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Capital is mobile within the tax system too.

September 08, 2011

There is a lot of evidence that U.S. corporate rates are too high. Even Charlie Rangel was on board with that. These rates are counterproductive, as the Tax Policy Blog points out:

So, paradoxically, raising rates would have the effect of lowering revenues. Alex Brill and Kevin Hassett do a more rigorous analysis and find that revenue is maximized at about a 26 percent federal rate - a full 9 points lower than the current U.S. rate of 35 percent.

The reason is that capital is mobile, and increasingly so. Corporate decision makers have a fiduciary responsibility to maximize shareholder value, which is achieved by maximizing sales (making customers happy, both here and abroad) while minimizing costs, including tax costs. When a company chooses to move operations to, say, Switzerland, it is because there is a better mix of tax costs, social benefits, and business opportunities. America is simply losing on this front, and the tragedy is that it could be changed very quickly by lowering the statutory rate.

While there is a lot of movement to lower corporate rates, many politicians and policy wonks think individual tax rates need to go up. President Obama would raise the top individual rate to (effectively) over 43%, and for left-side think-tanks like Citizens for Tax Justice, the sky's the limit.

Tax Analysts eocnomist Martin Sullivan notes that increasing marginal personal tax rates would increase taxes on many businesses:

Now we can quibble about whether the percentage of passthrough income potentially exposed to higher rates is 45 or 48 or 50 or even 60 percent. (There is no one way to do the calculation.) But the point made by Hassett and Viard in their article stands irrespective of the computational details. Tax increases on high-bracket taxpayers will hurt passthrough businesses because a large share of all passthrough business activity is from businesses owned by those taxpayers. Democrats in and out of the Obama administration should stop trying to deny it. It cheapens the legitimate arguments against extending tax cuts for the wealthy.

So how long would it take businesses that now pay taxes on owner tax returns -- S corporations and partnerships -- to opt into a corporate tax system with a 26% top rate if they face a 43% or higher marginal rate on their 1040s? Slightly longer than it takes to write this sentence.

As mobile as capital is among countries, it is even more mobile within the tax system. Every pass-through entity could move into the corporate tax system tomorrow by filing some token paperwork. If 35% rates are too high for business income, certainly 43% is too -- especially if corporate rates go down to 26%. Given the choice of 26% rates, businesses won't meekly pay a 43% rate. That means advocates of higher personal rates will be greatly disappointed by their revenue take if they ever succeed.

Related: It doesn't affect most businesses. Just most business income

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So Peter, your argument just shows that reducing the corporate tax rate to 26% would be foolhardy. Instead, we should greatly simplify the tax system by banning the use of pass-through regimes for large companies and making the partnership tax rules more reasonable (get rid of the carried interest silliness, mandate remedial method calculations for built-in-gain properties, tighten the allocation rules to prevent the kind of gamesmanship that still goes on around that, etc.). At the same time, just let all the Bush tax cuts expire except for the cuts that benefit those in the lower 50% of the income distribution.

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