In the past few weeks, President Obama (who can’t seem to get out of “election mode” with all his stump speeches) has stated that corporations must “pay their fair share.” In furtherance of this Democratic mantra of “paying their fair share,” Democrats have proposed to raise corporate taxes to offset the mountainous budget deficits caused by entitlement spending. Unfortunately, corporations don’t, despite corporate tax rates, actually pay taxes.
Now I’m sure you’re thinking, "yeah, corporations have all those tax loopholes and things to avoid paying taxes." Or as Tim Robbins so eloquently puts it in Team America: “the corporations sit there in their... in their corporation buildings, and ... and, and see, they're all corporation-y ... and they make money.” Nope. The reason corporations don’t pay taxes is because they’re not actually people. Shocking, I know that there isn’t actually a person named General Mills walking around Golden Valley Minnesota making cereal.
You see, legally, corporations are viewed, for all intents and purposes, as people. They have names, can be liable or sued in court, and possess certain rights under the Constitution (e.g., free speech). But unlike an actual person, corporations don’t accumulate wealth for themselves. Rather, they are what’s known as a “pass through entity,” meaning all gains or losses are passed through to shareholders. Thus, when the government raises corporate taxes, what they’re actually doing is raising taxes on the shareholders.
Here’s an example: Government General Motors. When GM makes and then sells a car, presumably it makes a profit (otherwise it's not very good at making and selling cars … wait ...). Unlike an actual person, that profit, or income, doesn’t go into a savings account at a local Detroit bank owned by General Motors. Rather, it gets passed on to shareholders who own stock in the company (share price goes up). If the government raises the corporate tax rate, which is currently 35%, to say 50%, three things can happen.
First, GM can pass the higher rate along to shareholders. It keeps its car prices the same, keeps its wages and production costs the same, and simply reports a smaller earnings per share at the end of the fiscal year. Second, GM can pass the higher tax rate cost along to its customers by raising the price on its products, its cars. Shareholder profits and employee wages would remain unchanged. Third, GM can offset the higher tax cost by lowering its cost of production (e.g., laying off workers and/or cutting wages). Shareholder profits and consumer car prices would remain unchanged. Finally, it could do a combination of these three options. In the end though, regardless of what GM does or how high the corporate tax is, either the worker, consumer, or shareholder is paying the tax, not GM.
Most GM employees, especially the ones who would be laid off, would likely fall into the middle class of America. Similarly, it is primarily middle class Americans who purchase GM cars. Lastly, given most blue chip stocks, like GM, are primarily owned by mutual funds, which in turn form the bulk of most 401ks and municipal pension plans, the shareholders who actually own GM are mainly middle class Americans. In the end, regardless of what GM does, it's mostly middle class Americans paying corporate taxes.
If the government raises corporate tax rates, middle class Americans will either pay more for things they purchase, earn less from their investments in stocks, or make less money as their employers cut wages. People who make less spend less, so the economy will either get worse or continue to stagnate if corporate taxes go up. Additionally, higher corporate tax rates will provide less incentive for foreign corporations to base themselves in America and create a greater incentive for domestic companies to base themselves overseas. Whatever positive revenue the government might gain to justify increased corporate tax rates will be more than offset by the negative economic impact described above.
What the government should do instead is eliminate the corporate tax altogether and offset this by slightly (and I mean slightly) by raising the capital gains rate so that tax rates on investment income are in the 20-25% range. Investors would make more money, have more incentive to invest (which is good for economic growth), and between the economic growth and slightly higher rates, the government would likely make more money to … waste because it's horrible at managing money. If the government had to have a corporate tax rate just so politicians could say corporations are “paying their fair share” (which I’ve just shown they don’t), because it sounds good on TV, then the rate should be reduced to make America an attractive place to do business (at this point, I’d rather incorporate in Latvia where the corporate tax rate is like 10%) compared to other countries, and to make investment in equities more profitable/attractive than gambling (Fact: If your $2,000 investment in a corporation yielded a $10,000 profit per share for the corporation, you’d only get about $5,500 of that profit because of the combination of corporate taxes and capital gains taxes; whereas if you gambled that $2,000 in a casino and made a $10,000 profit, you’d keep anywhere from $8,000 to $6,500 back, depending on your tax bracket).
* Note, this article doesn’t even account for state corporate tax rates which: (1) drive big corporations out of the state; (2) fall instead on small, local corporations that can’t leave the state; and (3) big corporations negotiate not to pay in return for not leaving the state (see Illinois and Caterpillar, Sears, and Motorola).