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Capital Income Taxation and Progressivity in a Global Economy

Rosanne Altshuler, Benjamin H. Harris, Eric Toder

Published: May 19, 2010
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The text below is an excerpt from the complete document. Read the full report in PDF format.

Abstract

Corporate level income taxes encourage the outflow of capital and the shifting of reported profits to other jurisdictions. The outflow of capital shifts some of the burden of the tax from owners of capital to workers. In contrast, individual level taxes on corporate income lower the after-tax return to saving, but have less effect than corporate level taxes on the location of investment. Reversing recent cuts in the tax rates on capital gains and dividends would finance a substantial cut in the corporate tax rate, reduce the outflow of capital, and make the tax system more progressive.


Introduction

Throughout the entire history of the U.S. income tax, income of equity owners of U.S. corporations has been subject to two levels of tax. The income is first taxed under the corporate profits tax, which allows deductions for wages and interest payments, but not for distributions to shareholders. Distributions are then taxed again as dividend income to shareholders and a portion of retained earnings is also taxed a second time when shareholders realize capital gains that arise from those retentions.

While both the corporate and shareholder level taxes on corporate equity income make pre-tax returns to corporate equity investments higher than after-tax returns to shareholders, the two levels of tax have very different economic effects in an open economy with internationally mobile capital. The corporate level tax is largely a source-based tax on the returns to corporate investments in the United States. Both U.S. and foreign-owned multinationals are taxable on their income from investments in the United States, but U.S. multinational corporations pay little additional tax on profits from overseas investments because of provisions such as deferral and foreign tax credits (Grubert and Altshuler 2008). This means that the corporate-level tax may raise the cost of corporate capital in the United States much more than it lowers after-tax returns to U.S. investors. As a result, some analysts have suggested that the corporate income tax is mostly shifted to U.S. workers through a decline in the capital-labor ratio in the United States (Harberger 1995, 2006 and Randolph 2006), although others (Gravelle and Smetters 2006) dispute this finding.

In contrast, shareholder-level taxes are residence-based taxes imposed on worldwide dividends and equity of U.S. citizens, but not foreign investors. This means that the shareholder-level tax may raise the cost of corporate capital in the United States by much less than it lowers after-tax returns to U.S. investors. The result would be that U.S. shareholders would continue to bear the burden of individual-level taxes on corporate equity, even if much of the burden of the corporate-level tax is shifted to labor.

(End of excerpt. The entire report is available in PDF format.)