Corporate Taxes: “Fairness”, Induced Leverage, and the Banking Crisis

Politicians are happy to raise corporate taxes because they can get applause from leftist supporters for doing so. Your typical leftist cheers for corporate taxes out of fairness. Their willful ignorance of the nature of ownership blinds them to this simple fact: corporations are owned by individuals who are subject to personal income taxes and tax-exempt institutions, such as their beloved Harvard University. It’s pointless to tax corporations out of fairness because any desired distribution of the tax burden can be achieved by taxing the personal income of the owners of a corporation. There’s no reason to tax Exxon because you can just wait for them to declare a dividend and tax John Q. Greedy at a higher rate on a dividend that is larger because the corporation didn’t have to pay any taxes. If you think that Harvard is an angelic institution, then you should have no objections to them receiving increased income once the corporations in which they are shareholders are no longer taxed. If you think it’s unfair that rich Harvard University pay no taxes itself while it coddles its limousine liberal law students in the lap of luxury as it trains them to shred the Constitution, then this is a good reason to consider changing the standards for qualifying as a tax-exempt institution.

A previous posting, Who Pays Corporate Taxes?, discussed quite a few consequences of corporate taxation. Most people are not aware that corporations can deduct interest expenses from their taxable income. Unlike individuals, who cannot deduct interest payments to credit card companies and are limited in the extent to which they can deduct mortgage interest, corporations are not subject to any limitations on the size of this deduction. Consequently, corporations issue massive amounts of debt in order to take advantage of this. The Harvard endowment doesn’t have to wait for an enterprising member of The Club for Growth to repeal corporate taxes. It can simply buy bonds issued by Wal-Mart and enjoy the interest payments as if they were dividends on tax-exempt corporate income. This pressure to avoid corporate taxes isn’t just exerted by non-profit endowments. The total rate of taxation on a dividend is calculated based upon what is left after both corporate and personal income taxes ((1-(1-0.35)*(1-0.15) = 44.75%, 35% corporate rate and 15% through 2010 at the federal level). The total rate of taxation on interest is just a given person’s marginal tax rate, currently topping out at 35%.

(Scroll down to the U.S. dividend table. http://en.wikipedia.org/wiki/Dividend_tax)

It’s pretty clear that investors would rather only pay 35% tax rates on the operating profits of a corporation than 44.75%. An individual in the top tax bracket who gets a dividend only gets 55.25% of the operating profits as income after federal corporate and individual income taxes). It is this rightful desire to avoid taxes that induces corporations to leverage themselves so that investors might extract their operating profits without subjecting them to intermediate taxation.

So, what does all of this have to do with the banking crisis? As demonstrated above, the deductibility of interest causes the owners of corporations to leverage until their operating profits are completely covered by interest payments. Of course, sensible corporations don’t do this because if they owe too much money, then there’s a good chance they’ll miss a bond payment and then the shareholders and creditors will fight it out in bankruptcy court, and end up collectively losing because they will have to pay a lot of attorneys while alienating suppliers, customers, and employees. Of course, how much debt is too much depends on the business. Some companies have extremely predictable results, and can sustain a very high ratio of interest payments to operating profits. Quite often, however, this perceived stability is illusory, and a minor cold in the economy can send highly leveraged companies to the morgue.

This was a partial cause of the banking crisis. Banks were highly leveraged in order to minimize the taxes indirectly paid by their investors. Of course some investors prefer to own bonds instead of shares because they prefer less risk, but the desire to minimize taxes greatly inflates leverage. If corporate taxes were lower or non-existent, banks would be less leveraged, so they would be able to absorb greater losses before requiring federal bailouts to prevent failure.

Take a look back at the Wikipedia article on dividend tax rates. In 2011, the top personal tax rate is scheduled to rise to 39.6% and dividends will once again be taxed at ordinary income rates. This will mean that the total federal taxation rate on corporate operating profits will be 1 – (1-.35)*(1-.396) = 60.74% versus the new tax rate on interest income of 39.6%. If you thought that our businesses were levered with a 9.75% differential in aggregate taxation, just wait until you see the effects of the increase to 21.14%!

Perhaps more vigilant regulators and fear of another crisis will keep the leverage of the banking system moderated, but I fully expect there to be a lot of leveraged recapitalizations and buyouts of major non-financial institutions in order to shield them from taxation. It’s all well and good that private enterprise will act within the law to maximize its profits, but isn’t it time that we asked ourselves if it makes sense for our tax code to incentivize corporations to increase their risk of bankruptcy?