sort is one step along the way, and charity is probably one of the most “useful” loopholes for any good accountant.

And once these loopholes and write-offs are eliminated, the tax rates we all pay can lowered, benefiting just about everyone, including those who don’t have the means to game the system and those who don’t support causes other people might find offensive.

Update… Added slightly to the conclusion, then modified it marginally.

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The Cactus Tax Proposal, Part I: What Matters More than Anything Else

Since I’ve been criticized for critiquing other people’s tax proposals without putting forward my own, I figured I’d start writing some posts with my thoughts on the subject. I’m going to start, here, in this post, by laying out what I think is by far the single most important thing, the sine qua non without which a tax system can only be the dysfunctional mess we see before us today.

Now, regular readers know I’m a numbers guy, but in the end, I think the numbers – people (or corporations) making X a year should pay Y% – are just details. Sure, they’re important details, but the system doesn’t live or die based on whether tax rates are too high or too low. The top marginal rate was 91% every year of JFK administration. (And because it bears repeating, Kennedy did not cut taxes. LBJ invoked JFK’s name to get tax cuts in 1964.) If that isn’t too high, its hard to imagine what is, and yet, Kennedy paid down the debt as a percentage of GDP and oversaw comfortably faster growth in real GDP per capita than Reagan or Clinton. The recession in 1990, on the other hand, began at a time when the top marginal tax rates were at their lowest since 1931, and we all remember what happened to debt as tax rates fell between 1981 and 1990.

So if it isn’t numbers, and rates, what is it? Simple: its the perception that there is some fairness, and that the rules apply to everyone. Fairness does not mean everyone is treated exactly the same; when the ship goes down, maybe everyone fights for a spot on the lifeboat, but if there’s cellphone video of a person pushing a child, expectant mother, or a handicapped person off the raft to save himself, that person will be a pariah forever, everywhere. Even in this dog eat dog world, we still believe in “pick on someone your own size.” And as to rules applying to everyone – for the remaining spots on the lifeboat, for those that do not go automatically to the children or expectant women – we’re willing to tolerate lines, maybe a lottery, or even a free for all, but we aren’t willing to tolerate a person shooting their way on board. Again, video of such behavior would make a person a pariah upon his return… though apparently some groups do tolerate such people.

When it comes to a tax system, most people are willing to allow the poor – the equivalent of the children and expectant mothers and the handicapped people on a lifeboat – to be given a step up. Most people are incensed when they hear of situations geared specifically to benefit those with means and everyone else. A tip to folks on the right – putting a lower marginal tax on capital rather than the sweat of one’s brow also qualifies. Most people have to work for a living, and while you can talk about how such a tax scheme would benefit people who saved and scrimped their whole lives too, even those who saved and scrimped recognize that Paris Hilton benefited from this scheme from day her parents’ accountants took care of her first first tax filing.

And there is one more unfairness, perhaps the hardest one to deal with. Long ago and far away, I once dated a girl for a while whose father owned a textile company. His wife and kids were all officers of the company, even as children, apparently. On their sixteenth birthday, each of the kids got a luxury vehicle… which was a company expense, as was the gasoline, insurance, and many of their meals. Folks on the right like to pretend that this isn’t going on, but I think most people know it is pretty widespread among the class of people who can afford good accountants.

I’m not sure how to cure the problem of crazy-high business expenses and similar gaming of the system, except to say this… we need the laws to mean something. Which doesn’t necessarily mean more auditing and investigation. Perhaps it does, but that would be meaningless without a stick. In other words, what is needed is increased punishment for offenders. Significant jail time for all involved, including the enablers (i.e., attorneys, accountants, audit directors). If a person steals ten million dollars from the public coffers, treat it like you would someone stealing the same amount by holding-up liquor stores. You have to rob a lot of liquor stores to get your hands on ten million dollars. And if that goes some way toward ensuring that white collar criminals are no longer coddled relative to blue collar criminals, well, that would just strengthen the perception of fairness in the mind of most people, which is what we need for any system to actually work.

I’m not sure when I’ll post on this topic again… I have a few random thoughts and they take a while to congeal. But expect more.

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