Further reflections on corporate taxes

Kevin Milligan and I had a little back and forth a couple weeks ago about the use of privately owned corporations by the wealthy to reduce their tax liabilities (in the comments here). This provoked a few thoughts, which I was going to write up. I was inspired to move them back to the front burner today, while reading Andrew Coyne’s provocatively titled column, “If we really want to soak the rich, we should abolish the corporate income tax.” He wrote this, it would appear, after having read the recent Mowat Centre working paper, Corporate Tax Reform, by Robin Boadway and Jean-François Tremblay.

First a bit of housecleaning. Not only is the headline misleading, but Coyne mucks things up when stating their central thesis:

If you want to soak the rich, in other words, abolish the corporate income tax — and with it the tax break on dividends and capital gains. That in a nutshell is what the economists Robin Boadway and Jean-Francois Tremblay have proposed in a recent paper for the Toronto-based Mowat Centre.

This is actually not what they propose — in or out of a nutshell. In the section titled “Abolish the Corporate Tax?” this is what Boadway and Tremblay write:

This efficiency benefit would come at a substantial cost in terms of tax revenue forgone. The same efficiency gains can be achieved without sacrificing all revenues by designing the corporate tax to be a tax on rents. We would therefore rule it out as a desirable tax reform (p. 47).

If you’re willing to use the term “abolish” quite loosely, e.g. the way that Jean Chretien “abolished” the GST, then you might say that they want to “abolish” corporate taxes. But what they really want to do is replace the tax on profits with a tax on rents, or supra-normal profits. Later on in the column Coyne explains it correctly. One can think of this as a different sort of tax, but I think it’s easier just to think of it as giving a deduction to corporations for payment of the normal rate of return on capital, to be applied to both debt and equity. So in the same way that the interest the firm pays on debt is deductible, the firm would also be able to deduct a portion of the dividends it pays to shareholders, and it would only have to declare as “profit,” for tax purposes, earnings that exceed this normal rate of return. The details are complicated, but I think that instead of thinking of this as “abolishing” corporate tax, it’s actually closer to the truth to describe it as giving corporations something like the “personal deduction” that individuals enjoy. Also, it is worth noting that Boadway and Tremblay recommend that a shift to a tax on rent be accompanied by an increase in the rate of corporate tax.

Finally, Coyne slips it in a bit sideways, but a crucial part of the Boadway and Tremblay proposal is to increase the personal income tax rate on dividends and capital gains. That’s where the “soak the rich” part comes in. The argument — and it is an interesting argument — is that dividends are currently taxed at a lower rate in the hands of individuals, in order to avoid “double taxation,” once in the hands of the firm, again in the hands of the beneficiary. However, if the corporation is able to shift the tax on profits to other constituencies, then the tax paid by corporations isn’t really being paid by shareholders. So by taxing corporations less, and taxing individual investment income more, the Boadway/Tremblay policy makes it more difficult for the rich to shift their tax liabilities onto others.

I can see the argument for this. However, there always the danger of equivocation when talking about “the rich” or “inequality.” There is broad-based economic inequality, of the sort captured by a GINI coefficient, and then there is the specific problem of the very rich (whom we can refer to, for simplicity, as the 1%). While it is true that most Canadians are already able to exempt the entirety of their investment income from taxation (through home ownership, RRSPs, TFSAs), this is manifestly not the case with the 1%, who continue to use corporate ownership as a vehicle for tax avoidance.

Shortly after writing about this, I came across the following working paper, by Michael Wolfson, Mike Veall and Neil Brooks, “Piercing the Veil – Private Corporations and the Income of the Affluent.” It seems to me that before we talk about “soaking the rich,” or about the distributive effect of corporate taxes generally, the issues raised by this paper need to be addressed.

Finally, it may be just me, since I don’t talk to a lot of quantitative analysis people, but it seems me the way that Wolfson, Veall & Brooks got their data (described on p. 9, and in appendix A) is incredibly cool. I look forward to reading the additional papers based on this data set that they promise at the end.



Further reflections on corporate taxes — 2 Comments

  1. I don’t understand how whether or not the rich keep their stocks and bond trading within closely held corporations is relevant to the issue whether or not we have corporate taxes. Hear me out on this one.

    That the 1% will use corporate ownership as a vehicle for tax avoidance is abundantly clear but I don’t think this is cause for concern. If investing in other businesses (and their debt’s) benefits the economy and is a legitimate thing for a corporate business to do (something which even the most wavering believer in capitalism would agree with), then it necessarily follows that those in the 1% who use their corporate ownership to trade stocks and bonds (even if they only use a corporation for tax purposes) are also practicing a legitimate behaviour and benefiting the economy.

    Think of it this way, a 1%er wanting to grow their capital, instead of creating a complex and regularly cycled portfolio, could just as easily invest in a large diversified conglomerate like General Electric, the company, and our 1%er’s money, would grow about as fast as the overall stock market and our 1%er could plow their dividends into buying more stock (they would pay tax on the dividends, however they could just as easily buy a company like Google, which has no dividend, and the story would be the same). As long they don’t sell these stocks they won’t pay a dime in tax as we don’t tax capital accumulation until it is turned into spendable income, thus the tax’s name: capital gains.

    In effect the other 1%ers, who have private corporations set up to avoid the capital gains tax, are no different than our 1%er, except instead of using an already existing corporation as their vehicle for capital accumulation they prefer to go to the trouble, and expense (their are taxes associated with incorporation), of creating their own company, in the hopes that it can better match their risk tolerance, investment style, stock preference, ethical considerations ect.

    In effect “The General Electric Company” and “Bill’s Dodge the Capital Gains Tax Company” are no different in terms of how they relate to the wealthy investor and the Canadian Revenue Agency. The only difference is how they relates to the wealthy investor and their future. There are maybe 3 people out there for who the combination of assets known as GE represents an ideal portfolio, while a self-directed investment company would be ideal for anyone (who is requisitely wealthy). To prevent the wealthy from using corporate ownership as a vehicle for tax avoidance would be to arbitrarily create a preference for those individuals whose investment preferences match up with specific corporations (or combinations of corporations), and to create an industry for corporations whose combination of assets most closely represent an investment portfolio. The latter would definitely happen as I would be personally working round the clock to make it happen (a boy has to make his fortune somewhere).

    Now one might object and say that, in that case, instead of NOT going after 1%ers who create corporations for (relatively) tax free capital accumulation, we should simply go after them AND 1%er’s who use EXISTING corporations for tax free accumulation, however this would be a failure to recognise the difference between taxes dodged, and taxes differed.

  2. If I have $100 and I invest it in one stock that returns 10% I will have $133.10 at the end of three years. If I then cash out a pay the capital gains on stock, for simplicity’s sake lets say it’s 10%, then I would pay $3.33 on the $33.10 I made, for an after tax gain of 29.77. If however capital gains applies each year, as it would if I changed stocks every year, I would owe $1.00 on the $10.00 I made the first year, $1.10 on the $11 I made the second year and $1.21 on the $12.10 I made the third year, or $3.31 total. I would pay exactly the same amount in taxes whether the capital gains tax applied every year or just the last year.

    The only difference is that if the taxes are applied every year then they inhibit the total amount of capital that accumulates, this becomes obvious once we apply the taxes to the capital. In the second year I would make $10.90($9.81 after tax) as I would only have $109.00 at the end of the first year, and in the third year I would only make about $11.88 (about 10.69$ after tax)as I would only have $118.81 at the end of the second year. At the end of the three years I would have about $129.50, having made about $29.50 and would only have paid about $3.28, less than what the CRA would have gotten if I had kept my money in only one stock, or had done my within a corporation.

    Now admittedly the difference between the two tax revenues is only about 1.5% divided over three years. that’s .5% less revenue a year, an incredibly marginal amount. Indeed even i wouldn’t have much to complain about as CRA would actually lose More than I do (.91% over 3 years) as a percentage of their overall take. However these percentages do not represent a constant ratio and the longer it is left the more extreme they would become. After three years of one turnover a year, total lost tax revenue would be only about 1.5%, but after 50 years of multiple turnovers each year their could easily be several hundreds of percent difference between tax revenue collected each turnover and tax revenue collected once at the end.

    There is a valid objection to be raised that this description doesn’t take into account the cost of capital. 1 dollar today is worth more than a dollar a year from now as a dollar today can be used during the interceding year. Indeed in our example the cost of the capital across those three years would greatly exceed the additional revenue to be gained by leaving it with the investor, however in cases where either the investor switches assets very regularly or where the investor keeps investing for decades (what every wealthy person does) the rate of return to the taxman who leaves the money with the investor should exceed the costs of capital. The stock market averages about 7% and the lowest rate of interest the CRA charges on taxes not paid is 5%, so it’s not unreasonable to conclude that over long periods of time or many asset turnovers this would be the case. Additionally if taken as a policy it could argued that the cost of capital would actually be closer to 3% or 4%, as almost every wealthy Canadian would be represented in this investor class and the risk associated with tax revenue left out, like the risk associated with insurance sold, would decrease the more participants there are.

    Assuming the numbers work out I can’t see many valid objections to just letting the wealthy keep their assets in corporations (or better yet setting up an equivalent investment vehicle: an unlimited rrsp/tax free savings account with income tax applicable before investment, and capital gains applicable at withdrawal) from a revenue perspective. Obviously this would great alter the regularity with which taxes on capital are added to the public coffers, but once the new equilibrium is established there shouldn’t be any real difference year over year, presumably averaged over everyone, people withdrawal their funds and die (all capital gains are payable at death) pretty consistently every year.

    The only objection I can see is from a concern for equality, as this policy would enable the wealthy (and everyone else) to accumulate capital like never before. This clearly presents the dichotomy between efficiency and equality, either we can be more equal or we can all grow wealthier together ( through increased growth in the overall economy and more tax revenue for transfer programs).