The Severe Inefficiency of the Corporate Income Tax

Most governments raise money in backwards ways. They punish behavior that is productive – taxing sales, property improvements, capital gains, and more – so people do less of those things (or pretend not to by doing so under the table). The corporate income tax is another example. Although corporate profits grow the economy, the government and the populist left see them as triggering inequality, and taxing such profits as a matter of fairness. This leads to avoidance strategies, whether through creative writedowns or relocating operations. There is much inefficiency in the whole setup.

How Corporate Taxes Work

For corporations, all revenue except that spent on business expenses is subject to tax. America’s corporate income tax has been a flat 21% since the 2017 Tax Cuts and Jobs Act (TCJA). Worldwide, rates are all over the map: many countries have no corporate income tax, while in Europe, Malta has the highest rate (35%) and Hungary has the lowest (9%). Norway, a country long thought to be “democratic socialist”, has a corporate tax rate between 22-25% for non-oil businesses, well lower than the U.S.’ before TCJA.

In the US, corporations face a double tax: The code imposes liability on corporations when they make profit, and shareholders must pay taxes if that profit is distributed as dividend income.

Then there are state tax rates: again, several states have no corporate income tax, while California and many of the northern ones have, depending on income, rates in the 6-11% range. 

“Profit Shifting”

But these rates are rarely what big corporations actually pay. 

Among the most famous examples: Amazon paid no corporate income tax through much of the 2010s due to many factors, namely their use of tax credits.

Having worked for several years in the corporate world, I’ve seen Amazon’s strategies and others firsthand. They can include the following, which are often organized in December to reduce that year’s reported profits: 

• Shifting profit from one LLC to another, as to make profits look more evenly distributed (thus lower)
• Making long-term capital expenditures for coming years, whether or not they’re needed at that moment 
• Paying higher salaries, bonuses, and stock options, whether or not it bears resemblance to the market wage rates 
• Donating to charities that the company may not fundamentally believe in
• Delaying sales activity so that profits won’t be reported until next year 

None of this is illegal. But to reiterate, it’s all inefficient, by delaying or redirecting money from productive uses to potentially unproductive ones. The accounting services needed for it cost time and money, which means that this whole “writedown” game is better played by big businesses, not small ones, giving them yet another advantage.

How Avoidance Hurts the Economy

But the real inefficiency happens when corporations leave high-tax countries altogether. The Tax Justice Network estimates that “multinational corporations…shift $1.38 trillion worth of profit into tax havens every year, costing countries $245 billion in lost corporate tax every year.”

This doesn’t just mean lower receipts, but less innovation for the countries seeing the exodus. And it is less convenient for the companies themselves, which now must spread their operations around. 

For example, Nike has long offshored the rights to its intellectual property in tax havens such as Bermuda. One of Nike’s subsidiaries technically owns the brand and charges royalties to other Nike companies for their use of logos and more. While Nike is savvy for doing this, it doesn’t make the company stronger to shift around like this. It amounts to misdirected capital, as they must locate certain functions in areas that have no comparative advantage other than the tax arbitrage they offer.

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The most commonly-proposed solution is to close as many of the loopholes as possible. The Cato Institute argues that doing so would level the playing field and limit special interest power. TCJA already accomplished some of that. But even under a more streamlined corporate tax structure, corporations would still try to reduce their tax liability as much as possible. 

Ultimately, the U.S. and other legacy nation-states need to get past the idea that taxation, especially on income, is the best way to fund government. Many countries with little or no income tax have better services than the U.S., because they generate revenue through user fees or state-run enterprises. Such tax havens are scattered about – particularly concentrated in the Caribbean and Middle East – and successfully profit off their oil, real estate, tourism and more. They’re not “socialist”, per say, but their state management often complements or even invests in what is produced by the private sector, collecting the passive income.  

Having a corporate income tax looks anachronistic compared to these models, and helps explain, for example, the steady stream of millionaires from European regulatory states to Dubai. If America wants to stay competitive and avoid this fate, it should consider repealing the tax. 

Cover image is available in the public domain.