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Monday, August 04, 2008

Why tax entities?

Over at Conglomerate this week, they're discussing Heather Field's fine and ambitious new paper, "Checking in on Check the Box."  One of the many tough questions Heather takes on is whether there should be a separate layer of tax for entities -- that is, whether we should tax corporations at all.  (In contrast, partnerships and certain small corporations are generally not taxed directly -- their equity holders pay tax as individuals on their share of profits).  Corporate tax is complicated, as the intricacy of Heather's other arguments shows, and most economists would tell you the corporate tax inefficiently influences business decisions.  So why bother?  It's hard to improve on the work Reuven Avi-Yonah has done on this, but let me throw out a couple of other possibilities.

(Ok, this is tax greek central, but you'll find it strangely interesting, I promise.  Go ahead and click for more...)

One reason I see is precisely to influence business decisions.  If, as seems likely, there's slack in shareholder control over managers, the managers won't be fully concerned with individual-level taxes.  This suggests that, if we want to use tax as a corporate regulatory tool with maximal effectiveness, we need a corporate tax.  For example, one might think of the entire regime of the federal law of nonprofit organizations as a corporate regulatory tool that can exist only because of the threat of a corporate tax for noncompliance.  It's possible that the welfare gains from using tax as market-failure corrective, rather than the second-best regulatory regime exceed the welfare losses of the corporate tax.

Next, and sticking with efficiency, consider corporate-form neutrality.  (This point is inspired by Chris Sanchirico's work on "carried interest").  Our tax system doesn't count as income goods and services that a person -- or an entity -- provides to herself or itself.  If Beyonce sings in the shower, she doesn't have to pay tax on the price of a front-row ticket.  When integrated firms exchange information, pass a product along from factory to retailer, or do their own books, they (generally speaking) don't report any of that value as income.  The value does get taxed later, as corporate revenue, but revenue gains often arise long after the value was first generated.  This means there is a tax advantage -- the time value of this implicit income -- in integrating the function, rather than contracting with a third part.  Tax therefore may distort the basic Coasian decision whether to contract or incorporate.  The corporate tax should, at a minimum, be set at a level that would leave firms tax-indifferent between the two choices.   

But, as Larry Solum would say, read Field!  (Also, I admit, this post wasn't strangely interesting.  But was the Beyonce example at least a little funny?  Funny for tax?)


Posted by BDG on August 4, 2008 at 09:40 PM in Corporate | Permalink


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I have some difficulty understanding the point that Prof. Polsky makes albeit I have not read the article he cites. In fairness, I am not sure that Prof. Polsky was making that point or merely noting that it might follow from the article he cited. If allowing a corporation a deduction for advertising expenses is improper because they should be capitalized, I do not see how having a corporate tax is justified as a mitigation of that "inappropriate" tax benefit. There would be no tax benefit to a corporation for an improper deduction if there were no corporate tax, since there would be no deductions at all if the entity were not subject to an income tax.Surely, the imposition of a corporate tax cannot be justified as mitigation of a problem that would not exist if there were no corporate tax.
if the objection is that the deduction for advertising expenses would pass through to the shareholders if there were no corporate tax, that is not necessarily true. Moreover, if allowing an advertising expense is improper, then why should it be so only for corporations and not for individuals or ordinary partnerships? It is no more an excessive deduction for a corporation than for any other taxpayer.

Posted by: Douglas Kahn | Aug 8, 2008 3:14:18 PM

Very interesting, but the second point is somewhat mysterious. It seems that the value a corporation accrues is (and should be) ultimately measured in revenue. What if a CEO sings at a corporate event, and the resulting boost in morale increases next year's revenue by a million dollars. The million dollars will be taxed (next year). The value of the singing at the time of singing is not a million dollars; it's a million dollars next year. The value to the corporation and the resulting tax should be (and are) effectively discounted at the time of singing.

If the corporation hires Beyonce to sing instead, the value of that singing surely wouldn't enter into the balance sheets except through the ultimate rise in revenue. (Of course the cost of hiring her would, but that's a different side of the balance sheet.) Where's the tax advantage to internal singing?

Posted by: Guest 1L/2L | Aug 5, 2008 11:17:45 AM

Interesting point, Brian. A related point that has been made is that the current corporate tax targets businesses who are able to generate significant goodwill via tax-deductible expenditures (e.g., advertising). In theory, these expenditures ought to be capitalized (because they create long-term value), but for strictly administrative reasons they are allowed to be currently deducted. So, the argument goes, the corporate tax is a way to recapture (in a rough justice sort of way) the resulting tax benefit from the accelerated deductions. See Robert Cassanos, Single Taxation of Publicly Traded Entities, 99 Tax Notes 1663 (June 16, 2003). Note that this theory would suggest quite strongly that Blackstone (which has significant goodwill) should not be eligible for the publicly traded partnership exception.

Posted by: Gregg Polsky | Aug 5, 2008 9:55:34 AM

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