A rare disagreement with the NZ Initiative

Oliver Hartwich writes:

Why do companies have to pay taxes at all?
Before anyone hurls abuse at me, let me clarify where I am coming from.

Companies are not real persons but legal fictions. Companies do not enjoy the fruits of their operations: their shareholders do. And therefore companies never actually pay taxes, either.

Of course, companies have to make tax payments. In a technical sense, it is them writing cheques to Inland Revenue. But that does not mean that companies really shoulder the economic burden.

In reality, there is always some natural person that pays. That person can be a customer, a supplier, an employee or a shareholder.

In economics, we call this phenomenon ‘tax incidence’. Put simply, there is a difference between those nominally paying a tax and those effectively bearing the tax burden.

Most economists would agree that for this reason companies never really pay tax at all. So my question is why do we keep pretending that they do?

To apply this logic to Apple’s case, what if we got rid of corporate taxes altogether and only levied income tax on the dividends shareholders received?

Such a practice would make it harder to avoid taxes since shareholders would have to physically move to tax havens to escape income tax. It would also allow companies to reinvest profits not paid out as dividends, thus creating an incentive to grow.

I know the devil is in the detail. For a start, we would need to ensure that individuals do not avoid tax by channeling their incomes through company structures.

However, Apple’s case demonstrates why it might be desirable to move beyond corporate taxes as they exist today. This could well simplify tax compliance and lead to stronger investment.

It would also eliminate the need to use countries like Ireland for tax avoidance schemes. And it would leave some tax lawyers unemployed.

But would that be such a bad thing?

It’s a nice idea but I can’t see it as practical.

One problem is overseas shareholders who don’t pay tax in NZ. If the company is based in NZ we can tax them, but we can’t tax the shareholders. You could do a with-holding tax but at what rate do you apply it? Would a with-holding tax be that different to a company tax?

Another major problem is that with no capital gains tax, many company would never pay dividends. People would invest in companies to get untaxed capital gains and would always want profits to remain with the company (which is good for the company but not so good for tax revenues).

And a third is sole shareholder businesses. You would have a huge incentive to pay yourself as low a salary as possible to live on, and have the company make larger profits. Then when you get to retirement you have the company pay you dividends, which will be taxed at a much lower rate.

An example of this might be that instead of paying yourself $200,000 a year for 20 years you pay yourself $100,000 a year for 20 years. Then you stop working, and pay $100,000 dividend a year for say 20 years in retirement.

Paying yourself $100,000 a year for 40 years means you pay $24,000 of tax a year or $960,000 in total.

Paying yourself $200,000 a year for 20 years means you pay $57,000 of tax a year or $1,140,000 in total.

To some degree you already get this as the company rate is 5% lower than the top personal tax rate. But the level of arbitrage would grow if there was no company tax rate at all.

Having no company tax would work if we had a flat personal tax rate and a capital gains tax. Both would be good things to have. But until such a day, I think it would mean more tax lawyers, not less!