Among the tax reform proposals currently under Congressional consideration are a reduction in the double taxation of dividends and a reduction in the corporate tax rate. A reduction in the corporate tax rate would go a long way toward offsetting the adverse effects of inflation upon corporations. It is well known that, under a progressive tax system, inflation pushes individuals into higher and higher tax brackets. It is less well known that inflation also raises the effective tax rate on corporations.
In inflationary periods, corporate financial statements based on historical cost understate depreciation and overstate inventory holding gains, creating illusory profits that are taxed as though they were real. In 1974, for example, the 41.5 per cent tax rate on reported profits amounted to taxes equaling 71.8 per cent of real, inflation-adjusted profits. At the same time, inflation was raising interest rates, forcing corporations to pay more for both borrowed and equity capital.
A reduction in the effective corporate tax rate would (1) increase real, after-tax returns on new corporate projects and (2) significantly improve corporate cash flow, thereby helping to provide the funds necessary for such projects. This should stimulate capital investment and increase employment.
The effects of a reduction in the double taxation of dividends will depend on the specifics of the eventual legislation. Under the so-called “partial integration” system, the portion of corporate taxes paid on that part of earnings distributed as dividends is regarded as taxable income to the shareholder withheld by the corporation. In determining his taxable dividend income, the shareholder “grosses up” his cash dividends by his share of the withheld amount. From the taxes due on the total amount, he subtracts the amount withheld for him by the corporation, treating it as a tax credit. The so-called “tax-matching” methods proposed by Congressman Ullman and the Treasury Department resemble this system in some respects.