The Integration and Dis-integration of the Corporate Tax Regime
INTRODUCTION
One of the first items of business on every new administration’s list of things to do (and to do early while there is still political capital to spend) is tax reform. Such a phenomenon is not unexpected or unreasonable. The tax regime is one of the foremost means by which a political movement implements its conception of social justice. Determining the appropriate level of taxation and the raising or lowering of tax rates as a consequence thereof is part and parcel of that process.
The current administration is no exception. Within 100 days of taking office, President Biden announced a number of plans that, taken together, would overhaul the current income tax regime, increasing the tax rate on individuals—both for ordinary income and for capital gains and dividends— and raising the corporate tax rate. More recently, the House of Representative’s Committee on Ways and Means [hereinafter Ways and Means] published its own proposal, which adopted some elements of the president’s plan and modified others. It too includes provisions for raising both individual and corporate tax rates.
Although the proposals emerging from the White House and from Capitol Hill have stimulated passionate public debate, one particular aspect of these proposals seems to have escaped attention: the interplay between the corporate and the individual tax rates. A close examination of the relationship between individual and corporate taxation and of the historical process that led to the adoption of the current corporate tax regime will enable us to analyze more comprehensively the current proposals and others that are likely to emerge in the months ahead.
In this essay I will describe the basic models of corporate taxation and the historical march during recent decades from a classical double taxation model to one that approaches full integration. I will then analyze the current proposals in that light.
THE CLASSICAL MODEL
Until the turn of the twenty-first century, U.S. corporate taxation was based on what is commonly referred to as either the “classical model” or the “double taxation model.” The idea behind this model is that a corporation is a legal person. Like a natural person, it can own property, it can incur debt, and – what is particularly important for our purposes – it can earn income. The reasoning is that if a corporation can earn income like a natural person, it can also pay taxes like a natural person. Therefore, the first element in the classical model is the imposition of income tax on corporations.
The second element of the classical model concerns the distribution of earnings to the corporation’s shareholders. Like interest, rent, and wages, dividends constitute gross income. Therefore, when shareholders receive a dividend, they report the dividend as income and pay the appropriate tax.
Superficially, the classical model – corporations pay tax on their income as it accrues and shareholders pay tax on dividends when they receive them – seems conceptually sound. Legally, the corporation is a person and its shareholders are separate persons. In a classical model, each person pays tax on his, her, their, or its income, and each dollar of income is taxed once and only once.
However, if we dig a little deeper, we will discover a problem with the classical model. The payment of tax by the corporation reduces the earnings available for distribution to shareholders. This means that shareholders bear the indirect burden of the corporate-level tax. Imposing an additional shareholder-level tax on the dividend amounts to double taxation of the corporation’s earnings. In other words, shareholders indirectly bear the burden of the corporate-level tax and then they directly bear the burden of the shareholder-level tax.
To demonstrate, let’s use the highest marginal tax rates that were in force at the turn of the current century: 39.6% for individuals and 35% for corporations. Assume that a corporation earned $100,000 and that it distributed its entire after-tax income as a dividend:
Corporate Level Income $100,000
Tax (35%) ($35,000)
After-tax income $65,000
Shareholder Level Income $65,000
Tax (39.6%) ($25,740)
After-tax income $39,260
Of the $100,000 that the corporation earned, only $39,260 is available to the shareholders for consumption or investment. A total of $60,740 went to taxes. The total tax burden was 60.74%. In other words, although legally each person’s income was taxed only once, economically there was double taxation.
INTEGRATION MODELS
Due to this fundamental flaw in the classical model, many other countries abandoned this model during the course of the twentieth century and adopted in its stead one of the various “integration models.” As their name indicates, the idea behind these models is to integrate the corporate-level tax and the shareholder-level tax.
Some, known as full integration models, seek to impose the same tax burden on income derived through a corporation as that which would be imposed on income earned directly by an individual. For example, they might exempt the corporation from tax and only tax the shareholders.[1] More sophisticated means of fully integrating the corporate tax regime include taxing at both levels but permitting corporations to deduct the dividends they distribute or allowing shareholders a full credit for taxes paid by the corporation.
Others, known as partial integration models, are located somewhere along the spectrum between full integration and the classical model. On either the corporate level or the shareholder level (or possibly both), they take the other level of tax into account, but do not totally neutralize the sting of double taxation. For example, they may impose a relatively low rate of tax on one of the levels. Alternatively, they may allow the shareholder only a partial credit for taxes paid by the corporation. The total tax burden under a partial integration model is less than under the classical model but greater than under a model of full integration.
Continuing along the spectrum from double taxation past partial integration and full integration, we come to super-integration. In a super-integrated tax structure, the total tax burden on distributed corporate earnings is less than the ordinary individual tax rates.
Often, the question of whether a given regime is partially integrated, fully integrated, or super-integrated does not yield a simple answer. For example, assume that corporations pay tax on their income and that dividends are tax exempt in the hands of shareholders. If the corporate tax rate is greater than the ordinary tax rate of a particular individual shareholder, then from the perspective of that individual, the regime is partially integrated. If the corporate tax rate is equal to the shareholder’s tax rate, the regime is fully integrated. If the corporate tax rate is less than the shareholder’s tax rate, then the regime is super-integrated.
THE EVOLUTION OF INTEGRATION
During the first two decades of the twenty-first century, U.S. corporate taxation has gradually moved from a classical structure to one approaching full integration.
The opening salvo in the battle for integration was fired in 2003 by President George W. Bush.[2] He proposed that dividends distributed out of earnings on which taxes were paid at the corporate level would be exempt from tax on the shareholder level. If, for whatever reason, tax was not paid at the corporate level, then the shareholders would be liable for tax on the dividend. The result would have been that any income earned by a corporation would be taxed once and only once.
Congress refused to go that far and instead enacted a compromise formula.[3] Dividends received by individuals would be taxed at the same rate as long-term capital gains,[4] which was then 15%. The result was a partially integrated corporate tax structure:
Corporate Level Income $100,000
Tax (35%) ($35,000)
After-tax income $65,000
Shareholder Level Income $65,000
Tax (15%) ($ 9,750)
After-tax income $55,250
The total tax burden of 44.75% was more than it would have been under a model of full integration (at the time the top individual rate was 35%), but less than under the classic model (57.75%).[5]
Under the Obama administration, the principle of partial integration was preserved.[6] Although tax rates rose for high-end taxpayers, dividends continued to be subject to tax at the same rate as long-term capital gains. The only difference was that the top rate for long term capital gain was raised to 20% and an expanded Medicare tax tacked on an additional 3.8%.[7] Thus, dividends were effectively subject to a top rate of 23.8%.
To calculate the overall tax burden on distributed corporate earnings under the Obama-era tax regime, assume again that a corporation earned $100,000 and distributed its entire post-tax earnings as a dividend:
Corporate Level Income $100,000
Tax (35%) ($35,000)
After-tax income $65,000
Shareholder Level Income $65,000
Tax (23.8%) ($15,470)
After-tax income $49,530
The overall tax burden was 50.47%, less than under a classic model (63.21% at the then-current tax rates)[8] but more than under a fully integrated model (the top individual tax rate at the time was 43.4%, composed of 39.6% income tax and 3.8% Medicare tax).[9]
The next step toward full integration occurred under President Trump in 2018,[10] when the corporate tax rate was lowered to 21%.[11] At the same time, the top individual tax rate (including Medicare tax) was reduced to 40.8%.[12]With regard to capital gains and dividends, the Obama-era top individual rate of 23.8% was retained.[13]
As before, we will assume that a corporation earns $100,000 and distributes its entire after-tax earnings as a dividend:
Corporate Level Income $100,000
Tax (21%) ($21,000)
After-tax income $79,000
Shareholder Level Income $79,000
Tax (23.8%) ($18,802)
After-tax income $60,198
The overall tax burden of about 39.8% is very close to the top individual tax rate of 40.8%, so if our goal is full integration, then the 2017 reform may not get to the exact right result, but it’s pretty close.
Given the one-percent discrepancy, one might ask why the Tax Cuts and Jobs Act adopted a corporate tax rate of 21% instead of 22%. With a 22% tax rate, the overall tax burden on distributed corporate profits would be about 40.6% (which would almost exactly equal the 40.8% top individual tax rate):
Corporate Level Income $100,000
Tax (22%) ($22,000)
After-tax income $78,000
Shareholder Level Income $78,000
Tax (23.8%) ($18,568)
After-tax income $59,436
The reason for the discrepancy appears to be that, in making their calculations, the framers of the Tax Cuts and Jobs Act ignored the effect of the 2.8% Medicare tax, despite the fact that the Medicare tax is an income tax in all but name. Whether they were led astray by semantics or whether for ideological reasons they opposed the Medicare tax and assumed that it would eventually be repealed—or simply refused to dignify it by recognizing its existence—is unclear, but ignore it they did. Thus, if we stick to the income tax stricto sensu, with a top individual rate of 37% on ordinary income and a top rate of 20% on capital gains and dividends, then the 21% corporate tax rate is indeed the closest whole number percentage to full integration (the actual tax burden working out as 36.8%):
Corporate Level Income $100,000
Tax (21%) ($21,000)
After-tax income $79,000
Shareholder Level Income $79,000
Tax (20%) ($15,800)
After-tax income $63,200
THE WAY FORWARD
Even under current rates, there could be a significant difference between the tax burden imposed on distributed corporate earnings and that imposed on income earned directly by an individual, resulting in either partial integration or super-integration. Here are a few pertinent examples:
1. As already noted, for individuals in the highest tax bracket, income they earn directly is subject to tax at the rate of 40.8%, while corporate earnings distributed to them are subject to an overall tax burden of only 39.8% (super-integration).
2. Individuals are currently entitled to deduct up to 20% of their “qualified business income.”[14] For individuals able to take full advantage of this deduction, the top effective rate of tax is 33.4%,[15] which is considerably less than the 39.8% on distributed corporate earnings (partial integration).
3. Although the overall tax burden of 39.8% on distributed corporate earnings is close to the top individual tax rate of 40.8%, there could be a significant difference in timing. When income is earned via a corporation, only the 21% corporate-level tax is payable immediately. The shareholder-level tax is payable only when the income is distributed. The deferral means that the present value of the shareholder-level tax liability might be significantly less than the nominal liability (super-integration).[16]
4. For individuals who are not in the highest tax bracket, the total tax burden on distributed corporate earnings is much higher than their marginal rates. For example, although individuals in the lowest two brackets (10% and 12%) are exempt from tax on dividends and long-term capital gains,[17] the 21% corporate-level tax by itself greatly exceeds their effective marginal tax rate (partial integration).[18]
5. For individual taxpayers, whatever their tax bracket, long-term capital gain is taxed at preferential rates.[19]No such allowance is made for long-term capital gain earned by a corporation: the gain is subject to the usual 21% corporate tax rate and, upon distribution, to the usual shareholder-level tax. Thus, instead of bearing a total tax burden of between 0% and 23.8%, capital gain accrued by a corporation bears a total tax burden of between 21% and 39.8% (partial integration).
Thus, there is still work that needs to be done if we are to achieve the goal of a fully integrated corporate tax structure. Ideally policy makers would attempt to bridge the gap between the combined corporate-level and shareholder-level tax on the one hand and the ordinary individual tax rates on the other. This goal, it should be mentioned, should be unrelated to a person’s views on the appropriate level of taxation or the degree of progressivity of the tax structure. Those who argue that tax rates should be higher than they are now and those who argue that they should be lower should all be able to agree that whatever the rate of tax, the same rate that applies to income earned directly by an individual should apply to income earned by that same individual via a corporation. Any corporate tax regime that imposes a burden on income earned via a corporation different from that imposed on income earned directly by an individual – whether the former is greater or less than the latter – would be horizontally inequitable (similarly situated taxpayers are subject to different tax burdens) and economically inefficient (people will tend to structure their operations in accordance with tax dictates instead of as required by strictly business requirements).[20] It is likely to be vertically inequitable as well, as wealthier taxpayers tend to be better advised and have more flexibility in structuring their business operations.[21]
CURRENT PROPOSALS
Let us now turn our attention to current proposals for tax reform and consider them in light of the historic move toward full integration of the corporate tax regime.
The tax reform plans published by the Biden administration this last spring include raising the top individual rate to 39.6% (43.4% including Medicare tax),[22] raising the corporate tax rate to 28%,[23] and eliminating the preferential tax rates imposed on capital gains and dividends received by individuals earning more than $1,000,000 a year.[24]Eliminating the preference would mean that the tax rates on those two types of income for the wealthiest Americans would rise from 20% to 39.6% (23.8% and 43.4% respectively, including Medicare tax).
Under the Biden proposals, the total tax burden imposed on corporate income distributed to top-end taxpayers would be about 59.25%:
Corporate Level Income $100,000
Tax (28%) ($28,000)
After-tax income $72,000
Shareholder Level Income $72,000
Tax (43.4%) ($31,248)
After-tax income $40,752
Far from continuing along the path of corporate tax integration, this proposal, were it enacted, would constitute a retreat to a partially integrated tax regime, in fact one that is considerably closer to a classical double tax regime (68%) than it is to one that is fully integrated (43.4%).
One might, of course, believe that a 59.25% marginal tax rate is appropriate for those with income of over $1,000,000 a year. Such an opinion is certainly legitimate. However, it does not make much sense to impose a 59.25% tax burden on distributed corporate earnings within the framework of a tax regime in which the top individual tax rate is only 43.4%. In other words, a proposal to impose a top individual rate on ordinary income of 59.25%, a top individual rate on dividends of 43.4% and a corporate tax rate of 28% would be internally consistent, and the question of whether such a tax burden is too high (or too low) could be the subject of reasonable political debate. However, as already noted, imposing a tax burden of 59.25% on distributed corporate earnings alongside a 43.4% tax on income earned directly by an individual (partial integration tending toward classical double taxation) would violate established norms of horizontal and vertical equity and economic efficiency. Moreover, such a regime would likely be ineffective at reaching the income of wealthy individuals, as they are precisely the group of taxpayers with the means to structure their investments so as to avoid the double tax.
Ways and Means modified the Biden tax plan, and the bill that it published is in effect a compromise between the president’s proposals and current law.[25] Under the Ways and Means version, the top individual tax rate for ordinary income would be 43.4% (the same as under the administration’s proposal and as opposed to 40.8% under current law),[26] the top individual tax rate for dividends would be 28.8% (as opposed to 43.8% under the administration’s proposal and 23.8% under current law),[27] and the top corporate tax rate would be 26.5% (as opposed to 28% under the administration’s proposal and 21% under current law).[28] Running the numbers, we can see that under the Ways and Means proposal, the overall tax burden on distributed corporate earnings would be about 47.7%:
Corporate Level Income $100,000
Tax (26.5%) ($26,500)
After-tax income $73,500
Shareholder Level Income $73,500
Tax (28.8%) ($21,168)
After-tax income $52,332
The concept of partial integration covers a wide field, ranging from classical double taxation on one extreme to full integration on the other. The president’s proposal and that of Ways and Means both fall within this broad continuum; however, while the former is closer to the classical double tax end of the spectrum, the latter is closer to the full integration end. Nevertheless, like the Biden tax plan, the Ways and Means proposal constitutes a retreat from the current tax regime, which approaches full integration, back to partial integration. Again, the critique expressed here is not that the tax burden imposed on distributed corporate earnings under the Ways and Means is intrinsically too high. The critique here is limited to the contention that it is inappropriate to impose a 47.7% tax burden on distributed corporate earnings within the framework of a tax regime with a top individual tax rate of 43.4%.
CONCLUSION
An ideal corporate tax regime would impose the same overall tax burden on income earned via a corporation as it did on income earned directly by an individual. Any discrepancy between the two violates the norms of horizontal equity, economic efficiency, and most likely vertical equity. For the last twenty years, lawmakers have responded to these concerns by gradually transforming the corporate tax regime from a classical double taxation model to one that at least in very broad outline encapsulates the notion of full integration. True, the current state of affairs does not entirely eliminate the discrepancies. While closer to full integration than any corporate tax regime that the United States has until now experienced, it does contain pockets of both partial integration and (more rarely) of super-integration. The goal of corporate tax reform should be to remove those incongruities and mold a more coherent overall income tax structure.
Unfortunately, the tax reform proposals that have recently been published by the administration and by Ways and Means appear to be pushing in the opposite direction. Instead of moving toward more fully integrating the corporate tax regime, they constitute a retreat from the idea of integration. Without regard to one’s views on the appropriate level of taxation, the dis-integration of the corporate tax regime would be regrettable.
David Elkins is a legal scholar focusing on the areas of income tax, international taxation, corporate taxation, and distributive justice. Prof. Elkins is a professor at Netanya College School of Law in Israel, and he is currently a visiting professor at New York University Law School.
[1] See, e.g., I.R.C. §§1361-1378 (S Corporations).
[2] See Gen. Explanations of the Admin.’s Fiscal Year 2004 Revenue Proposals 11–22 (Feb. 2003), https://home.treasury.gov/system/files/131/General-Explanations-FY2004.pdf.
[3] See Jobs and Growth Tax Relief Reconciliation Act of 2003 §302.
[4] See I.R.C. §1(h)(11).
[5] Corporate Level Income $100,000
Tax (35%) ($35,000)
After-tax income $65,000
Shareholder level Income $65,000
Tax (35%) ($22,750)
After-tax income $42,250
[6] American Taxpayer Relief Act of 2012.
[7] I.R.C. §§1401(b)(1), 1401(b)(2), 3101(b)(1), 3111(b).
[8] Corporate Level Income $100,000
Tax (35%) ($35,000)
After-tax income $65,000
Shareholder level Income $65,000
Tax (43.4%) ($28,210)
After-tax income $36,790
[9] See I.R.C. §1(a)–(e).
[10] See Tax Cuts and Jobs Act of 2017 §§11001, 13001.
[11] See I.R.C. §11(b).
[12] See I.R.C. §1(j)(2) (establishing a top individual tax rate of 37%). The current top rate of 40.8% is comprised of income tax of 37% plus Medicare tax of 3.8%.
[13] See I.R.C. §1(h)(1), (11).
[14] See I.R.C. §199A.
[15] The effective income tax rate is 37% x 80% = 29.6% plus Medicare tax of 3.8%.
[16] Cf. Michael S. Knoll, The TCJA and the Questionable incentive to Incorporate, 162 Tax Notes 977, 980–86 (Mar. 4, 2019), who argues that the advantage of deferral is much less significant than is often supposed.
[17] See I.R.C. §§1(h)(1)(B), (11), (j)(2), (5)(A)(i), 5(B)(i).
[18] With regard to taxpayers in lower brackets, the analysis is actually more complicated. First, for taxpayers whose modified adjusted gross income is less than $250,000, earned income is subject to Medicare tax of 2.9%, while unearned income is not subject to Medicare tax at all. Therefore, when we compare the overall tax burden on distributed corporate earnings to the shareholder’s own tax bracket, we need to consider separately income that would have been classified as earned income in the hands of the individual shareholder and income that would have been classified as unearned income. Second, earned income up to about $130,000 is subject to social security tax. Here, in addition to having to consider separately income that would be have been classified as earned and income that would have been classified as unearned, we also need to consider the fact that social security benefits are a function of how much one pays, so that in economic terms the “tax” component of the payment is the difference between the amount paid and the actuarial value of the expected benefits (in those cases in which the actuarial value of the expected benefits is greater than the payment, there is effectively a negative tax). The “tax” component (whether positive or negative) of the social security payment will vary from individual to individual. Third, as with taxpayers in the upper brackets, if the source of the income is a trade or business, the individual might have been entitled to the deduction for qualified business activity.
[19] See I.R.C. §1(h)(1).
[20] See, e.g., Calvin Johnson, Integration Highlights AALS Meeting in San Antonio, 54 Tax Notes 114 (Jan. 13, 1992) (“The classical, double tax on corporate income distorts economic choices in several ways: The double tax discourages investment in new shares; It [sic] encourages corporations to finance projects with retained earnings or debt, rather than sale of shares; It [sic] encourages corporations to distribute earnings in redemptions or other nondividend distributions, so that shareholders can use their basis and be eligible for capital gain; and it encourages corporations to retain corporate earnings to avoid shareholder-level taxes.”).
[21] For example, wealthy taxpayers may be more capable of investing via S corporations or other pass-through entities that are not subject to the double or only partially integrated tax regime.
[22] See FACT SHEET: The American Families Plan 15 (April 28, 2021), https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/28/fact-sheet-the-american-families-plan/
[23] See U.S. Department of the Treasury, The Made in America Plan 11 (April 2021), https://home.treasury.gov/system/files/136/MadeInAmericaTaxPlan_Report.pdf; FACT SHEET: The American Jobs Plan (March 31, 2021).
[24] See American Families Plan, supra note 20, at 15.
[25] See Committee on Ways and Means, Subtitle I – Responsibly Funding Our Priorities, https://waysandmeans.house.gov/sites/democrats.waysandmeans.house.gov/files/documents/SubtitleISxS.pdf
[26] See id., at Part 2, Sec. 138201 (proposing increasing the top marginal individual income tax rate to 39.6%). The 43.4% rate in the text included Medicare tax.
[27] See id., at Part 2, Sec. 138202 (increasing the top capital gains tax rate to 25%). The 28.8% rate in the text includes Medicare tax.
[28] See id., at Part I, Subpart A, Sec. 138101.
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