The holy grail of tax policy
© Greg Nash

Not unlike King Arthur's quest for the Holy Grail, Sen. Orrin HatchOrrin Grant HatchTrump to award racing legend Roger Penske with Presidential Medal of Freedom Trump awards Presidential Medal of Freedom to economist, former Reagan adviser Arthur Laffer Second ex-Senate staffer charged in aiding doxxing of GOP senators MORE (R-Utah) set his sights two years ago on a highly desirable and elusive objective: corporate integration.

The concept of corporate integration is foreign to most Americans. As Sen. Ron WydenRonald (Ron) Lee WydenWyden blasts FEC Republicans for blocking probe into NRA over possible Russia donations Wyden calls for end to political ad targeting on Facebook, Google Ex-CIA chief worries campaigns falling short on cybersecurity MORE (D-Ore.) quipped last May, this "isn't exactly a topic that comes up at summer picnics."

Nonetheless, this little-known concept promises to play an important role in next year's anticipated drive to reform the federal tax code.

What is corporate integration? It's the solution to the problem of double taxation.

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Under current law, corporate income is generally double-taxed. For example, if a corporation earns $1 and pays a combined federal and state corporate income tax of nearly 40 percent, that leaves roughly 60 cents that the corporation can either retain or pay out to its shareholders.

To the extent the corporation retains that income and the company's stock price reflects that gain, the income will be taxed again at the individual level when the shareholder realizes a capital gain and pays the capital gains tax.

To the extent the corporation distributes that income to its shareholders in the form of a dividend, the income will be taxed again at the individual level when the shareholder pays personal income tax on those dividends. If the shareholder pays a combined federal and state income tax of 30 percent on his dividend income, he ultimately keeps only 42 cents out of the dollar of income earned by the corporation on his behalf.

Corporate integration entails integrating the corporate and individual income tax systems so that all income is taxed once and only once, preferably at a low marginal rate.

This is important because double taxation distorts economic and financial decision-making which, in turn, harms national well-being. Double taxation favors debt over equity financing, skews corporate decisions regarding the use of earnings and discourages businesses from incorporating.

It's this distortion and the damage it does that prompted Hatch to lambast double taxation as "among the most significant and inexplicable inefficiencies in our business tax system."

As chairman of the Senate Finance Committee, Hatch directed the committee's staff — his Knights of the Round Table — to begin laying the groundwork for an eventual push to achieve corporate integration. Two years, a few congressional hearings, and countless hours of effort later, the senator is on the verge of unveiling his long-awaited proposal.

One method of integrating corporate and shareholder-level taxes on corporate earnings is the dividends-paid deduction. This is the approach Hatch will propose.

Under this method, a corporation deducts dividends it pays to its shareholders. A withholding tax applies to all dividends and (possibly) interest payments made by a corporation to its shareholders and creditors. The result would be a single level of tax on corporate earnings and nearly equal tax treatment of debt and equity.

In addition, by reducing the tax bias toward debt and against equity, the proposal could eliminate some of the gamesmanship that occurs in tax planning. Withholding at the source is simpler and more effective than the labyrinth of current rules. The latest example of this complexity is exemplified by the release of the U.S. Treasury's 518 pages of regulations under Section 385. Withholding could address these debt/equity issues and earnings stripping concerns.

Aside from preserving a politically popular source of revenue, few experts have made the case, on policy grounds, for maintaining the status quo. By stipulating conventional revenue neutrality and distributional neutrality as goals, Hatch hopes to eliminate this source of political resistance to transitioning to a more economically efficient, integrated system.

History isn't on the senator's side. Integration has been the subject of numerous studies, hearings and proposals stretching back to at least 1936 when Congress enacted a split rate corporate income tax — a form of corporate integration. Unfortunately, it was in existence for only two years.

Reports issued by the U.S. Treasury in the 1970s, 1980s, 1990s and 2000s recommended integrating corporate and individual income taxes. In 1992, the Treasury estimated integration could increase the capital stock by as much as $500 billion and yield an annual gain to the economy of as much as $25 billion. And remember, that was at a time when the U.S. economy was, in nominal terms, barely more than a third of its current size.

While the United States has toyed with integration — and at times made progress in that direction — our international competitors have already acted. Today, according to the nonpartisan Tax Foundation, "Many countries in the OECD have fully or partially integrated corporate tax systems that eliminate or limit double taxation."

Because the United States already has the highest corporate income tax rate in the industrialized world, our double taxation of corporate income is particularly severe. Double taxation pushes the U.S. tax rate on corporate income well beyond 50 percent.

Worse yet, the U.S. employs an archaic "worldwide" system for taxing international income that most of our competitors have long abandoned. The combination of high rates, double taxation and the worldwide system places U.S.-headquartered companies at a stiff competitive disadvantage.

The practical result of this is to encourage U.S.-headquartered corporations to invert. Those that don't invert are made more vulnerable to foreign acquisition. Just ask Monsanto. Given the eruption of inversions and foreign takeovers of U.S. employers in recent years, the need for integration grows more apparent with every passing day.

Creating a dividends-paid deduction would be, in many ways, equivalent to a corporate tax rate cut. Moreover, it can be accomplished without having to eliminate many popular corporate tax deductions and credits, such as research and development incentives, and still be revenue neutral.

The bottom line? "Double-taxation of corporate income is," according to the Tax Foundation, "one of the biggest weaknesses of the U.S. tax code. Hatch's plan to integrate the corporate and individual income tax systems would be a huge improvement over current law."

By refusing to adopt tax policies more in line with those employed by our international competitors, the U.S. continues to damage its international competitiveness. And the damage we're inflicting on ourselves is, to quote the Black Knight from "Monty Python and the Holy Grail," more than "just a flesh wound."

Carter served as deputy assistant secretary of the Treasury under President George W. Bush and later served on the staff of the U.S. Senate Budget Committee.


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