Why We Should Kill the Corporate Tax

As we watch the turmoil in Europe, the U.S. gets closer and closer to a sovereign debt crisis of its own. Yet the most recent public uproar over whether corporations are paying their fair share of taxes distracts from the far more important question: Why are we wasting time worrying about a tax that hasn't contributed all that much to the government's coffers for decades?

Much ado about little
Last week, TheWall Street Journal raised the hackles of tax reformers everywhere by highlighting a statistic from the Congressional Budget Office. According to the CBO, corporations paid just over 12% of their profits in taxes last year -- the lowest percentage since 1972.

The resulting outcry was fast and furious. Fellow Fool Alyce Lomax pointed to a report from the Citizens for Tax Justice and the Institution on Taxation and Economic Policy that pointed to 280 profitable Fortune 500 companies that received $223 billion in tax subsidies, and paid an average effective rate of 18.5%. Thirty of those companies had negative tax rates, with Wells Fargo (NYS: WFC) topping the list with $18 billion in tax breaks from the Treasury, according to the report.

Much ado about little
But amid all this turmoil is an often-forgotten point: Corporate tax revenue didn't disappear overnight. It's been an insignificant part of tax revenues for a long time. In fiscal 2010, for instance, corporate income tax represented only 6% of the total federal income for the year. But as long ago as 2003, the figure was just 7.4%. To give some sense of perspective, when you combine personal income taxes with payroll taxes like Social Security, Medicare, and unemployment, those payments added up to more than half of federal tax revenue in 2010.

This trend away from corporate tax goes back for decades. According to the Center on Budget and Policy Priorities, the percentage of federal revenue coming from corporate income taxes has fallen from a peak of 32% in 1952 to around 15% on average in the 1970s, and dropping further into the 10% range from the mid-1980s forward.

Why did corporate tax revenue largely go away? A lot of it has to do with the ease with which corporations can take advantage of tax structures that avoid it. Consider:

  • Annaly Capital (NYS: NLY) doesn't have to pay corporate tax because it qualifies as a real estate investment trust. All it has to do is pay out 90% of its income every year, and it avoids corporate-level tax entirely.

  • Linn Energy (NAS: LINE) doesn't have to pay corporate tax because its LLC structure qualifies as a master limited partnership for tax purposes. By generating 90% of its income from qualifying sources like energy production and transportation, it also frees itself from the corporate tax structure.

  • Prospect Capital (NAS: PSEC) and Apollo Investment (NAS: AINV) don't have to pay corporate-level tax because they qualify as business development companies. By getting at least 90% of their income from dividends, interest, capital gains, or other investment income, and then paying it out to shareholders, BDCs steer clear of corporate tax requirements. That's also how Prospect and Apollo pay such attractive yields: They have to in order to keep their favorable tax status.

But the rest of why corporate income tax revenue has fallen is simple: The government has passed laws giving corporations big tax breaks, and corporations have taken full advantage of them. The WSJ acknowledges that so-called "bonus depreciation" is likely the culprit for the current drop in corporate tax receipts, as companies have been able to write off capital expenses immediately rather than depreciating them over time.

Set your priorities
Obama administration officials have said that the president expects to announce a revenue-neutral overhaul of the corporate tax system this month, which could include a cut in the current 35% tax rate in exchange for greater taxation on profits generated overseas.

But, to borrow a page from fellow Fool Morgan Housel's playbook, we might be better off doing nothing. In fact, I think eliminating the corporate income tax entirely might well work better -- as long as we made sure that business income was fully taxed at the shareholder level, and that shareholders had to pay the higher rates of tax that are slated to take effect at the beginning of 2013. In the long run, that would not only simplify taxes but also put investments on a more even keel, allowing money to gravitate to the most valuable enterprises rather than ones that provide artificial tax benefits.

Unfortunately, for now, we have to live with the tax system we have. One way to minimize taxes is to invest using tax-favored retirement accounts, but you need the right stocks to have a rich retirement. The Motley Fool's latest special report reveals three great stock names, and it doesn't cost a dime -- but it won't be around forever, so read it today while it's still available.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitterhere.

At the time thisarticle was published Fool contributor Dan Caplinger is fine with paying his fair share of taxes. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Annaly Capital and Wells Fargo and has created a covered strangle position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Annaly Capital. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is never taxing.

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