Can (and Should) Corporations Be Taxed?

Jonathan Berk: Welcome, everybody. Today we’re going to talk about corporate income taxes — that is, corporations pay taxes based on their profits.

Jules van Binsbergen: But of course, we shouldn’t think about the problem as corporations as individual entities that pay taxes. In the end, corporations can’t pay taxes; people pay taxes. And so, we need to ask the question, who are the groups of people behind corporations that end up bearing the brunt of the corporate income tax. 

Jonathan Berk: It’s not uncommon for people to say that corporations pay taxes, forgetting that that must mean that there’s a person involved who ultimately pays the taxes. If it were possible to tax an entity other than a person, none of us would need to pay taxes. We’d just tax that entity. So, the question is, who pays the corporate income tax?

Jules van Binsbergen: And all else equal, it is going to be the equity holders that do. Because after all, if the firm has fewer profits after taxes, there’s less money to pay in dividends, and so equity holders will bear the brunt of the income tax that way.

Jonathan Berk: But of course, all else is not equal. So, one thing that could happen if the government increases taxes is corporations could respond by investing less. And if they did that, they’d make less products, thus decreasing competition in the product market and raising prices. And similarly, they’d require less workers which would decrease wages. So, in that case, workers would bear the tax, and so would customers.

Jules van Binsbergen: So, in summary, it’s all the stakeholders in the firm that, in principle, could be affected by this corporate income tax, though I think most people would agree that the brunt of the corporate income tax is borne by equity holders.

Though Jonathan, there is another problem with the way that the U.S. government currently implements corporate income taxes; they tax profits after interest payments have been deducted. So, for that reason, the more debt a corporation has, the fewer taxes it needs to pay. And therefore, what we see is that corporations have more debt than they otherwise would have.

Jonathan Berk: Jules, that’s a good point. Okay, so now we understand that some group of individuals pays the corporate income tax, and as we’ve discussed, it’s likely the equity holders. But let’s understand the implications of that. Jules, the government should try not to tax a group of individuals as a whole, and instead, try to tax the individuals individually. Let’s understand why.

When any individual is deciding on the best strategy as far as taxes is concerned, they make a tradeoff. Either they pay the taxes, or they engage in a tax avoidance strategy to lower their taxes. For example, they could hire an accountant, they could look for loopholes, or they could try to create loopholes by hiring a lobbyist. But for most of us, that strategy makes no sense. The cost of a lobbyist far exceeds the amount we pay in taxes. So, for most of us, the optimal decision is just to pay the taxes.

But when you tax a group of individuals, the tax avoidance can be shared. That is, you only have to hire one lobbyist for all the equity holders who are paying the taxes. So, when you share the tax avoidance costs, it now becomes optimal to hire the lobbyist to lower taxes.

Jules van Binsbergen: And so, here it really comes through that the corporation isn’t an entity of itself. There’s a whole group of people behind it that is being taxed that jointly can engage in this activity. And so, now you may ask the question is that consistent what we see in the data? Is it indeed the case that corporations are trying to avoid paying taxes? Well, one thing we know for sure, and that is that the total amount of revenue that the government raises through corporate taxation is only seven percent of the total, so that is a relatively small amount.

Jonathan Berk: Yes. And added to that, there’s an entire industry of lobbyists in Washington arguing for corporate interests, and they affect the democracy. They help elect candidates. And by doing so, I think the political economy of the corporate income tax is quite bad. It affects how our legislators vote.

Jules van Binsbergen: So, in summary, the brunt of the corporate income taxation is borne by equity holders. There are two major issues associated with it that we need to discuss. The first one is, it could affect our democracy and the political economy behind it is quite a bad one in terms of the incentives that it has for lobbying. And secondly, the way that corporate income taxation is currently implemented is giving corporations an incentive to finance more of their investments with debt than they otherwise would.

Jonathan Berk: So, at this point, Jules, let’s introduce our guest, Larry Summers, who most people know was secretary of the treasury in the Clinton administration. And let’s see his views on the corporate income tax. Larry, welcome to the show.

Larry Summers: Glad to be with you.

Jules van Binsbergen: Larry, it’s great to have you. So, as you know, the podcast is called All Else Equal, as we want to explore the indirect effects that certain policy measures could have on what we call in economics the equilibrium effects.

Now when you hear politicians talk about increasing corporate taxes, it sometimes sounds a bit like we can simply take more money from corporations as independent units as if this has nothing to do with the people that are behind those corporations. Given that corporations are not units in and of themselves but rather a nexus between people, including employees, customers, shareholders such as pension plans and mutual funds and debtholders, who do you think ends up paying the brunt of the corporate tax?

Larry Summers: Let me just first say, Jules, that I think what you’re teaching people in your show is something that’s profoundly important, and I think of it as one of the three or four most important things you learn by having some exposure to economics. The classic example I use is a football game. If I stand up at the football game and nobody else does, I see better. If everybody stands up, nobody sees better, and everybody is a little bit less comfortable. And so, reasoning from the individual to the system can take you very badly wrong.

In the case of the corporate income tax that you raise, the first thing to say is that we’ve got an economy that produces goods and services, and we’ve got people. And if the government is going to take command from goods and services and is going to use them to serve government purposes, they’re going to come from somebody else who would’ve had them. There’s no Mars civilization to tax. And so, any analysis that treats the corporate sector like it’s Mars or like it’s an undiscovered gold mine is profoundly confused. Because resources are being extracted from corporations, there are fewer resources that are available.

And so, then the question is to sort through, who is really bearing the burden of that corporate tax? Economists have been thinking and writing and debating about this for 75 years now. And I think the conclusion that economists have come to is largely that it is substantially attacks on shareholders in the short run. But that over time, corporations invest less because it’s a taxed sector, and capital moves to less taxed sectors. And so, as capital moves from the corporate sector to the noncorporate sector, the capital becomes more scarce in the corporate sector, therefore its return is higher. And it becomes more abundant in the noncorporate sector, and so its return is lower.

Jonathan Berk: Larry, one of the facts about the corporate tax is it’s not very effective at raising revenue. I think usually it’s less than 10 percent of government revenue is raised in the corporate tax. And I would say one reason for that is that corporations engage in various tax avoidance strategies. And some of the strategies affect the political economy, especially lobbying and things like that. What would you say about the effect of the corporate tax on the democracy as a whole?

Larry Summers: I actually am not sure that I completely agree with you, Jonathan. I think one has to be careful when using the term tax avoidance. So, there are a variety of activities that congress wants to promote corporations doing. Congress thinks that if there’s more research and development done, that research and development done in Microsoft labs is going to have benefit for other parts of the economy, and therefore it says that Microsoft is going to get a 20 percent tax credit for its investments in R&D.

So, I think we have to be careful in defining what we mean by tax avoidance. I think that it is appropriate that when you have large, powerful institutions in our society that they be burdened. And especially when you recognize that many of their shareholders — I mean, what people say is, “Well, why tax corporations? If you want to tax the income, tax the shareholders.”

But it’s actually hard for the United States to tax the Singapore pension fund. It’s actually hard for the United States to tax Stanford University. It’s actually hard for the United States to reach into Larry Summers’ 401K plan. And so, what almost every country has done is decide that it’s a good idea to collect taxes on a certain amount of this profit income at the corporate sector, not for any deep conceptual reason, but just because of the practicability of it as a point for taxation.

Jules van Binsbergen: But Larry, what you just said is interesting. Because when we teach our finance classes, we very explicitly argue that interest payments are not a cost of doing business, and that the tax deductibility that we get from the interest payments is actually creating this distortion by subsidizing debt. Another way of saying that — and that argument goes back to John Burr Williams and later Modigliani-Miller — if I own both the debt and the equity in the firm, I can pay myself out through debt payments without being taxed, and through equity payments with being taxed.

And so, therefore we are encouraging corporations to take on more debt than they otherwise would. And wouldn’t you think that particularly since the financial crisis, and since lately we are giving a lot of attention to the argument that people are too indebted, do you think it’s a good idea to subsidize people to hold more debt?

Larry Summers: Respectfully, Jules, I think it’s a very difficult issue.

Jules van Binsbergen: Yep.

Larry Summers: And I, of course, do understand what you teach in your finance class, and I appreciate very much its logic. On the other hand, if you think about somebody who runs their shoe store. And they run their shoe store, and they have got to get inventory, and they’ve got a whole inventory in order to sell shoes. And so, they borrow money from the bank to get their shoe store started with an inventory of shoes.

And you say to them, “Which is that more like? Is that like a cost of doing business, like painting my shoe store and putting a sign up outside my shoe store? Or is that like a return of capital like when I get profit for having started this business?” Anyone who hasn’t spent too much time in an MBA classroom thinks the answer to that question is obvious, and that the answer is that the debt is a cost, and so they want to be able to deduct it.

And I think your concern about when the tax system can encourage excess leverage is a real one and it’s something that I’ve, many years ago with your colleague, Jeremy Bulow, I wrote a paper. But I would caution you that it is very hard to simplistically address these problems.

Jonathan Berk: Larry, let me bring this back to basically tradeoffs. Okay, so you’ve outlined a strong argument that the corporate tax has the simplicity associated with it. You can identify the corporation, you can tax the corporation. And I think you’ll agree there are costs, one of which Jules has spoken about, which is the subsidy of debt. And my big concern is the lobbying that goes on and the other things that I think affect the democracy.

But now, wouldn’t you agree that our ability to technologically identify people and tax them has gotten better over time? Today we’re a lot more efficient at finding money and taxing that money. Wouldn’t that then argue that since the costs of collection have gone down, that the tradeoff is now so that we should think about other ways to tax rather than tax the corporation [and] bear the costs?

Larry Summers: I’m not sure, Jonathan, for two reasons. First, it’s a game of cat and mouse. And it’s true if you say that our ability to find money has gone up, it’s also true that people’s ability to hide money has gone up and people’s ability to avoid paying taxes, to take an example that finance professors at Stanford have contributed to over time.

Because of modern computer technology, it’s now possible to invest in a mutual fund that invests in large numbers of stocks. And whenever one goes down, they sell it. And whenever one goes up, they hold it. And so, the result is that even if the mutual fund is doing well, what’s recorded for tax purposes is very substantial losses. That type of thing is much more present than it used to be. So, I’m not sure that the collectability of taxes from individuals has gone up as much as you suggest.

The second issue is that I’m not sure the real barrier is the findability. It feels wrong to people to levy a tax on the Catholic Church. Feels wrong to people to levy a tax on the nonprofit institution which is Stanford University. There are aspects of international relations that make it hard to levy a tax directly on the Norwegian sovereign wealth fund.

So, I don’t think it’s a technological change. It more has to do with a sense of appropriateness and morality. And I promise, I really do understand that when you levy the tax at the corporate level, you’re actually levying the tax on the shareholder and all of that. But I think in terms of what seems right to people, this seems a more natural and appropriate way of levying the tax.

Jonathan Berk: But isn’t there a better way to design the tax? My big concern about the corporate tax is the tax avoidance that the corporations undertake affect the democracy in a sense that to get special treatment, they finance particular candidates and they wield influence in Washington. Wouldn’t there be a way to collect the taxes that would not also have those negative —

Larry Summers: Talk about destroying the village to save it. What you’re proposing to do is make the greatest gift to corporate lobbyists in the history of the planet.

Jonathan Berk: But we would put them out of businesses.

Larry Summers: What’s that?

Jonathan Berk: We put them out of business. I want them [out of business].

Larry Summers: No, no. No, no, no, no, no. Maybe put them out of business, but only with one last and enormous payday. Because what you would do is you would eliminate a stream of cash flows that, depending on just how you value it, probably has a present value of $15 trillion. So, I’m all ears, but I would want to hear the viable proposal that would replace the corporate tax.

And I think in a world where our politics are excessively captured by the wealthy, to argue against the corporate tax, which is one of the more effective things we do that cause them to pay their fair share — or at least more towards their fair share — I would argue before we are critical of that tax, we better make awfully sure that we have a superior alternative. And I’ve spent decades in this business, and I don’t know of a superior alternative. So, reform, yes. But abolish, huge error in my view.

Jonathan Berk: Larry, I would disagree with you. The last time I looked, the corporate income tax raised 7 percent of total revenues. I’m not sure I agree with you that it’s actually effective to actual taxation. I think if you are going to replace the tax, and we agree most likely that the entity that pays the corporate tax are equity holders, so you’d have to think about a tax on equity. But the big advantage of taxing equity at the individual level is then it’s difficult for individuals to group together and hire a lobbyist. Whereas when you tax at the corporate level, the corporation can hire a lobbyist.

Larry Summers: Jonathan, respectfully — respectfully, Jonathan, you’re just wrong. The vast majority of equity is held by institutions — pension funds and the like — that would be hard to tax directly. The remainder of the equity is held through institutions like brokerage firms who would be delighted to organize the hiring of lobbyists on their behalf.

There is no sector so shot through with lobbying and special interest as oil and gas and real estate where the taxation flows through to the owners and where the abuse is substantially greater than it is in the case of the corporate sector. So, the idea that you are somehow going to decorrupt American politics by eliminating the corporate income tax is, I think, a very dangerous and misguided one.

Jonathan Berk: Larry, I don’t think you can have it both ways. You can’t both say that only rich people own equity, and the vast majority of equity is held by pension plans and the like.

Larry Summers: Let me be precise. There is equity that is held in a form where it is very difficult to tax directly, through pension funds, IRAs, 401Ks and the like. That equity you’re not going to be able to tax. About 25 percent of the equity is held directly by individuals who you can tax, and that 25 percent of the equity is all held by very wealthy people, or is very disproportionately held by very wealthy people.

And so, I’m not sure what you’re proposing. If what you’re proposing is that we place a set of new taxes on pension funds and 401Ks and the like, I think, to put it mildly, you don’t have a very realistic proposal. If what you’re proposing is that we tax the corporate equities that I hold more directly, and that are held by individuals, A, you’re only going to tax about 20 to 25 percent of the equity, and B, it’s going to be very disproportionately wealthy people.

And you have to ask yourself how wealthy people will organize themselves. And we do have a good test, which is real estate. We do have a good test, which is oil and gas. And we do have a good test, which is the estate tax. And it’s just not right to say that somehow the corporate tax is more uniquely flawed by lobbyists. It’s just not right.

Jules van Binsbergen: But Larry, one thing that I find that I want your thoughts on is this. You’re saying a whole bunch of reasons for why it’s difficult to get owners taxed. And you mentioned 401K plans, you mentioned pension plans, you mentioned universities. But all of those are not taxed by choice, right, by explicit regulation that makes them nontaxable. You can save in a nontaxable way. We also have rules where universities cannot be taxed.

So, that is a government choice, too, to not tax there, and that does have consequences. But it seems like you seem to be saying that that’s a problem that we cannot get to it. We could get to it if we wanted to. We just choose not to get to it, right?

Larry Summers: I think one can have these conversations at several different levels. One can have them at the level of abstraction, or one could have them at the level of some kind of political reality and proposals that might actually take place.

Jules van Binsbergen: Yes.

Larry Summers: When you introduce the concept of lobbying and lobbyists as an important aspect of the problem, I think you’re approaching it from a relatively pragmatic approach.

Jules van Binsbergen: But then let’s for a second leave the world of political pragmatism, and let’s just ask the question what in your opinion would be the least distortionary way of levying taxes, given that political constraints are not an issue. So, take the politics off the table just for a second. Just as an economist, if you could choose the tax system that was the least distortionary, what would you pick?

Larry Summers: I would pick some kind of, some form of comprehensive, highly progressive expenditure tax coupled with some kind of very large tax on intergenerational transfers for those with substantial net worth. But I think I would, as I studied this, come to the same conclusion that almost every country has come to, which is that if you want to best approximate that, you are likely to do it with a set of more complicated and messy instruments given the realities of tax collection and the realities of enforcement.

Jules van Binsbergen: Larry, thanks so much for being with us. It was a wonderful conversation. I hope you enjoyed it as well.

Larry Summers: I did very much.

Jonathan Berk: Larry, it was really stimulating. Thank you so much for being here.

Larry Summers: Thanks. Bye.

Jules van Binsbergen: Bye.

Jonathan Berk: Well, thank you, everybody, for listening to the show, and please keep your comments coming.

Jules van Binsbergen: In our next episode, we’re going to discuss impact investing, or what some people also call ESG investing.

Jonathan Berk: We hope you will join us.

Jules van Binsbergen: Thanks for listening to the All Else Equal Podcast. Please leave us a review at Apple Podcasts. We love to hear from our listeners. And be sure to catch our next episode by subscribing or following our show wherever you listen to your podcasts. For more information and episodes, visit allelseequalpodcast.com or follow us on LinkedIn. The All Else Equal Podcast is a joint venture of Stanford University’s Graduate School of Business and the Wharton School at the University of Pennsylvania, and is produced by Podium Podcast Co.