Capitalism and Western Civilization: Taxation

William H. Young

The Tax Reform Act of 1986 reduced the tax rate on corporate earnings (profits) from 50 percent to 35 percent and the highest tax rate on individual incomes from 50 percent to 28 percent. The tax rate on long-term capital gains was increased to 28 percent. Along with the lower statutory rates, tax loopholes were reduced to make the Act revenue neutral. Ensuing unforeseen consequences and other changes have made further tax reform imperative

Other nations of the Organization for Economic Cooperation and Development (OECD) have reduced their corporate tax rates until, in 2012, the U. S. corporate tax rate became the highest in the industrialized world. (Scott A. Hodge, “The Countdown is Over. We’re #1,” Tax Foundation, April 1, 2012) Many loopholes have returned to the U. S. corporate tax code, especially for politically influential companies, and to the individual tax code. The lower tax rate on individual income versus corporate earnings led to a massive shift after 1986 in how businesses, mostly small, are organized for tax purposes. The highest tax rate on individual incomes has since increased to 35 percent; the rate on capital gains has returned to 15 percent. Both political parties propose to change all of those tax rates, but in different ways.  Let’s examine some details, beginning with our crony capitalist discussed last week:

General Electric…had a very good year in 2010. The company reported worldwide profits of $14.2 billion, and said $5.1 billion of the total came from its operations in the United States. Its American tax bill? None. In fact, General Electric claimed a tax benefit of $3.2 billion….Its extraordinary success is based on an aggressive strategy that mixes fierce lobbying for tax breaks and innovative accounting that enables it to concentrate its profits offshore.…While General Electric is one of the most skilled at reducing its tax burden, may other companies have become better at this as well….increasingly using a maze of shelters, tax credits and subsidies to pay far less.

(David Kocieniewski, “G.E.’s Strategies Let It Avoid Taxes Altogether,” The New York Times, March 24, 2011)

“Only 25 percent of the largest American corporations pay anywhere close to the statutory corporate tax rate…while 40 percent pay half that rate.” (Bruce Bartlett, “Cutting the Corporate Tax Rate Is No Economic Panacea,” The New York Times, December 20, 2011) The editors of The Wall Street Journal observed (“Review & Outlook,” August 15, 2008) that:

America now has the worst of all worlds: high corporate tax rates, but also lots of loopholes passed by Congress at the behest of favored businesses to avoid the confiscatory rate. This imposes huge compliance costs as businesses scramble to exploit the loopholes, with the result of less revenue for the government. The average European nation has tax rates on corporate income 10 percentage points lower than the U. S., but those countries on average raise 50 percent more as a share of GDP in corporate taxes than does the U. S., according to a 2007 study by the Treasury Department.

A study by the OECD (Taxes and Economic Growth, July 11, 2008) examined national tax burdens and their impact on growth and incomes in member countries. It concluded that “corporate taxes are…most harmful for growth, followed by personal income taxes, and then consumption taxes.” “Cutting the corporate tax rate would be positive for investment, productivity and economic growth. It would also reduce a tax burden now borne in large part…by labor, bolstering wages.” (Glenn Hubbard, “The Corporate Tax Myth,” The Wall Street Journal, July 26, 2007)

The Business Roundtable (Taking Action for America: A CEO Plan for Jobs and Economic Growth, 2012) recommends that the corporate tax rate be reduced to 25 percent along with loophole closure and a territorial system like that of most other industrialized nations, which exempts offshore earnings from taxation. Republicans suggest a similar tax reform. (The Path to Prosperity: A Blueprint for American Renewal, Fiscal Year 2013 Budget Resolution) President Obama plans to reduce the corporate tax rate to 28 percent while establishing a minimum tax on multinational corporations’ foreign earnings. (Jackie Calmes and John H. Cushman Jr., “Obama Unveils Proposal to Cut Corporate Tax Rate,” The New York Times, February 22, 2012) He also proposes to return the capital gains tax rate to 28 percent.

In the Democratic presidential debate on April 16, 2008, ABC News moderator Charlie Gibson asked Senator Obama about the effects of his proposal to increase the tax rate on capital gains from 15 percent to 28 percent:

In each instance, when the rate dropped, revenues from the tax increased; the government took in more money. And in the 1980s, when the tax was increased to 28 percent, the revenues went down. So why raise it at all, especially given the fact that 100 million people in this country own stock and would be affected?

Mr. Obama replied:

Well, Charlie, what I’ve said is that I would look at raising the capital gains tax for purposes of fairness….Those who are able to work the stock market and amass huge fortunes on capital gains are paying a lower rate than their secretaries. That’s not fair.

(Gerald Prante, “Obama and Gibson Capital Gains Tax Exchange,” Tax Foundation, April 17, 2008)  Ironically, President Obama would later enlist that supreme capitalist, Warren Buffet, to make his point.

When the Tax Reform Act of 1986 was passed, note Phil Gramm and Steve McMillin of U. S. Policy Metrics, “half of all businesses in America were organized as C-Corporations and taxed as corporations. By 2007, only 21 percent of businesses in America were taxed as corporations and 79 per cent were organized as pass-through entities, with four million S-Corporations and three million partnerships, filing taxes as individuals….A significant amount of what is now declared as individual income is actually earnings from businesses that are now taxed as individuals.” (“Gramm and McMillin: The Real Causes of Income Inequality,” The Wall Street Journal, April 6, 2012)

Some large business entities, including private-equity firms such as Blackstone Group and Kohlberg Kravis Roberts, have become pass-through S-Corporations. (John D. McKinnon, “More Firms Enjoy Tax-Free Status,” The Wall Street Journal, January 10, 2012) Along with hedge funds, private-equity firms enjoy the special “carried interest” provision of the individual tax code. Carried interest—taxed at the capital-gains rate of 15 percent—is a share of the profits of an investment fund that is paid to the investment manager in excess of the amount that the manager contributed. The Senate has thwarted attempts to tax carried interest at the ordinary-income rate applied to performance fees paid to other corporate managers. (David Tuerck, “Should Carried Interest Be Taxed as Ordinary Income, Not as Capital Gains?” The Wall Street Journal, May 14, 2012)

“A least 75 percent of small businesses file taxes on business income at the individual rate and reinvest those earnings to grow the business and hire workers.” (Dan Danner, “Statement on White House Deficit Plan,” National Federation of Independent Businesses, September 19, 2011) For most entrepreneurs, the individual tax rate, not the corporate rate, affects their job creation. Increasing taxes on individuals with income above $200,000, who also run small businesses, takes away earnings available for investment to produce jobs and economic growth. Reform to lower the highest individual tax rate, while reducing individual tax preferences and closing loopholes, best supports growth and jobs.

The kind of college education sought by NAS would include the study of economics and provide some perspective on the effects of tax policy on business and the economy.

Next week’s article will discuss compensation of corporate executives and others.

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This is one of a series of occasional articles applying the lessons of Western civilization to contemporary issues relevant to the academy.

The Honorable William H. Young was appointed by President George H. W. Bush to be Assistant Secretary for Nuclear Energy and served in that position from November 1989 to January 1993. He is the author of Ordering America: Fulfilling the Ideals of Western Civilization (2010) and Centering America: Resurrecting the Local Progressive Ideal (2002).

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