The pending 2007 Tax Reform Act introduced by Ways and Means Committee Chairman Charles Rangel would reduce the top corporate tax rate to 30.5 percent. This is the part of the Rangel bill that many taxpayers like. It is generally thought that U.S. corporate income tax rates are out of step with those of other developed countries and that a reduction is overdue. Of course Congress has been effecting ad hoc reductions by means of the domestic production deduction (to be repealed by the Rangel bill) and the one-time repatriation of foreign income rate reduction, plus the usual mix of depreciations and expensings. And on the shareholder end the 15 percent tax rate is near universal for dividends and gains, thus further reducing the aggregate taxation of C corporation income.

What Goes Down Affects What Goes Up

The Congressional Research Service has reminded us, however, that reduction of corporate tax rates cannot occur in a vacuum; it always interacts with the balance between the corporate and the individual rates. Back in the mid-twentieth century when the individual rate was much higher than the corporate rate, incorporations were desirable and individuals often used corporations to shield their incomes from higher rates.

In the 1986 Act the relationship flipped, with corporate rates higher than individual rates. It did not take long for that and other changes (repeal of the General Utilities doctrine being the primary one) to generate an accelerating shift to unincorporated business activity whenever possible, and S elections.

Since then the individual rate has crept over the corporate rate, but not enough to encourage much reentry into the lobster pot that is the C corporation. However, pushing the top corporate rate down to 30.5 percent would create a nine-point spread against the top individual rate.

There is some point beyond which the corporate rate cannot be lowered before it will begin again to look attractive as an alternative to the individual tax for non-public companies. Meanwhile the corporate tax will remain mostly a levy on traded companies, which now tend to be increasingly multinational businesses. And multinational companies have two features of growing importance: (1) more and more of them will be subsidiaries of foreign parents, and (2) even if they are home-grown, they will continue to be able to defer much of their foreign income in foreign subsidiaries. Both of these features tend to shrink the U.S. C corporation tax base, which tends to be limited to income earned in the United States.

Reactions to Shrinking Tax Base

Whether this trend leads to adoption of a territorial system in which the U.S. abandons its historic choice to tax the worldwide income of its taxpayers (subject to deferral in foreign corporations) remains to be seen. But if it did, that fact would add significantly to the rethinking of the entire effort to tax corporations, given the complexity and effort required for that enterprise.

All of these considerations may mean that the effort to tax C corporations on their incomes, separate from taxing their shareholders and creditors, may fall of its own weight, in our lifetimes. Of course reports of the death of the C corporation tax have been greatly exaggerated many times.

For decades economists have recommended integration of the corporate tax with the shareholder tax, and bar associations and the Treasury have written proposals. That led to a more general focus on taxing all business income once and in unified ways, as proposed in the 1991 Treasury study Taxing Business Income Once. Such proposals were overtaken by “flat tax” advocates of the 1990s who emphasized the adverse effects of income taxes as contrasted with various sorts of cash flow taxes, of which the VAT is the classic example.

2009

All of these forces will come together in 2009-2010 with the end of the 10-year rate cuts of the early Bush years, the looming fiscal needs of the country and the change of administration, and the need to deal with the AMT. Conventional wisdom has it that some sort of significant tax change will occur at that time; perhaps not a whole new tax system, but some major tinkering with the income tax.

The Rangel bill can be viewed as the real opening shot of that debate.