Crawl Across the Ocean

Wednesday, May 11, 2005

Corporate Taxes

The topic of corporate tax rates has come up a lot here lately so I thought I'd take a look at corporate taxes from a (somewhat) theoretical perspective. Specifically, I want to look at what happens to taxation as a whole when corporate tax rates are cut and think about whether we need corporate taxes at all.

Right now in Canada, the (federal) corporate tax rate is 21% (down from 28% a few years ago). So if a company made a profit of $100 million (and didn't have any previous losses stored up1) it would owe $21 million in federal taxes. Now, say the tax rate was 15% instead. That would mean a tax bill of $15 million, a savings of $6 million for the company.

What would happen to this $6 million? I see three possibilities: 1) The money could be distributed to shareholders in the form of a dividend, 2) The money could be invested/saved by the company, increasing the value of the company accordingly or 3) the money could be 'wasted' on items like massive stock option grants to senior management, travel costs for corporate meetings in the Bahamas, ego-stroking diversification/expansion plans and so on. I'm not taking the time to do serious research here, so I have no idea what the exact breakdown would be, but for reference, this paper (which is excellent and deserves a post of its own) suggests that about 20% of total corporate profits goes to dividends in Canada (if you know the exact figure, please let me know, I looked for it but couldn't find it).

Money given out in dividends would be taxed at the dividend rate which has been constructed to roughly approximate personal tax rates (that is, when you combine the corporate tax with the tax on dividends the effect is the same as if the money had just been personal income to begin with - for an idea of the theory of how this works, see here).

If we assume that the government wants to maintain this 'neutral' taxation of dividends, then a cut in the corporate tax rate would be matched by an increase in the dividend tax rate so to the extent that lower corporate taxes leads to more dividends, there would be no impact on the federal tax take or it's distribution (progressiveness). Of course if the government cut corporate tax rates and didn't increase the dividend tax rate then the tax rate for dividends would fall below taxes for personal income and the government would suffer a loss in tax revenue.

Money kept by the corporation would, on average, be recovered as a capital gain by shareholders and eventually taxed at 1/2 the personal rate of tax (since income from capital gains is taxed at a 50% of the normal personal income rate).

Money wasted on various bad ideas would go all over the place but seems likely to generally end up in the hands of management and friends.

So to sum up, there are three potential sources of lost tax revenue for the government: dividend tax rates falling below personal income rates, more money going to capital gains which are only taxed at 50% the rate of personal income (likely to be lower than the 21% charged against corporations) and money wasted which never shows up as income at all.

Given that the vast majority of shares are owned by wealthy individuals and that the wealthy would likely be the beneficiaries of most wasteful corporate spending as well, it seems clear that the change would be regressive in that the poor would see very little benefit from this reduction in taxes.


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OK, let's look at this from another angle. Consider the following from the 1997 Canadian federal budget:

"A key element of a fair tax system is that corporations should pay their fair share of tax. Some have argued that corporations should not pay taxes at all since, sooner or later, corporate income ends up in the hands of individuals and is taxed under personal income tax. This view is inaccurate and corporations should pay tax for three key reasons. First, businesses benefit from public services in many of the same ways that individuals do. Second, in the absence of tax on corporations, it would be possible for individuals to postpone tax on income or capital gains indefinitely by placing income-producing assets in a corporation and thereby having the income or gains accrue within the corporation. Corporate income tax addresses this problem by imposing a tax on profits and capital gains prior to their distribution to individuals in the form of dividends. Third, corporate taxes allow the taxation of income accruing to foreigners and ensure that foreign-based corporations operating in Canada pay tax on income earned in Canada."


Now, the first reason doesn't make a lot of sense to me. OK, businesses benefit from public services, but to the extent that they benefit, this is reflected in the gains made by the owners of the corporation. I don't see how this refutes the argument that we should just tax profits as personal income when they end up in the hands of the owners.

The second reason, avoiding an indefinite delay of taxes, makes more sense to me, although if the owners never get any profit out of the corporation, one wonders why they invest in it.

The third reason, lost government revenue from taxing foreigner's investments in Canada is valid as well, but more of a technical concern which could probably be worked around.

Personally, I have a different concern, which is that by delaying tax until shares change hands or a dividend is paid, the corporation will have more money on hand with which to exert an influence on society. Ideally, any profits a corporation makes would either be invested if deemed necessary by the shareholders (represented by management) or returned to the shareholders. But in reality, corporate profits might well be spent frivolously and, more perniciously, used to lobby the public / government to change the social/legislative framework in their favour.

In this view, corporations are a danger to society which need strong oversight in order to be kept to their beneficial role of providing goods and services efficiently without overstepping into trying to buy legislation/influence to create artificial monopolies, exclude competitors from the market, get subsidies for their operations, etc. etc.

Clearly, taxation of corporations is not a substitute for regulation and citizen vigilance in trying to keep corporations out of politics but it's something to consider when thinking about big changes to corporate taxes.

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Putting the pieces together, the logical solution, which I personally first saw recommended in David Korten's brilliant, "When Corporations Rule the World2", is to reduce the corporate tax rate to 0, but mandate automatic 100% dividends on all profits.

This would address our earlier concerns about lost tax revenue in that dividends would now be taxed exactly the same as personal income (a nice side effect of this change is the simplification of the tax code) so we don't have to worry about a discrepancy between dividend tax rates and personal tax rates. Furthermore, profits will be taxed as personal income not as capital gains which would only be taxed at half the personal rate. Finally, companies would have to make a case for needing money for investment and being able to spend it wisely to entice shareholders to reinvest their (post-tax) dividends back in the company.

Similarly, this addresses the budget's concern about people indefinitely postponing their taxes by leaving the profits in a corporation. As for foreigners, I'm sure the government could withhold an equivalent amount of taxes to foreign countries as those countries withhold on money which would go to Canadian shareholders.

Another benefit is that this change would remove the perverse incentives which are often created when corporations pursue specific strategies because they are tax-optimal rather than market-optimal. Furthermore, it would shift the balance of power from management to shareholders by leaving the decision of how much of the profit should remain with the organization in the hands of shareholders. This change would also serve to delegitimize corporate interference in our legislatures. Right now, given that they pay tax, it is logical for the corporations to feel they have a right to influence government. Taxing people instead of corporations would be a reminder of where legitimacy and power should reside. It would also act as a brake the growth of corporations where the shareholders themselves don't support that growth explicitly. Finally, the income, now taxed as personal income, would be subject to the same progressive rates of taxation as all other income.

I should note that this change would probably be much less radical in it's impact on corporate finances than you might think at first glance. For one thing it's not that different from the income trust3 model which has spread rapidly in Canada over the last few years. For another, I imagine that most shareholders would sign up with plans to have their post-tax share of the corporate income automatically re-invested in the company.

Anyway, I make no claims to have thought this through fully and there are likely any number of technical details which would be tough to work out - even if there aren't any big theoretical obstacles. I'm really just thinking out loud (so to speaktype) and inviting thoughts from anyone who may see flaws in my thinking. I ran it by a friend who's a tax accountant and we basically had a philosophical difference. He felt that the decision of whether profits should be reinvested or given out as dividends should be left in the hands of management since it was part of managing. I felt that this is an important enough decision that it, like the election of the board of directors, should be left in the hands of the shareholders directly. What do you think?



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1 The big difference between corporate taxes and personal taxes is that corporations are taxed on profit (net income) whereas people are taxed on revenue (i.e. your tax bill is unaffected by your expenses - except specific expenses which generate tax credits like tuition). So when corporations suffer net losses they can save those losses to offset against a profit made in a future year.

2 Don't let the title fool you into thinking this is just some mindless anti-corporate rant. The author lays out his extensive conservative credentials in the prologue and the book is a very fair and well reasoned look at what corporations are and the reasons why and manner in which their influence has grown in our society. It's a good read.

3 For an introduction to income trusts, see here (or here) In a nutshell, an income trust is an extra layer on top of an existing company which focusses on extracting wealth from the company and distributing it to the trust's owners (unitholders). The primary purpose is to avoid corporate taxes and just pay personal income taxes on the received income.

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4 Comments:

  • Wow, you really don't like corporations.

    A quibble: Your statement that most shares are held by wealthy individuals. In fact, the CAW article you link to plays some games. It's equating a pure majority of equities (total number of shares) with value of shares.

    For example: If I have a corporation, which employs one person, and I say there are 1 million shares outstanding, maybe I own 900,000 and another investor owns 100,000. Does this mean I'm rich? No. Does this mean I own a greater number of shares than the vast majority of Canadians? Very probably.

    Your point would be far better made by a breakdown in equity. If (for example), the value of shares in Canada is $400 billion, and $250 billion of that is owned by indivduals, then your point is correct. I have read previous studies however which show that institutional investors hold the balance (although I'm too lazy to look them up now - maybe I'll try later).

    By Blogger Ginna, at 8:08 AM  

  • I don't dislike corporations (I've happily worked for a number of them) - I just don't trust them, and I think it's very important that their influence be limited to the market and not extended into politics.

    Your quibble is perfectly valid, I looked for a better breakdown but got lazy and gave up - if you can find some clearer numbers I'd certainly be happy to update the post. Either way, I'd be shocked if share ownership isn't heavily skewed towards the wealthy, notwithstanding pension plans and rrsp's and employee stock ownership plans (all of which are good of course, I just don't think they're enough to level the stock ownership playing field significantly).

    By Blogger Declan, at 8:46 AM  

  • Aren't there a lot of unneccessary transaction/administrative costs being introduced when corporations have to mail out dividends to everyone, and then pay a big investment firm money to help them raise capital/debt?

    Also - shouldn't corporations be encouraged to make capital investments to improve productivity - and ultimately our standard of living? This would have the opposite effect.

    Thirdly, the current system allows capital gains to not be taxed while the gains are unrealized. Isn't this a reasonable incentive for people to save? This saving reduces future reliance by these individuals on the public purse.

    By Blogger dejour, at 9:15 AM  

  • Some good points dejour.

    Re: transaction costs, I think there would be no real mipact on large companies which already declare dividends and raise capital regularly. Where I see a risk is for small companies which have widely held shares. I'm optimistic that the market would develop efficient ways to manage the paperwork (automatic reinvestment of dividends being the main one) but it is a conern for sure.

    re: incentives for investment - In an ideal world, corporations would be forced into more productive investment strategies by having to justify investments to current/potential shareholders. But the more cynical viewpoint might be that corporations would just make sure to spend enough money to ensure that they don't record any paper profits.

    re: capital gains, I wasn't really proposing a change to capital gains taxation, just replacing the current flat 21% tax rate on corporate profit with personal tax instead. The change is intended to be revenue neutral.

    By Blogger Declan, at 10:56 AM  

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