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Megan McArdle needs a tax primer

Her article in the Atlantic today, "Why We Should Eliminate the Corporate Income Tax," makes some good points. Missing, of course, is any sense of the revenue implications of eliminating the corporate income tax given the long-term fiscal gap.

Two more fundamental problems are the following. First, she is effectively arguing for corporate integration via elimination of the entity-level tax, but relying purely on the taxation of dividends and capital gains to ensure that corporate income is taxed once. This is inadequate. It would create a tax preference for business income earned through a corporation, as compared to other business income, and worsen problems of lock-in of corporate earnings.

Second, she misconceives the nature of the objections regarding how tax planners would exploit exemption of corporations alongside retention of the income tax in other respects. She thinks the basic problem of using corporations as a tax shelter would be no worse than under present law. Thus, she thinks it dispositive that people don't currently shelter income in corporations as much as one might have feared, even though "corporations can deduct all sorts of things that people can't--rent, cars, utilities, non-mortgage interest payments, and so forth." Hence, there must be big practical deterrents limiting the use of corporations as a tax shelter, that she assumes would carry over.

But that stuff is both relatively penny-ante and generally ineffective under present law, unless one is playing the audit lottery, under the business versus personal line. By contrast, the really big problem that her proposal would invite, which is owner-employees under-paying their own wages so that they could avoid any tax, would require substantial new law to avoid its making huge numbers of high-income people effectively tax-exempt (especially if their stock got stepped-up basis at death).

Recommended reading for McArdle: (1) Ed Kleinbard, An American Dual Income Tax: Nordic Precedents (discussing this issue),

(2) my book Decoding the U.S. Corporate Tax.

Full post as published by Start Making Sense on November 02, 2010 (boomark / email).