Why do we tax corporations instead of the shareholders who own them?

Why do we tax corporations instead of the shareholders who own them?

Why do we tax corporations instead of the shareholders who own them?

Answers to your questions about the news.
Oct. 17 2008 6:02 PM

Why Do We Tax Corporations?

Wouldn't it be easier just to tax individuals?

Barack Obama and John McCain have butted heads recently over whose tax plan would benefit "Joe the Plumber" and whose would benefit large corporations. John McCain has proposed cutting the corporate tax rate from 35 percent to 25 percent. Obama says he would close corporate tax loopholes but would not lower the rate. Why do we tax corporations in the first place—why not just tax the shareholders individually?

Because the alternative would be even worse. There are several reasons why we have a corporate income tax in addition to the personal income tax. The first is a basic idea of taxation called the benefit principle—that people pay for the government services they consume. If you're a frequent driver, the gas tax means that you end up subsidizing roads. If you spend a lot of time in national parks, an entry fee makes sure you help pay for their upkeep. And if you're a business that benefits from legal protections and police protections and financial regulations, you're expected to pay money to support the system.

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Another reason to tax corporations directly is simplicity. It's a lot easier to collect taxes from a single entity than thousands of individual shareholders. Plus, if something goes wrong, it's easier to fix. Say a company reported earnings of $1 million one year, only to discover a year later that it had actually made $2 million. Currently, the IRS can go back to the company and collect taxes owed. But if all the income was distributed to individuals, the IRS would have to deal with them all separately.

Another problem with eliminating the corporate tax: It would create bad incentives. Say a company wants to set aside 50 percent of its income for reinvestment and give the rest to shareholders. If the reinvestment money weren't taxed—if the government taxed only the money that went to the individuals—then the company would have an incentive to hoard it all and never pay shareholders.

Also—some would say most important—taxing corporations directly can be more profitable for the government. Economists argue that under the current system, individual shareholders get taxed twice—first under the corporate income tax and again under the personal income tax. This allows state and federal governments to collect more money than they would otherwise. "Why tax just once when you can tax twice?" says Dan Mitchell of the libertarian Cato Institute.

To fix this "double taxation" problem, some economists propose "integration"—the fusing of the corporate and personal income taxes. One solution is to scrap the corporate income tax and instead have shareholders pay taxes based on how many shares they own. * (This would basically treat shareholders like small business owners, who report income according to their stake in the partnership.) Another solution is to keep the corporate income tax but give shareholders a tax credit based on how much corporate tax has already been paid. That way, you're not paying tax on the same income twice.

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Other economists suggest abolishing corporate taxes entirely. One alternative is the flat tax, promoted most famously by Steve Forbes in 1996. This proposal would tax everyone's income at the same rate. Another option is the value-added tax, which taxes every stage of the production process of goods, which then gets passed on to the consumer. And lastly, there's the national sales tax, which would simply tax everything at the register. These ideas have their downsides—the flat tax would hurt the working poor, while some argue the national sales tax would create a black market for every good and service you can imagine.

Got a question about today's news? Ask the Explainer.

Explainer thanks Daniel Mitchell of the Cato Institute, Joel Slemrod of the University of Michigan, and Robert Williams of the Urban Institute.

Correction, Oct. 20, 2008: This article incorrectly described the process of scrapping corporate taxes and taxing shareholders instead as "dividend imputation." ( Return to the corrected paragraph.)