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Tax policy colloquium on Michael Doran's "Managers, Shareholders, and the Double Corporate Tax"

Yesterday's discussion returned to more traditional law school tax policy fare, concerning corporate integration and the Bush Administration's partly failed 2003 attempt to accomplish it via dividend exemption. Michael's thesis in his paper is that the political economy story developed in prior work, such as the well-known article by Jennifer Arlen and Deborah Weiss, needs to be revised. Arlen-Weiss emphasize agency costs, in the form of managers not really caring about the transition windfall to shareholders that unanticipated adoption of dividend exemption would provide, and preferring instead to get incentives for new investment plus an excuse not to incur tax burdens by making dividend distributions.

I like the Arlen-Weiss paper, though my views differ a bit in emphasis since I give greater relative importance to (a) the "populist" problem of people thinking that corporations are "people" and should pay tax plus shareholders are wholly separate people and should also pay tax, plus (b) the interest group problem in which managers are aligned with shareholders to prefer targeted tax breaks for their own industries rather than a general corporate-sector improvement in tax treatment. [Actually, diversified shareholders might rationally prefer general corporate tax reform after all, but as shareholders of a given company their interests arguably are aligned with managers regarding targeted giveaways.] But this isn't a big disagreement, just a difference in shading or emphasis.

Anyway, Michael posits that the Arlen-Weiss story is too simple [note: Jennifer Arlen might not agree with how her story is characterized] and needs to be overhauled to give much more pride of place to the issue of heterogeneity. Lots of different players are affected by corporate integration in different ways. E.g., for a given integration proposal, those in some industries might be aided while others are hurt, depending on differences in industry, effective tax rate, shareholder clientele base, etc. Michael reviews the 2003 story, and sees it as all about heterogeneity creating gridlock, rather than the managers defecting from being the shareholders' faithful agents.

As lead commentator, Alan Auerbach emphasized that heterogeneity exists on all sorts of issues yet legislation happens, and presumably exists worldwide with respect to corporate integration yet it has frequently happened everywhere else around the world (albeit that it's been in retreat lately in Europe due to EU problems). So why is this issue special and why is the U.S. different on this issue?

Further discussion pushed us (or at least me) towards the view that the 2003 issue is a bit of a simpler story (and less of a change to Arlen-Weiss) than generalized heterogeneity. The 2003 dividend exemption would have been a substantial blow to the value of corporate tax preferences because it only offered dividend exemption to previously taxed corporate income. This meant that, if you used tax preferences to avoid corporate-level tax, you would get hit at the shareholder level by distributions. Companies that use lots of tax preferences (such as the low-income housing credit) screamed bloody murder and got House Ways and Means Chair Thomas on their side, whereupon it was game over. The proposal went to a 15% rather than a 0% dividend rate, and the feature requiring previous corporate-level tax payment on the distributed income disappeared.

As a general matter, I happen to like reducing the value of corporate-level tax preferences. But it seems clear that, due to this feature, the 2003 dividend exemption was not pure corporate integration. It was corporate integration PLUS corporate-level base-broadening. A pure corporate integration approach would have been "ceasefire in place" regarding the value and usefulness to taxpayers of corporate-level preferences. It's no big surprise that base-broadening faces heavy political obstacles, so what we really had in 2003 was a standard interest group story, much more than a broader heterogeneity story about corporate integration or dividend exemption in general.

CLARIFICATION: After sidebar conversations with a reader who disagreed with my apparent statement that "pure" corporate integration means keeping the preferences, I should emphasize that what I meant above is not (a) that "pure" integration means having tax preferences, but rather (b) that, given where we are now, changing the corporate tax rules purely on the integration dimension would mean ceasefire in place as to the tax preferences. Again, I'd greatly prefer corporate integration with smaller tax preferences than with the same ones, but I would then regard myself as having changed two dimensions.

One further interesting point that came up in the discussion concerned the reasons for U.S. exceptionalism with regard to the double corporate tax. People in the audience noted that U.S. shareholding in public companies is much more diversified than, say, in Europe, where family corporations play a much bigger role. So the publicly traded sector in the U.S. does less to fight for corporate integration than it would in the family firm scenario (basically for Arlen-Weiss reasons). But then it was further noted that there are plenty of closely-held businesses in the U.S.; only, they can generally avoid falling into the C corporation tax world, even if they want limited liability for owners, as they can elect to be taxed on a flowthrough basis as S corporations, or can be LLCs that elect to be taxed as partnerships. Other countries don't have the S corporation route as such. So the hypothesis is that the U.S. is less politically unusual than it seems (or rather is unusual only in having a distinctive institutional twist). If this view is correct, we have simply let the closely held firms opt out of the double tax on the side and hence faced less political pressure to let out the rest.

Full post as published by Start Making Sense on March 06, 2009 (boomark / email).