Reform the Corporate Income Tax, Don’t Ditch It

Apple CEO Timothy Cook testifies before the Senate Homeland Security and Governmental Affairs Committee's Investigations Subcommittee about the company's offshore profit shifting and tax avoidance in the Dirksen Senate Office Building on Capitol Hill May 21, 2013 in Washington, DC. A Congressional report released yesterday said that Apple, America's most profitable technology company, used a complex system of international subsidiaries and tax avoidance efforts to shift at least $74 billion out of the reach of the Internal Revenue Service between 2009 and 2012.
Apple CEO Timothy Cook testifies in Washington, DC. Photo: Chip Somodevilla/Getty Images

Earlier this week, Apple CEO Tim Cook and several other Apple executives testified before a Senate subcommittee about Apple’s fabled tax-avoidance strategies, telling a group of senators how they save billions of dollars a year in taxes through some creative accounting maneuvers involving Irish subsidiaries and profit-sharing arrangements designed to funnel profits to the places where they’ll be taxed the least.

Lots of people quickly seized on the Apple hearings to argue that the corporate income tax — the tax Apple works so hard to avoid paying — should be abolished entirely. This isn’t surprising. The corporate income tax provides a relatively small slice of the nation’s tax revenues (10 percent in 2012), but it is one of the most controversial parts of the tax code, and calling for its abolition is a perennial hobby of econo-bloggers and fiscal conservatives. Megan McArdle has said that the corporate income tax “may be the stupidest tax we have.” Matt Yglesias doesn’t like it; Ezra Klein says he’s “sympathetic” to those who want to get rid of it; Evan Soltas suggests replacing it with a carbon tax. And the Wall Street Journal editorial page devoted yesterday’s column to declaring the corporate income tax a “genuine outrage.”

Why does everyone hate the corporate income tax? Well, broadly speaking, conservatives hate it because it punishes job-creators and because it makes America a less friendly place for business. Progressive econ wonks hate it because it’s an inefficient tax that ends up being borne mostly by the wrong people (middle-class workers, through lower wages, rather than executives) and because it favors huge corporations like Apple —which have fancy accountants, global sales, and the ability to shift their profits around the world to take advantage of tax havens — over other kinds of businesses. Instead of taxing corporate profits, these people say, we should eliminate the corporate income tax and find other ways to tax the owners of capital more directly.

I find some of these arguments convincing. But I’ll offer a partial defense of the corporate income tax, for a few reasons. First is that the corporate income tax is the best mechanism we have for checking the power of multinational corporations operating abroad. Second is that repealing it would put the capital class at an advantage over the wage-earning class when it came to personal tax planning. Third has to do with the political feasibility of replacing the corporate income tax with other kinds of taxes. Let’s take these in turn.

First: the checking-power argument. This is best elucidated by University of Michigan professor Reuven S. Avi-Yonah, who wrote the 2004 paper “Corporations, Society and the State: A Defense of the Corporate Tax” [PDF]. Avi-Yonah’s argument is that the corporate income tax, which began as “a regulatory device to limit the power of management,” is the best way a nation can exert regulatory influence over multinational enterprises (MNE) that operate outside its borders.

He writes:

The rise of MNEs has significantly weakened the regulatory power of the state since MNEs by definition operate across jurisdictions and can set one jurisdiction off against another. Taxation is one vehicle of regulation and an area in which extraterritorial jurisdiction is well established in international law. Therefore, it offers a promising venue to regulate MNEs.

To apply Avi-Yonah’s argument to Apple: If we give up the corporate income tax, we lose the best mechanism we have for imposing any oversight on what Apple does abroad. The reach of most U.S. laws stops at the border, which is why, for example, we can’t make Apple’s Chinese suppliers pay their employees an American minimum wage. But the tax code has longer arms. And through it, we can incentivize Apple to do things we deem good (like pushing its suppliers to increase wages and make factories safer) and penalize it for things that we deem bad (like dodging taxes through complicated shell-games), even if it’s doing those things outside the nation’s physical borders.

A corporate income tax opponent would argue that those incentives and penalties could just as easily be applied through other means — trade agreements, say, or taxing shareholders and executives of corporations rather than to the corporations themselves. But evidence suggests that they work better as part of the corporate tax code. In 1994, taxes were raised on shareholders of American companies that “inverted” — that reincorporated in a low-tax haven like Bermuda for the purposes of avoiding taxes — in an attempt to convince more of these companies to stay in the U.S. This rule change did basically nothing — as Avi-Yonah points out, the shareholder tax increase “had no effect whatsoever on the rate of inversions.” But in 2002, when Congress threatened to raise the corporate income taxes of companies that did the same thing, the number of inversions dropped dramatically. Clearly, there is something about the threat of increased taxes on the corporation itself that keeps corporate managers in check. Give up the corporate income tax and you lose a great mechanism for incentivizing ethical business practices.

Second is the tax-planning issue. One of the side effects of repealing the corporate income tax would be the popularization of a nifty tax-avoidance trick: You, as an individual, could set up a corporation for yourself, direct all your income into that corporation, withdraw only the money you want to spend, and shield the rest from taxes indefinitely. (You could theoretically do this now, but you’d have to pay corporate taxes on the money coming into your corporation — which would sort of negate the point.) This trick, and other tax-deferral strategies like it, would be used disproportionately by the wealthy, who can afford accountants and choose how and where their income is paid, unlike most wage-earners. McArdle claims that the IRS would try to punish those who abuse such a scheme, and she’s right. But there’s nothing the IRS could do about legal, non-abusive uses of this system, and the result would be an advantage for those capital-class over middle-class wage earners.

Third, there’s a political problem with what many progressive econ wonks say they want to do — repeal the corporate income tax and replace it with increased taxes on dividends, capital gains, and/or carbon emissions. Namely, it would never happen. Republicans could get behind the corporate tax repeal, and Democrats could get behind raising taxes that affect owners of capital. But getting both in a single step would be nearly impossible in today’s political climate. To most progressives, repealing the corporate tax would look too much like a brazen handout to big business. (Would you want to be the rust-belt Democrat explaining to your constituents why Wal-Mart’s taxes are being cut to zero?) And conservatives would run screaming from tax hikes affecting individuals, even if they would be offset by the corporate tax abolition. As we saw during the fiscal-cliff negotiations, it’s hard to make even small changes to the tax code without provoking all-out warfare between the parties; the idea of radically overhauling several major parts of the tax code all at once is the stuff of political fantasy. And without compensating for the corporate tax cut by substantially raising other taxes, all you’d have is a big revenue gap and a few very grateful corporations.

There are certainly problems with the current corporate tax regime. And, yes, it’s possible to imagine a taxation scheme that would better allocate the tax burden to the owners of capital. But the tax isn’t going anywhere, which means we should instead be focusing on closing existing loopholes and reforming the code to make it harder to get away with the kinds of globe-trotting tax arbitrage practiced by Apple and other multinational corporations. That might not be as satisfying as throwing the entire corporate income tax out the window, but it will be a much better use of time and energy.