Why getting rid of the corporate income tax makes sense

August 14, 2014, 11:30 AM UTC
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Kyle Bean for Fortune

Big banks can breathe a sigh of relief. The public has a new villain—tax inverters—companies that renounce their U.S. citizenship to get better tax rates overseas. And I say, “Go get those traitors!” Hey, my family pays a marginal tax (federal and state) of 53%. And yet corporate America has warned us for years about our uncompetitive tax code. Washington has done nothing, and foreign countries keep cutting their rates. The tepid recovery has pressured CEOs to generate earnings by slashing expenses. Telling them to ignore foreign tax dodges to save money is like telling a toddler to keep his hands out of a cookie jar sitting in easy reach.

To be sure, we need a short-term fix for inversions. But longer term, we need to fundamentally rethink our corporate tax system. Corporate taxes are a dwindling resource, threatening to become as scarce as clean air in Beijing. Is it even practicable to have a corporate income tax in a globalized and digitized economy? We aren’t taxing something tangible, like a person or property, but rather an extremely portable organizational structure.

Even if Washington finally gets around to reducing corporate tax rates, what’s to prevent other countries from lowering theirs even more? It’s just too tempting and easy for many American businesses to move, particularly when they can realize other savings, such as lower labor costs. What a game changer it would be if instead we simply eliminated corporate income taxes altogether. We would dramatically decrease the cost of doing business here, ease pressure on U.S. wages, bring back jobs, and repatriate an estimated $2 trillion in corporate profits now sitting overseas to avoid our top 35% tax rate.

DISAPPEARING CORPORATE TAXES As U.S. companies get more adept at gaming the tax code, their tax payments have shrunk to a small percentage of the whole. DISAPPEARING CORPORATE TAXES As U.S. companies get more adept at gaming the tax code, their tax payments have shrunk to a small percentage of the whole.Graphic Source: Center on Budget and Priorities

Progressives mistakenly see corporate income taxes as a way to tax the rich. But we aren’t taxing the rich; we’re taxing a corporate entity, and studies show that much of the tax is passed on to employees and customers, not shareholders. The current system actually favors wealthy shareholders because we impose a lower tax on their capital gains and dividends to mitigate the impact of “double taxation.” It would be smarter to tax corporate profits once, at the shareholder level, and apply the same, higher rates on their capital gains and dividends that apply to us wage earners.

Conservatives, on the other hand, want to preserve the tax-privileged status of capital gains and dividends, arguing that it encourages investment and creates jobs. But alignment between real economic growth and investment returns is far from perfect. These days, when the economy strengthens, the stock market actually drops because investors fear that an improving economy will cause the Fed to exit its easy-money policies. Corporations game the system by issuing debt (whose interest is deductible) to increase dividends. Those are not activities that reduce our unemployment rate. Workers’ returns on their labor—wages—are just as important as investors’ returns. With the elimination of corporate taxes, there is no reason for the tax code to favor one over the other.

While stronger economic growth would add to our tax coffers, we would also lose about $350 billion in corporate tax revenue. Applying ordinary tax rates to realized investment income would make up about $90 billion of the difference. Reforming the individual tax code to cap the excessive use of tax breaks and loopholes—as Harvard’s Martin Feldstein has proposed—could add another $220 billion. A financial transaction tax of 3¢ on every $100 traded could yield $35 billion annually.

One thing is sure: We are on an unsustainable path. Caught between eroding corporate revenue on one side and low tax rates for wealthy investors on the other, middle- and upper-income wage earners are being squeezed—and there are only so many of us. At some point we might start thinking about moving too.

Fortune contributor Sheila Bair, former chair of the FDIC, is an independent board member of global companies with U.S. operations. The views expressed are her own.

This story is from the September 1, 2014 issue of Fortune.

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