A political theory of corporate taxation.

• Author: Arlen, Jennifer

1. Introduction

   The American tax system imposes a double tax on the profits of corporations. This two-tier taxation is unusual,(1) unfair,(2) and inefficient. The ill-effects of the double tax are well known in Washington. Congress regularly considers legislation to eliminate the double tax by integrating the personal and corporate taxes into a single system. These initiatives have had the support of tax scholars, the Treasury, the public, and several Presidents. Yet proposals to integrate the tax system invariably die a quiet death.

   The persistence of the double-level tax is puzzling. To be sure, the tax code contains many provisions in desperate need of revision. Typically, though, these provisions are supported by a well-organized interest group that lobbies vigorously to retain its cherished preference. The corporate tax, in contrast, appears to benefit no one directly and to hurt the corporate sector, which is large, well organized, and generally able to defend its own interests. Nor does the double tax persist because of public support. Opinion polls regularly show public opposition to double taxation.

   In this Article, we argue that the resilience of the corporate tax is a manifestation of the most enduring source of problems in corporate law, the separation between ownership and control of large corporations. Large corporations might be expected to lead the fight against the double tax. Their managers, however, have chosen not to lobby vigorously for integration, even though shareholders often would benefit from integration. In this managerial diffidence lies the key to explaining the failure of integration efforts.

   Managers' lack of interest in integration, we argue, results from the fact that managers and shareholders pursue different objectives when firm ownership is separated from control. Shareholder objectives are served both by new investments and by higher returns on old investments. Managerial objectives, in contrast, are served primarily by new investments. This difference in objectives leads shareholders and managers to have different views on corporate investments and on tax policy. Shareholders benefit both from measures such as integration that provide windfalls to their existing shares and from measures such as accelerated depreciation (ACRS)(3) and investment tax credits (ITCs) that increase the return on new investments. Managers, in contrast, benefit only from policies that stimulate new investment. Thus, while many managers support integration, they would rather devote corporate resources to lobbying for tax preferences, such as ACRS and the ITC, that encourage new investment.(4)

   The separation of ownership and control may have an even more surprising consequence. Some managers, we argue, may actively oppose integration because the double tax serves their interests. These managers may support the double tax for one of the very reasons that reformers oppose it: Double taxation traps earnings in the corporation. This retained earnings trap enables managers to pursue investments from which they benefit at the expense of shareholders.

   Understanding the failure of past reform efforts is key to the success of future efforts. Managers have been the only vocal public participants in earlier debates. Reformers, we believe, must secure the support of managers in their quest for integration. Managers, in our view, can be persuaded to support integration by the introduction of proposals that avoid windfalls and, perhaps, those that lock in earnings.

   Part II examines alternative explanations of the double tax, including various populist arguments. Parts III and IV examine our hypothesis that the separation of ownership and control explains managerial apathy - and sometimes antipathy - towards integration. Part III examines why most managers have so little enthusiasm for integration: Integration provides a windfall for existing equity, whereas managers would prefer to lobby for tax preferences that promote new investment. Part IV explains why some managers actively oppose integration. Finally, Part V employs our analysis to explore strategies that future reformers might use.

2. Why a Corporate Tax?

   Under the Internal Revenue Code, the profits of most corporations are, in theory, subject to a two-tier tax.(5) Each year a corporation's profits are taxed at the corporate level according to a corporate rate schedule.(6) Any earnings distributed immediately to shareholders as dividends are taxed again as ordinary income at personal rates.(7) Earnings that are retained by the corporation escape double taxation only temporarily. As these retained earnings generate profits, the new profits are taxed at the corporate level. These earnings are taxed again at the shareholder level when they are distributed or when a shareholder sells his shares.

   The corporate tax creates significant efficiency losses.(8) Some of these losses occur because the tax is effective. By lowering the return to corporate capital,(9) the corporate tax discourages investment in the corporate sector.(10) This may reduce efficiency by lowering output in industries that find a corporate form of organization particularly suitable.(11) Other losses occur because corporations can avoid the tax, but only by using evasive strategies that impose new social costs. Corporations can, for instance, reduce the burden of the double tax by retaining and reinvesting earnings rather than paying them out as dividends. This strategy will often produce suboptimal investment policies that injure shareholders.(12) Corporations can also reduce the double tax by financing investment with debt rather than equity, since only corporate equity is subject to the double tax. In so doing, however, a corporation may raise its risk of bankruptcy to inefficient levels.(13)

   The double tax, moreover, is inconsistent with currently accepted views of tax equity.(14) Most contemporary academics regard the corporation as simply a conduit of profits to shareholders and thus see it as an inappropriate unit of taxation.(15)

   Integration would considerably reduce many of the problems created by double taxation.(16) It thus has long had the enthusiastic backing of academic observers, professional groups,(17) Various Treasury Department reports,(18) and several presidential administrations.(19) Members of both houses of Congress have introduced a steady stream of bills to integrate the tax System.(20) Nonetheless, the double tax persists.

   The continued vitality of the double tax has puzzled many observers. A number of scholars have offered explanations for the persistence of the double tax that do not recognize the central role of agency costs. In this part, we will explore these alternative theories. Any theory of corporate taxation, we believe, must explain three facts. First, public corporations are subject to a double tax. Second, although Congress has not integrated the tax system, it regularly enacts other tax measures that reduce the tax burden on corporations. Finally, publicly held corporations have not lobbied for integration. No argument that ignores agency costs, we believe, explains all three of these facts.

   1. Populist Entity Theory

      Many scholars have suggested that the double tax persists because the public supports it.(21) These explanations for voter support of double taxation can be loosely characterized as populist.

      In one view, the double tax persists because the public views corporations as distinct entities, not merely as vehicles for transferring profits to shareholders. According to this theory, the public supports the double tax because it believes that all individuals, including corporations, should pay taxes on their income.(22)

      The entity theory was indeed the original basis for imposing a separate corporate tax,(23) and it may in part though only in part - characterize the public's view of corporations.(24) Yet even if the public completely accepted it, the entity theory cannot explain all of the stylized facts of corporate taxation. The entity theory can only explain why two levels of tax would be imposed. It has nothing to say about why Congress regularly reduces the burden of corporate taxation through ACRS instead of integration, or why corporations have lobbied more heavily for ACRS than for integration.

   2. Rational Populism

      Another populist explanation treats the corporate tax as simply another tax on capital. Voters, in this view, favor the corporate tax because they believe that the tax falls on owners of capital; they do not themselves own significant amounts of capital;(25) and they feel that those who do should be taxed.(26)

      This populist account of the persistence of the double tax fails to explain any of the three fundamental facts. First, even if correct, this argument would at most explain why corporate capital is taxed, but not why profits to capital are taxed twice.(27) Second, it cannot account for why Congress rejects integration while regularly enacting sweeping capital tax cuts in the form of ACRS, corporate rate reductions, and capital gains cuts.(28) Finally, it fails to explain why corporate managers lobby more vigorously for ACRS and related cuts than for integration.

   3. Congress and Hidden Taxes

      Some commentators have argued that the corporate tax persists because it serves congressional objectives. The most common variation on this theme is the "hidden tax" argument: The corporate tax is a politically expedient way of raising revenue because the public does not understand that it ultimately bears the burden of the tax.(29)

      One version of the hidden-tax argument suggests that taxpayers regard themselves as owners of capital but do not understand that they, as shareholders, pay the corporate tax. This explanation has all the shortcomings of the rational-populist hypothesis. First, it might explain the corporate tax, but it does not explain the additional tax on dividends. Indeed, if voters regard themselves as...