[Senate Hearing 114-654]
[From the U.S. Government Publishing Office]
S. Hrg. 114-654
INTEGRATING THE CORPORATE AND
INDIVIDUAL TAX SYSTEMS: THE DIVIDENDS
PAID DEDUCTION CONSIDERED
=======================================================================
HEARING
before the
COMMITTEE ON FINANCE
UNITED STATES SENATE
ONE HUNDRED FOURTEENTH CONGRESS
SECOND SESSION
__________
MAY 17, 2016
__________
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COMMITTEE ON FINANCE
ORRIN G. HATCH, Utah, Chairman
CHUCK GRASSLEY, Iowa RON WYDEN, Oregon
MIKE CRAPO, Idaho CHARLES E. SCHUMER, New York
PAT ROBERTS, Kansas DEBBIE STABENOW, Michigan
MICHAEL B. ENZI, Wyoming MARIA CANTWELL, Washington
JOHN CORNYN, Texas BILL NELSON, Florida
JOHN THUNE, South Dakota ROBERT MENENDEZ, New Jersey
RICHARD BURR, North Carolina THOMAS R. CARPER, Delaware
JOHNNY ISAKSON, Georgia BENJAMIN L. CARDIN, Maryland
ROB PORTMAN, Ohio SHERROD BROWN, Ohio
PATRICK J. TOOMEY, Pennsylvania MICHAEL F. BENNET, Colorado
DANIEL COATS, Indiana ROBERT P. CASEY, Jr., Pennsylvania
DEAN HELLER, Nevada MARK R. WARNER, Virginia
TIM SCOTT, South Carolina
Chris Campbell, Staff Director
Joshua Sheinkman, Democratic Staff Director
(ii)
C O N T E N T S
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OPENING STATEMENTS
Page
Hatch, Hon. Orrin G., a U.S. Senator from Utah, chairman,
Committee on Finance........................................... 1
Wyden, Hon. Ron, a U.S. Senator from Oregon...................... 4
WITNESSES
Graetz, Michael J., Wilbur H. Friedman professor of tax law and
Columbia alumni professor of tax law, Columbia University, New
York, NY....................................................... 6
Miller, Judy A., director of retirement policy for the American
Retirement Association and executive director of the American
Society of Pension Professionals and Actuaries, College of
Pension Actuaries, Arlington, VA............................... 9
Rosenthal, Steven M., senior fellow, Urban-Brookings Tax Policy
Center, Urban Institute, Washington, DC........................ 11
Wells, Bret, associate professor of law, Law Center, University
of Houston, Houston, TX........................................ 12
ALPHABETICAL LISTING AND APPENDIX MATERIAL
Graetz, Michael J.:
Testimony.................................................... 6
Prepared statement........................................... 33
Hatch, Hon. Orrin G.:
Opening statement............................................ 1
Prepared statement........................................... 46
Miller, Judy A.:
Testimony.................................................... 9
Prepared statement........................................... 48
Rosenthal, Steven M.:
Testimony.................................................... 11
Prepared statement with attachment........................... 53
Wells, Bret:
Testimony.................................................... 12
Prepared statement........................................... 71
Wyden, Hon. Ron:
Opening statement............................................ 4
Prepared statement........................................... 73
Communication
Center for Fiscal Equity......................................... 75
(iii)
INTEGRATING THE CORPORATE AND
INDIVIDUAL TAX SYSTEMS: THE DIVIDENDS
PAID DEDUCTION CONSIDERED
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TUESDAY, MAY 17, 2016
U.S. Senate,
Committee on Finance,
Washington, DC.
The hearing was convened, pursuant to notice, at 10:10
a.m., in room SD-215, Dirksen Senate Office Building, Hon.
Orrin G. Hatch (chairman of the committee) presiding.
Present: Senators Crapo, Thune, Isakson, Portman, Heller,
Scott, Wyden, Stabenow, Cantwell, Carper, Cardin, Bennet, and
Casey.
Also present: Republican Staff: Chris Campbell, Staff
Director; Mark Prater, Deputy Staff Director and Chief Tax
Counsel; Tony Coughlan, Tax Counsel; Chris Hanna, Senior Tax
Policy Advisor; and Nicholas Wyatt, Tax and Nominations
Professional Staff Member. Democratic Staff: Joshua Sheinkman,
Staff Director; Ryan Abraham, Senior Tax Counsel; and Tiffany
Smith, Senior Tax Counsel.
OPENING STATEMENT OF HON. ORRIN G. HATCH, A U.S. SENATOR FROM
UTAH, CHAIRMAN, COMMITTEE ON FINANCE
The Chairman. The hearing will come to order. I would like
to welcome everyone here this morning.
Even a cursory examination of the business tax system
demonstrates clearly the problems that arise from the out-of-
step corporate tax, which contributes significantly to our
anti-competitive business climate and leads sophisticated tax
planners to engage in costly efforts--which some would call
gamesmanship or tax avoidance--to either minimize their taxes
or manage competitive tax pressures from abroad. Without
significant reforms to the corporate tax system, we will
continue to see an erosion in our overall tax base along with
diminished growth and diminished investment.
Among the most significant and inexplicable inefficiencies
in our business tax system is the fact that a significant
portion of U.S. business income is taxed more than once. Under
the current system, income earned only once by corporations--on
behalf of its shareholders--is taxed twice, thanks to a fiction
created in the law that treats a business and its owners as two
separate, taxable entities.
Specifically, when a corporation turns a profit, those
earnings are taxed under the corporate income tax system,
generally at a rate of 35 percent. When the corporation
distributes a portion of those earnings to its shareholders in
the form of dividends, we tax those earnings a second time at
the individual level, with a maximum dividend tax rate
approaching 25 percent.
This, put simply, is a problem. We have this problem, in
large part, due to the fact that rules for taxing corporations
were written without taking into account the rules for taxing
individuals, and vice versa. A better, more efficient system
would be one that integrates the taxation of corporate and
individual income. That is what we are here to discuss today.
The current system of double taxation has resulted in a
number of unintended economic distortions that would not exist
under a more integrated system. I will discuss just a few of
those distortions here this morning. For example, the current
system creates a bias in the choice of business entity,
disfavoring the corporate model versus others. Of course,
businesses--small and start-up businesses in particular--should
have the flexibility to determine how to organize themselves.
But our tax code should not punish any particular business with
double taxation simply because it was organized a certain way.
Double taxation also discourages savings and investment and
is a major factor in our current domestic savings and
investment shortage. Savings and investment are essential to
capital formation, increased job productivity, wage growth, and
adequate retirement savings. Yet, we have created a system that
essentially punishes those who save and invest. In addition,
the current system explicitly favors debt-financed investment
over equity-financed investment.
In the U.S., corporations can deduct interest paid to bond
holders, but no similar deduction exists for dividends paid to
stockholders. Now, in some situations, there may be strong
reasons for a company to opt for debt financing, but there is
no real reason why the tax code should favor debt over equity.
Double taxation also contributes to the problem of lock-
out; that is, it discourages businesses from bringing income
earned overseas back into the U.S. As many have already noted,
with the highest corporate tax rate in the developed world,
American multinational companies are often loath to repatriate
their foreign earnings and subject them to U.S. taxes on top of
the taxes they have already paid in foreign jurisdictions.
Their shareholders rarely demand that they do so, because those
earnings would be taxed again if and when they are ever paid
out as dividends. As a result, experts estimate that U.S.
corporations have over $2 trillion in earnings that are locked
out of the U.S. due, in large part, to our stupid tax system.
These problems--and there are many others--have been
observed for years. As a result, many have argued for the
elimination of double taxation and in favor of integrating the
individual and corporate tax system. We are going to continue
that discussion here today.
In any discussion of an integrated system, the fundamental
design choice that has to be made is whether the single
instance of taxation should fall on the corporation or the
shareholders. Given the substantial burdens our corporate tax
system already imposes on U.S. businesses, coupled with the
relatively high mobility of corporate residence in the age of
globalization, as illustrated by the recent wave of inversions
and foreign takeovers, some have questioned the wisdom of
collecting the tax on the corporation side.
Another method of integrating the two systems would be to
impose a single layer of tax at the shareholder level by
allowing companies to deduct any dividends they pay out. As I
see it, there are a number of benefits to this approach. I will
mention just a few.
First, a deduction for dividends paid would allow
businesses to cut their own effective tax rates. There is
bipartisan agreement on the need to bring down corporate tax
rates. A dividends paid deduction could accomplish the same
goal without many of the trade-offs associated with a reduction
in the statutory tax rate.
Second, this type of deduction would create greater parity
between debt and equity. As I noted earlier, current law
generally allows corporations to deduct earnings paid out as
interest on debt obligations. A dividends paid deduction would
provide similar tax treatment for earnings paid out as
dividends to investors, allowing the companies to make debt-
versus-equity decisions after considering market conditions
instead of simply referencing biases in the tax code.
Third, a dividends paid deduction could help with some of
our international tax problems by reducing the pressure on
companies to invert and greatly reducing the lock-out effect.
To hopefully take advantage of these and other benefits, I
have been working for over a year now on a tax reform proposal
that would eliminate double taxation of corporate income by
providing this type of deduction. While I plan to unveil that
proposal here in the next several weeks, I am hoping we can
inform this ongoing effort by having a more detailed discussion
of these concepts and others during the course of today's
hearing.
Before I conclude, I want to acknowledge that some groups--
including tax-exempt entities and retirement plans--may have
some concerns with a dividends paid deduction. However, at the
end of the day, I believe we can craft a system where these
parties will be treated in a manner that is comparable to
current law or, in fact, in many cases, be better off. At the
same time, our overall tax system will, in the opinion of many,
be very much improved.
Still, I want everyone to know that I am preparing our
integration proposal, and I am aware of the concerns that these
and other groups might raise, and I am studying them very
closely. Today, and going forward, we seek your comments and
suggestions.
With that, I just want to say that I appreciate the fine
panel of witnesses being here today, sharing their knowledge
and expertise with the committee. I think this is going to be a
very informative hearing.*
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* For more information, see also, ``Overview of Approaches to
Corporate Integration,'' Joint Committee on Taxation staff report, May
13, 2016 (JCX-44-16), https://www.jct.gov/
publications.html?func=startdown&id=4913.
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[The prepared statement of Chairman Hatch appears in the
appendix.]
The Chairman. With that, I will turn the time over to the
distinguished ranking member, Senator Wyden, for his opening
statement as well.
OPENING STATEMENT OF HON. RON WYDEN,
A U.S. SENATOR FROM OREGON
Senator Wyden. Thank you very much, Mr. Chairman. I share
your view that we have an excellent panel of witnesses and this
is going to be a valuable morning.
Mr. Chairman and colleagues, we are going to discuss the
concept today of corporate integration, which is not exactly a
topic that comes up at summer picnics. But this issue is
important to the tax reform debate, and I want to thank
Chairman Hatch and his staff who have put an enormous amount of
sweat equity into this topic.
I am glad the committee is going to have the opportunity to
dig into the specifics about this issue. This morning I am
going to focus primarily on questions about what corporate
integration could mean for hardworking middle-class families
and small businesses that are looking for opportunities to get
ahead.
Now, by way of making sure everybody understands what it is
we are talking about, corporate integration is about
eliminating what some people call double taxation, where income
is taxed once at the corporate level and again at the
individual level. Once in place, this kind of tax change would
allow companies to write off payments they make to shareholders
in the form of dividends.
The theory goes, the profit corporations bring in would go
out as dividends, and corporate tax bills would shrink. But to
finance the big corporate tax cut, 35 percent of the money paid
out in dividends and bond interest would be withheld
automatically by the Treasury.
Now this raises, in my view, a number of questions. For
example, I am particularly interested--as I indicated--in what
this would mean for middle-class people, their retirement
savings, and what it means for small businesses. Small
businesses dominate the economic landscape of our country.
In my State, when you are done with a handful of big
businesses, that is it for big business. We are overwhelmingly
a small business State.
So I want to make sure that we drill deeply, and the
chairman has talked to me about this. When his proposal is
formally unveiled, he knows that our staff is going to look
into it in great detail. So it is important to dig into these
issues, and I am especially interested this morning in looking
at retirement savings and small business.
Now it looks, on its face, like this proposal could go from
double-taxing corporate income to double-taxing retirement
plans. Let me be specific about it. Today, most middle-class
savers put their money into retirement plans that are tax-
deferred. It is a good deal for working families, and this
country's savings crisis would probably be a lot worse without
it.
Retirement plans invest in lots of stocks and bonds, but
under a corporate integration plan, when you withhold a chunk
of the dividends and interest payments that go to retirement
plans, suddenly they could get hit with a big, new tax bill for
the first time. Their special tax-deferred status--which today
is the key that unlocks opportunities to save for millions of
Americans--could go away.
Right now, most savers already face a tax bill when they
take money out of their accounts. Corporate integration could
often add a second tax hit up front. So if you are an
electrician in Medford, OR or a teacher in Salem and you have
an IRA or a 401(k), you are going to wonder if this system says
that the dollar you socked away is worth less than it used to
be.
If the math on retirement plans suddenly looks worse to
small business owners, there is a possibility they might think
twice about offering a plan to their employees.
Now, on the question of the impact on businesses, and
particularly small businesses that, as I indicated, are the
foundation of so much of the American economy, I think there
are real questions about whether corporate integration, in
effect, gets America into the business, once again, of picking
winners and losers with respect to businesses.
Companies that run airlines and wind farms, which need
capital to invest and operate, could face higher costs if
interest rates jump. Start-ups may not necessarily want to pay
dividends to shareholders because they need to turn their
earnings into growth instead of dividends.
A corporate integration plan might look great to
established companies with lots of cash on hand, but not so hot
to the small businesses that I have indicated dominate the
economic landscape in my State and hundreds of communities
across the country.
So we have big issues to discuss today. I thank our
witnesses.
Before I conclude, I want to recognize that we have one of
our witnesses, Ms. Judy Miller, who is retiring at the end of
the summer. She served as a senior pension advisor to this
committee under Senator Baucus for 4\1/2\ years. She has
testified before us a number of times. I think all of the
members congratulate and thank Ms. Miller for her service and
her valuable advice over the years, and wish her well.
So, Mr. Chairman, thank you, and I look forward to digging
into these issues.
The Chairman. Well, thank you, Senator.
[The prepared statement of Senator Wyden appears in the
appendix.]
The Chairman. We have a very impressive group of
individuals here today. I would like to thank each of you for
coming.
First we will hear from Mr. Michael Graetz, Wilbur H.
Friedman professor and Columbia alumni professor of law at
Columbia University. Prior to coming to Columbia Law School in
2009, Mr. Graetz served as the Justus S. Hotchkiss professor of
law at Yale University, where he started teaching in 1983.
Prior to Yale, Mr. Graetz was a professor of law at the
University of Virginia and the University of Southern
California law schools. Before that, he served as professor of
law in social sciences at the California Institute of
Technology.
He is a prominent researcher in the tax field and has
written far too many books and articles to list here today. Mr.
Graetz also dabbled in government service when he served as
Assistant to the Secretary and Special Counsel at the Treasury
Department in 1992 and as the Treasury Deputy Assistant
Secretary for Tax Policy from 1990 to 1991.
Next we would hear from Ms. Judy Miller, the director of
retirement policy for the American Retirement Association and
the executive director of the ASPPA College of Pension
Actuaries. Prior to joining ARA, Ms. Miller served as the
Senior Benefits Advisor on the staff of the Senate Finance
committee from 2003 through 2007. We welcome you back.
Ms. Miller. Thank you.
The Chairman. Before joining the Finance Committee staff,
Ms. Miller provided consulting and actuarial services to
employer-
sponsored retirement programs for nearly 30 years. She is a
member of ACOPA, a member of the Society of Actuaries, a member
of the American Academy of Actuaries, and an enrolled actuary.
She received her bachelor of science degree in mathematics
from Carnegie Mellon University.
Third, we will hear from Mr. Steve Rosenthal, senior fellow
in the Urban-Brookings Tax Policy Center at the Urban
Institute. Mr. Rosenthal's week primarily revolves around
Federal income tax issues with a particular focus on business
taxes.
In 2013, Mr. Rosenthal served as the staff director of the
DC Tax Revision Commission. Before joining the Urban Institute,
Mr. Rosenthal practiced tax law in the private sector for over
25 years, most recently as a partner at Ropes and Gray.
He also deserves a warm welcome back, because he previously
served as legislative counsel with the Joint Committee on
Taxation. Mr. Rosenthal is also the former chair of the
taxation section of the District of Columbia Bar Association.
He holds an A.B. and a J.D. from the University of California
at Berkeley, and an M.P.P. from Harvard University.
Finally, we will hear from Mr. Bret Wells, associate
professor of law at the University of Houston. Mr. Wells
currently teaches at the University of Houston Law Center,
where he specializes in the fields of tax and oil and gas law.
Prior to his current position, Mr. Wells served as the vice
president, treasurer, and chief tax officer for BJ Services
Company and as head of tax for Cargill Corporation. He received
his bachelor's degree from Southwestern University and earned
his law degree at the University of Texas School of Law.
I want to thank all of you for taking time out of your busy
schedules to be in attendance today. We will hear from the
witnesses in the order they were introduced.
So, Mr. Graetz, please proceed with your opening statement.
STATEMENT OF MICHAEL J. GRAETZ, WILBUR H. FRIEDMAN PROFESSOR OF
TAX LAW AND COLUMBIA ALUMNI PROFESSOR OF TAX LAW, COLUMBIA
UNIVERSITY, NEW YORK, NY
Mr. Graetz. Thank you, Mr. Chairman, Senator Wyden, and
members of the committee. I thank you for inviting me to
participate in today's hearing. I have been involved with the
subject of corporate integration for 25 years now, in
particular working on the Treasury report on this topic in 1992
and the ALI report in 1993.
In the 1990s, when integration was the topic du jour,
domestic tax policy issues were the principal concern. They
included things like the chairman mentioned, including the
relative treatment of income earned through corporations and
pass-throughs, the comparative taxation of debt and equity, the
relationship of entity taxation to investor taxation, the
relative treatment of distributed and retained earnings, and
the relative treatment of dividend and non-dividend
transactions such as share purchases.
Today, international income issues have come to be also
prominent. These include the relative treatment of domestic and
foreign income, differences in the treatment of domestic and
foreign corporations, the coordination of domestic and foreign
taxes, and the problem of repatriation of foreign earnings to
the United States. Needless to say, these domestic and
international policy issues, in combination, make business tax
reform a daunting task.
I strongly support corporate integration through a dividend
deduction with withholding, but I want to make clear that while
this would improve the system by shifting taxation from
companies that are highly mobile to shareholders who are not,
we should not regard this as a cure-all for all of the ills
that ail the tax system.
As members of this committee know, I have long proposed a
much lower corporate tax rate, as low as 15 percent. That kind
of solution would eliminate incentives for investing abroad,
for shifting income abroad, and for foreign takeovers. But I do
not believe we can really fix our Nation's tax system without
another revenue source.
I have been a supporter of the progressive consumption tax
proposal of Senator Cardin, but that does not seem to be
imminent. So the question is, ``What should we do in the
meantime?'' I should also add that, in order to combat income
shifting by U.S. corporations, I have argued that we ought to
locate more profit in the country where the goods are sold,
rather than where the IP is owned or used.
But these are not on today's agenda. So the key question is
whether we move to these kinds of reforms or not--whether
corporate integration could solve some of these questions that
I began my testimony with, and that the chairman began with.
My written statement goes through all of the main issues of
corporate integration, so I will just make a few limited
remarks.
The first is that, when the Treasury and the ALI considered
integration in detail in the 1990s, they both rejected a
dividend deduction because it automatically extended to foreign
shareholders and tax-exempt entities, at considerable revenue
costs, the benefits of integration.
The staff of this committee and Senator Hatch deserve
credit for recognizing that this problem can be solved through
a nonrefundable withholding tax that retains the advantages of
the dividend deduction, shifting the tax burden from
corporations to shareholders, and lowering the effective tax
rate for companies, while avoiding that revenue loss and the
tax reductions that would otherwise occur for foreigners and
tax-exempts.
This proposal has all of the benefits of shareholder or
imputation credit integration, which is a system that has been
proven to work well in European countries and in Australia and
is a far better system than our current law, which imposes a
low shareholder tax and a high corporate rate. Shifting the tax
from corporations to shareholders would be more advantageous
and more progressive than the current system.
Let me just, with my limited amount of time, make one
comment about one of the major design issues. Others, I am
sure, will come up during the questions and answers, but I want
to say something about the treatment of interest in this
proposal.
Retaining a withholding tax on dividends of 35 percent is a
way of avoiding a tax reduction for those tax-exempt and
foreign shareholders who are now paying the corporate tax
through nondeductible dividends. So it is not an increase in
tax on those shareholders. On the other hand, a similar
withholding tax on interest is an increase in tax on those
shareholders, because that interest is now deductible and not
taxed if you are tax-exempt or a foreign shareholder.
This raises some important questions. It is worth saying
that you cannot equate debt and equity without making some
changes in the way that tax-exempt and foreign shareholders are
now treated. It is impossible to do so in the absence of that.
Let me just say that I am concerned about the fact that, if
you have withholding on corporate interest but not withholding
on other forms of interest, such as Treasury bills and bank
accounts and so forth, this may induce portfolio effects by
tax-exempt and foreign shareholders who will look for the
interest in the form that has no withholding.
It seems to me that one thing we ought to think about is
the option of limiting the deduction for interest as an
alternative. It turns out, Senator Wyden, you have proposed
eliminating the deduction for interest. Eliminating the
deduction for interest and a 35-
percent withholding tax on interest are, essentially, the same.
They have some differences for higher-income taxpayers, but
they are very close. The biggest difference is that by
eliminating the deduction, you do not reduce the effective rate
at the corporate level, which you do with a dividend deduction.
But it might avoid the kinds of portfolio realignments that
would occur with withholding on interest, and it seems to me
something that ought to be considered. Even though at first
blush a full deduction for dividends with withholding and a
partial or limited deduction for interest seems odd, it would
actually better align the tax system.
I am sure this is an issue we will come back to. It is an
important issue. It is one we struggled with at the Treasury
Department, along with many other issues that Senator Wyden and
others have raised. I am sure we will have a chance to talk
about these other issues.
Thank you very much.
The Chairman. Thank you, Mr. Graetz.
Senator Wyden. Mr. Chairman, just before we go on, on the
point that you touched on with respect to eliminating the
deduction for interest, Mr. Graetz, the bill that Senator Coats
and I have would just take a tiny part of it, not the entire
thing. Thank you.
[The prepared statement of Mr. Graetz appears in the
appendix.]
The Chairman. Ms. Miller, we will turn to you.
STATEMENT OF JUDY A. MILLER, DIRECTOR OF RETIREMENT POLICY FOR
THE AMERICAN RETIREMENT ASSOCIATION AND EXECUTIVE DIRECTOR OF
THE AMERICAN SOCIETY OF PENSION PROFESSIONALS AND ACTUARIES,
COLLEGE OF PENSION ACTUARIES, ARLINGTON, VA
Ms. Miller. Thank you, Chairman Hatch, Ranking Member
Wyden, and members of the committee, for the opportunity to
talk with you about the impact of corporate integration on
qualified retirement plans with an emphasis on retirement plans
for small business.
Data clearly shows that workplace savings are critical to
retirement security. In fact, workers earning between $30,000
and $50,000 are 15 times more likely to save if they have a
plan at work than if they have to set up an IRA and save on
their own. This means the impact of corporate integration on
the establishment and maintenance of workplace retirement plans
has to be considered when assessing the proposal's impact on
the retirement security of American workers.
Two key features distinguish retirement savings tax
incentives from other incentives in the Internal Revenue Code:
the deferral nature of the incentive and the nondiscrimination
rules that make employer-sponsored retirement plans efficient
at delivering benefits across the income spectrum.
These incentives play an especially critical role in
encouraging a small business owner to establish and maintain a
retirement plan. When that small business owner decides to set
up a 401(k) plan, they agree to take on administrative costs
and responsibilities, including fiduciary liability for
operating that plan, but that is not all. To comply with the
nondiscrimination rules, they usually have to also make
contributions for their employees. So they are not just putting
money aside for themselves, they are putting money aside for
their workers.
A corporate integration proposal that treats retirement
plan assets the same as investments made outside of a plan
would be a broadside hit on the tax incentives for
establishing, maintaining, and participating in a retirement
plan. The impact can be illustrated by considering a couple of
examples.
For illustration purposes, I am assuming the proposal
requires mandatory 35-percent withholding on dividends and
interest paid on all domestic stocks and bonds, including those
held in a retirement plan, with no ability to recover
withholding. Also, I am assuming investment income is from
dividends and interests, funds are initially invested 50-50 in
equities and bonds, the annual rate is 5 percent, which is not
terribly relevant, and the taxpayers marginal rate is 28
percent.
So first, let us look at somebody who has $10,000 to
invest, and they are considering, should I put it in the 401(k)
plan or should I invest it outside of the plan? With corporate
integration, both accounts are going to net the same amount
after 20 years, so there would be no tax incentive for
investing in the 401(k) plan instead of just putting it in your
personal account.
Since money held in a 401(k) plan and other qualified
retirement plans has a lot of withdrawal restrictions, you are
actually tying up the money, giving yourself less flexibility,
and possibly incurring a 10-percent penalty if you need it
before retirement by putting it in the plan. So there is
actually a disincentive to save through a 401(k) plan if there
is no tax incentive to do it.
Corporate integration looks even worse if you look at a
small business owner deciding whether or not to set up a 401(k)
plan. The business has been in operation for 5 years and is now
turning a profit. There are five non-owner employees with total
payroll of $300,000. The owner takes $10,000 a month during the
year, so they have $120,000 in compensation. At the end of the
year, they take a bonus which is equal to profits. They ``clean
it out'' so to speak. In the current year, it is $65,000.
Without a retirement plan, the owner is going to pay
individual income taxes on the bonus, at a marginal rate of 28
percent. So they would have $46,800 left after tax that they
could invest outside of the plan.
The retirement plan consultant recommends setting up a safe
harbor 401(k) plan with an additional cross-tested contribution
instead of taking the bonus. With this type of plan, the owner
can contribute $50,000 of the profits to the plan on her own
behalf, and thanks to the nondiscrimination rules, the owner
will also contribute $15,000, 5 percent of pay, for the staff.
So instead of taking home $46,800 and sending the IRS a
check for $18,200, the owner would contribute $50,000 to the
plan on her own behalf and $15,000 on behalf of the employees.
With corporate integration, the deduction for the
contribution is still going to cover the cost of the
contribution for the other staff, or largely cover it. If the
owner just paid on the $65,000 now and invested the difference,
though, she would end up with significantly more savings 20
years from now than if she put in the 401(k) plan. That is even
if she were to drop to a 15-percent marginal rate in
retirement.
In this case, with the 28-percent rate in retirement, she
can actually increase her savings by 30 percent by not putting
in a 401(k) plan. Given all of the strings attached to
withdrawing money from a 401(k) plan, she would also have more
flexibility holding those savings outside of the plan.
In other words, with corporate integration, the owner would
not only have less expense, less liability, and more
flexibility, she would actually have more long-term savings by
just saying ``no'' to putting in that 401(k) plan.
In summary, corporate integration may be good tax policy in
theory, but it would be horrible retirement policy in practice
if there is no incentive for a small business owner to set up
and maintain a workplace retirement plan. Without a plan at
work, most workers with modest income just are not going to
save for retirement.
We would be pleased to work with the committee on how the
proposal can be fashioned to preserve the tax incentives for
retirement savings. Again, I want to thank you for inviting me,
and I would be pleased to discuss this issue or answer any
questions you may have. Thank you.
[The prepared statement of Ms. Miller appears in the
appendix.]
The Chairman. Well, thank you.
Mr. Rosenthal?
STATEMENT OF STEVEN M. ROSENTHAL, SENIOR FELLOW, URBAN-
BROOKINGS TAX POLICY CENTER, URBAN INSTITUTE, WASHINGTON, DC
Mr. Rosenthal. Chairman Hatch, Ranking Member Wyden, and
other members of the committee, I am Steve Rosenthal, senior
fellow at the Urban-Brookings Tax Policy Center. Thank you for
inviting me to testify today.
I would like to highlight some new research which we
published yesterday, and the implications of that new research
on the effort to further integrate the corporate and individual
tax systems.
Let me draw your attention to Figure 1 of my written
testimony, which is displayed on the monitors to my left. My
co-author, Lydia Austin, and I found a seismic shift of stock
ownership from taxable accounts to nontaxable accounts over the
last 50 years. We estimate that the share of U.S. corporate
stock that is held in taxable accounts of individuals fell from
80 percent in 1965 to less than 25 percent in 2015, which is
the gray shaded area at the bottom of the figure.
What happened? Nontaxable retirement accounts, the blue
shaded area, and foreigners, the white at the top, displaced
much of the stock holdings of taxable accounts. As a result of
the downward trend in taxable stock ownership and the reduction
in tax rates on individuals for qualified dividend income and
long-term capital gain, corporate earnings now face a very low
effective tax rate at the shareholder level. The base is small,
and the tax rates are low.
I would like to highlight three important implications to
further integrating taxes on corporate earnings. Corporate
earnings are ostensibly taxed twice, but in practice rarely
are.
By our calculations, more than three-quarters of the
shelter base is untaxed, and those remaining face reduced tax
rates. Second, taxing corporate earnings only at the corporate
level is challenging in today's environment, as Chairman Hatch
has noted. Corporations are mobile, and they can easily shift
their earnings abroad.
To further integrate our tax system, we can either
strengthen corporate taxes by closing corporate loopholes or
shift taxes more aggressively to the shareholder level, as is
being explored by staff today. But shifting taxes to
shareholders is much more difficult if few shareholders pay
tax.
The best policy answer is creating more taxable
shareholders, which will be challenging politically. A
nonrefundable withholding tax on dividends paid to shareholders
would help.
Thank you for allowing me to speak at today's hearing. I am
happy to answer any of your questions.
The Chairman. Well, thank you very much. We appreciate your
work.
[The prepared statement of Mr. Rosenthal appears in the
appendix.]
The Chairman. Mr. Wells, we will turn to you now for your
statement.
STATEMENT OF BRET WELLS, ASSOCIATE PROFESSOR OF LAW, LAW
CENTER, UNIVERSITY OF HOUSTON, HOUSTON, TX
Mr. Wells. My name is Bret Wells, and I am an associate
professor of law at the University of Houston Law Center. I too
would like to thank Chairman Hatch, Senator Wyden, and the
other members of the committee for inviting me to testify. I am
testifying in my individual capacity, so my views do not
necessarily represent the views of the University of Houston
Law Center.
As both Chairman Hatch and Senator Wyden have said, our tax
system is in need of fundamental reform. Finding a path to
rationalizing the taxation of active business income in the
United States is an important goal--a monumental goal, in
fact--and the integration of shareholder and corporate taxation
can achieve that goal. Corporate integration has been
extensively studied for decades by prior administrations, the
American Law Institute, and numerous highly respected
academics, one of whom joins me on this panel.
As this committee staff has recently written, a broad
consensus exists that significant efficiencies can be achieved
through corporate integration. Thus, before one gets enmeshed
in the important details of how to create an appropriately
functioning corporate integration regime, it is important to
say that reform along these lines can significantly improve our
tax system.
Focusing specifically on the dividends paid regime, this
particular method of achieving corporate integration would, as
to distributed earnings, harmonize the tax treatment between
debt and equity and would level the playing field between pass-
through entities and C corporations. There is much to commend
this proposal. But, notwithstanding the potential benefits of
corporate integration, the reality is that business tax reform
must carefully consider the international tax implications of
any new paradigm, and to that end, the United States must
ensure that its tax regime withstands at least three systemic
international tax challenges.
First, a critical international tax challenge is the
inbound earnings stripping challenge, and this earnings
stripping challenge can be further categorized along the
following types of tax base erosion strategies: related party
interest stripping transactions, related party royalty
stripping transactions, related party lease stripping
transactions, supply chain restructuring exercises, and related
party service stripping transactions.
The second key international tax challenge relates to
corporate inversions. Corporate inversions are often
categorized as a discrete stand-alone policy problem, but in my
view, the corporate inversion phenomenon provides unmistakable
evidence of the enormity of the inbound earnings stripping
advantage that exists for all foreign-based multinational
corporations.
A foreign-based multinational corporation can engage in an
inbound related party interest stripping transaction, royalty
stripping transaction, and an inbound related party lease
stripping transaction without any concern for the U.S. subpart
F rules, whereas these very same transactions would create
subpart F inclusions if conducted by a U.S. multinational
corporation.
Corporate inversions, rightly understood, represent an
effort by U.S. multinational corporations to place their U.S.
businesses into an overall corporate structure that affords
them the full range of inbound earnings stripping techniques
without being impeded by the backstop provisions of the subpart
F rules.
Third, fundamental tax reform must deal with the so-called
lock-out effect.
As to the earnings stripping challenge and its alter ego,
the corporate inversion phenomenon, the dividends paid
deduction regime, by itself, does not equalize the tax position
of the U.S. multinational corporation with that of a foreign-
based multinational corporation. Even though the dividends paid
deduction regime provides a corporate-level tax deduction for
dividend payments, the dividend payment is subject to a
corresponding withholding tax.
In comparison, a foreign-based multinational corporation
can engage in all five of the enumerated earnings stripping
strategies to create a comparable U.S. tax deduction without
incurring a corresponding withholding tax. Thus, the dividends
paid deduction regime does not eliminate the financial
advantage that motivates earnings stripping or that fuels the
inversion phenomenon.
In order to address those two key international issues, the
United States must impose an equivalent withholding tax or a
surtax or--building on the idea advanced by Professor Graetz in
his earlier written testimony--disallow a deduction on all
related party base erosion strategies. An expansive approach--
and not just one that is focused on interest stripping
transactions or royalty stripping transactions--is needed.
Let me conclude my oral statement by stating that an
appropriately structured corporate integration regime has much
to offer. The committee is to be commended for considering
fundamental business tax reform, but at the same time, this
committee must ensure that the dividends paid deduction regime
is structured to withstand the systemic international tax
challenges that face the United States.
Thank you for allowing me to speak at today's hearing. I
would be happy to answer any of your questions.
[The prepared statement of Mr. Wells appears in the
appendix.]
The Chairman. Thank you. All four of you have been very
interesting to me, and I am sure to other members of the
committee.
Mr. Graetz, this question is for you, but the other
witnesses are certainly welcome if they want to weigh in with
their thoughts as well. This relates to the international tax
rules.
Specifically, we hear a lot about the $2 trillion locked
out from the United States because of our worldwide deferral
tax system. There are over $2 trillion that the foreign
subsidiaries of U.S. corporations have that no U.S. tax has
been paid on and that the companies are loath to bring back to
the U.S. because of the high 35-percent U.S. corporate tax rate
that awaits them.
Now, I have heard that the dividends paid deduction would
lessen this lock-out effect, but not necessarily eliminate it.
Do you agree or disagree?
Mr. Graetz. I agree with that. I think it would lessen the
lock-out effect, especially for companies that are distributing
their earnings to shareholders. They get the deduction and
would not pay the 35-percent tax at the corporate level, so it
would definitely help.
It is worth saying that integration systems of this sort
can work well with either the foreign tax credit system that we
now have or with a territorial system which provides an
exemption for foreign earnings. That is the system in
Australia. They have a shareholder credit system and a
territorial system, for example.
The Chairman. Mr. Rosenthal, in your written testimony, you
note that ``having two levels of tax distorts business
decision-
making in several important ways: whether to establish as a
corporation, partnership, or other business form; whether to
finance with debt or equity; and whether to retain or
distribute earnings.''
Now, I would like to focus on the second distortion that
you note: whether to finance with debt or equity. Could you
elaborate on the distortion created by the debt financing
versus equity financing? And how would you eliminate that
distortion?
Mr. Rosenthal. Yes. Under present law, corporations can
take a deduction on the interest they pay to bondholders. By
contrast, corporations cannot deduct the dividends they pay to
shareholders. As a result, under present law, there is an
incentive to issue more debt to reduce corporate taxes instead
of issuing equity.
As I described in my testimony, effectively today, we
collect most taxes at the corporate level and few at the
shareholder level, which particularly exacerbates that
incentive to issue debt over equity. If we were to shift to
collecting taxes at the shareholder level through allowing a
dividends paid deduction, that also would accomplish
integration, collecting at the shareholder level rather than as
we do today, principally at the corporate level.
That form of collection would eliminate the debt-equity
bias that you have highlighted, Chairman Hatch.
The Chairman. Thank you. Mr. Wells, in your written
testimony you write that ``it is important to say that reform
along the lines of corporate integration can significantly
improve our tax system.''
Now, you were formerly vice president of tax at a large
publicly traded company. Now, how do the two levels of taxes of
corporate earnings distort business decision-making, and would
a dividends paid deduction eliminate some or all of those
distortions, and how would it improve our tax system?
Mr. Wells. For a company to distribute earnings, it would
create a shareholder tax, a double tax on the distributed
earnings that is avoided if the company simply reinvests the
earnings back in the business. By having a corporate
integration regime, the company would get a deduction
currently, and there would be an offsetting withholding tax,
and that would ensure that the company makes the most efficient
decision as to what to do with that income.
There would not be a double tax cost. The decision of what
to distribute to shareholders or to invest in the business
would be solely one based upon the right economics for that
company.
Today, companies suffer a double tax issue if they want to
distribute earnings to their shareholders. That is a distortion
that need not be there.
What is a better answer is to ensure that there is one
level of tax and that it is taxed at the shareholder level at
the high shareholder effective tax rate, whatever rate this
committee wants to put in for individuals. That would be the
most efficient system and the way to ensure a progressive tax
system, in my view.
The Chairman. Well, thank you.
Senator Wyden?
Senator Wyden. Thank you very much, Mr. Chairman.
Ms. Miller, let us start with this question of the
retirement plans, and particularly small employers, because I
know you have done a lot of work with them over the years.
Hypothetically, let us say that you are the owner of ABC
Plumbing in Coos Bay, OR, which has five employees. And you are
beginning to have some success with your business. You are
interested in putting some money aside.
How would these corporate integration ideas, 35-percent
withholding proposals, impact my business in Coos Bay, OR and
my decision on whether or not to set up a 401(k) plan?
Ms. Miller. That is a great question. Thank you.
Right now, when that business gets to that point, they have
their payroll, they feel like employees are fairly compensated,
so when you are approaching that employer about putting in a
plan, you are really talking, largely, about their personal tax
situation. If they have profits, you can show on the current
year's tax basis that they are going to make a contribution for
employees, but the overall deduction is going to pretty much
cover that cost.
But then you get into, okay, is this plan the right place
for you to invest your money, or would you be better off just
not setting up the plan and going elsewhere? That is where an
example in my testimony comes into play, because under current
law, if you put in the 401(k) plan, you get the current-year
deduction, you feel very good about putting money in your
employees' accounts as well--it is little net cost.
Then you project your retirement, and depending on what
your effective tax rate is when you retire, you might have a
little less than if you just invested outside the plan, but you
might have more. It is pretty much a wash, so it is a good
situation. You say, I would rather give the money to my
employees than Uncle Sam, and you can put in the plan.
But with corporate integration--because you lose that
inside tax-deferred buildup--you will actually find that the
owner would be better off, by a substantial amount, to not put
in the 401(k) plan at all. So if you are advising that
employer----
Senator Wyden. That is why the five employees ought to be
concerned about this.
Ms. Miller. Right. Exactly. The five employees should be
concerned, because the employer probably is not going to put
that plan in, and they are not going to get that contribution
from the employer that they would be getting now.
Senator Wyden. Let me ask you about another challenge that
the chairman and I have talked about, all the members are
talking about, and that is the ramifications for the
multiemployer pension situation. As you know, there are many of
these multiemployer pensions that are in financial peril, a
number of them running out of money. The Pension Benefit
Guaranty Corporation estimates that it would cost $100 billion
to provide full plan benefits for participants and
multiemployer plans that are currently insolvent or expected to
be insolvent over the next 20 years.
Describe what these proposals could mean in terms of the
funding levels for these kinds of plans.
Ms. Miller. That is a really critical point, in that if
bond interest that is currently not taxable becomes taxable and
dividends, to the extent that there is not an increase in the
dividend amount to absorb the withholding--there is an argument
that there would be, but possibly not. Basically, the
investments you are now holding in the plan are worth less, so
when you look at the underfunding in that plan, your assets
will have shrunk. This proposal that has 35-percent withholding
on dividends and interest without the ability to recapture it
if you are in a qualified retirement plan trust, if it goes
into effect today, tomorrow your bonds are worth less than they
are today, and your underfunding has grown.
Senator Wyden. Thank you.
One question for you, Mr. Rosenthal. You say that,
``Ostensibly, corporate earnings are taxed twice.'' The
committee was told during our last tax reform hearing that less
than a quarter of corporate equities are now subject to the so-
called double tax.
Can you describe current situations in which corporate
earnings may be taxed only once or not at all?
Mr. Rosenthal. Well, there is the theory, and then the
practice. In theory, if a corporation issued a bond, and the
bond was held by a tax-exempt, there would be no level of tax
on the corporate earnings. If the corporation had issued equity
to a tax-exempt shareholder, it would be taxed once at the
corporate level.
In practice, as a result of carefully looking at the data,
I believe that today we principally or overwhelmingly collect
our tax on corporate earnings at the corporate level, and very
little tax at the shareholder level. So I use the words
``ostensibly taxed twice.'' I think the important issue is not
how many times we tax corporate earnings, but how much we tax
corporate earnings.
Senator Wyden. Mr. Chairman, my time is up. I have
indicated to the chairman that I am going to work closely with
him to explore any of the ideas he has. I just want to come
back to the proposition that, to get tax reform passed, it is
going to have to be bipartisan. That is how we are going to get
to tax reform. To me, that means giving everybody in America a
chance to get ahead, not just the fortunate few, but everybody.
Small businesses and the middle class, especially, have to be
part of that effort to give everybody a chance to get ahead.
That will be the key, in my view, to getting a bipartisan bill.
Thank you, Mr. Chairman.
The Chairman. All right.
Senator Thune?
Senator Thune. Thank you, Mr. Chairman. I think all of us
would like to see comprehensive tax reform: business and
individual done at the same time. I think moving to a
territorial system--in a perfect world, that is what we would
like to see happen here. In the more realistic world, it may be
that we get some rifle-shot opportunities.
I guess my question kind of gets at the point you were
making earlier, Mr. Wells; that is, is it possible to do
corporate integration without creating a lot of unintended
consequences--earnings stripping, the sorts of things that you
described--where you would actually, perhaps, do more harm than
good? Can this be done in a vacuum? Can we rifle-shot this, or
does this have to be done in that broader context?
Mr. Wells. It has to be done in a broader context. And the
thought you need to have in your mind--I would urge, Senator--
is that when you have a deduction at the corporate level under
the dividends paid deduction regime that creates a 35-percent
withholding tax, you have to compare that to the other earnings
stripping opportunities.
And, if an inbound company has the opportunity to create a
tax deduction in their U.S. affiliate at the same benefit but
through interest stripping, royalties, and the rest, and those
are not subject to a withholding tax, then there is a
structural competitive advantage for that foreign-based
multinational in the United States, even though they both get a
corporate tax deduction.
So if we want to have horizontal equity between domestic
corporations and foreign corporations, we need to ensure that
the tax base will not be reduced through a deduction that
avoids the withholding tax through intercompany arrangements
for the inbound foreign company that does not exist for the
U.S. multinational. As I said in my testimony, many of those
earnings stripping techniques, if tried by a U.S.
multinational, would be subject to the U.S. subpart F regime
and would be currently taxed.
So today, there are earnings stripping opportunities to the
inbound foreign-based multinational that give them a deduction
with no withholding. If we want to have a level playing field,
we need to make those not exist for one group of companies when
they are not available for the other group of companies.
Senator Thune. Mr. Graetz, you mentioned in your testimony
that the form of corporate integration that was advanced by the
Bush administration in 2003, which is taxing business income
once at the entity level--you state that approach is no longer
apt today.
So my question is, can you discuss why those corporate
integration proposals from the 1990s and the early 2000s are no
longer apt? What has changed since then?
Mr. Graetz. Yes, I can. I was responsible, in large part,
for the 1992 proposal which would have located the single tax
at the corporate level, which then was proposed again by
President George W. Bush and became the blueprint for the 2003
legislation.
It is hard for me to admit I am wrong, so I am fond of
saying, if I was right then, I am wrong now because the world
has changed. The competition globally was not as much on our
radar screen as it should have been at the time. Foreign
takeovers were not nearly as important as they are now. There
were not the non-repatriated profits sitting offshore that we
are now looking at, and we did not have significant inversions
of U.S. companies to speak of. They were very minor, and all
they did was send paper to Bermuda instead of sending jobs to
Europe. So, it was a very different world than we are in now.
Now I think it is a huge mistake to locate the high tax at
the corporate level and the low tax or the zero tax at the
shareholder level. We are much better off taxing the
shareholders who are going to stay in the United States, who
are going to be residents of the United States, than the
corporations who will change their residence through paper
transactions and will also shift a tremendous amount of income
abroad, as we have seen.
So we now have the tax at exactly the wrong place. We have
a low tax on the shareholders and a high tax on the
corporations.
Senator Thune. Do you believe--and this is for any of you--
that a dividends paid deduction coupled with withholding at the
shareholder level can be done in a manner that is consistent
with our existing tax treaties?
Mr. Graetz. If you withhold at 35 percent on foreign
shareholders, you have treaty issues. If you do not withhold at
35 percent on foreign shareholders, you will have given a tax
cut to those foreign shareholders and increased the revenue
cost of the proposal. So it is a difficult issue.
I will say one thing, and that is that the United Kingdom
in adopting its so-called ``diverted profits tax,'' and
Australia in doing something similar, have claimed, oh well,
that is just a different tax. That is not the same tax that we
are talking about in the treaties. So maybe if you call this
something other than withholding tax, you could make similar
claims and then let everybody fight about the treaties
subsequently and put us in a stronger negotiating position vis-
a-vis our treaty partners, but you could not call it a
withholding tax and not get into treaty issues.
Senator Thune. All right. Thank you, Mr. Chairman.
The Chairman. Okay. Senator Scott?
Senator Scott. Thank you, Mr. Chairman. Thank you to the
panelists for being here this morning to discuss this very
important issue.
Without any question, when you think about the fact that we
have the highest corporate tax rate in the world at 35 percent,
we have the second-highest integrated tax rate on corporate
income at 56.6 percent, it is no wonder that we find ourselves
in the situation that we do today. Investment levels are not
where they should be. Debt financing is preferred, and
inversions will continue.
I applaud the chairman for his efforts to make any progress
on this antiquated, outdated, should-be-obsolete tax code
without any question. I am concerned, however, that absent a
total overhaul of our tax code, the United States is going to
become more and more uncompetitive in our global economy.
Further, as the United States becomes less competitive and
fewer domestic profits and revenue are realized, there will be
a greater negative impact on middle-
income Americans and poor and economically disadvantaged
communities.
To me, one of the major focuses of tax reform must center
on helping middle-income Americans and the poor. We know that
so many families are just trying to find a way to the American
dream. Too often, our policies at the Federal level are
preventing that from happening. Actually, the inability for us
to come together in a bipartisan fashion to eliminate the
highest corporate tax rate, to allow for repatriation, and to
eliminate this global form of taxation--as opposed to
territorial taxation--is crippling job creators in this Nation.
One of the reasons why I have introduced new legislation,
called the Investing in Opportunities Act, is to help more than
50 million Americans living paycheck to paycheck, and to look
for ways to encourage and to incent trillions of dollars into
these distressed communities. My legislation does not create
new government programs but rather focuses on private-sector
investment.
My home State of South Carolina has done a really good job
attracting enormous growth and opportunities in the industrial,
manufacturing, and high-tech economies that has helped those
folks living in distressed communities consistently.
We still have a very long way to go, but I believe that my
legislation and other tax proposals for lower rates on the
over-burdened middle class will have a positive impact in
improving regional economic conditions across the country. And
while I certainly appreciate the hearing today, my thoughts are
still the same, that ultimately, until we have a panoramic view
of our tax code and drill into ways for us to reduce the
overall corporate tax rate and then deal, as well, with our
business organization--LLCs, other forms and entities in our
business structure--we will still find ourselves struggling for
a real solution.
Thank you, Mr. Chairman. No questions.
The Chairman. Thank you, Senator.
Senator Casey?
Senator Casey. Thank you, Mr. Chairman. We appreciate the
opportunity to talk about this subject.
Ms. Miller, I will start with you--not only because you
went to Carnegie Mellon in Pittsburgh, but that always helps.
I was noting in your testimony, the first page of your
testimony, that you said in pertinent part, ``workers earning
between $30,000 and $50,000 per year are 15 times''--and you
emphasize those two words--``15 times more likely to save at
work than to go out and set up an IRA to save on their own.''
Your source for that was the Employee Benefits Research
Institute.
So based upon that statement in your testimony--and I share
a lot of your concerns, especially as it relates to nonprofits
and retirement vehicles--can you walk through how corporate
integration would reduce incentives for small business owners
to set up, establish retirement plans for them and for their
employees? How do you summarize that? I know you walked through
some of it already.
Ms. Miller. It really relates to the growth of the
investment during the deferral period, what is now a deferral
period, to the extent that the investment income is interest
and dividends. Corporate integration is going to modify it. In
fact, that is going to be reduced somewhat.
But in addition, to the extent that there is now double
taxation, and there would not be outside of the program, there
will be kind of a bump-up in how their savings would grow if
they were outside of the program as opposed to inside the
program.
So if you were only looking at an individual, it is going
to pretty much equalize things inside and outside of the plan.
But when you are looking at a small business owner--because
they have to make that contribution for other employees as
well--you are really, under current law, kind of counting on
the tax-deferred inside buildup to kind of make up what they
have spent by making those contributions for other people.
So it really just shifts what looks like a good place to
put your money to, ``Do not put it in that plan. Let us take
the money and just invest it outside of the plan.''
Senator Casey. In terms of a broader, more particular
concern about access to retirement vehicles and savings rates,
what would you conclude about those two issues?
Ms. Miller. Well, I think there are a certain number of
people who save no matter what, but they tend not to be people
that we are most concerned about. For people in the more modest
income level, there is lots of evidence, not just that data,
about the need to have automatic savings to enroll them at
work, and to the extent that you do not have those programs at
work, the savings rate will fall. I do not have an estimate of
how much, but it is clear that there would be a dramatic drop
for people who are in those more modest income levels.
Senator Casey. Mr. Rosenthal, I was noting in your
testimony on page 3 that, in reference to the work that you and
your colleague did, you say, ``The share of corporate stock
issued by U.S. corporations that is held in taxable accounts
fell by more than two-thirds over a period of 50 years from
83.6 percent in 1965 to 24.2 percent in 2015.''
Is it fair to conclude from those numbers that--and this is
an opinion--but, based upon those numbers, is it fair to say
that relatively few shareholders pay at that second level of
taxation?
Mr. Rosenthal. Yes, Senator. That is the inference that I
draw from the data. You can see the decline on the monitor to
your right. The taxable ownership dropped quite considerably
from 1965 to 2015.
I think the decline changes the way we look at a lot of the
different tax issues that this committee and the Congress
address.
Senator Casey. And in particular, can you walk through for
us--and I know you have been through this a little bit
already--the type of taxpayers who might be subject to
withholding tax under corporate integration?
Mr. Rosenthal. Well, as our research illustrates, only
about 25 percent of shareholders are taxable, and the balance
are tax-
exempt. They fall in different categories; most principally,
retirement plans and then foreigners.
If we shift to a dividends paid deduction with a
withholding tax, the issue arises as to whether that
withholding tax would be refundable or nonrefundable. I think
most expect it would be nonrefundable for a variety of revenue
and policy reasons, but the consequence of that--as Ms. Miller
has observed--would be to collect a withholding tax at the
corporate level that would not be of any value to the
retirement plans or presumably to foreigners, and that is going
to put a lot of stress on shifting the tax on corporate
earnings from the corporate level to the shareholder level, how
we can address that issue.
Senator Casey. Thank you. I know I am over time. Thank you,
Mr. Chairman.
The Chairman. Thank you, Senator.
Senator Portman?
Senator Portman. Thank you, Mr. Chairman.
Thank you all for being here. This is a terrific group of
witnesses. We are talking about an issue that is incredibly
important to America's economy right now. We have a tax code
that is not competitive, and we need to do a number of things
to change it, and quickly; otherwise, we will continue to lose
jobs and investment.
We also have a retirement system, as Ms. Miller has talked
about, that is in need of restoring. Senator Cardin and I
worked a lot on this over the years, together. You are
absolutely right. We do not want to create disincentives for
people to save for their retirement at a time when we need more
and more people to be saving--10,000 baby boomers retiring
every day and a Social Security system that is incredibly
important, but also in trouble based on the fiscal outlook.
My biggest concern right now, frankly, is what is going on
with our companies taking their jobs and investment overseas.
Professor Graetz, you have been terrific on this issue over the
years. I am going to take you back in time here to an article
that you wrote that I pulled up. It was in December, at the end
of year. It was about what is going on right now. Right now, as
we sit here, the European Commission is taking state aid cases
against U.S. companies that are overseas in European countries,
although this is happening more broadly with the BEPS project
with all OECD and G20 countries.
But with regard to these state aid cases, we are looking at
the possibility of U.S. companies being told that whatever
arrangement they have worked out with another country is no
longer valid on a retroactive basis, to the tune of millions if
not billions of dollars. This is money that, frankly, comes out
of the U.S. Treasury, because that is where it, otherwise,
should go. So, because we have a worldwide tax system--that is
true--but also because of the reform efforts that Senator
Schumer and I and others have been talking about--now Speaker
Ryan, former Chairman Ryan, and others--you have a toll charge
on your earnings overseas, and that is how you pay for going to
a territorial system, which I think we all should agree is the
way to go. I will just presume that is the way you all feel.
That will not be there if these state aid cases continue,
and they will. There are another 300 cases, we are told, that
are on the docket.
I guess my concern is, what is happening now is not
working. I think, frankly, both governments are looking at the
symptoms of the problem rather than the problem. Our own
Treasury Department has just issued these new regulations under
section 385 for earning strippings that I think are an
overreach. I am against inversions. I want to stop them, but I
want to stop them by dealing with the underlying problem, and,
frankly, it has some unintended consequences, what is going on
right now.
So I am bringing you right up to the present. This is what
is happening. Both the EU and the United States government are
reacting to the problem in ways that I think are
counterproductive to our interests as Americans to create more
jobs and opportunity here. So I would ask you to comment on
that, and in the area of corporate integration, how does that
work with what we know we have to do on the international side?
I think this is urgent. The house is on fire. We need to
get the fire truck up there to start putting it out quickly.
Some of you have probably read the Wall Street Journal story--I
think it appeared yesterday--where Ernie Christian, who has
worked with Mr. Graetz over the years on tax policy and other
issues, just laid out what is happening with these foreign
transactions. So it is not just about inversions. That is
almost the tip of the iceberg.
There are companies in the United States that, because of
our tax code, are targets for takeover because these foreign
companies can pay a premium, and it is escalating every year--
again this year.
So I guess I would start with you, Mr. Graetz. And you have
commented on this briefly, but do you not think we have a
crisis here that you have written about, and how does this
corporate integration idea help or hurt in terms of dealing
with this underlying problem we have, which is a corporate
international tax code that is not competitive and leads to job
loss here in this country?
Mr. Graetz. Thank you, Senator. As you know, I agree
entirely we have a crisis. We have a terrible tax system. Its
distortions and complexities and inefficiencies would take us
more time to list than we have. The state aid cases are
troubling, both for their retroactivity and for, I think, their
potential discrimination against U.S. corporations. There are
some European corporations that are also under investigation,
but they seem to be small potatoes compared to what the
European Commission is going after with U.S. companies.
Senator Portman. Five big ones right now, and four are U.S.
companies, and the fifth is Fiat with huge U.S. holdings.
Mr. Graetz. Yes, exactly. The foreign tax credit means that
any additional taxes that are paid will be borne not by the
companies, but by the U.S. taxpayer. So it is a reason for
concern.
All of the things that you mentioned, I think, are reasons
for concern. Yes, there is a crisis.
I was thinking, as Senator Wyden was talking, about a
variety of issues. Integration is not penicillin. It is not a
cure-all. It is not a new antibiotic. It is a step--I think an
important step--in the right direction in terms of improving
the U.S. tax system.
I regard it, as I said in my testimony, as a useful step
and an important step, but not a cure-all. I have said this
many times--I think the only solution for the U.S. is a very
low corporate rate. I think in order to do that, we probably
have to tax consumption more than we are taxing it.
Senator Portman. But you have also said we need to go to a
territorial system.
Mr. Graetz. I have. I have, because I think that this
current system, which creates a disincentive for bringing money
home to invest in America, is foolish at the current time.
Senator Portman. My time has expired. I appreciate it. Mr.
Chairman, I hope we will have a hearing also on the
international tax issues and, specifically, what Treasury is
doing with these new regulations and the unintended
consequences of the section 385 changes, and hopefully we can
deal with this immediate problem that we have. If we do not, I
think we will see our corporate community and our businesses
and jobs continue to go overseas. Thank you, Mr. Chairman.
The Chairman. I intend to do that, Senator. I agree with
you on that and have been one of the pushers for that.
Mr. Wells, let me ask you this question. There have been
several questions regarding corporate integration and
retirement plans and small businesses. Would you like to
comment on anything like that?
Mr. Wells. Okay. From my perspective, this is not a
disadvantage to anyone, is the way you ought to think about it.
When you take a distortion away from a group of taxable
shareholders and you make them not suffer a double tax, then
those who are benefitted under current law because they don't
suffer from that double tax distortion are not disadvantaged.
The reform is simply removing a double tax distortion that
makes taxable shareholders less efficient. It is only in that
sense that tax-exempts can say that the reform proposal is a
relative disadvantage to them.
I think what this committee ought to understand--and I
think the corporate inversion phenomenon is getting us to
understand--is the following: if we allow one group the
opportunity to erode the corporate tax base as a subsidy,
whether that is an inbound earnings stripping advantage,
whether that is this particular technique, then the result will
be a source of market inefficiency going forward.
I think what is a better system--a thoughtful system that
this committee ought to adopt--is to collect one level of tax
on active business income. When the dividends paid deduction
regime imposes the 35-percent withholding tax, it is only
because the tax system has given a dividend deduction that
eliminated the corporate tax. There is not a net increase. With
the 35-percent withholding tax, all we are saying is that we
want to preserve the corporate tax base to be taxed once at the
shareholder level.
Senator Hatch, I will conclude by saying this: if you tell
me the one person who can get a dividend under the dividend
reduction regime without a corresponding withholding tax, I
will tell you to whom everyone in the market will sell their
stock the day before the deductible dividend is paid, and then
from whom everyone will buy the stock back from that preferred
person the day after the deductible dividend has been paid.
That person will be the source of eroding the corporate tax
base.
From a tax policy perspective, I think this committee needs
to say that we need to preserve one level of efficient tax on
active business income. Having that active business income
taxed at the shareholder level assures individual
progressivity. That is a wonderful goal.
If we take the distortions out of who the owner is, whether
that is a foreign-based multinational or a pension or the
others, that creates the tax symmetry that I think the system
needs.
The Chairman. It seems to me corporate integration helps us
to get there.
Mr. Wells. It absolutely is the vehicle to get there,
whether it is the dividends paid deduction regime or other
forms of integration, but I think it is absolutely a wonderful
first step. The committee is to be commended for thinking
through it.
The Chairman. Thank you.
Mr. Graetz, in your written testimony you note that, with
respect to tax-exempt shareholders and debtholders, ``The
approach of the ALI report was to subject these entities to a
tax on investment income. This would maintain a single level of
tax on corporate income received by such investors at whatever
rate Congress deems appropriate and could serve to eliminate
tax-induced distortions between debt and equity.''
Now the Treasury report estimated that in 1992, a uniform
tax of 6 to 8 percent would have approximated the tax burden on
investment income received by tax-exempt shareholders. Now,
some have suggested that under a corporate integration
proposal, tax-
exempts would bear the same tax burden on corporate earnings as
taxable shareholders and bondholders. Would a modest tax on the
investment income of tax-exempts alleviate such concerns?
Mr. Graetz. Mr. Chairman, I actually think it would. Just
to be clear about this, at least as I understand Ms. Miller's
testimony, the way in which dividends would be treated under
integration would be the same for these retirement funds and
tax-exempts as under current law. They are paying the corporate
level tax, and the same would be true of retained earnings.
I think what is pressing the numbers that she has given
us--if I understand them--is interest withholding, where you
are putting in a new tax that is now not paid by tax-exempt
organizations or retirement funds, and that is the additional
tax burden.
So the question that we asked at the Treasury and that the
ALI asked was, at what rate are tax-exempts now taxed because
they are paying tax at the corporate level on their ownership
of corporate equity? We ran some estimates when I was at the
Treasury--it was the early 1990s--and we concluded it was about
6 to 8 percent. That is as you said, what is their investment
income? It is about a 6- to 8-percent tax.
It is now completely imposed on corporate equity. There is
a zero tax on debt. If you put in a 6- or 7- or 8-percent tax--
I do not know what the number would be today; you would have to
ask the Joint Committee or the Treasury, but it is probably
about the same. If you put in that kind of tax, you could then
make the withholding refundable to tax-exempts and to lower-
bracket taxpayers and not have the revenue costs. Now it would
be an explicit tax on tax-exempts, so it may raise some
political problems. We certainly thought there were some
political problems at the Treasury.
But the goal was to equate debt and equity, treat them the
same, without increasing the tax burden on tax-exempts. That
was the goal. In order to do that, you either have to raise the
tax on interest or lower the tax on dividends, or both. We
concluded that doing it on an evenhanded basis, a 7- to 8-
percent tax, and then allowing a refund of the credits would
get you to about the same place as you are today for those
taxpayers.
I think if you are really considering providing withholding
on the interest side, this is certainly something that is
worthy of consideration.
The Chairman. Thank you. This question is for Mr. Graetz
and Mr. Rosenthal. But the other witnesses, if you care to,
feel free to weigh in.
Would the dividends paid deduction coupled with a
withholding tax simply make more transparent to tax-exempt
entities the current corporate tax that they are bearing?
Mr. Rosenthal. I would say, yes, that if we had a dividends
paid deduction with a nonrefundable withholding tax, that would
make quite clear the tax that a tax-exempt such as a retirement
fund or foreigner is paying.
I would just add that I agree with Professor Wells and
Professor Graetz that if we collect one tax from taxable
entities, we will inevitably disadvantage tax-exempts if we
also tax them once, whereas today, we tax taxable entities
twice and tax-exempts once. That is inevitable.
But I cannot see us move to a system in which business
profits are not taxed at all. Our tax code is framed around
collecting one level of tax on profits from a trade or
business, and we make sure of collecting with our UBIT on the
profits of a trade or the business of tax-exempts. We also tax
the effectively connected income of a U.S. trade or business of
foreigners. We make sure of that, by and large, with the way we
tax capital gains.
So the notion of trying to exempt completely wide classes
of taxpayers from any tax on a trade or business, I think would
be a huge revenue loss and a mistake.
The Chairman. Mr. Graetz?
Mr. Graetz. I basically agree with what Mr. Rosenthal has
said. I think that the question is--as I said earlier--at what
rate are we now taxing tax-exempts? We are taxing them on the
retained earnings and the dividends that are paid by
corporations when they invest in equity.
I do think there are some questions about what would happen
to dividend payments. Ms. Miller has raised them, and we talk
about them in our testimonies. I talk about them in my
testimony--what would happen to interest rates, especially
corporate interest rates which are subject to withholding, and
whether those rates would have to go up. Ms. Miller, I think,
assumes in her examples that interest rates are the same as
they now are for corporations and that they would not go up.
But I think if there is going to be this kind of
withholding, in order to sell bonds, interest rates are going
to have to go up in some manner. So I think that there are
issues here. But I basically agree with Mr. Rosenthal.
The Chairman. Thank you.
Senator Cardin, I will turn to you.
Senator Cardin. Well, thank you, Mr. Chairman. Thank you
for continuing the questions so I could get back into the
committee room. I appreciate it.
Let me thank the entire panel. I did hear your testimony. I
am ranking member on Senate Foreign Relations, which is meeting
at the same time. So I apologize for not being here for the
entire hearing. I appreciate all of your testimony.
Ms. Miller, you raised some very important points on
retirement issues. We have been working a long time to make
sure our tax code, at a minimum, does not hurt the current
incentives that we have for retirement savings, considering we
still do not have enough retirement security in this country.
We would certainly like to do better, but we do not want to
do worse. I think your point about corporate integration and
how it impacts the incentives for retirement savings is a point
that needs to be taken into consideration.
The easiest way to deal with that is to follow Professor
Graetz's point of changing the reliance on our revenues from
income to consumption, at least doing that in a more balanced
way. I guess my first question, Professor Graetz, would be
that, if we get corporate tax rates to a level that you are
suggesting, which is, I think, 10 percent or somewhere on that
level, or legislation that I filed which gets it down to 17
percent, and you get the individual rates down by at least 10,
11, 12 points, we really do not run into the same problems of
discriminating how business sets up its tax structure, because
the tax rates become much less significant.
Mr. Graetz. Senator Cardin, as you know, I agree entirely
with your proposal and with the direction that you are going.
Frankly, I do not think there is any other solution to the
problem we now have. The British have now announced that they
are moving their corporate rate down to 17 percent. I have
suggested 15 percent.
We are now taxing earnings domestically at the 35-percent
rate in many cases, and we are taxing, at least, equity-
financed investment in the U.S., and we are now taxing foreign
earnings at a very low rate. This makes absolutely no sense,
because we have created an incentive for U.S. companies to
invest abroad rather than domestically, and we have inhibited
our ability to attract foreign investment with a high corporate
tax rate. The evidence is increasing that a greater and greater
share of the corporate tax is being borne by labor because
capital is so mobile in the current economy. So it is not as
progressive as taxing the shareholders directly on their
earnings, on their dividends, on their interest, on their
capital gains, and so forth.
So, I think this is the only solution that is a solution to
fix our current system. I think it is worth saying, just given
the nature of this hearing, that integration of the sort that
is being discussed here is compatible with a lower-rate
corporate tax. In the same way, you would have a lower-rate
withholding tax if you lowered the corporate rates.
So there is nothing that is incompatible with doing
integration and moving to a lower tax rate, but as I said--I
think while you were in the Foreign Relations Committee--
integration is not penicillin and it is not going go solve our
problems.
Senator Cardin. I agree. I think you are absolutely correct
in that the only way you are going to deal with this is through
some type of proposal that we are suggesting. You are not going
to solve it otherwise. We will move the chairs around the deck
a little bit, but we are not going to really deal with the
fundamental problems.
Ms. Miller, did you want to comment more on the retirement
aspect of this?
Ms. Miller. Thank you. I mentioned earlier that the issue
is really with interest and not with dividends, and it is
actually with dividends to the extent that there is double
taxation of dividends now because we are talking about a
relative advantage to investing in a qualified retirement plan
over investing outside the plan. So to the extent that somebody
outside the plan is paying that second level of tax and now
they will only be paying one, they have bumped up. You have
given an advantage to investing outside the plan. So the issue
is both dividends and interest. So it is really on both sides.
Senator Cardin. I just really want to throw one thing out,
Mr. Chairman, that I do not think has been mentioned yet, and
that is, as we look at these proposals, we also have to look at
the impact they have on tax credits that we currently have in
law. I have been a strong proponent of the New Market Tax
Credits. Their value will change under this proposal. What
impact does it have on those, and historic tax credits?
I think those issues need to be understood, the impact they
would have. In trying to reform our current tax structure in an
important way, but a modest way on the overall structure, and
in a way that has an impact on incentives that may be
unintended, I think we need to understand those issues.
Mr. Wells, I see you are very anxious to reply.
Mr. Wells. I am. I just want to--what I would urge you to
also consider is that, if you drop the tax rate to 15 percent,
you should consider that high net wealth individuals are not
going to earn active business income outside of the C
corporation at substantially higher individual tax rates. So we
will have laborers paying individual taxes at a high rate, and
corporations paying taxes at a 15-percent rate.
The wonder of this proposal, this integration regime, is it
gets us a zero corporate rate as to distributed corporate
earnings, and it gets that income at the shareholder level to
pay tax at a progressive individual rate schedule. So if you
really want to get to a zero corporate tax result, I think
corporate integration does that.
Senator Cardin. If you use the model that we are using,
there will be an individual tax as the money is taken out of
the C corporations.
Mr. Wells. But I will not do that until I die, and my stock
goes----
Senator Cardin. Not necessarily. It depends on the type of
structure that you have, and that is why most people in that
circumstance have used pass-through entities rather than using
the C corporation. So I think it really argues against your
point. The point is that, if you are a large company, you are
organized as a C, and you are not the one holding the wealth in
the company because your impact is much smaller. If you are a
small company, you are more likely to be holding wealth, but
you are using it through pass-through entities, by and large.
So you are already paying the individual rate.
So I do not see the lower corporate rate--and again, the
difference between the C rate and the pass-through individual
rates in the models that we are using is about the same as it
is today. So we really are not changing the equation of an
individual deciding whether to use a pass-through entity or
using C rates.
I do not quite follow your point, but I appreciate that
exchange.
The Chairman. Thank you, Senator.
Let me just ask you--this is a question for each of you,
and it can be answered ``yes'' or ``no,'' I believe. Do you
agree that there would be a behavioral response to a dividends
paid deduction? I will start with you, Mr. Graetz.
Mr. Graetz. All right. Yes, if you want a ``yes'' or ``no''
answer.
The Chairman. Well, if you want to add more, that is fine
with me.
Mr. Graetz. Well, I think it does reduce the burden for
repatriations, which is an important point, because you get to
deduct the dividends at the corporate level. I think it would,
perhaps, increase the distribution of earnings as dividends. It
would certainly increase the distribution of earnings as
dividends versus share repurchases, which are now favored. So
it would certainly change that balance, and one would hope that
it would change the debt-equity balance, which of course, is
one of the important reasons to go forward.
So I think it would reduce all of the distortions that you
began this hearing with and also have some international
advantages. It would not eliminate all of these problems, but
it would certainly make them less important.
The Chairman. Well, I am not bringing up corporate
integration as a cure-all of all problems, but I bring it up as
something that would put us in the right direction and solve a
number of problems, and then we could work on the rest of them
as we go along. Ms. Miller, what do you think about that?
Ms. Miller. I think there definitely would be problems. As
I have said, my concern is that it be structured such that it
is not a negative behavioral change.
The Chairman. Sure. Okay.
Mr. Rosenthal. Yes, Mr. Chairman, there would be a big
change to our tax system, and we could expect behavioral
consequences. I would worry about unintended consequences. For
instance, if the committee goes down the path of having a
nonrefundable withholding tax so that tax-exempts, in effect,
bear a U.S. tax on corporate income but perhaps avoid a foreign
tax on corporate income or a U.S. tax by moving the corporation
abroad to a tax haven, you might see more inversions depending
on the structures that are pursued.
So we have to be careful in the way we change our rules,
because there are various issues that could pop up.
The Chairman. Okay. Mr. Wells?
Mr. Wells. Yes, I think there would be a definite response.
I think that the parity this committee is attempting to achieve
is wonderful and would be a good avenue for corporate tax
reform.
I think where the real difficulty will be, Chairman Hatch,
will be the earnings stripping, the deductions we can get at
the corporate level, where the income goes to someone who is
not taxable on that income, and if we need to protect the
corporate tax base to one level of tax, that is where the
complexity is going to be.
What I would urge you to consider is that, as soon as you
let one avenue of those profits be deducted and paid to someone
without a comparable withholding or surtax, then you have
created a market distortion. But I agree, this is a step
towards correcting systemic distortions that the current system
has.
The Chairman. Am I correct in believing that there would be
appreciatively more dividends under a DPD system with
withholding?
Mr. Graetz. I would assume that the companies would
increase their dividends, to some extent at least, to gross up
the benefit of the dividend deduction. I think there you would
certainly see a substitution of dividend payments for share
repurchases, which I think is a very important beneficial step
given the current advantages for nondividend distributions over
dividend distributions.
The Chairman. It seems to me that every company would want
to get their shareholders to reinvest those dividends in the
company, which would help the company to expand or, at least,
do much better than it, perhaps, had been doing. At least, that
is one of the goals that we would have, I would think, with
this program.
Mr. Graetz. Both the Treasury Department and the ALI
proposals had a reinvestment option in them, which both
Professor Warren and I thought was a useful and important piece
of the proposal.
The Chairman. Let me ask you just another question, Mr.
Graetz. In your written testimony you note that, ``A deduction
for dividends and domestic earnings could serve as a full or
partial substitute for rules directly limiting erosion of the
U.S. corporate income tax base, and for rules explicitly
directed at curtailing or prohibiting corporate inversions.''
Now as you know, erosion of the U.S. tax base is a
significant concern, as are corporate inversions. Could you
elaborate on your statement that a dividends paid deduction
could address both base erosion and inversions?
Mr. Graetz. Well, Mr. Chairman, with regard to base
erosion, I would cite the experience in Australia, where
Australia has had very good success in its integration system
because, in order to be eligible for the integration system,
you have to pay domestic taxes. It sort of puts a floor on the
domestic tax that has been paid.
There is also an empirical study by Dan Amiram and some
colleagues at the Columbia Business School in which he
investigates both the European experience and the Australian
experience, and he found that base erosion increased after the
repeal of integration systems in Europe, which was due to a
series of decisions by the European Court of Justice at the
time. He found that the Australian system does protect against
base erosion.
When I was in Australia last winter, I spoke to people at
the Treasury and in the business community who all agreed that
the Australian companies, at least, were much less likely to
look to shifting their taxes and income abroad because of the
integration system. In Australia, this is referred to as an
integrity benefit. I think it is real.
It would also, I think, help with the inversion problem.
Although again, I do not think it is a complete solution to
either of these problems, but it would help with the inversion
problem, because U.S. companies paying U.S. dividends to U.S.
shareholders would be able to pay considerably more dividends
under more advantageous circumstances than foreign companies.
And by eliminating the barrier on repatriating for those
companies that distribute their earnings, that also takes some
of the pressure off of inversions.
As long as foreign rates are dramatically lower than U.S.
rates and as long as other countries have a territorial system
and looser Controlled Foreign Company or subpart F rules than
we do, there are going to continue to be advantages for foreign
parents over domestic parents, however.
The Chairman. Well, thank you. I want to thank our
fantastic panel of witnesses for appearing here today.
Professors Graetz and Wells, I think you made compelling
cases for taking the next steps on exploring corporate
integration.
Ms. Miller, thank you for pointing out some important
design issues with respect to the impact of corporate
integration on retirement plans.
Mr. Rosenthal, I want to thank you and the Tax Policy
Center for all of your research on domestic corporate stock
ownership trends. That has been very important. Your research
is very informative.
My take is, it shows that investors and management are
voting with their feet. The double tax burden is driving
taxable shareholders away from corporate shares. It is driving
management towards debt financing. Once more, it shows the
premium put on transactions to minimize exposure to U.S.
corporate tax, like corporate inversions.
I take it TPC would agree with the Treasury Department, the
Joint Committee on Taxation, and the Congressional Budget
Office that driving economic activity towards debt financing
and other techniques to minimize the corporate tax would lead
to more distortions. More distortions mean less growth, fewer
jobs, and loss of the U.S. tax base.
I also want to thank my colleagues for their participation
as well. I think we can all agree here today that the system
needs to be changed.
I hope that my colleagues on both sides of the aisle will
work with me to ensure that my proposed changes take as many
perspectives into account as possible. The more I get to hear
from each of you, the better my proposal will likely be. Now,
it is up to each of us to try to get the system right for the
first time since World War II.
Now, let me just say that this may be a small step, but it
is a step that would be pretty impressive over the long run if
we could actually get both sides to agree to work together to
get this done. If anything, this committee has shown that we
can do a lot of bipartisan work together.
Last year, we passed 37 bipartisan bills out of this
committee. Most of them are law today. Some are being made law
this year. This year we have had a pretty impressive year as
well.
I just hope we can all work together in the best interest
of our country. Clearly, we are not going to be able to do
comprehensive tax reform this year. I would love to do it, but
there is no way that I think with the current makeup of
Congress we are going to be able to do that, as complex as that
would be. It took 3 years last time. I do not think it needs to
take 3 years, but I think if we could do something like
corporate integration, that would let people know that we are
making headway, that we are moving forward, that true tax
reform is something that is not only a possibility, but a
probability.
To that extent, I think your testimonies here today have
really been helpful to the committee, and certainly to me. So I
want to thank you for being here and tell you I appreciate each
one of you making the effort to be here. I hope you will
continue to enlighten the committee as much as you can, because
I think we can do some really great work together if we can
just get rid of all of the partisan crap around here and work
together as people who love to do bipartisan work.
Thank you so much. With that, let me just say that we will
recess this committee until further notice, but we will ask
that any questions for the record be submitted by Tuesday, May
31, 2016.
With that, the hearing is adjourned. Thanks so much.
[Whereupon, at 11:55 p.m., the hearing was concluded.]
A P P E N D I X
Additional Material Submitted for the Record
----------
Prepared Statement of Michael J. Graetz, Wilbur H. Friedman Professor
of Tax Law and Columbia Alumni Professor of Tax Law, Columbia
University
Mr. Chairman, Senator Wyden, and members of the committee, thank
you for inviting me to participate in today's hearing on integrating
the corporateand individual tax systems.\1\ I have been involved with
the issue of corporate-shareholder integration for 25 years. I was
intensely involved in the Treasury Department's 1992 Report on
integration, Taxing Business Income Once, while serving as Deputy
Assistant Secretary (Tax Policy); I served as a consultant on what
became a reporter's study of integration by Harvard Law Professor Alvin
Warren for the American Law Institute, published in 1993; and I have
published several articles on the subject, co-authored with Professor
Warren.
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\1\ This testimony represents only the views of Michael J. Graetz
and not any organization with which I am or have been affiliated.
In the 1990s, when integration came to the fore, domestic tax
policy issues were of principal concern. These include: (1) the
relative treatment of income earned through corporations and pass-
through entities, (2) the comparative taxation of debt and equity
finance, (3) the relationship of entity taxation to investor taxation,
(4) the relative treatment of distributed and retained corporate
earnings, and (5) the relative treatment of dividend and non-dividend
distributions, such as share repurchases. Today, international issues
are also important. These include: (1) the relative treatment of
domestic and foreign income, (2) differences in the treatment of
domestic and foreign corporations, and (3) the coordination of domestic
and foreign taxes. In combination, these domestic and international
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policy concerns make business tax reform a daunting task.
As this committee knows, I have long advocated a major
restructuring of our Nation's tax system. The ``Competitive Tax Plan,''
described in my book 100 Million Unnecessary Returns: A Simple, Fair,
and Competitive Tax Plan for the United States, has five key elements:
First, enact a VAT, a broad-based tax on sales of goods and
services, now used by more than 160 countries worldwide. Many English-
speaking countries call this a goods and services tax (GST).
Second, use the revenue produced by this consumption tax to
finance an income tax exemption of $100,000 of family income--freeing
more than 120 million American families from income taxation--and lower
the income tax rates on income above that amount.
Third, lower the corporate income tax rate to 15 percent.
Fourth, protect low-and-moderate-income workers from a tax
increase through payroll tax cuts.
Fifth, protect low- and moderate-income families from a tax
increase by substantially expanding refundable tax credits for
children, delivered through debit cards to be used at the cash
register.
Such a plan has major advantages for the United States, including the
following:
It would take advantage of our status as a low-tax country,
making the U.S. a low income-tax country.
Most Americans would owe no tax on their savings and all
Americans would face lower taxes on savings and investments.
Over the longer term, such a tax reform would make the United
States a much more favorable place for savings, investment, and
economic growth, without shifting the tax burden down the income scale.
The vast majority of Americans would never have to deal with the
IRS.
By returning the income tax to its pre-World War II role as a
relatively small tax on a thin slice of high-income Americans, there
would be no temptation for Congress to use tax breaks as if they are
solutions to America's social and economic problems. We have tried
that, and it doesn't work.
Unlike other unique consumption tax proposals (e.g., the Flat
Tax; David Bradford's X-Tax; George W. Bush's panel's Growth and
Investment Tax), this proposal fits well with existing international
tax and trade agreements.
A 15% corporate tax rate would solve the problems caused by
international tax planning by multinational corporations, corporate
inversions, and competition for corporate investments among nations.
By taxing imports and exempting exports, this plan would yield
hundreds of billions of dollars for the U.S. Treasury from sales of
products made abroad in the decade ahead--$600 to $700 billion at
current trade levels.
During the interval of up to 2 years between enactment and
commencement of the VAT, Americans would accelerate their purchase of
durables, such as cars and large appliances, providing a short-term
boost to our economy.
Senator Benjamin Cardin has introduced a progressive consumption
tax proposal that has much in common with my plan, and I heartily
endorse his efforts and his Progressive Consumption Tax Act of 2014.
But such a major restructuring of our Nation's tax system may not
be imminent and such a goal need not stand in the way of incremental
reforms that could significantly improve our broken tax system. In my
view, integration of the corporate and shareholder taxes presents an
important opportunity for such improvement. Importantly, integration,
done right, would move us in the right direction. Indeed a dividend
deduction with withholding system of integration could improve our
Nation's tax system either as a stand-alone measure or as a part of a
more comprehensive business tax reform.
When the Treasury and the ALI considered corporate-shareholder
integration nearly 25 years ago, their emphasis was on domestic policy
concerns--in particular, narrowing the income tax advantages for debt
over new equity and for retained over distributed earnings, while
creating greater parity between corporate and partnership taxation.
Although reducing or even eliminating these distortions remains
important, additional advantages of integration now include its
potential to reduce incentives for U.S. multinationals to shift income
abroad or to retain earnings abroad. Integration could also reduce
incentives for U.S. businesses to change their domicile to a foreign
jurisdiction in an ``inversion'' transaction and for foreign takeovers
of U.S. businesses.
In the 1990s, principally because of its administrative advantages,
the Treasury Department recommended taxing business income once--at the
business level. This form of integration was advanced by President
George W. Bush in 2003, but Congress instead simply lowered
shareholders' income tax rates on dividends.\2\ That approach is no
longer apt today. Locating the income tax at the shareholder level
would be more progressive and, given the mobility of business capital
and operations, makes much more sense in today's global economy.
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\2\ Internal Revenue Code section 1(h)(11).
Simultaneously with the Treasury Report, a reporter's study by
Alvin Warren for the American Law Institute (ALI) recommended
integrating corporate and shareholder taxes by converting the corporate
tax into a withholding levy on income ultimately distributed to
shareholders, who would receive a credit for the corporate tax. This
option was also discussed in the Treasury report. Shareholder-credit
integration--also known as imputation-credit integration because
corporate taxes are imputed to shareholders as credits--is not a new or
untried idea, as there have been many years of experience with this
---------------------------------------------------------------------------
form of taxation in developed economies.
In 2015, a working group of the Senate Finance Committee discussed
integration of corporate and shareholder taxes by combining a corporate
dividend deduction with withholding on dividends (U.S. Senate 2015),
based on an earlier in-depth staff study (U.S. Senate 2014). As
emphasized in the various documents released by this committee, this
combination could retain the advantages of shareholder-credit
integration while also reducing effective corporate tax rates.
The remainder of my written testimony here is taken from an article
on corporate-shareholder integration, co-authored with Professor Alvin
Warren, to be published in the National Tax Journal this fall. We begin
with a bit of history; next we describe how a shareholder credit or a
dividend deduction with withholding would work; then we review some of
the major design issues to be considered (including extension of
withholding to interest) and discuss how integration would address
those issues.
a bit of history
If integration offers such promise, why has it not already been
enacted? The answer involves a bit of history regarding corporate
taxation in Europe, the United States, and Australia.
Shareholder-credit (or imputation) integration was originally
developed after World War II in Western Europe (Ault 1978, 1992).
France, Germany, and the United Kingdom, for example, all adopted some
variant of the system.
By 2003, these European countries had all repealed (in form or
substance) their shareholder-credit systems after decisions by the
Court of Justice of the European Union (CJEU) suggested that those
systems violated European Union treaties (Graetz and Warren 2006). Tax
policy changes concerning income taxes at the EU level require
unanimity of the member states, so such changes are extremely rare and
are typically quite limited in scope. Given that void, the CJEU has
become a major arbiter of national income tax policies by applying to
member state income tax laws the fundamental treaty principles that
prohibit discrimination against cross-border investments and ensure the
free movement of capital within the EU.
Consider a French investor in a German company in an integrated
shareholder-credit system. Should Germany refund the credit to a French
investor who is not otherwise subject to German taxation? Should France
give a credit for German corporate taxes that France did not receive?
Notwithstanding years of analysis and debate, EU member states were
unable to reach unanimous agreement on those questions. That failure
left shareholder-credit systems vulnerable to attack under the CJEU's
treaty jurisprudence. Several adverse CJEU decisions--unrelated to any
underlying tax policy--eventually led to the repeal of shareholder-
credit integration systems by the national legislatures (Graetz and
Warren 2006, 2007).
Two conclusions emerge from this history. First, shareholder-credit
systems have been successfully implemented in numerous major economies.
Second, the reason for their demise in the EU has no relevance for the
United States, which obviously is not a party to the European treaties
and is not subject to the constraints imposed by European courts.
As we have said, integration of corporate and investor taxes was
intensively studied in the United States in the 1990s. In January 1992,
Treasury published a comprehensive study of integration that discussed
several alternative methods of corporate-shareholder integration. (U.S.
Treasury 1992a). It analyzed and described, but did not recommend,
shareholder credits. Instead, Treasury supported an exclusion for
dividends as the way to reduce double taxation of corporate income. In
1993, the American Law Institute published a comprehensive analysis and
proposal for shareholder-credit integration in the United States
(Warren 1993).
Neither study proposed extending to corporations a partnership
system of directly allocating earnings to investors. The complex
capital structures of many public companies, along with the frequency
and volume of changes in share ownership, make such allocation
impractical.\3\
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\3\ For the Treasury report's discussion, see U.S. Treasury
(1992a), in Graetz amd Warren (2014b) at Amazon Location 1771.
Congress eventually acted in 2003 and reduced shareholder tax
rates, rather than accepting the exclusion of dividends then
recommended by Treasury. This approach left in place the separate
---------------------------------------------------------------------------
corporate tax at the rate of 35 percent.
Remarkably (and contrary to the original 1992 Treasury study), the
2003 legislation reduced shareholder tax rates even on dividends that
have not been subject to taxation at the corporate level. Reducing the
shareholder tax on dividends that have not borne corporate tax is not a
coherent approach to rationalizing the tax burden on corporate income.
That approach provides a tax benefit for high-income shareholders on
income that may not have borne any corporate-level tax.
Whatever the merits of the 2003 legislation at the time, it is no
longer a sensible component of a system of business and investment
taxation in the world of international competition now faced by
American companies. Given the ability of multinational corporations to
create new entities in low-tax jurisdictions, to shift items of income
and deduction among countries to obtain tax advantages, and even to
change the residence of the parent company, it is the corporate, not
the shareholder, rate that needs to be reduced today. Shareholder
residence is far less mobile than corporate income. In addition,
because economists now agree that some portion of the corporate tax is
borne by labor (although they disagree over how much), shifting income
tax from the corporate to the shareholder level could increase the
progressivity of the tax system.\4\ Locating the ultimate business tax
at the shareholder level could therefore be both more efficacious and
more progressive than the current system (Altshuler, Harris, and Toder
2010).
---------------------------------------------------------------------------
\4\ See, for example, Liu and Altshuler (2013), Cronin et al.
(2013), and Altshuler, Harris, and Toder (2010).
In the 1990s, most U.S. corporate managers did not favor
shareholder-credit integration. They generally preferred a tax
reduction for retained rather than distributed earnings and were
particularly interested in preserving certain tax preferences, which
might have been eliminated on payment of dividends under shareholder-
credit integration (Arlen and Weiss 1995). Today, most of these
preferences seem certain to be eliminated or reduced in any business
tax reform, and it is the high U.S. corporate tax rate that most
---------------------------------------------------------------------------
concerns corporate management.
The potential of shareholder-credit integration for business tax
reform in the United States is demonstrated by considering briefly the
experience in Australia, which for many years has combined territorial
taxation for its companies with a shareholder credit for dividends
(Vann 2013). The credit is generally refundable to Australian resident
individuals and to pension funds (which are usually taxable at lower
rates than individuals in Australia). Individuals and pension funds are
significant holders of shares in Australian companies, so Australian
corporations distribute a large proportion of their profits as
dividends with shareholder credits attached. Because Australia allows
no shareholder credits for foreign corporate taxes, Australian
companies have considerably less incentive to shift corporate taxable
income abroad than under the current U.S. system. The result is a
corporate tax that operates both as a final tax on foreign investors
and as a withholding tax on Australian investors. A recent study of
European and Australian shareholder-credit systems found that erosion
of the domestic corporate tax base increased in European countries
after repeal of imputation, while such erosion has decreased under the
Australian integration system (Amiram, Bauer, and Frank, 2014). While
the American and Australian economies are obviously different, the
Australian experience offers important evidence that shareholder
credits can be both practical and beneficial.
how integration by a shareholder credit or a dividend deduction
with withholding would work
Present Law
Let us briefly describe present Federal law. If a U.S. corporation
earns $100 of domestic taxable income and distributes its after-tax
income as a dividend to its shareholders, the corporation will owe
corporate tax of 35%. A taxable individual shareholder in the top
bracket will owe 23.8% tax on the dividend, and a foreign shareholder
would owe from zero to 30%, depending on its circumstances and any
relevant tax treaties. A tax-exempt domestic shareholder, of course,
would owe no tax on the dividend. In combination, the current tax
burden is 35% for the tax-exempt shareholder, 50.5% for the taxable
U.S. individual,\5\ and from 35% to 54.5% for foreign shareholders.\6\
By comparison, partnerships will owe no entity-level tax on business
income, and taxable individual partners who materially participate in
the business will be taxed at a top rate of 39.6% on the partnership's
income. Tax exempt organizations will not be taxed (unless the income
is subject to the unrelated business income tax of 35% which often can
be avoided). Foreign partners will pay tax at the U.S. rate (up to
39.6%), perhaps with a credit against their domestic taxes. In 2011,
54.2% of U.S. business income was earned by partnerships (or other
pass-through entities) compared to 20.7% in 1980 (Cooper et al., 2015).
Today, only about 25% of U.S. corporate stock is held in individuals'
taxable accounts. (Austin, Berman, and Rosenthal, 2014).
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\5\ Thirty-five percent plus 23% tax on $65 dividend equals 54.47%.
\6\ Thirty-five percent plus 30% withholding on $65 dividend equals
54.5%.
---------------------------------------------------------------------------
Shareholder-Credit Integration
Under shareholder-credit integration, the corporate tax is
essentially converted into a withholding tax that is creditable against
the shareholder tax due on dividends. By way of example, assume that
the corporate tax rate is 35 percent and dividends are taxed as
ordinary income. A company that earns $100 of income would pay $35 in
corporate tax, leaving $65 for distribution as a dividend. Assume now
that a $65 cash dividend is paid to a domestic shareholder whose
individual tax rate is, alternatively, 20 percent, 25 percent, or 40
percent. Individual shareholders would include $100 in their taxable
income (just as employees include pre-withholding wages in income),
apply their normal tax rate, and, assuming that the credit is
refundable, offset the resulting tax by a credit for the $35 corporate
tax (just as employees receive a credit for taxes withheld by their
employers).
As shown in Table 1 below, the result would be that the ultimate
tax burden would be the same as if the shareholders had earned the
business income directly:
Table 1. $65 Cash Dividend Out of $100 Corporate Income After $35
Corporate Tax Payment
------------------------------------------------------------------------
Shareholder tax rate 20% 25% 40%
------------------------------------------------------------------------
1. Shareholders' taxable income 100 100 100
------------------------------------------------------------------------
2. Initial tax 20 25 40
------------------------------------------------------------------------
3. Tax credit (35% x line 1) 35 35 35
------------------------------------------------------------------------
4. Final tax or refund (line 2-line 3) -15 -10 5
------------------------------------------------------------------------
5. Net shareholder cash ($65-line 4) 80 75 60
------------------------------------------------------------------------
As this example illustrates, a refundable shareholder credit would
incorporate the entity-level business tax into the graduated individual
income tax. The resulting integration of the two taxes would advance
the goal of ultimately taxing income, from whatever source derived, at
an individual's personal tax rate, thereby reducing the differences in
partnership and corporate taxation described above.
If no refunds of imputation credits were allowed, corporate income
would be taxed at the 35% corporate rate (as under present law), unless
the individual shareholder's rate is higher, in which case the higher
rate would apply. As Table 2 shows, an integrated tax at the highest
current individual rate would be lower than the combined corporate and
shareholder taxes of present law, even given the current low rate
applied to dividends.
Dividend Deduction Integration With Withholding
When integration has been proposed for the United States in the
past, corporate managers have been unenthusiastic--in part because
integration proposals have largely benefited only distributed
earnings.\7\ Some corporate managers have preferred a dividend
deduction, which would permit corporations to deduct dividends when
paid. By directly reducing corporate taxes and thus a company's tax
expense for financial reporting purposes, a dividend deduction could
have the effect of reducing effective corporate tax rates and thereby
increasing a company's earnings per share.
---------------------------------------------------------------------------
\7\ The 1992 Treasury Report and the ALI proposal included
recommendations for dividend reinvestment plans that, in effect, would
have extended the benefits of integration to retained earnings. See
U.S. Treasury Department (1992a), in Graetz and Warren (2014b) at
Amazon Location 3273 and Warren(1993), in Graetz and Warren (2014b) at
Amazon Location 10451. President Bush's 2003 dividend exclusion
recommendation also included such a feature but it was widely
criticized for its complexity and not adopted by Congress. A discussion
of the recommendation can be found in Joint Committee on Taxation
(2003). For analysis of the opposition see Sullivan (2005).
The Treasury and the ALI Reports rejected dividend-deduction
integration because it would automatically extend the tax reductions of
integration to foreign and exempt shareholders. However, by coupling a
deduction for dividends with withholding on dividends, results can be
achieved that combine the benefits of shareholder-credit integration
with reduction of effective corporate tax rates. (U.S. Senate 2014,
2015). The withholding credits in this case would fulfill the same
function as imputation credits and, if nonrefundable, would eliminate
the automatic tax reduction for foreign and exempt shareholders that
would occur with a deduction for dividends without withholding. This,
---------------------------------------------------------------------------
of course, would also reduce the revenue cost of integration.
In addition, a deduction for dividends of domestic earnings could
serve as a full or partial substitute for rules directly limiting
erosion of the U.S. corporate income tax base and for rules explicitly
directed at curtailing or prohibiting corporate inversions (Sullivan
2016a, 2016b). A dividend deduction would also permit U.S.
multinationals to repatriate foreign earnings to the United States free
of any residual U.S. corporate tax when those earnings were distributed
as dividends to shareholders.
To demonstrate how a dividend deduction with withholding might
achieve results similar to shareholder-credit integration, we consider
a corporation that earns $100 and distributes $30 of cash as a dividend
to its shareholders. Table 2 shows the results under present law,
shareholder-credit integration, and a dividend deduction with
withholding for a top bracket individual U.S. shareholder.
Table 2. Comparison of Present Law, Shareholder Credit, and Dividend
Deduction PWith Withholding Cash Dividend of $30
Assumptions: Corporate and withholding tax rates are 35%. Shareholder
tax rate is 20% under current law and 40% with a shareholder credit or
dividend deduction. The corporation receives $100 in taxable income and
pays a cash dividend of $30 (i.e., a dividend that reduces corporate
cash by $30 and increases shareholder cash by $30).
------------------------------------------------------------------------
Dividend
Imputation deduction and
Taxpayer Present Law credit withholding
tax
------------------------------------------------------------------------
CORPORATION
1. Taxable income before $100.00 $100.00 $100.00
dividend
2. Corporate tax before $35.00 $35.00 $35.00
dividend
3. Corporate cash before $65.00 $65.00 $65.00
dividend
4. Declared dividend $30.00 $30.00 $46.15
5. Corporate tax to be NA $16.15 NA
imputed to shareholder
(35/65 x line 4)
6. Dividend withholding NA NA $16.15
(35% x line 4)
7. Tax reduction due to NA NA $16.15
dividend deduction (35%
x line 4)
8. Total corporate tax $35.00 $35.00 $18.85
(line 2-line 7)
9. Remaining corporate $35.00 $35.00 $35.00
cash (line 3-line 4 +
line 7)
10. Reduction in $30.00 $30.00 $30.00
corporate cash (line 3-
line 9)
11. Effective corporate 35% 35% 18.85%
tax rate * (line 8/line
1)
U.S. SHAREHOLDER
12. Cash dividend (line $30.00 $30.00 $30.00
4-line 6)
13. Taxable dividend $30.00 $46.15 $46.15
(line 4 + line 5)
14. Shareholder tax $6.00 $18.46 $18.46
before imputation or
withholding credit
15. Imputation or 0 $16.15 $16.15
withholding credit
(line 5 or 6)
16. Net shareholder tax $6.00 $2.31 $2.31
(line 14-line 15)
17. Net shareholder cash $24.00 $27.69 $27.69
(line 12-line 16)
COMBINED CORPORATE AND
SHAREHOLDER TAXES
18. Total tax (line 6 + $41.00 $37.31 $37.31
line 8 + line 16)
19. Corporate tax on $16.15 $16.15 0
distributed income [(35/
65 x line 10)-line 7]
20. Shareholder tax on $6.00 $2.31 $18.46
distributed income
(line 16 + line 6)
21. Total tax on $22.15 $18.46 $18.46
distributed income
(line 19 + line 20)
22. Pre-tax distributed $46.15 $46.15 $46.15
income (line 10/.65)
23. Total effective tax 48% 40% 40%
rate on distributed
income * (line 21/line
22)
------------------------------------------------------------------------
* Assumes book and taxable income are the same.
As Table 2 illustrates, identical results can be reached under a
shareholder credit and a dividend deduction with withholding. There
are, however, several important differences in the characterization of
those results even when they are identical. Notice first that the
declared dividend under the deduction in Table 2 is higher, because it
includes the withholding tax of $16.15. As compared to the shareholder
credit, the dividend deduction reduces the ``corporate'' tax to $18.85.
The company's effective tax rate would therefore be 18.85% (assuming
that book income also equals $100), rather than 35% under the
imputation credit. In both cases, the government receives total
payments from the corporation of $35 and a total 40% tax on the
distributed earnings, but, as shown in lines 6, 16 and 19, those
amounts are classified differently, as among corporate, withholding,
and shareholder taxes.
Table 2 illustrates the proposal for the dividend deduction with
withholding under discussion in the Senate Finance Committee, given a
corporate and withholding tax rate of 35%. The proposal is, of course,
fully compatible with other rates. Table 2 displays the results for a
declared dividend of $46.15. To explore further how such a system would
work, Table 3 displays the results for a similar analysis for a
declared dividend of $30. Once again, identical results could be
obtained under a shareholder credit, but some of the elements of those
results would be characterized differently.
Table 3. Comparison of Present Law, Shareholder Credit, and Dividend
Deduction With Withholding Deductible Dividend of $30
Assumptions: Corporate and withholding tax rates are 35%. Shareholder
tax rate is 20% under current law and 40% with a shareholder credit or
dividend deduction. The corporation receives $100 in taxable income and
pays a cash dividend of $19.50 (i.e., a dividend that reduces corporate
cash by $19.50 and increases shareholder cash by $19.50).
------------------------------------------------------------------------
Dividend
Imputation deduction and
Taxpayer Present Law credit withholding
tax
------------------------------------------------------------------------
CORPORATION
1. Taxable income before $100.00 $100.00 $100.00
dividend
2. Corporate tax before $35.00 $35.00 $35.00
dividend
3. Corporate cash before $65.00 $65.00 $65.00
dividend
4. Declared dividend $19.50 $19.50 $30.00
5. Corporate tax to be NA $10.50 NA
imputed to shareholder
(35/65 x line 4)
6. Dividend withholding NA NA $10.50
(35% x line 4)
7. Tax reduction due to NA NA $10.50
dividend deduction (35%
x line 4)
8. Total corporate tax $35.00 $35.00 $24.50
(line 2-line 7)
9. Remaining corporate $45.50 $45.50 $45.50
cash (line 3-line 4 +
line 7)
10. Reduction in $19.50 $19.50 $19.50
corporate cash (line 3-
line 9)
11. Effective corporate 35% 35% 24.5%
tax rate* (line 8/line
1)
U.S. SHAREHOLDER
12. Cash dividend (line $19.50 $19.50 $19.50
4-line 6)
13. Taxable dividend $19.50 $30.00 $30.00
(line 4 + line 5)
14. Shareholder tax $3.90 $12.00 $12.00
before imputation or
withholding credit
15. Imputation or 0 $10.50 $10.50
withholding credit
(line 5 or 6)
16. Net shareholder tax $3.90 $1.50 $1.50
(line 14-line 15)
17. Net shareholder cash $15.60 $18.00 $18.00
(line 12-line 16)
COMBINED CORPORATE AND
SHAREHOLDER TAXES
18. Total tax (line 6 + $38.90 $36.50 36.50
line 8 + line 16)
19. Corporate tax on $10.50 $10.50 $0
distributed income [(35/
65 x line 10)-line 7]
20. Shareholder tax on $3.90 $1.50 $12.00
distributed income
(line 16 + line 6)
21. Total tax on $14.40 $12.00 $12.00
distributed income
(line 19 + line 20)
22. Pre-tax distributed $30.00 $30.00 $30.00
income (line 10/.65)
23. Total effective tax 48% 40% 40%
rate on distributed
income * (line 21/line
22)
------------------------------------------------------------------------
* Assumes book and taxable income are the same.
In this example, with a smaller dividend deduction of $30, the
corporation's effective tax rate would be 24.5%. The amount withheld
would be 35% of the dividend or $10.50. An individual shareholder in
the 40% bracket would include $30 in income, owe $12 of tax and receive
credit for the $10.50 withheld, paying a total of 40% on the pre-tax
dividend of $30. Again, the total corporate and withholding taxes equal
35% of the company's income.
Notice that in both of the dividend deduction examples of Tables 2
and 3, the total taxes collected from the corporation on its $100 of
earnings are the same: in the first case, $18.85 as corporate tax and
$16.15 of withholding tax for a total of $35, and in the second case a
corporate tax of $24.50 and $10.50 of withholding, again for a total of
$35. The individual shareholder's taxes are different: the shareholder
owes a residual tax of $2.31 in the first case and $1.50 in the second.
The individual shareholder's after-tax cash is also different in the
two cases: $27.69 in the first case and $18.00 in the second. This
reflects the fact that the corporation pays a pre-tax dividend of
$46.15 in the first case and of $30.00 in the second, a difference that
also shows up in greater retained earnings by the corporation in the
second case.
Together these two examples show that a corporation may achieve
results equivalent to a shareholder credit if it increases its declared
dividend by the amount of withheld taxes. If it does not increase the
declared dividend by that amount, both its retained earnings and its
corporate tax rate will be higher. The key point for our purpose here
is to demonstrate the close relationship between a shareholder credit
and a dividend deduction with withholding.
Either of these two integration methods offers a promising approach
for mitigating the distortions of present law described in our
introduction. As illustrated in these examples, the tax burden on
income received by individual investors would become less dependent on
the form of business organization. The discontinuities between debt and
equity finance, between retention and distribution of earnings, and
between different forms of distributions would also be mitigated.
Moreover, as in the Australian system, the incentives for corporations
to shift their income or their domicile abroad could be reduced.
The real world is considerably more complicated than these
introductory examples, so a number of important design issues would
have to be addressed, including the treatment of corporate income that
has not borne U.S. corporate tax, retained earnings, tax-exempt
shareholders, foreign income, foreign shareholders, distributions other
than dividends (such as share repurchases), and interest payments. As
described below, substantial work has already been done on addressing
these issues.
some major design issues
Adoption of a shareholder credit or a dividend deduction with
withholding has the potential for rationalizing and simplifying the
taxation of business income. Like any significant reform of corporate
taxation, such a change raises a series of design issues. The most
important of these issues have been extensively analyzed in the ALI and
Treasury studies, which were recently republished in electronic form
(Graetz and Warren 2014b), as well as in the recent Senate Finance
Committee studies (Senate Finance Committee 2014, 2015). Here we are
able only to sketch the major design issues and describe some potential
resolutions. The key point is that integration provides a very flexible
framework for addressing the major tax policy issues regarding domestic
and international corporate taxation.
Untaxed Corporate Income
How would integration take account of the fact that some corporate
income is distributed to shareholders without bearing a full corporate
tax? There are two basic approaches. The first would apply at the
corporation level, so that shareholder treatment would not depend on
whether the dividend had borne corporate tax. For example, the ALI
report follows the approach of some previous European systems in
requiring a compensatory corporate tax if untaxed income is distributed
to shareholders. Similarly, a dividend deduction could be limited to
undistributed corporate taxable income (Senate Finance Committee,
2014).
A different approach, which would apply at the shareholder level,
was recommended in the 1992 Treasury report (U.S. Treasury 1992a).
Instead of requiring a withholding tax on any dividends paid by the
corporation, individual taxpayers would be allowed to treat dividends
as taxable or nontaxable, based on a statement from each corporation
regarding the amount of its dividends that had borne corporate tax.
This is similar to the law in Australia and New Zealand. Such a system
would require a corporate-level account to keep track of what income
has borne corporate taxes.
Both of the foregoing approaches would prevent pass-through of
corporate tax preferences to shareholders, If, on the other hand,
Congress wanted to pass certain tax preferences through to
shareholders, it would be possible to allow certain dividends to be
free of corporate tax. The ALI report describes a method to accomplish
this result, although neither the ALI report nor the Treasury report
recommended doing so. The Treasury report explicitly rejected passing
through corporate tax preferences to shareholders, which current law
avoids, principally on the ground that allowing individuals to take
advantage of corporate tax preferences would produce a large revenue
loss that would have to be offset by raising other taxes.\8\ By
requiring that withholding applies to every dividend distribution, the
proposal under discussion in the Senate Finance Committee reaches a
similar result.\9\ The major disadvantage of not allowing individual
shareholders the benefit of corporate tax preferences would be a
continued difference in the treatment of corporate and noncorporate
businesses in this regard.
---------------------------------------------------------------------------
\8\ A subsequent version of a dividend exclusion proposed by
Treasury includes some passthrough of corporate preferences (U.S.
Treasury, 1992b).
\9\ A corollary to this treatment would be that unused deductions
for dividends out of untaxed income should not be added to corporate
net operating loss carryovers.
---------------------------------------------------------------------------
Retained Earnings
Under a shareholder credit or a dividend deduction with
withholding, retained corporate earnings raise two problems. First,
even if withholding credits are refundable, shareholders whose marginal
tax rates are below the corporate tax rate would be disadvantaged by
such retentions. Corporate earnings would compound at the lower after-
corporate-tax rate of return, potentially creating an incentive to
distribute earnings. Making credits nonrefundable would increase the
disadvantage to lower-bracket shareholders.
Second, taxation of shareholder capital gains due to retained
corporate earnings could, as under current law, in some cases
constitute multiple taxation of the same gain.\10\ It is sometimes
suggested that the second problem could be addressed by retaining
preferential taxation of gains on corporate stock, but such a
preference would be overbroad, because not all gains on corporate stock
are due to taxable retained corporate earnings.
---------------------------------------------------------------------------
\10\ Whether or not there was multiple taxation would depend in
part on the availability of offsetting capital losses in the future.
See the discussion in Part 3 of Warren (1993), in Graetz and Warren
(2014b) at Amazon Location 10309.
The ALI and Treasury addressed both problems by providing for
constructive dividend and reinvestment plans, which are sometimes
identified by the acronym DRIP. Under such an option, corporations
could make tax credits available to shareholders without the necessity
of a cash distribution. The corporation could elect to treat retained
earnings as if they had been paid to shareholders as dividends and
immediately recontributed as equity to the corporation. The increase in
shareholder basis resulting from the constructive reinvestment would
eliminate the possibility of double taxation on sale of the stock. The
Treasury recommended a DRIP option in its 2003 dividend exclusion
proposal, but Congress rejected the idea.\11\
---------------------------------------------------------------------------
\11\ For an overview of the proposal including the DRIP option, see
Burman and Rohaly (2003).
---------------------------------------------------------------------------
Exempt Shareholders and Creditors
Current law taxes corporate income without regard to the tax status
of shareholders, so tax-exempt suppliers of corporate capital, such as
charitable endowments and pension funds, do not now necessarily receive
their share of corporate income free of tax. The portion of corporate
income distributed to such investors is sometimes taxed (due to the
corporate tax on income distributed as dividends) and sometimes is not
(due to the corporate deduction for interest payments and to corporate
preferences for some dividends). Since one of the goals of integration
is to reduce such discontinuities, any system of integration will
necessarily affect tax-exempt shareholders. Neither the ALI report
(Warren 1993), the Treasury report (1992a), nor the dividend deduction
proposal under discussion in the Senate Finance Committee recommends
elimination of taxation of corporate-source income attributable to tax-
exempt investors. Indeed, none of these proposals recommends refunding
withholding taxes to such investors unless an explicit tax is imposed
on their income.
The approach of the ALI report is to subject entities that are
nominally exempt under current law to a tax on investment income,
subject to shareholder (and debtholder) withholding and credits, with
any excess credits potentially refundable. This would maintain a single
level of tax on corporate income received by such investors, at
whatever rate Congress deems appropriate, and could serve to eliminate
tax-
induced distortions between debt and equity. The rationale for this
proposal is that the rate of tax on income from corporate investment
received by exempt entities should be uniform and explicitly determined
as a matter of tax policy. (Warren 1993).\12\ The tax rate on tax-
exempt investors might be set to maintain a similar amount of revenue
as is currently collected on corporate income attributable to exempt
shareholders, to increase that amount, or to decrease it.
---------------------------------------------------------------------------
\12\ For more, see the discussion in Part 6, Proposal 9 in Warren
(1993), and in Graetz and Warren (2014b) at Amazon Location 10906.
The Treasury report (1992a) also discusses a uniform tax on tax-
exempt investors' investment income along similar lines, but does not
propose such a tax, probably because the Treasury did not regard that
tax as politically viable. The Treasury report estimated that in 1992 a
uniform tax of 6 to 8 percent would have approximated the tax burden on
investment income received by tax-exempt shareholders ($29 billion in
1992, or about a third of corporate tax revenue).
International Income
Under the current classical tax system and longstanding treaty
practice, taxes on corporate income are collected primarily by the
source country, while taxes on interest and dividends are collected
primarily by the investor's country of residence (Ault 1992).
Integration of the corporate and individual taxes generally shifts
taxes from corporations to shareholders and in some cases might
undermine this historical division completely by collapsing the two
levels of tax into one. The trend in Europe, after the collapse of
integration systems due to decisions of the CJEU has been to reduce
corporate tax rates and make up for the revenue lost through higher
income or consumption taxes on individuals.
Two important international questions must be considered in
designing an integration system for the United States. First, what
should be the extent of U.S. taxation of U.S. corporate income paid to
foreign investors and parent companies? Second, how should foreign
taxes paid by U.S. companies or their subsidiaries on foreign income
affect the U.S. taxation of U.S. shareholders on distribution of those
earnings? Resolution of these issues is complicated by the existence
under current law of nonrefundable ``withholding'' taxes on U.S.
dividends and interest paid to certain foreign recipients. These taxes
theoretically substitute for the income tax applicable to domestic
recipients of such income, but are generally eliminated or reduced to
low levels by bilateral income tax treaties or by statute.
The approach of the ALI report with respect to foreign parent
companies and investors is similar to that for domestic exempt
investors. Foreign parents and investors would be subject to a new
withholding tax on their U.S. investment income and would receive
potentially refundable integration credits. This tax would replace the
current nonrefundable withholding tax, which applies to some, but not
all, U.S. corporate income distributed abroad. The rationale for this
proposal is again to make the rate of tax on U.S. income uniform and
explicitly determined as a matter of U.S. tax policy, first by
legislation and then through treaty negotiation.\13\ The uniform tax
developed in the ALI report would be an innovation in international
taxation and would therefore require discussion and perhaps
coordination with our trading partners. The Treasury report considered
the possibility of a uniform tax on foreign parent companies and
investors along these lines, but ultimately concluded that such changes
should not be made legislatively by the United States. The Treasury
recommended instead that withholding be imposed on dividends paid to
foreign shareholders but not refunded to them except by treaty, thereby
preserving our bargaining power in treaty negotiations with our trading
partners.\14\ The dividend deduction under discussion in the Senate
Finance Committee also imposes withholding taxes on dividends paid to
foreign shareholders and does not provide for refunds.
---------------------------------------------------------------------------
\13\ See Part 7 in Warren (1993), available in Graetz and Warren
(2014b) at Amazon Location 10959.
\14\ See the discussion in Chapter 7 in U.S. Treasury (1992a), in
Graetz and Warren (2014b) at Amazon Location 2853.
With respect to foreign income of U.S. companies, shareholder-
credit integration is compatible with either the traditional U.S.
foreign tax credit or replacement of the credit with an exemption for
dividends paid to U.S. parents out of their subsidiaries' foreign
business income. The Senate Finance Committee proposal for a dividend
deduction with withholding is also designed to be compatible with
---------------------------------------------------------------------------
either a tax credit or exemption for foreign income.
If the U.S. were to adopt integration and retain a foreign tax
credit, conversion of the U.S. corporate tax into a withholding tax
would pose the question whether credits for foreign taxes paid by U.S.
companies should be passed through to U.S. shareholders on distribution
of dividends out of the foreign income. Passing through foreign taxes
would be approximated under the ALI report with considerably less
complexity by treating an appropriate amount of corporate foreign
income as tax exempt when distributed as dividends. As with the
recommendation regarding foreign investors, this proposal could be
limited to income from countries that agreed to reciprocal treatment
for U.S. shareholders. The Treasury report discusses the possible pass-
through of foreign tax credits, but concludes that the U.S. should not
after such a change unilaterally. The Treasury estimated that allowing
foreign tax credits to offset the single level of tax in an integrated
system would in 1992 have entailed a revenue loss of $17 billion a
year, or 19 percent of corporate tax revenues.\15\
---------------------------------------------------------------------------
\15\ A subsequent Treasury recommendation proposed unilateral pass-
through of some foreign tax credits to U.S. shareholders, presumably in
an effort to make the proposal more attractive to U.S. multinational
corporations (U.S. Treasury 1992b).
Limiting shareholder credits to the amount of U.S. corporate taxes
paid on income distributed as dividends has the advantage of reducing
incentives of dividend-paying U.S. corporations to shift their income
from the United States to lower tax foreign jurisdictions. In
Australia, this ``integrity'' benefit of integration is important
(Australian Government, 2015). As described above, this limitation can
be achieved either by maintaining a taxes-paid account or by imposing
withholding on all dividend distributions. Limiting the allowance of
dividend deductions to U.S. taxable income would decrease the incentive
for U.S. corporations to re-domicile to a foreign jurisdiction,
although such a limitation might raise issues under the
nondiscrimination provisions of our income tax treaties (Verlarde and
Basu 2016), (Herzfeld 2016), (Sullivan 2016b).
Nondividend Distributions
There are a variety of transactions other than dividends by which
corporate income may be distributed to shareholders, including
repurchases by a corporation of its stock, purchases by one corporation
of the stock of another corporation from noncorporate shareholders, and
payments in liquidation. Under current law, the tax treatment of such
nondividend distributions to individuals can be less onerous than that
of dividends, because selling shareholders benefit from basis recovery.
Since 2003, qualified dividends have been taxed at capital gains rates,
but under either an imputation credit or a dividend deduction with
withholding, the rationale for this preferential treatment of dividends
(reduction of double taxation) would disappear, so the regular
individual income tax rates should apply to dividends.
The principal tax policy issue presented by nondividend
distributions in the design of an integration system is whether any of
the benefits of integration should be available for such distributions
in order to achieve neutrality with dividends. The ALI report
recommended that nondividend distributions should carry out some
shareholder credits to approximate parity with dividends.\16\ To the
contrary, the Treasury report concluded that no change in the current
law treatment of nondividend distributions would be necessary, because
the incentive to engage in such distributions would be reduced under
integration (U.S. Treasury, 1992a).
---------------------------------------------------------------------------
\16\ See Part 4, Proposal 7 in Warren (1993), in Graetz and Warren
(2014b) at Amazon Location 10667.
Under the proposal under discussion in the Senate Finance Committee
illustrated in Tables 2 and 3, the dividend deduction could increase
reported earnings per share, if the accounting authorities classified
withholding as shareholder, rather than corporate, taxes. Companies
that used share repurchases under current law to increase earnings per
share might therefore find the current law advantage of share
repurchases over dividends reversed, even with dividends taxed at
ordinary income rates and the capital gains preference retained for
repurchases.\17\
---------------------------------------------------------------------------
\17\ We are indebted to Peter Merrill for this point.
Debt
An important goal of integration is to reduce the differential
income tax treatment of corporate equity and debt. Equivalent treatment
would be achieved under the ALI report (Warren, 1993) by imposing a
withholding tax on corporate interest payments. The proposal under
discussion in the Senate Finance Committee might also include a
withholding tax on certain interest payments. The withholding credit
for interest would then function in the same manner as a shareholder or
withholding credit for dividends. However, as discussed above (and
recommended in the ALI report), achieving equivalence for debt and
equity for tax-exempt and foreign investors under such a system
requires imposing a separate tax on their U.S. investment income.
In the absence of a tax on U.S. investment income of tax-exempt
organizations and foreign shareholders (coupled with refundability of
the withholding tax on interest), extending withholding to corporate
suppliers of debt financing could raise serious economic concerns. If,
for example, nonrefundable withholding on interest applied only to
corporate debt, portfolio shifts by foreigners and tax-exempt investors
might occur. Corporate interest payments would be subject to a
nonrefundable withholding tax, but interest paid by the Treasury bonds,
by banks or other financial institutions, or by foreign corporations
would not bear such a tax. In such a case, foreigners and tax exempt
investors would likely prefer debt not subject to withholding since
they would receive no benefit from credits for withheld taxes.
A less disruptive option might be to deny deductions for all or
part of interest payments at the corporate level. This could avoid the
kinds of portfolio realignments that might accompany nonrefundable
withholding on interest and could be achieved in a number of ways,
including by tightening the provisions of current law regarding
interest deductibility.\18\ A full deduction for dividends with
withholding, coupled with limited deductions for interest without
withholding, might seem an odd combination, but it might achieve a
better balance of incentives for debt and equity finance than current
law while avoiding potential disruptions in the debt markets.
---------------------------------------------------------------------------
\18\ See Internal Revenue Code sections 163(j) and 385, as well as
U.S. Treasury (2015, 2016). See also the discussion in the OECD's early
BEPS discussion draft for a similar proposal (OECD, 2014).
---------------------------------------------------------------------------
Noncorporate Taxpayers
By relieving the double corporate tax, integration would reduce the
current law advantages of operating in partnership or other
noncorporate form. As we have emphasized, however, in the absence of a
new tax applicable to tax exempt or foreign shareholders, integration
with nonrefundable withholding would preserve an advantage for
investments in noncorporate entities by tax exempt and foreign
investors. The growth in businesses organized outside of corporate form
in the quarter century since the Treasury and ALI reports suggests
eliminating the distinction between corporate and noncorporate business
entities, at least for businesses of a certain size. Absent such a
change, an alternative would be to extend nonrefundable withholding to
noncorporate income, but none of the proposals have yet advanced such a
recommendation. Thus, integration seems likely to reduce, but not
eliminate, differences in the taxation of corporate and noncorporate
entities.
We have discussed integration here in the context of present law,
with its 35-
percent rate and foreign tax credit, rather than assuming a lower rate
and an exclusion for dividends paid to a U.S. parent from a foreign
subsidiary. But, as previously discussed, either a shareholder credit
or a dividend deduction with withholding is fully compatible with a
territorial system of taxing foreign source income or a lower corporate
rate. The magnitude of the distortions of current law would of course
be reduced as the corporate rate is lowered.
conclusions
In the absence of another revenue source that would permit a
drastic reduction in the corporate tax rate (see, e.g., Graetz, 2010),
we continue to believe that a shareholder credit or a dividend
deduction with withholding provides an important avenue for corporate
tax reform today. Depending on a series of design decisions to be made,
transforming the corporate tax into a withholding levy would reduce or
eliminate the vexing domestic and international tax distortions with
which we began this testimony. To be sure, the integration framework
does not eliminate all the problems of current law, such as
international transfer pricing, but it is fully consistent with
additional measures to address such problems (Wells 2016). Foreign
experience has shown that a shareholder credit can be effectively
implemented in a major economy, and significant work has already been
done on designing a shareholder credit or a dividend deduction with
withholding for the United States.
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______
Prepared Statement of Hon. Orrin G. Hatch,
a U.S. Senator From Utah
WASHINGTON--Senate Finance Committee Chairman Orrin Hatch (R-Utah)
today delivered the following opening statement at a hearing to examine
corporate integration, and specifically, how allowing corporations to
deduct dividends could create a more efficient and fairer system of
taxation of corporate profits:
I'd like to welcome everyone here this morning.
Even a cursory examination of the business tax system demonstrates
clearly the problems that arise from our out-of-step corporate tax,
which contributes significantly to our anti-competitive business
climate and leads sophisticated tax planners to engage in costly
efforts--which some would call gamesmanship or tax avoidance--to either
minimize their taxes or manage competitive tax pressures from abroad.
Without significant reforms to the corporate tax system, we will
continue to see an erosion in our overall tax base along with
diminished growth and investment.
Among the most significant--and inexplicable--inefficiencies in our
business tax system is the fact that a significant portion of U.S.
business income is taxed more than once. Under the current system,
income earned only once by corporations--on behalf of its
shareholders--is taxed twice, thanks to a fiction created in the law
that treats a business and its owners as two separate, taxable
entities.
Specifically, when a corporation turns a profit, those earnings are
taxed under the corporate income tax system, generally at a rate of 35
percent. When the corporation distributes a portion of those earnings
to its shareholders in the form of dividends, we tax those earnings a
second time at the individual level, with a maximum dividend tax rate
approaching 25 percent. This, put simply, is a problem.
We have this problem, in large part, due to the fact that rules for
taxing corporations were written without taking into account the rules
for taxing individuals, and vice versa. A better, more efficient system
would be one that integrated the taxation of corporate and individual
income.
That's what we're here to discuss today.
The current system of double taxation has resulted in a number of
unintended economic distortions that wouldn't exist under a more
integrated system. I'll discuss just a few of those distortions here
this morning.
For example, the current system creates a bias in the choice of
business entity, disfavoring the corporate model versus others. Of
course, businesses--small and start-up businesses in particular--should
have the flexibility to determine how to organize themselves. But, our
tax code shouldn't punish any particular business with double taxation
simply because it was organized a certain way.
Double taxation also discourages savings and investment and is a
major factor in our current domestic savings and investment shortage.
Savings and investment are essential to capital formation, increased
job productivity, wage growth, and adequate retirement savings. Yet,
we've created a system that essentially punishes those who save and
invest.
In addition, the current system explicitly favors debt-financed
investment over
equity-financed investment. In the United States, corporations can
deduct interest paid to bond holders, but no similar deduction exists
for dividends paid to stockholders. Now, in some situations, there may
be strong reasons for a company to opt for debt-financing, but there is
no real reason why the tax code should favor debt over equity.
Double taxation also contributes to the problem of lock-out; that
is, it discourages businesses from bringing income earned overseas back
into the U.S. As many have already noted, with the highest corporate
tax rate in the developed world, American multinational companies are
often loath to repatriate their foreign earnings and subject them to
U.S. taxes on top of the taxes they've already paid in foreign
jurisdictions. And, their shareholders rarely demand that they do so,
because those earnings will be taxed again if and when they are ever
paid out as dividends. As a result, experts estimate that U.S.
corporations have over $2 trillion in earnings that are locked out of
the United States due, in large part, to our tax system.
These problems--and there are many others--have been observed for
years. And, as a result, many have argued for the elimination of double
taxation and in favor of integrating the individual and corporate tax
systems. We're going to continue that discussion here today.
In any discussion of an integrated system, the fundamental design
choice that has to be made is whether the single instance of taxation
should fall on the corporation or the shareholders. Given the
substantial burdens our corporate tax system already imposes on U.S.
businesses, coupled with the relatively high mobility of corporate
residence in the age of globalization, as illustrated by the recent
wave of inversions and foreign takeovers, some have questioned the
wisdom of collecting the tax on the corporation side.
Another method of integrating the two systems would be to impose a
single layer of tax at the shareholder level by allowing companies to
deduct any dividends they pay out. As I see it, there are a number of
benefits to this approach. I'll mention just a few.
First, a deduction for dividends paid would allow businesses to cut
their own effective tax rates. There is bipartisan agreement on the
need to bring down corporate tax rates. A dividends paid deduction
could accomplish the same goal without many of the trade-offs
associated with a reduction in the statutory tax rate.
Second, this type of deduction would create greater parity between
debt and equity. As I noted earlier, current law generally allows
corporations to deduct earnings paid out as interest on debt
obligations. A dividends paid deduction would provide similar tax
treatment for earnings paid out as dividends to investors, allowing
companies to make debt-vs.-equity decisions after considering market
conditions instead of simply referencing biases in the tax code.
Third, a dividends paid deduction could help with some of our
international tax problems by reducing the pressure on companies to
invert and greatly reducing the lock-out effect.
To hopefully take advantage of these and other benefits, I've been
working for over a year now on a tax reform proposal that would
eliminate double taxation of corporate income by providing this type of
deduction. While I plan to unveil that proposal here in the next
several weeks, I'm hoping we can inform this ongoing effort by having a
more detailed discussion of these concepts and others during the course
of today's hearing.
Before I conclude, I want to acknowledge that some groups--
including tax-exempt entities and retirement plans--may have some
concerns with a dividends paid deduction. However, at the end of the
day, I believe we can craft a system where these parties will be
treated in a manner that is comparable to current law or, in fact, in
many cases, be better off. And at the same time, our overall tax system
will, in the opinion of many, be very much improved.
Still, I want everyone to know that, as I am preparing my
integration proposal, I am aware of the concerns that these and other
groups might raise and I am studying them very closely. Today, and
going forward, we seek your comments and suggestions.
With that, I just want to say that I appreciate this fine panel of
witnesses being here today, sharing their knowledge and expertise with
the committee. I think this is going to be a very informative hearing.
______
Prepared Statement of Judy A. Miller, Director of Retirement Policy
for the American Retirement Association and Executive Director of the
American Society of Pension Professionals and Actuaries, College of
Pension Actuaries
The American Retirement Association (``ARA'') thanks Chairman
Hatch, Ranking Member Wyden, and the other members of the Senate
Finance Committee for the opportunity to testify regarding the impact
of corporate integration on small business qualified retirement plans.
The ARA is an organization of more than 20,000 members nationwide
who provide consulting and administrative services to retirement plans
that cover millions of American workers and retirees. ARA members are a
diverse group of retirement plan professionals of all disciplines,
including financial advisers, consultants, administrators, actuaries,
accountants, and attorneys. The ARA is the coordinating entity for its
four underlying affiliate organizations, the American Society of
Pension Professionals and Actuaries (``ASPPA''), the National
Association of Plan Advisors (``NAPA''), the National Tax-deferred
Savings Association (``NTSA'') and the ASPPA College of Pension
Actuaries (``ACOPA''). ARA members are diverse but united in a common
dedication to America's private retirement system.
A workplace retirement plan is the single most important factor
that determines whether or not workers accumulate significant savings
for retirement. Data from the Employee Benefits Research Institute
shows that workers earning between $30,000 and $50,000 per year are 15
times more likely to save at work than to go out and set up an IRA to
save on their own. Because moderate income earners almost exclusively
save at work through plans like the 401(k)--the most widely known
section of the tax code--it is not surprising that Internal Revenue
Service data shows that nearly 80% of participants in 401(k) and other
profit sharing plans make less than $100,000 per year, and 43% of
participants in these plans make less than $50,000 per year. Simply
stated, saving at work, works. That is why it is so critical that
businesses, especially small businesses, be encouraged to maintain
workplace retirement plans.
The tax incentives for employer-sponsored plans in place today do
an efficient and effective job in allowing Americans across the income
spectrum to build a secure retirement. These incentives play a critical
role in encouraging small business owners to establish and maintain a
qualified retirement plan. Nondiscrimination rules combined with
compensation and contribution limits assure that non-highly compensated
employees also benefit from these programs. Proposals such as corporate
integration that would reduce the incentives for small business owners
to save for themselves through a qualified retirement plan will
discourage the establishment and maintenance of these retirement plans,
and so reduce the availability of workplace retirement savings.
background
What are the current tax incentives?
Employer contributions made to qualified retirement plans are
deductible to the employer when made. Income tax on investment earnings
on those contributions is deferred until amounts are distributed from
the plan. When a distribution is made to a plan participant, all
amounts are subject to ordinary income tax. Employer contributions made
on a participant's behalf are not subject to FICA. In addition,
individuals with adjusted gross income (``AGI'') of less than $30,750,
and married couples with AGI of less than $61,500, may qualify for a
Saver's Credit ranging from 10% to 50% of the first $2,000 the
individual contributes to an IRA or employer-sponsored defined
contribution plan.
Limits are placed on contributions to defined contribution plans,
and on benefits payable from defined benefit plans:
Certain defined contribution plans permit employees to
contribute on their own behalf by electing to have a certain dollar
amount or percentage of compensation withheld from pay and deposited to
the plan. These ``elective deferrals'' are excludable from income for
income tax purposes, but FICA is paid on the amounts by both the
employer and the employee. For 2016, the maximum elective deferral to a
401(k) or similar plan is $18,000. Employees age 50 or over can also
make a ``catch-up contribution'' of up to $6,000. Elective deferrals to
a SIMPLE plan are limited to $12,500, plus a $3,000 catch-up
contribution for those age 50 or over.
If the employer also contributes to a defined contribution
plan (such as a 401(k) plan), the maximum contribution for any employee
is $53,000. This limit includes any elective deferrals other than
catch-up contributions. This means a participant that is age 50 or
over, and who makes the full $6,000 catch-up contribution, would have a
total limit of $59,000.
The maximum annual benefit payable from a defined benefit
plan cannot exceed the lesser of the average of 3 year's pay or
$210,000. If retirement is before age 62, the dollar limit is reduced.
Employers can deduct the amount required to fund promised benefits.
Annual IRA contributions are limited to $5,500, plus
``catch-up'' contributions of $1,000 for those age 50 or over.
Compensation in excess of $265,000 cannot be considered in
calculating contributions or in applying nondiscrimination rules under
either defined benefit or defined contribution plans. For example, if a
business owner makes $400,000, and the plan provides a dollar for
dollar match on the first 3% of pay the participant elects to
contribute to the plan, the match for the owner is 3% of $265,000, not
3% of $400,000.
What are the current nondiscrimination rules?
The higher contribution limits for qualified retirement plans--both
defined contribution and defined benefit plans--come with coverage and
non-discrimination requirements. For example, a small business owner
with several employees cannot simply put in a defined contribution plan
and contribute $53,000 to his or her account. Other employees who have
attained age 21 and completed 1 year of service with at least 1,000
hours of work must be taken into consideration, and the employer must
be able to demonstrate that benefits provided under the plan do not
discriminate in favor of ``Highly Compensated Employees'' (``HCEs''),
which would include the owner.
Generally, contributions or benefits that are proportionate to an
individual's compensation are considered fair. Age can also be
considered when determining the amount of contributions that can be
made on a participant's behalf. A larger contribution (as a percentage
of pay) can be made for older employees because the contribution will
have less time to earn investment income before the worker reaches
retirement age (usually age 65). Safe harbors are also available. For
example, if all employees covered by a 401(k) plan are provided with a
contribution of 3% of pay that is fully vested, the HCE can make the
maximum elective deferral, regardless of how much other employees
choose to contribute on their own behalf.
These nondiscrimination rules, coupled with the limit on
compensation that can be considered under these arrangements, are
designed to ensure that qualified
employer-sponsored retirement plans do not discriminate in favor of
HCEs. Non-
discrimination rules do not apply to other forms of tax-favored
retirement savings. For example:
IRAs share the incentive of tax deferral. However, if a
small business owner makes a personal contribution to an IRA, there is
no corresponding obligation to contribute to other employees' IRAs.
However, under the current rules, the contribution limit for IRAs is
set low enough (and the limit for employer-sponsored plans high enough)
to make a qualified retirement plan attractive to a business owner who
can afford it.
Annuities purchased outside of a qualified plan share the
benefit of ``inside buildup''--the deferral of income tax on investment
earnings until distributed from the arrangement--but have no limit on
contributions or benefits, and no non-discrimination requirements.
This means the attraction of a qualified retirement plan for a
small business owner is heavily dependent on the interaction of non-
discrimination rules and the tax incentives for saving through a
qualified retirement plan.
corporate integration
For purposes of this discussion, we consider a corporate
integration proposal under which mandatory 35% withholding would apply
to dividends and interest paid on all domestic stocks and bonds,
regardless of the tax status of the holder of the securities. Taxpayers
with a marginal tax rate of less than 35% would not be able to recover
any portion of the withholding.
How would corporate integration affect the tax incentives for qualified
retirement plans?
The tax incentive for saving through a qualified retirement plan is
the deferral of income tax on the contributions made to the plan, and
on investment earnings on those contributions, for so long as the funds
are held in trust by the plan. Distributions from the plan are then
included in ordinary income when payments are made from the plan,
usually when the plan participant has retired. Corporate integration
would result in taxation of dividends and interest earned by the plan's
investments while held in the plan, with the contributions and
remaining investment earnings taxed again when the amounts are
withdrawn from the plan. The result would be a substantial reduction in
the tax incentive to save through a qualified retirement plan relative
to current law.
For example, consider a small business owner with $10,000 to
contribute to a traditional account in a 401(k) plan. Assume the
contribution earns a 5% annual rate of investment return. The initial
investment is 50% stocks and 50% bonds, with dividends and interest
reinvested in the same type of security. Under current law, the
contribution and investment earnings will accumulate tax free until the
employee terminates employment and begins to withdraw the account
balance. If the accumulation period is 10 years, the account balance
attributable to that contribution will have grown to $16,289. In 20
years, the balance would be $26,533. Income tax will be paid upon
withdrawal. Assuming a marginal rate of 28%, the after-tax balance
attributable to that contribution would be $11,728 after 10 years and
$19,104 after 20 years.
If the business owner chose not to contribute the $10,000 to the
401(k) plan, but invested the after-tax amount outside of a plan, the
initial investment would be $7,200 ($10,000 less $2,800 income tax).
Dividends received would be taxed at a 15% rate, and interest at 28%,
so the net rate of return on stocks would be 4.25%, and 3.6% on bonds.
The balance after 10 years would be $10,586, which is $1,142 less than
the after-tax 401(k) plan amount. The balance after 20 years would be
$15,579, which is $3,535 less than the after-tax amount from the 401(k)
plan after 20 years. In other words, assuming 5% rates of return, the
business owner would gain 22.6% over 20 years by investing in the
401(k) plan.
Now assume a corporate integration proposal with mandatory 35%
withholding is adopted. Instead of earning 5% per year, net investment
return on the amount invested in the 401(k) plan is only 3.25% (65% of
5%). After 10 years with 3.25% rates of return, the $10,000
contribution would accumulate to $13,769. After 20 years, the balance
would be $18,958. Income tax will still be paid upon withdrawal.
Assuming a marginal rate of 28%, the after-tax balance attributable to
that contribution would be $9,914 after 10 years and $13,650 after 20
years.
In other words, corporate integration will have reduced the value
of a retirement contribution by 15% after 10 years, and 27% after 20
years. In fact, corporate integration without recovery of amounts
withheld on dividends and interest paid to a qualified retirement
plan's trust effectively eliminates the tax incentive for saving
through a qualified retirement plan to the extent investment earnings
are attributable to dividends and interest. Assume the $10,000 is not
contributed to a 401(k) plan. Income tax at the 28% rate would be paid
on that amount, leaving $7,200 to be invested. After 10 years with a
net investment earnings rate of 3.25%, the $7,200 would accumulate to
$9,914--the same as the after-tax accumulation in the 401(k) plan.
After 20 years, the accumulation outside the plan would be $13,650--
same as the 401(k) plan. Amounts invested outside of a qualified
retirement plan are not subject to the restriction for accessing monies
in a 401(k) or similar account, so without the tax incentive, investing
outside of the 401(k) plan could be more attractive than contributing
to the plan.
In theory, with corporate integration, dividends could be grossed
up to reflect that the corporation no longer has to pay income tax on
the dividends. If that were true, the net dividend paid with corporate
integration would equal amount of dividend that would have been paid
under current law. Assuming this is true, the accumulated balance
attributable to the $10,000 contribution to the 401(k) plan would be
$15,029 after 10 years and $22,746 after 20 years. Assuming a 28% rate,
the after-tax amounts would be $10,821 and $16,377 respectively. The
reduction in the value of the contribution as compared to current law
would be 7% after 10 years and 14% after 20 years. However, the tax
incentive for saving through a 401(k) plan instead of outside of the
plan would still be eliminated. An investment of $7,200 outside of the
plan would also yield $10,821 after 10 years and $16,377 after 20
years.
For simplicity, these examples assume all investment earnings are
comprised of interest and dividends on domestic securities. To the
extent investment earnings include capital gains, the impact would be
lessened.
How would the reduced tax incentive affect small business retirement
plans?
The current tax incentives play a critical role in encouraging
small business owners to establish and maintain a qualified retirement
plan. Because of the nondiscrimination rules, a business owner can only
save through the plan if other employees are also benefitting. As a
result, a decision to establish and maintain a plan such as a 401(k)
plan not only involves taking on fiduciary responsibilities and
administrative costs, but often the cost of making contributions for
the non-highly compensated employees who participate in the plan. For
example, very small employers are often ``top heavy,'' and are required
to make contributions of 3% of pay for all eligible non-key employees--
whether or not the employees contribute on their own behalf. Other
small business owners contribute 3% of pay to satisfy a 401(k)
nondiscrimination testing safe harbor. Still others contribute 5% of
more to be eligible to apply other nondiscrimination testing
approaches. The cost of these contributions can be significant, and the
availability of the tax incentives to offset all or part of the cost is
critical to the decision to maintain a qualified retirement plan.
Consider the following situation:
ABC Company has been in operation for 5 years. The owner has
some retirement savings in an IRA, but has never taken time to
think about retirement. The business has five other employees
earning from $35,000 to $75,000, with total payroll of
$300,000. The owner takes compensation of $10,000 per month
during the year, then takes a year-end bonus of the amount of
company profits, which amount to $65,000 for the current year.
The owner will pay individual income taxes on the full amount
of the profits at a marginal rate of 28%, leaving $46,800 after
paying taxes in the amount of $18,200.
Before taking the bonus, the owner meets with a retirement
plan consultant. The owner is older than most of the other
workers, so the consultant recommends a safe harbor 401(k) plan
with an additional ``cross-tested'' contribution. With this
type of plan the owner could contribute $50,000 of the profits
to the plan on her own behalf. Thanks to the nondiscrimination
rules that apply to qualified retirement plans, putting $50,000
of the profits into the 401(k) plan for the owner means the
owner must contribute at least 5% of pay for the employees,
which is $15,000. So, instead of taking home $46,800 and
sending IRS a check for $18,200, the owner will contribute
$50,000 to the plan on her own behalf and $15,000 for the
employees. A tax credit for the cost of setting up and
operating a new plan will help defray any startup and initial
operating costs.
Under current law, the arrangement makes sense for the small
business owner. Instead of sending a check to IRS, she can make
a contribution of $15,000 for her employees. The deferral of
tax on investment earnings means the amount the owner will have
accumulated in after-tax savings in 20 years is similar to what
she would have if she paid taxes now on the $65,000, and
invested the remainder outside of the qualified plan. If the
owner is in the 28% tax bracket at retirement, she will have
about $10,000 less from the plan than if she saved outside of
the plan, but if she is in a lower tax bracket, she will come
out ahead because she chose to set up and contribute to the
plan. In short, both the owner and the employees are on the
road toward a secure retirement.
How would this scenario change with corporate integration? The
deduction for the contribution would still largely cover the costs of
the contribution, but the longer-
term view would lead to a very different conversation. The owner would
be advised that if she just paid tax on the $65,000 now and invested
the difference without setting up a plan, she would end up with
significantly more savings 20 years from now than if she put in the
plan, even if she is down to a 15% marginal rate in retirement. She
would also have more flexibility by holding those savings outside of a
qualified plan. If she put the money in a 401(k) plan and needed it
before she reached retirement age, she would have to prove hardship, or
even go through the formal process of terminating the plan, in order to
get to her account. She would also have to pay a 10% penalty if she
chose to withdraw it before retirement, death or disability. In other
words, with corporate integration the owner would have less expense,
less liability, more flexibility and more long term savings by just
saying ``no'' to setting up a 401(k) plan.
The following table summarizes the 20-year projections of the value
of the owner's contributions based on both 28% and 15% marginal rates
at retirement. For purposes of this illustration, it was assumed that
with corporate integration, dividends would be increased to absorb the
35% mandatory withholding. Note that if the owner is in the 28% bracket
at retirement, under the proposal she could increase her savings by 30%
by not sponsoring a 401(k) plan.
Table 1
------------------------------------------------------------------------
Net amount with
marginal rate at
Invested 20-year retirement of
amount balance -----------------------
28% 15%
------------------------------------------------------------------------
Current law
401(k) plan $50,000 $132,665 $95,520 $112,765
Nonqualified account $46,800 $101,264 $101,264 $101,264
------------------------------------------------------------------------
Proposal
401(k) plan $50,000 $113,728 $81,884 $96,670
Nonqualified account $46,800 $106,450 $106,450 $106,450
------------------------------------------------------------------------
The loss of deferral of income tax on dividends and interest with
corporate integration would significantly reduce, and for more
conservative investors even eliminate, the tax incentive for saving
through a qualified retirement plan. Given the costs and obligations
that come with sponsoring a qualified retirement plan, the result would
be a reduction in the number of plans sponsored by small businesses,
and a loss of coverage, and retirement security, for small business
employees.
Small business employees would not be the only ones to suffer,
however. The lack of deferral of income tax on dividends and interest
will reduce the account balances of any participant whose account is
invested in an asset that pays interest (or dividends to the extent
dividends payable on the investments held by the plan do not increase
sufficiently to cover the withholding), and do serious harm to the
retirement security of American workers.
summary
Access to a retirement plan at work is the key to successfully
preparing for retirement. Reducing the tax incentives to save through a
qualified retirement plan will discourage small business owners from
establishing and maintaining qualified retirement plans, and so reduce
the availability of workplace savings. A corporate integration proposal
under which mandatory 35% withholding would apply to dividends and
interest paid on all domestic stocks and bonds, regardless of the tax
status of the holder of the securities, including securities held in
qualified retirement plans would substantially reduce the tax
incentives for these plans, and so discourage plan formation and
maintenance.
We thank you for the opportunity to submit these comments. The ARA
would be pleased to work with this Committee to assure the tax
incentives for qualified retirement plans are maintained or enhanced as
this or other proposals move forward.
______
Prepared Statement of Steven M. Rosenthal,\1\ Senior Fellow,
Urban-Brookings Tax Policy Center, Urban Institute
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\1\ The views expressed are my own and should not be attributed to
the Tax Policy Center or the Urban Institute, its board, or its
funders. I would like to acknowledge the suggestions of Alan Auerbach,
Lydia Austin, Richard Auxier, Len Burman, Frank Clemente, Howard
Gleckman, Joe Rosenberg, Frank Sammartino, Steve Shay, Eric Toder, and
Bob Williams.
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Chairman Hatch, Ranking Member Wyden, and members of the committee,
thank you for inviting me to appear today to discuss integrating the
corporate and individual tax systems.
In my testimony, I first describe how taxes on corporate earnings
have dropped because of corporate moves to avoid taxes and because of
shareholder shifts from taxable to nontaxable accounts. Both trends are
important to thinking about corporate tax integration--particularly in
the form of a dividends paid deduction. The shareholder shift is less
obvious because the published data are hard to parse, leading even
sophisticated analysts to overstate the taxable share of U.S. stock.
Second, I describe how a lower estimate of the taxable share of
U.S. stock complicates attempts to integrate corporate and individual
taxes further. Finally, I suggest some areas for further research on
the competitiveness of U.S. corporate taxes.
u.s. stock ownership trends
The usual story we tell is that corporate earnings are generally
subject to two levels of tax: first, the company pays the corporate
income tax; second, the shareholders pay individual income tax on
dividends and realized capital gains. Yet reality may differ from that
simple story.
Many commentators have noted the sharp decline at the first level:
corporate tax receipts fell from 3.6 percent of gross domestic product
in 1965 to 1.9 percent in 2015. However, observers have overlooked the
substantial erosion at the second level of taxation of corporate
income. Over the same 50-year period, U.S. retirement accounts and
foreigners have largely displaced taxable accounts as the owners of
stock issued by U.S. corporations (figure 1).\2\ As a result, corporate
earnings are largely exempt at this level.
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\2\ For a complete discussion, see Steven M. Rosenthal and Lydia S.
Austin, ``The Dwindling Taxable Share of U.S. Corporate Stock,'' Tax
Notes (May 16, 2016). I attach this article for the record.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
My colleague Lydia Austin and I estimate that the share of
corporate stock issued by U.S. corporations that is held in taxable
accounts fell more than two-thirds over the past 50 years, from 83.6
percent in 1965 to 24.2 percent in 2015.\3\ Our estimates are based on
data from the Federal Reserve Board's Financial Accounts of the United
States (often called the Flow of Funds Accounts) and other sources. The
Flow of Funds Accounts, which go back to 1965, are the most common
source used to measure U.S. stock ownership.
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\3\ In constant (2015) dollars, we estimate that total household
ownership increased slightly from $4.5 trillion to $5.5 trillion from
1965 to 2015, while total outstanding stock increased more than
fourfold from $5.4 trillion to $22.8 trillion. I am attaching this
paper for the record.
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u.s. stock ownership highlights
There are two major factors in the decline in the share of
corporate stock held in taxable U.S. accounts. The first is the
increase held in tax-favored retirement accounts such as IRAs, 401(k)
plans, and traditional defined-benefit pension plans. We estimate that
share is now about 37 percent of U.S. corporate stock. The second is
the increase in portfolio investment by foreigners; that share is about
26 percent of corporate stock (the foreign share would be greater if we
included foreign direct investment, which is a controlling interest in
a U.S. corporation, 10 percent or more). Foreigners generally pay no
U.S. tax on capital gains from the sale of U.S. corporate stock, and
the U.S. withholding taxes they pay on dividends are often reduced
greatly by treaty.
Retirement Account/Plan Holdings
Retirement accounts and plans held about 37 percent of U.S. stock
in 2015, worth roughly $8.4 trillion. Over the past 30 years, IRAs grew
faster than other components, largely because of rollovers of assets
from defined contribution plans (figure 2).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Income accrued within retirement accounts, including both (i) Roth
and traditional IRAs and (ii) defined-contribution and defined-benefit
retirement plans, is effectively tax-free. In general, investment
returns in these retirement accounts are tax-free in two different
manners. Contributions to Roth IRAs and Roth 401(k) are nondeductible,
and withdrawals are nontaxable. Alternatively, contributions to
traditional IRAs or 401(k) plans are deductible and earnings are
taxable upon withdrawal. If account owners face the same tax rate when
they contribute to or withdraw from their accounts, the two forms of
retirement savings are economically equivalent to the individual (given
the same after-tax contribution); the benefit of a Roth plan's full tax
exclusion for withdrawals equals the benefit of a traditional IRA or
401(k) plan's tax deduction for contributions.
Foreign Holdings
Foreigners owned about 26 percent of U.S. stock in 2015, worth
about $5.8 trillion (figure 3). Foreign multinational corporations own
another $4.6 trillion of ``direct'' investments in U.S. companies. Like
the Fed, we counted portfolio stock in corporate equity but not foreign
direct investment, although direct investment is growing as fast as
portfolio investment.\4\
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\4\ Similarly, we and the Fed do not count U.S. intercompany
holdings.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
We treat foreigners as nontaxable, as their income from stock
generally is not subject to U.S. tax--or subject to just a little tax.
Their stock gains almost always are exempt from taxation. Their
dividends are subject to a 30 percent U.S. withholding tax for
portfolio investments, which is typically reduced by treaty to 15
percent or, for direct investment, to 5 percent (or sometimes to zero).
implications for corporate integration
As I observed at the start, corporate earnings are ostensibly taxed
twice, first to the corporation and second to the shareholders. Having
two levels of tax distorts business decision-making in several
important ways: whether to establish as a corporation, partnership, or
other business form; whether to finance with debt or equity; and
whether to retain or distribute earnings.
Many reformers propose to end double-taxation by integrating
corporate and shareholder taxes on corporate earnings. For example, the
United States could tax corporate earnings (1) just to the corporation,
(2) just to the shareholders, or (3) to both the corporation and the
shareholders, but with a credit to the shareholders for taxes paid by
the corporation.
In 2003, Treasury proposed the first option: to tax corporate
earnings just to corporations by excluding dividends to shareholders
from taxation at the individual level.\5\ At that time, Congress chose
instead to reduce the top tax rate on qualified dividends to the same
rate permitted for long-term capital gains.\6\ Both are now taxed at a
maximum rate of 23.8 percent (rather than the 43.4-percent tax rate
that applies to other forms of income).
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\5\ See Joint Committee on Taxation, Description of Revenue
Provisions Contained in the President's Fiscal Year 2004 Budget
Proposal, JCS-7-03 (2003), at 18-33.
\6\ Jobs and Growth Tax Relief Reconciliation Act of 2003, Pub. L.
No. 108-27, 108th Cong., 1st Sess. (May 28, 2003).
Because of the trends in stock ownership, and the reduction in tax
rates, corporate earnings now face a very low effective tax rate at the
shareholder level. Three-fourths goes untaxed, by our estimate, and
much of the rest faces low rates. Further, the tax on any gain can be
deferred or eliminated if the stock is held until death or donated to
charity. So, the United States effectively tries to collect the bulk of
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the tax on corporate earnings at the corporate level.
But many commentators have observed that taxing earnings only to
corporations is problematic in today's environment, and I agree.
Corporations are mobile--generally more so than individuals.\7\ As a
result, some U.S. corporations have shifted their residence abroad to
avoid U.S. taxes (``inversions''). Others shift their income to lower-
taxed jurisdictions through transfer pricing. The United States makes
this possible by delaying the tax on these overseas earnings until they
are repatriated (``deferral''). U.S. multinationals now have stockpiled
huge amounts of earnings overseas--$2.4 trillion by some estimates.\8\
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\7\ Avi-Yonah, Reuven, ``And Yet It Moves: Taxation and Labor
Mobility in the Twenty-First Century,'' 67 Tax. L. Rev. 169 (2014).
\8\ Citizens for Tax Justice, ``Fortune 500 Companies Hold a Record
$2.4 Trillion Offshore,'' March 4, 2016, http://ctj.org/ctjreports/
2016/03/fortune_500_companies_hold_a_record_24_
trillion_offshore.php#.VzMBv4QrJD8. See also Richard Rubin, ``U.S.
Companies Are Stashing $2.1 Trillion Overseas to Avoid Taxes,''
Bloomberg, March 4, 2015, https://www.bloomberg.com/news/articles/2015-
03-04/u-s-companies-are-stashing-2-1-trillion-overseas-to-avoid-taxes.
An alternative approach would tax corporate earnings only to
shareholders, who cannot expatriate easily or shift their income to
foreign affiliates.\9\ The United States could move to such a system in
a couple of different ways.
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\9\ Individuals face an exit tax on expatriating under Code sec.
877A, which Congress passed unanimously as part of the Heroes Earnings
Assistance and Relief Tax Act of 2008 (HEART Act), Pub. L. No. 110-245,
110th Cong., 2nd Sess. (June 17, 2008).
The United States could allow corporations to deduct dividends paid
to shareholders. That would reduce the taxable income of corporations
and increase that of shareholders. By our calculations, however, only
about a quarter of dividends are paid to taxable accounts. So, the
shift might generate relatively little revenue. To keep reform revenue
neutral, Congress would need to substantially increase the tax rate on
dividends and capital gains--perhaps both to individuals and tax-exempt
accounts and institutions.\10\
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\10\ For example, Congress could treat part or all of the dividends
and capital gains from stock of U.S. corporations as unrelated business
taxable income for tax-exempts.
Equivalently, the United States might tax corporate earnings at the
entity level but allow the shareholders to claim a credit for the tax
paid by the corporation (or, alternatively, permit a dividends paid
deduction coupled with a withholding tax on dividends paid to
shareholders).\11\ Presumably, the credit or withholding tax would be
nonrefundable to prevent a windfall for tax-exempt shareholders. But if
these taxes were nonrefundable, tax-exempt shareholders, who represent
the largest block of shareholders, might still pressure their
corporations to shift income to lower-tax jurisdictions--or to move
abroad.\12\
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\11\ For a discussion, see Republican Staff of the Senate Finance
Committee, Comprehensive Tax Reform for 2015 and Beyond, at 201-203,
113th Cong. S. Prt. No. 113-31 (Dec. 2014).
\12\ Congress might also treat part or all of the dividends and
capital gains from stock of foreign corporations as unrelated business
taxable income to address this problem.
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final thoughts for business income tax reform:
is the u.s. corporate income tax uncompetitive?
A key reason often given to pursue business tax reform is to lower
U.S. corporate tax rates in order to make U.S. corporate taxes more
competitive with the corporate taxes of other countries. Many
commentators gauge U.S. corporate tax competitiveness by comparing U.S.
corporate income taxes to foreign corporate income taxes (whether
statutory, effective, or marginal).\13\ But, as noted earlier, the
effective tax rate on corporate earnings depends on both the corporate
and shareholder income taxes. Today, in the United States, relatively
few shareholders pay the second level of tax on corporate earnings.
Those that do, face a reduced rate on qualified dividends and long-term
capital gains.
---------------------------------------------------------------------------
\13\ See, for example, Jane G. Gravelle, International Corporate
Tax Rate Comparisons and Policy Implications (Washington, DC:
Congressional Research Service, 2014), comparing and describing
corporate statutory, effective, and marginal tax rates, but not
shareholder tax rates.
To fully compare the U.S. tax burden on corporate earnings to
foreign tax burdens, we should also compare the combined corporate and
shareholder effective taxes. In some instances, this comparison may
provide a better gauge of U.S. tax competitiveness. For example, some
countries may tax corporate earnings more fully at the shareholder
level, and that could increase the cost of corporate capital in their
countries (if their corporations depend substantially on local capital
markets). More research is necessary to gauge the effective combined
---------------------------------------------------------------------------
U.S. and foreign tax burden on corporate earnings.
Table 1. Comparing Effective Tax Rates Across Countries 2015
----------------------------------------------------------------------------------------------------------------
Effective
Corporate Personal Capital Corporate
Income Tax Dividend Gains Tax and Integrated Tax System
Rate Income Tax Rate Shareholder
Rate Tax Rate
----------------------------------------------------------------------------------------------------------------
Canada 26.3% 39.3% 22.6% ? Full credit imputation
France 34.4% 44.0% 34.4% ? Partial dividend exemption
Germany 30.2% 26.4% 25.0% ? Classical
Italy 27.5% 26.0% 26.0% ? Classical
Japan 32.1% 20.3% 20.3% ? Modified classical system
United Kingdom 20.0% 30.6% 28.0% ? Partial credit imputation
United States 39.0% 30.3% 28.7% ? Modified classical system
G7 excluding U.S.* 29.1% 29.1% 25.5% ?
----------------------------------------------------------------------------------------------------------------
* Weighted by 2015 GDP.
Sources: OECD Tax Database, Tables II.1 and II.4; OECD Quarterly National Accounts: Historical GDP--expenditure
approach; Tax Foundation, ``Eliminating Double Taxation through Corporate Integration.''
Note: Tax rates are combined national and subnational.
______
SPECIAL REPORT
_______________________________________________________________________
Tax Notes
May 16, 2016
The Dwindling Taxable Share of U.S. Corporate Stock
By Steven M. Rosenthal and Lydia S. Austin
Steven M. Rosenthal is a senior fellow and Lydia S. Austin is a
research assistant at the Urban-Brookings Tax Policy Center.
The authors wish to thank Leonard Burman for his encouragement
and suggestions on earlier drafts. They are also grateful to
Alan Auerbach, Gerry Auten, Richard Auxier, Paul Burnham, Tim
Dowd, Howard Gleckman, John McClelland, Robert McClelland,
Peter Merrill, Jim Nunns, Frank Sammartino, Mike Schler, Steve
Shay, Eric Toder, and Bob Williams. The views and mistakes
herein are the authors' and not those of the Tax Policy Center,
the Urban Institute, the Brookings Institution, or any other
entity or person.
In this report, Rosenthal and Austin demonstrate that the share
of U.S. stocks held by taxable accounts has declined sharply
over the last 50 years, and they urge lawmakers to carefully
consider this shareholder base erosion when determining how
best to tax corporate earnings.
Copyright 2016 Steven M. Rosenthal and Lydia S. Austin.
All rights reserved.
I. Introduction
Corporate earnings are generally subject to two levels of tax--
first, the company pays a corporate income tax; second, the
shareholders pay an individual income tax on dividends and capital
gains.
Many commentators have noted the sharp decline at the first level:
corporate tax receipts fell from 3.6 percent of GDP in 1965 to 1.9
percent in 2015.\1\ However, observers have overlooked the substantial
erosion at the second level of taxation of corporate income. Over the
same 50-year period, retirement plans and foreigners displaced taxable
accounts as the owners of U.S. stocks. (See Figure 1.) As a result,
corporate earnings are largely exempt at this level.\2\
---------------------------------------------------------------------------
\1\ Office of Management and Budget, ``Table 2.3--Receipts by
Source as Percentages of GDP: 1934-2021.''
\2\ Also, the returns on the stock of the remaining shareholders
are taxed lightly. The tax rates are reduced for qualified dividends
and long-term capital gains. Tax on gains from appreciated stock is
deferred until the stock is sold or disposed--and gains are eliminated
if the stock is held until death.
We estimate that the share of U.S. corporate stock held in taxable
accounts fell more than two-thirds over the last 50 years, from 83.6
percent in 1965 to24.2 percent in 2015.\3\ We document this decline
using data from the Federal Reserve's ``Financial Accounts of the
United States,'' previously the ``Flow of Funds Accounts,'' which is
the most commonly used data source for measuring U.S. stock ownership.
Figure 1 reflects data back to 1965, but we focus on stock held in
2015, the year for which the most recent data are available.
---------------------------------------------------------------------------
\3\ In constant (2015) dollars, we estimate that total taxable
ownership increased slightly from $4.5 trillion to $5.5 trillion, while
total outstanding stock increased more than fourfold from $5.4 trillion
to $22.8 trillion.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Understanding the erosion of the taxable shareholder base is
critical for determining how best to tax corporate earnings--and
capital more generally.\4\ Acknowledging the decline is particularly
important for evaluating proposals to reform (or eliminate) the
corporate income tax and collect taxes exclusively from
shareholders.\5\ These corporate tax reforms are much more difficult if
few shareholders pay tax.
---------------------------------------------------------------------------
\4\ Congressional Budget Office, ``Taxing Capital Income: Effective
Marginal Tax Rates Under 2014 Law and Selected Policy Options''
(December 2014).
\5\ See, e.g., Michael J. Graetz and Alvin C. Warren Jr.,
``Unlocking Business Tax Reform,'' Tax Notes, November 10, 2014, p.
707; Harry Grubert and Rosanne Altshuler, ``Shifting the Burden of
Taxation From the Corporate to the Personal Level and Getting the
Corporate Tax Rate Down to 15 Percent'' (2015); and Eric Toder and Alan
D. Viard, ``Major Surgery Needed: A Call for Structural Reform of the
U.S. Corporate Income Tax,'' American Enterprise Institute (2014).
Prior literature suggests that taxable stock ownership ranges from
44 percent to 68 percent, which we review in Section II of this report.
Our estimates are 22 percent to 37 percent for the corresponding years,
and we describe our estimates in Section III (and the appendices). Our
estimates are only approximations, based on the best available data and
reasonable assumptions. In Section IV, we analyze the sensitivity of
our estimates by varying the assumptions. Finally, at the end of this
report, we suggest areas for further research in light of our new
---------------------------------------------------------------------------
estimates.
II. Previous Estimates
The Fed reported that ``households'' own most of the value of the
outstanding stock issued by U.S. corporations.\6\ Many view the
household share of corporate equity holdings as a good proxy for the
taxable share of ownership. However, the Fed included a substantial
amount of equity in the households category that is not subject to
income tax.
---------------------------------------------------------------------------
\6\ Federal Reserve, ``Financial Accounts of the United States:
Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts,
Fourth Quarter 2015,'' March 10, 2016.
The Fed reported both the ownership of all stock issued by U.S.
corporations and the holdings by U.S. investors of stock issued by
foreign corporations.\7\ It then disaggregated these figures into stock
ownership by different categories of institutional and foreign
investors: \8\ state and local governments, defined benefit and
contribution plans, life insurance companies, foreigners, and others
(including mutual funds, exchange-traded funds (ETFs), and closed-end
funds (CEFs)).\9\ The Fed allocated the remaining balance to
households, including stock held in IRAs and by nonprofit institutions.
In other words, the Fed treated households as ``a plug for all assets
not classified into other sectors.'' \10\
---------------------------------------------------------------------------
\7\ The Fed counts only the U.S. residents' ownership of foreign
stock, not the foreign residents' ownership of foreign stock. Foreign
stock includes American depository receipts, which are trust interests
that trade in the United States that represent beneficial ownership of
shares in a foreign corporation.
\8\ Chris William Sanchirico, ``As American as Apple Inc.:
International Tax and Ownership Nationality,'' 68(2) Tax L. Rev. 207
(2015) (discussing the challenge of distinguishing categories of
shareholders, including problems with classifications in the data).
\9\ Federal Reserve, supra note 6, at Table L.223, line 11. These
holdings are generally not taxable, except that taxable individuals may
own, indirectly, the stock held by insurance companies and mutual
funds.
\10\ See Amanda Sneider et al., ``An Equity Investor's Guide to the
Flow of Funds Accounts,'' Goldman Sachs Group Inc., March 11, 2013.
The Fed reported that in 2015, households directly owned 37.3
percent of corporate equity.\11\ Households owned another 13 percent
indirectly through mutual funds (and more through ETFs and CEFs).\12\
In total, the Fed reported that households owned more than 50.3 percent
of the value of outstanding U.S. stock.
---------------------------------------------------------------------------
\11\ Federal Reserve, supra note 6, at Table L.223, line 11.
\12\ Id. at Table B.101.e, line 14.
The economics literature generally uses the Fed's figures for
household ownership, including both direct and indirect holdings, as a
measure of equities held in taxable accounts. James M. Poterba added
stock owned directly by the household sector with stock beneficially
held through mutual funds--and estimated that the taxable household
share of corporate equity was 57.2 percent in 2003.\13\ In so doing,
Poterba counted stock owned by IRAs and nonprofits in his taxable
sector.
---------------------------------------------------------------------------
\13\ Poterba, ``Taxation and Corporate Payout Policy,'' 94(2) Am.
Econ. Rev. 171 (2004). For 2003 we estimated that taxable accounts held
29.6 percent of U.S. corporate stock.
Similarly, Alan J. Auerbach estimated that U.S. households
(including IRAs) directly owned about 42 percent of the market value of
U.S. corporations and 26 percent more through mutual funds in 2004.\14\
In his paper, Auerbach flagged the difficulty of tracing corporate
taxes through to individual shareholders using the Fed data.\15\
---------------------------------------------------------------------------
\14\ See Auerbach, ``Who Bears the Corporate Tax? A Review of What
We Know,'' in Poterba (ed.), Tax Policy and the Economy, Volume 20, 1-
40, Table 1 (2006). By comparison, for 2004, we estimate that taxable
accounts held 28.9 percent. Auerbach netted the U.S. resident holdings
of foreign equity against foreign resident holdings of U.S. equity, and
we do not.
\15\ See id. at 4-8.
Goldman Sachs observed that the Fed's ``broad category definitions
can make it difficult to use Flow of Funds data to analyze trends in
the domestic public equity market.'' \16\ Instead, Goldman used
company-specific ownership data from LionShares to estimate that retail
investors (including IRAs) directly owned 23 percent of public U.S.
single-stock equities in 2013 (and indirectly owned much more through
mutual funds and pension funds).
---------------------------------------------------------------------------
\16\ See Sneider, supra note 10, at 8.
In lieu of using Fed data, William G. Gale \17\ and Joseph
Rosenberg \18\ used data from tax returns to estimate the taxable share
of U.S. stock by individuals.\19\ They measured the ratio of total
qualified dividends reported on individual tax returns (Forms 1040)
divided by total dividends.\20\ Gale estimated that individuals
received 46 percent of dividends paid by U.S. corporations in 2000, and
Rosenberg estimated 44 percent in 2009.\21\ Gale and Rosenberg included
both domestic and foreign dividends in the qualified dividends received
by U.S. individuals in their numerator but only dividends paid by U.S.
corporations in their denominator.\22\
---------------------------------------------------------------------------
\17\ Gale, ``About Half of Dividend Payments Do Not Face Double
Taxation,'' Tax Notes, November 11, 2002, p. 839.
\18\ Rosenberg, ``Corporate Dividends Paid and Received, 2003-
2009,'' Tax Notes, September 17, 2012, p. 1475.
\19\ See also Jane G. Gravelle and Donald J. Marples, ``The Effect
of Base-Broadening Measures on Labor Supply and Investment:
Considerations for Tax Reform,'' Congressional Research Service, at 27
(October 22, 2015) (estimating that 25 percent of U.S. dividends appear
on U.S. personal returns by comparing dividends received by individuals
(as reported by the IRS Statistics of Income division) and dividends
reported in the National Income and Product Accounts). Gravelle and
Marples offer little information on their methods.
\20\ Gale used dividends reported in the National Income and
Product Accounts, and Rosenberg used dividends reported on corporate
tax returns (Form 1120).
\21\ Rosenberg, supra note 18. We estimate 36.9 percent and 21.7
percent for 2000 and 2009, respectively.
\22\ We can reduce Rosenberg's number to 34 percent by subtracting
foreign dividends from his numerator, assuming foreign dividends/total
dividends equals foreign stock/total stock (23.3 percent, the share of
foreign equity in 2009). In practice, the dividend yield on foreign
stock may be much higher than the yield on U.S. stock. If so, we would
reduce the estimate further.
---------------------------------------------------------------------------
III. Our Estimate
The Fed's household sector is too broad for our purposes and thus
overestimates the ownership of U.S. stock in taxable accounts. To more
accurately measure taxable ownership, we adjusted the Fed's data in
several important respects:
1. We excluded foreign equity held by U.S. residents--and
measured only U.S. stock.\23\
---------------------------------------------------------------------------
\23\ Our estimate (24.2 percent in 2015) of taxable holdings is
most appropriate to evaluate an integration plan with shareholder
credits limited to U.S. taxes paid, as under the plan suggested by
Graetz and Warren, supra note 5. If individual taxes on capital gains
and dividends are increased as part of an integration plan, a more
appropriate estimate (28.6 percent) would include U.S. holdings of
foreign stock. Grubert and Altshuler, supra note 5.
2. We measured only the stock of corporations that are
separately taxable under subchapter C of the IRC.\24\ We
excluded passthrough corporations such as mutual funds, S
corporations, ETFs, CEFs, and real estate investment trusts,
which generally are not separately taxable.\25\
---------------------------------------------------------------------------
\24\ There are also S corporations and M corporations (regulated
investment companies, REITs, ETFs, and CEFs), which are generally not
separately taxable--and are named based on their location in the tax
code.
\25\ We simply look through to attribute the underlying stock held
by these passthrough corporations to the beneficial owners of the
passthrough corporations, which is how the Fed treats mutual funds.
That is, the Fed already excludes mutual funds, which are also
passthrough corporations, from its issuers of corporate equity.
3. We excluded stock held by nonprofits from the household
---------------------------------------------------------------------------
sector.
4. We excluded stock held by IRAs and section 529 accounts (as
well as defined benefit and defined contribution plans, which
the Fed already does).
5. We added back stock that taxable individuals held
beneficially through mutual funds, ETFs, and CEFs (that is, in
the underlying portfolios of these passthrough
corporations).\26\
---------------------------------------------------------------------------
\26\ We do not add back stock for REITs, which generally hold only
real estate and mortgages.
The first two steps isolate the stock of corporations that are
subject to U.S. tax and, potentially, a double layer of U.S. taxation.
Step 3 removes extraneous amounts from the residual household sector.
Step 4 excludes holdings in IRAs and section 529 accounts, which is
consistent with the Fed's method. Finally, step 5 combines indirect
---------------------------------------------------------------------------
ownership with direct ownership by taxable accounts.
After these adjustments, we reallocated stock ownership to several
categories: taxable accounts, foreigners, insurance companies,
nonprofits, defined benefit plans, defined contribution plans, IRAs,
and other investors.\27\ We followed the procedures detailed below (and
in Appendix 1) to estimate ownership for 2015 as well as for previous
years back to 1965. We calculated that the total value of outstanding
U.S. corporate stock is $22.8 trillion, of which $5.5 trillion is held
in taxable accounts, or 24.2 percent of the total.
---------------------------------------------------------------------------
\27\ We treat only accounts of investors that are subject to tax on
their capital gains and dividends as ``taxable accounts.'' We consider
the other categories nontaxable. For example, insurance companies hold
stock in segregated reserves to fund annuity contracts and whole life
insurance of their beneficiaries, but the companies themselves are not
subject to tax on the income from the segregated accounts. Rather, the
beneficiaries themselves will generally be subject to tax to the extent
payments exceed basis.
---------------------------------------------------------------------------
A. Outstanding C Corporation Stock
The Financial Accounts data for 2015 show a total of $35.7 trillion
of corporate equity, which excludes U.S. intercorporate holdings of
public stock and foreign direct investments in U.S. companies.\28\
---------------------------------------------------------------------------
\28\ Direct investments are controlling blocks of stock in a
company, which means 10 percent or more ownership. For example, foreign
multinational corporations often hold direct investments in stock of
their U.S. affiliates.
The Fed included (1) some foreign stock held by U.S. residents and
(2) stock issued by U.S. passthrough corporations.\29\ Because we
wanted to measure only the outstanding stock of corporations that are
taxable by the United States, we subtracted both.\30\ As a result, we
estimated that $22.8 trillion of stock issued by domestic C
corporations was outstanding in 2015 (see Table 1).\31\
---------------------------------------------------------------------------
\29\ Passthrough corporations are corporations that are generally
not subject to the U.S. corporate income tax, such as S corporations,
mutual funds, ETFs, CEFs, and REITs.
\30\ Federal Reserve, supra note 6, at Table L.223. At our request,
the Fed recently published its estimate of the value of stock issued by
S corporations from 1996 to 2015 (Table L.223, line 30), which we
subtract. The Fed also estimates the value of stock issued by ETFs and
CEFs (Table L.123) but not REITs, which we obtained back to 1971 from
the National Association of Real Estate Investment Trusts, all of which
we subtract.
\31\ The Fed already subtracts stock issued by mutual funds. See
id. at Table L.223, n.1.
Table 1. C Corporation Equity Outstanding
(2015, market value in billions)
------------------------------------------------------------------------
------------------------------------------------------------------------
Total foreign and domestic corporate stock (including stock $35,687
issued by C and S corporations, ETFs, CEFs, and REITs)
------------------------------------------------------------------------
Foreign stock held by U.S. residents ($6,732)
------------------------------------------------------------------------
Stock issued by passthrough entities
------------------------------------------------------------------------
S corporations ($2,838)
------------------------------------------------------------------------
Exchange-traded funds ($2,106)
------------------------------------------------------------------------
Closed-end funds ($260)
------------------------------------------------------------------------
REITs ($939)
------------------------------------------------------------------------
All outstanding C corporation stock $22,812
------------------------------------------------------------------------
B. C Corporation Stock in Taxable Accounts
The Fed allocated corporate stock to households but not to taxable
accounts. We estimated that taxable accounts held $5.5 trillion in
2015, 24.2 percent of the $22.8 trillion of outstanding C corporation
stock (see Table 2).\32\ We detail these adjustments in Appendix 1.\33\
---------------------------------------------------------------------------
\32\ By comparison, for 2013, the Fed's Survey of Consumer Finances
determined that households held $8 trillion of both domestic and
foreign equity outside retirement accounts. Federal Reserve, ``2013
Survey of Consumer Finances,'' October 20, 2014. The Fed conducts the
survey every 3 years, independent of its Financial Accounts estimates.
If we estimate and subtract the foreign equity, the survey estimate is
only $6.16 trillion. For 2013, we estimated $5.4 trillion in taxable
accounts.
\33\ We describe our methods, data sources, and assumptions in more
detail in Appendix 1.
Table 2. Total Taxable Holdings of C Corporation Stock
(2015, market value in billions)
------------------------------------------------------------------------
------------------------------------------------------------------------
Outstanding C corporation stock (from Table 1) $22,812
------------------------------------------------------------------------
Less:
------------------------------------------------------------------------
Stock held by pensions, mutual funds, insurance $11,487
companies, and others
------------------------------------------------------------------------
Stock held by foreign residents $5,543
------------------------------------------------------------------------
Equals: C corporation stock held directly by U.S. residents $5,781
------------------------------------------------------------------------
Less:
------------------------------------------------------------------------
Stock held directly by U.S. nonprofits $956
------------------------------------------------------------------------
Equals: C corporation stock held directly by U.S. $4,826
households
------------------------------------------------------------------------
Less:
------------------------------------------------------------------------
Stock held in IRAs $1,479
------------------------------------------------------------------------
Stock held in section 529 plans $89
------------------------------------------------------------------------
Equals: Taxable C corporation stock held directly in U.S. $3,274
taxable accounts
------------------------------------------------------------------------
Plus:
------------------------------------------------------------------------
Taxable C corporation stock held indirectly by U.S. $2,268
households
------------------------------------------------------------------------
Equals: Total holdings of taxable C corporation stock in $5,525
U.S. taxable accounts
------------------------------------------------------------------------
The Fed's household category includes the U.S. stock holdings of
U.S. partnerships. It excludes the U.S. stock holdings of foreign
partnerships, which the Fed counts in the holdings of foreign
residents. Thus, the classification of the U.S. stock of a partnership
(such as a hedge fund or a private equity fund) turns on the domicile
of the partnership, not the domicile of the beneficiaries.
We did not distribute the stock held through hedge funds and
private equity (or the tax-exempt holdings through these funds), as we
explain in Appendix 2. (In short, we believe we can reasonably net the
share of the U.S. stock of foreign funds that is held beneficially in
U.S. taxable accounts against the share of U.S. stock of U.S. funds
held beneficially by nontaxable accounts.)
IV. Sensitivity Analysis
Although we varied our assumptions in several ways, we found only a
few adjustments that are potentially significant.
A. Stock Issued by Passthrough Corporations
We subtracted the stock issued by passthrough corporations and
distributed the stock held by these corporations to their beneficial
owners. If we did not subtract the stock issued by S corporations,
ETFs, CEFs, or REITs (but subtracted only the stock issued by mutual
funds, as the Fed had done), all U.S. corporate equity would total $29
trillion in 2015, and taxable accounts would hold $9.6 trillion, or
33.3 percent. Thus, subtracting stock issued by passthrough
corporations substantially reduced our estimate.
B. Beneficial Ownership
To distribute the equity held by passthrough corporations to their
beneficial owners, we used the ownership proportions for mutual funds
to estimate the ownership proportions of ETFs and CEFs. The Fed
provided data only on ownership of mutual funds, and we could not find
data on ETFs and CEFs elsewhere.\34\ In 2015 the Fed reported
``households'' owned about 63 percent of mutual funds, so we assumed
that households also owned 63 percent of ETFs and CEFs, and we
distributed the equity holdings accordingly. If we instead assumed that
households held less (50 percent) or more (70 percent) of passthrough
corporations, we would decrease our estimate to 22 percent or increase
it to 25.8 percent. Thus, our estimate of taxable ownership of
corporate equity is somewhat sensitive to our assumptions about
ownership of CEFs and ETFs.
---------------------------------------------------------------------------
\34\ Federal Reserve, supra note 6, at Table L.224. ETFs, CEFs, and
mutual funds are very similar: they are diversified pools of stocks and
bonds and are taxed identically under subchapter M of the code.
---------------------------------------------------------------------------
C. Nonprofit Ownership
Our estimate of taxable ownership is sensitive to our calculation
of nonprofit ownership, which was $1.4 trillion, or 4.9 percent of
corporate equity. For example, if we shifted our estimate of nonprofit
share from 4.9 percent in 2015 to 4.4 percent or 5.7 percent in 2015
(which is the range we observed for 1987-2001), we would increase or
reduce our estimate of taxable share to 24.7 percent or 23.4
percent.\35\
---------------------------------------------------------------------------
\35\ Our 4.9-percent estimate seems about right because we estimate
for 2012 that nonprofits owned about $1.06 trillion of U.S. stock,
while the IRS estimated for 2012 that nonprofits owned $1.04 trillion
of public securities--and the IRS estimate included Treasury and
corporate bonds and excluded other securities like private equity and
hedge funds, which would offset.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
V. Areas for Further Research
A. Retirement Account and Plan Holdings
Retirement accounts and plans held about 37 percent of U.S. stock
in 2015, worth roughly $8.4 trillion. Over the last 30 years, IRAs grew
faster than other components, partly due to rollovers of assets from
defined contribution plans.
Retirement accounts are effectively nontaxable, including both (i)
Roth and traditional IRAs and (ii) defined-contribution and defined-
benefit retirement plans. In general, investment returns in these
retirement accounts are tax-free in two different manners: either (1)
contributions to Roth IRAs and Roth 401(k) plans are nondeductible and
earnings are nontaxable; or (2) contributions to traditional IRAs or
401(k) plans are deductible and earnings are taxable upon withdrawal.
If account owners face the same tax rate when they contribute to or
withdraw from their accounts, the two forms of retirement savings are
economically equivalent; the benefit of a Roth plan's full tax
exclusion for withdrawals equals the benefit of a deductible plan's tax
deduction for contributions.
B. Foreign Holdings
Foreigners owned about 26 percent of U.S. stock in 2015, worth
about $5.8 trillion. Foreign multinational corporations owned another
$4.6 trillion of ``direct'' investments in U.S. companies (direct
interests are controlling interests in U.S. companies, 10 percent or
more). Like the Fed, we counted portfolio stock in corporate equity but
not foreign direct investment (just as we do not count U.S.
intercompany holdings).\36\
---------------------------------------------------------------------------
\36\ Individuals typically make portfolio investments.
Corporations, such as foreign multinationals, typically make direct
investments, which are controlling interests of a U.S. company. The
Fed's exclusion of foreign direct holdings is consistent with its
exclusion of intercorporate holdings of public securities.
We treated foreigners as nontaxable as their income from stock
generally is not subject to U.S. tax--or subject to just a little
tax.\37\ Their stock gains almost always are exempt from taxation.
Their dividends are subject to a 30 percent U.S. withholding tax for
portfolio investments, which is typically reduced, by treaty, to 15
percent, or for direct investment, to 5 percent (or sometimes to zero).
Further research is necessary to unravel the foreign ownership trend,
especially the sizable increase in direct ownership (which might
suggest more foreign multinational holdings of U.S. companies, perhaps
resulting from inversions).\38\
---------------------------------------------------------------------------
\37\ In limited instances, foreign shareholders are subject to tax
on their gains under section 897 (the 1980 Foreign Investment in Real
Property Tax Act).
\38\ If we added foreign direct investment to our denominator, the
taxable ownership of U.S. stock would fall from 24.2 percent to 19.9
percent. If we added U.S. intercompany holdings, our share would drop
even further.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
C. Nonprofit Holders
From 1988 to 2000, the Fed used data from the IRS and surveys to
separate holdings of corporate equities by nonprofits from holdings by
households. We could not find better data on holdings by nonprofits, so
we extended the 4.9 percent average from the earlier nonprofit Fed data
to more recent estimate holdings. However, in recent years, nonprofits
have shifted the mix of equities they own. Starting in 2006, the IRS
separated security holdings of nonprofits into publicly traded
securities (which include both stock and bonds) and other securities
(which include holdings of private equity funds and hedge funds). Over
the 6-year period for which data are available, nonprofit holdings of
other securities have nearly tripled. Further research might help
unravel this trend.
D. Cost of Corporate Capital Across Countries
A key reason to pursue business tax reform is to lower U.S.
corporate tax rates, in order to make U.S. corporate taxes more
competitive with other countries. Many commentators gauge U.S. tax
competitiveness by comparing just corporate income taxes to foreign
corporate income taxes (whether statutory, effective, or marginal).\39\
But, as noted earlier, the effective tax rate on corporate earnings
depends on both the corporate and shareholder income taxes. Today, in
the United States, relatively few shareholders pay the second level of
tax on corporate earnings. Those few only pay at the reduced rate for
qualified dividends and long-term capital gains.
---------------------------------------------------------------------------
\39\ Jane G. Gravelle, ``International Corporate Tax Rate
Comparisons and Policy Implications,'' Congressional Research Service,
Jan. 6, 2014 (comparing and describing corporate statutory, effective,
and marginal tax rates, but not shareholder tax rates).
To fully compare the U.S. tax burden on corporate earnings to
foreign tax burdens, we might also compare the combined corporate and
shareholder effective taxes. In some instances, this comparison may
provide a better gauge of U.S. tax competitiveness. For example, some
countries may tax corporate earnings more fully at the shareholder
level, which could increase the cost of corporate capital in their
countries (if their corporations depend substantially on local capital
markets). More research is necessary to determine the relative U.S. and
---------------------------------------------------------------------------
foreign tax burden on corporate earnings.
Figure 4. Comparing Effective Tax Rates Across Countries, 2015
----------------------------------------------------------------------------------------------------------------
Effective
Corporate Personal Capital Corporate
Income Tax Dividend Gains Tax and Integrated Tax System
Rate Income Tax Rate Shareholder
Rate Tax Rate
----------------------------------------------------------------------------------------------------------------
Canada 26.3% 39.3% 22.6% ? Full credit imputation
----------------------------------------------------------------------------------------------------------------
France 34.4% 44% 34.4% ? Partial dividend exemption
----------------------------------------------------------------------------------------------------------------
Germany 30.2% 26.4% 25% ? Classical
----------------------------------------------------------------------------------------------------------------
Italy 27.5% 26% 26% ? Classical
----------------------------------------------------------------------------------------------------------------
Japan 32.1% 20.3% 20.3% ? Modified classical system
----------------------------------------------------------------------------------------------------------------
United Kingdom 20% 30.6% 28% ? Partial credit imputation
----------------------------------------------------------------------------------------------------------------
United States 39% 30.3% 28.7% ? Modified classical system
----------------------------------------------------------------------------------------------------------------
G-7 excluding U.S.* 29.1% 29.1% 25.5% ?
----------------------------------------------------------------------------------------------------------------
* Weighted by 2015 GDP.
Note: Tax rates are combined national and subnational.
Sources: OECD Tax Database, Tables II.1 and II.4; OECD Quarterly National Accounts: Historical GDP--Expenditure
Approach; Tax Foundation, ``Eliminating Double Taxation Through Corporate Integration.''
VI. Conclusion
The Fed's Financial Accounts data, as well as economic observers,
report that households own most of the market value of outstanding
corporate equity. While correct, that category is much different from
taxable accounts. After adjusting the data in several important
respects, we estimated that taxable accounts held only 24.2 percent of
C corporation equity in taxable accounts in 2015. Our exercise revealed
that the share of U.S. stocks held by taxable accounts declined sharply
over the last 50 years, by more than two-thirds.
This sizable decrease affects many of the current tax policy
debates, including how to structure a revenue-neutral corporate
integration regime and, more generally, how we tax capital. We believe
policymakers should carefully consider this decline.
Appendix 1: Methods, Data Sources, and Assumptions
To estimate the fraction of C corporation stock held in taxable
accounts, we started with the measure of corporate equity reported by
the Fed and subtracted the foreign and passthrough equity issues. We
next subtracted stock holdings of nonprofits, IRAs, and section 529
accounts. Finally, we added the stock held in taxable accounts
(indirectly) through mutual funds, CEFs, and ETFs. In total, for 2015,
we estimated that taxable accounts held $5.5 trillion of the $25.8
trillion of C corporation stock, or 24.2 percent.
First, we subtracted the $6.7 trillion of foreign stock held by
U.S. residents from the $35.7 trillion of total outstanding corporate
stock. We assumed thatU.S. investors held the same proportion of
domestic and foreign stock and, thus, subtracted the $6.7 trillion
proportionately from their holdings. We did not subtract any foreign
stock from the $5.7 trillion of foreign holders because the Fed does
not count the foreign stock held by foreigners.\40\
---------------------------------------------------------------------------
\40\ See Federal Reserve, supra note 6, at Table L.223, n.5. Thus,
foreign stock is 22.45 percent of the holdings of U.S. residents
($6,732 /($35,687-$5,707)).
Step 1. Subtract Foreign Stock Held by U.S. Residents
(2015, market value in billions of dollars)
----------------------------------------------------------------------------------------------------------------
All Corporate Equity - Foreign Equity = U.S. Equities
----------------------------------------------------------------------------------------------------------------
All holders $35,687 ($6,732) $28,955
----------------------------------------------------------------------------------------------------------------
Household and $13,311 ($2,989) $10,322
nonprofit
----------------------------------------------------------------------------------------------------------------
Insurance companies $2,087 ($469) $1,618
----------------------------------------------------------------------------------------------------------------
Defined benefit $3,295 ($740) $2,555
plans
----------------------------------------------------------------------------------------------------------------
Defined $1,623 ($364) $1,258
contribution plans
----------------------------------------------------------------------------------------------------------------
Foreigners $5,707 $0 $5,707
----------------------------------------------------------------------------------------------------------------
Other $481 ($108) $373
----------------------------------------------------------------------------------------------------------------
Mutual funds $7,327 ($1,645) $5,682
----------------------------------------------------------------------------------------------------------------
Closed-end funds $100 ($22) $77
----------------------------------------------------------------------------------------------------------------
Exchange-traded $1,756 ($394) $1,362
funds
----------------------------------------------------------------------------------------------------------------
Step 2. Subtract Passthrough Holdings From Investors
(2015, market value in billions of dollars)
----------------------------------------------------------------------------------------------------------------
Take Out Passthroughs
-----------------------------------------------------------------------------------------------
S U.S. C
U.S. - Corporation ETFs CEFs REITs = Corporation
Equities Equity Equity
----------------------------------------------------------------------------------------------------------------
All holders $28,955 ($2,838) ($2,106) ($206) ($939) $22,812
----------------------------------------------------------------------------------------------------------------
Household and $10,322 ($2,838) ($1,331) ($164) ($207) $5,781
nonprofit
----------------------------------------------------------------------------------------------------------------
Insurance $1,618 ($43) ($5) ($131) $1,439
companies
----------------------------------------------------------------------------------------------------------------
Defined benefit $2,555 ($297) ($37) ($33) $2,189
plans
----------------------------------------------------------------------------------------------------------------
Defined $1,258 ($275) ($34) ($33) $917
contribution
plans
----------------------------------------------------------------------------------------------------------------
Foreigners $5,707 ($95) ($12) ($56) $5,543
----------------------------------------------------------------------------------------------------------------
Other $373 ($64) ($8) ($56) $245
----------------------------------------------------------------------------------------------------------------
Mutual Funds $5,682 ($310) $5,372
----------------------------------------------------------------------------------------------------------------
Closed-end funds $77 $77
----------------------------------------------------------------------------------------------------------------
Exchange-traded $1,362 ($113) $1,249
funds
----------------------------------------------------------------------------------------------------------------
Second, we subtracted the value of stock issued by S corporations,
ETFs, CEFs, and REITs. Because only individuals and some nonprofits
hold S corporation stock, we subtracted the $2.8 trillion of S
corporation equity from only the household and nonprofit
categories.\41\
---------------------------------------------------------------------------
\41\ As a general matter, nonprofits do not own S corporations
because of a special tax on the income of S corporations for
nonprofits--which does not apply to employee stock ownership plans.
The Financial Accounts data do not allocate ETF and CEF equity
across owners. Instead, we assumed investors owned the ETFs and CEFs in
the same proportions as the investors that own mutual funds, which the
Fed reports. For 2015 households and nonprofits held 63 percent of
mutual funds, so we assumed the households and nonprofits likewise held
63 percent of ETFs and CEFs, or $1.5 trillion.\42\
---------------------------------------------------------------------------
\42\ Federal Reserve, supra note 6, at Table L.224.
We estimated the investor ownership of REITs based on a 2015
Citibank report.\43\ According to that report, mutual funds and ETFs
are the predominant owners of REITs.\44\ We subtracted $207 billion of
outstanding REIT issues in 2015 from the household sector and another
$732 billion from other investors, after redistributing the mutual fund
and ETF holdings of REITs.\45\
---------------------------------------------------------------------------
\43\ See Citi Research, ``REITs for Sale,'' at Figure 4 (September
11, 2015) (available upon request). REITs own a pool of real estate
assets, not stocks. Moreover, the profile of the investors that own
REITs differs somewhat from the profile of investors in mutual funds,
ETFs, and CEFs.
\44\ The other cross-holdings are small. Legally, mutual funds,
ETFs, and CEFs can hold only a small amount of shares of each other.
See section 12(d)(1) of the Investment Company Act of 1940.
\45\ Later, we distribute some of the mutual funds' and exchange-
traded funds' holdings of REITs to the household sector.
Third, we subtracted nonprofit holdings from the Fed's household
category. From 1988 to 2000, the Federal Reserve estimated corporate
equities held by nonprofits based primarily on Forms 990 that
nonprofits filed with the IRS.\46\ During that period, the share of
equities held by nonprofits as a share of all domestic and foreign C
corporation equities ranged from 4.4 percent to 5.7 percent. From 2001
to 2015 and before 1988, we used the 4.9 percent average ratio to
estimate domestic and foreign equity holdings of nonprofits, which
totaled $1.5 trillion in 2015.
---------------------------------------------------------------------------
\46\ See Federal Reserve, supra note 6, at Table L.101.a, lines 13-
14. Total securities from IRS Forms 990 included U.S. and foreign
stocks and bonds.
We added our estimate of $327 billion of foreign equities held by
nonprofits to the $1.5 trillion to avoid removing those equities twice
(once as foreign stock and again as nonprofit stock). We also adjusted
nonprofit holdings by $49 billion to reflect that we previously
subtracted issues of CEFs, ETFs, and REITs from the household and
---------------------------------------------------------------------------
nonprofit sector.
We also added back to our estimate of nonprofit equity their
holdings of S corporation equity through employee stock ownership
plans, using data from EY and the Labor Department.\47\ We estimated
that the market value of ESOPs was double the amount of net assets and
attributed this entire amount, $124 billion in 2015, to the nonprofit
sector.\48\
---------------------------------------------------------------------------
\47\ See EY, ``Contribution of S ESOPs to Participants' Retirement
Security'' (March 2015).
\48\ The Fed follows this method to value closely held stock.
Step 3. Subtract Stock Held by Nonprofits
(2015, market value in billions of dollars)
------------------------------------------------------------------------
------------------------------------------------------------------------
Total household and nonprofit holdings of C corporation $5,781
equity
------------------------------------------------------------------------
-Nonprofit holdings of corporate equity (other than ($1,455)
mutual funds)
------------------------------------------------------------------------
+ Foreign stock held by nonprofits, already subtracted $327
------------------------------------------------------------------------
+ ETFs held by nonprofits, already subtracted $18
------------------------------------------------------------------------
+ CEFs held by nonprofits, already subtracted $2
------------------------------------------------------------------------
+ REITs held by nonprofits, already subtracted $28
------------------------------------------------------------------------
+ S Corp shares held by ESOPs, already subtracted $124
------------------------------------------------------------------------
Household direct holdings of C corporation equities $4,826
------------------------------------------------------------------------
Fourth, we subtracted the stock held in self-directed IRAs based on
data from the Investment Company Institute, which lists IRA assets by
type of institution: mutual funds, bank and thrift deposits, life
insurance companies, and ``other assets'' (self-directed accounts).\49\
---------------------------------------------------------------------------
\49\ See Investment Company Institute, ``Report: The U.S.
Retirement Market, Fourth Quarter 2015,'' at Table 7 (March 24, 2016).
To estimate the amount of C corporation equity in other assets, we
---------------------------------------------------------------------------
took a few extra steps:
1. We assumed that 75 percent of the other assets are stock held
through self-directed accounts.\50\
---------------------------------------------------------------------------
\50\ Brad M. Barber and Terrance Odean, ``Are Individual Investors
Tax Savvy? Evidence From Retail and Discount Brokerage Accounts,'' 88
J. Pub. Econ. 419 (2003) (finding that 74 percent of brokerage assets
were stock).
2. We assumed that equity in self-directed accounts comprises C
corporation equity, ETF equity, CEF equity, and REIT equity. We focused
on C corporation equity (because we had previously removed the other
issuances). We assumed self-directed accounts held C corporation equity
in the same proportion as the equity universe.\51\ In 2015 that was 87
percent.
---------------------------------------------------------------------------
\51\ (C corporation equity/(the sum of C corporation equity, REIT
equity, ETF equity, and CEF equity)).
3. We reduced our estimate for foreign equity ownership (assuming
that all U.S. investors held the 22.45 percent of their equity in
foreign equity). As a result, we removed $1.5 trillion of C corporation
---------------------------------------------------------------------------
equity held in IRAs from the household sector.
We also subtracted equity holdings of section 529 accounts that are
included in the residual household sector. The Fed separates assets
held in section 529 college plans into assets held in college savings
plans and assets held in prepaid tuition plans.\52\ We assumed that
half of the assets in college savings plans were C corporation equity
and subtracted $89 billion from household holdings in 2015.
---------------------------------------------------------------------------
\52\ Federal Reserve, supra note 6, at Table B.101.
Step 4. Subtract Holdings by IRAs and Section 529 Accounts of C
Corporation Stock
(2015, market value in billions of dollars)
------------------------------------------------------------------------
------------------------------------------------------------------------
Household direct holdings of C corporation equities (from $4,826
Step 3)
------------------------------------------------------------------------
Corporate equities in self-directed IRAs ($1,479)
------------------------------------------------------------------------
Corporate equities held in 529 plans ($89)
------------------------------------------------------------------------
Taxable direct C corporation holdings $3,257
------------------------------------------------------------------------
Finally, we added the stock that taxable accounts held beneficially
through mutual funds, CEFs, and ETFs.
The Fed categorized mutual funds as a separate holder of corporate
equity.\53\ We added $1.6 trillion of the mutual funds' holdings of
corporate stock to taxable accounts. We did not add the stock holdings
of mutual funds that are attributable to nonprofits, IRAs, insurance
companies, pension funds, and foreigners.
---------------------------------------------------------------------------
\53\ Id. at Table B.101.e.
The Fed also separately listed ETFs and CEFs as owners of corporate
equity.\54\ We assumed that the household sector held 63 percent of ETF
and CEF assets. Thus, we added $645 billion of CEF and ETF holdings to
the household sector (but excluded the equity holdings of nonprofits,
IRAs, insurance companies, pension funds, and foreigners).
---------------------------------------------------------------------------
\54\ Id. at Table L.223, lines 18 and 19.
Step 5. Add Indirect Holdings of C Corporation Equity
(2015, market value in billions of dollars)
------------------------------------------------------------------------
------------------------------------------------------------------------
Taxable C corporation holdings $3,257
------------------------------------------------------------------------
+ Mutual fund holding of equities (except those mutual $1,600
funds held by nonprofits, IRAs, insurance companies,
pension funds, and foreigners)
------------------------------------------------------------------------
+ Closed-end fund holding of equities (except those CEFs $39
held by nonprofits, IRAs, insurance companies, pension
funds, and foreigners)
------------------------------------------------------------------------
+ ETF holding of equities (except those ETFs held by $630
nonprofits, IRAs, insurance companies, pension funds,
and foreigners)
------------------------------------------------------------------------
Taxable account direct and indirect C corporation holdings $5,525
------------------------------------------------------------------------
Thus, we calculated that taxable accounts hold $5.5 trillion, or
24.2 percent of the $22.8 trillion in taxable accounts of C corporation
stock.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
Appendix 2: Hedge Fund/Private Equity Holdings
In theory, we should (1) subtract from taxable accounts the share
of U.S. stock of U.S. funds held beneficially by nontaxable accounts
(the blue box in Figure A1) and (2) add to taxable accounts the share
of the U.S. stock of foreign funds that is held beneficially by U.S.
taxable accounts (the orange box in Figure 6). However, the actual
holdings, owners, and residence of the funds are not publicly
available, so we could not estimate the size of the boxes. Because we
lacked detailed data, we did not adjust for the misallocation of the
partnership holdings in our main estimates.
As illustrated in Figure A1, for our estimate, we could assume the
assets, owners, and residence funds are split evenly.\55\ As a result,
the blue and orange boxes are the same size and cancel each other out.
Thus, by adjusting in this manner, our estimate would remain at 24.2
percent.\56\
---------------------------------------------------------------------------
\55\ U.S. and foreign funds with 50 percent U.S. taxable partners
are plausible, because both U.S. general partners and U.S. limited
partners may be U.S. taxable investors. For example, a general partner
often gets a profits interest to manage a fund (the ``20'' in ``2 +
20''). As a result, a U.S. general partner typically earns capital
gains and dividend income on its profits interest, which is taxed at
reduced rates. That said, U.S. limited partners generally invest
through U.S. funds, and nonprofits and foreigners generally invest
through foreign funds.
\56\ In theory, we still ought to slightly adjust the holdings of
subcategories of tax-exempt owners (e.g., nonprofits, foreigners,
etc.)--which we lack the data to accomplish.
We could test the sensitivity of our estimate by varying the split
of assets, owners, and residence of hedge funds and private equity
funds. From industry sources, we estimated that the total assets
managed by hedge funds and private equity funds were $5.8 trillion in
2015.\57\ In Figure A2, we again split the assets and residence of the
hedge funds and private equity funds evenly--but assumed only 25
percent U.S. taxable owners of the foreign funds. With this change, our
taxable share fell to 22.7 percent in 2015.
---------------------------------------------------------------------------
\57\ Preqin, ``2016 Global Private Equity and Venture Capital
Report''; and BarclayHedge, ``Hedge Fund Industry--Assets Under
Management.''
However, U.S. and foreign assets under the management of hedge
funds and private equity funds have increased greatly over the last few
years--highlighting their growing importance for stock ownership (see
Figure A3). Further research and data on their assets, partners, and
residence would help provide a clearer picture of who owns U.S.
corporate stock.\58\
---------------------------------------------------------------------------
\58\ Michael Cooper et al. recently tried to untangle the ownership
of partnerships, with some difficulty. They explain that partnerships
``constitute the largest, most opaque, and fastest growing type of
pass-through.'' Cooper et al., ``Business in the United States: Who
Owns It and How Much Tax Do They Pay?'' (October 2015).
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
______
Prepared Statement of Bret Wells, Associate Professor of Law,
Law Center, University of Houston
My name is Bret Wells, and I am an Associate Professor of Law at
the University of Houston Law Center. I would like to thank Chairman
Hatch, Senator Wyden, and the other members of the committee for
inviting me to testify. I am testifying in my individual capacity, and
so my testimony does not represent the views of the University of
Houston Law Center or the University of Houston. I request that my full
written testimony be included in the record.
Our tax system is in need of fundamental tax reform. Finding a path
to rationalize the taxation of active business income in the United
States is an important goal, and integration of shareholder and
corporate taxation can achieve that goal. Corporate integration has
been extensively studied for decades by prior administrations, the
American Law Institute, and numerous highly respected academics--one of
whom joins me on this panel.\1\ As this committee's staff has recently
written,\2\ a broad consensus exists that significant efficiencies can
be achieved through corporate integration. Thus, before one gets
enmeshed in the important details of how to create an appropriately
functioning corporate integration regime, it is important to say that
reform along these lines can significantly improve our tax system.
Focusing specifically on the dividends paid deduction regime, this
particular method of achieving corporate integration would, as to
distributed earnings, harmonize the tax treatment between debt and
equity and would level the playing field between pass-through entities
and C corporations.\3\ There is much to commend this proposal.
---------------------------------------------------------------------------
\1\ See e.g., Michael J. Graetz and Alvin C. Warren, Integration of
the U.S. Corporate and Individual Income Taxes: The Treasury Department
and the American Law Institute Reports (1998).
\2\ See Republican Staff of the Senate Finance Committee,
Comprehensive Tax Reform for 2015 and Beyond at 122-237, 113th Cong.,
S. Prt. No. 113-31 (December 2014).
\3\ See Joint Committee on Taxation, Overview of Approaches to
Corporate Integration at 32 (JCX-44-66) (May 13, 2016).
---------------------------------------------------------------------------
i. three key international tax challenges
But, notwithstanding the potential benefits of a corporate
integration regime, the reality is that business tax reform must
carefully consider the international tax implications of any new
paradigm, and to that end the United States must ensure that its tax
regime withstands at least the following three systemic international
tax challenges.\4\
---------------------------------------------------------------------------
\4\ These same tax challenges exist whether or not Congress adopts
a dividends paid deduction regime, retains its classic double taxation
of corporate earnings, or bolts on a territorial tax regime to either
of these two paradigms. For a more in-depth analysis of my views of the
base erosion and profit shifting challenges created under a territorial
tax regime, see Bret Wells, ``Territorial Taxation: Homeless Income is
the Achilles Heel,'' 12 Hous. Bus. and Tax L.J. 1 (2012).
First, a critical international tax challenge is the inbound
earning stripping challenge,\5\ and this earning stripping challenge
can be further categorized along the following types of base erosion
strategies: (1) related party Interest Stripping Transactions; (2)
related party Royalty Stripping Transactions; (3) related party Lease
Stripping Transactions; (4) Supply Chain restructuring exercises; and
(5) related party Service Stripping Transactions.
---------------------------------------------------------------------------
\5\ My views on the genesis of the ``Homeless Income mistake'' and
its solution are set forth in Bret Wells and Cym Lowell, Tax Base
Erosion and Homeless Income: Collection at Source is the Linchpin, 65
Tax Law Rev. 535 (2012).
The second key international tax challenge relates to corporate
inversions.\6\ Corporate inversions are often categorized as a
discreet, stand-alone tax policy problem, but, in my view, the
corporate inversion phenomenon provides unmistakable evidence of the
enormity of the inbound earning stripping advantage that exists for all
foreign-based multinational corporations. A foreign-based multinational
corporation can engage in an inbound related party Interest Stripping
Transaction, an inbound related party Royalty Stripping Transaction,
and an inbound related party Lease Stripping Transaction without any
concern about the U.S. subpart F regime, whereas these very same
inbound transactions would create a subpart F inclusion if conducted by
a U.S. multinational corporation. Corporate inversions represent an
effort by U.S. multinational corporations to place their U.S.
businesses into an overall corporate structure that affords them the
full range of inbound U.S. earning stripping techniques without being
impeded by the backstop provisions of the U.S. subpart F rules.
---------------------------------------------------------------------------
\6\ For a more in-depth discussion of my views on the corporate
inversion phenomenon and what it means to U.S. tax policy, see Bret
Wells, ``Corporate Inversions and Whack-a-Mole Tax Policy,'' 143 Tax
Notes 1429 (June 23, 2014); Bret Wells, ``Cant and the Inconvenient
Truth About Corporate Inversions,'' 136 Tax Notes 429 (July 23, 2012);
Bret Wells, ``What Corporate Inversions Teach Us About International
Tax Reform,'' 127 Tax Notes 1345 (June 21, 2010).
Third, fundamental tax reform must deal with the so-called lock-out
effect.
ii. international implications of dividends paid deduction regime \7\
---------------------------------------------------------------------------
\7\ For a more in-depth assessment of my views on the international
tax implications of a dividends paid deduction proposal, see Bret
Wells, ``International Tax Reform By Means of Corporate Integration,''
19 Fla. Tax Rev. (2016) (forthcoming), available at http://
papers.ssrn.com/sol3/papers.cfm?abstract_id=2766618.
As to the earning stripping challenge and its alter ego the
corporate inversion phenomenon, the dividends paid deduction regime, by
itself, does not equalize the tax position of a U.S. multinational
corporation with that of a foreign-based multinational corporation.
Even though the dividends paid deduction regime provides a corporate
level tax deduction for dividend payments, the dividend payment is
subject to a corresponding shareholder withholding tax. In comparison,
a foreign-based multinational corporation can engage in all five of the
previously enumerated earning stripping strategies to create a
comparable U.S. corporate tax deduction without incurring a
corresponding withholding tax. Thus, the dividends paid deduction
regime does not eliminate the financial advantages that motivate
earning stripping or that fuel the corporate inversion phenomenon. In
order to address these two key international tax challenges, the United
States must impose an equivalent withholding tax, or a surtax, on all
of the related party base erosion strategies and not just on Interest
---------------------------------------------------------------------------
Stripping Transactions or Royalty Stripping Transactions.
As to the lock-out effect, the dividends paid deduction regime
should substantially eliminate the lock-out effect with respect to the
repatriation of low-tax foreign earnings. For companies that repatriate
a significant amount of low-tax foreign income, the dividends paid
deduction regime will likely represent a net benefit versus existing
law. But, outside that low foreign tax context, the interplay of the
dividends paid deduction regime with the U.S. foreign tax credit regime
creates complex trade-offs. In particular, where a high percentage of a
company's total income constitutes foreign income that has been
subjected to high foreign taxes, the dividends paid deduction regime
likely represents a net cost over existing law.\8\
---------------------------------------------------------------------------
\8\ Consequently, companies in this posture may forgo the dividend
deduction allowed under the dividends paid deduction regime and instead
rely on the U.S. foreign tax credit regime to offset a substantial
portion of its corporate level tax and in turn might then distribute
cash to shareholders through share repurchases that are eligible for
section 302 treatment. This strategy would provide shareholders the
potential for favorable capital gains treatment and in any event avoids
the new shareholder dividend withholding tax. The interplay of whether
to utilize the foreign tax credit regime to offset corporate level tax
or instead to rely on the dividend paid deduction regime creates a new
complexity.
Finally, under a dividends paid deduction regime, a new tax design
challenge will be added to our tax laws. In this regard, to the extent
that the shareholder withholding tax can be cross-credited against the
shareholder's residual income tax liability arising from other income,
the marketplace will attempt to structure transactions that will
exploit that cross-crediting opportunity and, if successful, will
create a new set of tax distortions to plague the U.S. tax laws. Thus,
if a dividends paid deduction regime were adopted, it would be
important to ensure that the incidence of the shareholder dividend
withholding tax cannot be shifted, cross-credited against other
shareholder income, monetized, or reduced. Congress is likely to
receive pleas from various constituencies to exempt specific
sympathetic groups from the shareholder dividend withholding tax or the
complimentary taxes that would need to be imposed on all base erosion
payments, but Congress must resist those calls or else another source
of tax distortions will be created through the tax system.
iii. conclusion
Let me conclude my oral testimony by stating that an appropriately
structured corporate integration regime has much to offer. The
committee is to be commended for considering fundamental business tax
reform, but at the same time this committee must ensure that the
dividends paid deduction regime is structured to withstand the systemic
international tax challenges that face the United States. Thank you for
allowing me to speak at today's hearing. I would be happy to answer any
of your questions.
______
Prepared Statement of Hon. Ron Wyden,
a U.S. Senator From Oregon
This morning the Finance Committee will discuss the concept of
corporate integration, which isn't exactly a topic that comes up at
summer picnics. But this issue is important to the tax reform debate,
and I want to thank Chairman Hatch and his staff for putting a whole
lot of sweat equity into this topic. I'm glad the committee will have
this opportunity today to dig into the specifics. Today I want to begin
mostly with questions about what corporate integration would mean for
middle-class families and small businesses looking for opportunities to
get ahead.
Corporate integration is about eliminating what some people call
double taxation, where income is taxed once at the corporate level and
again at the individual level. Once in place, this kind of tax change
would allow companies to write off payments they make to shareholders
in the form of dividends. The theory goes, the profit corporations
bring in would go out as dividends, and corporate tax bills would
shrink. But to finance that big corporate tax cut, 35 percent of the
money paid out in dividends and bond interest would be withheld
automatically by the Treasury.
Now this raises a question with respect to retirement savings.
It looks, on its face, like this proposal could go from double
taxing corporate income to double taxing retirement plans. Here's why.
Today, most middle-class savers put their money into retirement plans
that are tax-deferred. It's a good deal for workers, and this country's
savings crisis would probably be a lot worse without it. Retirement
plans invest in a lot of stocks and bonds. But under a corporate
integration plan, when you withhold a chunk of the dividends and
interest payments that go to retirement plans, suddenly they could get
hit with a big, new tax bill for the first time. Their special tax-
deferred status--which today is the key that unlocks opportunities to
save for millions of Americans--would go away.
Right now, most savers already face a tax bill when they take money
out of their accounts. Corporate integration could often add a second
tax hit up front. So if you're an electrician in Medford or a teacher
in Salem and you've got an IRA or a 401(k), you'd have to wonder if
this system says the dollar you socked away is worth less than it used
to be. If the math on retirement plans suddenly looks worse to small
business owners, there's a possibility they might think twice about
offering a plan to their employees.
There is another question whether corporate integration could wind
up picking winners and losers in how it affects businesses. Companies
that run airlines and wind farms, which need capital to invest and
operate, would face higher costs if interest rates jump. And start-ups
may not necessarily want to pay dividends to shareholders because they
need to turn their earnings into growth instead of dividends. A
corporate integration plan might look great to established companies
with lots of cash, but not so hot to the small businesses that dominate
the economic landscape in Oregon and in hundreds of communities across
the country. These are big issues to discuss today.
I want to thank our witnesses for being here this morning, and I
look forward to hearing their testimony. And before I conclude, I want
to recognize one of our witnesses today, Judy Miller, who is retiring
at the end of the summer. Judy served as a senior pension advisor to
this committee under Senator Baucus for 4\1/2\ years. She's also
testified before the committee a number of times. I'd like to
congratulate and thank Judy for her service and invaluable advice over
the years and wish her well in the future.
______
Communication
----------
Center for Fiscal Equity
237 Hannes Street, Silver Spring, Maryland 20901
Comments for the Record by Michael Bindner
Chairman Hatch and Ranking Member Wyden, thank you for the opportunity
to address this topic. The Center for Fiscal Equity believes that
dealing with the question of taxing dividends is a key issue in
constructing tax reform legislation and ultimately in achieving
comprehensive deficit reduction.
As always, our proposals come within the context of our four-point tax
reform and deficit reduction plan:
A Value Added Tax (VAT) to fund domestic military spending and
domestic discretionary spending with a rate between 10% and 13%, which
makes sure very American pays something.
Personal income surtaxes on joint and widowed filers with net
annual incomes of $100,000 and single filers earning $50,000 per year
to fund net interest payments, debt retirement and overseas and
strategic military spending and other international spending, with
graduated rates between 5% and 25% in either 5% or 10% increments.
Heirs would also pay taxes on distributions from estates, but not the
assets themselves, with distributions from sales to a qualified ESOP
continuing to be exempt.
Employee contributions to Old-Age and Survivors Insurance (OASI)
with a lower income cap, which allows for lower payment levels to
wealthier retirees without making bend points more progressive.
A VAT-like Net Business Receipts Tax (NBRT), essentially a
subtraction VAT with additional tax expenditures for family support,
health care and the private delivery of governmental services, to fund
entitlement spending and replace income tax filing for most people
(including people who file without paying), the corporate income tax,
business tax filing through individual income taxes and the employer
contribution to OASI, all payroll taxes for hospital insurance,
disability insurance, unemployment insurance and survivors under age
60.
We do not believe that providing a tax cut for dividends to
corporations is appropriate at this or any other time. Such a tax cut
could not be duplicated for pass-through businesses, partnerships and
sole proprietorships--the majority of business taxpayers. It would
foreclose the possibility of enacting consumption taxes, which tax
labor and capital at the same rate. Indeed, such a deduction would
essentially turn consumption taxes into a payroll tax, provided that
all profits were distributed as dividends (which is actually a proposal
for followers of Louis Kelso and his Two Factor Theory). This proposal
is exactly the wrong way to go in this Congress, where it would be
vetoed by the sitting President.
The Center for Fiscal Equity believes that lower dividend, capital
gains, and marginal income taxes for the wealthy actually destroy more
jobs than they create. This occurs for a very simple reason--management
and owners who receive lower tax rates have more an incentive to
extract productivity gains from the work force through benefit cuts,
lower wages, sending jobs offshore or automating work. As taxes on
management and owners go down, the marginal incentives for cost cutting
go up. As taxes go up, the marginal benefit for such savings go down.
It is no accident that the middle class began losing ground when taxes
were cut during the Reagan and recent Bush administrations, both of
which saw huge tax cuts. Keeping these taxes low is also part of why we
are experiencing a recovery performing at half speed now.
As long as management and ownership benefit personally from cutting
jobs, they will continue to do so. Tax reform must reverse these
perverse incentives.
Tax cuts on capital also produce a host of bad investments that would
not otherwise occur. Every major asset bubble, including the 2008
recession, arose from dividend and capital gains taxes that were too
low. If capital is needed for business because of a demand driven
expansion, the Federal Reserve is quite able to make this happen.
Fiscal policy is not, and never has been, the answer to making credit
available for expansion.
Our Principal Analyst served on the Computer-Aided Manufacturing--
International Cost Management System Project, part of which was the
Multi-Attribute Decision Model for investment. Cost of capital was not
a major driver. Customers who are able and willing to spend had a much
greater impact on why investment should take place. There is one word
which typifies an investment manager who follows supply-side economic
theory in recommending business investments: unemployed.
Double-taxation of dividends by taxing as value-added and as income to
the shareholder is a myth, and a bad one at that.
If corporate income taxes were expanded to be a subtraction VAT or net
business receipts tax that all firms pay, an additional tax on
shareholders is merely a surtax paid because there is no other way to
fully tax profit at the business level without doing major damage to
equity and privacy.
In testimony before the Senate Budget Committee, Lawrence B. Lindsey
explored the possibility of including high income taxation as a
component of a Net Business Receipts Tax. The tax form could have a
line on it to report income to highly paid employees and investors and
pay surtaxes on that income.
The Center considered and rejected a similar option in a plan submitted
to President Bush's Tax Reform Task Force, largely because you could
not guarantee that the right people pay taxes. If only large dividend
payments are reported, then diversified investment income might be
under-taxed, as would employment income from individuals with high
investment income. Under collection could, of course, be overcome by
forcing high income individuals to disclose their income to their
employers and investment sources--however this may make some inheritors
unemployable if the employer is in charge of paying a higher tax rate.
For the sake of privacy, it is preferable to leave filing
responsibilities with high income individuals.
Accomplishing deficit reduction with income and inheritance surtaxes
recognizes that attempting to reduce the debt through either higher
taxes on or lower benefits to lower income individuals will have a
contracting effect on consumer spending, but no such effect when
progressive income taxes are used. Indeed, if progressive income taxes
lead to debt reduction and lower interest costs, economic growth will
occur as a consequence.
Using this tax to fund deficit reduction explicitly shows which
economic strata owe the national debt. Only income taxes have the
ability to back the national debt with any efficiency. Payroll taxes
are designed to create obligation rather than being useful for
discharging them. Other taxes are transaction based or obligations to
fictitious individuals. Only the personal income tax burden is
potentially allocable and only taxes on dividends, capital gains and
inheritance are unavoidable in the long run because the income is
unavoidable, unlike income from wages.
Even without progressive rate structures, using an income tax to pay
the national debt firmly shows that attempts to cut income taxes on the
wealthiest taxpayers do not burden the next generation at large.
Instead, they burden only those children who will have the ability to
pay high income taxes. In an increasingly stratified society, this
means that those who demand tax cuts for the wealthy are burdening the
children of the top 20% of earners, as well as their children, with the
obligation to repay these cuts. That realization should have a healthy
impact on the debate on raising income taxes rather than carving out
even more tax breaks for the wealthy, such as making dividends
deductible in the corporate income tax.
Thank you for the opportunity to address the committee. We are, of
course, available for direct testimony or to answer questions by
members and staff.