Somewhere in the midst of this year’s elections, there is a debate about the structure of the federal government’s tax system. A common complaint about the system (and, increasingly, the Affordable Care Act) is dubbed “double taxation.” In this post, I describe the complaint and note its nonsensical nature.
In a nutshell (and framed in terms of corporate taxes, perhaps the most frequent target of this charge), the complaint about double taxation is as follows. Suppose you own a corporation that earns $100, taxed at 35%. The corporation’s after tax revenue is $65. Suppose, as the sole shareholder, you take this income as a dividend. TO keep things simple, suppose that this dividend income is taxed at the highest personal marginal income tax rate, also 35% (some dividends are currently taxed at lower marginal rates). Then you end up with $42.25 after both rounds of taxation. In other words, the income was taxed at an effective tax rate of 57.75%.
I have two points. First, the concept of double taxation by the same government is a red herring. It is misleading, in the sense that it suggests that you’re paying twice for the same thing. That is, the implicit claim is that you’re paying twice for that admittedly abstract service, “governance.” But, in reality, since we’re running a deficit, you’re currently not even paying a full “once” for it. Consider first the following example.
Suppose that the government sends you two tax bills, one for “domestic spending,” and another for “defense spending.” After you pay the first one, the resulting money from which you have to pay the second has already suffered the ignominy of taxation! The second tax bill is less legitimate, no? No.
Put another way, suppose that the government outsourced all of defense to Chuck Norris and a band of mercenary zombies (to prepare for the 1000 years of darkness). Instead of collecting the second tax to pay Chuck and his loyal brain eaters, you are instead directly sent a bill from Chuck for the same amount as you would have paid in taxes. Is this double taxation? No, because it’s a bill, not a tax, right? In other words, is it double taxation whenever someone pays an admission fee to a National Park? Or how about when you pay for a passport? In short, the correct answer is “double taxation is a red herring.”
Corporations are a choice. The second point I will make is more specific. The point of most double taxation arguments these days is that corporate income is double taxed and, essentially, this is unfair. I am not in the business of saying what is fair, but I am happy to describe my reasoning for why something is reasonable.
A simple argument for why it is reasonable for corporations to pay taxes goes as follows. Corporate taxes are avoidable: simply carry on the same economic activity without a corporate structure. That is, make all of the arrangements using traditional contracts, signed by you as the sole proprietor.
Why don’t corporations do this? Well, because corporations extract large and real benefits from resource pooling made possible through the provision of limited liability to shareholders. (There are also tax benefits from incorporating, but I will set this obvious target to the side. And I won’t touch this one.)
Without going into too much detail about limited liability, suffice it to say that the benefits corporate structure are entirely derived from the state’s role in enforcing contracts and adjudicating liability. In other words, corporations are ancillary to the rule of law of which the state is the ultimate purveyor. Accordingly, any constitutional tax structure that the state’s citizens choose to impose on corporate income is reasonable. (By constitutional, I am waving off tax structures such as those that base tax rates on forbidden criteria such as the race or ethnic origins of the shareholders.)
Note that this point implies that fairness objections to international double taxation (taxation by two nations’ governments) are inconclusive as well.
There are a number of other arguments (e.g., the voluntary nature of dividend distribution, the issue of capital gains and (expected future) taxes being priced into assets), but I will conclude here by pointing out that I am not arguing that the taxation of income necessarily should be differentiated according to the income’s source. Rather, the argument that it should not should be engaged directly. Arguing that something is “double taxed” shows that one is either thinking only halfway or telling a half-truth.