David Weisbach’s new work argues that integration methods eliminating the double tax on corporate earnings should focus on alleviating the double tax on new corporate equity, but not on old equity already invested in corporate form. Limiting integration to new equity achieves all of the efficiency gains achieved through complete integration with respect to all equity, at a lower revenue cost.
As we are often told, the corporate tax discourages investors from using the corporate form, and encourages corporations to retain earnings and to favor issuing debt over equity. Corporate integration would generally eliminate these inefficiencies by equalizing the tax rates on investments through corporations with the tax rates on investments outside the corporate sector.
Weisbach’s basic conclusion, that integration should only apply to new equity, holds under both the “traditional” and “new” views of the effect of dividend taxation. Under the traditional view, corporations are funded at the margin by new equity, and the dividend tax distorts investment behavior with respect to this equity. Corporations must earn a higher pretax return on new equity investments to offer the same after-tax return as non-corporate investments, and have an incentive to defer the distribution of earnings. Under the new view, in contrast, the divided tax has no effect on the timing of distributions by mature corporations, with investments funded at the margin by retained earnings, rather than new equity. In this case, eliminating, the dividend tax has no further effect on the after-tax return to shareholders, resulting in a pure windfall gain with no efficiency improvements.
Under the new view, the negligible efficiency gains from integration may not outweigh the revenue cost. Under the traditional view, the efficiency gains may be more significant, but will still only apply to new corporate equity. Weisbach therefore argues that under either the new view or the traditional view, corporate integration should only be extended to new equity, thereby achieving the efficiency gains while minimizing the revenue costs.
The article proceeds to evaluate three different proposals for integration with respect to new equity alone: (1) complete integration with respect to both new and old equity, combined with a one-time transition tax on old equity to account for the windfall gains from integration, (2) a tracing method that estimates new corporate equity and allows a corporate deduction for an imputed return on this amount, and (3) methods based on the same principles as a cash flow consumption tax, which would exempt the return on new equity but preserve the tax on old equity by allowing corporations a deduction upon the receipt of new capital and an offsetting tax liability upon distributions. While each method faces its own administrative complexities, Weisbach suggests that complete integration combined with a one-time tax on old equity is the cleanest approach, with no ongoing administrative costs.
In effect, the arguments for only integrating with respect to new equity, and the solution of a transition tax on existing equity, both stem from two basic principles in tax policy: There is generally no efficiency gain from favoring behavior that already happened, which will result in pure revenue loss, and there is generally no efficiency loss to taxing behavior that already happened, which will result in pure revenue gains.
In prior work, Weisbach has similarly favored similar “rough justice” approaches to vexing problems in tax design, on the grounds that any inaccuracies at the margins are preferable to overly complex solutions that seek to “get it right.” For example, in his proposal for a partial mark-to-market system, Weisbach argued that non-traded assets (which cannot be taxed under mark-to-market, and therefore still benefit from tax deferral under the realization rule) can be taxed at a higher rate than mark-to-market assets, with the rate differential set to approximate the deferral benefit of the non-traded assets. Like in the case of new equity integration, an enormous amount of administrative complexity can be avoided by using approximated tax adjustments. In both cases, however, the challenge is determining the proper adjustments, a challenge Weisbach readily acknowledges.
In the case of old equity integration, however, the calculus in setting the transition tax amount may be slightly different, since in principle there would not be the same efficiency consequences to setting the tax on old equity too high or too low. In effect, setting the transition tax rate will largely be a question of fairness (setting aside questions of tax planning and avoidance of the transition tax). The setting of the transition tax would largely be zero sum between the fisc and taxpayers, like any retroactive tax, with the only difference being that the government is also offering a retroactive benefit from integration. Furthermore, if the integration method adopted has different consequences for investors with different tax characteristics, then there is no generally applicable rate that equally offsets the benefits of integration for all shareholders. In either case, the principle that might guide policymakers in setting the tax rate might be “something is better than nothing.”
Returning to the Article’s core argument, David Weisbach argues convincingly that there is no policy justification for granting shareholders a windfall by eliminating the corporate double tax with respect to existing equity investments. This essential point is rarely heard in the current political debate over corporate tax reform. For example, GOP House’s tax reform plan from last summer lauds the efficiency gains from corporate tax reform, while eliding over the degree to which reform would generate a windfall to existing corporate shareholders.