Corporate Tax Integration and Tax Reform

Summary

In January 2016, Senator Orrin Hatch, chairman of the Senate Finance Committee, announced plans for a tax reform that would explore corporate integration. Corporate integration involves the elimination or reduction of additional taxes on corporate equity investment that arise because corporate income is taxed twice, once at the corporate level and once at the individual level. Traditional concerns are that this system of taxation is inefficient because it (1) favors noncorporate equity investment over corporate investment, (2) favors debt finance over equity finance, (3) favors retained earnings over dividends, and (4) discourages the realization of gains on the sale of corporate stock. Increasingly, international concerns such as allocation of investment across countries, repatriation of profits earned abroad, shifting profits out of the United States and into tax havens, and inversions (U.S. firms using mergers to shift headquarters to a foreign country) have become issues in any tax reform, corporate integration included.

This report first examines the four traditional efficiency issues by comparing effective tax rates. These estimates suggest that there is little overall difference between corporate and noncorporate investment or even favorable treatment of corporations, for several reasons. A larger share of corporate assets benefits from tax preferences. Moreover, only a quarter of shares in U.S. firms is held by taxable individuals; the remainder is held by tax-exempt and largely tax-exempt pension and retirement accounts, nonprofits, and foreigners. Additionally, tax rates on individual dividends and capital gains are lower than ordinary rates.

However, effective tax rates across assets differ markedly, with intangible assets most favored and structures least favored. Debt is treated favorably in both the corporate and noncorporate sectors, but more so in the corporate sector, so that the total stock of assets in the corporate sector is taxed less heavily than in the noncorporate sector when both debt and equity are considered. The distortion between debt and equity finance is large in each sector, with negative tax rates for debt finance in many cases, while differences in taxes affecting dividend payout choices or realization of capital gains on stock appear to be small because of low tax rates.

The report outlines several approaches to integration. Full integration would address both dividends and retained earnings. One approach would tax on a partnership basis by allocating income to shareholders and using the firm to withhold taxes. Credits for withheld taxes would be provided to shareholders, and credits could be made nonrefundable for tax-exempt and foreign shareholders. A different full integration approach would eliminate shareholder taxes and tax only at the firm level. A third would tax at the shareholder level and not the firm by imposing ordinary rates and taxing not only dividends and realized capital gains but also unrealized gains by marking shares to market prices (i.e., mark-to-market). Partial integration focuses on dividends and could provide either a dividend deduction by the firm (with a withholding tax and credits) or a dividend exclusion to the shareholder. Disallowing interest deductions in full or in part could be combined with most proposals.

The report compares these proposals with respect to impact on revenue, administrative feasibility, and effects on both traditional and international tax choices. Shareholder allocation or deductions with refundable credits produce relatively large revenue losses, as does mark-to-market. Nonrefundability and making modifications in mark-to-market can substantially reduce these revenue losses. Most proposals would have modest efficiency gains, and some would modestly increase efficiency losses. Mark-to-market would tax economic income and potentially produce a number of efficiency gains but may not be feasible on administrative grounds. Disallowing or restricting deductions for interest would lead to efficiency gains on a number of margins and provide revenue to help achieve revenue-neutral reforms.