Senator Ron Johnson of Wisconsin announced last week that he couldn’t support the Senate tax reform bill because it failed to align the treatment of corporate income (which is taxed once when it’s recorded as profit and again when distributed to shareholders) with “passthrough” income, which is taxed only when it is reported on an individual taxpayer’s return. Rather than trying to align the total tax paid on the two forms of income through crazy schemes of allocating certain income to capital and other income to labor, Johnson’s preferred approach is to tax all business income as passthrough income.
This is a surprisingly good idea, and if you have the political will to radically reform the tax system it has a lot of advantages over the current Republican proposals. However, implementing it would require a lot of interlocking changes in order to more-or-less replicate the total taxes we levy on corporate profits today. Here’s how I would set up such a system.
Tax dividends and capital gains as ordinary income
Today taxes are paid on corporate profits once at a rate up to 35%, then again on qualified dividends and long term capital gains at a preferential rate of between 0% and 20%. That means the total tax collected on a corporation’s profits theoretically ranges from 35% to 55% depending on the precise composition of the corporation’s shareholders: if a corporation happens to have a disproportionate number of shares owned by low-income taxpayers, tax-free or tax-deferred savings vehicles, and untaxed endowments, its profits will be taxed less than a corporation with a disproportionate number of shares owned in taxable accounts by high-income taxpayers.
Since the point of Johnson’s proposal is not to privilege one business structure over another, you would want to strip out that difference by taxing all corporate distributions at ordinary income tax rates. Otherwise, profits distributed to low-income shareholders would never be taxed at all (because of the preferential 0% capital gains rate), while high-income taxpayers would see a 64% cut in the taxes they pay on corporate profits, since they would only pay taxes on profits once, at the 20% rate.
If a business’s profits ultimately belong to the business’s owners, applying the same progressive income tax rates to business income as we do to labor income makes perfect sense: low-income business owners will pay lower income tax rates on their combined labor and capital income, and high-income business owners will pay higher income tax rates on their total income, without the artificial floor created by the corporate income tax.
This also has the advantage of obviating the need to distinguish “active” and “passive” ownership, since income, rather than ownership, would become the basis for taxation.
Impose an excise tax on corporate profits distributed to foreign shareholders and endowments
Similarly, if corporate profits were distributed to foreign shareholders without being taxed at the corporate level, they would never be taxed at all, so you’d need to impose an excise tax of 30-40% on corporate profits distributed to non-US persons in order to not create a massive distortion in the ownership of US assets. Presumably our hardworking diplomats could hammer out the details in tax treaties to include reciprocal treatment of such income so foreign shareholders aren’t punished for investing in US companies, and vice versa.
A similar logic applies to untaxed foundations and endowments. Currently their income from corporate ownership is taxed when the corporation records it but not when it’s distributed to them; levying a roughly 35% excise tax on such distributions would keep such entities from shielding corporate profit from taxes indefinitely.
Lower the estate and gift tax exemption
The extremely high estate and gift tax exemptions we have today mean that assets in tax-deferred savings vehicles are only taxed once, at the corporate level, and then never taxed again as their distributions and appreciation accumulate before being transferred to heirs tax-free. If we eliminated the tax on corporate profits, then those profits would never be taxed at all. This may be reasonable for small inheritances in order to avoid the administrative hassle of filing estate tax returns, but lowering the exemption to $500,000 or $1,000,000 would ensure that as much untaxed corporate profit as possible is eventually recorded. This could be even paired with a lower rate for smaller estates which are less likely to engage in the elaborate tax planning extremely wealthy shareholders have access to, and therefore more likely to have paid taxes at some point on the corporate profits they contain.
You can imagine achieving a similar result by eliminating the stepped-up basis rule but that approach would be much more administratively complex and we’re trying to simplify, not complicate the tax code!
This is one combination of policies that would achieve the dual objectives of treating business income equally regardless of the legal structure the business uses to organize and raising roughly the same amount of revenue from capital income as we do today. I suspect that if completely implemented this combination of policies would in fact raise an enormous amount of revenue which could be used to cut the marginal tax rates paid on all forms of income (if you were so inclined).
So, hand it to Ron Johnson: he may not have any idea what he’s doing in the Senate, but the idea of equalizing corporate income taxation with passthrough income taxation makes a hell of a lot more sense than the attempts in the House and Senate to do the opposite.