For Tax Reform, Form Matters More Than Substance

Or, Dog Bites Man

While the #DBCFT has been scoring all the early tax-reform headlines, skeptical Senate Republicans have quietly been working on their own major overhaul of the corporate tax system. Under the leadership of Finance Chair Orrin Hatch, they’ve been preparing a proposal for corporate “integration” — in effect, a repeal of the tax on corporate income. A key question for Senate-side efforts is whether they, like the DBCFT, will fall victim to the inability even of fairly sophisticated advocates to understand the difference between statutory and economic incidence. Opponents of integration are already lining up, and …most of the opponents don’t face any real tax hike. Hatch has said publicly he expects his proposal to be revenue neutral, and it looks as though the way it achieves this is by, basically, taking tax dollars out of taxpayers’ left pocket instead of out of their right. So, on the other pocket, we have supporters of the reform who aren’t actually saving any money. This is a weird one. Are you ready for the explanation?

Okay, now the obligatory background section. Corporate integration proposals come in two (really, eight, but let’s simplify) similar flavors — think of them as vanilla and French vanilla. In one version, corporations will receive a deduction for dividends paid. In the other, shareholders will receive a (non-refundable, probably) credit against any taxes on dividends they might owe to the extent that the dividend income was previously taxed at the corporate level. (You can check out this explainer by Graetz & Warren for more on the credit system). Either way, investors ultimately pay tax once, and only once, on corporate profits.

The draft Hatch proposal I’ve heard discussed is plain vanilla flavored, but with one important mix-in: it’s a dividends-paid deduction system, but with a withholding tax, collected by the dividends-paying firm, on shareholders who are exempt from U.S. tax. On top of that, the hot fudge sauce: a similar withholding tax for interest payments to exempt creditors. Ok, now, can you guess who hates this new proposal?

Corporate america, reportedly, could just eat up the Hatch sundae with a spoon. Under current accounting rules, the DPD would allow firms to report a lower effective tax rate for financial statements (not mention, as Ed Kleinbard has emphasized, allowing repatriation without taking a financial-accounting charge for the taxes paid, as long as the repatriated dollars are distributed as dividends). As Lily Batchelder recently has pointed out, this is unlike, say, the likely treatment of accelerated depreciation (or expensing, under a DBCFT), where firms would be unable to report their full tax savings. Batchelder argues this would diminish the supposed behavioral response to the tax. Whether that’s true of firms’ financial decisions or not, it certainly seems true of their political responses, as businesses have been quite cool to the idea of a shareholder-credit integration system. This despite the fact that we should expect that a shareholder credit would increase the value of U.S. equity by about the dividend tax rate, assuming the marginal equity investor is taxable.

It’s tax-exempt entities (and advocates for retirees with tax-exempt pensions) who prefer French vanilla. These are the shareholders who currently bear no legal responsibility to pay taxes on dividends or interest, and who would be subject to what they see as a new tax on what they apparently view now as exempt income. I put a lot of qualifiers in that sentence, and you can probably guess why: “tax exempt” dividends are not tax exempt, because the dividend income is paid out of after-tax corporate profits. If we eliminate the corporate tax and replace it with a withholding tax, exempt investors should come out about the same, depending on rates.

In defense of everyone I’ve been making fun of so far (albeit more gently than some — Kleinbard’s heading on this topic is “How Stupid Are We?”), general equilibrium here is a little tricky. A large share of U.S. equity is now held by tax-exempts. Maybe the marginal investor is tax-exempt, in which case a shareholder-credit system might not move stock prices all that much — a hollow victory for firms themselves, although a nice one for wealthy individual investors (including firm managers, presumably). For exempts, the effective rate of tax their investments now face at the corporate level might be quite low compared to any likely withholding tax rate — for instance, a university invested entirely in Apple stock might now be paying a rate of around 10%, much less than the withholding tax rate is likely to be set at.

And, of course, a withholding tax on debt payments is a bit revolutionary. It would cripple a lot of international tax planning, at least at firms that rely on inter-corporate debt, rather than rents or royalties (many multi-national firms eliminate their corporate tax in high-tax countries by making “interest” payments to related firms in low-tax countries). For U.S. exempts, many of them with large corporate debt portfolios, the tax on interest paid would be a genuine tax hike: since debt payments are deductible at the corporate debtor level, and excludible for the exempt payee, debt-funded corporate profits are taxed at a zero current rate. Arguably, again, general equilibrium is more complex, depending on who is the marginal holder of corporate debt. The apparent tax hike might simply be offset by higher interest payments (e.g., see the comments here on “financing costs”). But it is at least more understandable why exempt investors would be chary that these adjustments would really leave them harmless in the long run.

So, long story short, just as for the DBCFT, corporate integration has interests who see themselves as winners and losers. And, again just as in the DBCFT fight, economists and folks who read this blog can tell those interests they haven’t got much to lose…and they don’t believe us.

Next time: some thoughts on whether integration is a good idea, from optimal tax and charitable-sector perspectives.