Corporations don’t pay taxes, people incorporated into for-profit limited-liability organizations do by mattsteinglass
March 8, 2009, 2:32 pm
Filed under: Economics

Megan McArdle argues again that predatory lending largely didn’t happen. In making the argument she brings up this old favorite:

“But second of all, just as there is no way to tax a corporation, there is no way to default on a corporation.  Whenever you default, you are taking money from some person:  a shareholder, a creditor, an employee who loses their job when the corporation is liquidated.”

I was about to write that I’ve never understood this “there is no way to tax a corporation” argument, but that’s not true. I do understand it, and it’s wrong. The claim is that one cannot tax a corporation, one can only tax people. This is true only in the same sense in which one cannot attack an army, one can only attack people. The questions remain: which people, organized how, for what behaviors is one taxing them, and what is the goal of taxing them in this way rather than another way?

The “taxing corporations is impossible” folks argue that corporate taxes are simply passed on seamlessly to the people who stand behind the corporations, as customers, employees, or shareholders. The first claim is that to tax a corporation’s profits is to raise the prices it charges its customers. This is a pretty flimsy claim. Prices are determined by supply and demand, not by the amount of profit accruing to the seller. To the extent that profitability is a demand signal that drives corporations to increase supply and hence lower prices, taxing the profit is usually unlikely to have much effect on that demand signal, because it doesn’t change the situation in the market: if the corporation can raise profits by increasing supply, it will do so whether or not the profits are taxed, while if it can’t raise profits by increasing supply, refraining from taxing profits isn’t going to seduce it into increasing supply. For a thought experiment, consider the likelihood that a reduction in corporate taxes on oil companies would induce them to lower the price of gasoline. Of course it wouldn’t. Such a move would be a betrayal of their shareholders’ interests. Corporate taxes surely involve some deadweight loss in some situations, but the deadweight loss of corporate income tax is vastly lower than the deadweight loss of, say, sales or VAT taxes, which are charged whether or not the sale is profitable and thus eliminate some economic activity that would be profitable in the absence of taxes.

Next comes the claim that taxing corporate profits simply lowers the salaries of employees. Again, labor is a commodity; there is no reason to believe that higher corporate profits generally lead to workers being paid more than their market value, or that taxation of profits enables corporations to pay their employees less than their market value.* Ah, but if a corporation’s profits were not taxed, it could use the money to hire more employees, right? Unless I’m missing something, this is exactly wrong. If a corporation thinks it can increase profitability by hiring another employee, it will do so, and the revenue used to pay that employee will be an expense rather than profit and thus will not be taxed. To put it another way: a company has X dollars in net revenue. It can either list that revenue as profit, in which case it will be distributed as dividends and raise the share price (benefiting shareholders, usually including executives) but will be taxed. Or it can use that revenue to hire another employee or invest in new equipment, in which case it will not be taxed. The corporate income tax is an incentive for corporations to spend more on employee salary and investment in equipment, and less on distributing dividends.

The final claim, that corporate income tax is simply the same as taxing shareholder dividends, stands on firmer ground than the first two. The question is: so what? Well, goes the argument, that’s double taxation. Profits are taxed first as profits for the company, then as income for the shareholder. Yes; and? If I sell you a glass of lemonade, the state will charge a sales tax on the transaction. Then, it will charge me income tax on the profit I made by selling you the glass of lemonade. Double taxation! So what? Should we eliminate sales tax? Income tax?

The question comes down to whether there are valid reasons for charging a certain kind of tax. Why is it reasonable to charge corporations income tax separately from the taxes assessed on their shareholders? Because corporations are a legal fiction created by the government in order to enable people to act in certain potentially sociopathic but economically productive ways — notably, to incur large debts without putting their personal assets at risk. The government protects the shareholders from the full consequences of the behavior of the corporate officers they employ. In exchange, the corporation pays income tax, to defray the costs which the government and society have shouldered on its shareholders’ behalf.

If an organization doesn’t want to pay corporate income tax, it doesn’t have to. The solution is simple: don’t incorporate. If you don’t want to pay corporate income tax, operate as a partnership. You’ll give up some access to capital markets in exchange for escaping taxes amounting to, on average, 10% or so of profits. And, for that matter, because the US political system has been resolutely trying since the 1980s to eliminate any kind of personal responsibility for businesspeople of any kind, you can now make it a limited-liability partnership. You get all the benefits of limited liability, and you don’t have to give a cent back to society for it.

In other related claims, you sometimes here that the corporate income tax is a newfangled thing that liberal governments came up with in their ever expanding search for revenue. In fact, corporations have been paying income tax in the US slightly longer than individuals have. The most solid sounding charge against corporate income tax that I’ve heard is that it distorts the economy by driving capital towards businesses which can be efficiently organized as partnerships, such as real-estate partnerships. But for normal partnerships, the increased risk of not having limited liability should compensate for this effect. What would seem appropriate to me, at first glance, would be abolishing the limited-liability partnership. But that’s a pretty different place to be having a discussion than the idea that it’s “impossible to tax a corporation”.

* Add.: I may be wrong about this. I read in this OECD report that in fact higher corporate taxes are associated with lower wages. I suppose the mechanism would be that corporations expecting higher profits will be more flexible in bargaining negotiations with employees, but one would imagine this would be blunted by all of the wage setting that goes on in the non-corporate economy, which competes with corporations for workers; if corporations really tried to cut salaries due to higher profit taxes, they would presumably lose employees to unincorporated businesses. Still, empirical evidence wins the argument.


3 Comments so far
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I’m a little confused about why you seem to imply that incorporating is like a subsidy: “You get all the benefits of limited liability, and you don’t have to give a cent back to society for it.” Not that it matters really, but this seems like a weird statement.

Comment by jsalvati

I think you make a good point that its meaningful to “tax a corporation”, but you don’t really respond to McArdle’s actual arguments about why the corporate income tax is a bad idea (which she linked to: She probably should not have said that “you can’t tax a corporation” though.

Comment by jsalvati

As I said in the post, limited liability is a grant of immunity by society towards the investors in a corporation. You’re suspending the normal rules of how liability would function for the benefit of this group of people. So the shareholders of Enron weren’t personally liable for the unmet debts their company incurred to the state of California, etc. That’s a substantial private benefit granted to them by society, and if they take advantage of that benefit to make a lot of profit, they should pay those profits back to society at a higher rate than someone (like a private unincorporated business owner) who earned their money without having society shoulder some of the risk for them. In other words, private business owners risk more than corporate shareholders, so they should have to pay less.

Only a minority of the people who write about corporate income tax accept this ethical theory for why corporate income should be taxed, but that’s because most of the people who write about corporate income tax are radical pro-business folks arguing for the elimination of the tax.

Comment by mattsteinglass

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