The corporate income tax—a feature of the U.S. tax system for several decades—is a natural part of a tax system that seeks out income and taxes it wherever it is found. Such a system is flawed, however, and the corporate income tax is one of its most serious flaws.
Through a corporation, large groups of investors can pool their resources, share their risks, and adjust their investments through stock market trading. Although partnerships are a less flexible way to organize a business in that they rely on a relatively small number of investors who can adjust their share only through costly negotiations, their small size creates more accountability. The choice between organization types depends on various trade-offs that the market can work out.
A firm becomes a corporation when it needs capital to grow, even though this decision brings with it the corporate income tax, which effectively takes one-third of all profits ever generated by a new corporation but puts up no cash.
The corporate income tax distorts the allocation of capital between partnerships and corporations by forcing corporations to offer a higher return on investment since they must both pay their investors a competitive return and give the government its third. Thus enterprises that can be efficiently organized as partnerships, such as commercial real estate companies, have easier access to capital since they do not pay corporate income tax, causing too much capital to be directed to such activities.
This misallocation of capital is particularly damaging for a dynamic economy such as that of the United States, whose economic growth comes from innovation. Innovation is an expensive and risky activity, however, and often requires the advantages of a corporation. The United States tax policy should be revised to encourage innovation, which benefits not only the innovator but also consumers through new products and workers through higher productivity. Instead, the corporate income tax discourages innovation and thus damages growth.
The burden of the corporate income tax can be reduced by a variety of reforms. For instance, many European countries allow investors to be credited on their personal tax bills for income taxes paid by the corporations they own. Phasing out the corporate income tax for old firms and eliminating it for new corporations would produce large benefits with small losses in revenue. With some ingenuity, the political process can find some way to rid our economy of this burden and benefit investors, consumers, and workers.
The corporate income tax is an anachronism. Eliminating it would help maintain strong economic growth.