Reducing the Political Power of Corporate Money
Change the tax system to incentivize corporations to accept limits on political spending
Welcome Back to Win-Win Democracy
In the last five issues of this newsletter, we’ve discussed how our tax system helps people and corporations become unimaginably wealthy and how our SCOTUS-defanged campaign finance system allows such wealth to be turned into political power. Our democracy is in grave danger because, among other reasons, big money dominates our political decision making.
People and organizations who hold power will fight hard to keep it. To reduce the power of money we need to reinstate limits on the use of money in politics and reduce the accumulation of vast wealth. Passing a constitutional amendment to reinstate limits is exceedingly unlikely, so we have to take a different approach, one involving incentives for changing behavior.
We’re going to explore an idea for doing so. It involves two coupled ideas:
Offer corporations a major financial incentive — elimination of corporate income taxes — in exchange for accepting limits on using corporate money in politics.
For individuals, tax investment income as ordinary income, which will slow the accumulation of unimaginable individual wealth and offset the loss of tax revenue from eliminating corporate income tax. At the same time, higher corporate earnings will offset some of the effect of taxing investment income as ordinary income.
To simplify, I will first describe proposed changes as if they are separate. They are not. After describing the individual changes, I’ll circle back and discuss how they need to be coupled.
Eliminate Corporate Income Taxes
Lower corporate taxes has been a long-time goal of the conservative movement.
As we saw in High-Flying Corporations, corporate income tax collected as a share of GDP has fallen dramatically from 7% in 1945 to less than 1% now. The 2017 TCJAdelivered a historically low advertised corporate income tax rate of 21%, but as we saw, the average effective rate is around 12%, with some major, profitable corporations paying no corporate income taxes.
The average effective rate is so low because the political pressure to lower corporate taxes has delivered large tax breaks for corporations.
Moreover, large corporations employ some of the best tax accountants and tax lawyers to help them structure their global businesses to reduce taxes. With its limited budget, the IRS can’t compete with the legion of tax lawyers working to lower corporate taxes.
What would happen if we eliminated corporate income taxes?
The federal government would lose around $230B in annual tax revenue (the 2019tax receipts). If states followed suit, they’d also lose their corporate income tax revenues.
US-based multinational corporations would no longer be encouraged by tax avoidance goals to adopt convoluted structures in foreign countries where they don’t actually do much business.
Corporations would have more money to invest in their businesses for future growth and deliver higher returns to their shareholders (thus raising their stock prices and executive compensation).
The tax code would be dramatically simplified, including eliminating a slew of corporate deductions that distort the way businesses operate. For example, under current law it is more tax efficient to borrow money than to raise funds by selling stock because loan interest is deductible.
Corporate accounting and treasury operations would be simpler, freeing up resources for more productive work.
Conservatives have long complained about double taxation, which now occurs when corporate income is first taxed by the corporate income tax and again when investors receive dividends or capital gains. Double taxation would be eliminated.
Passthrough corporate structures, like S corporations and large partnerships, have been devised as ways to avoid double taxation. Some of those structures and all the mechanisms that go with them would no longer be necessary.
Corporate executives and shareholders would be ecstatic about eliminating corporate income taxes. Presumably, so would “business-friendly” politicians and conservativevoters.
My liberal friends are no doubt aghast at the idea of eliminating corporate income tax. Please stay with me as we continue to develop the overall picture.
Tax Investment Income as Ordinary Income
Liberals have long wanted to tax investment income like ordinary income because the large tax breaks on capital gains and dividends overwhelmingly benefit the wealthiest households.
Investment income comes in three flavors:
Interest: This is what you earn on bank accounts and bonds.
Dividends: A company may choose to distribute a portion of its income directly to its investors.
Capital Gains: Capital gains are the profit realized when selling an asset, such as stocks, bonds, or property.
For all individuals earning $200K or more, investment income is also subject to the net investment income tax (NIIT) of 3.8%.
What Changes Would be Needed?
Part of taxing investment income as ordinary income would be to eliminate the NIIT. Beyond eliminating the NIIT, let’s consider what taxing these three types of investment income as ordinary income would mean.
Interest Income and Short-Term Capital Gains
Interest income and short-term capital gains (for assets held less than a year) are already taxed as ordinary income.
Most dividend income is taxed at the rates for long-term capital gains, which are lower than the rates for ordinary income. So, all dividend income would simply be taxed at the ordinary income rates.
Long-Term Capital Gains Income
Recall from the newsletter’s Growing Oligarchs issue that long-term capital gains get preferential treatment in three important ways:
Lower tax brackets for long-term capital gains
Deferral of capital gains taxes until an asset is sold
Upon the owner’s death, the step-up in basis means that the gain in value during the owner’s lifetime is never taxed.
Treatments #2 and #3 combine to make the buy-borrow-die strategy the choice of wealthy people to avoid ever paying capital gains taxes. This is a key strategy for building fabulous wealth, subsidized by tax avoidance.
Suppose we taxed capital gains in the same way that we tax ordinary income — no preferential rates, no deferral of taxes, and no step-up in basis at death.
What would this even mean? Let’s keep it simple for now and just talk about assets that are easy to value at any time. Think publicly-traded stocks, not art, real estate, small businesses or other difficult-to-value assets.
For such easy-to-value assets, one would pay ordinary income tax on the gain in the asset’s value during the tax year, just like one pays ordinary income tax on wages earned during the tax year.
For example, if I owned 10,000 shares of XYZ Corp valued at $1 per share on January 1 and $3 per share on December 31st, $20,000 of earnings would be added to my other earnings (e.g., wages) when filing my tax return. Brokers would provide this number on a W2-like form each year.
It might seem odd to pay the tax on the $20,000 when you don’t actually receive the money. But we already do this with original issue discount, which is a type of interest one receives when a bond is issued at a discount from its face value. Even though you don’t receive the interest until the bond matures, you pay tax on the interest that accrues every year.
What if you couldn’t afford the tax on that $20,000? Well, you’d have to pay it, just as you do with original issue discount. You could sell some of the shares to get the money for the taxes. You make the decision as to whether it is better to sell shares or pay the taxes from another source.
So far, I’ve simplified the discussion by assuming that the asset is easy to value and that the asset’s value goes up every year. There are ways to deal with other situations where this is not the case, but discussing them here would be a distraction. I will return to these situations in the next issue of the newsletter.
What Would Happen?
Predicting the impact of major tax changes is difficult because changing tax policy might also cause people’s behavior to change. The best numbers we have are the CBO’s estimates of the size of major tax expenditures, which do not consider behavior changes.
Using these numbers, taxing investment income as ordinary income would:
Eliminate the $39B tax expenditure for step-up in basis.
Eliminate the $140B tax expenditure for preferential tax rates on long-term capital gains and dividends. This estimate includes the effect of eliminating the NIIT but not the effect of deferring taxes until the assets are sold.
Eliminate the tax revenue lost by deferring tax on capital gains until the assets are sold. The Wharton Business School at the University of Pennsylvania has modeled the revenue potential of eliminating deferral under various scenarios, and, even with a grandfather clause that locks in existing unrealized capital gains, their model shows over $20B in revenue starting in 2023 rising to $64B by 2031.
Substantially slow the rapid accumulation of incredible individual wealth made possible by the combination of deferring taxes on unrealized capital gains and the step-up in basis at death.
Comparison to Other Proposals
President Biden proposed changes in taxation of capital gains as part of his 2023 budget proposal. The details, which are complex, are designed to exempt people with income less than a million dollars from any of the changes. (Biden’s proposal is almost certainly dead in the Senate.)
Senator Ron Wyden, chair of the Senate Finance Committee has proposed a tax on unrealized capital gains of billionaires.
I favor a simpler plan that applies to everyone. The CBO’s tax expenditure analysis says that the vast majority of the impact of these changes would fall on high income households, but political reality might make it expedient to specifically exempt lower income households.
Tax Passthrough Business Income as Ordinary Income
Some businesses are structured to avoid double taxation by passing their profit directly to the individuals that own the business, without any corporate income tax. People receiving such income from so-called qualified businesses (the rules are complex) get a 20% income tax deduction on their personal income taxes, intended to roughly bring the tax on passthrough income in line with the TCJA’s lowered corporate income tax rates. (Note that this deduction is currently set to sunset on January 1, 2026, unless extended by Congress.)
The qualified business income deduction results in a $41B tax expenditure, which would be eliminated.
With the corporate income tax eliminated, passthrough structures would not be necessary for avoiding double taxation, which would put all corporate structures on an equal footing.
Looking at the Whole Picture
So far, I've proposed that we make two big and one small change to our tax system: eliminate corporate income taxes, tax capital gains as ordinary income, and — the small one — eliminate the qualified business income deduction. Let’s look at how these changes work together.
Impact on Tax Revenues
Eliminating corporate income tax will reduce tax revenues by $230B. This loss will be counterbalanced by eliminating $220B in tax expenditures and adding $20B (rising over time) from not allowing deferral of tax on capital gains.
The bottom line is that the changes I’m proposing would increase tax revenues, likely by some tens of billions of dollars yearly.
Impact on Investment
Some will argue that eliminating preferred treatment of capital gains will reduce investment in companies. There are two reasons that this is wrong:
The reduced investment claim is predicated on returns to the investor being lower. If all we were doing is treating capital gains as ordinary income, this would be valid. But, because we are also eliminating corporate income tax, companies’ earnings will increase. Higher company earnings will translate to higher before-tax investment returns, offsetting the effect of higher capital gains taxes.
Wealthy people don’t sit on cash — they invest their money. Even without the benefits of preferential treatment of capital gains and dividends, they’ll still invest in companies as the place that will yield the best returns.
Reduce Government Guidance of the Economy
Conservatives advocate reducing government’s role in guiding the economy, preferring free-market forces to guide the economic decisions that individuals and companies make. The current treatment of capital gains and dividends biases economic decision making to favor returning profits to shareholders and others as capital gains, which promotes various actions to manipulate stock prices. This bias will go away.
Increase Investor Flexibility and Market Efficiency
Investor behavior is currently distorted by the deferral aspect of our current taxation of capital gains. Here’s an example. Say I bought 10,000 shares of XYZ Corp at $10 in 2010 and it is now at $100. I believe that while XYZ has had a great run, its future is not nearly as bright as ABC Corp. So, I’d like to sell my XYZ shares to invest in ABC. But, I have an unrealized capital gain of $900,000 and I’ll have to pay tax on that gain, which makes me reluctant to sell XYZ unless ABC’s potential gain is both likely to happen and large.
If we eliminate preferential treatment of capital gains, I would have already paid the taxes on the gain in XYZ over time, so there’s no reason not to shift my investment to where I think I’ll get the highest returns. This makes the market more efficient.
Impact on Existing Individual Wealth
What I’m proposing should not be confused with a wealth tax, which some argue would be unconstitutional. Depending on how one treats existing unrealized capital gains during a transition, it could impact existing wealth that is in the form of unrealized gains. I will discuss various transition approaches, and their impacts, in the next newsletter issue.
What I propose is about slowing down the future accumulation of vast wealth, not taxing wealth per se.
Impact on Corporate Wealth
Without a corporate income tax, concentrated corporate wealth, and the power that comes with it, might increase further. But, since most large corporations take extensive measures to reduce or eliminate the amount of corporate tax that they actually pay, eliminating the corporate income tax has less effect than one might expect.
Nevertheless, corporations collectively, would gain approximately $230B annually in earnings. Since investors would be paying higher taxes on capital gains, they would likely demand that some or even most of that $230B be paid to them in dividendsrather than retained by corporations.
Impact on Corporate Political Power
To the extent that investors allow corporations to retain their extra earnings, the corporations would be able to deploy that money to build more political power. This is a significant problem given that our fundamental goal is to defend against the loss of democracy.
Reigning in Corporate Political Power
We saw in Turning Money Into Power that the 2010 Citizens United decision opened up the floodgates of corporate money into politics by invalidating restrictions on corporate political spending imposed by the Bipartisan Campaign Reform Act of 2002 (also known as the BCRA and the McCain-Feingold bill). SCOTUS has ruled that limiting the “speech” of corporations is unconstitutional.
The obvious approach to reversing this is a Constitutional Amendment. Several have been proposed but it seems unlikely that any such amendment could get passed in the current environment, much less ratified by three-fourths of the States.
Might there be a way to discourage excessive corporate political spending without prohibiting it? And would that pass SCOTUS muster? Of course, no one knows.
Here’s an idea:
Instead of eliminating corporate income tax for all corporations, only eliminate corporate income tax for corporations that agree to comply with the provisions of the BCRA (or something similar devised specifically for this purpose).
In other words, a corporation is exempt from income tax only if it meets certain criteria, much like a corporation can receive tax-exempt non-profit status only if it complies with the requirements of IRS Code Section 501(c).
The bet would be that being exempt from corporate income taxes would be a strong enticement to agree voluntarily to the criteria. Perhaps, investors would even favor corporations that comply.
Contracts and legislation often contain a separability clause, which says that if some provisions of the contract or legislation are declared invalid, other provisions remain in force.
We need the opposite here: In particular, if the changes in treatment of capital gains were invalidated, the corporate income tax would be restored.
How could we possibly get these changes passed? The key is for people with different perspectives to each get something important to them. Let’s consider what this looks like.
Increases profit, share prices, and, hence, executive compensation
Reduces the impact of tax policy on corporate decision making
Reduces spending for tax compliance and planning
Provides more funds for capital investments.
Eliminates double taxation of business profits
Reduces government’s role in directing the economy
Potentially heads off liberals’ desire to tax wealth
Reduces political corruption by restoring BCRA-like campaign finance rules for most corporations (most conservative politicians have supported weakening of campaign finance rules, but I believe that there are many conservative citizens who would like to reduce the role of money in our politics)
Reduces and slows wealth accumulation
Reduces economic inequality by taxing labor and capital equally
Reduces political corruption by restoring BCRA-like campaign finance rules for most corporations
Politicians spend an inordinate amount of their time fundraising. It has grown worse since the Citizens United decision opened the floodgates of corporate money into politics. Politicians will benefit by needing to spend less time fundraising if we can close the floodgates signficantly.
I’ve proposed a set of major policy changes that, taken as a whole, provide important benefits to conservatives, liberals, and corporations; additionally, these changes could make a dent in the corrupting nature of our pay-to-play political system by reinstating important aspects of the BCRA in exchange for large benefits to corporations..
The proposed changes would be controversial for different reasons among different people.
Eliminating the corporate income tax is the opposite of what leading progressive liberals, like Bernie Sanders and Elizabeth Warren, advocate, although taxing labor and capital equally should be attractive to progressive liberals.
Similarly, increasing capital gains taxes is the opposite of what conservatives advocate, although conservatives should be attracted to eliminating double taxation, eliminating corporate income taxes, and reducing government meddling in the way businesses are run.
With our country and government divided, policy changes that are attractive to only one party will not get passed. That’s why it seems necessary to “swing for the fences” with coupled changes that could provide a win-win.
I’ve left out many important issues related to taxing capital gains the same as taxing ordinary income. These include how to handle hard-to-value assets, assets that decline in value, and the transition to no deferral of taxes on capital gains. Fortunately, academics and think tanks have studied these issues. I’ll discuss them next time.
I’d also value your feedback on the ideas I’ve proposed and will summarize and discuss whatever feedback I receive.
Tax Cut and Jobs Act, better know as the Trump tax cuts.
I’m using 2019 data for two reasons. First, these data are pre-pandemic so are not affected by the pandemic-related stimulus. Second, we’ll examine next how other changes could offset the revenue lost by eliminating corporate income tax. That analysis needs the CBOs analysis of tax expenditures that we used in an earlier newsletter, which is based on 2019 data.
I’m using the word “conservative” to mean traditional Republican conservatives, not Trumpists trying to replace democracy with authoritarian forms of government.
Currently, most investors prefer capital gains instead of dividends because tax on capital gains is deferred. With the proposed changes, dividends would once again be attractive to investors.
In 2016, CBS 60 Minutes ran an episode called Dialing for Dollars (see the script here). They interviewed several members of Congress about fundraising, learning that both parties have call centers from which all members of Congress are expected to make fundraising calls for their own campaigns and for their party’s coffers. Both parties expect newly elected members of Congress to spend 30 hours a week on such fundraising calls. These expectations arose from the flood of money after the Citizens United decision.