Why do we tax corporate profits?

There is a periodically-fashionable argument in the United States that a key obstacle to economic growth is the “double-taxation” of corporate earnings: once at the corporate level, and a second time when profits are distributed to shareholders and (eventually) reported on their individual income tax returns.

This argument is typically made by people who, for ideological or self-interested reasons, want to eliminate either one tax or the other: either tax corporate profits but not dividends and capital gains, or tax dividends and capital gains but not corporate profits.

In fact, this so-called “double” taxation is a very sensible answer to a very particular problem.

The corporate tax rate is relatively flat

Many people use as a shorthand for corporate profit taxation the maximum corporate profit tax of 35%. This is not strictly speaking true since like the personal tax code the corporate income tax is somewhat progressive. However, for large corporations it’s true that profits are taxed, in general, at a marginal rate of 35%.

The federal income tax is relatively progressive

Unlike the relatively flat corporate tax rate, the federal income tax on qualified dividends and long-term capital gains is quite progressive. No federal income tax at all is owed on such income for taxpayers in the 10% and 15% federal income tax brackets, and the federal income tax tops out at 20% for taxpayers in the top income tax bracket (there is an additional Medicare surcharge I’m ignoring for simplicity’s sake).

Many corporate distributions are untaxed

While relatively few low-income taxpayers receive any qualified dividends or long-term capital gains, there’s another class of entities that receives a vast quantity of dividends and capital gains: untaxed endowments and foundations.

Harvard University’s $35 billion endowment pays no taxes whatsoever on any dividends it receives from its extensive portfolio or on any capital gains it realizes on its investments.

However, its investment portfolio is still taxed: what critics call “double” taxation of both corporate profits and capital gains in fact results in the only form of taxation Harvard’s endowment is ever subject to!

Corporate profits are taxed twice, but differently

In reality, we have two taxes sitting on top of each other: a relatively flat corporate income tax on profits as they are realized and before they are distributed to shareholders, and a relatively progressive personal income tax that is applied only to distributions and capital gains realized in taxable accounts, and completely untaxed for the endowments and foundations that hold a great many shares.

Today’s tax on corporate profits has a floor of 35% (for distributions to untaxed shareholders) and a ceiling of 59.6% (for distributions to high-income shareholders in taxable accounts). Referring to that as “double” taxation misses the point: it’s a relatively progressive taxation scheme, based primarily on ability to pay.

A world with only a corporate income tax would be a world with a flat tax on corporate profits, without respect to ability to pay: low-income shareholders would pay the same tax rate as wealthy shareholders.

A world with taxes levied only on profits distributed to shareholders would be one where corporate profits distributed to tax-exempt shareholders and to those with shares held in tax-advantaged accounts avoided taxes completely.

Instead, we levy one tax on corporations based on the profits they choose to distribute to shareholders, and a second tax is levied on shareholders based on their ability to pay.

This system may not be (in fact, is certainly not) ideal, but it is a concrete solution to a real problem: with many shares held in different structures, including tax-exempt, tax-advantaged, and overseas accounts, profits are taxed in multiple different places to ensure they are, in fact, taxed at all.