Taxing Bigness

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Wednesday February 6, 2013 at 9:50 am
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Editor’s Note: The following post comes to us from Steven A. Bank, Vice Dean and Professor of Law at UCLA School of Law.

The graduated corporate rate structure was publicly promoted as a tax on “bigness” when President Franklin D. Roosevelt first introduced it in 1935. In proposing the graduated rates, Roosevelt explained “[t]he advantages and the protections conferred upon corporations by Government increase in value as the size of the corporation increases . . . it seems only equitable, therefore, to adjust our tax system in accordance with economic capacity, advantage and fact. The smaller corporations should not carry burdens beyond their powers; the vast concentrations of capital should be ready to carry burdens commensurate with their powers and their advantages.” Given the relatively modest graduation in the original rates, however, this move is often portrayed as largely a political ploy rather than a serious tax measure. Paul Conkin noted that the 1935 tax bill in which the graduated rates were imposed “neither soaked the rich, penalized bigness, nor significantly helped balance the budget.” Even at the time its opponents called it a “legislative absurdity” enacted on the “whim” of the President. The conventional wisdom is that the graduated corporate income tax structure was designed to appeal to populist voters as part of the “rhetoric and psychological warfare” of New Deal-era politics, but was not designed to actually change the economics of operating businesses through large corporations. At best, it has been characterized as “an aid to small business.”

In Taxing Bigness, recently published on SSRN, I review the origins of the graduated corporate income tax and conclude that it was not intended as either mere populist symbolism or as primarily a small business subsidy. It was intended to permit government to tax large corporations differently. The marginal rate structure adopted in 1935 was admittedly not steep enough to disrupt the economic dominance of big business. Nevertheless, it did allow differentiation among large and small corporations to occur, which was a reversal of prior policy. Although a nominal flat rate had been in existence from the outset of the income tax, it was really a de facto two rate corporate tax because of the existence of a zero rate exemption. In the last revenue act of the Hoover Administration, however, even the exemption was repealed. This meant that between 1932 and 1935 all corporations, regardless of size, were subject to the same flat rate tax during a period in which most businesses operated in the corporate form. In order to lay the foundation for taxing bigness, Roosevelt had to create a scheme to differentiate among corporations according to the size of their income. This explains why he was more concerned about establishing the principle than the actual rates in his original proposal and why he was willing to accept an even smaller amount of graduation in the rates contained in the final legislation passed by Congress. This focus on being able to target large corporations, rather than providing a subsidy to small corporations, also explains why a graduated rate scheme was more important to Roosevelt than merely restoring the pre-1932 exemption for small corporations.

This ability to differentiate among different-sized corporations, while potentially valuable in an era in which a significant amount of business was done by corporations, has long since out-lived its purpose. From the development of Subchapter S for certain types of less complex corporations in 1958, to the advent of limited liability companies in 1977 and their spread to all states along with the check-the-box regulations in the 1990s, businesses during the second half of the twentieth century have had a variety of means of opting out of the corporate income tax applicable to Subchapter C corporations. Congress has also adopted a number of deductions and other special provisions targeted at “small business,” defined in a number of ways. As a result, even if differentiation is justifiable, it no longer needs to occur through the corporate income tax rate structure itself. Moreover, the current corporate rate structure is a poor vehicle for this goal. The current rates rise unevenly and several phaseouts have led to the creation of “bubble” marginal rates that can cause lower-earning corporations to pay higher taxes than higher-earning corporations. The result is that corporations are neither strictly taxed according to their ability to pay nor is there much of a redistribution effect as a result of the tax.

Removing the graduated marginal rate structure would simplify the tax and potentially would allow for lower rates with the same or even higher revenues due to the broader base. According to the Congressional Budget Office, the repeal of the graduated corporate tax rates would raise as much as $2.8 billion in additional revenue in 2013 and $24.4 billion over the next decade or so. At a time when the President is seeking a revenue-neutral way to reduce the top corporate income tax rates, ending the graduated marginal rate scheme’s ineffective small subsidy may be a logical first step.

The full paper is available for download here.


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