President’s Advisory Panel on Federal Tax Reform Integration of Corporate and Individual Income Taxes Alvin Warren Harvard Law School May 12, 2005

2 Two Questions to be Addressed: 1. Why should corporate and individual income taxes be integrated? 2. How can it be done?

3 Why should corporate and individual income taxes be integrated? Two components to the answer: A. Taxable corporate income distributed to taxable shareholders is taxed twice, once when earned by the corporation and again when received by shareholders as a dividend. This “double taxation” can create incentives for: - individuals to invest outside of corporations, - corporations to issue debt, rather than equity (because interest, but not dividends, are deductible), - retention, rather than distribution, of corporate earnings (depending on the relationship of corporate and shareholder tax rates), and - distribution of earnings as capital gains, rather than dividends (particularly if taxed at different rates).

4 B. On the other hand, not all corporate income is subject to double taxation: Some is taxed once at the investor level (e.g., corporate earnings distributed as interest to taxable lenders). Some is taxed once at the company level (e.g., corporate earnings distributed as dividends to exempt or foreign shareholders). Some is taxed at neither the company nor the investor level (e.g., corporate earnings distributed as interest to exempt or foreign lenders).

5 Goal of integration: Corporate income should be taxed once, but only once, to reduce tax-induced distortions. Three methods: - Shareholder credit for corporate taxes paid - Shareholder exclusion for dividends received - Corporate deduction for dividends paid

6 Shareholder Credit for Corporate Taxes Paid Basic idea: Shareholder receives credit for corporate taxes paid with respect to earnings distributed as a dividend. Result: Corporate earnings are taxed to shareholders at their individual rates, so corporate tax becomes simply a withholding tax.

7 Shareholder Credit Example Corporation earns $200, pays $60 in corporate taxes (at 30%), and distributes the remaining $140 equally to shareholders A and B, whose tax rates are 25% and 35%. Corporate income $200 Corporate tax 60 Cash dividend 140 Shareholders A B Shareholder cash dividend $ 70 $ 70 Shareholder taxable income Preliminary shareholder tax Tax credit (30) (30) Final shareholder tax ( 5) 5 Net shareholder cash 75 65

8 Shareholder Exclusion for Dividends Basic idea: Shareholder excludes dividends already taxed at the corporate level. Result: Corporate earnings are taxed at the corporate rate, rather than the individual investor’s rate. Example: Corporation again earns $200, pays $60 in corporate taxes (at 30%), and distributes the remaining $140 equally to shareholders A and B, whose tax rates are 25% and 35%. Dividends are excluded from shareholder taxable income, so each shareholder receives cash of $70, reflecting the corporate tax rate of 30%.

9 Corporate Deduction for Dividends Basic idea: Corporation deducts dividends paid to shareholders. Result: Corporate income ultimately taxed at shareholder tax rates, as under a shareholder tax credit. Caveat: Without a withholding tax, the deduction method automatically extends the benefit of integration to tax- exempt and foreign shareholders. Coupling a deduction with withholding essentially reproduces the shareholder- credit method.

10 Some Integration Tax Policy Issues Distribution of untaxed corporate income: How can a shareholder credit or exclusion be limited to income taxed at the corporate level? International investment: Should the benefits of integration be extended to foreign investment or foreign investors? Tax-exempt investors: Should the benefits of integration be extended to tax-exempt investors? Conformity with debt: How closely should the integration method be aligned to the treatment of debt to prevent distortions?

11 Recent Developments United States In 2003, the tax rate on dividends was conformed to the preferential tax rate on capital gains. - This is a partial step toward dividend exclusion, which was originally proposed by the President. - As enacted, the lower shareholder rate applies even if income was not subject to corporate tax. European Union Several important trading partners of the U.S. have recently replaced their longstanding shareholder-credit integration systems with a partial exclusion for dividends, in order to avoid judicial decisions prohibiting discrimination against investment involving other E.U. countries.

12 Conclusions 1. The basic idea of integrating individual and corporate income taxes is that corporate income should be taxed once, but only once, to reduce economic distortions. 2. The principal design question raised by integration is whether corporate income should ultimately be taxed at shareholder or corporate rates. The first answer would suggest a shareholder credit, the second a shareholder exclusion. 3. Under either approach, the shareholder credit or exclusion should be available only for income that was actually taxed at the corporate level.

13 Appendix A few additional thoughts on a some issues of tax policy and legislative design that would be implicated by integration of the individual and corporate income taxes in the U.S.: 1. Partial dividend exclusion in the E.U. would not be incompatible with a shareholder credit in the U.S. The previous E.U. credit systems discriminated against international income, but such discrimination is not a necessary feature of shareholder-credit integration. 2. Discrimination against outgoing investment under a shareholder credit could be avoided by passing through the foreign tax credit or partially exempting foreign income from shareholder taxation.

14 3. Limiting shareholder credits or exclusions to income taxed at the corporate level could be accomplished by (a) a withholding tax on dividends paid out of untaxed income or (b) requiring corporations to notify shareholders of whether corporate tax had been paid with respect to the dividend. The former puts an additional burden on corporations, but is much simpler for shareholders, who can treat all dividends identically. 4. The tax burden on investment income flowing to tax exempts could either be left unchanged under integration (such as by making shareholder credits nonrefundable) or modified (as by setting an explicit tax rate against which credits could be taken).

15 These and many other issues of tax policy and legislative design are considered in two in-depth studies of integration for the U.S.: U.S. Department of the Treasury, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Income Once (1992) Alvin C. Warren, Jr., Integration of Individual and Corporate Income Taxes (American Law Institute, 1993) Those two studies are reprinted in: Michael J. Graetz and Alvin C. Warren, Jr., Integration of the U.S. Corporate and Individual Income Taxes: The Treasury Department and American Law Institute Reports (Tax Analysts, 1998)